Chapter 5: M&A Deals and Merger Models

Why might one company want to buy another company?

One company might buy another if it believes it will be better off after the acquisition. Reasons include: the Seller's price is less than its Implied Value, the expected IRR exceeds the Buyer's Discount Rate, cost savings via consolidation and economies of scale, geographic expansion or market share gains, acquiring new customers or distribution channels, expanding products and services, and realizing synergies through departmental consolidation or revenue boosts. Deals may also be motivated by competition, office politics, and ego.

How can you analyze an M&A deal and determine whether it makes sense?

Use qualitative analysis (geographic expansion, products, customer bases, IP, team improvements) and quantitative analysis (valuation of the Seller to check if undervalued, comparison of expected IRR to Buyer's Discount Rate). EPS accretion/dilution is important because Buyers prefer accretive deals that increase their EPS, which Boards and investors favor.

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

Start by projecting financials of Buyer and Seller. Estimate Purchase Price and mix of Cash, Debt, and Stock. Create Sources & Uses and Purchase Price Allocation schedules. Combine Balance Sheets (reflecting Cash, Debt, Stock used, new Goodwill, write-ups/downs). Combine Income Statements (reflecting Foregone Interest on Cash, Interest on New Debt, Synergies). Combined Net Income = Combined Pre-Tax Income × (1 – Buyer's Tax Rate). Combined EPS = Combined Net Income / (Buyer's Existing Shares + New Shares Issued). Accretion/dilution = (Combined EPS / Buyer's Standalone EPS) – 1.

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

A deal is accretive if the extra Pre-Tax Income from the Seller exceeds the cost of acquisition (Foregone Interest on Cash + Interest on New Debt + New Shares Issued). It's dilutive if the opposite happens. Example: Seller contributes $100 in Pre-Tax Income but costs only $70 in Interest = accretive. If it costs $130 in Interest = dilutive.

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

Compare the Weighted Cost of Acquisition to the Seller's Yield at its Purchase Price. Cost of Cash = Foregone Interest Rate × (1 – Buyer's Tax Rate). Cost of Debt = Interest Rate on New Debt × (1 – Buyer's Tax Rate). Cost of Stock = Reciprocal of Buyer's P/E. Seller's Yield = Reciprocal of Seller's P/E at Purchase Price. Weighted Cost = %Cash × Cost of Cash + %Debt × Cost of Debt + %Stock × Cost of Stock. If Weighted Cost < Seller's Yield = accretive. If Weighted Cost > Seller's Yield = dilutive.

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

Because EPS is the only easy-to-calculate metric that captures the FULL impact of the deal—the Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued. While EBITDA and Unlevered FCF more accurately approximate cash flow, they don't reflect the deal's full impact because they exclude Net Interest and new shares effect.

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

For public Sellers: assume a premium to current share price (usually 10-30%) based on similar deals, then cross-check with DCF, Public Comps, and other valuation methodologies. For private Sellers: use standard valuation methodologies, usually linking to a multiple of EBITDA, EBIT, or Revenue. If Buyer expects significant Synergies, it may pay a higher premium if the PV of Synergies exceeds the premium.

What are the advantages and disadvantages of Cash in M&A deals?

Advantages: tends to be cheapest option (companies earn little Interest Income on it), fastest and easiest to close. Disadvantages: limits Buyer's flexibility if funds needed for something else soon.

What are the advantages and disadvantages of Debt in M&A deals?

Advantages: normally cheaper than Stock but more expensive than Cash. Disadvantages: takes more time to close due to marketing new Debt to investors, limits Buyer's flexibility by making future Debt issuances more difficult and expensive.

What are the advantages and disadvantages of Stock in M&A deals?

Advantages: prevents Buyer from paying additional cash expense, can sometimes be issued more quickly than Debt, Seller's shareholders not taxed immediately (vs. immediate taxes with Cash/Debt). Disadvantages: tends to be most expensive option (though can be cheapest on paper if Buyer has extremely high P/E), dilutes Buyer's existing investors.

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

Cash is cheapest for most Acquirers, so use all available Cash first (Current Cash – Minimum Cash, may include Target's Cash if significant). Debt is next cheapest—can raise up to level where Debt/EBITDA and EBITDA/Interest ratios remain in-line with peers. Stock is used for remainder. Few companies would issue enough Stock to give up control, and some Acquirers issue Stock only up to the point where the deal turns dilutive.

