Merger Models

Question 1

What is Accretion / (Dilution)?

Answer 1

• income statement impact of an acquisition
• reflects if buyer is better or worse off as a result of acquisition
• Accretion: Pro forma EPS > Acquirer’s EPS
• Dilution: Pro forma EPS < Acquirer’s EPS
• Breakeven: No impact on Acquirer’s EPS –> Greatest price Acquirer can afford to pay before deal starts to hurt

Level of accretion or dilution is a critical issue; determines affordability to potential acquirers

Question 2

How do you calculate Pro Forma EPS?

Answer 2

Pro Forma EPS = (Acquirer’s Net Income + Target’s Net Income + After-tax “Incremental Adjustments”) / (Acquirer’s Shares Outstanding + New Shares Issued)

What are the incremental adjustments?

• incremental after-tax interest expense from new debt financing (if we pay with cash)
• after-tax synergies
• after-tax depreciation and amortization expense (from write-ups)

Question 3

What is Goodwill?

Answer 3

• goodwill = excess purchase price over fair market value of net identifiable assets acquired
• target’s assets and liabilities are reported at FMV on date of acquisition (you “write up” to FMV)
• Net Identifiable Assets = Assets - Target’s existing goodwill - Liabilities

Question 4

Relative P/E Analysis (100% stock, no write-ups, no synergies)

Answer 4

Accretive if Acquirer P/E > Offer P/E
- lower exchange ratio

Dilutive if Acquirer P/E < Offer PE
- raises exchange ratio

Question 5

What are some financial reasons for an acquisition?

Answer 5

1) consolidation / economies of scale: if the 1st and 2nd biggest companies combine, they can get better deal with suppliers and save money
2) geographic expansion
3) gain market share
4) seller is undervalued
5) acquire customers or distribution channels
6) product expansion or diversification

The goal of each of these reasons: boost EPS and result in IRR > WACC

Question 6

What are some of the fuzzy reasons for an acquisition?

Answer 6

1) intellectual property/patent/key technology (that the acquirer wants but can’t quite determine the value of)
2) defensive acquisition (fearful of fast-growing competitor, acquire it to prevent disruption)
3) acqui-hire (recruiting top notch employees is expensive… shortcut the whole process by buying an entire, smaller co and hiring everyone)
4) the “intangibles”
5) Office politics, ego, and pride
6) potential for extremely high growth (these cos may have no profits/cash flow/revenue, so acquisitions are not based in financial criteria such as EPS accretion/dilution)

Most M&A deals fall into this category of fuzzy reasons, but companies often make up financial reasons to justify them.

Question 7

The steps in a sell-side process

Answer 7

1) plan the process and create the marketing material
2) contact the initial set of buyers (NDA)
3) set up management meetings and presentations
4) solicit initial and subsequent bids from buyers
5) conduct final negotiations, arrange financing, and close the deal

Question 8

What do companies prefer to fund acquisitions with: Debt or Equity?

Answer 8

Debt, because its cheaper

However, if the co has extra Cash, it will almost always prefer to use that Cash first because Cash is cheapest (companies earn almost nothing on extra cash)

Question 9

What are the advantages and disadvantages of the various acquisition financing options (cash, debt, stock)?

Answer 9

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 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.

Finally, 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.

Question 10

Walk me through a merger model

Answer 10

1) Get the financial stats for the buyer and seller (at minimum, Current Equity Value and Net Income, along with everything that goes into those calculations: Current Share Price, Shares Outstanding, Pre-Tax Income, and Tax Rate)
2) Determine the Purchase Price and Cash/Debt/Stock Mix (Sources & Uses Sched to estimate true cost of acquisition and its effects)
3) Combine Both Companies’ Pre-Tax Incomes and Adjust for the Acquisition Effects (e.g. Foregone Interest on Cash, Interest on Debt, synergies)
4) Calculate Combined Net Income (using Buyer’s tax rate) and EPS (by putting Combined Net Income / Buyers Existing Share Count + New Shares Issued in Deal)
5) Calculate the Combined EPS Accretion/Dilution and Draw Conclusions (by taking the Combined EPS, dividing it by the Buyer’s standalone EPS, and subtracting 1)

