M&A Deals and Merger Models

Why might one company want to buy another company?

One company might want to buy another company if it believes it will be better off after the acquisition takes place. For example:

• The Seller’s asking price is less than its Implied Value, i.e., the Present Value of its future cash flows.

• The expected IRR from the acquisition exceeds the Buyer’s Discount Rate.

Buyers often acquire Sellers to save money via consolidation and economies of scale, to expand geographically or gain market share, to acquire new customers or distribution channels, and to expand their products and services.

Synergies, or the potential to combine and reduce expenses through departmental consolidation or to boost revenue through additional sales, also explain many deals.

Deals may also be motivated by competition, office politics, and ego.

How can you analyze an M&A deal and determine whether or not it makes sense?

The qualitative analysis depends on the factors above: could the deal help the company expand geographies, products, or customer bases, give it more intellectual property, or improve its team?

The quantitative analysis might include a valuation of the Seller to see if it’s undervalued, as well as a comparison of the expected IRR to the Buyer’s Discount Rate.

Finally, EPS accretion/dilution is important in most deals because Buyers prefer to execute accretive deals, i.e., ones that increase their Earnings per Share (EPS). The Board of Directors is more likely to approve of accretive deals, and investors also like accretive deals more than dilutive ones.

Walk me through a merger model (accretion/dilution analysis).

In a merger model, you start by projecting the financial statements of the Buyer and Seller.

Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition and its after-effects.

Then, you combine the Balance Sheets of the Buyer and Seller, reflecting the Cash, Debt, and Stock used, new Goodwill created, and any write-ups and write-downs. You then combine the Income Statements, reflecting the Foregone Interest on Cash, Interest Paid on New Debt, and Synergies. If the New Debt balance changes over time, the Interest Paid on New Debt should reflect that.

The Combined Net Income equals the Combined Pre-Tax Income times (1 – Buyer’s Tax Rate), and to get the Combined EPS, you divide that number by (the Buyer’s Existing Share Count + New Shares Issued in the Deal).

You calculate the accretion/dilution by taking the Combined EPS, dividing it by the Buyer’s standalone EPS, and subtracting 1 to make it a percentage.

Why might an M&A deal be accretive or dilutive?

A deal is accretive if the extra Pre-Tax Income from a Seller exceeds the cost of the acquisition in the form of Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer only $70 in additional Interest Expense, and the Buyer doesn’t issue any new shares, the deal will be accretive because the Buyer’s Earnings per Share (EPS) will increase.

A deal will be dilutive if the opposite happens. For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer $130 in additional Interest Expense, and its share count remains the same, its EPS will decrease.

How can you tell whether an M&A deal will be accretive or dilutive?

You compare the Weighted Cost of Acquisition to the Seller’s Yield at its Purchase Price.

• Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate)

• Cost of Debt = Interest Rate on New Debt * (1 – Buyer’s Tax Rate)

• Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e., Net Income / Equity Value.

• Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase Equity Value.

Weighted Cost of Acquisition = % Cash Used * Cost of Cash + % Debt Used Cost of Debt + %Stock Used * Cost of Stock.

If the Weighted Cost is less than the Seller’s Yield, the deal will be accretive; if the Weighted Cost is greater than the Seller’s Yield, the deal will be dilutive.

Why do you focus so much on EPS in M&A deals?

Because it’s the only easy-to-calculate metric that also captures the FULL impact of the deal – the Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

Although metrics such as EBITDA and Unlevered FCF more accurately approximate cash flow and the value of the company’s core business, they don’t reflect the deal’s full impact because they exclude Net Interest and the effect of new shares.

How do you determine the Purchase Price in an M&A deal?

If the Seller is public, you assume a premium to the Seller’s current share price based on the average premiums for similar deals in the market (usually between 10% and 30%). You can then use the DCF, Public Comps, and other valuation methodologies to cross-check this figure.

The Purchase Price for private Sellers is based on the standard valuation methodologies, and you usually link it to a multiple of EBITDA, EBIT, or Revenue since private companies don’t have easy-to-determine share prices.

If the Buyer expects to realize significant Synergies, it is often willing to pay a higher premium for the Seller because the Present Value of the Synergies might exceed this premium to the Seller’s current market value.

What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?

Cash tends to be the cheapest option; most companies earn little Interest Income on it, so they don’t lose much by using it to fund deals. It’s also the fastest and easiest to close Cash-based deals.

The downside is that using Cash limits the Buyer’s flexibility if it needs the funds for something else soon.

Debt is normally cheaper than Stock but more expensive than Cash, and deals involving Debt take more time to close because of the need to market the new Debt to investors.

Debt also limits the Buyer’s flexibility because additional Debt makes future Debt issuances more difficult and expensive.

Stock tends to be the most expensive option, though it can sometimes be the cheapest (on paper) if the Buyer trades at an extremely high P / E multiple.

It dilutes the Buyer’s existing investors, but it also prevents the Buyer from paying an additional cash expense for the deal.

In some cases, the Buyer can also issue Stock more quickly than it can issue Debt.

Finally, the Seller's tax implications are different: its shareholders are not taxed immediately if they receive shares from the Buyer, but they do pay taxes immediately if they receive cash proceeds for their shares (corresponding to Cash and Debt).

How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?