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

The Seller must balance taxes with certainty of payment and potential future upside. Debt and Cash mean immediate payment and immediate capital gains taxes with no upside if Buyer's share price increases, but also no risk if it decreases. Stock is more of a gamble—could result in higher price if Buyer's share price increases or lower if it drops. Seller's shareholders avoid immediate taxes with Stock (pay only when they sell shares). Preferred method depends on Seller's confidence in Buyer: Cash and Debt better with higher uncertainty, 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?

Foregone Interest on Cash represents Cost of Cash (Acquirer loses future projected Interest Income). Interest Expense on New Debt represents Cost of Debt. For both, multiply interest rate by (1 – Acquirer's Tax Rate) to estimate after-tax costs. Cost of Stock is represented by additional shares created and how they reduce Combined Company's EPS, equal to reciprocal of Acquirer's P/E Multiple (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. If an Acquirer expects $90 in Operating Income and $10 in Interest Income for $100 total 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 Cost of Equity. The "Reciprocal of P/E Multiple" method measures Cost of Equity in terms of EPS impact, while CAPM method measures it based on stock's expected annualized returns. Neither method is "correct" because you use them in different contexts. In most cases, Stock will be the most expensive funding source regardless of method used.

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

The Acquirer might not draw on entire Cash balance if much of the Cash is in overseas subsidiaries or otherwise restricted. Also, Acquirer might be preserving Cash for future expansion plan or Debt maturity. Finally, if Acquirer is trading at high multiples (such as 100x P/E), 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, many cases where it's less important or irrelevant. For example, if Buyer is private or already has negative EPS, it won't care about accretion/dilution. Also makes little difference if Buyer is far bigger than Seller (10x-100x its size). Besides EPS accretion/dilution, can analyze deal's qualitative merits, compare IRR to Discount Rate, value Seller + Synergies and compare to Equity Purchase Price, create Contribution Analysis to compare contribution percentages to ownership percentages, or use Value Creation Analysis to determine how Buyer's share price will change after deal closes.

How does a merger differ from an acquisition?

There's no mechanical difference in merger model or analyses because there's always a Buyer and Seller. Difference is that in merger, companies are closer in size, while Buyer is significantly larger than Seller in acquisition. 100% Stock or majority-Stock deals are more common in mergers because similarly sized companies can rarely use Cash or Debt to acquire each other. Place more weight on 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 meaningful metric. Second, Net Income and cash flow are quite different, so EPS-accretive deals might be horrible from cash-flow perspective. Third, merger models don't capture true risk inherent in M&A deals—100% Cash deals almost always look accretive even though integration might go wrong, legal issues might arise, customers or shareholders might revolt. Fourth, merger models often fail to consider what happens if Buyer or Seller's share prices change significantly before deal closes, especially in 100% Stock deals. Finally, merger models don't capture qualitative aspects like 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?

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

Walk through the full math: Company A has 10 shares at $25.00/share and Net Income of $10. It acquires Company B for Purchase Equity Value of $150. Company B has Net Income of $10. Assume same tax rates. How accretive is this deal?

Company A's EPS = $10 / 10 = $1.00. To do deal, Company A must issue 6 new shares ($150 / $25.00 = 6), so Combined Share Count = 10 + 6 = 16. Since no Cash or Debt used and tax rates are same, Combined Net Income = $10 + $10 = $20. Combined EPS = $20 / 16 = $1.25, so it's accretive by 25%.

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

Weighted Cost of Acquisition = 8% × (1 – 25%) = 6%, so deal is still accretive because that Cost is less than Seller's Yield of 6.7%. For deal to turn dilutive, After-Tax Cost of Debt would have to exceed 6.7%. Since 6.7% / (1 – 25%) = 8.9%, deal would turn dilutive at interest rate ≥ 8.9%.

What are the Combined Equity Value and Enterprise Value in this deal? Assume Equity Value = Enterprise Value for both Buyer and Seller and use 100% Stock funding

Combined Equity Value = Buyer's Equity Value + Market Value of Stock Issued = $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?

