"A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and it determines whether the buyer's EPS increases or decreases afterward.
Step 1 is making assumptions about the acquisition - the price and whether it was done using cash, stock, debt, or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project the Income Statements 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."
You could also add in the part about Goodwill and combining the Balance Sheets, but it's best to start with answers that are as simple as possible at first.
In this scenario, Company B's Market Cap gets wiped out because it no longer exists as an independent entity, and Company A's cash balance decreases because it has used its cash to acquire Company B.
So, the Combined Market Cap = 80. Previously, A had 20 more Debt than Cash, and B had the same amount of Cash and Debt.
To get real numbers here, let's just say that A had 60 of Debt and 40 of Cash. Afterward, the Debt remains at 60 but all the cash is gone because it used the Cash to acquire B. We don't need to look at B's numbers at all because its Cash and Debt cancel each other out.
So the Combined Enterprise Value = 80 + 60 = 140. It is no coincidence, of course, that Combined Enterprise Value = Company A Enterprise Value + Company B Enterprise Value. That is how it should always work in an acquisition where there was no premium paid for the seller.
You add the EBITDA and Net Income from both companies to get the combined figures. This is not 100% accurate because Interest Income changes for Company A since it's using cash and because the tax rates may be different, but we're going to ignore those for now since the impact will be small:
• Combined EV / EBITDA = 140 / (10 + 8) = 140 / 18 = 7.8x.
• Combined P / E = 80 / (4 + 2) = 80 / 6 = 13.3x.
Once again, Company B's Market Cap gets wiped out since it no longer exists as an independent entity.
So Combined Market Cap = 80.
The combined company has 40 of additional Debt, so if we continue with the assumption that A has 60 of Debt and 40 of Cash the Enterprise Value is 80 + 60 + 40 - 40 = 140, the same as in the previous example (Important: Regardless of the purchase method, the combined Enterprise Value stays the same).
The Combined EBITDA is still 18, so EV / EBITDA = 140 / 18 = 7.8x.
But the combined Net Income has changed. Normally, Company A Net Income + Company B Net Income = 6...
But now we have 40 of debt at 10% interest, which is 4, and when multiplied by (1 - 25%), equals 3. So Net Income falls to 3, and Combined P / E = 80 / 3 = 26.7x.
"Sure. Let's say that Company A sells 10,000 widgets per year in North America at an average price of $15.00, and Company B sells 5,000 widgets per year in Europe at an average price of $10.00. Company A believes that it can sell its own widgets to 20% of Company B's customers, so after it acquires Company B it will earn an extra 20% 5,000 $15.00 in revenue, or $15,000.
It will also have expenses associated with those extra sales, so you need to reflect those as well - if it has a 50% margin, for example, it would reflect an additional $7,500, rather than $15,000, to Operating Income and Pre-Tax Income on the combined Income Statement."
This last point about expenses associated with revenue synergies is important and one that a lot of people forget - there's no such thing as "free" revenue with no associated costs.
For all acquisitions where over 50% but less than 100% of another company gets acquired, you still go through the purchase price allocation process and create Goodwill, but you record a Noncontrolling Interest on the Liabilities side for the portion you do not own. You also consolidate 100% of the other company's statements with your own, even if you only own 70% of it.
Example: You acquire 70% of another company using Cash. The company is worth $100, and has Assets of $180, Liabilities of $100, and Equity of $80.
You add all of its Assets and Liabilities to your own, but you wipe out its Equity since it's no longer considered an independent entity. The Assets side is up by $180 and the Liabilities side is up by $100.
You also used $70 of Cash, so the Assets side is now only up by $110.
We allocate the purchase price here, and since 100% of the company was worth $100 but its Equity was only $80, we create $20 of Goodwill - so the Assets side is up by $130.
On the Liabilities side, we create a Noncontrolling Interest of $30 to represent the 30% of the company that we do not own. Both sides are up by $130 and balance.
Yes. You can use something called a collar, which guarantees a certain price based on the range of the buyer's stock price to the seller's stock price. Here's an example:
Suppose that we had a 100% stock deal with a 1.5x exchange ratio, i.e. the seller receives 1.5 of the buyer's shares for each 1 of its own shares. The buyer's share price is $20.00 and the seller has 1,000 shares outstanding. Right now, it's worth $30,000 (1,000 1.5 $20.00) to the seller. Here's how we could set up a collar:
• If the buyer's share price falls below $20.00 per share, the seller still receives the equivalent of $20.00 per buyer share in value. So if the buyer's share price falls to $15.00, now the seller would receive 2,000 shares
• If the buyer's share price is between $20.00 and $40.00 per share, the normal 1.5x exchange ratio is used. So the value could be anything from
$30,000 to $60,000.
• If the buyer's share price goes above $40.00 per share, the seller can only
receive the equivalent of $40.00 per buyer share in value. So if the buyer's share price rises to $80.00, the seller would receive only 750 shares instead.
Collar structures are not terribly common in M&A deals, but they are useful for reducing risk on both sides when stock is involved.
First off, you would reverse any new write-ups to Assets to handle this scenario the easy way, if possible. So if we had Asset Write-Ups of $300 then it would be easy to simply reverse those and make it so the Assets were only worth $1700, which would result in positive Goodwill instead.
If it is not possible to do that - e.g. there were no Asset Write-Ups or they cannot be reversed for some reason - then we need to record a Gain on the Income Statement for this "Negative Goodwill."
In this case, the company's Shareholders' Equity is $1200 but we paid $1000 for it, so we do the following:
Income Statement: Record a Gain of $200, boosting Pre-Tax Income by $200 and Net Income by $120 at a 40% tax rate.
Cash Flow Statement: Net Income is up by $120, but we subtract the Gain of $200, so Cash is down by $80 so far. Under CFI we record the $1000 acquisition, so Cash at the bottom is down by $1080.
Balance Sheet: Cash is down by $1080. But we have $2000 of new Assets, so the Assets side is up by $920. On the other side, Liabilities is up by $800 and Shareholders' Equity is up by $120 due to the increased Net Income, so both sides are up by $920 and balance.