Since Cash is cheapest for most Acquirers, they’ll use all the Cash they can before moving to the other funding sources. So, you might assume that the Cash Available equals the Acquirer’s current Cash balance minus its Minimum Cash balance. You may also include the Target’s Cash balance if it is significant.

After that, Debt tends to be the next cheapest option. An Acquirer might be able to raise Debt up to the level where its Debt / EBITDA and EBITDA / Interest ratios remain in-line with those of peer companies.

So, if it’s levered at 2x EBITDA now, and similar companies have 4-5x Debt / EBITDA, it might be able to raise Debt up to that level. Again, you may also factor in the Target’s Debt and EBITDA if they are significant.

Finally, there’s no strict limit on the amount of Stock an Acquirer might issue, but few companies would issue enough to give up control of the company, and some Acquirers will issue Stock only up to the point at which the deal turns dilutive.

Which purchase method does a Seller prefer in an M&A deal?

The Seller has to balance taxes with the certainty of payment and potential future upside.

To a Seller, Debt and Cash are similar because they mean immediate payment, but also immediate capital gains taxes for the shareholders and no potential upside if the Buyer’s share price increases. But there’s also no risk if the Buyer’s share price decreases.

Stock is more of a gamble because the Seller could end up with a higher price if the Buyer’s share price increases, but it could also get a lower price if the Buyer’s share price drops. The Seller’s shareholders also avoid immediate taxes with Stock since they pay taxes only when they sell their shares.

So, the preferred method depends on the Seller’s confidence in the Buyer: Cash and Debt are better with higher uncertainty, while Stock may be better with large, stable Buyers.

What’s the impact of each purchase method in an M&A deal, and how do you estimate the Cost of each method?

The Foregone Interest on Cash represents the Cost of Cash. The Acquirer loses future projected Interest Income by using Cash to fund a deal. The Interest Expense on New Debt represents the Cost of Debt.

For both of these, you take the interest rate and multiply by (1 – Acquirer’s Tax Rate) to estimate the after-tax costs.

The Cost of Stock is represented by the additional shares created in a deal and how those shares reduce the Combined Company’s EPS. It’s equal to the reciprocal of the Acquirer’s P / E Multiple, i.e., Acquirer’s Net Income / Acquirer’s Equity Value.

Isn’t the Foregone Interest on Cash just an “opportunity cost”? Why do you include it?

No, it’s not just an “opportunity cost” because the Acquirer’s projected Pre-Tax Income already includes the Interest Income that the company expects to earn on its Cash balance!

So, if an Acquirer expects $90 in Operating Income and $10 in Interest Income for a total of $100 in Pre-Tax Income, its projected Pre-Tax Income will fall if it uses Cash to fund the deal.

Isn’t it a contradiction to calculate the Cost of Stock by using the reciprocal of the Acquirer’s P / E multiple? What about the Risk-Free Rate, Beta, and the Equity Risk Premium?

It’s not a contradiction; it’s just a different way of measuring the Cost of Equity.

The “Reciprocal of the P / E Multiple” method measures the Cost of Equity in terms of EPS impact, while the CAPM method measures it based on the stock’s expected annualized returns.

Neither method is “correct” because you use them in different contexts.

In most cases, regardless of the method you use, Stock will be the most expensive funding source for a company.

Why might an Acquirer choose to use Stock or Debt even if it could pay for the Target with Cash?

The Acquirer might not necessarily draw on its entire Cash balance if, for example, much of the Cash is in overseas subsidiaries or otherwise restricted.

Also, the Acquirer might be preserving its Cash for a future expansion plan or Debt maturity. Finally, if the Acquirer is trading at high multiples, such as a 100x P / E multiple, it might be cheaper to use Stock to fund the deal.

Are there cases where EPS accretion/dilution is NOT important? What else could you look at?

Yes, there are many cases where EPS accretion/dilution is less important or irrelevant.

For example, if the Buyer is private, or it already has negative EPS as a standalone entity, it won't care about whether the deal is accretive or dilutive.

It also makes little difference if the Buyer is far bigger than the Seller (e.g., 10x – 100x its size).

Besides EPS accretion/dilution, you can also analyze the deal's qualitative merits, compare the IRR to the Discount Rate, and value the Seller + Synergies and compare that to the Equity Purchase Price.

Finally, you can create a Contribution Analysis to look at how much the Buyer and Seller "contribute" to each financial metric and then compare the contribution percentages to their respective ownership percentages.

Value Creation Analysis, to determine how the Buyer’s share price will change after the deal closes, may also be useful in certain contexts, such as if the Buyer + Seller together will resemble a larger, more valuable public company in the market.

How does a merger differ from an acquisition?

There’s no mechanical difference in a merger model or the other analyses because there’s always a Buyer and Seller in any M&A deal.

The difference is that in a merger, the companies are closer in size, while the Buyer is significantly larger than the Seller in an acquisition.

100% Stock or majority-Stock deals are also more common in mergers because similarly sized companies can rarely use Cash or Debt to acquire each other.

You’ll also place more weight on the Contribution Analysis and Value Creation Analysis methods in mergers because 100% Stock deals are so common.

What are the main PROBLEMS with merger models?

First, EPS is not always a meaningful metric. Second, Net Income and cash flow are quite different, so EPS-accretive deals might be horrible from a cash-flow perspective.

