M&A

Question 1

In an all-stock transaction, a company with a lower P/E is buying a company with a higher P/E. What is the effect of this transaction? What happens if you use debt/cash to make part of the above transaction? Why?

Answer 1

The point of this question is to get you to say whether the acquisition is accretive or dilutive.

Generally, companies do not want dilutive acquisitions since they destroy shareholder value.

The combined company’s ratio will have a higher P/E than the acquirer originally did (but lower than the seller, obviously). However, since more shares will have to be issued by the lower P/E company (than would have been needed if the acquirer had a higher P/E ratio), the combined company will have a lower EPS (dilutive acquisition). Typically, the company with the higher growth rate and growth potential commands a higher P/E . The opposite is true for companies with lower P/E ratios. If you throw in debt/cash, fewer shares will be needed for the acquisition, thus the transaction will be less dilutive, and potentially accretive.

Question 2

What is the role of an associate process in a sell-side M&A? (Especially important at Goldman)

Answer 2

1) Bake-Off

2) Preparation
Associates = reviewing financial statements, projections, underlying assumptions, other areas of risk, build sensitivity models, and identify key issues and discrepancies

3) Identifying the Buyer Universe
Associates = helping find potential buyers within a space, marketing materials (teaser, information memorandum, decks for management presentations)

4) Launch
Associates = Data room prep & management

5) Diligence
Associates = manning diligence meetings and calls, identifying areas of information gaps, working with the company to address all buyer questions. Usually the junior bankers are the first line of defense when detailed diligence lists come in so as not to overwhelm the client

6) Bids
Associates = analyzing as they come in, especially if not apples-to-apples comparison (deal funding composition)

7) Evaluation & Signing

8) Closing

Question 3

What is the associate’s role in the process of a buy-side M&A?

Answer 3

1) M&A strategy = complements corporate strategy quantitatively and qualitatively

2) Target Screening
Associates = identify acquisition candidates based on specific criteria to achieve strategy

3) Due Diligence
Associates = valuation, operational synergies, value creation

4) Integration Pre-close
Associates = anticipate integration risks, pre-deal rationale

5) Close

Question 4

If an M&A deal is EPS dilutive is that always a bad thing, and if it isn’t how can you qualitatively and quantitatively explain it?

Answer 4

If the deal has strategic value, it can potentially lead to a sufficient increase in EPS in later years.

Quantitatively you can say a deal will allow for cost and revenue synergies that will long-term increase in Net Income which will in turn increase EPS.

Question 5

Share Price: $100 EPS: $8 what is the P/E?

Answer 5

P/E = price per share / earnings per share

P/E = 100 / 8 = 12.5

Question 6

What are the 5 basic acquisition effects?

Answer 6

1) Foregone Interest on Cash = loses the interest if it had kept the cash it used for acquisition. Reduces Pre-Tax Income, Net Income, EPS

2) Additional Interest on Debt = pays additional interest expense for debt used in acquisition. Reduces Pre-Tax Income, Net Income, EPS.

3) Additional Shares Outstanding = buyer paying with stock increases outstanding share count, reduces EPS.

4) Combined Financial Statements = seller’s financial statements are added to buyer’s.

5) Creation of Goodwill & Other Intangible Assets = represent the premium buyer paid over seller’s Shareholder’s Equity, required to ensure BS balances

Question 7

What is the shortcut for determining Accretion/Dilution for all deals via costs? What are the problems with this shortcut?

Answer 7

BUYER
* CostCash = (Foregone Interest on Cash)(1-Buyer Tax Rate)
* CostDebt = (Interest on New Debt)(1-Buyer Tax Rate)
* CostStock = E/P = (Net Income) / (Equity Value)

SELLER
* Seller’s Yield = E/P at purchase price

SHORTCUT
Buyer Cost = weighted average of transaction components

Buyer Cost > Seller Yield DILUTIVE

Buyer Cost < Seller Yield
ACCRETIVE

PROBLEMS
1) assumes buyer/seller have same tax rates
2) doesn’t account for other acquisition effects = synergies, D&A
3) doesn’t account for premium paid for the seller UNLESS the Seller’s Yield is calculated at Purchase Price
4) no transaction fees/synergies

Question 8

Beyond the 5 basic acquisition effects, what are more advanced acquisition effects?

Answer 8

6) PP&E and Fixed Asset Write-Ups = writing up under the assumption that market values exceed book values

7) Deferred Tax Liabilities - normally you write off seller’s existing DTL and create new ones based on (Buyer’s Tax Rate)(PP&E/Fixed Asset Write-Ups + Newly Created Intangibles)

8) Deferred Tax Assets - usually write seller’s DTA off completely, depending on tax situation

9) Transaction & Financing Fees = expense legal & advisory fees (deduct from Cash/RE at time of transaction) & capitalize financing fees

10) Inter-Company Accounts Receivable & Accounts Payable - eliminate this if they companies owed each other money before the merger

11) Deferred Revenue write down - you can only recognize the profit portion, and need to write down the expense portion

Question 9

Most M&A deals fail. Why is that?

Answer 9

Possible reasons
1) Buyer Overpays for Seller = enormous Goodwill & Other Intangible Assets created, and then massive write-downs when buyer re-asses what seller is really worth

2) Poor Rationale = original reason the acquisition made sense no longer holds up

3) Synergy Failures = buyer acquired seller to access customer base, only to find customer doesn’t want products

4) Integration Difficulties = integrating separate employee bases, supply chains, retail networks

5) Cultural Differences = issues with employees working together successfully

Question 10

Why would a company want to acquire another company?

Answer 10

For a good ROI (return on investment) either literally or higher EPS, which appeals to shareholders.

