Merger Model

Created by Cap_Concept 

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Walk me through a basic merger model.

"A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer's EPS increases or decreases.
Step 1 is making assumptions about the acquisition - the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one.
Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS."

What's the difference between a merger and an acquisition?

There's always a buyer and a seller in any M&A deal - the difference between "merger" and "acquisition" is more semantic than anything. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

Why would a company want to acquire another company?

Several possible reasons:
• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow more quickly and sees an acquisition as a way to do that.
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller's customers so it can up-sell and cross-sell to
them.
• The buyer thinks the seller has a critical technology, intellectual property or some
other "secret sauce" it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make the deal
accretive for its shareholders.

Why would an acquisition be dilutive?

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer's foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares.
Acquisition effects - such as amortization of intangibles - can also make an acquisition dilutive.

Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller's Pre-Tax Income.
And if it's an all-stock deal you can use a shortcut to assess whether it is accretive (see question #5).
But if the deal involves cash, stock, and debt, there's no quick rule-of-thumb you can use unless you're lightning fast with mental math.

A company with a higher P/E acquires one with a lower P/E - is this accretive or dilutive?

Trick question. You can't tell unless you also know that it's an all-stock deal. If it's an all-cash or all-debt deal, the P/E multiples of the buyer and seller don't matter because no stock is being issued. Sure, generally getting more earnings for less is good and is more likely to be accretive but there's no hard-and-fast rule unless it's an all-stock deal.

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.
On an intuitive level if you're paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you're paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.

What are the complete effects of an acquisition?

1. Foregone Interest on Cash - The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition.
2. Additional Interest on Debt - The buyer pays additional Interest Expense if it uses debt.
3. Additional Shares Outstanding - If the buyer pays with stock, it must issue additional shares.
4. Combined Financial Statements - After the acquisition, the seller's financials are added to the buyer's.
5. Creation of Goodwill & Other Intangibles - These Balance Sheet items that represent a "premium" paid to a company's "fair value" also get created.
Note: There's actually more than this (see the advanced questions), but this is usually sufficient to mention in interviews.

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

It might be saving its cash for something else or it might be concerned about running low if business takes a turn for the worst; its stock may also be trading at an all-time high and it might be eager to use that instead (in finance terms this would be "more expensive" but a lot of executives value having a safety cushion in the form of a large cash balance).

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

Because the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effective valuation for the target company.

Why do Goodwill & Other Intangibles get created in an acquisition?

These represent the value over the "fair market value" of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price.
More specifically, Goodwill and Other Intangibles represent things like the value of customer relationships, brand names and intellectual property - valuable, but not true financial Assets that show up on the Balance Sheet.

What is the difference between Goodwill and Other Intangible Assets?

Goodwill typically stays the same over many years and is not amortized. It changes only if there's goodwill impairment (or another acquisition).
Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line.
There's also a difference in terms of what they each represent, but bankers rarely go into that level of detail - accountants and valuation specialists worry about assigning each one to specific items.

Is there anything else "intangible" besides Goodwill & Other Intangibles that could also impact the combined company?

Yes. You could also have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off.
The first refers to any Research & Development projects that were purchased in the acquisition but which have not been completed yet. The logic is that unfinished R&D projects require significant resources to complete, and as such, the "expense" must be recognized as part of the acquisition.
The second refers to cases where the seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-down the value of the Deferred Revenue to avoid "double-counting" revenue.

What are synergies, and can you provide a few examples?

Synergies refer to cases where 2 + 2 = 5 (or 6, or 7...) in an acquisition. Basically, the buyer gets more value than out of an acquisition than what the financials would predict.
There are 2 types: revenue synergies and cost (or expense) synergies.
• Revenue Synergies: The combined company can cross-sell products to new customers or up-sell new products to existing customers. It might also be able to expand into new geographies as a result of the deal.
• Cost Synergies: The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.

How are synergies used in merger models?

Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue - this additional Revenue then flows through the rest of the combined Income Statement.

Cost Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.

Are revenue or cost synergies more important?