Third, merger models don’t capture the true risk inherent in M&A deals. 100% Cash deals almost always look accretive, even though the integration process might go wrong, legal issues might arise, and customers or shareholders might revolt.

Fourth, merger models often fail to consider what might happen if the Buyer or Seller’s share prices change significantly before the deal closes – especially in 100% Stock deals.

Finally, merger models don’t capture the qualitative aspects of a deal, such as cultural fit or management’s ability to work together.

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x. Will the deal be accretive?

Walk me through the full math for the deal now.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10.

It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies. How accretive is this deal?

You can’t tell unless you know that it’s a 100% Stock deal. If it is a 100% Stock deal, then it will be accretive because the Buyer’s P / E is higher than the Seller’s, indicating that the Buyer’s Cost of Acquisition (1 / 25, or 4%) is less than the Seller’s Yield (1 / 15, or 6.7%).

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Company A’s EPS is $10 / 10 = $1.00.

To do the deal, Company A must issue 6 new shares since $150 / $25.00 = 6, so the Combined Share Count is 10 + 6 = 16.

Since no Cash or Debt were used and the tax rates are the same, the Combined Net Income = Company A Net Income + Company B Net Income = $10 + $10 = $20.

Therefore, the Combined EPS is $20 / 16 = $1.25, so it’s accretive by 25%.

Assume that Company A (trading at P/E of 25x) has 10 shares outstanding at a share price of $25.00, and its Net Income is $10.

It acquires Company B (trading at P/E of x15) for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

Company A now uses Debt with an Interest Rate of 8% to acquire Company B. Is the deal still accretive? At what interest rate does it change from accretive to dilutive?

The Weighted Cost of Acquisition is 8% * (1 – 25%), or 6%, so the deal is still accretive because that Cost is less than the Seller’s Yield of 6.7%.

For the deal to turn dilutive, the After-Tax Cost of Debt would have to exceed 6.7%. Since 6.7% / (1 – 25%) = 8.9%, the deal would turn dilutive at an interest rate >= 8.9%.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10.

It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

What are the Combined Equity Value and Enterprise Value in this deal?

Assume that Equity Value = Enterprise Value for both the Buyer and Seller and use 100% Stock funding.

Combined Equity Value = Buyer’s Equity Value + Market Value of Stock Issued in the Deal = $250 + $150 = $400.

Combined Enterprise Value = Buyer’s Enterprise Value + Purchase Enterprise Value of Seller = $250 + $150 = $400.

How do the Combined TEV / EBITDA and P / E multiples change if the deal financing method changes?

The Combined TEV / EBITDA stays the same regardless of the financing method, but the Combined P / E multiple will change based on the Stock issued and the Cash and Debt used.

The Stock issued affects the Combined Equity Value, and the Cash and Debt used affect the Combined Net Income because of the Foregone Interest on Cash and Interest Paid on New Debt.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10.

It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

Without doing any math, what range would you expect for the Combined P / E multiple?

The Combined P / E multiple should be between the Buyer’s P / E multiple and the Seller’s Purchase P / E multiple, so between 25x and 15x here. Since Company A is larger than Company B, we would expect the Combined P / E multiple to be closer to Company A’s multiple of 25x.

Now assume that Company A is twice as big financially, so its Equity Value is $500, and its Net Income is $20. It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

Will a 100% Stock deal be more or less accretive as compared the the situation below:

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10.

It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well. Assume the same tax rates for both companies.

Now, do the math. What is the accretion/dilution in a 100% Stock deal with a $150 Purchase Equity Value for Company B? Feel free to write down the numbers.

The deal will be less accretive.

The intuition is that Company A’s P / E remains the same, but it’s significantly bigger, so the higher-yielding Company B provides less of a boost to Company A’s EPS.

The Combined P / E multiple will still be between 15x and 25x, but it will be even closer to 25x because Company A has a greater weighting in the combined company.

The Buyer previously represented $250 / $400, or 63%, of the total company, but now it represents $500 / $650, or 77%, of the total company, so we’d expect the accretion to fall by around 10-15%.

Company A’s share price is now $50.00, it still has 10 shares outstanding, and its Equity Value is $500. Its EPS is $20 / 10 = $2.00.

To acquire Company B, Company A must issue 3 additional shares since $150 / $50.00 = 3.

Since both companies have the same tax rate and no Cash or Debt was used, you can add the Net Income figures: Combined Net Income = $20 + $10 = $30.

The new share count is 10 + 3 = 13, and $30 / 13 = $2.31. This is about 15% higher than the Buyer’s standalone EPS ($0.15 is 15% of $1.00, and $0.30 is 15% of $2.00).

So, it’s about 10% lower than the 25% accretion when Company A was smaller.

Company A has a P / E of 10x, a Debt Interest Rate of 8%, a Cash Interest Rate of 4%, and a Tax Rate of 25%.

It wants to acquire Company B at a purchase P / E multiple of 16x using 1/3 Stock, 1/3 Debt, and 1/3 Cash. Will the deal be accretive?

Company A’s After-Tax Cost of Stock is 1/10, or 10%, its After-Tax Cost of Debt is 8% * (1 – 25%) = 6%, and its After-Tax Cost of Cash is 4% * (1 – 25%) = 3%.