Reasons
1) gain market share
2) grow more quickly
3) seller is undervalued
4) seller’s customers
5) critical technology/IP
6) synergies

One company might want to buy another company if it believes it will be better off after the acquisition takes place. For example:
* The Seller’s asking price is less than its Implied Value, i.e., the Present Value of its future cash flows.
* The expected IRR from the acquisition exceeds the Buyer’s Discount Rate.
Buyers often acquire Sellers to save money via consolidation and economies of scale, to expand geographically or gain market share, to acquire new customers or distribution channels, and to expand their products and services.

Synergies, or the potential to combine and reduce expenses through departmental consolidation or to boost revenue through additional sales, also explain many deals.

Deals may also be motivated by competition, office politics, and ego.

Question 11

Walk me through a basic merger model

Answer 11

A merger model is used to analyze the financial profiles of 2 companies, the purchase price, how the purchase is made = determine if buyer EPS increases or decreases afterward.

1) make assumptions about M&A = price, components cash/debt/stock

2) determine valuations & shares outstanding of buyer/seller & project IS for each

3) combine both IS - add line items like Revenue/OpEx, adjust Foregone Interest on Cash, Interest on Debt on Pre-tax Income. Add potential revenue synergies to combined revenue, subtract cost & expense synergies from COGS and operating expenses. Apply Buyer’s tax rate to get Combined Net Income, then divide by buyer’s shares outstanding for new EPS.

4) option = goodwill, combining BS, but better to start simple.

Question 12

What’s the difference between a merger and acquisition?

Answer 12

The relative sizes of the buyer and seller.

If the buyer and seller are approximately the same size = Merger

If buyer > seller by revenue or market cap (2-3x) = Acquisition

100% stock transactions more common in mergers bc similarly sized companies rarely have enough cash to buy each other, and can’t usually raise enough debt either.

Question 13

Why would an acquisition be dilutive?

Answer 13

If the additional Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest expense, effect of issuing shares, or acquisition effects like amortization of Other Intangible Assets.

Question 14

The buyer’s P/E multiple is 8x, seller’s P/E multiple is 10x. The buyer’s interest rate on cash is 4%, interest rate on debt is 8%. The buyer is paying for the seller with 20% cash, 20% debt, and 60% stock. The buyer’s tax rate is 40%.

Answer 14

Buyer
CostCash = (0.04)(1-0.4)
= (0.04)(0.6) = 0.024
CostDebt = (0.08)(0.6) = 0.048
CostStock = 1/8 = 0.125
Weighted Buyer Cost = 0.2(0.024) + 0.2(0.048) + (0.6)0.125
= 8.9%

Seller
Yield = 1/10 = 0.1

Accretive

Question 15

A company with a higher P/E acquires a company with a lower P/E. Is this deal accretive or dilutive?

Answer 15

Trick question.

You can’t know unless you know it’s an all stock deal. If it’s an all cash or debt deal, the P/E multiple doesn’t matter because no stock is being issued.

If it is an all-stock deal, then the deal will be accretive since the buyer “gets” more earnings for each $1 used to acquire a company than it does from its own operations. The opposite applies if buyer’s P/E < seller’s P/E

Example:

P/E = Equity Value / Net Income

Buyer P/E = 10x
Seller P/E = 8x

Buyer = for each $1 you pay in value, earnings increases by $0.1 (1/10)

Seller = for each $1 you pay in value, earnings increases by $0.125 (1/8)

Question 16

Why do we focus so much on accretion/dilution? Are there cases where it’s not relevant?

Answer 16

EPS is important bc institutional investors value it and base many decisions on EPS and P/E multiples.

A merger model has many purchases besides just calculating EPS accretion / dilution
1) calculate the IRR of an acquisition if you assume that the acquired company is resold in the future, or generates cash flows indefinitely
2) see changes in the combined financial statements

Question 17

How do you determine Purchase Price for the target company in an acquisition?

Answer 17

You use the same Valuation methodologies = Comparable Companies, Precedent Transactions, DCF.

If the seller is a public company, you pay more attention to the premium paid over the current share price to make sure it’s “sufficient” (generally in the 15-30% range) to win shareholder approval.

For private sellers, more weight is placed on the traditional methodologies.

Question 18

All else being equal, which method would a company prefer to use when acquiring another company - cash, stock, or debt?

Answer 18

Cash

1) Cost
- cheaper than debt (foregone interest on cash = under 5%, debt almost always higher additional expense)
- cheaper than stock (most companies P/E range is 10-20x, 5-10% cost of stock)

2) Risk
- cash < risk than debt = no change buyer might fail to raise sufficient funds, or default
- cash < risk than stock = buyer’s share price could change dramatically after deal announced

Question 19

Are there cases where cash is actually more expensive than stock?

Answer 19

With debt this is impossible = why would a bank pay more on cash deposited than debt it’s issued? Goes against the primary moneymaking.

With stock almost impossible = if the buyer has extremely high P/E multiple (100x), the reciprocal might create a Cost of Stock < Cost of Cash. Extremely rare.

Question 20

If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?

Answer 20

1) saving cash for something else
2) concerned about running low on cash if things take a turn
3) stock might be trading at a high and they want to take advantage of lower Cost of Stock

Question 21

How much debt should a company issue in a merger or acquisition?

Answer 21

Comparable Companies and Precedent Transactions to determine this. Use the combined company’s EBITDA figure, find median Debt/EBITDA ratio of companies or deals, and apply that to company’s own EBITDA figure to get a rough idea of how much debt to raise.

Could also look at “Debt Comps” for similar, recent deals and see what types of debt and how many tranches they have used.

Question 22

When would a company be MOST likely to issue stock to acquire another company?

