Merger Model Quiz Basic
Acquirer Co. has an Equity Value of $200M and Net Income of $10M. It is considering buying Target Co., which has an Equity Value of $80M and the same Net Income of $10M. Assuming that Acquirer Co. completes a 100% stock deal to acquire Target Co. and does NOT pay a premium for it, would this hypothetical deal be accretive or dilutive to Acquirer Co.'s earnings per share? a. Accretive to EPS b. Dilutive to EPS c. Neutral to EPS d. Cannot say without additional information
Explanation: The correct answer choice is A. On the surface, this question does not provide enough information to determine whether the deal is accretive or dilutive to EPS - but remember that all you need to determine the P / E multiple is Price Per Share / Earnings Per Share, or Equity Value / Net Income. Acquirer Co. has a P / E of 20.0x (i.e. $200M Equity Value / $10M Net Income), whereas Target Co. has a P / E of 8.0x. The other trick is that the question specifically states that Acquirer Co. is doing an all-stock deal and not paying a premium over Target Co.'s current share price. The general rule of thumb is that in an all-stock deal, if Acquirer Co. has a higher P/E ratio that Target Co.'s P/E ratio, then the deal will likely be accretive to EPS.
A start-up company has an Equity Value of $2.3 billion and $23M in Net Income. Its cash interest rate is 2.3%, its debt interest rate is 12.5%, and its tax rate is 20%. It wants to buy a $350 million Equity Value seller with a P/E of 15x. Which financing structure would be most DILUTIVE? a. 100% stock b. 100% debt c. 50% cash / 50% debt d. 20% cash / 20% debt / 60% stock
Explanation: First, let's calculate the "cost" of cash, debt, and stock for the buyer. Cost of Cash = 2.3% * (1 - 20%) = 1.8%. Potential Cost of Debt = 12.5% * (1 - 20%) = 10%. Cost of Stock = Reciprocal of P / E multiple = 1 / ($2.3 billion / $23M) = 1.0%. The seller's "yield" is 1/15, or 6.7%. Based on this information alone, we can see that the Cost of Stock is the least expensive, even cheaper than cash (since the start-up has an exceptionally high P/E multiple). Therefore, answer choice A is eliminated as that would result in the most accretion to EPS. The more stock we use, the more the deal will be accretive to EPS. We also know that issuing debt will be the most expensive form of consideration. We could go through the calculation for answer choice C and D to determine the weighted average costs for each. However, intuitively (and without the use of any math calculations) we can tell that if debt is the MOST expensive form of consideration, then more debt used will always make the deal more dilutive. Furthermore, answer choices C and D use greater amounts of much cheaper forms of consideration (namely, stock and cash). Therefore, via process of elimination we forego calculating the weighted avg. cost for the remaining answer choices and know that answer choice B will be most dilutive to acquirer's EPS, since the Cost of Debt exceeds the Cost of Cash and Cost of Stock here.
Why do many M&A deals fail to produce value for investors and shareholders? a. The buyer overpays, which results in trouble in the future b. There's a cultural mismatch and it's too difficult to integrate both companies c. Realizing the expected synergies proves to be impossible or very difficult d. The original reasoning for the acquisition was completely flawed and made no sense e. All of the above
Explanation: It could be any of these, or any combination of these. Acquisitions happen for irrational reasons all the time, and most M&A deals do not actually work out as intended. Hindsight is 20/20, and it's very difficult to tell far in advance whether or not everything above will go as intended, or if problems will arise.
Acquirer Co. has a P/E multiple of 15.0x and Target Co. has a P/E multiple of 7.0x. Acquirer Co. is trying to figure out how to pay for the acquisition - cash, stock, or debt. The cash on Acquire Co.'s balance sheet would yield an interest rate of 3%, but if it wanted to raise debt to finance the deal it would have to pay an interest rate of 5.5%. Finally, Acquirer Co.'s marginal tax rate is 38.0%. Assuming that there are no synergies assumed in this transaction (and ignoring all other possible expenses or balance sheet write ups or write downs), which acquisition type will result in EPS accretion for Acquirer Co.? a. 100% Cash b. 100% Debt c. 100% Acquirer Co. Stock d. All of the above
Explanation: Let's calculate all the costs here. Acquirer Cost of Stock = 1 / 15.0 = 6.7%. Acquirer Cost of Cash = 3% * (1 - 38%) = 1.9%. Acquirer Cost of Debt = 3.4%. Seller's "Yield" = 1 / 7.0 = 14.2%. Since that yield is significantly higher than the buyer's Cost of Stock, Cost of Cash, and Cost of Debt, it's clear that no matter how the buyer pays for the seller, this acquisition will be accretive - if you ignore acquisition effects, a possible premium paid for the seller, and so on.