Company B’s Yield is 1 / 16, or 6.25% (mental math: 1 / 4 = 25%, and 1 / 8 = 12.5%, so 1 / 16 = 6.25%).

The Weighted Cost of Acquisition is 10% 1/3 + 6% 1/3 + 3% * 1/3 = 3.33% + 2% + 1% = 6.33%.

Since the Weighted Cost is slightly above Company B’s Yield, the deal will be dilutive.

Company A acquires Company B using 100% Debt. Company B has a purchase P / E multiple of 12x, and Company A has a P / E multiple of 15x.

What interest rate on Debt is required to make the deal dilutive?

Company B’s Yield is 1 / 12, or 8.3%, so the After-Tax Cost of Debt must be above 8.3% for the deal to be dilutive.

Assuming the company has a tax rate of 25%, 8.3% / (1 – 25%) = 11.1%, which you can round to “Around 11%.”

That is a high interest rate for most companies, so a 100% Debt deal would almost certainly be accretive.

Company A has an Equity Value of $1,000 and a Net Income of $100. Company B has a Purchase Equity Value of $2,000 and a Net Income of $50.

For a 100% Stock deal to be accretive, how much in Synergies must be realized?

Company A’s P / E is $1,000 / $100 = 10x, so its Cost of Stock is 10%. Company B’s P / E is $2,000 / $50 = 40x, so its Yield is 1 / 40, or 2.5%.

Therefore, without Synergies, this deal would be highly dilutive.

For the deal to turn accretive, Company B’s Yield must exceed 10%. That means that its Purchase P / E multiple must be below 10x, which means its Net Income must be above $200.

So, there must be $150 in After-Tax Synergies for this deal to be accretive. At a 25% tax rate, that means at least $200 in Pre-Tax Synergies.

An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million, Net Income of $50 million, and a Debt / EBITDA of 2x. Peer companies have a median Debt / EBITDA of 4x.

It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller has a Net Income of $30 million, EBITDA of $50 million, and no Debt.

What’s the best way to fund this deal? Use the Combined EBITDA figures in the calculations.

The Acquirer would prefer to use its Cash balance to do this deal, but $50 million is likely close to the minimum Cash balance for a company of this size, so Cash financing is unlikely.

The Acquirer’s P / E multiple is 20x, so its Cost of Stock is 1 / 20, or 5%. That’s a fairly low Cost of Stock, so there’s a chance that the company’s After-Tax Cost of Debt might be higher.

However, there’s no information on the Cost of Debt, so our best guess is that Debt is still cheaper than Stock.

The company could afford to boost its Debt / EBITDA from 2x to 4x since peer companies have leverage in that range.

The Combined Company has $150 million in EBITDA, and 4 * $150 million = $600 million.

The Acquirer has $200 million in Debt, and the Target has no Debt, so the Acquirer could afford to issue $400 million in new Debt to fund the deal.

The remaining $100 million could be issued in Stock. If the Acquirer used part of its Cash balance or the Target’s Cash balance, the $100 million Stock portion would be reduced.

An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50 million, Net Income of $25 million, and Debt / EBITDA of 3x.

Similar companies in the market have Debt / EBITDA ratios of 5x.

What’s the BIGGEST acquisition this company might be able to complete?

You can’t answer this question precisely without knowing the Target’s Net Income and EBITDA, but you can make a rough estimate.

The Acquirer couldn’t use its entire Cash balance to fund a deal, but it might be able to use a substantial portion of it, such as $50 million, since its Cash balance would then equal its annual EBITDA.

It could afford to use leverage up to 5x EBITDA, which means that it could use $100 million in additional Debt to fund a deal (since it currently has $150 million of Debt, or 3 * $50 million).

That number might change based on the Target’s Debt and EBITDA as well.

There’s no limit on how much Stock the company could issue, but it would be unlikely to issue so much that it lost control of the company.

Therefore, the likely maximum is around $500 million of Stock, and a more realistic level might be about half its Current Equity Value ($250 million), or whatever amount turns the deal dilutive.

So, a reasonable answer might be: “In theory, the Acquirer might be able to fund a deal for up to $650 million. But unless it wanted to issue a massive amount of Stock, the maximum realistic level would be closer to $400 to $650 million.”

An Acquirer with an Equity Value of $500 million and Enterprise Value of $600 million buys another company for a Purchase Equity Value of $100 million and a Purchase Enterprise Value of $150 million.

What are the Combined Equity Value and Enterprise Value?

The Combined Enterprise Value equals the Enterprise Value of the Buyer plus the Purchase Enterprise Value of the Seller, so it’s $600 million + $150 million = $750 million.

You can’t determine the Combined Equity Value because it depends on the deal financing:

Combined Equity Value = Acquirer’s Equity Value + Market Value of Stock Issued in Deal.

If it’s a 100% Stock deal, the Combined Equity Value will be $500 million + $100 million = $600 million, but if it’s 100% Cash or Debt, the Combined Equity Value = $500 million.

If the % Stock is between 0% and 100%, the Combined Equity Value will be between $500 and $600 million.

How do the Combined Equity Value and Enterprise Value change based on the deal financing?

The Combined Enterprise Value is not affected by the deal financing: it’s always equal to the Buyer’s Enterprise Value plus the Purchase Enterprise Value of the Seller.