Question 11

Shouldn’t we use the Purchase Enterprise Value in determining how much an acquirer pays? Enterprise Value represents the true cost of acquiring the co

Answer 11

No. In Merger Models, you always start with the Seller’s Purchase Equity Value because, at the bare minimum, the Buyer needs to pay that much to acquire the Seller’s shares

Beyond that, the price the Buyer pays is NOT necessarily the Purchase Enterprise Value, because

1) The Buyer doesn’t just “get” all the Seller’s Cash
2) The Buyer may choose to refinance the Seller’s Debt (so the existing Debt may not cost the Buyer anything)
3) Or the Buyer may choose to completely repay the Seller’s Debt using the deal funding, in which case Debt DOES increase the purchase price
4) There are also transaction fees and integration costs associated with the deal that may add to the upfront price

Question 12

How do you calculate Cost of Debt, Cash and Equity / Weighted Cost of Acquisition?

Answer 12

• Cost of Debt: just like Cost of Debt in WACC calculation; it’s the interest rate the company would have to pay if it issued additional Debt
• Cost of Cash: based on interest rate the co is currently earning on its Cash balance, which tends to be very low
• Cost of Equity: based on the Buyer Net Income / Buyer Equity Value, or the RECIPROCAL of the Buyer’s P / E multiple (this is different from how you calculate Cost of Equity in WACC equation. It’s different because you are looking at Cost of Equity in terms of its IMPACT on the COMPANY’S EPS, not the company’s overall discount rate)
• Once, costs are calculated, Weighted Cost of Acquisition = % Cash Used * After-Tax Cost of Cash + % Debt Used * After-Tax Cost of Debt + % Stock Used * After-Tax Cost of Stock

Question 13

Yield

Answer 13

The Yield is how much you get in Net Income for each $1.00 spent on Acquiree’s stock

Yield = Net Income / Purchase Equity Price

Whether a deal is accretive or dilutive depends on how the Seller’s Yield compares with the Weighted Cost of Acquisition

WCA < Yield of Seller: Accretive (i.e., co is paying LESS than what seller is yielding)
WCA = Yield of Seller: Neutral
WCA > Yield of Seller: Dilutive

Question 14

In a 100% stock deal, how do you know if the deal is accretive or dilutive?

Answer 14

You can look at the P/E multiples of the Buyer and Seller (at the Seller’s Purchase Equity Value) to see if the deal is accretive or dilutive

Buyer’s P / E > Seller’s P / E at Purchase Price: Accretive
Buyer’s P / E = Seller’s P / E at Purchase Price: Neutral
Buyer’s P / E < Seller’s P / E at Purchase Price: Dilutive

Question 15

What are the “Acquisition Effects” referenced in Step 3?

Answer 15

Debt: If an Acquirer uses Debt, it will have to pay Interest Expense on that Debt in the future, which will reduce its Pre-Tax Income, its Net Income, and its EPS

Stock: If an Acquirer uses Stock, it will have additional shares outstanding in the future, which will reduce its EPS

Cash: If an Acquirer uses Cash, it will give up future Interest Income on that Cash, which will reduce its Pre-Tax Income, its Net Income, and its EPS

Question 16

What happens to the Seller’s shares in an acquisition?

Answer 16

They are removed from the combined share count because the Seller is no longer an independent entity after the deal closes

The shares don’t “disappear,” but they are removed from the market

They are “transferred” to the Cash, Debt and Stock that the Acquirer used

Question 17

How do you know that an acquisition was accretive or dilutive?

Answer 17

If the combined EPS is higher than the Buyer’s standalone EPS, the deal is accretive; if the combined EPS is lower, the deal is dilutive; and if it’s the same, the deal is neutral

• Create Sensitivity Tables to assess changes in EPS at different purchase-prices, transaction structures and purchase methods

Question 18

What are some shortcomings of EPS and merger models as a metric?

