Top Stories | Fri, 29 Nov 2024 01:11 PM

Top 30 Investment Banking Questions and Answers on Merger model

Posted by : SHALINI SHARMA

1. Take me through a simplemerger model.

A merger model is an analysis ofthe acquisition impact on two companies, evaluating the purchase price, paymenttype (cash, stock, debt, or a combination), and its impact on the buyer's EPS,or Earnings Per Share.

Steps to build the model:

Step 1: Make acquisitionassumptions: purchase price, payment type(s), and financing structure.

Step 2: Calculate both buyer andseller valuations and shares outstanding. Project independent income statementsfor both.

Step 3: Combine the incomestatements by adding line items like revenues and operating expenses. Accountfor:

Forborne Interest on Cash (incase of cash).

Interest Paid on Debt (in case ofdebt).

Apply the tax rate of the buyerto the pre-tax income to find combined net income.

Calculate the new EPS by dividingthe combined net income by the updated share count.

2. What is the differencebetween a merger and an acquisition?

In M&A deals, there is alwaysa buyer and a seller. The difference is mainly semantic:

Merger: Both companies are ofrelatively similar size.

Acquisition: One company (thebuyer) is significantly larger than the other (the seller).

 

3. Why would a company want toacquire another company?

Common reasons include:

Expanding market share oreliminating competition by acquiring a competitor.

Gaining access to the seller'scustomer base to cross-sell and upsell.

Acquiring critical technology,intellectual property, or unique assets that enhance the buyer's operations.

Achieving synergies (cost savingsor revenue enhancements), making the deal financially accretive forshareholders.

 

4. Why would an acquisition bedilutive?

An acquisition is dilutive if:

 

The seller's net incomecontribution doesn't offset the buyer's foregone interest on cash, interestpaid on new debt, or the dilution from issuing additional shares.

Accounting factors, such asamortization of intangibles, can further decrease earnings, causing dilution.

 

5. Is there a rule of thumbfor figuring out whether an acquisition is going to be accretive or dilutive?

For cash and debt deals, comparethe interest expense on debt and foregone interest on cash with the seller'spre-tax income.

For all-stock deals, use P/Emultiples to determine accretion or dilution (see question 7).

For mixed-payment deals, no quickrule applies—you must calculate manually.

 

6. A company with a higher P/Ebuy one with a lower P/E – is this accretive or dilutive?

Answer: It depends on the paymentmethod.

In all-cash or all-debt deals,the P/E multiples don't matter since no stock is issued.

In an all-stock deal, acquiring acompany with a lower P/E is generally accretive, as the buyer is obtainingearnings at a lower price than its own valuation.

 

7. What is the rule of thumbfor assessing whether an M&A deal will be accretive or dilutive?

For all-stock deals, if thebuyer's P/E is higher than the seller's, the deal is likely accretive.

If the buyer's P/E is lower thanthe seller's, the deal is likely dilutive.

Intuition: Paying more forearnings than the market values your own earnings is dilutive, while payingless is accretive.

 

8. What are the completeeffects of an acquisition?

Key effects include:

Foregone Interest on Cash: Usingcash reduces interest income.

Additional Interest on Debt: Theuse of debt results in additional interest expense.

Additional Shares Outstanding:Paying with stock reduces the value of existing shares.

Combined Financial Statements:The seller's financial statements are combined with the buyer's.

Goodwill and IntangiblesCreation: Balance sheet adjustments to recognize premiums paid over the fairvalue of the target.

 

9. If a company could pay 100%in cash for another company, why might it not?

Reasons include:

Maintaining cash for futureopportunities or as a rainy day.

Worries about liquidity if marketconditions deteriorate.

The buyer's equity might beovervalued in the marketplace, so that stock offering would be an attractiveoption to finance the acquisition, although it is more costly in financialterms.

 

10. Why would a strategicacquirer typically pay more for a company than a private equity firm?

A strategic acquirer can realizerevenue and cost synergies that a PE firm typically would not be able toachieve without integrating the company with another portfolio company. Thesesynergies increase the target's effective valuation, enabling a strategic buyerto pay an appropriate premium.

 

11. Why do Goodwill and OtherIntangibles come in during an acquisition?

Goodwill and Other Intangiblesare essentially the 'sum of money paid over seller's fair market value. Theyrepresent that premium arising as customer relationship, brand equity or anyintellectual property which the selling entity would not classify to includeunder tangible assets on their financial balance sheet.

