M&A

What happens if the Acquirer purchases another company for a $1 billion Equity Purchase Price, but the Target's Common Shareholders' Equity is $1.5 billion? Assume there are no write-ups or other adjustments

"Negative Goodwill" cannot exist per the rules of IFRS and U.S. GAAP. So in this situation, you record this $500 million difference as a Gain on the Income Statement. The Balance Sheet combination still works the same way, but you don't record any Goodwill; you just add all the acquired Assets and Liabilities. The Balance Sheet still balances because Net Income increases as a result of this Gain. But this Gain is non-cash, so the company's Cash balance declines and Shareholders' Equity on the L&E side increases.

Why might an M&A deal be accretive or dilutive?

-Accretive if extra Pre-Tax Income from a Seller exceeds the cost of the acquisition in the form of Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

Why might an Acquirer choose to use Stock or Debt even if it could pay for the Seller in Cash?

-Buyer has cash trapped offshore -preserving its cash for a future expansion or debt maturity -buyer is trading at very high multiples then it might be cheaper to use stock to fund the deal

An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million, Net Income of $50 million, and a Debt / EBITDA ratio of 2x. Peer companies have a median Debt / EBITDA ratio of 4x. It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller has a Net Income of $30 million, EBITDA of $50 million, and no Debt. What's the best way to fund this deal?

1) cash balance too low 2) check cost of stock and debt (debt is prob cheaper) 3) Use leverage ratio to say company could use more debt -Check combined EBITDA -Comb EBITDA* industrydebt/eda = total debt after transaction-current debt = what it could use 4)remaining amount is issued in stock

Let's say this same Acquirer (Equity Value of $500 million and Enterprise Value of $600 million) has Net Income of $50 million and EBITDA of $100 million. The Target (Purchase Equity Value of $100 million and Purchase Enterprise Value of $150 million) has Net Income of $10 million and EBITDA of $15 million. What are the Combined P / E and EV / EBITDA multiples in a 100% Stock deal? Assume the same tax rates for the Acquirer and Target.

1) combine EqV (since 100% stock) and NI calculate new P/E 2)Combine EV and EBITDA ~ 6.5x

Company A has P/E of 10x, a debt interest rate of 10%, a cash interest rate 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, 1/3 cash. Will the deal be accretive?

1) find after tax cost CoC = 5%*(1-40)=3% CoS=1/p/e=10% CoD=6% 2) find weighted cost 1/3*(3%+10%+6%)=6.33% 3) find seller yield 1/p/e of seller = 6.25% 4) compare Yield < cost => dilutive

An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50 million, Net Income of $25 million, and a Debt / EBITDA ratio of 3x. Similar companies in the market have Debt / EBITDA ratios of 5x. What's the BIGGEST acquisition this company might be able to complete?

1) for a precise answer you would need the target's net income and EBITDA, but you can make a rough estimate 2)Acquirer can use cash but won't use the whole cash balance, since it needs a minimum to operate. Maybe it'll use half of it 3) Compay is levered 3x but could afford to go 5x => buyer can raise 100 million more in debt to fund the deal. Keep in mind, that these numbers might be affected by the seller's debt and ebitda as well. 4)There's no limit to how much stock a company can use, but it would be unlikely to give up control just to make an acquisition. So 500 mil stock is the max, but a more realistic level would be around 250

Company A buys Company B using 100% Debt. Company B has a purchase P / E multiple of 10x and Company A has a P / E multiple of 15x. What Debt interest rate is required to make the deal dilutive?

1)find seller yield 2) cost of acq = cost of debt > seller yield for deal to be dilutive => x(1-tax)>10% x=16.7%

I don't believe you. Walk me through what happens if an Acquirer purchases a Target for an Equity Purchase Price $80, in 100% Cash, and the Target has $200 in Assets, $100 in Liabilities, and $100 in Common Shareholders' Equity.

1)write down seller's CSE, add the 200 assets and 100 liabilities to the Buyer's BS, then reduce the cash by 80. Asset = 120 Liab = 100 So record 20 gain on IS to reflect this "bargain purchase" which boosts pretax Inc by 20 and NI by 12 CFS: 12-20=-8cash BS: -8 cash Assets = 112 Liab = 100 Equity from RetEarn = +12

What are the main PROBLEMS with merger models?

1. EPS is not always a meaningful metric 2. Net Income and CF are very different, so EPS-accretive deals might be horrible from a CF perspective 3. Merger models don't capture risk inherent in M&A deals. 100% cash deals almost always look accretive, even though integration processes might go wrong. 4. Merger models don't capture qualitative factors of a deal such as cultural fit or management's ability to work together.