Answer 18

1) Not always meaningful, e.g., if Acquirer is a private company, or if the Acquirer has a negative Net Income
2) Net Income and Cash Flow are very different, i.e., there is a difference between profits and cash flows, and deals that look great based on EPS might look terrible based on Cash Flow
3) Merger Models don’t capture the risk of M&A deals, e.g., teams might not mesh, could be legal issues, etc.
4) Merger Models don’t reflect the qualitative factors

Question 19

What’s the REAL price the Buyer pays?

Answer 19

At minimum, Acquirer must pay for all the Target’s shares, so the Purchase Equity Value is always the starting point for the purchase price.

Beyond that, the exact purchase price depends on the terms of the deal. The main factors that affect it are:

1) Treatment of Seller’s existing Debt

Seller’s Debt is Assumed with No Changes: Does NOT increase the amt the Buyer “really pays” for Seller. Interest doesn’t change
Seller’s Debt is Repaid with Buyer’s Cash: DOES increase the amt the Buyer “really pays.” Interest changes.
Seller’s Debt is Replaced with New Debt: Does NOT increase the amount the Buyer “really pays,” but it may affect the interest slightly.

2) Treatment of Seller’s existing Cash
3) Transaction Fees, Unfunded Pensions, and Other Items

Question 20

When Company A acquires Company B, how do you determine the Combined Equity Value?

Answer 20

If no new Stock is issued, Combined Equity Value = Acquirer’s Equity Value

If it’s a 100% Stock deal, Combined Equity Value = Company A’s Equity Value + Company B’s Purchase Equity Value

Because the Combined Equity Value and Combined Net Income change based on purchase method, the combined P / E multiple changes

Question 21

When Company A acquires Company B, how do you determine Combined Enterprise Value?

Answer 21

Combined Enterprise Value = Combined Equity Value + Debt (and other Debt-like Liabilities) - Cash (and other non-core Business Assets)

• This includes the Cash or Debt used to fund the deal

Or, more simply put: Combined Enterprise Value = Acquirer’s Current Enterprise Value + Seller’s Purchase Enterprise Value

The Combined Enterprise Value tells you how much the Combined Company’s core business will be worth to ALL investors, regardless of how the Buyer pays for the Seller

Combined Enterprise Value stays the same regardless of purchase method (therefore, Enterprise Value-based multiples also stay the same regardless of purchase method)

Question 22

Summary of Combined Enterprise Value, Equity Value, and valuation multiples in M&A deals

Answer 22

1) Combined Equity Value = Acquirer’s Equity Value + Value of Stock Issued in Deal
2) Combined Enterprise Value = Acquirer’s Enterprise Value + Purchase Enterprise Value of Target
3) How the Combined Valuation Multiples Change - the Combined Multiples will be ibtw the Acquirer’s multiples and the Target’s purchase multiples
4) Combined Enterprise Value-Based Multiples - these will NOT change regardless of the purchase method because Combined Enterprise Value isn’t affected by the purchase method, and neither are metrics like Revenue, EBIT or EBITDA
5) Combined Equity Value-Based Multiples - These WILL change based on purchase method because the Combined Equity Value will change based on the amount of Stock used, and the Combined Net Income changes based on the amount of Cash and Debt used and interest rates on them

Note: These rules are simplifications. E.g., revenue synergies will affect Combined EV / Revenue multiple.

Question 23

What is a merger model? (short answer)

Answer 23

An affordability analysis in which you estimate the purchase price and the Cash / Debt / Stock mix and then use the Weighted Cost of Acquisition and the Seller’s Yield to predict whether the deal will be accretive or dilutive.