No one in M&A takes revenue synergies seriously because they're so hard to predict. Cost synergies are taken a bit more seriously because it's more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.That said, the chances of any synergies actually being realized are almost 0 so few take them seriously at all.

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

Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company. Why?
• Cash is "cheaper" than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than that. Thus, foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt.
• Cash is also less "risky" than debt because there's no chance the buyer might fail to raise sufficient funds from investors.
• It's hard to compare the "cost" directly to stock, but in general stock is the most "expensive" way to finance a transaction - remember how the Cost of Equity is almost always higher than the Cost of Debt? That same principle applies here.
• Cash is also less risky than stock because the buyer's share price could change dramatically once the acquisition is announced.

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

Generally you would look at Comparable Companies/ Precedent Transactions to determine this. You would use the combined company's LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of whatever companies you're looking at, and apply that to your own EBITDA figure to get a rough idea of how much debt you could raise.
You would also look at "Debt Comps" for companies in the same industry and see what types of debt and how many tranches they have used.

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

You use the same Valuation methodologies we already discussed. If the seller is a public company, you would 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.

Let's say a company overpays for another company - what typically happens afterwards and can you give any recent examples?

There would be an incredibly high amount of Goodwill & Other Intangibles created if the price is far above the fair market value of the company. Depending on how the acquisition goes, there might be a large goodwill impairment charge later on if the company decides it overpaid.
A recent example is the eBay / Skype deal, in which eBay paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and eBay later ended up writing down much of the value and taking a large quarterly loss as a result.

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

The buyer's share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would not necessarily be cut in half.
Depending on how the deal was structured, the seller would effectively only be receiving half of what it had originally negotiated.
This illustrates one of the major risks of all-stock deals: sudden changes in share price could dramatically impact valuation.

Why do most mergers and acquisitions fail?

Like so many things, M&A is "easier said than done." In practice it's very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division.
Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders. Any deal done without both parties' best interests in mind is likely to fail.

What role does a merger model play in deal negotiations?

The model is used as a sanity check and is used to test various assumptions. A company would never decide to do a deal based on the output of a model.
It might say, "Ok, the model tells us this deal could work and be moderately accretive - it's worth exploring more."
It would never say, "Aha! This model predicts 21% accretion - we should definitely acquire them now!"
Emotions, ego and personalities play a far bigger role in M&A (and any type of negotiation) than numbers do.

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

The most common variables to look at are Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies. Sometimes you also look at different operating sensitivities, like Revenue Growth or EBITDA Margin, but it's more common to build these into your model as different scenarios instead.
You might look at sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Price vs. Cost Synergies, Purchase Price vs. Revenue Synergies, or Purchase Price vs. % Cash (and so on).

*What's the difference between Purchase Accounting and Pooling Accounting in an M&A deal?

In purchase accounting the seller's shareholders' equity number is wiped out and the premium paid over that value is recorded as Goodwill on the combined balance sheet post-acquisition. In pooling accounting, you simply combine the 2 shareholders' equity numbers rather than worrying about Goodwill and the related items that get created.
There are specific requirements for using pooling accounting, so in 99% of M&A deals you will use purchase accounting.

*Walk me through a concrete example of how to calculate revenue synergies.

"Let's say that Microsoft is going to acquire Yahoo. Yahoo makes money from search advertising online, and they make a certain amount of revenue per search (RPS). Let's say this RPS is $0.10 right now. If Microsoft acquired it, we might assume that they could boost this RPS by $0.01 or $0.02 because of their superior monetization. So to calculate the additional revenue from this synergy, we would multiply this $0.01 or $0.02 by Yahoo's total # of searches, get the total additional revenue, and then select a margin on it to determine how much flows through to the combined company's Operating Income."

*Walk me through an example of how to calculate expense synergies.

"Let's say that Microsoft still wants to acquire Yahoo!. Microsoft has 5,000 SG&A-related employees, whereas Yahoo has around 1,000. Microsoft calculates that post-transaction, it will only need about 200 of Yahoo's SG&A employees, and its existing employees can take over the rest of the work. To calculate the Operating Expenses the combined company would save, we would multiply these 800 employees Microsoft is going to fire post-transaction by their average salary."

