Merger Models

Question 1

What are two financial criteria for a merger deal?

Answer 1

1) the asking price must be reasonable

2) The deal must have a decent chance of being neutral or accretive to EPS

Question 2

What are financial reasons for a M&A?

Answer 2

1) Consolidation / Economies of Scale: bigger companies can combine to get better deals and cheaper expenses
2) Geographic Expansion: grow presence through acquisition
3) Gain market share: capture market share inorganically
4) Seller is undervalued: significantly undervalued firm with opportunities to leverage out of acquisition
5) Tax reductions: Buyer could invert by acquiring a seller in a low-tax jurisdiction
6) Product Expansion / Diversification: Expand industry through acquisition

Question 3

What are more qualitative reasons for M&A?

Answer 3

1) IP and Key Technology: acquiring for intellectual property and hoped competitive advantage as a result
2) Defensive acquisition: acquire to remain ahead of smaller, more agile competitors
3) Acquihire: acquire for employee base and shared knowledge
4) Name: Acquiring for press coverage and name-brand
5) Ego: no real reason, acquiring because one can.

Question 4

What are the advantages of using cash to fund a transaction?

Answer 4

It is typically the cheapest method.

Seller receives cash-in-hand immediately.

No time-consuming financing process.

Question 5

What are the disadvantages for using cash?

Answer 5

The seller is taxed immediately on a cash transaction.

The seller receives no potential upside in buyer’s stock price.

Question 6

What are advantages of using debt?

Answer 6

Typically cheaper than stock.

Seller receives cash immediately.

You don’t dilute your ownership by issuing debt to finance a transaction.

Question 7

What are the disadvantages of using debt?

Answer 7

The debt increases the debt profile for the combined firm.

Financing can be expensive and time-consuming.

Seller is taxed immediately.

Seller does not receive potential upside in buyer’s stock price

Combined company has obligations to debt holders to pay interest on debt.

Question 8

What are the advantages of using stock?

Answer 8

Can sometimes be cheaper if the buyer has a higher stock price and P/E.

Can be faster than raising debt.

Seller is motivated to participate long-term with the company growth.

No taxation event until stock sale.

Question 9

What are disadvantages of using stock>

Answer 9

More risk for the seller since the buyer share price could change

There may be lock-up periods for stock and seller may have to hold stock for long-time

Fixed shares vs fixed value can make a long impact on the seller if the buyer’s share price changes a lot.

Question 10

Why is EPS used as a key metric in the analysis for Merger Models?

Answer 10

EPS is an easy-to-calculate metric that captures the full impact of the deal.

The impacts include Net Interest Expenses.

Question 11

If the target has 100 shares outstanding, at $5/share and the acquirer pays a 20% premium, what is the offer value?

Answer 11

If the buyer pays a 20% premium, the buyer is paying 1.20*$5 per share = $6 per share.

1.21005 = $600

Question 12

How do you value cost of debt for financing

Answer 12

You look at the yield to maturity or coupon rates of the company’s current debt, or the YTM or coupon rates of peer companies’ debts.

Question 13

What is the weighted cost of acquisition?

Answer 13

cost of cash * (1-Tax) * proportion of cash + cost of debt * (1-Tax) * proportion of debt + cost of stock * proportion of stock

Question 14

When is a deal accretive, neutral, or dilutive?

Answer 14

WCA < Yield of Seller: Accretive

WCA = Yield of Seller: Neutral

WCA > Yield of Seller: Dilutive

Question 15

What are the effects on EPS if the buyer uses stock, debt and cash?

Answer 15

Stock: By using stock, the buyer issues more shares so its total shares outstanding will increase and reduce EPS.

Debt: By using debt, the buyer will have additional interest expenses representing the mandatory interest payments to debt holders. This will reduce pre-tax income, net income, and resultingly EPS

Cash: By using cash, the buyer forgoes future interest on cash, while ill reduce pre-tax income, net income, and EPS.