Question 24

Another method of evaluating an M&A deal: IRR vs. Discount Rate (WACC)

Answer 24

Rather than setting up an accretion/dilution analysis, you could estimate the IRR of the deal and compare it to the Acquirer’s Discount Rate

For this analysis to make sense, Buyer must plan to sell the Seller in the future (its almost always impossible to realize a positive IRR otherwise because the Seller’s annual cash flow is a tiny percentage of the purchase price)

But, this method of evaluating a deal is not that common–Buyers don’t like to admit that they might re-sell acquired companies in the future; it’s hard to get the market to buy into arguments for longer-term value creation; it’s hard to estimate a company’s long-term cash flow and resale value in 5-10 years

Question 25

Another method of evaluating an M&A deal: “Value Creation” Analysis (Valuation Before and After a Deal)

Answer 25

You can also evaluate an M&A deal by seeing if it increases the Acquirer’s Implied Value

To complete this process, you would set up a DCF analysis for the Combined Company, select and use Public Comps and Precedent Transactions, and make sure that you’ve reflected the Cash, Debt, and Stock used in the deal

This method of evaluating a deal is not that common because it takes a lot of extra work and its very speculative (projecting two companies’ future earnings, Discount Rate for combined co, its FCF and FCF growth)

Question 26

Another method of evaluating an M&A deal: Contribution Analysis

Answer 26

The idea is simple: if the Acquirer attributes 80% of the Combined Company’s Revenue, EBITDA, and other financial metrics, will it own 80% of the Combined Company afterward?

If it owns less than 80%, then perhaps its paying too much for the Target; if it owns more than 80%, then perhaps its paying too little.

Contribution analysis is most relevant for:

• 100% stock deals (all changes to purchase price directly affect ownership since Buyer is issuing shares to Seller)
• Merger of Equals deals (these transactions almost always use 100% stock because the Buyer and Seller are close in size)
• Private Company M&A deals (private Buyers don’t care about EPS as much as public Buyers, so the Contribution Analysis is the most relevant methodology for them in 100% stock deals)

NOT relevant for 100% Cash or 100% Debt deals because the Combined Company’s ownership won’t change: The Acquirer will still own everything.

Question 27

What kills deals?

Answer 27

1) Time
2) Price
3) Deal Terms
4) Ego
5) Material Adverse Changes (rarely)
6) Cultural Mismatch
7) What You Didn’t Know
8) Financial Failings

Question 28

Why would an acquisition be dilutive?

Answer 28

1. If the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares.
2. Acquisition effects - such as amortization of intangibles - can also make an acquisition dilutive.

Question 29

Intuition behind accretion and dilution

Answer 29

If you’re paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you’re paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive

Question 30

Example of dilutive acquisition

Answer 30

Given:
-Deal financed by 50% Cash & 50% Debt
-Seller Contributes $100 in pretax income
-Buyer pays $80 interest on debt
-Buyer foregoes $25 Interest on cash
Result:

Dilutive: because buyer gains $100 in pretax income, but loses $105

Question 31

What are all of the effects of an acquisition?

Answer 31

1. Foregone Interest on Cash - Buyer loses the Interest on cash it would have otherwise earned
2. Additional Interest on Debt - Buyer pays additional Interest Expense if it uses debt
3. Additional Shares Outstanding - If Buyer pays with stock, it must issue additional shares- lowering EPS
4. Combined Financial Statements - Seller’s financials added to buyers
5. Creation of Goodwill & Other Intangibles-represent a “premium” paid to a company’s “fair value”

Question 32

What’s the difference between Goodwill and Other Intangible Assets?

Answer 32

• Goodwill typically stays the same over many years and is not amortized. It changes only if there’s goodwill impairment (or another acquisition).
• Other Intangible Assets are amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line.

Question 33

Revenue Synergies

Answer 33

The combined company can cross-sell products to new customers or up-sell new products to existing customers. It might also be able to expand into new geographies as a result of the deal.

Question 34

Cost Synergies

Answer 34

The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.

Question 35

How are revenue synergies used in merger models?

Answer 35

Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue - this additional Revenue then flows through the rest of the combined Income Statement.

Question 36

How are cost synergies used in merger models?

Answer 36

Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.

Question 37

Why is cash always preferred to finance a purchase, rather than stock or debt?