Since using debt to acquire a company is almost always cheaper than using stock, then the more debt an acquirer uses to purchase the target, the less risky the deal becomes. a. True b. False
Explanation: One reason this statement is false is that if an acquirer tries to make a large acquisition, using 100% (or any other high percentage) debt financing can result in a highly over-leveraged combined company, which would drastically increase the credit risk of the combined company post-acquisition. Investment bankers always take note of how the credit rating agencies will view the surviving entity from a credit risk perspective. So while debt may be "cheaper" than stock, it is not necessarily less risky, because unlike stock, debt will increase the chances of bankruptcy and/or extremely high interest payments and principal repayments.
How can you estimate the "cost" of issuing stock and approximate whether a 100% stock deal is accretive or dilutive? a. Since stock does not have an associated interest rate, it's impossible to do this and make a direct comparison b. Compare the P / E multiples of the buyer and seller - if the seller's is lower, it will be accretive c. Flip the P / E multiple of the buyer and compare that to the flipped P / E multiple of the seller - if the seller's flipped multiple is lower, it will be accretive d. You must have more detailed information to make any type of estimate, including the tax rates of the buyer and seller, whether or not there are any one-time charges, and the full list of acquisition effects
Explanation: Technically, yes, D, is true, but consider what the question states: "estimate" and "approximate." We are not looking for a 100% precise number here - just an estimate. A is wrong because although stock does not have an interest rate, the P / E multiple and its reciprocal effectively give you the yield on the stock. C is incorrect because it reverses this relationship - if the seller's flipped multiple is higher, it will be accretive because the buyer is getting a higher "yield" than what its own current yield is. B states it correctly - if the P / E multiple of the seller is lower, its earnings yield (i.e. what you get in earnings for each $1.00 in stock you buy) is higher and therefore it will add to the buyer's EPS if it's a 100% stock deal.
In an acquisition, the Goodwill created will not be amortized but is instead tested for impairment annually, whereas Other Intangible Assets will be amortized, similar to Depreciation on PP&E. a. True b. False
Explanation: The correct answer choice is A. Ever since 2001 Goodwill has ceased to be amortized annually for GAAP / IFRS purposes. Rather, it is tested annually for impairment (i.e. whether or not its value has declined). On the other hand, any Intangible Asset created in an M&A transaction that has a 'definite' life - that is, an asset whose useful life can be approximated - will continue to be amortized annually over its useful life, similar to how PP&E is Depreciated on a straight-line basis until its Book Value is zero.
What type of synergy is taken most seriously in a merger model scenario? a. Expense Synergies b. Revenue Synergies c. CapEx Synergies d. None of the above
Explanation: The correct answer choice is A. Expense synergies are much more concrete a concept than revenue synergies, which are more abstract and uncertain. For example, if the company plans to reduce headcount it is easy to estimate how much money it can save because you multiply the average salary, benefits, and bonus by the number of employees laid off. Revenue synergies are very tricky to estimate because they depend on assumptions about how well cross-selling and up-selling will actually work in a given customer base. CapEx Synergies are also difficult to predict because most companies cannot just "cut" their CapEx spending without negatively impacting growth.
What's the proper method of estimating the "cost" of debt when the buyer uses SOME debt (less than 100%) to acquire the seller in an M&A deal? a. Interest Rate on Debt * % Debt Used * (1 - Buyer's Tax Rate) b. Interest Rate on Debt * (1 - Buyer's Tax Rate) c. Interest Rate on Debt * % Debt Used * (1 - Seller's Tax Rate) d. None of the above
Explanation: A is correct because interest on debt is tax-deductible... but the combined company will use the buyer's tax rate, not the seller's tax rate, since the seller no longer exists after the fact. B is incorrect because we know that it's not a 100% debt deal - so we need to factor in the percentage of debt that is used, and then add the "costs" of cash and/or stock as well to get the total effective cost. D is incorrect because we have enough information in the choices above to calculate the cost of debt.