Why do Deferred Tax Liabilities get created in many M&A deals?

A Deferred Tax Liability, or DTL, represents the expectation that cash taxes will exceed book taxes in the future. It gets created because Depreciation & Amortization on Asset Write-Ups is not deductible for cash-tax purposes in a Stock Purchase As a result, the Buyer will pay more in cash taxes than book taxes until the Write-Ups are fully depreciated.

Consider this M&A scenario: - Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%. - Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%. Calculate the EV / EBITDA and P / E multiples for each company. --------------------------------------------- Company A acquires Company B using 100% Cash and pays no premium to do so. Assume a 5% Foregone Interest Rate on Cash. What are the Combined EBITDA and P / E multiples ------------------------------------------------ Company A instead uses 100% debt with a 10% interest rate to acquire company B. Again, A pays no premium. What are the combined multiples?

A) EBITDAx=10x and P/E=20x EBITDAx=5x and P/E=20x --------------------------- CoC = 5%*(1-50%)=2.5% Yield =5% (deal is accretive, but its not relevant) EBITDA = 10+8 =18 EV = 100+40 =140 EBITDAx = 7.8x NOW: combined EqV is just buyer's since no stock was issued NI = NI_a + NI_b - foregone int on cash after tax cash used = 40*0.05=2*tax rate =$1 aftertax (-1 loss) comb NI = 4+2-1 = 5 80/5 = P/E = 16x ------------------------------ EV-multiples stay the same Combined Equity Value is 80 NI = 4+2 - interest on new debt NI = 4+2- (0.1*40puchare eqv*(1-tax)) = 4 P/E = 80/4=20x

What information do you need from the buyer and the seller to create a full merger model?

At the minimum: IS projections for both companies over the next 1-2 years. Ideally, you will also create cash-flow projections that show how both companies' Cash and Debt will change over time You do not need full 3-statement projections for both companies

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 on New Debt, and New Shares Issued. Although metrics such as EBITDA and Unlevered FCF are better in some ways, they don't reflect the deal's full impact because they exclude Interest and the effects of new shares

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

Buyer's will usually use as much of each of the cheapest methods of funding before moving onto more expensive ones. So they'll use as much cash as possible, before moving onto debt, then stock. At the same time, while determining the proportion of each, the buyer will factor in their current leverage ratio and their desired leverage ratio into the equation. They will also consider the fact that they need a minimum cash balance to operate the company.

How do the Combined Equity Value and Enterprise Value relate to the purchase method?

Comb EV isn't affected by purchase method, it's ways the buyers Ev plus seller's purchase EV because it is capital structure neutral Comb EqV = Buyer EqV + VALUE of shares issued in the deal, which could be from 0 to Purchase EqV of Seller So if its a 100% stock deal, comb EqV is essentially b_EqV + s_EqV

What are the possible ranges for the combined multiples after a deal takes place?

Combined multiples should always be between the Buyer's multiples and the Seller's purchase multiples. However, you can't just average the multiples to determine the combined multiples because the companies could be different sizes And its not as simple as using the weighted average because the proportion of EV and EBITDA from each company might be different. Ultimately, the combined multiples will be closer to the buyer's multiples if the buyer is much bigger.

How do the combined multiples change based on the purchase method?

EV-based multiples dont change because combined ev is not affected by the purchase method. EV-based metrics like revenue, ebtida and ebit are also not affected EquityV multiples will change based on the purchase method, because combined EqV depends on the % stock used, and Equity value-based metrics such as net income and free cash flow are impacted by the foregone interest and interest on new debt

How would those combined multiples change in a 100% cash or debt deal?

EV/EBITDA stay the same, because neither the numerator or denom is affected by the purchase method. P/E would change because combined EqV would be lower in a no stock deal, and net income would change because of the foregone interest on cash and interest on debt issued. In most cases, the Combined P / E multiple will be lower in a 100% Cash deal because the Combined Equity Value will decline by a greater percentage than the Combined Net Income.

How do Pro-Forma EPS and Pro-Forma accretion/dilution from the standard, or IFRS/GAAP-compliant, figures?

This one gets very confusing because there's no "standard" definition for Pro-Forma EPS. But most people calculate it by adding back non-cash expenses created in an M&A deal, primarily the Amortization of Intangibles and the Depreciation of PP&E Write-Ups, and calculating Combined Net Income based on this "Pro-Forma" Pre-Tax Income. Some people also add back Stock-Based Compensation and other non-cash charges, effectively making Pro-Forma EPS into "Cash EPS." Many companies report Pro-Forma EPS and calculate accretion/dilution based on these figures, but you should be skeptical because these numbers understate the true costs of acquisitions where Buyers pay high premiums.