Combined TEV/EBITDA stays the same regardless of financing method, but Combined P/E multiple will change based on Stock issued and Cash and Debt used. Stock issued affects Combined Equity Value, and Cash and Debt used affect Combined Net Income because of Foregone Interest on Cash and Interest Paid on New Debt.

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

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

Company A is twice as big financially (Equity Value $500, Net Income $20). Will a 100% Stock deal be more or less accretive?

Deal will be less accretive. Intuition: Company A's P/E remains same, but it's significantly bigger, so higher-yielding Company B provides less of a boost to Company A's EPS. Combined P/E multiple will still be between 15x and 25x, but even closer to 25x because Company A has greater weighting in combined company.

Now do the math. Company A has Equity Value $500, Net Income $20, 10 shares at $50.00/share. It acquires Company B for Purchase Equity Value $150 (Company B Net Income $10). What is accretion/dilution?

Buyer previously represented 63% of total company, but now represents 77%, so expect accretion to fall by ~10-15%. Company A's EPS = $20 / 10 = $2.00. To acquire Company B, must issue 3 shares ($150 / $50.00 = 3). Combined Net Income = $20 + $10 = $30. New share count = 10 + 3 = 13. $30 / 13 = $2.31, about 15% higher than Buyer's standalone EPS. About 10% lower than 25% accretion when Company A was smaller.

Company A has P/E of 10x, Debt Interest Rate of 8%, Cash Interest Rate of 4%, Tax Rate of 25%. It wants to acquire Company B at purchase P/E of 16x using 1/3 Stock, 1/3 Debt, 1/3 Cash. Will the deal be accretive?

Company A's After-Tax Cost of Stock = 1/10 = 10%, After-Tax Cost of Debt = 8% × (1 – 25%) = 6%, After-Tax Cost of Cash = 4% × (1 – 25%) = 3%. Company B's Yield = 1/16 = 6.25%. Weighted Cost of Acquisition = 10% × 1/3 + 6% × 1/3 + 3% × 1/3 = 3.33% + 2% + 1% = 6.33%. Since Weighted Cost is slightly above Company B's Yield, deal will be dilutive.

Company A acquires Company B using 100% Debt. Company B has purchase P/E of 12x, Company A has P/E of 15x. What interest rate on Debt is required to make the deal dilutive?

Company B's Yield = 1/12 = 8.3%, so After-Tax Cost of Debt must be above 8.3% for deal to be dilutive. Assuming 25% tax rate, 8.3% / (1 – 25%) = 11.1%, or "Around 11%". That's a high interest rate for most companies, so 100% Debt deal would almost certainly be accretive.

Company A has Equity Value $1,000 and Net Income $100. Company B has Purchase Equity Value $2,000 and Net Income $50. For a 100% Stock deal to be accretive, how much in Synergies must be realized?

Company A's P/E = $1,000 / $100 = 10x, so Cost of Stock = 10%. Company B's P/E = $2,000 / $50 = 40x, so Yield = 1/40 = 2.5%. Without Synergies, deal would be highly dilutive. For deal to turn accretive, Company B's Yield must exceed 10%, meaning Purchase P/E must be below 10x, meaning Net Income must be above $200. So, must be $150 in After-Tax Synergies for deal to be accretive. At 25% tax rate, that means at least $200 in Pre-Tax Synergies.

Acquirer has Equity Value $1B, Cash $50M, EBITDA $100M, Net Income $50M, Debt/EBITDA 2x. Peers have median Debt/EBITDA 4x. It wants to acquire for Purchase Equity Value $500M. Seller has Net Income $30M, EBITDA $50M, no Debt. What's best way to fund this deal?

Acquirer would prefer Cash, but $50M is likely close to minimum Cash balance, so Cash financing unlikely. Acquirer's P/E = 20x, so Cost of Stock = 1/20 = 5%, fairly low. Best guess is Debt still cheaper than Stock. Company could boost Debt/EBITDA from 2x to 4x since peers have leverage in that range. Combined Company has $150M EBITDA, and 4 × $150M = $600M. Acquirer has $200M Debt, Target has no Debt, so could afford to issue $400M in new Debt. Remaining $100M could be issued in Stock. If used part of Cash balance or Target's Cash, $100M Stock portion would be reduced.