Question 16

How do you calculate the number of shares issued in a deal? What is the transaction was $600 in a 1/3 stock, 2/3 debt deal. Share price is $10.

Answer 16

You take the cost of the transaction (TARGET PURCHASE EQUITY VALUE) and then multiply it by the proportion of the deal funded by stock. Then we divide it by the company share price to figure out the amount of shares issued to fund the stock portion.

In this case, we are funding $200 of the transaction with stock, so we need to sell or issue 20 shares of $10 to fund it.

Question 17

What happens if the sellers’ debt is assumed with no changes?

Answer 17

There is no change in the cost of purchasing the firm.

Question 18

What happens if the sellers’ debt is repaid with the buyer’s cash?

Answer 18

This increases the cost of purchasing the firm as interest changes.

Question 19

What happens if the sellers’ debt is replaced with new debt?

Answer 19

Does not increase the purchase price but may affect interest expense.

Question 20

How do you calculate the combined equity value?

Answer 20

Acquirer’s equity value + value of stock issued in deal

Question 21

How do you calculate the combined enterprise value?

Answer 21

Acquirer’s enterprise value + purchase enterprise value of target

Question 22

How do combined valuation multiples change?

Answer 22

The combined multiples will be in between the acquirer’s multiples and the target’s purchase multiples.

Question 23

How do combined enterprise value-based multiples change?

Answer 23

The combined enterprise value-based multiples will not change as they are not affected by purchase method (Interest expense or forgone interest on cash does not effect Revenue, EBIT, EBITDA) and neither is the combined enterprise value.

This is unless Revenue synergies are realised or D&A or asset write-ups.

Question 24

How do combined equity value-based multiples change?

Answer 24

These will change based on the amount of stock used, and the combined net income changes based on the amount of cash and debt used and their respective interest rates.

Question 25

What do you do during the Financial Statement Projection step?

Answer 25

You need estimates for each company’s projected cash flow for major line items - Revenue, COGS, Net Interest Expense, Taxes, Cash Flow items.

You also ensure Stock Based compensation is zero as it can distort the accretion dilution calculations.

Question 26

How do you estimate the purchase price?

Answer 26

If the seller is public, you link the purchase price to an offer price per share (higher than current price). Look at premiums of similar companies in the market. Then you check to make sure it is in line with the company’s implied share price.

For private companies, you base it on EV/EBITDA, EV/EBIT, P/E multiples based on peer companies and valuation methodologies.

Question 27

What happens at the Sources and Use Schedule?

Answer 27

The real amount the buyer pays is not exactly equal to the Purchase Equity Price or the Purchase Enterprise Value of the seller. This is tracked using the Sources and Uses Schedule.

Source of Funds: anything the buyer uses to pay for the company: Cash, Debt, Stock

Use of Funds: Anything that increases the real amount that a Buyer must pay for the Seller.

Question 28

What happens in the Purchase Price Allocation Schedule?

Answer 28

This helps identify the premium paid over book value of the company to calculate intangible assets and goodwill, as well as reevaluating PPE (writeups), creating deferred tax liabilities, and writing down existing DTAs and DTLs.

In an M&A deal, items set to reverse eventually must reverse immediately on acquisition close.

Question 29

When is a new Deferred Tax liability Created? How is it calculated?

Answer 29

When there is a write up of PPE or of other intangible assets (are created).

DTL = (Intangible + PPE Write Up)*Tax Rate

Question 30

How do Asset write ups affect Goodwill created?

Answer 30

Asset write-ups reduce goodwill created because they increase the Asset side of the Balance Sheet.

Question 31

How do Liability write-downs affect Goodwill created?

Answer 31

Liability write-downs reduce Goodwill created because they make the L&E side of the balance sheet smaller.

Question 32

How do DTLs affect goodwill created?

Answer 32

Liability increases, or DTLs, increase goodwill created. Similar to Asset writedowns.

Question 33

Why may EPS not work when evaluating M&A?

Answer 33

EPS may not work if the companies you are analysing are 1) private (and thus no shares to calculate) or if the EPS is extremely negative.