Answer 22

1) Buyer’s stock is trading at an all time high = cheaper cost of stock
2) seller is close in size to buyer, it’s impossible to raise enough cash to acquire the seller otherwise

Question 23

Let’s say a buyer doesn’t have enough cash available to acquire the seller. How could it decide between raising debt, issuing stock, or some combo of those?

Answer 23

No simple rule.

Key factors
1) relative cost of debt and stock = interest rate vs E/P
2) Existing Debt = high current debt balance, can’t raise more debt
3) shareholder dilution = shareholders don’t like dilution, companies try to minimize this
4) expansion plans = if the buyer expands, begins huge R&D effort, or buys factory in the future, it’s less likely to use cash and/or debt and more likely to issue stock so it has available funds

Question 24

Let’s say that Company A buys Company B using 100% debt. Company B has a P/E multiple of 10x and Company A has a P/E multiple of 15x. What interest rate on the debt will make the deal accretive?

Answer 24

Buyer
Cost of debt = interest rate(1-buyer tax rate)

Seller
Yield = E/P = 1/10 = 0.1

after tax Cost of Debt < 0.1 will make the deal accretive

0.1 = x(0.8)
x = 12.5%
Any interest rate on Debt less than 12.5% is accretive, anything above is dilutive

Question 25

Part 1) Company A has a P/E of 10x, which is higher than P/E of Company B. The interest rate on debt is 5%. If Company A acquires Company B and they both have 40% tax rates, should Company A use debt or stock for the most accretion?

Answer 25

PART 1

Buyer = A
CostDebt = 0.05(1-0.4)
= 0.05(0.6) = 0.03
CostStock = 1/10 = 0.1

Seller = B
Lower P/E = 8x example
Yield = 1/8 = 0.125

Both deals will be accretive, but the Debt 100% deal will be more accretive because its cost is lower than the cost of Stock.

Question 26

Company A
- TEV 100
- Market Cap 80
- EBITDA 10
- Net Income 4
- Debt 60
- Cash 40

Company B
- TEV 40
- Market Cap 40
- EBITDA 8
- Net Income 2
- Cash 30
- Debt 30

Part 1) What are the TEV/EBITDA multiples for each?

Part 2) Company A decides to acquire Company B using 100% cash. What are the combined EBITDA and P/E multiples?

Part 3) Company A instead uses 100% debt, at 10% interest rate and 25% tax rate, to acquire Company B. What are the combined multiples?

Answer 26

TBD need this explained

PART 1
Company A
TEV / EBITDA = 100/10 = 10x

Company B
TEV / EBITDA = 40/8 = 5x

Combined Multiples
- Add Market Caps
- Adjust for Cash, Debt, Stock used

PART 2
Combined EqValue / Market Cap = 80 + 40 = 120

CoA Debt > Cash
CoB Debt = Cash

Adjustments
CoA Debt remains 60
CoA Cash gone, used to acquire CoB
CoB Cash/Debt cancel each other

Combined TEV = 120 + 60

You add EBITDA and Net Income from both companies to get the combined figures. This is not 100% accurate bc Interest Income changes for Company A since it’s using cash, but it’s small enough to ignore here:

Combined TEV / EBITDA = 180 / (10 + 8) = 10x
Combined P / E = 120 / (2 + 4) = 20x

PART 3
Combined EqVal = 120 (same, you add Market Caps)

Combined TEV = 180, same as before

Combined EBITDA = 18 same as before

TEV / EBITDA = 10x same as before

But combined Net Income changes. Company A raises 40 in debt at 10% interest. Net Income = 40*0.1(1-0.25) = 4(0.75) = 3

Combined P/E = 120 / 3 = 40x

Question 27

What happens to valuation multiples (P/E, TEV/EBITDA) depending on M&A activity or purchase method?

Answer 27

1) the combined P/E multiple may be different depending on the purchase method (cash/stock/debt)
2) the EV/EBITDA multiple is not affected bc EBITDA excludes net interest expense. Regardless of cash/stock/debt TEV is always the same.

Question 28

Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?

Answer 28

Because the strategic acquire can realize cost/revenue synergies that a PE firm cannot unless it combines the company with a complementary portfolio company. Those synergies make it easier for the strategic acquirer to pay a higher price and still realize a solid return on investment.

Question 29

What are the effects of an acquisition?

Answer 29

1) Foregone Interest on Cash - buyer loses the interest it would have otherwise earned on its cash it uses for the acquisition
2) Additional Interest on Debt - buyer pays additional interest expense when using debt
3) Additional Shares Outstanding - using stock creates more outstanding shares
4) Combined Financial Statements
5) Creation of Goodwill & Other Intangibles - represent the premium paid to a seller’s SE

Question 30

Why do Goodwill and Other Intangible Assets get created in an acquisition?

Answer 30

These represent the amount the buyer paid OVER the book value of the seller’s Shareholder’s Equity.

Equity Purchase Price - Seller’s Shareholder’s Equity = Goodwill and Other Intangible Assets

Question 31

What’s the difference between Goodwill and Other Intangible Assets?

Answer 31

Goodwill = same for many years, not amortized.

Other Intangible Assets = identifiable line items that are amortized

Question 32

What are synergies, can you provide a few examples?

Answer 32

2 + 2 = 5, aka when companies get more value out of acquisition than what the financials otherwise suggest.

Revenue Synergies or Cost Synergies.

Revenue Synergy example: combined company can cross-sell products, or expand into new geographies

Cost Synergy example: combined company can lay off redudant employees, or close redudant stores

Question 33

How are synergies used in merger models?

Answer 33

Revenue Synergies = normally you add these to Revenue figure for combined company on Income Statement, then assume a certain margin on the Revenue bc all revenue costs something.

