Walk me through a basic merger model.
- basic merger model: used to evaluate whether the transaction will be beneficial to the company’s earnings.
- Determine the purchase price
- Determine how to finance the transaction (cash, stocks, debt, or combinations of those)
- Determine Valuations and Project Income Statements
- Combine Income Statements
- add key line items (combine revenue and operating expense)
- adjust for financing effects (forgone interests on cash & interest paid on debt)
- to calculate the pre-tax income - Apply the buyer’s tax rate
- Divide by New Share Count to determine the EPS
What’s the difference between a merger and an acquisition?
semantic difference
- merger: same size
- acquisition: big size company acquire small size company
- Why would a company want to acquire another company?
- Gain market share
- Needs to grow more quickly and see an acquisition is a way to do that
- Seller is undervalued
- Wants to acquire the seller’s customers ==> can up-sell and cross-sell
- seller has a critical technology
- believes that there are significant synergy
- Why would an acquisition be dilutive?
If the additional net income the seller contributes is not enough to offset the foregone interest on cash, interest paid on debts, and the effects of issuing new shares
- Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?
- If the deal involves just cash and debt ==> sum up interest expense for debt and foregone interest on cash, and compare it with the seller’s pre-tax income
- if it’s an all stock deal ==> if the buyer has a higher P/E than seller ==> accretive; if buyer has a lower P/E than seller ==> dilutive
- If the deal involves stock, cash, and debt ==> no short cut
A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?
trick question. can’t tell unless this is an all stock deal. if an all stock deal:
accretive
What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?
if is an all-stock deal
- buyer has a higher P/E/ ==> accretive
- seller has a higher P/E ==> dilutive
- What are the complete effects of an acquisition?
- foregone interest on cash
- interest paid on debt
- additional shares outstanding
- combined financial statements
- creation of goodwill & other intangible
- If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so
- save cash for something else
- concerned if the business is taking a turn for the worst
- its stock may be trading at all-time-high and would prefer to use stock
- Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?
- strategic acquirers can realize cost and revenue synergies PE firms can’t
- Why do Goodwill & Other Intangibles get created in an acquisition?
premium above fair market value
- What is the difference between Goodwill and Other Intangible Assets?
- Goodwill doesn’t amortize
- other intangible assets do amortize and affect the I/S by hitting the pre-tax income line
- Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?
- Purchase in process R&D
- Deferred Revenue write-off: The second refers to cases where the seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-down the value of the Deferred Revenue to avoid “double-counting” revenue.
- What are synergies, and can you provide a few examples?
Basically, the buyer gets more value than out of an acquisition than what the financials would predict.
1. Revenue synergies
2. Cost synergies
- How are synergies used in merger models?
- Revenue synergy:
- estimate the additional revenue that the combined company will generate because of synergies and apply a margin assumption
- Cost synergy: reduce the combined COGS or Operating Expenses
- Are revenue or cost synergies more important?
No one in M&A takes revenue synergies seriously because they’re so hard to predict. Cost synergies are taken a bit more seriously because it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.
- All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?
it would always prefer to use cash when buying another company.
1. Cash is cheaper than debt because interest rate on cash are usually under 5%, and interest of debt are a lot always higher than that
2. Cash is less risky
3. stock is the most expensive way to finance a transaction because it’s not tax deductible
4. cash is also less risky than stock because share price could change dramatically
- How much debt could a company issue in a merger or acquisition?
- look at debt comps
- use the combined company’s Last Twelve Month EBITDA figure, find the median Debt/EBITDA ratio, and apply that to your own EBITDA figure
- How do you determine the Purchase Price for the target company in an acquisition?
Same valuation methodologies as we discussed.
- Let’s say a company overpays for another company – what typically happens afterwards and can you give any recent examples?
- increadible high amount of goodwill and other intangibles created
- there might be large impairments later on
- such as the eBay/Skype deal
- A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it’s only worth $50 million. What happens?
The seller effectively only receives half of what it had originally negotiated because the value of the shares they were paid in has decreased.
- Why do most mergers and acquisitions fail?
- difficult to realize synergies
- CEO ego or pressure from shareholders.
- What role does a merger model play in deal negotiations?
- used as a sanity test
- A company would never decide to do a deal based on the output of a model.
- What types of sensitivities would you look at in a merger model? What variables would you look at?
- purchase price
- % stock/cash/stock
- Revenue synergies
- Expense synergies