Answer 37

1. Interest on Cash is always lower than interest on Debt, meaning foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt.
2. Cash is cheaper than stock
3. Cash is less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds from investors.
4. Cash is also less risky than stock because the buyer’s share price could change dramatically once the acquisition is announced.

Question 38

Why do most mergers and acquisitions fail?

Answer 38

Like so many things, M&A is “easier said than done.” In practice it’s very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division.
Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders. Any deal done without both parties’ best interests in mind is likely to fail.

Question 39

Why might an M&A deal be accretive?

Answer 39

A deal is accretive if a Seller’s Pre-Tax Income exceeds the cost of the acquisition, namely, the Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

For example, if the Seller contributes $X in Pre-Tax Income, but the deal costs the Buyer less than $X in Interest Expense, and it doesn’t issue any new shares, the deal will be accretive because the Buyer’s EPS will increase.

A deal will be dilutive if the opposite happens.

Question 40

How can you tell whether an M&A deal will be accretive or dilutive?

Answer 40

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)
*For Cash and Debt, you do the (1 - Buyer’s Tax Rate) to estimate the after-tax costs
-Cost of Stock = The Cost of stock is represented by the additional shares that get created in a deal and how those shares reduce the Combined Company’s EPS. It’s equal to the Reciprocal of the Buyer’s P / E multiple, i.e. 1 . (Buyer’s P / E multiple)
-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.

Question 41

Why do you focus so much on EPS in M&A deals?

Answer 41

Because it’s the only 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.

EBITDA and Unlevered FCF, on the other hand, don’t reflect the deals full impact because they exclude Interest and the effects of new shares.

Question 42

How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?

Answer 42

Since Cash is cheapest for most Acquirers, they’ll use all the Cash they can before moving to the other funding sources. So you might assume that the Cash Available equals the Acquirer’s current cash balance minus its Minimum Cash balance.

After that, Debt tends to be the next cheapest option. An acquirer might be able to raise Debt up to the level where its Debt / EBITDA and EBITDA / Interest ratios stay in-line with those of peer companies.

Finally, there’s no strict limit on the Stock an Acquirer might issue, but very few companies would issue enough to give up control of the company, and some Acquirers will issue Stock only up to the point at which the deal turns dilutive.

Question 43

What are the main PROBLEMS with merger models?

Answer 43

1) EPS is not always a meaningful metric
2) Net Income and Cash Flow are very different, so EPS-accretive deals might be horrible from a cash-flow perspective
3) Merger models don’t capture the risk inherent in M&A deals. 100% cash deals almost always look accretive, even thought the integration process might go wrong, legal issues might arise, and customers or shareholders might revolt
4) Finally, merger models don’t capture the qualitative factors of a deal such as cultural fit or management’s ability to work together

Question 44

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x. Will the deal be accretive?

Answer 44

You can’t tell unless you know that it’s a 1000% stock deal

If it is a 100% stock deal, then it will be accretive, because the Buyer’s P / E is higher than the Seller’s, indicating that the Buyer’s Cost of Acquisition (1 / 25, or 4%) is less than the Seller’s Yield (1 / 15, or 6.7%).

Question 45

Walk me through the math of this deal.

Answer 45

Assume co A has 10 shares outstanding at a share price of $25.00, and it’s Net Income is $10. It acquire’s company B for a purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

Company A’s EPS is $10/10 = $1.00

To do the deal, Company A must issed $150 / $25 = 6 new shares, so the Combined Share count is 16

Since no Cash or Debt were used and the tax rates are the same, the Combined Net Income = $10 + $10 = $20

So, the Combined EPS is $20 / 16 = $1.25; there is 25% accretion

Question 46

Company A now uses Debt with an Interest Rate of 10% to acquire Company B. Is the deal still accretive? At what interest rate does it change from accretive to dilutive?

Answer 46

The Weighted Cost of Acquisition would be %10 * (1 - 40%), or 6%, so the deal would still be accretive because that cost is less than the Seller’s Yield of 6.7%.