Cost Synergies = reduced combined COGS or Operating Expenses on the Income Statement

An increase in either synergies boost Net Income, increasing the EPS and making the deal more accretive.

Question 34

Are revenue or expense synergies more important?

Answer 34

Revenue synergies are rarely taken seriously because they’re so hard to predict.

Expense synergies are taken more seriously because it’s more straightforward to see how buildings/locations/employees might be consolidated.

Question 35

Let’s say a company overpays for another company - what happens?

Answer 35

Overpaying creates a high Goodwill and Other Intangible Assets value. In the years after the acquisition, the buyer may record a large Goodwill Impairment Charge if it reassesses the value of the seller and determines it overpaid.

Question 36

A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides that it’s only worth $50 million. What happens?

Answer 36

The buyer’s share price would fall by whatever per-share dollar amount that leads to a decrease in $50 million of stock value.

It would not necessarily cut the share price in half.

Depending on the deal structure, the seller would effectively receive only half the value it originally intended.

This illustrates one of the major risks of all stock deals - sudden changes in share price could dramatically impact the valuation.

Question 37

What role does a merger model play in transactions?

Answer 37

It’s a sanity check and a way to check a range of assumptions. It’s used as supporting evidence in negotiations.

Emotions, ego, and personalities play a bigger role in M&A than numbers.

Question 38

What types of sensitivities would you look at in a merger model? What variables would you analyze?

Answer 38

Variables
1) Purchase Price
2) % Cash/Stock/Debt
3) Revenue & Expense Synergies

Sensitivity Tables
EPS accretion/dilution at different ranges of
1) Purchase Price vs Cost Synergies
2) Purchase Price vs Revenue Synergies
3) Purchase Price vs % Cash
etc

Question 39

If the seller has existing Debt on its Balance Sheet in an M&A deal, how do you deal with it?

Answer 39

You assume that the debt either stays on the Balance Sheet or is paid off in the acquisition. The terms of most Debt issuances state that they must be repaid in a “change of control” senario (when a buyer acquires more than 50% of a company), so you often assume Debt is paid off in a deal.

That increases the price the buyer needs to pay for the seller.

Question 40

If you use Cash or Debt to acquire another company, it’s clear how you could use them to pay off existing Debt… but how does that work with Stock?

Answer 40

Remember what happens when a company issues shares: it sells the shares to new investors and receives cash in exchange for them. Here it would do the same = issue a small portion of shares to 3rd party investors rather than the seller to raise the cash necessary to repay the debt.

The buyer might also wait until the deal closes before it issues additional shares to pay off the debt. It could also use cash-on-hand, or refinance the debt with a new issuance.

Question 41

Can you tell me the advantages and disadvantages of each purchase method (cash, debt and stock) in
M&A transactions?

Answer 41

Cash
* The cheapest option; most companies earn little Interest Income on it, so they don’t lose much by using it to fund deals
* Fastest and easiest to close Cash-based deals
* Limits the Buyer’s flexibility in case it needs the funds for something else in the near future

Debt
* Normally cheaper than Stock but more expensive than Cash
* Take more time to close because of the need to find investors
* Limits the Buyer’s flexibility because additional Debt makes future Debt issuances more difficult and expensive

Stock
* Most expensive option (though it can sometimes be the cheapest, on paper, if the Buyer trades at very high multiples)
* Dilutes the Buyer’s existing investors, but it also prevents the Buyer from paying any
additional cash expense for the deal.
* In some cases, the Buyer can also issue Stock more quickly than it can issue Debt.

Question 42

Company A has a P/E of 20x, and it acquires Company B, which has a P/E of 25x. Is the deal accretive or dilutive?

Answer 42

Trick question: depends on the considerations of the deal (e.g., cash, stock, debt). P/E comparison shortcut can only be used if it is an all-stock deal

• Answer: the deal will be dilutive
• If Acquirer’s P/E > Target’s P/E, then the deal is accretive
• If Acquirer’s P/E < Target’s P/E, then the deal is dilutive
• Intuitively, if you take the inverse of P/E and look at “earnings per share,” Company A (in this example) has EPS of $0.05 and Company B has EPS of $0.04. Thus, Company A is acquiring a company with a lower EPS, thus the deal will be dilutive

Question 43

How can you analyze an M&A deal and determine whether it makes sense?

Answer 43

Qualitative and Quantitative Analysis.

qualitative: expand geographies, products, or customer bases, give it more intellectual property, or improve its team?

quantitative: valuation of the Seller to see if it’s undervalued, as well as a comparison of the expected IRR to the Buyer’s Discount Rate.

Finally, EPS accretion/dilution is important in most deals because Buyers prefer to execute accretive deals, i.e., ones that increase their Earnings per Share (EPS). The Board of Directors is more likely to approve of accretive deals, and investors also like accretive deals more than
dilutive ones.

Question 44

Walk me through a merger model (accretion/dilution analysis).

Answer 44

1) In a merger model, you start by projecting the financial statements of the Buyer and Seller.

2) Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal.

3) You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition, its funding sources, and its after-effects.

4) 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 and write-downs.

5) You then combine the
Income Statements, reflecting the Foregone Interest on Cash, Interest Paid on New Debt, and Synergies. If the New Debt balance changes over time, the Interest Paid on New Debt should reflect that.

6) 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 number by (the Buyer’s Existing Share Count + New Shares Issued in the Deal).

7) You calculate the accretion/dilution by taking the Combined EPS, dividing it by the Buyer’s standalone EPS, and subtracting 1 to make it a percentage

Question 45

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

Answer 45

A deal is accretive if the 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.

