M&A Deals and Merger Models

Question 1

Why would one company buy another company?

Answer 1

Because you think you’ll be better off after buying the company

Question 2

If a target’s implied value is $625M, but the firm is asking $500M for the business, when would a company purchase this company?

Answer 2

• Asking Price is less than its Implied Value
• The Acquirer’s expected IRR rom the acquisition exceeds its WACC

Question 3

What is the definition of accretive?

Answer 3

characterized by gradual growth or increase.

Question 4

If a deal is accretive to EPS, then the transaction must _______ its EPS.

Answer 4

If a deal is accretive to EPS, then the transaction must increase its EPS.

Question 5

What is the definition of dilutive?

Answer 5

Causing a reduction in the value of a shareholding due to the issue of additional shares in a company without an increase in assets.

Question 6

What are the two most important financial criteria for a deal to occur?

Answer 6

1. Target price must be reasonable
2. Deal must be neutral or accretive to EPS

Question 7

When would consolidation drive a financial decision to acquire a company?

Answer 7

If the biggest and second-biggest companies in the market combine, they can get better deals with suppliers and save money

Question 8

When would geographic expansion drive a financial decision to acquire a company?

Answer 8

The Buyer operates mostly in Europe, which is a declining/mature market. It wants to acquire the Seller to expand into Asia and grow more quickly.

Question 9

When would gaining market share drive a financial decision to acquire a company?

Answer 9

Neither the Buyer nor the Seller is growing because the market is competitive and the products/services are nearly the same. But if one company acquires another, it instantly captures market share.

Question 10

When would an undervalued company drive a financial decision to acquire a company?

Answer 10

Seller is Undervalued: The Seller’s asking price seems attractive because its share price has fallen significantly; the Buyer sees an opportunity to get a cheap Asset

Question 11

When would a tax reduction drive a financial decision to acquire a company?

Answer 11

Tax Reductions: The Buyer could “invert” by acquiring a Seller in a low-tax jurisdiction like Ireland and then claiming it is “headquartered” there.

Question 12

What is the sell-side M&A process?

Answer 12

1. Plan the process and create marketing materials
2. Contact the initial set of buyers
3. Set up management meetings
4. Solicit bids from buyers
5. Conduct final negotions, arrange financing, and close the deal.

Question 13

Why do companies frequently fund acquisitions with debt?

Answer 13

Companies prefer to fund acquisitions with Debt rather than Equity because Debt is cheaper.

Question 14

Why is debt cheaper than equity?

Answer 14

Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders).

Question 15

What is the dividend payout ratio?

Answer 15

The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.

Question 16

What is the average dividend payout ratio?

Answer 16

15%

https://www.readyratios.com/sec/ratio/dividend-payout/

Question 17

Which is the cheapest source of financing among these three choices:

• Debt
• Cash
• Stock

Answer 17

Cash, it will almost always prefer to use that Cash first because Cash is even cheaper than Debt (companies earn almost nothing on extra Cash).

Question 18

Which financing is most common with a merger of equals?

• Cash
• Debt
• Stock

Answer 18

Usually 100% stock because company doens’t have enough cash and would have to take out a large amount of debt.

Question 19

What are the components of a merger model?

Answer 19

• Summarizes the financial profiles of the Buyer and Seller, including projections and each company’s Equity Value and Enterprise Value.
• Lists the purchase price, i.e. the amount the Buyer is planning to pay for the Seller, and the mix of Cash, Debt, and Stock the Buyer will use.
• Includes other key terms of the deal, such as the interest rates on Cash and Debt and estimates for synergies – ways to boost revenue or cut costs.
• Shows what the Buyer and Seller look like as a combined entity and how the combined EPS compares with the Buyer’s standalone EPS.

Question 20

Why is EPS used as a key metric for the merger model?

Answer 20

It’s the only easy-to-calculate metric that captures the FULL impact of the deal.

Question 21

Why are EBITDA and NOPAT poor metrics to use when looking at outcome of a merger?

Answer 21

Metrics such as EBITDA and NOPAT will never capture the effects of the deal because they are before Interest Income and Interest Expense and they do not reflect the share count.

Question 22

Other than EPS, what could be used to asses the impact of a deal?

Answer 22

Levered Free Cash Flow per Share

Question 23

What is “Fully diluted shares outstanding”?

Answer 23

Fully diluted shares outstanding is the total number of shares a company would theoretically have if all dilutive securities were exercised and converted into shares. Dilutive securities include options, warrants, convertible debt, and anything else that can be converted into shares.

Question 24

What is the simplified equation for calculating new EPS following a deal?

Answer 24

Question 25

**Which of the following metrics** is used as the *base* price of a firm using the _merger model_? * Enterprise Value * Equity Value _and_ **Why**?

Answer 25

you always start with the Seller’s **Purchase Equity Value** because, at the _bare minimum_, the Buyer needs to pay that much to acquire the Seller’s shares.

Question 26

Why isn't Enterprise Value used as the *base* price of a company in the merger model?

Answer 26

1. The seller may not provide the buyer with the company's cash 2. The buyer may choose to refinance debt, so does not pay debt up front.

Question 27

How do you find the **cost (rate) of debt** for a deal?