*How do you take into account NOLs in an M&A deal?

You apply Section 382 to determine how much of the seller's NOLs are usable each year.
Allowable NOLs = Equity Purchase Price * Highest of Past 3 Months' Adjusted Long Term Rates
So if our equity purchase price were $1 billion and the highest adjusted long-term rate were 5%, then we could use $1 billion * 5% = $50 million of NOLs each year.
If the seller had $250 million in NOLs, then the combined company could use $50 million of them each year for 5 years to offset its taxable income.

*Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in
M&A deals?

These get created when you write up assets - both tangible and intangible - and when you write down assets in a transaction. An asset write-up creates a deferred tax liability, and an asset write-down creates a deferred tax asset.
You write down and write up assets because their book value - what's on the balance sheet - often differs substantially from their "fair market value."
An asset write-up creates a deferred tax liability because you'll have a higher depreciation expense on the new asset, which means you save on taxes in the short-term - but eventually you'll have to pay them back, hence the liability. The opposite applies for an asset write-down and a deferred tax asset.

*How do DTLs and DTAs affect the Balance Sheet Adjustment in an M&A deal?

You take them into account with everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma balance sheet. The formulas are as follows:

Deferred Tax Asset = Asset Write-Down Tax Rate Deferred Tax Liability = Asset Write-Up Tax Rate

So let's say you were buying a company for $1 billion with half-cash and half-debt, and you had a $100 million asset write-up and a tax rate of 40%. In addition, the seller has total assets of $200 million, total liabilities of $150 million, and shareholders' equity of $50 million.

Here's what would happen to the combined company's balance sheet (ignoring transaction/financing fees):
• First, you simply add the seller's Assets and Liabilities (but NOT Shareholders' Equity - it is wiped out) to the buyer's to get your "initial" balance sheet. Assets are up by $200 million and Liabilities are down by $150 million.
• Then, Cash on the Assets side goes down by $500 million.
• Debt on the Liabilities & Equity side goes up by $500 million.
• You get a new Deferred Tax Liability of $40 million ($100 million * 40%) on the
Liabilities & Equity side.
• Assets are down by $300 million total and Liabilities & Shareholders' Equity are
up by $690 million ($500 + $40 + $150).
• So you need Goodwill & Intangibles of $990 million on the Assets side to make
both sides balance.

*Could you get DTLs or DTAs in an asset purchase?

No, because in an asset purchase the book basis of assets always matches the tax basis. They get created in a stock purchase because the book values of assets are written up or written down, but the tax values are not.

*How do you account for DTLs in forward projections in a merger model?

You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pretax Income on its books, and then you determine what it actually pays in cash taxes based on its NOLs and newly created amortization and depreciation expenses (from any asset write-ups).
Anytime the "cash" tax expense exceeds the "book" tax expense you record this as an decrease to the Deferred Tax Liability on the Balance Sheet; if the "book" expense is higher, then you record that as an increase to the DTL.

*Explain the complete formula for how to calculate Goodwill in an M&A deal.

Goodwill = Equity Purchase Price - Seller Book Value + Seller's Existing Goodwill - Asset Write-Ups - Seller's Existing Deferred Tax Liability + Write-Down of Seller's Existing Deferred Tax Asset + Newly Created Deferred Tax Liability
A couple notes here:
• Seller Book Value is just the Shareholders' Equity number.
• You add the Seller's Existing Goodwill because it gets written down to $0 in an
M&A deal.
• You subtract the Asset Write-Ups because these are additions to the Assets side
of the Balance Sheet - Goodwill is also an asset, so effectively you need less
Goodwill to "plug the hole."
• Normally you assume 100% of the Seller's existing DTL is written down.
• The seller's existing DTA may or may not be written down completely (see the
next question).

*Explain why we would write down the seller's existing Deferred Tax Asset in an M&A deal.