Goodwill equals to differencebetween the purchase consideration with respect to equity of purchase on booksof the seller.

 

12. What is the differencebetween Goodwill and Other Intangible Assets?

Goodwill:

Does not change over time exceptwhen there is an impairment or another acquisition.

Represents broad value, such asbrand reputation and overall business synergy.

Other Intangible Assets:

 

Are amortized over their usefullife, which affects the income statement by reducing pre-tax income.

Represent specific assets likepatents or trademarks.

Bankers usually don't go intothese details; this is the level of detail that accountants or valuationspecialists would go into.

 

13. Are there other"intangible" factors besides Goodwill and Other Intangibles thatcould impact the combined company?

Yes, two significant examplesare:

Purchased In-Process R&DWrite-Off:

This applies to R&D projectsacquired in the deal which are not complete. These projects consume a lot ofresources to complete, so the expense is recognized as part of the acquisition.

Deferred Revenue Write-Off:

This occurs when the seller hasreceived payment for services not yet provided. The buyer decreases thedeferred revenue to avoid counting income twice.

 

14. What are synergies, andcan you give me some examples?

Synergies arise when the value oftwo companies combined is greater than the sum of their individual values. Theyfall into two categories:

Revenue Synergies:

Cross-selling products to newcustomers.

Upselling new products toexisting customers.

Entering new markets orgeographies.

Cost Synergies:

Eliminating redundant headcountor locations.

Administrative or logisticsconsolidation.

 

15. How are synergies deployedin the merger models?

Revenue Synergies: Added to therevenue of the combined company, with assumed profit margin, and with theresulting income passing through the income statement.

Cost Synergies: Deducted fromCOGS or operating expenses. This enhances pre-tax and net income and, in turn,the EPS, thus making the transaction more accretive.

 

16. Which is more importantfor revenue or cost synergies?

Cost synergies are intuitivelytaken more seriously because they are easier to measure (e.g., fewer employees,reduced overhead offices).

Revenue synergies, whiletheoretically valuable, are hard to anticipate and are typically viewed with scepticismsin M&As.

Many synergies- particularlyrevenue-related-are rarely fully exploited.

 

17. Everything else beingequal, what is the better way to buy a company: cash, equity or debt?

Cash is more commonly usedbecause:

Lower cost: The foregone intereston cash is generally lower than the interest on debt.

Lower risk: No risk of failing toraise funds from investors.

Predictability: Stock prices canfluctuate after the deal is announced, making stock financing riskier.

Although debt is cheaper thanequity, there is a risk of repaying it. Stock is usually the most expensivetype of finance because the cost of equity is higher.

 

18. How much debt can acompany raise in a merger or acquisition?

This is derived by considering:

Comparable Companies: Take themedian Debt/EBITDA multiple of comparable companies and apply it to thecombined EBITDA.

Debt Comps: Consider industrynorms of what types and levels of debt to use, including tranches andstructures used by comparable companies.

 

19. How do you arrive at thepurchase price for the target company in an acquisition?

This methodology would be in DCF,precedent transactions, and comparable company analysis.

For a public company, the premiumover the current share price should consider gaining shareholder approval(typically 15-30%).

For a private company, it's moreintrinsic valuation.

 

20. What happens when onecompany overpays to another?

When a buyer overpays, excessiveGoodwill and Other Intangibles are created. If the deal does not deliverexpected benefits, then goodwill impairment occurs that reduces net income andresults in a loss.

eBay's acquisition of Skype. eBaypaid a high premium that created substantial goodwill. When the acquisition didnot meet expectations, eBay had to write down much of the goodwill, resultingin huge losses.

 

21.Explain how to calculaterevenue synergies with an example.

Assume Microsoft acquires Yahoo,which already has revenue from search ads at $0.10 per search (RPS).Post-acquisition, Microsoft can monetize that better and increase the RPS by$0.01–$0.02.

 

Calculate the incremental revenueas follows:

 

Multiply the RPS increase($0.01–$0.02) by the total number of searches that Yahoo gets.

Apply a margin to this revenue tofind out how much it will flow through to Operating Income for the combinedcompany.

