Miscellaneous Questions Flashcards
How do Net Operating Losses (NOLs) affect a company’s 3 statements?
The “quick and dirty” way to do this: reduce the Taxable Income by the portion of the
NOLs that you can use each year, apply the same tax rate, and then subtract that new
Tax number from your old Pretax Income number (which should stay the same).
The way you should do this: create a book vs. cash tax schedule where you calculate the
Taxable Income based on NOLs, and then look at what you would pay in taxes without
the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on
the Balance Sheet.
This method reflects the fact that you’re saving on cash flow – since the DTL, a liability,
is rising – but correctly separates the NOL impact into book vs. cash taxes.
How do you account for convertible bonds in the Enterprise Value formula?
If the convertible bonds are in-the-money, meaning that the conversion price of the
bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they’re out-of-the-money then you count the face value of the
convertibles as part of the company’s Debt.
A company has 1 million shares outstanding at a value of $100 per share. It also has
$10 million of convertible bonds, with par value of $1,000 and a conversion price of
$50. How do I calculate diluted shares outstanding?
This gets confusing because of the different units involved. First, note that these
convertible bonds are in-the-money because the company’s share price is $100, but the
conversion price is $50. So we count them as additional shares rather than debt.
Next, we need to divide the value of the convertible bonds – $10 million – by the par
value – $1,000 – to figure out how many individual bonds we get:
$10 million / $1,000 = 10,000 convertible bonds.
Next, we need to figure out how many shares this number represents. The number of
shares per bond is the par value divided by the conversion price:
$1,000 / $50 = 20 shares per bond.
So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2
million diluted shares outstanding.
We do not use the Treasury Stock Method with convertibles because the company is
not “receiving” any cash from us.
How do you value Net Operating Losses and take them into account in a valuation?
You value NOLs based on how much they’ll save the company in taxes in future years,
and then take the present value of the sum of tax savings in future years. Two ways to
assess the tax savings in future years:
1. Assume that a company can use its NOLs to completely offset its taxable income
until the NOLs run out.
2. In an acquisition scenario, use Section 382 and multiply the adjusted long-term
rate (http://pmstax.com/afr/exemptAFR.shtml) by the equity purchase price of
the seller to determine the maximum allowed NOL usage in each year – and then
use that to figure out the offset to taxable income.
You might look at NOLs in a valuation but you rarely add them in – if you did, they
would be similar to cash and you would subtract NOLs to go from Equity Value to
Enterprise Value, and vice versa.
How do you take into account NOLs in an M&A deal?
You apply Section 382 to determine how much of the seller’s NOLs are usable each year.
Allowable NOLs = Equity Purchase Price * Highest of Past 3 Months’ Adjusted Long
Term Rates
So if our equity purchase price were $1 billion and the highest adjusted long-term rate
were 5%, then we could use $1 billion * 5% = $50 million of NOLs each year.
If the seller had $250 million in NOLs, then the combined company could use $50
million of them each year for 5 years to offset its taxable income.
Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in
M&A deals?
These get created when you write up assets – both tangible and intangible – and when
you write down assets in a transaction. An asset write-up creates a deferred tax liability,
and an asset write-down creates a deferred tax asset
You write down and write up assets because their book value – what’s on the balance
sheet – often differs substantially from their “fair market value.”
An asset write-up creates a deferred tax liability because you’ll have a higher
depreciation expense on the new asset, which means you save on taxes in the short-term
– but eventually you’ll have to pay them back, hence the liability. The opposite applies
for an asset write-down and a deferred tax asset.
How do DTLs and DTAs affect the Balance Sheet Adjustment in an M&A deal?
You take them into account with everything else when calculating the amount of
Goodwill & Other Intangibles to create on your pro-forma balance sheet. The formulas
are as follows:
Deferred Tax Asset = Asset Write-Down * Tax Rate
Deferred Tax Liability = Asset Write-Up * Tax Rate
So let’s say you were buying a company for $1 billion with half-cash and half-debt, and
you had a $100 million asset write-up and a tax rate of 40%. In addition, the seller has
total assets of $200 million, total liabilities of $150 million, and shareholders’ equity of
$50 million.
Here’s what would happen to the combined company’s balance sheet (ignoring
transaction/financing fees):
• First, you simply add the seller’s Assets and Liabilities (but NOT Shareholders’
Equity – it is wiped out) to the buyer’s to get your “initial” balance sheet. Assets
are up by $200 million and Liabilities are down by $150 million.
• Then, Cash on the Assets side goes down by $500 million.
• Debt on the Liabilities & Equity side goes up by $500 million.
• You get a new Deferred Tax Liability of $40 million ($100 million * 40%) on the
Liabilities & Equity side.
• Assets are down by $300 million total and Liabilities & Shareholders’ Equity are
up by $690 million ($500 + $40 + $150).
• So you need Goodwill & Intangibles of $990 million on the Assets side to make
both sides balance.
Could you get DTLs or DTAs in an asset purchase?
No, because in an asset purchase the book basis of assets always matches the tax basis.
They get created in a stock purchase because the book values of assets are written up or
written down, but the tax values are not.