Stock is "more expensive" than debt and cash in most cases - why might a buyer want to issue stock anyway, and why might a seller want to accept stock? a. If the buyer's stock price is at an all-time low b. If the seller wants to avoid a taxable transaction c. If the buyer wants the seller to share in the upside of possible synergies d. None of the above
Explanation: A is wrong because a buyer (and seller) would be more motivated to do an all-stock deal if the buyer's share price is at a very high-level, meaning that there's less dilution for the buyer and that the seller gets a more valuable "currency." B is correct because all- stock deals are not taxed upon close - the seller would only be taxed when and if it actually sells the shares. C is also correct because if both the buyer and seller own percentages of the combined entity, theoretically they will both be motivated to perform as highly as possible.
Which of the following items below represent the most BASIC acquisition effect as a result of a merger or acquisition? a. Additional interest on debt raised b. Foregone interest on cash used c. Additional shares outstanding from stock issued d. Repayment of the seller's debt
Explanation: A, B, and C all represent basic acquisition effect. Answer choice A represents the additional incremental interest expense paid from debt used to finance the transaction. Answer choice B represents the opportunity cost of foregone interest income earned on cash a company has on its Balance Sheet. Answer choice C represents the dilution that occurs from additional shares being issued by buyer to purchase the selling company. It should be noted there are many acquisition effects, but these 3 represent the most basic effects seen. D is incorrect because while the buyer sometimes repays the seller's debt, that does not happen in all acquisitions and would not be considered a "basic" effect.
What might be a sign that a buyer has overpaid for a seller in an acquisition? a. It pays a 100x revenue multiple for a start-up with almost no revenue and negative profitability b. Goodwill from the acquisition constitutes over 90% of the purchase price c. Two years after the acquisition, the acquirer recognizes a massive Goodwill Impairment charge on its Income Statement d. The acquirer is unable to realize any synergies immediately after the acquisition
Explanation: A, B, and C are all correct. A 100x revenue multiple is exceptionally high in any industry, and often indicates an acquisition based purely on hype rather than financial metrics. B is also correct because if Goodwill represents over 90% of the purchase price, the company did not have much in hard assets that were worth a significant amount. And C is also correct and represents a very common scenario in tech deals where the buyer has greatly overpaid for the seller and realizes that it's not worth as much after the fact. D is not correct because being unable to realize synergies is not necessarily a sign that the buyer has paid too much - it is very difficult to realize synergies in almost all cases.
Acquirer Co. pays $100 million for Target Co. with 100% stock. When the deal closes, the market decides that Target Co. was only worth $33 million. Which of the statements below are TRUE? a. Acquirer Co.'s share price will fall by whatever per-share dollar amount corresponds to the $67 million loss b. Acquirer Co.'s stock price would drop by exactly 67% per share, corresponding to the percentage value lost c. All the shareholders, in aggregate, would lose $67 million on the deal d. Acquirer Co. and Target Co. shareholders could have protected themselves by using a fixed / floating exchange ratio as part of the deal
Explanation: A, C, and D are all correct. The buyer paid $100 million to purchase the seller, and issued stock for 100% of the purchase price. After the deal closes the market as a whole feels the true value of seller was only $33 million; thus the buyer overpaid by $67 million. As a result, the buyer's stock price would fall in value to reflect that it overpaid by $67 million total. HOWEVER, the buyer's share price won't necessarily fall by 67% because of all its existing shares outstanding. Let's say the buyer is worth $1 billion and has 100 million shares outstanding at $10 each, so it issues 10 million shares to acquire the seller. If its share price fell by 67%, the entire company would now only be worth $363 million rather than $1.1 billion, which would never happen. Instead, the combined company should be worth $1.033 billion, and the share price would only fall to $9.39. Answer choice C is true because, in aggregate, all shareholders will lose a total of $67 million; it's important to note that this $67 million loss does NOT accrue just to the Target Co.'s shareholders, but rather to the entire company now because the new company's share price has dropped, which affects ALL shares issued. Answer choice D is true too and represents the very reason why public-to-public M&A deals paid for with stock usually employ fixed (or floating) exchange ratios to protect the final value received (paid) by selling (buying) shareholders.