For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer only $70 in additional Interest Expense, and the Buyer doesn’t issue any new shares, the deal will be
accretive because the Buyer’s Earnings per Share (EPS) will increase.

\A deal will be dilutive if the opposite happens. For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer $130 in additional Interest Expense, and its share
count remains the same, its EPS will decrease.

Question 46

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

Answer 46

You compare the Weighted Cost of Acquisition to the Seller’s Yield at its Purchase Price.

• Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate)
• Cost of Debt = Interest Rate on New Debt * (1 – Buyer’s Tax Rate)
• Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e., Net Income / Equity Value.
• Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase
  Equity Value.

Weighted Cost of Acquisition = % Cash Used * Cost of Cash + % Debt Used * Cost of Debt + %
Stock Used * Cost of Stock.

If the Weighted Cost is less than the Seller’s Yield, the deal will be accretive; if the Weighted Cost is greater than the Seller’s Yield, the deal will be dilutive.

Question 47

Why do you focus so much on EPS in M&A deals?

Answer 47

Because it’s the only easy-to-calculate metric that also captures the FULL impact of the deal – the Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

Although metrics such as EBITDA and Unlevered FCF more accurately approximate cash flow and the value of the company’s core business, they don’t reflect the deal’s full impact because they exclude Net Interest and the effect of new shares issued.

Question 48

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

Answer 48

If the Seller is public, you assume a premium to the Seller’s current share price based on the average premiums for similar deals in the market (usually between 10% and 30%). You can then use the DCF, Public Comps, and other valuation methodologies to cross-check this figure

The Purchase Price for private Sellers is based on the standard valuation methodologies, and you usually link it to a multiple of EBITDA, EBIT, or Revenue since private companies don’t have
easy-to-determine share prices.

If the Buyer expects to realize significant Synergies, it is often willing to pay a higher premium for the Seller because the Present Value of the Synergies might exceed this premium to the Seller’s current market value.

Question 49

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

Answer 49

Since Cash is cheapest for most Acquirers, they’ll use all the Cash they can before moving to the other funding sources.
So, you might assume that the Cash Available equals the Acquirer’s current Cash balance minus its Minimum Cash balance, also factoring in the Target’s Cash and Minimum Cash when applicable.

After that, Debt tends to be the next cheapest option. An Acquirer might be able to raise Debt up to the level where its Debt / EBITDA and EBITDA / Interest ratios remain in-line with those of peer companies.
So, if it’s levered at 2x EBITDA now, and similar companies have 4-5x Debt / EBITDA, it might be able to raise Debt up to that level. Again, you may also factor in the Target’s Debt and EBITDA if
they are significant.

Finally, there’s no strict limit on the amount of Stock an Acquirer might issue, but few companies would issue enough to give up control of the company, and some Acquirers will issue Stock only up to the point at which the deal turns dilutive.

Question 50

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

Answer 50

The Seller must balance taxes with the certainty of payment and potential future upside.

So, the preferred method depends on the Seller’s confidence in the Buyer: Cash and Debt are better with higher uncertainty, while Stock may be better with large, stable Buyers.

To a Seller, Debt and Cash are similar because they mean immediate payment, but also immediate capital gains taxes for the shareholders and no potential upside if the Buyer’s share price increases. But there’s also no risk if the Buyer’s share price decreases.

Stock is more of a gamble because the Seller could end up with a higher price if the Buyer’s share price increases, but it could also get a lower price if the Buyer’s share price drops.

The Seller’s shareholders also avoid immediate taxes with Stock since they pay taxes only when they sell their shares.

Question 51

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

Answer 51

The Foregone Interest on Cash represents the Cost of Cash. The Acquirer loses future projected Interest Income by using Cash to fund a deal. The Interest Expense on New Debt represents the Cost of Debt.

For both, you take the interest rate and multiply by (1 – Acquirer’s Tax Rate) to estimate the after-tax costs.

The Cost of Stock is represented by the additional shares created in a deal and how those shares reduce the Combined Company’s EPS. It’s equal to the reciprocal of the Acquirer’s P / E Multiple, i.e., Acquirer’s Net Income / Acquirer’s Equity Value

Question 52

Isn’t the Foregone Interest on Cash just an “opportunity cost”? Why do you include it?

Answer 52

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!

So, if an Acquirer expects $90 in Operating Income and $10 in Interest Income for a total of $100 in Pre-Tax Income, its projected Pre-Tax Income will fall in real, cash terms if it uses Cash to fund the deal.

Question 53

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?

Answer 53

It’s not a contradiction; it’s just a different way of measuring the Cost of Equity.

The “Reciprocal of the P / E Multiple” method measures the Cost of Equity in terms of EPS impact, while the CAPM method measures it based on the stock’s expected annualized returns.

Neither method is “more correct” because you use them in different contexts. In most cases, regardless of the method you use, Stock will be the most expensive funding source for a company.

Question 54

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

Answer 54

The Acquirer might not necessarily draw on its entire Cash balance if, for example, much of the Cash is in overseas subsidiaries or otherwise restricted.

Also, the Acquirer might be preserving its Cash for a future expansion plan or Debt maturity.

Finally, if the Acquirer is trading at high multiples, such as a 100x P/E multiple, it might be cheaper to use Stock to fund the deal.

Question 55

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

Answer 55

Yes, there are many cases where EPS accretion/dilution is less important or irrelevant.

1) For example, if the Buyer is private, or it already has negative EPS as a standalone entity, it won’t care about whether the deal is accretive or dilutive.
2) It also makes little difference if the Buyer is far bigger than the Seller (e.g., 10x – 100x its size).

