Structure Terms

Question 1

Step 1 - Determine the Offer Value

Answer 1

Need to calculate two things - the offer price and the target’s diluted shares outstanding

Question 2

What is the offer price

Answer 2

Price per share the Acquirer offers the Target in exchange for ownership…based on public comparables, acquisition comparables and DCF

Question 3

Offer premium

Answer 3

Offer premium = (Offer price / Target customer share price) - 1

Question 4

Why will acquirer be willing to pay a premium?

Answer 4

Control and Synergies - 1) Control - has salable value and substantial. Gain say in target’s business decision making and previous owners are relinquishing control over the business to you…requiring a premium. 2) Synergies - shareholders demand a premium knowing that there will be financial benefit because of the synergies of the acquisition - economies of scale, consolidating redundant technologies, accounting systems, back office operations and revenue synergies…translating into higher cash flows and profits…and therefore want a piece

Question 5

Merger of Equals

Answer 5

When the combined entity is owned about equally by Acquirer and Target - no control premium

Question 6

Risk is a ?

Answer 6

Cost

Question 7

Control Premium amounts

Answer 7

Generally between 20 - 40% over the Target’s stock price

Question 8

Offer Value

Answer 8

Offer Value = Offer price per share X Target’s Diluted Shares Outstanding. Diluted shares outstanding can be found via basic share count of common shares plus dilutive securities. The Offer Value is the total consideration offered to the Target shareholders in exchange for their stock equivalent to equity value, however offer value factors in control premium, and the equity value represents the standalone value of the company’s stock.

Question 9

Offer Value vs Transaction Value

Answer 9

Offer value essentially equivalent to equity value…Transaction value is equivalent to Enterprise value => both are all-inclusive as it factors in all forms of capital to include equity, debt, non-controlling interest, and preferred stock. It measures the size of the entire transaction including the offer value paid to Target’s shareholders along with the assumed liabilities of other capital holders (debt, preferred stock and non-controlling interest)

Question 10

Determine Consideration Mix - Stock

Answer 10

Acquirer issues stock by issuing new shares of its own stock in exchange for shares of Target. Acquirer matches the value of the offer price with its own shares…Target price is $100 and Acquirer shares are worth $50…Acquirer would issues two of its own shares to Target. Unlike debt, there is no interest expense, and therefore no reduction to earnings and no additional balance sheet risk. However it does dilute the ownership of the acquiring company. Issuing shares can have a more dilutive effect to earnings than using debt.

Question 11

Impact of Stock considerations

Answer 11

Depending on how much stock is issued, the Target shareholder can wield significant influence in the merged company, becoming an issue if their are significant clashes between Acquirer management and shareholders. Stock deals are tax deferred until ultimate disposition of those shares

Question 12

Determine Consideration Mix - Cash

Answer 12

Typically the Acquirer will go to the capital markets to borrow debt and uses the proceeds to finance the transaction. Key concern is additional interest expense, reduces earning and shareholder returns and increases balance sheet risk. If the amount of debt borrowed and the accompanying interest expenses too high, the Acquirer may not be able to meeting financial obligations to debt holders leading to default and bankruptcy.

Question 13

Determine Consideration Mix - Cash & Stock

Answer 13

Mix of two in order to maximize benefit and minimize cons of both.

Question 14

Impact of Cash deal

Answer 14

Cash represents an immediate and full exit. No upside or downside risk after the merger event. Acquirer will need to borrow the amount promised to Target…and a cash consideration is generally taxed upon distribution to the shareholder.

Question 15

Two types of Transaction Structures

Answer 15

1) Asset Purchase; and 2) Stock Purchase

Question 16

When make adjustments, then are generally done on the…?

Answer 16

1) Balance Sheet; and 2) Income Statement

Question 17

Balance Sheet adjustments…

Answer 17

1) Debt Financing: How much debt (principle payments and interest expense) can the Acquirer take on. 2) Goodwill - New Asset (Purchase accounting)

Question 18

Income Statement adjustments…

Answer 18

Moves us from Acquirer’s standalone EPS to its pro forma EPS. Adjust for the following after-tax adjustments Benefits 1) Target’s Net Income; and 2) After-Tax Synergies. Costs 1) After-Tax Interest on New Debt; and 2) New Shares Issued.