 

22. Illustrate an expensesynergy calculation.

Assume that Microsoft buys Yahooand that at the time of acquisition, Microsoft has 5,000 SG&A employees,whereas Yahoo has 1,000. After acquisition, it is determined that only 200 ofYahoo's SG&A employees will be needed.

Expense savings =

Multiply the number of employeesto be laid off, 800 times average salary.

The result is the operatingexpense reduction for the combined company.

 

23. How are NOLs treated in adeal?

Apply Section 382 to compute theannual allowable usage of the seller's NOLs as follows:

Allowable NOLs = Equity PurchasePrice × Highest Adjusted Long-Term Rate (of the past 3 months).

For example, assuming thepurchase price is $1 billion and the long-term rate is 5%, the allowable NOLsper year are $50 million ($1 billion × 5%).

 

If the seller has $250 million inNOLs, the combined company can use $50 million annually for 5 years to offsettaxable income.

 

24. Why are DTLs and DTAscreated in M&A deals?

DTLs and DTAs are created whenasset values are adjusted in a transaction:

Asset write-ups: Increase bookvalue above tax value, creating DTLs.

Asset write-downs: Decrease bookvalue below tax value, creating DTAs.

For instance, a write-upincreases depreciation, decreasing short-term taxes (a liability to be repaidin the future).

 

25. How do DTLs and DTAsimpact the balance sheet in an M&A transaction?

DTLs and DTAs are rolled into thecomputation of Goodwill & Intangibles on the pro forma balance sheet. Thecritical formulas are:

 

DTL = Asset Write-Up × Tax Rate.

DTA = Asset Write-Down × TaxRate.

Example:

 

Purchase Price: $1 billion (50%cash, 50% debt).

Asset Write-Up: $100 million.

Tax Rate: 40%.

Steps:

 

Seller's assets (+$200M) andliabilities (+$150M) added to buyer's balance sheet

Cash used (-$500M) deducted anddebt issued (+$500M) added

DTL: $100M × 40% = $40M added toliabilities

Goodwill: Balance both sides ofthe balance sheet to obtain $890M Goodwill

 

26. Do DTLs or DTAs exist inan asset purchase?

No. For asset purchases, book andtax bases are equivalent so no DTLs/DTAs are generated. In stock purchases,variations in book vs. tax value give rise to DTLs and DTAs.

 

27. How is DTL treated inmerger models' projections?

Book v. Cash tax schedule:

Book Taxes - Tax computed onincome reported to the shareholders

Cash Taxes - Taxes actually paidconsidering the savings through NOLs, depreciation and amortization of assetsthat were written-up.

As indicated below.

 

Cash taxes > book taxes, soreduce DTL.

Cash taxes < book taxes,therefore, increase the DTL.

 

28. Explain Goodwill formulaused in the calculation of M&A deal

Goodwill = Equity Purchase Price- Seller's Book Value + Seller's Existing Goodwill - Asset Write-Ups +Write-Down of Seller's DTL.

 

Explanation:

 Book value is referred to as Shareholders'equity by Seller's.

Sellers' goodwill is also assumedto be nil.

Asset write-ups reduce theGoodwill required since they increase the Assets side of the balance sheet.

DTLs are normally written downcompletely.

29. Why is the seller's DTAwritten down in an M&A deal?

DTAs include NOLs, which maypartially or fully offset the combined company's taxable income.

 

In a stock purchase, the formulafor DTA write-down is:

DTA Write-Down = Buyer Tax Rate ×MAX(0, NOL Balance - (Allowed NOL Usage × Expiration Period)).

 

In asset purchases or 338(h)(10)elections, the NOL balance is fully written down, and DTAs are adjustedaccordingly.

 

30. What is a Section338(h)(10) election, and why might it be used?

A Section 338(h)(10) election isa hybrid between a stock and an asset purchase:

Legally: It's a stock purchase.

Accounting-wise: It’s treated asan asset purchase, allowing the buyer to “step up” the tax basis of acquiredassets.

Advantages:

 

The buyer can depreciate/amortizethe new asset base, reducing taxes.

Sellers with high NOL balances orS-corporations (over 10 years) benefit from lower taxation.

The seller, however, faces doubletaxation: on asset appreciation and sale proceeds. Buyers may compensate byoffering a higher price due to the tax benefits.

 

Rarely do bankers handlethese—there are lawyers and tax accountants for that.