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

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. 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.

Are there cases where EPS accretion/dilution is NOT important? What else could you look at?

Yes, -Buyer is private -Buyer has negative eps -Buyer is far bigger than the seller (since eps wont be impacted by a significant amount) Other methods: -Analyze qualitative merits of the deal -Compare the IRR to the WACC -Value the buyer before and after the deal

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

You compare the Weighted Cost of Acquisition to the Seller's Yield at its purchase price. If the Weighted Cost < Seller's Yield, the deal will be accretive

How do you calculate the Combined Company's Debt repayment capacity in a merger model?

You do this by creating a "mini" Cash Flow Statement for the combined company. You eliminate most of the Financing and Investing sections, but you keep capex and most of the CFO section It's similar to what you do in a DCF to project Unlevered Free Cash Flow, but you're estimating the company's Free Cash Flow - which includes Net Interest Expense - here. You have to include the Net Interest Expense because it directly impacts a company's ability to repay Debt and to generate Cash; the purpose is different from that of a DCF since you're not valuing a company but instead tracking its Cash and Debt balances.

What are the main adjustments you make when combining the BS in an M&A deal?

You reflect the Cash, Debt, and Stock used in the deal, create new Goodwill, write up Assets such as PP&E and Other Intangibles, and reflect refinanced Debt. You also show new Deferred Tax Liabilities and the write-offs of existing DTLs and DTAs. You also have to write down the seller's CSE and refelct transaction and financing fees

Company A, with a P/E of 25x acquires Company B for a purchase P/E multiple of 15x. Will the deal be accretive? ----------------------------- Assume company A has 10 shares at a price of $25, NI = 10 B has Purchase EqV=150, NI =10. Assume same tax rate. How accretive is this deal? ------------------------------- Company A now only uses Debt with an interest rate of 10% to acquire B. is the deal still accretive? At what rate does it change from accretive to dilutive? --------------------------------- What are the combined EqV and EV in this deal? Assume the original 100% stock structure, and that Equity Value = Enterprise Value for both the Buyer and the Seller --------------------------------- How do the combined EV/EBITDA and P/E multiples change if the multiple changes? --------------------------------- Without doing any math, what do you expect the combined P/E multiple to be? --------------------------------- Now assume that company A is twice as big financially, so its EqV is $500 and its NI is $20. Will the 100% stock deal be more or less accretive? ----------------------------------- Now do the math. What is the accretion/dilution in a 100% Stock deal?

You would need to know if deal is 100% stock. If so, Cost of Acquisition = Cost of Stock = 1/25 Yield of B = 1/15 Since 1/25<1/15 = 4%<6.7% => wca<yield deal will be accretive ----------------------------- IF deal is all stock=> Initial EPS (A) = $10NI/10shares = $1 Shares issues = purchase EqV/Price per share of A = 150/25 = 6 Total Share Count = 10 + 6 = 16 New NI = NI(a) + NI(b) = 10+10=20 New EPS = New NI/Total shares = 20/16 = 1.25 % accretion = N/O-1 = 1.25/1-1 = 25% ------------------------ cost of acquisition = after tax cost of debt = int*(1-tax) = 10%(1-40%) = 6% < 6.7% => yield is higher so it will be accretive For the deal to turn dilutive, x(1-40%)>6.7 => x > 1.11 ----------------------------- EqV = Buyer's + Value of Stock issued = 250+6*25 = 400 EV = EV_b + EV_s = 400 ------------------------------ EV/EBITDA is capital neutral, so it stays the same P/e will change based on the proportions of each funding method since interest income on cash and interest on debt is part of Net Income which is the denominator of P/E ----------------------------- between the buyer's P/E and the seller's PURCHASE P/E multiple, so between 25x and 15x here. If comp A is much larger than comp b, P/E will be close to the 25x of company A. Otherwise, they'll be closer in size -------------------------------- The deal will be less accretive. The intuition is that the company that is not making the deal dilutive - the Buyer - now has a higher weighting in all the calculations. --------------------------------- Initial EPS (A) = $20NI/10shares = $2 Shares issues = purchase EqV/Price per share of A = 150/50 = 3 Total Share Count = 10 + 3 = 13 New NI = NI(a) + NI(b) = 20+10=30 New EPS = New NI/Total shares = 30/13 = 2.31 % accretion = N/O-1 = 2.31/2-1 = 15.5% < than before

An Acquirer with an Equity Value of $500 million and Enterprise Value of $600 million buys another company for a Purchase Equity Value of $100 million and Purchase Enterprise Value of $150 million. What are the Combined Equity Value and Enterprise Value?

combined EV = 600+150=750 comb eq = buyer eq+value of stock issued in deal assuming 100% stock deal: combine EqV = 500+100 =600 assuming 100% cash and debt: comb eq = just 500 if % of stock is between 0 and 100%: comb eq is between 500 and 600

Why do many merger models tend to overstate the impact of synergies?

