400 Question Flashcards - Merger Model Advanced

Question 1

What’s the purpose of Purchase Price Allocation in an M&A deal? Can you explain how it works?

Answer 1

• The ultimate purpose is to make the combined B/S balance. This is harder than it sounds b/c many items get adjusted up or down (e.g. PPE)‚ some items disappear altogether (e.g. the Seller’s Shareholders’ Equity)‚ and some new items get created (e.g. Goodwill).
• To complete the process‚ you look at every single item on the Seller’s B/S and then assess the fair market value of all those items‚ adjusting them up or down as necessary.
• So if the buyer pays‚ say $1B for the Seller‚ you figure out how much of that $1B gets allocated to each Asset on the B/S.
• Goodwill (and Other Intangible Assets) serves as the “plug” and ensures that both sides balance after you’ve made all the adjustments. Goodwill is roughly equal to the Equity Purchase Price minus the Seller’s Shareholders’ Equity and other adjustments.

Question 2

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

Answer 2

Goodwill = Equity Purchase Price - Seller Book Value + Seller’s Existing Goodwill - Asset Write-Ups - Seller’s Existing DTL + Write-down of Seller’s Existing DTA + Newly Created DTLs + Intercompany A/R - Intercompany A/P
• Seller Book Value is just the Shareholders’ Equity number (technically‚ the Common Shareholders’ Equity number)
• You add the Seller’s Existing Goodwill b/c it is “reset” and written down to $0 in an M&A deal.
• You subtract the Asset Write-Ups b/c these are additions to the Assets side of the B/S - 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.
• You add Intercompany A/R because they go away‚ which reduces the Assets side; the opposite applies for Intercompany A/P.

Question 3

Why do we adjust the value of Assets such as PP&E in an M&A deal?

Answer 3

• B/c often the fair market value is significantly different from the B/S value. A perfect example is real estate - usually it appreciates over time‚ but due to the rules of accounting‚ companies must depreciate it on the B/S and show a declining balance over time to reflect the allocation of costs over a long time period.
• Investments‚ Inventory‚ and other Assets may have also “drifted” from their fair market values since the B/S is recorded at historical cost for companies in most industries (exceptions‚ such as commercial banking‚ do exist).

Question 4

What’s the logic behind Deferred Tax Liabilities and Deferred Tax Assets?

Answer 4

• The basic idea is that you normally write down most of the seller’s existing DTLs and DTAs to “reset” its tax basis‚ since it’s now part of another entity.
• And then you may create new DTLs or DTAs if there are Asset Write-Ups or Write-Downs and the book and tax D&A numbers differ.
• If there are write-ups‚ a DTL will be created in most deals since the Depreciation on the write-ups is not tax-deductible‚ which means that the company will pay more in cash taxes; the opposite applies for write-downs and there‚ a DTA would be created.

Question 5

How do you treat items like Preferred Stock‚ Noncontrolling Interests‚ Debt‚ and so on‚ and how do they affect Purchase Price Allocation?

Answer 5

• Normally‚ you build in the option to repay (or in the case of Noncontrolling Interests‚ purchase the remainder of) these items or assume them in the Sources & Uses schedule. If you repay them‚ additional cash/debt/stock is required to purchase the seller.
• However‚ that choice‚ does NOT affect Purchase Price Allocation.
• You always start w/ the Equity Purchase Price there‚ which excludes the treatment of all these items. Also‚ you only use the seller’s Common Shareholders’ Equity in the PPA schedule‚ which excludes Preferred Stock and Noncontrolling Interests.

Question 6

Do you use Equity Value or Enterprise Value for the Purchase Price in a merger model?

Answer 6

• This is a trick question because neither one is entirely accurate. The PPA schedule is based on the Equity Purchase Price‚ but the actual amount of cash/stock/debt used is based on that Equity Purchase Price plus the additional funds needed to repay debt‚ pay for transaction-related fees‚ and so on.
• That number is not exactly “Enterprise Value” - it’s something in between Equity Value and Enterprise Value‚ and it’s normally labeled “Funds Required” in a model.

Question 7

How do you reflect transaction costs‚ financing fees‚ and miscellaneous expenses in a merger model?