How do you account for DTLs in forward projections in a merger model?
You create a book vs. cash tax schedule and figure out what the company owes in taxes
based on the Pretax Income on its books, and then you determine what it actually pays
in cash taxes based on its NOLs and newly created amortization and depreciation
expenses (from any asset write-ups).
Anytime the “cash” tax expense exceeds the “book” tax expense you record this as an
decrease to the Deferred Tax Liability on the Balance Sheet; if the “book” expense is
higher, then you record that as an increase to the DTL.
Explain the complete formula for how to calculate Goodwill in an M&A deal.
Goodwill = Equity Purchase Price – Seller Book Value + Seller’s Existing Goodwill –
Asset Write-Ups – Seller’s Existing Deferred Tax Liability + Write-Down of Seller’s
Existing Deferred Tax Asset + Newly Created Deferred Tax Liability
A couple notes here:
• Seller Book Value is just the Shareholders’ Equity number.
• You add the Seller’s Existing Goodwill because it gets written down to $0 in an
M&A deal.
• You subtract the Asset Write-Ups because these are additions to the Assets side
of the Balance Sheet – Goodwill is also an asset, so effectively you need less
Goodwill to “plug the hole.”
• Normally you assume 100% of the Seller’s existing DTL is written down.
• The seller’s existing DTA may or may not be written down completely (see the
next question).
Explain why we would write down the seller’s existing Deferred Tax Asset in an
M&A deal.
You write it down to reflect the fact that Deferred Tax Assets include NOLs, and that
you might use these NOLs post-transaction to offset the combined entity’s taxable
income.
In an asset or 338(h)(10) purchase you assume that the entire NOL balance goes to $0 in
the transaction, and then you write down the existing Deferred Tax Asset by this NOL
write-down.
In a stock purchase the formula is:
DTA Write-Down = Buyer Tax Rate * MAX(0, NOL Balance – Allowed Annual NOL
Usage * Expiration Period in Years)
This formula is saying, “If we’re going to use up all these NOLs post transaction, let’s
not write anything down. Otherwise, let’s write down the portion that we cannot
actually use post-transaction, i.e. whatever our existing NOL balance is minus the
amount we can use per year times the number of years.”
What’s a Section 338(h)(10) election and why might a company want to use it in an
M&A deal?
A Section 338(h)(10) election blends the benefits of a stock purchase and an asset
purchase:
• Legally it is a stock purchase, but accounting-wise it’s treated like an asset
purchase.
• The seller is still subject to double-taxation – on its assets that have appreciated
and on the proceeds from the sale.
• But the buyer receives a step-up tax basis on the new assets it acquires, and it can
depreciate/amortize them so it saves on taxes.
Even though the seller still gets taxed twice, buyers will often pay more in a 338(h)(10)
deal because of the tax-savings potential. It’s particularly helpful for:
• Sellers with high NOL balances (more tax-savings for the buyer because this
NOL balance will be written down completely – and so more of the excess
purchase price can be allocated to asset write-ups).
• If the company has been an S-corporation for over 10 years – in this case it
doesn’t have to pay a tax on the appreciation of its assets.
The requirements to use 338(h)(10) are complex and bankers don’t deal with this – that is
the role of lawyers and tax accountants.
Walk me through the most important terms of a Purchase Agreement in an M&A
deal.
There are dozens, but here are the most important ones:
• Purchase Price: Stated as a per-share amount for public companies.
• Form of Consideration: Cash, Stock, Debt…
• Transaction Structure: Stock, Asset, or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-compete
agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about their
respective businesses?
• No-Shop / Go-Shop: Can the seller “shop” this offer around and try to get a
better deal, or must it stay exclusive to this buyer?
What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?
An Earnout is a form of “deferred payment” in an M&A deal – it’s most common with
private companies and start-ups, and is highly unusual with public sellers.
It is is usually contingent on financial performance or other goals – for example, the buyer
might say, “We’ll give you an additional $10 million in 3 years if you can hit $100
million in revenue by then.”
Buyers use it to incentivize sellers to continue to perform well and to discourage
management teams from taking the money and running off to an island in the South
Pacific once the deal is done.
How do you handle options, convertible debt, and other dilutive securities in a
merger model?
The exact treatment depends on the terms of the Purchase Agreement – the buyer might
assume them or it might allow the seller to “cash them out” assuming that the per-share
purchase price is above the exercise prices of these dilutive securities.
If you assume they’re exercised, then you calculate dilution to the equity purchase price
in the same way you normally would – Treasury Stock Method for options, and assume
that convertibles convert into normal shares using the conversion price
What are the main 3 transaction structures you could use to acquire another
company?
Stock Purchase, Asset Purchase, and 338(h)(10) Election. The basic differences:
Stock Purchase:
• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet
items.
• The seller is taxed at the capital gains tax rate.
• The buyer receives no step-up tax basis for the newly acquired assets, and it can’t
depreciate/amortize them for tax purposes.
• A Deferred Tax Liability gets created as a result of the above.
• Most common for public companies and larger private companies.
Asset Purchase:
• Buyer acquires only certain assets and assumes only certain liabilities of the seller
and gets nothing else.