Question 34

Are there other ways to evaluate M&A deals?

Answer 34

Qualitative / Strategic Analysis:

1) Potential for extremely high growth
2) Defensive acquisition / Fear of competition

IRR / WACC:

Instead of setting up an accretion/dilution analysis, you could do something much simpler and evaluate an acquisition using an estimate for IRR and compare to the Acquirers discount rate.

Value Creation:

Evaluate deal seeing if it increases Implied Value.

1) Combined Equity Value = Acquirers Equity value + Stock issued in deal
2) Combined Enterprise Value = Acquirers Enterprise Value + Purchase Enterprise Value

Question 35

What is contribution analysis?

Answer 35

It is to understand what proportion of ownership the acquirer will have in the combined company if it contributes X% to specific financial metrics.

If the acquirer contributes 80% to revenue and EBITDA but only owns 50% of the company, then it is perhaps paying too much for the Target.

Question 36

When is a contribution analysis relevant?

Answer 36

100% stock deals: in these deals, all changes to purchase price directly affect ownership since it is funded through shares.

Mergers of Equals: these transactions almost always use 100% stock due to size similarities

Private Company deals: since private firms don’t care about EPS as much, Contribution Analysis is relevant and important in all stock deals

Majority-stock deals: at least 50% stock involvement could justify contribution analyses because it creates ownership motivations and changes.

Question 37

Why is contribution analysis common?

Answer 37

1) Grounded in reality
2) Doesn’t take much additional time to set up
3) Sometimes the only way to analyze a deal meaningfully

Question 38

What is a tender offer?

Answer 38

The buyer proposes an offer price directly to the seller’s shareholders, and each shareholder can decide whether or not to sell their shares for that price.

Nowadays tenders are used for speed, rather than hostile takeovers

Question 39

What is a merger?

Answer 39

The Buyer’s board of directors and the Board of the Seller agree on a price, negotiate the deal, and announce the deal for shareholders to vote.

Question 40

Why would tender offers yield a higher premium?

Answer 40

Again, control premium must be driven through purchasing from individual shareholders, so the buyer must convince individual shareholders to sell which may mean a high premium on the share price.

Question 41

What is a stock purchase?

Answer 41

The buyer purchases all the seller’s outstanding shares and receives its assets, liabilities, and off-balance sheet items.

Question 42

What is an asset purchase?

Answer 42

The buyer purchases only selected assets of the seller and assumes selected liabilities.

Question 43

When are asset purchases more common?

Answer 43

Divestitures, Spin-offs, Acquisitions of smaller private companies.

Question 44

Who prefers asset purchases?

Answer 44

Buyers prefer asset purchases because

1) They are able to pick and choose exactly what they get in deals(reducing risk)
2) Assets are written up both for Book and for Tax Purposes, meaning Buyers can deduct D&A on asset write-ups for tax purposes and no DTL is created.

Question 45

Who prefers stock purchases?

Answer 45

Sellers prefer stock purchases because;

1) Sellers must pay taxes on the entire purchase price plus gains on assets in asset purchases rather than just the purchase price in stock purchases
2) There’s less post-transaction risk. In Asset purchases, sellers still may keep some assets, liabilities and off-BS items which increases risk

Question 46

Which is faster, stock or asset purchases?

Answer 46

Stock purchases are faster to execute because there is no need to specify treatment of every single asset and liability of the seller.

Question 47

What is a 338(h)(10)

Answer 47

The 338(h)(10) is specific to the US tax code that affords buyers and sellers to treat a stock purchase like an asset purchase.

The buyer purchases all the seller’s shares and gets all its assets, liabilities, and off-BS items, but taxes work the same way as in an Asset Deal.

D&A on Asset write-ups is deductible for cash and tax purposes, no DTL is created, and Goodwill (Intangibles) and NOLs follow same treatment as in Asset Deals.

Question 48

What are the requirements of a 338(h)(10) deal?