Answer 7

• You expense transaction and miscellaneous fees (such as legal and accounting services) upfront and capitalize the financing fees and amortize them over the term of the debt.
• Expensed transaction fees come out of Retained Earnings when you adjust the B/S (and Cash on the other side)‚ while Capitalized Financing Fees appear as a new Asset on the Balance Sheet (and reduce Cash immediately) and are amortized each year according to the tenor of the debt.
• In reality‚ you pay for all of these fees upfront in cash. However‚ since financing fees correspond to a long-term item rather than a one-time transaction‚ they’re amortized over time on the Balance Sheet. It’s similar to how new CapEx spending is depreciated over time.
• NONE of this affects Purchase Price Allocation. These fees simply increase the “Funds Required” number discussed above‚ but they make absolutely NO impact on the Equity Purchase Price or on the amount of Goodwill created.

Question 8

How would you treat Debt differently in the Sources & Uses table if it is refinanced rather than assumed?

Answer 8

• If the buyer assumes the Debt‚ it appears in BOTH the Sources and Uses columns and has no effect on the Funds Required.
• If the buyer pays off the Debt‚ it appears only in the Uses column and increases the Funds Required.

Question 9

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

Answer 9

• The 3 main structures are the Stock Purchase‚ Asset Purchase‚ and 338(h)(10) Election.
• Note that Stock Purchases and Asset Purchases exist in some form in countries worldwide‚ but that the 338(h)(10) Election is specific to the US - however‚ there may be equivalent legal structures in other countries.
• Part of the reason that both parties favor the 338(h)(10) structure is that buyers typically agree to pay more to compensate sellers for the favorable tax treatment they receive.
• See p. 49 (of 66) of BIWS - Merger Model Guide for comparison table.

Question 10

Would a seller prefer a Stock Purchase or an Asset Purchase? What about the buyer?

Answer 10

• A seller almost always prefers a Stock Purchase to avoid double taxation and to dispose of all its Liabilities.
• A buyer almost always prefers an Asset Purchase so it can be more careful about what it acquires and to get the tax benefit from being able to deduct D&A on Asset Write-Ups for tax purposes.
• However‚ it’s not always possible to “pick” one or the other - for example‚ if the seller is a large public company only a Stock Purchase is possible in 99% of cases.

Question 11

Why might a company want to use 338(h)(10) when acquiring another company?

Answer 11

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 - capital gains on any 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 and amortize them so it saves on taxes.

Even though sellers still get taxed twice‚ buyers will often pay more in a 338(h)(10) deal b/c of the tax-savings potential. It’s particularly helpful for:
• Sellers w/ high NOL balances (more tax-savings for the buyer b/c this NOL balance will be written down completely - so more of the excess purchase price can be allocated to Asset Write-Ups)
• Companies that have been S-Corporations for over 10 years - in this case they do not have to pay taxes on the appreciation of their Assets.
• NOTE: The requirements to use 338(h)(10) are complex and it cannot always be used. For example‚ if the seller is a C-Corporation it can’t be applied; also‚ if the buyer is not a C-Corporation (e.g. a private equity firm)‚ it also can’t be used.

Question 12

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

Answer 12

• You apply Section 382 to determine how much of the Seller’s NOLs are usable each year.
• Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past 3 Months’ Adj. Long-Term Rates
• So if our Equity Purchase Price were $1B and the highest adj. long-term rate were 5%‚ then we could use $1B * 5% = $50M of NOLs each year.
• If the Seller had $250M in NOLs‚ then the combined company could use $50M of them each year for 5 years to offset its taxable income.

Question 13

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

Answer 13

• 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 DTL and an Asset Write-Down creates a DTA.
• You write down and write up assets b/c their book values (what’s on the B/S) often differ substantially from their “fair market values.”
• An asset write-up creates a DTL b/c you’ll have a higher Deprecation Expense on the new asset‚ which means you save on taxes in the short-term‚ but eventually you’ll have to pay them back‚ so you get a liability. The opposite applies for an asset write-down and a DTA.

Question 14

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

Answer 14

• You take them into account w/ everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma B/S. The formulas are as follows:
• DTA = Asset Write-Down * Tax Rate; DTL = Asset Write-Up * Tax Rate
• So let’s say you were buying a company for $1B w/ 50% cash and 50% debt‚ and you had a $100M asset write-up and a tax rate of 40%. In addition‚ the seller has total Assets of $200M‚ total Liabilities of $150M‚ and Shareholders’ Equity of $50M. Here’s what would happen on the combined company’s balance sheet (ignoring transaction and 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” B/S. Assets are up by $200M an Liabilities are up by $150M.
• Then Cash on the Assets side goes down by $500M.
• You have an Asset Write-Up of $100M‚ so Assets go up by $100M; Debt on the Liabilities & Equity side goes up by $500M.
• You get a new DTL of $40M ($100M * 40%) on the Liabilities & Equity Side.
• Assets are down by $200M total and Liabilities & Shareholders’ Equity are up by $690M ($500 + $40 + $150)
• So you need Goodwill & Intangibles of $890M on the Assets side to make both sides balance.

