06. M&A Flashcards
Walk me through an accretion/dilution analysis.
An accretion/dilution analysis (sometimes also referred to as a quick-and-dirty merger analysis) analyzes the impact of an acquisition on the acquirer’s EPS on a standalone basis. Essentially, it is comparing the pro-forma EPS (the “new” EPS assuming the acquisition occurs) against the acquirer’s stand-alone EPS (the “old” EPS of the status quo).
(1) Aggregate the projected net income for the two companies
(2) Plus: pre-tax synergies
(3) Less: interest expense on incremental debt and/or lost interest income from cash used
(4) Less: incremental D&A on write-up of book value
(5) Plus: tax benefits from merger adjustments
(6) Divide the resulting pro forma earnings number by the pro forma fully diluted shares outstanding to arrive at fully diluted pro forma EPS
(7) Calculate the change from pre-deal to post-deal EPS or the accretion/(dilution) percentage
- Note that the pro-forma share count reflects the acquirer’s share count plus the number of shares to be issued to finance the purchase (in a stock deal)
- Note that in an all-cash deal, the share count will not change
- Note that usually, this analysis looks at the EPS impact over the next two years
If you merge two companies, what does the pro-forma income statement look like? Discuss whether you can just add each line item for the proforma company. Please start from the top.
Revenues and operational expenses can be added together, plus any synergies. Fixed costs tend to have more potential synergies than variable costs. Selling, general and administrative (“SG&A”) expense is another source of synergy, as you only need one management to lead the two merged companies. D&A will increase more than the sum due to financing fees and assets being written up. This brings you to operating income. Any changes in cash will affect your interest income. Interest expense will change based on the new capital structure. New or refinanced debt will change pro-forma interest expense. For rolled over debt, since your cash flows will change, your debt paydown may alter, which also affects interest. Based on all the changes previously, this will obviously cause taxes to differ so you cannot just add the two old tax amounts. Also, if any NOLs are gained, those may offset the new combined taxable income. To summarize, nothing can be simply added together. If you have done EPS accretion/dilution analysis, you can mentally work your way through that to formulate your answer.
What is a merger model?
A merger model is used to analyze the financial profiles of two companies, the purchase price and how the purchase is made. It is also used to determine whether they buyer’s pro-forma EPS increases or decreases.
What is a stock swap?
Acquired company agrees to be paid in stock of the new combined company (instead of cash) because it believes in the potential success of the merger.
A stock swap is more likely to occur when the stock market is performing well and the stock price of the acquiring firm is relatively high, giving them something of high value to purchase the target with
Are most mergers stock swaps or cash transactions? Why?
In strong markets, most mergers are stock swaps mainly because the prices of companies are so high and the current owners will most likely desire stock in the new company, anticipating growth in the strong markets.
Which method would a company prefer to use when acquiring another company: cash, stock or debt?
Assuming the buyer has unlimited resources, it would always prefer cash because:
(1) Cash is “cheaper” because interest rates on cash are usually less than 5% (i.e. foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt)
(2) Cash is less risky – no chance that buyer might fail to raise sufficient funds
(3) Stock is usually most expensive and most risky because price fluctuates
What is a merger?
A merger is the combination of two companies, generally by offering the stockholders of Company B securities in Company A in exchange for the surrender of their stock.
What is an acquisition?
An acquisition is a corporate action in which a company purchases most, if not all, of the target company’s ownership stakes in order to assume control of the target company.
It is often more beneficial to acquire than to expand its own operations. Acquisitions are often paid for in cash and/or the acquiring company’s stock
What factors can lead to the dilution of EPS in an acquisition?
A number of factors can cause an acquisition to be dilutive to the acquirer’s EPS, including:
(1) target has negative net income
(2) target’s PE ratio is greater than the acquirer’s
(3) transaction creates a significant amount of intangible assets that must be amortized going forward
(4) increased interest expense due to new debt used to finance the transaction
(5) decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction
(6) low or negative synergies.
If a company with a low P/E acquires a company with a high P/E in an all stock deal, will the deal likely be accretive or dilutive?
Other things being equal, if the Price to Earnings ratio (P/E) of the acquiring company is lower than the P/E of the target, then the deal will be dilutive to the acquiror’s Earnings Per Share (EPS). This is because the acquiror has to pay more for each dollar of earnings than the market values its own earnings. Hence, the acquiror will have to issue proportionally more shares in the transaction. Mechanically, proforma earnings, which equals the acquiror’s earnings plus the target’s earnings (the numerator in EPS) will increase less than the proforma share count (the denominator), causing EPS to decline.
What is goodwill and how is it calculated?
Goodwill, a type of intangible asset on the balance sheet, is created in an acquisition and reflects the value (from an accounting standpoint) of a company that is not attributed to its other assets and liabilities.
Goodwill is calculated by subtracting the target’s book value (written up to fair market value) from the equity purchase price paid for the company. In other words, goodwill represents the excess of purchase price over the fair value of the target company’s net identifiable assets.
Excess Purchase Price = Purchase Price – FV of Target’s Net Identifiable Assets
Goodwill has an indefinite life and is therefore not amortized each year. However, it must be tested once per year for impairment. Absent impairment, goodwill can remain on a company’s balance sheet indefinitely.