Answer 27

Look at the YTM or coupon rates of the company’s current Debt or the YTM or **coupon rates for the Debt of peer companies**

Question 28

How do you find the **cost (rate) of equity** for a deal?

Answer 28

The Cost of Equity is based on Buyer Net Income / Buyer Equity Value, or the **reciprocal of the Buyer’s P / E multiple.**

Question 29

How do you find the **cost (rate) of cash** for a deal?

Answer 29

The Cost of Cash is supposed to be similar to the **Risk-Free Rate**, so the risk profile of Cash must be similar to the risk profile of government bonds.

Question 30

How do you _calculate_ the **weighted cost** of the **acquisition**?

Answer 30

Weighted Cost of Acquisition = % Cash Used \* After-Tax Cost of Cash + ...% Debt Used \* After-Tax Cost of Debt + ...% Stock Used \* After-Tax Cost of Stock This Weighted Cost tells us how much the Buyer is “giving up,” in percentage terms, to acquire the Seller.

Question 31

How is the "**yield**" of a _merger_ defined?

Answer 31

This “Yield” is how much you get in Net Income for each $1.00 spent on Company B’s stock.

Question 32

**Is the deal accretive, dilutive, or neutral to EPS?** Weighted Cost of Acquisition \< Yield of Seller

Answer 32

Accretive

Question 33

**Is the deal accretive, dilutive, or neutral to EPS?** Weighted Cost of Acquisition \> Yield of Seller

Answer 33

Dilutive

Question 34

**Is the deal accretive, dilutive, or neutral to EPS?** Weighted Cost of Acquisition == Yield of Seller

Answer 34

**Neutral**

Question 35

What is the **P/E ratio rule** for all-stock deals?

Answer 35

* 100% Stock Deal, Buyer’s P / E \> Seller’s P / E at Purchase Price: Accretive * 100% Stock Deal, Buyer’s P / E = Seller’s P / E at Purchase Price: Neutral * 100% Stock Deal, Buyer’s P / E \< Seller’s P / E at Purchase Price: Dilutive

Question 36

**Assume an all-stock deal** If the Buyer’s P / E is 10x and the Seller’s Purchase P / E is 5x, what is the: * Buyer’s Weighted Cost of Acquisition * Seller's Yield

Answer 36

So if the Buyer’s P / E is 10x and the Seller’s Purchase P / E is 5x, the **Buyer’s Weighted Cost of Acquisition is 1/10, or 10%, and the Seller’s Yield is 1/5, or 20%.**

Question 37

**Is the deal accretive, dilutive, or neutral to EPS?** * Buyer’s Weighted Cost of Acquisition is 1/10, or 10% * Seller’s Yield is 1/5, or 20%.

Answer 37

Accretive since the WAC \< Seller's Yield

Question 38

**Is the deal accretive, dilutive, or neutral to EPS?** * Buyer’s Weighted Cost of Acquisition is 1/4, or 25% * Seller’s Yield is 1/5, or 20%.

Answer 38

**Dilutive** since the WAC \> the Seller's Yield

Question 39

What are **some** **parameters** in the _merger model_ which could inject **error** into the analysis?

Answer 39

* **Share Prices and Tax Rates**: As mentioned above, the Buyer’s share price won’t necessarily stay the same after a deal is announced. And the Combined Tax Rate may not necessarily be the Buyer’s tax rate. * **Purchase Price:** We’ve assumed that the purchase price is the Seller’s Purchase Equity Value. But in real life, the Buyer may refinance the Seller’s Debt and pay for other fees associated with the deal. Sometimes the Seller can even use a portion of its Cash balance to fund the deal, further complicating the purchase price. * **Synergies: “Synergies”** are ways for the Combined Company to boost revenue or cut costs after the acquisition takes place. For example, maybe the Combined Company no longer needs 10 separate offices – it can consolidate and move everyone into 8 offices instead, which will reduce its rental expense.

Question 40

Under **what two conditions** would a _company not care about **EPS**_ when conducting a **merger model**?

Answer 40

1. Acquirer is a private company 2. Company has negative net income

Question 41

What is a **drawback** of a _merger model_ in terms of **risk**?

Answer 41

**Merger Models Don’t Capture the Risk of M&A Deals** – 100% Cash deals are almost always accretive. If the Acquirer earns 1.0% on Cash, that’s a 0.6% After-Tax Cast of Cash. So the Seller’s P / E would have to be above 166x for the deal to be dilutive.

Question 42

What **two aspects** drive the **purchase price** of an **M&A deal**?

Answer 42

1. The **company's implied/intrinsic value** (from DCF, etc.) 2. The **premium** above intrinsic value to purchase the company

Question 43

Why must company offer a **signficant premium over current share price** to buy that company?

Answer 43

Investors **need a higher price** to _incentivize_ them to sell everything.

Question 44

**What is a reasonable offer price?** * Current Share Price: $15.00 * Average Premium Paid in This Market for Acquired Companies: 30%

Answer 44

Calculated Offer Price for Company: $19.50

Question 45

What is the **minimum price** you can pay for a **private** company?

Answer 45

The **“minimum price”** is the lowest number the owners of the company will accept.

Question 46

For a **private seller**, how is the **purchase price** often **defined**?

Answer 46

For a _private Seller_, the **purchase price is linked to the company’s Implied Value** _from the valuation methodologies_ more closely.