Question 15

Could you get DTLs or DTAs in an Asset Purchase?

Answer 15

No‚ b/c in an Assets Purchase‚ the book basis of assets always matches the tax basis. DTLs and DTAs get created in Stock Purchases b/c the book values of Assets are written up or written down‚ but the tax values do not.

Question 16

How do you factor in DTLs into forward projections in a merger model?

Answer 16

• You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pre-Tax Income on its books‚ and then you determine what it actually pays in cash taxes based on its NOLs and its new D&A 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 B/S; if the “book” expense is higher‚ then you record that as an increase to the DTL.

Question 17

Can you give me an example of how you might calculate revenue synergies?

Answer 17

• Sure‚ let’s say that Company A sells 10‚000 widgets/year in N. America at an average price of $15 and Company B sells 5000 widgets/year in Europe at an average price of $10. 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% * 5000 * $15 in revenue or $15‚000.
• It will also have expenses associated w/ 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 w/ revenue synergies is important and one that a lot of people forget - there’s no such thing as “free” revenue with no associated costs.

Question 18

Should you estimate revenue synergies based on the seller’s customers and the seller’s financials‚ or the buyer’s customers and the buyer’s financials?

Answer 18

• Either one works. You could assume that the buyer leverages the seller’s products or services and sells them to its own customer base - but typically you assume an uplift to the seller’s average selling price‚ or something else that the buyer can do w/ the seller’s existing customers.
• You approach it that way b/c the buyer‚ as a larger company‚ can make more of an immediate impact on the seller than the seller can make on the buyer.

Question 19

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

Answer 19

• Let’s say that Company A wants to acquire Company B. Company A has 5000 SG&A related employees‚ whereas Company B has around 1000.
• Company A calculates that post-transaction‚ it will only need about 800 of Company B’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 200 employees that Company A is going to fire post-transaction by their average salary‚ benefits‚ and other compensation expenses.

Question 20

How do you think about synergies if the combined company can consolidate buildings?

Answer 20

• If the buildings are leased‚ you assume that both lease expenses go away and are replaced w/ a new‚ larger lease expense for the new or expanded building. So in that case‚ it is a simple matter of New Lease Expense - Old‚ Separate Lease Expense to determine the synergies.
• If the buildings are owned‚ it gets more complicated b/c one or both of them will be sold‚ or perhaps leased out to someone else. Then you would have to look at Depreciation and Interest savings‚ as well as additional potential income if the building is rented out.

Question 21

What if there are CapEx synergies? For example‚ what if the buyer can reduce its CapEx spending because of certain assets the seller owns?

Answer 21

• In this case‚ you would start recording a lower CapEx charge on the combined SCF‚ and then reflect a reduced Depreciation charge on the I/S from that new CapEx spending each year.
• You would not start seeing the results until Year 2 b/c reduced Depreciation only comes after reduced CapEx spending. This scenario would be much easier to model w/ a full PP&E schedule where you can adjust the spending and the resulting Depreciation each year.

Question 22

What happens when you acquire a 30% stake in a company? Can you still use an accretion/dilution analysis?

Answer 22

• You record this 30% as an “Investment in Equity Interest” or “Associate Company” on the Assets side of the B/S‚ and you reduce Cash to reflect the purchase (assuming that Cash was used). You use this treatment for all ownership percentages between 20% and 50%.
• You can still use an accretion/dilution analysis; just make sure that the new Net Income reflects the 30% of the other company’s Net Income that you are entitled to.

Question 23

What happens when you acquire a 70% stake in a company?

Answer 23

• 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 its 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.

Question 24

Let’s say that a company sells a subsidiary for $1000‚ paid for by the buyer in Cash. The buyer is acquiring $500 of Assets with the deal‚ but it’s assuming no Liabilities. Assume a 40% tax rate. What happens on the 3 statements after the sale?

Answer 24

• Income Statement: We record a Gain of $500‚ since we sold Balance Sheet Assets of $500 for $1000. That boosts Pre-Tax Income by $500 and Net Income by $300 assuming a 40% tax rate.
• Cash Flow Statement: Net Income is up by $300‚ but we subtract the Gain of $500 in the CFO section‚ so cash flow is down by $200 so far. We add the full amount of sale proceeds ($1000) in the CFI section‚ so cash at the bottom is up by $800.
• Balance Sheet: Cash on the Assets side is up by $800‚ but we’ve lost $500 in Assets‚ so the Assets side is up by $300. On the other side‚ Shareholders’ Equity is also up by $300 due to the increased Net Income.
• In this scenario‚ you’d also have to go back and remove revenue and expenses from this sold-off division and label them “Discontinued Operations” on the financial statements prior to the close of the sale.