• Seller is taxed on the amount its assets have appreciated (what the buyer is
paying for each one minus its book value) and also pays a capital gains tax on the
proceeds.
The buyer receives a step-up tax basis for the newly acquired assets, and it can
depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public
companies.
Section 338(h)(10) Election:
• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet
items.
• Seller is taxed on the amount its assets have appreciated (what the buyer is
paying for each one minus its book value) and also pays a capital gains tax on the
proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can
depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public
companies.
• To compensate for the buyer’s favorable tax treatment, the buyer usually agrees
to pay more than it would in an Asset Purchase.
Would a seller prefer a stock purchase or an asset purchase? What about the buyer?
A seller almost always prefers a stock purchase to avoid double taxation and to get rid
of all its liabilities. The buyer almost always prefers an asset deal so it can be more
careful about what it acquires and to get the tax benefit from being able to deduct
depreciation and amortization of asset write-ups for tax purposes.
How do you account for transaction costs, financing fees, and miscellaneous
expenses in a merger model?
In the “old days” you used to capitalize these expenses and then amortize them; with
the new accounting rules, you’re supposed to expense transaction and miscellaneous
fees upfront, but capitalize the financing fees and amortize them over the life of the debt.
Expensed transaction fees come out of Retained Earnings when you adjust the Balance
Sheet, while capitalized financing fees appear as a new Asset on the Balance Sheet and
are amortized each year according to the tenor of the debt.
A company begins offering 12-month installment plans to customers so that they can pay for $1,000 products over a year instead of 100% upfront. How will its cash flow change?
In the short term, the company’s cash flow is likely to decrease because some customers will no longer pay 100% upfront. So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on. The long-term impact depends on how much sales grow as a result of this change. If sales grow substantially, that might be enough to offset the longer cash-collection process and increase the company’s overall cash flow
A company decides to prepay its monthly rent by paying for an entire year upfront in cash, as the property owner has offered it a 10% discount for doing so. Will this prepayment boost the company’s cash flow?
In the short term, no, because the company is now paying 12 * Monthly Rent in a single month rather than making one cash payment per monthOn the Income Statement in Month 1, the company will still record only the Monthly Rent for that month. But on the Cash Flow Statement, it will record –12 * Monthly Rent under “Change in Prepaid Expenses” to represent the cash outflow. A 10% discount represents just over one month of rent, so the company’s cash flow in Month 1 will decrease substantially. Over an entire year, however, this prepayment will improve the company’s cash flow because there will be no additional cash rental payments after Month 1, and the total amount of rent paid in cash will be 10% less by the end of the year.
A company collects cash payments from customers for a monthly subscription service one year in advance. Why do companies do this, and what is the cash flow impact?
A company collects cash payments for a monthly service long in advance if it has the market and pricing power to do so. Because of the time value of money, it’s better to collect cash today rather than several months or a year into the future. This practice always boosts a company’s cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue is a positive entry that boosts a company’s cash flow. When this cash is finally recognized as Revenue, Deferred Revenue declines, which appears as a negative entry on the CFS
How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why are Prepaid Expenses an Asset?
Prepaid Expenses have already been paid in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they finally appear on the Income Statement, they’ll effectively be “non-cash expenses” that reduce the company’s taxes, which makes them an Asset. By contrast, Accounts Payable have not yet been paid in cash. When the company finally pays them, its Cash balance will decrease, which makes AP a Liability. Accounts Payable and Accrued Expenses work the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), while Accrued Expenses is used for monthly, recurring items without invoices (e.g., utilities). Accrued Expenses almost always result in an Income Statement expense before being paid in cash, and Accounts Payable often do as well. However, in some cases, Accounts Payable may correspond to items that have not yet appeared on the Income Statement, such as purchases of Inventory made on credit.
Your CFO wants to start paying employees mostly in Stock-Based Compensation, under the logic that it will reduce the company’s taxes, but not “cost it” anything in cash. Is the CFO correct? And how does Stock-Based Compensation impact the statements?
The CFO is correct on a superficial level, but not in reality. First, the full amount of Stock-Based Compensation is not deductible for Cash-Tax purposes when it is initially granted in most countries, so even if Book Taxes decrease, Cash Taxes may not change at all.
The eventual tax deduction will take place much further into the future when employees exercise their options and/or receive their shares. But the other problem with the CFO’s claim is that Stock-Based Compensation creates additional shares, diluting existing investors and, therefore, “costing” the company something. That makes it quite different from non-cash expenses that do not change the company’s capital structure, such as Depreciation and Amortization
Your company decides to sell equipment for a market value of $85. The equipment was listed at $100 on your company’s Balance Sheet, so you have to record a Loss of $15 on the Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement. Why is this Loss considered a “non-cash expense”?
This Loss is a non-cash expense because you haven’t “lost” anything in cash in the current period. When you sell equipment for $85, you get $85 in cash from the buyer. It’s not as if you’ve “lost” or “spent” $15 in cash because you sold the equipment at a reduced price.
The Loss means that you spent more than $85 to buy this equipment in a prior period. But non-cash adjustments are based on what happens in the CURRENT PERIOD.