Which of the following points represent "financial motivation" for buying another company? a. The buyer has run the numbers and determined that the seller represents a potential 18% IRR over 5-years, which exceeds its own cost of capital b. By acquiring the seller, the buyer could own 60% of the market and become the dominant player - and might be valued at a premium as a result c. The seller has renowned or "famous" executives and the buyer thinks it business will become more valuable by "acquiring" these employees d. The seller is dominant in Europe and the buyer wants to gain a foothold into that market e. The seller's stock is currently trading at $20.00 per share, but the buyer has valued the seller and believes it's actually worth $30.00 per share
Explanation: All of the answer choices, with the exception of C, represent financial reasons for a M&A transaction. Every business decision boils down to an acceptable ROI to shareholders, even business acquisitions, thus making answer choice A correct. In very mature and predictable industries, a key player may acquire a competitor so as to consolidate a 'fragmented industry' to gain market share and increase shareholder value; these 'consolidation' plays also constitute financial reasons for M&A. Geography also plays a key financial reason for M&A; perhaps a foreign competitor wants to gain entrance to USA market and does so via acquisition of a US company in the same industry. And finally, acquisitions often happen when a seller is perceived to be undervalued. However, acquisitions based on acquiring key employees or because of intellectual property are not 'financial' reasons for M&A in the strict sense of the word but rather fall into the category of 'fuzzy' reasons for M&A deals.
Which of the following examples below represent 'expense synergies' in an M&A deal? a. Up-selling existing products to new customers b. Cross-selling complementary products to existing customers c. Reduction in force d. Building consolidation e. None of the above
Explanation: Both answer choices A and B represent revenue synergies, which are distinctly different from expense synergies (with the latter taken more seriously in practice). Answer choice C is a very standard expense synergy - when one company buys another and there is always overlap in headcount, so the combined company no longer needs as many employees. Building consolidations is applicable when both the acquirer and target own or lease properties in the same city. In this case all employees of both companies can be centralized in one central office space to save on rent or property taxes.
Let's continue with this example. Which of the following acquisition effects would most likely result in the acquisition being EPS-dilutive, or at least having greatly reduced EPS accretion? a. Paying a high premium for the seller b. Paying a high price over the seller's Book Value, resulting in a high Other Intangible Assets balance and high Amortization number c. Revenue synergies not being realized properly d. Expense synergies being realized at 150% rather than 100%
Explanation: D is completely wrong because expense synergies always boost accretion. C is also wrong because revenue synergies have not been factored in at all to begin with - so if they're not realized, it doesn't affect anything. A is almost correct in that if you pay a high premium, yes, it's more likely to be dilutive... but what actually matters more in most cases is the premium and total price the buyer pays over the Book Value of the seller. That not only results in higher expenses for the buyer, but also in a potentially very high number for Amortization of Intangibles, especially for companies in intellectual property-driven industries like technology and biotech / healthcare.
What's the MAIN risk in using 100% stock to acquire a company in an M&A deal? a. There may be adverse tax consequences for the seller b. The buyer may not want to dilute existing shareholders and may face opposition from them c. The buyer's share price may fluctuate between deal announcement and close, resulting in a very different effective price d. The buyer may not be able to issue enough stock to finance the transaction
Explanation: Exactly what is stated. A is wrong because 100% stock deals are not taxed until someone actually sells the stock, so there are no "adverse tax consequences." B is true, but it's not the main risk - it is a risk for the buyer but it's less of a risk for the seller. C represents a risk to both parties, because it could result in the deal falling through for the buyer, and result in the seller being very unhappy / cancelling the deal depending on the share price movement. D is a possible risk, but it's less of a threat than either B or C - not being able to finance the deal is more of a concern if there is debt involved.