Question 25

Let's say that we decide to buy 100% of another company's subsidiary for $1000 in cash. This subsidiary has $500 in Assets and $300 in Liabilities‚ and we are acquiring all the Assets and assuming all the Liabilities. What happens on the statements immediately afterward?

Answer 25

* Income Statement: No changes. * Cash Flow Statement: We record $1000 for "Acquisitions" in the CFI section‚ so cash at the bottom is down by $1000. * Balance Sheet: Cash is down by $1000 on the Assets side‚ but we add in the subsidiary's Assets of $500‚ so this side is down by $500 so far. We also create $800 worth of Goodwill b/c we bought this subsidiary for $1000‚ but (Assets minus Liabilities) was only $200. So the Assets side is up by $300. The other side is up by $300 b/c of the assumed Liabilities‚ so both sides balance.

Question 26

What's the purpose of calendarization in a merger model?

Answer 26

* You need to make sure that the buyer and the seller use the same fiscal years post-transaction. Normally you change the seller's financial statements to match the buyer's. * If the buyer's fiscal year ends on December 31 and the seller's ends on June 30‚ for example‚ you would have to take Q3 (Jan - Mar) and Q4 (Apr - Jun) from the seller's most recent fiscal year and then add Q1 (Jul - Sep) and Q2 (Oct - Dec) from the seller's current fiscal year to match the buyer's current fiscal year. * The 2nd point here is that you may also need to create a stub period from the date when the deal closes to the end of the buyer's current fiscal year. * For example‚ if the deal closes on September 30 but the fiscal year ends on December 31‚ the buyer and seller are still one combined company for that 3-month period and you need to account for that‚ normally via a separate "stub period" right before the start of the first full fiscal year as a combined entity.

Question 27

Let's say that the buyer's fiscal year ends on December 31‚ the seller's fiscal year ends on June 30‚ and the transaction closes on September 30. How would you create a merger model for this scenario?

Answer 27

* You would need to create quarterly financial statements for both the buyer and the seller for the Sep 30 - Dec 31 period‚ and you would show that as the first "combined" period in the merger model. * So you would combine the Income Statements‚ Balance Sheets‚ and Cash Flow Statements for that 3-month period‚ and then keep them combined for the rest of the time after that (adjusting the seller's financial statements to match the fiscal year of the buyer‚ as in the example above). * Normally you do not care much about accretion/dilution for stub periods like this‚ so you would just calculate it for the first full fiscal year after the transaction close.

Question 28

Let's say that the buyer's fiscal year ends on December 31‚ the seller's fiscal year ends on June 30‚ and the transaction closes on March 31 (instead of Sep. 30 as previously assumed) How would you create a merger model for this scenario?

Answer 28

* In this case‚ you need a 9-month stub period rather than a 3-month stub period in the previous case. * So you would need to find or create quarterly financial statements for Q4 of the seller's fiscal year ending June 30‚ and then Q1 and Q2 for the next year. * You would also take the last 3 quarters of the buyer's fiscal year and combine the statements from that period w/ the seller's‚ taking into account all the normal acquisition effects for that period.

Question 29

Let's say that the buyer's fiscal year ends on December 31‚ the seller's fiscal year ends on June 30‚ and the transaction closes on a random date like August 17 (instead of Sep. 30 as previously assumed) How would you create a merger model for this scenario?

Answer 29

* There are a couple options here; you could attempt to "roll-forward" the financial statements to this date in between quarterly end dates. For example‚ you might create an Aug. 17 Balance Sheet by looking at the B/S as of Jun. 30 and the B/S as of Sep. 30 and averaging them (since Aug. 17 is roughly in the middle). * For the I/S and SCF‚ you could just take the Jul. 1 - Sep. 30 quarterly numbers and multiply by (43/90) since 43 days of the quarter will pass in the "combined" period between Aug. 17 and Sep. 30. * The main problem is that this method creates a lot of extra work‚ b/c now you have to roll forward all the statements to this random date‚ figure out the numbers from that date to the end of the quarter‚ and then add additional quarters until the end of the buyer's fiscal year. * So in practice‚ you usually assume a cleaner close date in merger models unless you need 100% precision for some reason.

Question 30

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

Answer 30

* An exchange ratio is an alternate way of restructuring 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 $100M in a 100% stock deal. Normally you would determine the number of shares to issue by dividing the $100M by the buyer's stock price. * 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.