First, many merger models do not include the costs associated with revenue synergies. Even if the Buyer or Seller can sell more products or services after the deal takes place, those extra sales cost something. Second, realizing synergies takes time. Finally, realizing synergies costs money. There will always be "integration costs" associated with a deal, and certain types of synergies

What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?

From cheapest to most expensive: cash, debt, equity. Cash: most companies earn little interest income on it, so they don't lose much by using it -using it decreases the flexibility in the near future to fund operations like expanding a factory or paying down debt Debt: cheaper than cash, more expensive than stock. Have to pay interest on debt, but that interest is tax deductible. Talk about leverage and risk Stock: most expensive, (can be cheapest if buyer trades at extremely high multiples). It dilutes investors and also dividends paid on equity are not tax deductible

What's the impact of each purchase method in an M&A deal, and how do you estimate the Cost of each method?

Impact is determined by the formula for the cost of each one: CoC=foregone int on cash*(1-t) CoD=int on new debt*(1-tax) CoS=E/P of buyer

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 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. 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 finding the % change of the combined eps and the buyer's old eps

Isn't it a contradiction to calculate the Cost of Stock by using the reciprocal of the Acquirer's P / E multiple? What about the Risk-Free Rate, Beta, and the Equity Risk Premium?

It's not a contradiction; it's just a different way of measuring the Cost of Equity. E/P measures CoE in terms of EPS impact CAPM measures it based on stock expected annual returns Neither is correct one, they are just used different contexts Regardless of the method used, equity will always be the most expensive funding source for a company

Why do many merger models misstate the Foregone Interest on Cash and Interest on Debt?

Many merger models do not track the Combined Company's Cash and Debt balances over time. If you don't track the changing Cash and Debt balances, Interest Income will be understated since the Cash balance tends to grow over time, while the Foregone Interest on Debt will be overstated since the Combined Company can repay Debt with its cash flow.

Why do most M&A deals fail?

Most deals fail because of the human element: There might be a culture mismatch, the buyer might have not uncovered something important in the due diligence phase, or the buyer might have had stupid reasons for doing the deal in the first place

How does a Merger differ from an Acquisition?

No mechanical difference because there's still a buyer and a seller in both deals. Difference is that in a merger, the companies will be closer in size. In an acquisition, buyer will be significantly larger than the seller. 100% stock or majority stock deals are also more common in mergers because similarly sized companies can rarely use Cash or Debt to acquire each other (sizes are similar think of agar.io)

Isn't the Foregone Interest on Cash just an "opportunity cost"? Why do you include it?

No, it's not just an "opportunity cost" because the Acquirer's projected Pre-Tax Income already includes the Interest Income that the company expects to earn on its Cash balance.

Company A has an Equity Value of 1000 and NI of 100. Company B has Purchase EqV of 2000 and NI of 50 For 100% stock deal to be accretive, how much in synergies must be realized?

P/E of A < P/E of B => dilutive P/E of has to be > P/E of B 10>2000/(50 NI + aftertax synergies) => 150 aftertax synergies => 150/(1-tax) = pretax = 250 pretax synergies

How do you determine the Purchase Price in an M&A deal?

Public Seller: assume a premium over the seller's current share price based on average premiums for similar deals in the market (10-30% avg). Use valuation methodologies to sanity check this figure. Private Seller: Purchase p is based on valuation methods, and it is usually linked to a multiple of EBITDA or EBIT Both cases: if the buyer expects significant synergies, it is often willing to pay a higher premium or multiple for the seller.

An Acquirer purchases a company for a $1 billion Equity Purchase Price, and this Target has $600 million in Common Shareholders' Equity and no Goodwill. The Acquirer plans to write up the Target's PP&E and Other Intangible Assets by $100. Walk me through the Purchase Price Allocation process, assuming a 40% tax rate.

