Merger Model QA

Question 1

Walk me through a basic merger model

Answer 1

A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases.

Question 2

Why would an acquisition be dilutive?

Answer 2

An acquisition is dilutive if additional Net Income < foregone interest on cash,
additional interest paid on
debt,
and issuing additional shares.

Acquisition effects – such as amortization of intangibles – can also make an acquisition
dilutive.

Question 3

Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

Answer 3

If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then

compare it against the seller’s Pre-Tax Income.

Question 4

What are the complete effects of an acquisition?

Answer 4

1. Foregone Interest on Cash – The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition.
2. Additional Interest on Debt – The buyer pays additional Interest Expense if it uses debt.
3. Additional Shares Outstanding – If the buyer pays with stock, it must issue
   additional shares.
4. Combined Financial Statements – After the acquisition, the seller’s financials are added to the buyer’s.
5. Creation of Goodwill & Other Intangibles – These Balance Sheet items thatrepresent a “premium” paid to a company’s “fair value” also get created.

Question 5

Why do Goodwill & Other Intangibles get created in an acquisition?

Answer 5

These represent the value over the “fair market value” of the seller that the buyer has paid.

You calculate the number by subtracting the book value of a company from its
equity purchase price.

Question 6

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?

Question 7

Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in M&A deals?

Answer 7

These get created when you write up assets – both tangible and intangible – and when you write down assets in a transaction.

Asset write-up –> 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

Asset write down –> Deferred tax Asset

Question 8

Why do you write up or down assets?

Answer 8

because their book value – what’s on the balance sheet – often differs substantially from their “fair market value.”

Question 9

Could you get DTLs or DTAs in an asset purchase?

Answer 9

No, because in an asset purchase the book basis of assets always matches the tax basis

Question 10

What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?

Answer 10

Earnout is a form of “deferred payment” in an M&A deal

contingent on financial performance or other goals

Question 11

How do you handle options, convertible debt, and other dilutive securities in a
merger model?

Answer 11

exact treatment depends on the terms of the Purchase Agreement

If you assume they’re exercised,
– Treasury Stock Method for options,
– convertibles convert into normal shares using the conversion price.

Question 12

Would a seller prefer a stock purchase or an asset purchase? What about the buyer?

Answer 12

• seller almost always prefers a stock purchase to avoid double taxation and to get rid of all its liabilities
• 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