You write it down to reflect the fact that Deferred Tax Assets include NOLs, and that you might use these NOLs post-transaction to offset the combined entity's taxable income.
In an asset or 338(h)(10) purchase you assume that the entire NOL balance goes to $0 in the transaction, and then you write down the existing Deferred Tax Asset by this NOL write-down.
In a stock purchase the formula is:
DTA Write-Down = Buyer Tax Rate MAX(0, NOL Balance - Allowed Annual NOL Usage Expiration Period in Years)
This formula is saying, "If we're going to use up all these NOLs post transaction, let's not write anything down. Otherwise, let's write down the portion that we cannot actually use post-transaction, i.e. whatever our existing NOL balance is minus the amount we can use per year times the number of years."

*What's a Section 338(h)(10) election and why might a company want to use it in an M&A deal?

A Section 338(h)(10) election blends the benefits of a stock purchase and an asset purchase:
• Legally it is a stock purchase, but accounting-wise it's treated like an asset purchase.
• The seller is still subject to double-taxation - on its assets that have appreciated and on the proceeds from the sale.
• But the buyer receives a step-up tax basis on the new assets it acquires, and it can depreciate/amortize them so it saves on taxes.
Even though the seller still gets taxed twice, buyers will often pay more in a 338(h)(10) deal because of the tax-savings potential. It's particularly helpful for:
• Sellers with high NOL balances (more tax-savings for the buyer because this NOL balance will be written down completely - and so more of the excess purchase price can be allocated to asset write-ups).
• If the company has been an S-corporation for over 10 years - in this case it doesn't have to pay a tax on the appreciation of its assets.

The requirements to use 338(h)(10) are complex and bankers don't deal with this - that is the role of lawyers and tax accountants.

*What is an exchange ratio and when would companies use it in an M&A deal?

An exchange ratio is an alternate way of structuring a 100% stock M&A deal, or any M&A deal with a portion of stock involved.
Let's say you were going to buy a company for $100 million in an all-stock deal. Normally you would determine how much stock to issue by dividing the $100 million by the buyer's stock price, and using that to get the new share count.
With an exchange ratio, by contrast, you would tie the number of new shares to the buyer's own shares - so the seller might receive 1.5 shares of the buyer's shares for each of its shares, rather than shares worth a specific dollar amount.

Buyers might prefer to do this if they believe their stock price is going to decline post- transaction - sellers, on the other hand, would prefer a fixed dollar amount in stock unless they believe the buyer's share price will rise after the transaction.

*Walk me through the most important terms of a Purchase Agreement in an M&A deal.

There are dozens, but here are the most important ones:
• Purchase Price: Stated as a per-share amount for public companies.
• Form of Consideration: Cash, Stock, Debt...
• Transaction Structure: Stock, Asset, or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-compete
agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about their
respective businesses?
• No-Shop / Go-Shop: Can the seller "shop" this offer around and try to get a better deal, or must it stay exclusive to this buyer?

*What's an Earnout and why would a buyer offer it to a seller in an M&A deal?

An Earnout is a form of "deferred payment" in an M&A deal - it's most common with private companies and start-ups, and is highly unusual with public sellers.
It is usually contingent on financial performance or other goals - for example, the buyer might say, "We'll give you an additional $10 million in 3 years if you can hit $100 million in revenue by then."
Buyers use it to incentivize sellers to continue to perform well and to discourage management teams from taking the money and running off to an island in the South Pacific once the deal is done.

*How would an accretion / dilution model be different for a private seller?

The mechanics are the same, but the transaction structure is more likely to be an asset purchase or 338(h)(10) election; private sellers also don't have Earnings Per Share so you would only project down to Net Income on the seller's Income Statement.

Note that accretion / dilution makes no sense if you have a private buyer because private companies do not have Earnings Per Share.

*How would I calculate "break-even synergies" in an M&A deal and what does the number mean?