The "Allocable Purchase Premium" equals the Equity Purchase Price minus the Common Shareholders' Equity, so $1 billion - $600 million = $400 million The PP&E and Other Intangible Assets increase by $100 million, so you subtract this figure because it means you won't need as much Goodwill. So the Purchase Premium is down to $300 million. Then, you must create a Deferred Tax Liability that corresponds to these write-ups. It's equal to $100 million * 40%, or $40 million, and you add it because an increase in the Liabilities side means that more Goodwill will be needed. So $340 million of Goodwill gets created, along with Asset write-ups of $100 million and a new Deferred Tax Liability of $40 million.

So you're saying that in a 100% Cash or Debt deal, the Seller's Equity Value just "disappears"? How is that possible?

The Seller's Equity Value doesn't "disappear" - it's just transformed into the Cash or Debt used by the Acquirer in the deal. The Combined Enterprise Value calculation demonstrates this point: Both companies' Enterprise Values still exist after the deal, so no value is "lost" along the way.

Why is a Sources & Uses schedule important in a full merger model?

The Sources & Uses schedule is important because it tells you how much the Buyer really pays for the Seller. The Purchase Equity Value and Purchase Enterprise Value can be deceptive for the reasons outlined above. But with the S&U schedule, you add up the total cost of acquiring the company - its shares, any refinanced Debt, and any transaction fees - and then show the amount of Cash, Debt, and Stock that will be used to pay for it. The S&U schedule is also helpful for reflecting more unusual scenarios, such as a Seller using some of its Cash in the deal or a Buyer repaying its own Debt.

Why would one company want to buy another company?

The buyer believes it will be better off after purchase takes place: -Seller asking price < Implied Value -IRR>WACC Buyers often acquire companies to save money via -Consolidation -Geographic growth -Product line expansion

How should you treat Stock-Based Compensation in a merger model?

The easiest approach is to ignore it and count it as a real cash expense. Just as in a DCF, SBC is problematic because it increases the company's share count and, therefore, reduces its value to existing investors, but it's difficult to estimate the precise impact since you have to project the company's share price to do that So it's better NOT to add it back as a non-cash expense on the Combined CFS and to keep the Buyer's share count the same in all years.

What's the purpose of a Purchase Price Allocation schedule in a merger model?

The main purpose is to estimate the Goodwill that will be created in a deal. Goodwill exists because Buyers often pay far more for companies than their Balance Sheets suggest they are worth; in other words, the Purchase Equity Value exceeds the acquired company's Common Shareholders' Equity (CSE). When this happens, the Combined Balance Sheet will go out of balance because the Seller's CSE is written down, but the total amount of Cash, Debt, and Stock used in the deal exceeds the CSE that was written down. So you estimate the new Goodwill with this schedule, factor in write-ups of Assets such as PP&E and Intangibles, and also include other acquisition effects such as the creation of Deferred Tax Liabilities and changes to existing Deferred Tax items.

Why is the Purchase Price in an M&A deal NOT equal to the Seller's Purchase Equity Value or Purchase Enterprise Value exactly?

The real price depends on the treatment of the seller's cash and debt in the deal. In most cases, the buyer will "replace" the seller's existing debt with new debt, which doesn't affect the cash price. And the Buyer hardly ever uses the Seller's entire Cash balance to fund the deal - at most, it might use a portion of it So the real price the Buyer pays is usually between the Purchase Equity Value and Purchase Enterprise Value of the Seller.

Which purchase method does a Seller prefer in an M&A deal?

The seller has to balance taxes with the certainty of payment and potential upside from stock. If seller is very bullish on the buyer's stock, they'll prefer stock. But will opt for debt and cash if they aren't as optimistic and are more risk averse. Cash and debt represent immediate payment to the seller.

How can you analyze an M&A deal and determine whether or not it makes sense?

There's 3 main avenues you can take Qualitative analysis which involves determining factors like: could the deal help the company expand products, geographies, or customer bases, give it more IP, etc? Quantitative analysis includes a valuation of the seller to determine if it's undervalued, as well as a comparison of the expected IRR to the buyer's WACC EPS analysis (accr/dilution) which is important because investors focus tremendously on near-term eps, so dilutive deals tend to make companies' stock prices decline.

Why might you calculate metrics such as Debt / EBITDA and EBITDA / Interest for the Combined Company in an M&A deal?

These metrics tell you whether the Combined Company could afford to use more Debt to fund a deal or if it's using too much Debt to fund a deal. Sometimes it's deceptive to look at a number like Debt / EBITA immediately after a deal closes because the Combined Company can de-lever rapidly by paying off Debt. So even if its Debt / EBITDA temporarily jumps up to a high level, such as 5x or 6x, if it can repay Debt quickly and bring it down to 2x or 3x in 1-2 years, it might be able to use more Debt to fund the initial deal.