The Combined Equity Value equals the Buyer’s Equity Value plus the Market Value of Stock Issued in the Deal, which could range from $0 up to the Purchase Equity Value of Seller.

So, in a 100% Stock deal, the Combined Equity Value = Buyer’s Equity Value + Purchase Equity Value of Seller.

Wait, you’re saying that in a 100% Cash or Debt deal, the Seller’s Equity Value just “disappears.” How is that possible?

The Seller’s Equity Value doesn’t “disappear” – it’s transformed into the Cash used or Debt issued by the Buyer in the deal.

The Combined Enterprise Value calculation demonstrates this point: both companies’ Enterprise Values still exist after the deal, so no value is “lost” along the way.

Wait a minute, you’re also saying that the purchase premium the Acquirer pays for the Target lasts after the deal closes? How is that possible?

The purchase premium does not necessarily “last” because it depends on the market’s reaction to the deal.

If the market believes the Target's premium was justified, then the rules about Combined Equity Value and Combined Enterprise Value will hold up.

However, if the market believes the Acquirer overpaid for the Target, the Acquirer’s share price will fall to reflect the amount by which it overpaid – whether that means the entire purchase premium, part of the premium, or more than the premium.

Let’s say an Acquirer has an Equity Value of $500 million and an Enterprise Value of $600 million. The Acquirer has 100 million shares outstanding at $5.00 per share.

The Target has an Equity Value of $100 million and an Enterprise Value of $150 million, and the Acquirer pays a 30% premium to acquire the Target in a 100% Stock deal.

A few months after the deal is announced, the market loses faith in the deal and believes the 30% premium is no longer justified.

What happens to the Combined Equity Value and Enterprise Value immediately after the deal is announced and several months after, when the market loses faith in the 30% premium?

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How does that last answer change if the Acquirer uses 100% Debt or Cash instead?

Immediately after, Combined Equity Value = $500 million + $130 million = $630 million since it’s a 100% Stock deal.

Combined Enterprise Value = $600 million + $180 million = $780 million.

When the market loses faith in this 30% premium, the Acquirer’s share price will fall, such that its Eq Val and TEV both fall by $30 million.

So, its share price will fall to $4.70, and the Combined Equity Value will decrease to $600 million because the Acquirer’s Equity Value is now only $470 million.

Combined Enterprise Value = $570 million + $180 million = $750 million, so it is also down by this $30 million premium.

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The Combined Enterprise Value changes the same way in both steps: initially, it’s $780 million, but then it falls to $750 million as the Acquirer’s share price falls.

The Combined Equity Value is initially only $500 million in a 100% Debt or 100% Cash deal because no Stock is issued. When the Acquirer’s share price falls, the Combined Equity Value drops to $470 million.

An Acquirer with an Equity Value of $500 million and an Enterprise Value of $600 million has Net Income of $50 million and EBITDA of $100 million.

The Target, with a Purchase Equity Value of $100 million and a Purchase Enterprise Value of $150 million, has Net Income of $10 million and EBITDA of $15 million.

What are the Combined P / E and TEV / EBITDA multiples in a 100% Stock deal? Assume the same tax rates for the Acquirer and Target.

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How would those Combined Multiples change in a 100% Cash or Debt deal?

The Combined Equity Value in a 100% Stock deal is $500 million + $100 million = $600 million, and the Combined Enterprise Value is $600 million + $150 million = $750 million.

The Combined EBITDA is $115 million, and the Combined Net Income, assuming the same tax rates and no interest effects since it’s a 100% Stock deal, is $50 million + $10 million = $60 million.

Therefore, the Combined P / E multiple is $600 million / $60 million = 10x, and the Combined TEV / EBITDA multiple is $750 million / $115 million = ~6.5x.

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The Combined TEV / EBITDA multiple would stay the same because neither the Combined Enterprise Value nor the Combined EBITDA is affected by the deal financing.

The Combined P / E multiple would change because the Combined Equity Value would be only $500 million in a 100% Cash or Debt deal.

The Combined Net Income would also change because of the Foregone Interest on Cash and Interest Paid on New Debt.

In most cases, the Combined P / E multiple will be lower in a 100% Cash or 100% Debt deal because the Combined Equity Value will decrease by a greater percentage than the Combined Net Income.

How do the Combined Multiples change based on the deal financing?

Enterprise Value-based multiples do not change based on the % Cash, Debt, and Stock used because the Combined Enterprise Value is not affected by the deal financing, and TEV-based metrics such as Revenue, EBITDA, and EBIT are also not affected by it.

Equity Value-based multiples do change based on the deal financing because the Combined Equity Value depends on the % Stock Used, and Equity Value-based metrics such as Net Income and Free Cash Flow are affected by the Foregone Interest on Cash and Interest Paid on New Debt.

What are the possible ranges for the Combined Multiples after a deal takes place?

Combined Enterprise Value-based Multiples will be between the Buyer’s standalone multiples and the Seller’s purchase multiples.

Combined Equity Value-based Multiples are often in that range as well, but they do not have to be (see the next question for an example).

You cannot average the Buyer’s multiples and the Seller’s purchase multiples to determine the Combined Multiples because the companies could be different sizes.

You also cannot use a weighted average because the proportions of Enterprise Value, EBITDA, and other financial metrics from each company might be different.

The Combined Multiples will be closer to the Buyer’s multiples if the Buyer is much bigger, but they’ll be in the middle of the range if the Buyer and Seller are closer in size.