To do this, you would set the EPS accretion / dilution to $0.00 and then back-solve in Excel to get the required synergies to make the deal neutral to EPS.
It's important because you want an idea of whether or not a deal "works" mathematically, and a high number for the break-even synergies tells you that you're going to need a lot of cost savings or revenue synergies to make it work.

*Normally in an accretion / dilution model you care most about combining both companies' Income Statements. But let's say I want to combine all 3 financial statements - how would I do this?

You combine the Income Statements like you normally would (see the previous question on this), and then you do the following:
1. Combine the buyer's and seller's balance sheets (except for the seller's Shareholders' Equity number).
2. Make the necessary Pro-Forma Adjustments (cash, debt, goodwill/intangibles, etc.).
3. Project the combined Balance Sheet using standard assumptions for each item (see the Accounting section).
4. Then project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model.

*How do you handle options, convertible debt, and other dilutive securities in a merger model?

The exact treatment depends on the terms of the Purchase Agreement - the buyer might assume them or it might allow the seller to "cash them out" assuming that the per-share purchase price is above the exercise prices of these dilutive securities.
If you assume they're exercised, then you calculate dilution to the equity purchase price in the same way you normally would - Treasury Stock Method for options, and assume that convertibles convert into normal shares using the conversion price.

*What are the main 3 transaction structures you could use to acquire another company?

Stock Purchase, Asset Purchase, and 338(h)(10) Election. The basic differences:
Stock Purchase:
• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
• The seller is taxed at the capital gains tax rate.
• The buyer receives no step-up tax basis for the newly acquired assets, and it can't
depreciate/amortize them for tax purposes.
• A Deferred Tax Liability gets created as a result of the above.
• Most common for public companies and larger private companies.

Asset Purchase:
• Buyer acquires only certain assets and assumes only certain liabilities of the seller and gets nothing else.
• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public
companies.

Section 338(h)(10) Election:
• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public companies.
• To compensate for the buyer's favorable tax treatment, the buyer usually agrees to pay more than it would in an Asset Purchase.

*Would a seller prefer a stock purchase or an asset purchase? What about the buyer?

A seller almost always prefers a stock purchase to avoid double taxation and to get rid of all its liabilities. The buyer almost always prefers an asset deal so it can be more careful about what it acquires and to get the tax benefit from being able to deduct depreciation and amortization of asset write-ups for tax purposes.

Explain what a contribution analysis is and why we might look at it in a merger model.

A contribution analysis compares how much revenue, EBITDA, Pre-Tax Income, cash, and possibly other items the buyer and seller are "contributing" to estimate what the ownership of the combined company should be.
For example, let's say that the buyer is set to own 50% of the new company and the seller is set to own 50%. But the buyer has $100 million of revenue and the seller has $50 million of revenue - a contribution analysis would tell us that the buyer "should" own 66% instead because it's contributing 2/3 of the combined revenue.
It's most common to look at this with merger of equals scenarios, and less common when the buyer is significantly larger than the seller.

How do you account for transaction costs, financing fees, and miscellaneous expenses in a merger model?

In the "old days" you used to capitalize these expenses and then amortize them; with the new accounting rules, you're supposed to expense transaction and miscellaneous fees upfront, but capitalize the financing fees and amortize them over the life of the debt.
Expensed transaction fees come out of Retained Earnings when you adjust the Balance Sheet, while capitalized financing fees appear as a new Asset on the Balance Sheet and are amortized each year according to the tenor of the debt.

What is the purpose of a merger model

It is used to analyze the financial profiles of two companies, the purchase price and how the purchase is made and determines whether the buyer's EPS increases or decreases

Walk me through a basic merger model

The first step is to make assumptions about the acquisition: The price and whether it was cash, stock or debt or some combination of those. Next you determine the valuations and shares outstanding of the buyer and seller and project out an income statement for each. Finally you combine the income statements, adding up line items such as revenue and operating expenses and adjusting foregone interest on cash and interest paid on debt. Then you apply the buyers tax rate to get the combined Net Income and divide by the new share count to determine combined EPS.

What is the difference between a merger and an acquisition?