Besides EPS accretion/dilution, you can also analyze the deal’s qualitative merits, compare the IRR to the Discount Rate, and value the Seller + Synergies and compare that to the Equity
Purchase Price.

Finally, you can create a Contribution Analysis to look at how much the Buyer and Seller “contribute” to each financial metric and then compare the contribution percentages to their
respective ownership percentages.

Value Creation Analysis, to determine how the Buyer’s share price will change after the deal closes, may also be useful in certain contexts, such as if the Buyer + Seller together will resemble a larger, more valuable public company in the market.

Question 56

How does a merger differ from an acquisition?

Answer 56

There’s no mechanical difference in a merger model or the other analyses because there’s always a Buyer and Seller in any M&A deal.

The difference is that in a merger, the companies are closer in size, while the Buyer is significantly larger than the Seller in an acquisition.

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.

You’ll also place more weight on the Contribution Analysis and Value Creation Analysis methods in mergers because 100% Stock deals are so common.

Question 57

What are the main PROBLEMS with merger models?

Answer 57

1) EPS is not always a meaningful metric

2) Net Income and cash flow are quite different, so EPS-accretive deals might be horrible from a cash-flow perspective

3) merger models don’t capture the true risk inherent in M&A deals. 100% Cash deals almost always look accretive, even though the integration process might go wrong, legal issues might arise, and customers or shareholders might revolt.

4) merger models often fail to consider what might happen if the Buyer or Seller’s share prices change significantly before the deal closes – especially in 100% Stock deals.

5) merger models don’t capture the qualitative aspects of a deal, such as cultural fit or management’s ability to work together

Question 58

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x. Will the deal be accretive?

Answer 58

You can’t tell unless you know that it’s a 100% Stock deal.

If it is a 100% Stock deal, then it will be accretive because the Buyer’s P / E is higher than the Seller’s, indicating that the Buyer’s Cost of Acquisition (1 / 25, or 4%) is less than the Seller’s Yield (1 / 15, or 6.7%).

Question 59

Walk me through the full math for the deal now.

Assume that Company A (P/E = 25x) has 10 shares outstanding at a share price of $25.00, and its Net Income is $10.

It acquires Company B (P/E = 15x) for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

PART 1)
How accretive is this deal?

PART 2)
Company A now uses Debt with an Interest Rate of 8% to acquire Company B. Is the deal
still accretive? At what interest rate does it change from accretive to dilutive?

Assume the tax rate is 25%

PART 3)
What are the Combined Equity Value and Enterprise Value in this deal?

Answer 59

Company A
EPS = Net Income / # Shares
= 10 / 10
= $1

additional stocks to acquire Company B
= Purchase EqV / Company A Share Price
= 150 / 25
= 6 shares

Combined share count = total Company A share count
= 10 + 6
= 16

No cash or debt, tax-rates same
Combined Net Income = Company A Net Income + Company B Net Income
= 10 + 10
= 20

Combined EPS
= 20/16 = 5/4 = $1.25

Accretive by 25%

—————————–PART 2
Cost of Debt
= 8%(1-0.25)
= 8%(0.75)
= 6%

Seller’s Yield
1/EPS = 1/15 = 6.67%

Still accretive, bc the cost of all-debt deal is less than the seller’s yield

For the deal to turn dilutive, the After-Tax Cost of Debt would have to exceed 6.7%.

x = after tax cost of debt
6.7% = x(1-0.25)
6.7% / 0.75
= 6.7% * 4/3
= 8.9%

the deal would turn dilutive at an interest rate >= 8.9%.

—————————–PART 3
Assume that Equity Value = Enterprise Value for both the Buyer and Seller and use 100% Stock funding.

Combined Equity Value
= Buyer’s Equity Value + Market Value of Stock Issued in the Deal
= $250 + $150 = $400.

Combined Enterprise Value = Buyer’s Enterprise Value + Purchase Enterprise Value of Seller
= $250 + $150 = $400.

Question 60

How do the Combined TEV / EBITDA and P/E multiples change if the deal financing
method changes?

Answer 60

The Combined TEV / EBITDA stays the same regardless of the financing method, but the Combined P / E multiple will change based on the Stock issued and the Cash and Debt used.

The Stock issued affects the Combined Equity Value, and the Cash and Debt used affect the Combined Net Income because of the Foregone Interest on Cash and Interest Paid on New Debt.

Question 61

Without doing any math, what range would you expect for the Combined P / E multiple?

Company A is larger, multiple of 25x

Company B is smaller, multiple of 15x

Answer 61

The Combined P / E multiple should be between the Buyer’s P / E multiple and the Seller’s Purchase P / E multiple, so between 25x and 15x here.

Since Company A is larger than Company B, we would expect the Combined P / E multiple to be closer to Company A’s multiple of 25x.

Question 62

Now assume that Company A is twice as big financially, so its Equity Value is $500, and its Net Income is $20. Will a 100% Stock deal be more or less accretive?

Company A is larger, multiple of 25x

Company B is smaller, multiple of 15x

———————————–Part 2
Now, do the math. What is the accretion/dilution in a 100% Stock deal with a $150 Purchase Equity Value for Company B? Feel free to write down the numbers.

Answer 62

The deal will be less accretive.

The intuition is that Company A’s P / E remains the same, but it’s significantly bigger, so the higher-yielding Company B provides less of a boost to Company A’s EPS.

The Combined P / E multiple will still be between 15x and 25x, but it will be even closer to 25x because Company A has a greater weighting in the combined company.

———————————–Part 2
Total Equity Value = 500 + 150 = 650
Net Income = 20 + NI(B) = 30
15 = 150/(NI(B))
NI(B) = 150/15 = 10

Question 63

Company A has a P/E of 10x, a Debt Interest Rate of 8%, a Cash Interest Rate of 4%, and a
Tax Rate of 25%.