Consider this M&A scenario:

• Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%.

• Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%.

Calculate the TEV / EBITDA and P / E multiples for each company.

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Company A acquires Company B using 100% Cash and pays no premium to do so. Assume

a 5% Foregone Interest Rate on Cash.

What are the Combined TEV / EBITDA and P / E multiples?

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Now, let’s say that Company A instead uses 100% Debt with a 10% interest rate to acquire Company B.

Again, Company A pays no premium for Company B. What are the combined multiples?

Company A TEV / EBITDA = $100 / $10 = 10x; P / E = $80 / $4 = 20x.

Company B TEV / EBITDA = $40 / $8 = 5x; P / E = $40 / $2 = 20x.

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Combined TEV / EBITDA = Combined Enterprise Value / Combined EBITDA = $140 / $18 = ~7.8x.

Combined P / E = Combined Equity Value / Combined Net Income.

The Combined Equity Value is the Acquirer’s Equity Value of $80 since no Stock was issued.

We can add both companies’ Net Incomes since they have the same tax rate, so the Combined Net Income is $6. But we have to adjust for the Foregone Interest on Cash as well.

The Acquirer used $40 in Cash, and 5% * $40 = $2. After the 50% tax rate, that’s a $1 reduction in Net Income.

So, the Combined Net Income is $5, which makes the Combined P / E = $80 / $5 = 16x.

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The Combined TEV / EBITDA multiple remains the same at ~7.8x because it is not affected by the deal financing.

The Combined Equity Value is still the Acquirer’s Equity Value of $80.

The Combined Net Income before adjustments is $6, but now we must adjust for the Interest Paid on New Debt.

If Company A uses $40 of Debt to acquire Company B, it will pay $40 10% (1 – 50%), or $2, in After-Tax Interest.

So, the Combined Net Income is $4, which makes the Combined P / E = $80 / $4 = 20x.

Why is the “real purchase price” in an M&A deal NOT equal to the Seller’s Purchase Equity Value or Purchase Enterprise Value?

The real price depends on the treatment of the Seller’s Cash and Debt in the deal and the transaction fees.

If the Buyer repays the Seller’s entire Debt balance with its Cash balance or it issues Stock to do so, and it uses the Seller’s entire Cash balance to fund the deal, the real price will be close to the Purchase Enterprise Value (but still not the same due to fees).

In most cases, the Buyer will refinance and replace the Seller’s existing Debt with the same amount of new Debt, but that does not “cost” the Buyer anything extra.

And the Seller’s existing Cash may be used to fund part of the deal or pay for transaction fees, but the entire balance can’t be used because of the Seller’s minimum Cash requirement.

So, the “real price” the Buyer pays is usually in between the Purchase Equity Value and Purchase Enterprise Value of the Seller.

What information do you need from the Buyer and Seller to create a full merger model?

At the minimum, you need Income Statement projections for both companies over the next few years. Ideally, you will also create simple cash flow projections that track the changes in each company’s Cash and Debt over the same period.

You do not need full 3-statement projections for both companies – similar to a DCF analysis, cash flow estimates without Balance Sheet projections are fine.

Why is a Sources & Uses schedule important in a full merger model?

The Sources & Uses (S&U) schedule is important because it tells you how much the Buyer really pays for the Seller.

The Purchase Equity Value and Purchase Enterprise Value can be deceptive for the reasons outlined above.

But in the S&U schedule, you add up the total cost of acquiring the company on the Uses side – its shares, any refinanced Debt, and the transaction fees – and then you show the amount of Cash, Debt, and Stock that will be used to pay for everything on the Sources side.

How does a Cash-Free, Debt-Free deal for a private Seller differ from a standard M&A deal for a public Seller?

In a Cash-Free, Debt-Free deal, the Seller’s existing Cash and Debt balances both go to 0 immediately after the deal closes.

So, if Debt > Cash, the Seller uses its Cash balance to repay as much Debt as it can, and then the Buyer repays the rest when it completes the deal.

If Cash > Debt, then the Seller repays its entire Debt balance using its Cash, and then it uses the remaining Cash to issue a special dividend to shareholders, repurchase shares, or do something else to reduce its Equity Value.

In these types of deals, the purchase price is usually based on a multiple such as TEV / EBITDA or TEV / Revenue rather than a share-price premium because the Seller is private.

Also, the Sources & Uses schedule is based on the Purchase Enterprise Value on the Uses side rather than the Purchase Equity Value, and “Refinanced” or “Assumed/Replaced” Debt is not shown because the Seller’s Debt always goes to 0 after the deal closes.

In most cases, this deal structure simply means that the additional New Debt on the Sources side is used to repay the Seller’s existing Debt.

What’s the purpose of a Purchase Price Allocation schedule in a merger model?

The main purpose is to estimate the Goodwill that will be created in a deal.

Goodwill exists because Buyers often pay far more for companies than their Balance Sheets suggest they are worth; in other words, the Purchase Equity Value exceeds the acquired company’s Common Shareholders’ Equity (CSE).

When this happens, the Combined Balance Sheet will go out of balance because the Seller’s CSE is written down to $0, but the total amount of Cash, Debt, and Stock used in the deal exceeds the CSE that was written down.

