MERGER MODELS Flashcards
Why might one company want to buy another company?
One company might want to buy another company if it believes it will be better off after the
acquisition takes place. For example:
The Seller’s asking price is less than its Implied Value, i.e., the Present Value of its future cash flows.
The expected IRR from the acquisition exceeds the Buyer’s Discount Rate. Buyers often acquire Sellers to save money via consolidation and economies of scale, to expand geographically or gain market share, to acquire new customers or distribution channels, and to expand their products and services. Synergies, or the potential to combine and reduce expenses through departmental consolidation or to boost revenue through additional sales, also explain many deals.
How can you analyze an M&A deal and determine whether or not it makes sense?
The qualitative analysis depends on the factors above: 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, as
well as a comparison of the expected IRR to the Buyer’s Discount Rate.
Finally, EPS accretion/dilution is important in most deals because Buyers prefer to execute
accretive deals, i.e., ones that increase their Earnings per Share (EPS). The Board of Directors is
more likely to approve of accretive deals, and investors also like accretive deals more than
dilutive ones.
Walk me through a merger model (accretion/dilution analysis).
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 after-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 and write-downs. You then combine the
Income Statements, reflecting the Foregone Interest on Cash, Interest Paid on New Debt, and
Synergies. If the New Debt balance changes over time, the Interest Paid on New Debt should
reflect that.
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 number 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 to make it a percentage.
Why do you focus so much on EPS in M&A deals?
Because it’s the only easy-to-calculate metric that also captures the FULL impact of the deal – the Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.
Although metrics such as EBITDA and Unlevered FCF more accurately approximate cash flow
and the value of the company’s core business, they don’t reflect the deal’s full impact because they exclude Net Interest and the effect of new shares.