There is always a buyer and a seller in any M&A deal, but with an acquisition the buyer tends to be larger than the seller and in a merger they tend to be close to the same size.

Why would a company want to acquire another company?

The buyer wants to gain market share by buying a competitor, the buyer needs to grow more quickly, the buyer believes the seller is undervalued, the buyer believes it can gain significant synergies making the deal accretive for shareholders.

Why would an acquisition be dilutive?

It would be dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer's foregone interest on cash, additional interest paid on debt and the effects of issuing more shares.

Is there a rule of thumb to determine if an acquisition will be accretive or dilutive.

If the deal involves cash and debt you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller's pre-tax income. If it is an all stock deal and the buyer has a higher P/E than the seller then it will be accretive, if it is lower it will be dilutive. If it involves cash, stock and debt, then there is no quick solution.

A company with a higher P/E acquires a company with a lower P/E is this accretive or dilutive?

You can't tell unless its an ALL STOCK DEAL. If it's all cash or all debt the P/E's don't matter.

What is the intuitive rule of thumb to determine if an acquisition will be accretive or dilutive.

Intuitively if you are paying more for earnings than what the market values your own earnings at then it will be dilutive and vice versa.

What are the complete effects of an acquisition

Foregone interest on cash- the buyer loses the interest it would have earned on the cash used
Additional interest on debt- the buyer pays additional interest if it uses debt
Additional shares outstanding- if the buyer pays with stock it must issue additional shares
Combined financial statements
Creation of Goodwill & other intangibles- they represent the premium paid to the company's fair value.

If a company were capable of paying 100% cash for another company why would it not?

It may be saving its cash for something else or holding on to it as a safety cushion in case things take a turn for the worst

Why would a strategic buyer be willing to pay more money than a PE firm would?

The strategic buyer can realize revenue and synergies that a private equity firm typically can not.

How do Goodwill and other intangibles get created in an acquisition

They represent the value paid over the "fair market value." You calculate the number by subtracting BV-equity purchase price. They represent brand-name, customer relationships, and intellectual property.

What is the difference between Goodwill and other Intangibles?

Goodwill typically stays the same and is not amortized. It only changes with goodwill impairment.
Intangibles are amortized over several years and affect the income statement by hitting the pre-tax income line

What are synergies

Synergies refer to cases where 2+2=5, 6, or 7. The buyer essentially gets more value out of the acquisition than the financials predict.

What are some examples of synergies

Revenue synergies: the combined company can cross-sell products to new customers or up-sell new products to existing customers.
Cost Synergies: The combined company can consolidate buildings and administration and lay off redundant employees and shut down redundant stores.

How are synergies used?

Revenue Synergies: are added to the revenue figure for the combined company and then assume a certain margin on the revenue.
Cost Synergies: reduce the COGS or the Operating expenses by this amount, which boosts the combined Pre-Tax Income and thus Net-Income and raising the EPS making the deal more accretive.

Are revenue or cost synergies more important?

No one in M&A takes revenue synergies seriously because they are so hard to predict. Cost synergies are easier to predict and thus taken more seriously. The chances of any synergies being realized are almost 0.

Which method would a company prefer to use when acquiring a company, Cash, stock or debt.

It would always prefer to use cash if it is available. Cash is less expensive than debt as interest rates are usually under 5% whereas debt is usually much higher.
Cash is less risky because there is almost no chance that a buyer would fail to raise sufficient capital
Stock is almost always the most expensive(COE>COD)

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

Use the same valuation methods used earlier and if the seller is a public company then you pay more attention to a "premium" paid over the current share price (typically 15-30%).

What would happen if a company overpays for another company.

There will typically be an very high amount of Goodwill and other Intangibles created. There could be a large goodwill impairment later on. Ex. eBay and Skype.

A buyer pays $100m for the seller in an all stock deal and a day later the market decides its only worth $100m. What happens?

The buyer's share price would fall by whatever the per share dollar amount is that corresponds to the $50m loss in value.

What is a merger model used for?

It is used as a sanity check but will never decide if a company will do a deal or not.

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