So, you estimate the new Goodwill with this schedule, factor in write-ups of Assets such as PP&E and Intangibles, and include other acquisition effects such as the creation of Deferred Tax Liabilities and changes to existing Deferred Tax items.

Why do Deferred Tax Liabilities get created in many M&A deals?

A Deferred Tax Liability, or DTL, represents the expectation that Cash Taxes will exceed Book Taxes in the future.

DTLs get created because the Depreciation & Amortization on Asset Write-Ups is not deductible for cash-tax purposes in a Stock Purchase (i.e., an M&A deal structured such that the Buyer purchases all the Seller’s shares and acquires everything the Seller has).

As a result, the Buyer will pay more in Cash Taxes than Book Taxes until the Write-Ups are fully depreciated/amortized. Each time the Buyer pays more in Cash Taxes than Book Taxes, the DTL decreases until it eventually reaches 0.

An Acquirer purchases a Target for a $1 billion Equity Purchase Price. This Target has $600 million in Common Shareholders’ Equity and no existing Goodwill.

The Acquirer plans to write up the Target’s PP&E and Other Intangible Assets by $100 million.

Walk me through the Purchase Price Allocation, assuming a 25% tax rate.

The “Allocable Purchase Premium” equals the Equity Purchase Price minus the Common Shareholders’ Equity plus the Target’s existing Goodwill, so $1 billion – $600 million + $0 = $400 million.

The PP&E and Other Intangible Assets increase by $100 million, so you subtract this figure because it means you’ll need less Goodwill to make the Balance Sheet balance. So, the Purchase Premium is down to $300 million.

Then, you create a Deferred Tax Liability that corresponds to these write-ups. It’s equal to $100 million * 25%, or $25 million, and you add it because an increase on the L&E side means that more Goodwill will be needed on the Assets side.

So, $325 million of Goodwill gets created, along with Asset Write-Ups of $100 million and a new Deferred Tax Liability of $25 million.

What happens if an Acquirer purchases another company for a $1 billion Equity Purchase Price, but the Target’s Common Shareholders’ Equity is $1.5 billion?

Assume there are no write-ups or other adjustments.

“Negative Goodwill” cannot exist per the rules of IFRS and U.S. GAAP.

So, in this situation, you record this $500 million difference as an Extraordinary Gain on the Income Statement, which increases Pre-Tax Income and Net Income.

On the Cash Flow Statement, Net Income is higher, and you reverse this Extraordinary Gain because it’s non-cash. You also reverse the additional Book Taxes paid on it via a positive adjustment in the Deferred Taxes line item on the CFS.

The initial Balance Sheet combination still works the same way, but you don’t record any Goodwill; you just add all the Target’s Assets and Liabilities to the Acquirer’s and reflect the Cash, Stock, and Debt used to fund the deal.

The increased Net Income (due to the Extraordinary Gain) flows into Common Shareholders’ Equity, and the DTL changes based on the adjustment in the Deferred Tax line item.

Cash does not change because the Extraordinary Gain is non-cash and the company’s Cash Taxes stay the same.

What are the main adjustments you make when combining the Balance Sheets in an M&A deal?

You reflect the Cash, Debt, and Stock used in the deal, create new Goodwill, write up Assets such as PP&E and Other Intangibles, and reflect the Seller’s assumed or refinanced Debt. You also show any new Deferred Tax Liabilities and the write-offs of existing DTLs and DTAs.

Then, you write down the Seller’s Common Shareholders’ Equity and reflect transaction and financing fees (transaction fees are deducted from CSE, and financing fees are deducted from the Book Value of the New Debt).

These are the most common adjustments, but there are others; for example, you might reduce the combined Accounts Receivable or Accounts Payable to reflect intercompany receivables or payables, and you might write down Deferred Revenue after the transaction closes because companies can recognize only the profit portion of the Seller’s Deferred Revenue following a deal.

Give me an example of how you might estimate Revenue and Expense Synergies in an M&A deal.

With Revenue Synergies, you might assume that the Seller can sell its products to some of the Buyer’s customer base.

So, if the Buyer has 100,000 customers, 1,000 of them might buy widgets from the Seller. Each widget costs $10.00, so that is $10,000 in extra Revenue.

There will also be COGS and Operating Expenses associated with these extra sales, so you must factor those in as well. For example, if each widget's cost is $5.00, then the Combined Company will earn only $5,000 in extra Pre-Tax Income.

With Expense Synergies, you might assume that the Combined Company can close a certain number of offices or lay off redundant employees, particularly in functions such as IT, accounting, and HR.

For example, if the Combined Company has 10 offices, management might feel that only 8 offices will be required after the merger.

If each office costs $100,000 per year, there will be 2 * $100,000 = $200,000 in Expense Synergies, which will boost the Combined Pre-Tax Income by $200,000.

Why do many merger models tend to overstate the impact of Synergies?

First, many merger models do not include the costs associated with Revenue Synergies. Even if the Buyer or Seller can sell more products or services after the deal occurs, those extra sales cost something, so you must also include the extra COGS and OpEx.

Second, realizing Synergies takes time. Even if a company expects $10 million in “long-term synergies,” it won’t realize all of them in Year 1; it might take years, and the percentage realized will increase gradually each year.

Finally, realizing Synergies costs money. There will always be “integration costs” associated with a deal, and certain types of Synergies, such as headcount reductions, will cost even more due to severance costs for employees.