Question 31

Isn't there still some risk with an exchange ratio? If the stock price swings wildly in one direction or the other‚ the effective purchase price would be very different. Is there any way to hedge against that risk?

Answer 31

* 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 w/ 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 and the seller has 1000 shares outstanding. Right now‚ it's worth $30‚000 (1000 * 1.5 * $20) to the seller. Here's how we could set up a collar: * If the buyer's share price falls below $20/share‚ the seller still receives the equivalent of $20 per buyer share in value. So if the buyer's share price falls to $15‚ now the seller would receive 2000 shares instead. * If the buyer's share price is between $20 and $40 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 per share‚ the seller can only receive the equivalent of $40 per buyer share in value. So if the buyer's share price rises to $80‚ 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.

Question 32

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

Answer 32

There are dozens‚ but here are the most important points: • Purchase Price: Stated as a per-share amount for public companies; just a number (the Equity Purchase Price) for private 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.

Question 33

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

Answer 33

* An earnout is a form of "deferred payment" in an M&A deal (it's most common w/ private companies and start-ups) and is highly unusual for public sellers. * It is usually contingent on financial performance or other goals - for example‚ the buyer might say "We'll pay you an additional $10M in 3 years if you can hit $100M 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.

Question 34

Normally we create Goodwill b/c we pay more for a company than what its Shareholders' Equity says it's worth. But what if the opposite happens? What if we paid $1000 in Cash for a Company‚ but its Assets were worth $2000 and its Liabilities were worth $800?

Answer 34

* 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 worth only $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.

Question 35

What if Shareholders' Equity [of the target] is negative?

Answer 35

Nothing is different. You still wipe it out‚ allocate the purchase price‚ and create Goodwill.

Question 36

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

Answer 36

* 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.

Question 37

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

Answer 37

* 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. * Example: Let's say that the buyer is set to own 50% of the new company and that the seller will own 50%. But the buyer has $100M of revenue and the seller has $50M of revenue - a contribution analysis would tell us that the buyer "should" own 66% instead b/c it's contributing 2/3 of the combined revenue. * It's most common to look at this w/ merger of equals scenarios‚ and less common when the buyer is significantly larger than the seller.

Question 38

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

Answer 38

* To do this‚ you would get 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 b/c 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.

Question 39

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

Answer 39

1. Always combine the buyer's and seller's Balance Sheets first (remember to wipe out the seller's Shareholders' Equity) 2. Make the necessary Pro-Forma Adjustments (cash‚ debt‚ stock‚ goodwill/intangibles‚ etc.) 3. Project the combined Balance Sheet using standard assumptions for each item. 4. Combine and project the Income Statement. 5. Then‚ project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model. You can usually just add items together here‚ but you may eliminate some of the seller's investing or financing activities depending on what the buyer wants to do. • You never combine the I/S or SCF BEFORE the acquisition closes. You only look at the combined statements immediately AFTER the acquisition and into future years.

Question 40

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

Answer 40

* 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" if the per-share purchase price is above the exercise prices of these dilutive securities. * If you assume that they're exercised‚ then you calculate dilution to the Equity Purchase Price in the same way you normally would - the Treasury Stock Method for options‚ and the "if converted" method for convertibles.

Question 41

Can you explain what "Pro Forma" numbers are in a merger model?

Answer 41

* This gets confusing b/c there are contradictory definitions. The simplest one is that Pro-Forma numbers exclude certain non-cash acquisition effects (e.g. Amortization of Newly Created Intangibles‚ Depreciation of PP&E Write-Up‚ Deferred Revenue Write-Down‚ Amortization of Financing Fees) * Some people include all of these‚ other people include only some of these‚ and companies themselves report numbers in different ways. Excluding Amortization of Intangibles is the most common adjustment here. * While a lot of companies report numbers this way‚ the concept itself is flawed and inconsistent b/c companies themselves already include existing non-cash charges like D&A and stock-based compensation. To make things even more confusing‚ some people will also add back some or all of those items as well.

Question 42

If you're looking at a reverse merger (i.e. a private company acquires a public company)‚ how would the merger model be different?

Answer 42

* Mechanically‚ it's similar b/c you still allocate purchase price‚ combine and adjust the Balance Sheets‚ and combine the Income Statements‚ including acquisition effects. * The difference is that accretion/dilution is not meaningful if it's a private company b/c it doesn't have an EPS number; so you would place more weight on a contribution analysis‚ or even on something like the IRR of the acquisition.