Merger Model - Supplement Flashcards
Why would one company want to buy another company?
One company will want to buy another company if it believes it will be better off after the acquisition takes place.
- The Seller’s asking price is less than its Implied Value, i.e. the Present Value of its future cash flows
- The Buyer’s expected IRR from the acquisition exceeds its WACC.
Buyers often acquire Sellers:
* Save money via consolidation and economies of scale
* grow geographically
* gain market share
* acquire new customers
* acquire distribution channels
* expand their products
How can you analyze an M&A deal and determine whether or not it makes sense?
Qualitative Analysis
* The qualitative analysis depends on the factors: Could the deal help the company expand geographies, products, or customer bases, give it more intellectual property, or improve its team?
The quantitative analysis might include
* a valuation of the Seller to see if it’s undervalued,
* comparison of the expected IRR to the Buyer’s WACC.
* EPS accretion/dilution is very important in most deals because few Buyers want to execute dilutive deals; investors focus tremendously on near-term EPS, so dilutive deals tend to make companies’ stock prices decline.
Walk me through a merger model (accretion/dilution analysis).
In a merger model,
1. you start by projecting the financial statements of the Buyer and Seller.
2. Estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal.
3. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition and its effects.
4. Then, you combine the Balance Sheets of the Buyer and Seller, reflecting the Cash, Debt, and Stock used, new Goodwill created, and any write-ups.
5. You then combine the Income Statements, reflecting the Foregone Interest on Cash, Interest on Debt, and synergies. If Debt or Cash changes over time, your Interest figures should also change.
- The Combined Net Income equals the Combined Pre-Tax Income times (1 – Buyer’s Tax Rate), and to get the Combined EPS, you divide that by the Buyer’s Existing Share Count + New Shares Issued in the Deal.
You calculate the accretion/dilution by taking the Combined EPS, dividing it by the Buyer’s standalone EPS, and subtracting 1.
Why might an M&A deal be accretive or dilutive?
A deal is accretive if the extra Pre-Tax Income from a Seller exceeds the cost of the acquisition in the form of Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.
For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer only $70 in Interest Expense, and it doesn’t issue any new shares, the deal will be accretive because the Buyer’s Earnings per Share (EPS) will increase. A deal will be dilutive if the opposite happens.
For example, if the Seller contributes $100 in Pre-Tax Income but the deal costs the Buyer $130 in Interest Expense, and its share count remains the same, its EPS will decrease.
How can you tell whether an M&A deal will be accretive or dilutive?
You compare the Weighted Cost of Acquisition to the Seller’s Yield at its purchase price.
- Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate)
- Cost of Debt = Interest Rate on New Debt * (1 – Buyer’s Tax Rate)
- Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e. Net Income / Equity Value.
- Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase Equity Value.
Weighted Cost of Acquisition = % Cash Used * Cost of Cash + % Debt Used * Cost of Debt + % Stock Used * Cost of Stock.
If the Weighted Cost is less than the Seller’s Yield, the deal will be accretive, if the Weighted Cost is greater than the Seller’s Yield, the deal will be dilutive.
Why do you focus so much on EPS in M&A deals?
Easy-to-calculate metric that also captures the FULL impact of the deal – the Foregone Interest on Cash, Interest on New Debt, and New Shares Issued.
Metrics such as EBITDA and Unlevered FCF are better in some ways, they don’t reflect the deal’s full impact because they exclude Interest and the effects of new shares
How do you determine the Purchase Price in an M&A deal?
If the Seller is public, you assume a premium over the Seller’s current share price based on average premiums for similar deals in the market (usually between 10% and 30%). You can then use the DCF, Public Comps, and other valuation methodologies to sanity-check this figure.
The Purchase Price for private Sellers is based on the standard valuation methodologies, and you usually link it to a multiple of EBITDA or EBIT since private companies don’t have publicly traded shares. If the Buyer expects significant synergies, it is often willing to pay a higher premium or multiple for the Seller, though the impact isn’t necessarily 1:1.
What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?
Cash
Cash tends to be the cheapest option; most companies earn little Interest Income on it, so they don’t lose much by using it to fund deals. It’s also fastest and easiest to close Cash-based deals.
The downside is that using Cash limits the Buyer’s flexibility in case it needs the funds for something else in the near future.
Debt
Debt is normally cheaper than Stock but more expensive than Cash, and deals involving Debt take more time to close because of the need to find investors.
Debt also limits the Buyer’s flexibility because additional Debt makes future Debt issuances more difficult and expensive.
Stock
Stock tends to be the most expensive option, though it can sometimes be the cheapest, on paper, if the Buyer trades at very high multiples. It dilutes the Buyer’s existing investors, but it also prevents the Buyer from paying any additional cash expense for the deal.
In some cases, the Buyer can also issue Stock more quickly than it can issue Debt.