Question 19

Benefit - Target Net Income

Answer 19

Gathered from equity research analysts (deal in prelim stages) or Management estimates (deal is further along)…both need to be scrutinized thoroughly - Mgmt will try to inflate to increase the valuation but also understands the inner workings of the business.

Question 20

Benefit - Revenue Synergies

Answer 20

1) Revenue; and 2) Cost. Revenue - most revenue synergies fail to materialize…they look great on paper…However some do like when a good product is acquired and pushed through strong distribution network. Sometimes excluded because they are illusory

Question 21

Benefit - Cost Synergies

Answer 21

Analyzing cost structure of the business and eliminating redundant operations, consolidating assets, downsizing personnel, streamlining internal processes, and pursuing other restructuring strategies that generate cash flow. Changes required to achieve these synergies often generate restructuring costs upfront. Example closing a facility may have disposal costs and severance pay for the employees…these are generally non-recurrent and are often excluded when calculating pro forma

Question 22

Costs

Answer 22

If the Acquirer is paying for 1) Target’s earnings; 2) Merger synergies…Then think of Acquirer’s costs as 3) the interest on acquisition debt; 4) new shares issues; and 5) one-time merger restructuring costs if they happen to be substantial.

Question 23

Cost of Burrowing requires a credit analysis that depends on the following…

Answer 23

1) the amount of debt being raised as compared to the pro forma cash flows of the combined company; 2) Acquirer and Target’s credit ratings; 3) the size of the Acquirer; 4) the possible cyclicality of the business…All of this is taken from the investment bank debt capital markets desk. Drives the merger’s impact on pro forma EPS through the numerator when cash-financed

Question 24

New Shares Issued

Answer 24

New shares do not reduce earnings, but they do increase the total number of shares outstanding and thereby reduce the returns to shareholders. Drives the merger’s impact on pro forma EPS through the denominator when stock-financed. The number of new shares the Acquirer must issue, in turn, depends on 1) the percentage of the consideration that’s being financed with stock; and 2) the value of Acquirer’s shares relative to the value of Target’s shares. The higher the price of the Acquirer shares compared to the Target shares, the less that will need to be offered and the less dilutive the deal.

Question 25

What determines the cost of using stock consideration

Answer 25

The Acquirer’s valuation, relative to the offer value, determines the cost of using stock consideration

Question 26

Which tax rate to use

Answer 26

If the Acquirer is significantly larger than the Target, use the Acquirer’s. If the Target is larger, use a blended average of the two.

Question 27

Accretive

Answer 27

Pro Forma EPS > Standalone EPS

Question 28

Dilutive

Answer 28

Pro Forma EPS < Standalone EPS

Question 29

Breakeven or EPS Neutral

Answer 29

Pro Forma EPS equal to Standalone EPS

Question 30

Leverage ratio of combined entity (Income Statement Metric)

Answer 30

EBITDA / Interest Expense => determines whether the company will generate enough operating cash flow to meet is regular interest obligations. The higher the ratio, the better.

Question 31

Leverage ratio of combined entity (Balance Sheet Metric)

Answer 31

Debt / EBITDA => determines whether the combined company can meet the principal obligations. The higher the ratio, the more risky the deal.

Question 32

Credit Ratings

Answer 32

Do not cross credit boundaries…could downgrade the company making it more costly to borrow money and hinder the ability to raise capital in the future. Depends on size of the company, operations and the robustness of the macro-economy and prevailing industry conditions.

Question 33

Goodwill Considerations

Answer 33

Goodwill is an asset, albeit it is an intangible one. It captures the economic benefit of a merger (synergies). If the synergies do not materialize, the company could face a write-down because of impaired goodwill. This would negatively affect the income statement, reduce earnings, and flow through retained earnings to reduce stockholder’s equity. It indicates lower expected profits in the future and that the Acquirer overpaid for the Target. A write-down could cause a company to lower its working capital, causing it to break potential loan covenants. Write downs also lower taxable income.

Question 34

Tax Consequences

Answer 34

1) Target - based on type of deal…transactions with significant percentage of stock will be tax-deferred (at least 40% stock consideration)…all cash will be taxed. 2) Purchase accounting, goodwill and potential write ups which result in deferred tax liabilities. 3) Transaction structure - depends on whether it is a stock purchase or an asset purchase. This will affect both the Acquirer and the Target