For the deal to turn dilutive, the After-Tax Cost of Debt would have to exceed 6.7%. Since 6.7% / (1 - 40%) = 11.1%, the deal would turn dilutive at an interest rate above 11.1%.

Question 47

How do the Combined EV / EBITDA and P / E multiples change if the purchase method changes?

Answer 47

The Combined EV / EBITDA stays the same regardless of the purchase method, but the combined P / E multiple will change based on the Stock issued and the Cash and Debt used since those affect the Combined Net Income.

Question 48

Walk me through a merger model.

Answer 48

In a merger model, you start by projecting the financial statements of the Buyer and Seller. Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate
the true cost of the acquisition and its effects.

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. 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.

Question 49

Give me an example of how you might estimate revenue and expense synergies in an M&A deal.

Answer 49

With revenue synergies, you might assume that the Seller can sell its products to some of the Buyer’s customer base. So if the Buyer has 100,000 customers, 1,000 of them might buy widgets from the Seller. Each widget costs $10.00, so that is $10,000 in extra revenue.

There will also be COGS and possibly Operating Expenses associated with these extra sales, so you must factor those in as well. For example, if the cost of each widget is $5.00, then the Combined Company will earn only $5,000 in extra Pre-Tax Income.

With expense synergies, you might assume that the Combined Company can close a certain number of offices or lay off redundant employees, particularly in functions such as IT, accounting, and administrative support.

So if both companies, combined, have 10 offices, and management feels that only 8 offices will be needed after the merger, the combined rental expense will decline.

If each office costs $100,000 per year to rent, there will be 2 * $100,000 = $200,000 in expense synergies, which will boost the Combined Pre-Tax Income by $200,000.

Question 50

What’s the difference in how Cost of Equity is measured in the context of an M&A transaction, versus via CAPM?

Answer 50

The “Reciprocal of the P / E Multiple” method measures Cost of Equity in terms of EPS impact, whereas the CAPM method measures it based on the stock’s expected annual returns.

Note: I think it’s only in a 100% Stock acquisition that Cost of Acquisition is the reciprocal of the Buyer’s P / E multiple

Question 51

Company A has a P / E of 10x, a Debt Interest Rate of 10%, a Cash Interest Rate of 5%, and a tax rate of 40%.

It wants to acquire Company B at a purchase P / E multiple of 16x using 1/3 Stock, 1/3 Debt, and 1/3 Cash. Will the deal be accretive?

Answer 51

Company A’s After-Tax Cost of Stock is 1/10, or 10%, its After-Tax Cost of Debt is 10% * (1 –
40%) = 6%, and its After-Tax Cost of Cash is 5% * (1 – 40%) = 3%.

The Weighted Cost of Acquisition is 10% * 1/3 + 6% * 1/3 + 3% * 1/3 = 3.33% + 2% + 1% =
6.33%.

Company B’s Yield is 1 / 16, or 6.25%.

Since the Weighted Cost is slightly above Company B’s Yield, the deal will be dilutive.

Question 52

What types of sensitivities would you look at in a merger model? What variables would you look at?

Answer 52

most common variables to look:

1. Purchase Price
2. % Stock/Cash/Debt
3. Revenue Synergies and Expense Synergies operating sensitivities:
4. Revenue Growth or EBITDA Margin, but it’s more common to build these into your model as different scenarios instead.
   - You might look at sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Price vs. Cost Synergies, Purchase Price vs. Revenue Synergies, or Purchase Price vs. % Cash (and so on).

Question 53

Can you walk me through a typical sell-side M&A deal?

Answer 53

• 1. Meet with company, create initial marketing materials like the Executive Summary and Offering Memorandum (OM), and decide on potential buyers.
• 2. Send out Executive Summary to potential buyers to gauge interest.
• 3. Send NDAs (Non-Disclosure Agreements) to interested buyers along with more detailed information like the Offering Memorandum, and respond to any follow-up due diligence requests from the buyers.
• 4. Set a “bid deadline” and solicit written Indications of Interest (IOIs) from buyers