Answer 48

The buyer must be a C corp. The Seller must be domestic and only certain types of Sellers qualify (S Corps, Subsidiaries in consolidated groups).

Question 49

What ownership will the seller have in a 100% stock deal where the buyer agrees to a 2:1 exchange ratio. Assume the seller has 10M shares outstanding and the buyer has 100M shares outstanding.

Answer 49

If the deal is all stock and a 2:1 exchange, the buyer issues 2*10M shares for the deal. So the seller receives 20M shares of the Buyer’s stock, and the Buyer increases its shares outstanding to 120M.

overall seller ownership is 20/120 = 16.67%

Question 50

What are earnouts and where are they common?

Answer 50

Earnouts are deferred payment as part of an M&A transaction to incentivise the seller to achieve certain goals. These may be common in biotech firms or firms with set future deadlines (Clinical trials etc.).

Question 51

Why do earnouts not work as often in public company acquisitions?

Answer 51

Because public sellers are run by shareholders and demand upfront compensation.

Question 52

How do Buyers account for Earnouts on the statements?

Answer 52

The buyer records a Contingent Consideration on the Liabilities section of the Balance sheet.

If the probability of paying out an earnout decreases, the buyer records this as a gain on the income statement,

The buyer adjusts this non-cash expense/gain on the Cash Flow statement.

If the buyer finally pays the earn-out, it will record the outflow on the Cash Flow statement (Financing) and reduce the liability to zero.

Question 53

How do earnouts affect goodwill?

Answer 53

Earnouts create Contingent Consideration Liabilities which increase the L&E side of the balance sheet and thus increase the goodwill of a transaction.

Question 54

What is a fixed share option?

Answer 54

It is a fixed exchange ratio and it corresponds to when a buyer defines a 2:1 share exchange with the seller (and the seller will always receive a set number of shares and set amount of ownership).

Question 55

What is a floating exchange ratio?

Answer 55

The seller always receives a specific price for the transaction but the amount of ownership will vary depending on the buyer’s share price.

eg. The buyer agrees to pay the seller $220M. The current share price is $11/share, so the buyer may issue 20M shares.

however, if the share price fell to $10/share, now the buyer would have to issue 22M shares. “

in scenario 1, if the shares outstanding were originally 100M. Ownership for the seller is 20/120 = 16.67%

in scenario 2, ownership is 22/122 = 18%.

Question 56

Who favours which type of transaction?

Answer 56

Buyers tend to favour fixed exchange ratios if it wants to limit dilution and prefers certainty over number of new shares issued, even at the expense of paying the Seller a lower price. Sometimes this is a sign that the buyer may not be confident in the value of its shares (negative signalling)

Sellers tend to prefer Floating Exchange Ratios: if the seller believes the Buyer’s stock will fall, it will get the same price AND a higher portion of ownership.

Question 57

What is a collar?

Answer 57

Collars are contractual agreements that offer further economic considerations in all-stock transactions, past those of fixed and floating exchange terms.

Question 58

When are collars useful?

Answer 58

1) When sellers are moderately sized relative to the buyer (10-20%)
2) The parties want risk-protection of a cash deal and tax benefits of a stock deal
3) The deal is cross border and different currencies are involved
4) The buyer’s share price has been volatile
5) The deal is a competitive auction
6) The deal will take a long time to close (and thus the stock value is much riskier since it has a longer period to fluctuate)

Question 59

What happens to NOLs in an Asset Purchase and 338(h)(10) deal?

Answer 59

NOLs are written down 100% and cannot be used at all post transaction.

Question 60

What happens to NOLs in a Stock Purchase?

Answer 60

The Buyer can use a limited amount of Seller NOLs each year, but it may have to write down a portion of the balance

Question 61

Say the seller has $100M NOLs, which are represented as $40M DTA (40% tax rate). The buyer pays $1,000M for the seller. What happens in an Asset or 338(h)(10) deal?

Answer 61

1) The buyer writes down the total DTA or $40M NOL. The $100M off BS goes to 0 and there is no utility of NOL in the future.