It wants to acquire Company B at a purchase P/E multiple of 16x using 1/3 Stock, 1/3 Debt,
and 1/3 Cash.

Will the deal be accretive?

Answer 63

Buyer’s Cost
CostDebt = 8%(1-0.25) = 8(3/4) = 6%
CostCash = 4%(1-0.25) = 3%
CostStock = 1/10 = 10%

Weighted Buyer Cost
= 6(1/3) + 3(1/3) + 10(1/3)
= 2 + 1 + 3.33
= 6.33%

Seller’s Yield
1/16 = 6.25%

Dilutive bc Buyer Cost > Seller’s Yield

Question 64

Company A acquires Company B using 100% Debt. Company B has a purchase P/E multiple of 12x, and Company A has a P/E multiple of 15x.

What interest rate on Debt is required to make the deal dilutive? Assume a 25% tax rate

Answer 64

CostDebt(1-TaxRate) = Seller’s Yield

x(1 - 0.25) = 1/12
(3/4)x = 1/12
x = (1/12)(4/3) = 1/9 = about 11%

Any Debt interest rate above 11% would be dilutive.

Question 65

Company A has an Equity Value of $1,000 and a Net Income of $100.

Company B has a Purchase Equity Value of $2,000 and a Net Income of $50.

For a 100% Stock deal to be accretive, how much in Synergies must be realized?

Answer 65

Company A
P/E = 1000/100 = 10x

Company B
P/E = 2000/50 = 40x

We need Company B’s P/E to be <10x

2000 / (50 + x) = 10
2000 = 10(50 + x)
2000 = 500 + 10x
1500 = 10x
x = 150 post-tax synergies
y(3/4) = 150
y = 200 pre-tax synergies

Question 66

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 of 2x. Peer companies have a median Debt/EBITDA 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? Use the Combined EBITDA figures in the calculations.

Answer 66

Aquirer
EqV $1b
Cash $50m
EBITDA $100m
Net Income $50m
Debt/EBITDA = 2x
Debt/EBITDA peer median = 4x

Target
PEqV = $500m
Net Income $30m
EBITDA $50m
Debt 0

Best way = minimize Buyer Costs
* would probably not use the Cash bc relatively small balance compared to EqV and total Debt of $400m
* second cheapest would be debt
Combined Debt/EBITDA = 4x
(DebtA + DebtT)/(EBITDAa + EBITDAb) = 4
(2*100m + 0 + x) / (100m + 50m) = 4
(200m + x) / 150m = 4
200m + x = 600m
x = 400m additional debt
* last $100 would likely come from stock

If the Acquirer used part of its Cash balance or the Target’s Cash balance, the $100 million Stock portion would be reduced.

Question 67

An Acquirer has:
Equity Value of $500 million
Cash of $100 million
EBITDA of $50 million
Net Income of $25 million
Debt / EBITDA 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?

Answer 67

If we’re trying to maximize the purchase price, we could assume we can use the Acquirer’s total Cash balance to start. However, that’s unrealistic, as most companies need a base level of cash for operating and for future use.

It could then use Debt, and increase its Debt from 150m to 250m, a 100m increase to match the Debt Ratio of its peers.

Then it could potentially issue stock up to the theoretical maximum of still maintaining a greater than 50% share of equity control, so potentially another $500m of Equity. However that’s again unrealistic bc it’s dilutive.

Unrealistic max = 100m cash + 100m debt + 500m equity = 700m

More realistic max = 0 cash + 100m debt + 250m equity = 350m

Question 68

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 a Purchase Enterprise Value
of $150 million.

What are the Combined Equity Value and Enterprise Value?

Answer 68

Combined TEV
= TEVacquirer + TEVtarget
= 600m + 150m
= 750m

Combined EqV
= EqVacquirer + additional acquirer equity in purchase

In an all-stock deal
= 500m + 100m
= 600m

In a cash/debt deal
= 500m + 0
= 500m

Question 69

How do the Combined Equity Value and Enterprise Value change based on the deal
financing?

Answer 69

The Combined Enterprise Value is not affected by the deal financing: it’s always equal to the Buyer’s Enterprise Value plus the Purchase Enterprise Value of the Seller.

The Combined Equity Value equals the Buyer’s Equity Value plus the Market Value of Stock
Issued in the Deal, which could range from $0 up to the Purchase Equity Value of Seller.

So, in a 100% Stock deal, the Combined Equity Value = Buyer’s Equity Value + Purchase Equity
Value of Seller.

Question 70

Wait, you’re saying that in a 100% Cash or Debt deal, the Seller’s Equity Value just “disappears.” How is that possible?

Answer 70

The Seller’s Equity Value doesn’t “disappear” – it’s transformed into the Cash used or Debt issued by the Buyer 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

Question 71

Wait a minute, you’re also saying that the purchase premium the Acquirer pays for the Target will last after the deal closes? How is that possible?

Answer 71

The purchase premium does not necessarily “last” because it depends on the market’s reaction to the deal.

If the market believes the Target’s premium was justified, then the rules about Combined
Equity Value and Combined Enterprise Value will hold up.

However, if the market believes the Acquirer overpaid for the Target, the Acquirer’s share price will fall to reflect the amount by which it overpaid – whether that means the entire purchase
premium, part of the premium, or more than the premium.

Question 72

Let’s say an Acquirer has an Equity Value of $500 million and an Enterprise Value of $600 million. The Acquirer has 100 million shares outstanding at $5.00 per share.

The Target has an Equity Value of $100 million and an Enterprise Value of $150 million, and
the Acquirer pays a 30% premium to acquire the Target in a 100% Stock deal.

