# Merger Model - Advanced

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What's the difference between Purchase Accounting and Pooling Accounting in an M&A deal?
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In purchase accounting the seller's shareholder's 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.
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 share (RPS). Let's say this RPS is \$0.01 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.
Let's say that Microsoft still wants to acquire Yahoo! Microsoft has 5,00 SG&A-related employees, whereas Yahoo has around 1,00. 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.
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.
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 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.
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 (DTAs) = Asset Write-Down * Tax Rate
Deferred Tax Liability (DTLs) = 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 gees):

- 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 DTL 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.
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 a 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.
Goodwill = Equity Purchase Price - Seller Book Value + Seller's Existing Goodwill - Asset Write0Ups - 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).
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, Balance - Allowed Annual NOL Usage Expiration Period in Years)

This formula is saying, "If we're going to use 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."