Question 62

Say the seller has $100M NOLs, which are represented as $40M DTA (40% tax rate). The buyer pays $1,000M for the seller. What happens in a Stock Deal?

Answer 62

The buyer can use a limited amount of the NOL annually.

Allowable Usage = Equity Purchase Price * Highest of past 3 months adjusted long-term rates.

Question 63

Say the rates for the last three months were 2%, 1.5%, 1.9% and the Equity Purchase price was $1,000M, what is the annual NOL allowed?

Answer 63

Annual NOL allowed = $1,000 * 2% = 20M NOL.

With an initial NOL balance of $100M, that means the buyer can use the whole balance in 5 years.

Question 64

What if these NOLs were set to expire in 3 years? Assume NOL balance is $100M.

Answer 64

If the buyer will only be able to use 3 years worth of NOL, the buyer must write down $40M of NOL immediately, which corresponds to $16M write down of DTA (40% tax rate).

Question 65

What are the considerations for a Stock or Asset (338(h)(10)) transaction?

Answer 65

If the seller has a huge NOL balance, both parties may prefer a Stock purchase (to utilize the NOLs and DTAs) whoever if the balance is smaller or non-existent, an Asset Purchase of 338(h)(10) election may offer more benefits due to the D&A on asset write ups and Amortization of Goodwill being deductible for cash-tax purposes.

Question 66

What happens to the 3 statements in an acquisition where the buyer acquires less than 50% of the seller. Assume its a 25% acquisition stake.

Answer 66

In this case, the financial statements are NOT consolidated.

Say the buyer pays $1000 in Cash for a 25% stake in the seller. Cash is down $1000 and Equity Investments are up $1000.

1) After the transaction closes, the Buyer will record 25%Seller’s Net Income at the bottom of its income statement and add this figure to the Net Income for total.
2) On the cash flow statement, the Buyer will subtract 25%Sellers Net Income because it doesn’t have control of the seller, but will add 25%Seller’s Dividends because it does receive this.
3) On the Balance Sheet, the Equity Investments line increases by 25%Net Income and decreases by 25%*Dividends. Cash adjusts per the cash flow statement. Net Income adjusts per the Income Statement.

Question 67

What happens to the 3 statements if the buyer owns 30% of the seller and decides to purchase 40% more for 480M in 1/3 cash debt stock.

Answer 67

If the seller agrees to 40% at $480, this means the purchase equity price is $1200 (480*100/40). The new equity value owned by the buyer is 480 + 360 = $840.

Now, if the buyer uses 1/3 cash stock debt for the $480 deal, the buyer uses $160 cash $160 debt $160 stock.

Question 68

What happens to the balance sheet if the buyer went from minority to majority stake.

Answer 68

The financial statements are consolidated.

The Equity Investments line is written down to 0

Shareholder’s Equity of seller is written down to 0. You also deduct transaction fees (or include as part of retained earnings)

Noncontrolling interest line item is created for the portion of the company the buyer did not acquire.

On the Income Statement, the buyer subtracts Portion of Seller it Does Not Own*Sellers Net Income (After Tax)

You then add this amount back in the Cash Flow Statement since the buyer has control of the seller and receives these in cash.

Question 69

How do mergers for private companies differ?

Answer 69

Purchase Price: It is based on a multiple of EBITDA, revenue, or some other financial metric, rather than share-price premium.

Form of Consideration: If the Buyer is private, it probably can’t use stock to do the deal.

Earnouts are common in acquisitions of private sellers. Sometimes the seller must maintain targeted levels of Working Capital as well, and the Buyer may end up paying more or less based on actual vs targeted Working Capital.

Deal Structure: The buyer is more likely to use an Asset Purchase or 338(h)(10) election for private sellers because there is more risk related to assets/liabilities/off-balance sheet items.

Meaningful analysis: EPS accretion/dilution is less meaningful. You usually focus on contribution analysis or IRR/WACC

Accounting Adjustments: You likely will need to be prepared for accounting adjustments unless the private company is large and established.