What are the three types of mergers and what are the benefits of each?
(1) Horizontal – merger with competitor and will ideally result in synergies
(2) Vertical – merger with supplier or distributor and will likely result in cost cutting
(3) Conglomerate – merger with company in a completely unrelated business and it is most likely done for market or product expansions, or to diversify its product platform and reduce risk exposure
What major factors drive mergers and acquisitions?
There are a variety of reasons, including:
(1) Depressed valuations
(2) Synergies (e.g. overhead, management, eliminate inefficiencies)
(3) Larger company is more industry defensible (more resilient to downturns or more formidable competitor)
(4) Buyer’s organic growth has slowed or stalled and needs to grow in other ways in order to satisfy Wall Street expectations
(5) Deploy excess cash
(6) CEO of the acquirer wants to be CEO of a larger company, either because of ego, legacy or because he/she will get paid more.
(7) New market presence or new product offering
(8) Consolidate industry
(9) Brand recognition
(10) Acquire certain PPE or intangibles
(11) Financial motives: large NOLs, LBO opportunity, lower cost of capital, debt tax shield, break-up opportunity
What are a few reasons why two companies would not want to merge?
(1) Operational: synergies that the acquirer hopes to gain may be difficult to realize
(2) Cultural: integration risk with clash of management egos and different cultures
(3) Financial: investment banking fees associated with completing merger can be prohibitively high; dilutive effects if overpaid or synergies not realized
Explain the concept of synergies and provide some examples.
In simple terms, synergy occurs when 2 + 2 = 5. That is, when the sum of the value and performance of the Buyer and the Target as a combined company is greater than the two companies on a standalone basis. In other words, the combined company is expected to generate higher EPS. Most mergers and large acquisitions are justified by the amount of projected synergies.
There are two categories of synergies: cost synergies and revenue synergies.
(1) Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations (e.g. closing one corporate headquarters, laying off one set of management, shutting redundant stores, etc)
(2) Revenue synergies refer to the ability to sell more products/services (because of co-branding and cross-marketing) or raise prices (because of decreased competition)
*Note that the concept of economies of scale can apply to both cost and revenue synergies
In practice, synergies are “easier said than done.” While cost synergies are difficult to achieve, revenue synergies are even harder. The implication is that many mergers fail to live up to expectations and wind up destroying shareholder value rather than create it.
How do you calculate fully diluted shares?
In order to hypothetically calculate the number of fully diluted shares outstanding, we add the basic number of shares (found on the cover of a company’s most recent 10Q or 10K) and the dilutive effect of employee stock options (found in the notes of the company’s latest 10K). To calculate the dilutive effect of options we typically use the Treasury Stock Method.
Under the TSM, we assume that all in-the-money options (i.e. strike price < current stock price or purchase price), warrants, convertible preferred stock and convertible debt are exercised and that the proceeds from such conversion are used to buy back shares.
Fully Diluted Shares equals the number of basic shares outstanding plus the number of exercisable options (new shares issued) minus the number of shares repurchased using the proceeds from the options that were exercised.
Fully Diluted Shares = Basic Shares Outstanding + In-the-Money Options – ∑[(In-the-Money Options * Weighted Average Exercise Price) / Current Stock Price]
- Note: If our calculation will be used for a control based valuation methodology (i.e. precedent transactions) or M&A analysis, use all of the options outstanding.
- Note: If our calculation is for a minority interest based valuation methodology (i.e. comparable companies) we will use only options exercisable.
- Note that options exercisable are options that have vested while options outstanding takes into account both options that have vested and that have not yet vested.
- Note: If the exercise price of an option is greater than the share price (or purchase price) then the options are out-of-the-money and have no dilutive effect.
What is the concept underlying the Treasury Stock Method?
When employees exercise options, the company has to issue the appropriate number of new shares but also receives the exercise price of the options in cash. Implicitly, the company can “use” this cash to offset the cost of issuing new shares. This is why the diluted effect of exercising one option is not one full share of dilution, but a fraction of a share equal to what the company does NOT receive in cash divided by the share price.
What is the difference between shares outstanding and fully diluted shares?
Shares outstanding represent the actual number of shares of common stock that have been issued as of the current date.
Fully diluted shares are the number of shares that would be outstanding if all of the in-the-money options and warrants were exercised with proceeds used to repurchase stock
What are the complete effects of an acquisition?
(1) Combined financial statements and possible synergies
(2) Additional interest expense if debt is used
(3) Foregone interest if debt is used
(4) Additional shares outstanding if stock is used
(5) Creation of goodwill
(6) Other intangibles – IPR&D (require additional expense) and deferred revenue write-off (avoid double counting)
You are advising a client on the potential sale of the company. Who would you expect to pay more for the company: a competitor or a LBO fund?
The competitor would likely pay more because it is a strategic buyer and is thus willing to pay more due to expected synergies. The strategic buyer is more likely to derive additional benefits (synergies) and therefore higher cash flows from the purchase than would a LBO fund, which is traditionally a financial buyer.
How is new goodwill calculated?
(1) Start with Purchase of equity
(2) Add advisory fees
(3) Add existing goodwill
(4) Subtract book value
(5) Subtract the PP&E step-up
(6) Subtract the newly identified intangibles
(7) Add the deferred tax liability from the step up