How do you calculate the Combined Company’s Debt repayment capacity in a merger model?

You do this by creating a “mini” Cash Flow Statement.

You eliminate most of the Financing and Investing sections (except for CapEx and potentially Dividends), but you keep most of the Cash Flow from Operations section.

It’s similar to what you do in a DCF to project Unlevered Free Cash Flow, but you’re projecting the company’s Free Cash Flow – which deducts Net Interest Expense – here.

You have to include the Net Interest Expense because it directly affects a company’s ability to repay Debt and generate Cash; the purpose is different from that of a DCF since you’re not valuing a company but instead tracking its Cash and Debt balances.

How should you treat Stock-Based Compensation (SBC) in a merger model?

The easiest approach is to count it as a cash operating expense. Just as in a DCF, SBC is problematic because it increases the company’s diluted share count and, therefore, reduces its value to existing shareholders.

But it’s difficult to estimate this impact since you would have to project the company’s share price and details of the SBC to do that. Also, it’s much easier to analyze M&A deals if each company’s standalone share count stays the same each year.

So, it’s easiest NOT to add back SBC as a non-cash expense on the standalone and combined Cash Flow Statements.

That way, it’s effectively a cash operating expense, and each company’s share count stays the same (assuming that Stock Issuances and Repurchases are also set to 0, which they should be).

Why might you calculate metrics such as Debt / EBITDA and EBITDA / Interest for the Combined Company in an M&A deal?

These metrics tell you whether the Acquirer could use more Debt to fund the deal or if it’s using too much Debt to fund the deal.

Sometimes, it’s deceptive to look at a number like Debt / EBITDA immediately after a deal closes because the Combined Company can de-lever rapidly by paying off Debt.

So, even if its Debt / EBITDA jumps up to a high level, such as 5x or 6x, if it can repay Debt and bring it down to 2x or 3x in a few years, it might be able to use more Debt to fund the initial deal.

How do Pro-Forma EPS and Pro-Forma accretion/dilution from the standard, or IFRS/GAAP-compliant, figures?

This one gets confusing because there’s no universal definition of Pro-Forma EPS.

But most companies calculate it by adding back non-cash expenses created in an M&A deal, primarily the Amortization of Intangibles and the Depreciation of PP&E Write-Ups, and some also add back Restructuring or Merger/Integration Costs – under the logic that they are “non-recurring.”

Then, they calculate the Combined Net Income based on this “Pro-Forma” Pre-Tax Income with these line items added back.

Many companies report Pro-Forma EPS and calculate accretion/dilution based on these figures, but you should be skeptical because these numbers tend to understate the true costs of acquisitions.

Suppose that you set up an IRR vs. Discount Rate analysis to judge the merits of an M&A deal. Why might you not be able to take the results of this analysis literally?

One problem with this analysis is that it’s not clear if you should use the Buyer’s Discount Rate, the Seller’s, or a weighted average of the two. Therefore, if the Buyer and Seller's Discount Rates are significantly different, the results could change dramatically.

Other problems relate to the treatment of the Synergies and the Terminal Value of the Synergies. Depending on whether the Buyer or Seller gets “credit” for the Synergies, the IRR could change significantly.

There are also questions about whether or not a “Terminal Value” for Synergies is justified, given that they probably won’t last forever. Similar to EPS accretion/dilution, the IRR vs. Discount Rate analysis is useful, but only one way to judge M&A deals.

Walk me through a Contribution Analysis for a 100% Stock M&A deal.

In a Contribution Analysis, you add up the Buyer and Seller's financial metrics, such as Revenue and EBITDA, and determine the percentage the Buyer and Seller “contribute” to each combined metric.

Then, you estimate the Pro-Forma Combined Enterprise Value based on Buyer’s Enterprise Value / Buyer’s Contribution Percentage for the relevant metric.

For example, if the Buyer’s Enterprise Value is $1,500, and it contributes 75% of the Combined Revenue, the Pro-Forma Combined Enterprise Value based on Revenue is $1,500 / 75% = $2,000.

You then subtract the Buyer’s Enterprise Value from this number to get the Seller’s Implied Enterprise Value, and you subtract the items in the TEV bridge to get its Implied Equity Value.

Then, you divide by its share count to get the Implied Offer Price. You can then compare this Implied Offer Price to the actual Offer Price in the deal to determine whether the Buyer is paying an appropriate price.

How does the Value Creation Analysis in M&A deals work, and when is it appropriate?

In a Value Creation Analysis, you assume that the Buyer + Seller as a combined entity will trade at higher valuation multiples, in-line with the multiples of larger public companies in the sector.

You calculate the Combined Enterprise Value based on those higher multiples, subtract all the TEV bridge items (and reflect the Cash and Debt used in the deal) to get the Combined Equity Value, and divide by the Combined Share Count to get the Implied Share Price for this entity.

If this share price is higher than the Acquirer’s standalone share price, the deal “created value.” This analysis is highly speculative because there’s no guarantee that the Buyer + Seller combined will magically trade at higher multiples; it’s most relevant if the deal represents a clear case of Companies #2 and #3 in the market combining to compete with Company #1.

It’s less relevant when the market is highly fragmented, and the Buyer + Seller together still does not resemble larger companies.