A buyer currently has a market cap (Equity Value) of $1 billion, with $100M in cash $100M of existing debt, and $200M in EBITDA and $100M in Net Income. Its cash interest rate is 1%, its interest rate on debt is 8%, and its tax rate is 40%. It is considering acquiring a seller that is worth $500 million (Equity Value) and has a P / E of 20x. What financing structure should the buyer use? a. 100% stock ($500 million of stock), since its cash is minimal and it cannot afford to raise more debt b. 100% debt ($500 million of debt), since its cash is minimal and stock would make this too dilutive c. 10% cash ($50 million of cash) and 90% debt ($450 million of debt) since it can easily afford to raise more debt, but should maximize cash usage first d. 20% cash ($100 million of cash) and 80% debt ($400 million of debt) since it can easily afford to raise more debt, but should maximize cash usage first
Explanation: First, let's calculate the "cost" of cash, debt, and stock for the buyer. Cost of Cash = 1% * (1 - 40%) = 0.6%, so clearly that's the cheapest. Cost of Debt = 8%* (1 - 40%) = 4.8%. Cost of Stock = Reciprocal of P / E multiple = 1 / ($1 billion / $100M) = 10.0%. The seller's "yield" is 1/20, or 5%. So it looks like anything with 100% cash and 100% debt will be accretive here, and 100% stock will make it more and more dilutive. So A is clearly wrong - we want to use as little stock as possible, especially since the company can likely afford to use some cash and raise some debt. B is wrong because cash is still cheaper to use than debt, and we can likely afford to use some of that cash balance. That leaves us with C and D. D is wrong because you can never use 100% of the company's cash in an M&A deal - it always needs some minimal amount on its Balance Sheet to continue operating and paying employees. So C is the best answer - use as much cash as possible since it's cheapest, and then use as much debt as possible. At this level, the company's leverage ratio, ignoring the seller's EBITDA, would be 2.75x ($550 million of debt / $200 million in EBITDA), which is very reasonable and not so high that it poses a serious risk to the combined company.
Acquirer Co. has a P/E multiple of 25.0x and Target Co. has a P/E multiple of 12.0x. Acquire Co.'s cash interest rate is 3.5%, its debt interest rate is 8.3%, and its tax rate is 40.0%. Ignoring synergies, premiums, and acquisition effects, a 33% cash / 33% stock / 33% debt transaction results in: a. EPS accretion for Acquirer Co. b. EPS dilution for Acquirer Co. c. EPS neutral for Acquirer Co. d. Not enough information to know
Explanation: The correct answer choice is A. Let's calculate all the costs here. Acquirer Cost of Stock = 1 / 25.0 = 4.0%. Acquirer after-tax Cost of Cash = 3.5% * (1 - 40%) = 2.1%. Acquirer after-tax Cost of Debt = 8.3% * (1 - 40%) = 4.9%. Seller's "Yield" = 1 / 12.0 = 8.3%. Next, we need to take the weighted average of the cost of cash, stock, and debt, with those weights being 1/3 = 33% each. The weighted average expense = (33% * 4.0%) + (33% * 2.1%) + (33% * 4.9%) = 3.6%. Since the weighted average cost of acquisition is significantly lower than the seller's yield, it's clear that this acquisition deal structure will be accretive - if you ignore acquisition effects, a possible premium paid for the seller, and so on. In real life, it is much harder to apply this rule because buyers almost always pay significant premiums to acquire sellers, and because you can't just "ignore" acquisition effects and synergies.
Acquirer Co. has $7,000 in Assets, $3,000 in Liabilities, and $4,000 in Shareholder's Equity. Target Co. has $1,000 in Assets, $500 in Liabilities, and $500 in Shareholder's Equity. Acquirer Co. pays $700 to buy the target, using 100% cash. How much Goodwill will be created in this acquisition? a. $300 b. $100 c. $200 d. $250
Explanation: The correct answer choice is C. The easiest way to explain this question is to walk through the combination of the two balance sheets. On the Liabilities side, the combined company will have a total balance of $3,500. The combined company's Shareholder's Equity will be $4,000 (note: we completely wipe out the Target Co. balance). This means that our combined Liabilities & Shareholder's Equity balance is $7,500. Now on the Asset side, we add together Acquirer Co. and Target Co. balances, which equal $8,000. However, we must remember to subtract out $700 from total Assets, as we used that amount in cash to acquire the target. Therefore, our combined Assets balance is $7,300. Our combined Assets do NOT equal Liabilities & Shareholder's Equity. The difference is $200, which we create on the pro-forma Balance Sheet and call Goodwill. In other words, we paid $700 for Target Co., which had a Book Value of $500, so we create $200 in Goodwill to represent the premium we paid over the company's Book Value.