A few months after the deal is announced, the market loses faith in the deal and believes the
30% premium is no longer justified.

What happens to the Combined Equity Value, Enterprise Value, and share price immediately after the deal is announced and several months after, when the market loses faith in the 30% premium?

How does that last answer change if the Acquirer uses 100% Debt or Cash instead?

Answer 72

Combined EqV
= EqVacquirer + PEqValtarget
= 500m + 130m
= 630m

Combined TEV
= TEVacquirer + TEVtarget
= 600m + (150m + 30m)
= 600m + 180m
= 780m
————————–
After market loses faith in 30% premium
Combined EqV
= 630m - 30m
= 600m

Combined TEV
= 780m - 30m
= 750m

Share Price
x = $ decrease/share
x(100m) = 30m
x = $0.3
new share price = 5-0.3 = $4.7
—————————
Combined EqV = 500m
Combined TEV = 780m
Both would decrease by 30m
Combined EqV = 470m
Combined TEV = 750m

Question 73

An Acquirer with an Equity Value of $500 million and an Enterprise Value of $600 million has Net Income of $50 million and EBITDA of $100 million.

The Target, with a Purchase Equity Value of $100 million and a Purchase Enterprise Value of $150 million, has Net Income of $10 million and EBITDA of $15 million.

What are the Combined P/E and TEV/EBITDA multiples in a 100% Stock deal? Assume the
same tax rates for the Acquirer and Target.

How would those Combined Multiples change in a 100% Cash or Debt deal?

Answer 73

Combined EqV
= EqValacquirer + EqValtargetstockpurchase
= 500m + 100m
= 600m

Combined TEV
= EVacquirer + EVtarget
= 600m + 150m
= 750m

Combined Net Income
= 50m + 10m
= 60m

Combined EBITDA
= 100m + 15m
= 115m

Combined P/E
= 600m/60m = 10x

Combined TEV/EBITDA
= 750m/115m
= about 6.5x

All Cash or Debt deals
* TEV/EBITDA would not change
* P/E would change. Price/Equity Value would decease by 100m, and Net Income/Earnings would decrease bc of Cost of Foregone Cash Interest or Cost of Debt. However those are unlikely to offset the 100m numerator decrease, so P/E will likely decrease

Question 74

How do the Combined Multiples change based on the deal financing?

Answer 74

Enterprise Value-based multiples do not change based on the % Cash, Debt, and Stock used because the Combined Enterprise Value is not affected by the deal financing, and TEV-based metrics such as Revenue, EBITDA, and EBIT are also not affected by it.

Equity Value-based multiples do change based on the deal financing because the Combined
Equity Value depends on the % Stock Used, and Equity Value-based metrics such as Net Income and Free Cash Flow are affected by the Foregone Interest on Cash and Interest Paid on New
Debt.

Question 75

What are the possible ranges for the Combined Multiples after a deal takes place?

Answer 75

Combined Enterprise Value-based Multiples will be between the Buyer’s standalone multiples
and the Seller’s purchase multiples.

Combined Equity Value-based Multiples are often in that range as well, but they do not have to be (see the next question for an example).

You cannot average the Buyer’s multiples and the Seller’s purchase multiples to determine the Combined Multiples because the companies could be different sizes.

You also cannot use a weighted average because the proportions of Enterprise Value, EBITDA,
and other financial metrics from each company might be different.

The Combined Multiples will be closer to the Buyer’s multiples if the Buyer is much bigger, but they’ll be in the middle of the range if the Buyer and Seller are closer in size

Question 76

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 TEV/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 TEV / EBITDA and P / E multiples?

Now, let’s say that Company A instead uses 100% Debt with a 10% interest rate to acquire
Company B. Again, Company A pays no premium for Company B. What are the combined multiples?

Answer 76

Company A
TEV/EBITDA = 100/10 = 10x
P/E = 80/4 = 20x

Company B
TEV/EBITDA = 40/8 = 5x
P/E = 40/2 = 20x

Combined TEV
= 100 + 40
= 140

Combined EBITDA
= 10 + 8
= 18

Combined TEV/EBITDA
= 140/18
= 70/9
= about 7.8

P/E
Combined EqV
= 80 + 0
= 80

Combined Net Income
= 4 - [5%(1-0.5)40] + 2
= 4 - (2.5%40) + 2
= 6 - 1
= 5

Combined P/E
= 80/5 = 16x

Combined TEV/EBITDA does not change

Combined EqVal does not change

Combined Net Income
= 4 - [10%(1-0.5)40] + 2
= 6 - (5%40)
= 6 - 2
= 4

Combined P/E
= 80/4 = 20x

Question 77

How would raising capital through share issuances affect earnings per share (EPS)?

Answer 77

The impact on EPS is that the share count increases, which decreases EPS.

But there can be an impact on net income, assuming the share issuances generate cash because there would be higher interest income, which increases net income and EPS. However, most companies’ returns on excess cash are low, so this doesn’t offset the negative dilutive impact on EPS from the increased share count.

Alternatively, share issuances might affect EPS in an acquisition where stock is the form of consideration. The amount of net income the acquired company generates will be added to the acquirer’s existing net income, which could have a net positive (accretive) or negative (dilutive) impact on EPS.

Question 78

How would a share repurchase impact earnings per share (EPS)?

Answer 78

The impact on EPS following a share repurchase is a reduced share count, which increases EPS. However, there would be an impact on net income, assuming the share repurchase was funded using excess cash. The interest income that would have otherwise been generated on that cash is no longer available, causing net income and EPS to decrease. But the impact would be minor since the returns on excess cash are low, and would not offset the positive impact the repurchase had on EPS from the reduced share count.