All of the following represent "non-financial reasons" to buy another company EXCEPT: a. For Acquirer Co. to up-sell and cross-sell its existing products to Target Co.'s customer base b. Target Co. is growing exponentially and represents a very real threat to Acquirer Co. within the next few years if it continues at this pace c. Target Co. has an experienced management team that is deemed the best in the entire industry d. Target Co. is undervalued by 30% based on a recent decline in its share price
Explanation: The correct answer choice is D. A, B, and C all represent non-financial reasons to do a deal, because they are based on speculation and future possibilities rather than concrete numbers. If choice A involved actual cost savings numbers (i.e. cost synergies), it would be closer to a real financial reason. Buying a company because its market price is undervalued constitutes a financial reason for M&A as opposed to a "fuzzy reason" and is the only correct answer choice.
All of the following represent potential acquisition effects that take place after a deal closes EXCEPT: a. Additional interest on debt b. Creation of Goodwill and Intangible Assets c. Foregone interest on cash d. Additional shares outstanding e. False and misleading question - these are all potential acquisition effects
Explanation: The correct answer choice is E. Depending on how the transaction is structured, each of the above effects typically take place in M&A deals. Answer choice A is relevant when part of the deal is financed via issuing debt, which the incremental interest effects being reflected in the accretion / dilution analysis. Answer choice B is relevant regardless of how the deal is financed so long as the purchase price is above the net identifiable assets of the seller. Answer choice C is relevant when using cash on the balance sheet to finance and acquisition, and answer choice D is relevant when Acquirer Co. issues its own stock to finance part (or all) of the acquisition of Target Co. shares.
How can you determine the appropriate amount of debt that can be used in a potential M&A deal? a. Look at "Debt Comps" and see the debt used in similar recent transactions b. Use the median Debt / EBITDA ratio from the Comparable Company or Precedent Transaction group c. Debt is cheaper than equity, so it's always best to use the maximum amount of Debt that the combined company can repay d. None of the above
Explanation: The correct answer choices are A and B. Usually when advising on an M&A transaction, you utilize debt comps for recent, similar deals to see what types of debt and how many tranches have been used. One financial metric used to measure debt capacity is Debt/EBITDA, which is referred to sometimes as the 'leverage ratio'. Once again you can refer to Public Trading comps or Precedent Transaction comps to find the median leverage ratio for the peer group and multiple that ratio by your company's EBITDA to calculate how much debt the acquirer can take on in a hypothetical transaction. Answer choice C is incorrect - yes, debt is less expensive than equity, but that dynamic changes based on what the total capitalization of the acquiring company is. In other words, maximizing debt without discretion results in lowered credit ratings, worse credit statistics, and the increased possibility of bankruptcy.
For which of the following reasons below might an acquirer decide to purchase another company? a. The acquisition represents a good potential Internal Rate of Return (IRR) and Return on Investment (ROI) b. To acquire a high-growth company to accelerate the buyer's growth rate c. To increase the buyer's Earnings Per Share (EPS), which may result in a higher stock price for the buyer d. Because of office politics, ego, and the need for management or executives to "prove" themselves or one-up their rivals in the company
Explanation: There are many reasons why an acquirer may purchase another company - some good and others bad. They can even be broken down as either financial reasons or more 'fuzzy' reasons. However, the main idea behind an acquisition of another company is always to earn a satisfactory ROI or IRR to enhance shareholder value, which is what answer choice A refers to. Sometimes a mature company may acquire a very young fast growing competitor so as to accelerate its own slower rate of growth, which is what answer choice B refers to. C refers to the main variable you're solving for in a merger model - whether or not EPS will go up or down, and how companies are always motivated to increase their EPS. And while D may sound ridiculous, office politics, ego, and pride motivate a lot of M&A deals (usually these do not end well).
If an M&A deal will be dilutive to the acquirer's EPS, it will destroy shareholder value and should always be avoided. a. True b. False
Explanation: While it is true that Acquirer Co.'s senior management will always prefer transactions that are accretive to EPS, many successful transactions may be dilutive to EPS for the fist few fiscal quarters before they turn accretive to EPS. Also, even if the acquisition is dilutive to EPS, there may be other reasons for doing it - maybe it's a defensive play to prevent a competitor from acquiring the company, or maybe the company has an asset that the acquirer really needs. So it's not as simple as just saying, "If it's dilutive, don't do the deal."