Acquirer has Equity Value $500M, Cash $100M, EBITDA $50M, Net Income $25M, Debt/EBITDA 3x. Similar companies have Debt/EBITDA 5x. What's the BIGGEST acquisition this company might be able to complete?

Can't answer precisely without knowing Target's Net Income and EBITDA, but can estimate. Acquirer couldn't use entire Cash balance but might use substantial portion like $50M since Cash would equal annual EBITDA. Could afford to use leverage up to 5x EBITDA, meaning could use $100M in additional Debt (currently has $150M Debt, or 3 × $50M). No limit on Stock but unlikely to issue so much that it loses control. Likely maximum ~$500M Stock, realistic level might be half Current Equity Value ($250M), or whatever amount turns deal dilutive. Reasonable answer: "In theory, Acquirer might be able to fund deal for up to $650M. But unless wanted to issue massive amount of Stock, maximum realistic level would be closer to $400-$650M."

Acquirer with Equity Value $500M and Enterprise Value $600M buys company for Purchase Equity Value $100M and Purchase Enterprise Value $150M. What are Combined Equity Value and Enterprise Value?

Combined Enterprise Value = Enterprise Value of Buyer + Purchase Enterprise Value of Seller = $600M + $150M = $750M. Can't determine Combined Equity Value because it depends on deal financing: Combined Equity Value = Acquirer's Equity Value + Market Value of Stock Issued in Deal. If 100% Stock deal, Combined Equity Value = $500M + $100M = $600M, but if 100% Cash or Debt, Combined Equity Value = $500M. If % Stock is between 0% and 100%, Combined Equity Value will be between $500M and $600M.

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

Combined Enterprise Value is not affected by deal financing: always equal to Buyer's Enterprise Value + Purchase Enterprise Value of Seller. Combined Equity Value = Buyer's Equity Value + Market Value of Stock Issued in Deal, which could range from $0 up to Purchase Equity Value of Seller. In 100% Stock deal, Combined Equity Value = Buyer's Equity Value + Purchase Equity Value of Seller.

You're saying in a 100% Cash or Debt deal, the Seller's Equity Value just "disappears." How is that possible?

Seller's Equity Value doesn't "disappear"—it's transformed into Cash used or Debt issued by Buyer in the deal. Combined Enterprise Value calculation demonstrates this: both companies' Enterprise Values still exist after deal, so no value is "lost" along the way.

You're saying the purchase premium the Acquirer pays for the Target lasts after the deal closes? How is that possible?

Purchase premium does not necessarily "last" because it depends on market's reaction to deal. If market believes Target's premium was justified, then rules about Combined Equity Value and Enterprise Value will hold up. However, if market believes Acquirer overpaid, Acquirer's share price will fall to reflect amount by which it overpaid—whether that means entire purchase premium, part of premium, or more than premium.

Acquirer has Equity Value $500M, Enterprise Value $600M, 100M shares at $5.00/share. Target has Equity Value $100M, Enterprise Value $150M, and Acquirer pays 30% premium in 100% Stock deal. Market loses faith in 30% premium several months later. What happens to Combined Equity Value and Enterprise Value immediately after announcement and several months after?

Immediately after: Combined Equity Value = $500M + $130M = $630M (100% Stock deal). Combined Enterprise Value = $600M + $180M = $780M. When market loses faith in 30% premium, Acquirer's share price falls such that its Eq Val and TEV both fall by $30M. Share price falls to $4.70, Combined Equity Value decreases to $600M (Acquirer's Equity Value now $470M). Combined Enterprise Value = $570M + $180M = $750M, also down by $30M premium.

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

Combined Enterprise Value changes same way in both steps: initially $780M, then falls to $750M as Acquirer's share price falls. Combined Equity Value is initially only $500M in 100% Debt or Cash deal because no Stock issued. When Acquirer's share price falls, Combined Equity Value drops to $470M.

Acquirer with Equity Value $500M and Enterprise Value $600M has Net Income $50M and EBITDA $100M. Target, with Purchase Equity Value $100M and Purchase Enterprise Value $150M, has Net Income $10M and EBITDA $15M. What are Combined P/E and TEV/EBITDA multiples in 100% Stock deal?

Combined Equity Value in 100% Stock deal = $500M + $100M = $600M. Combined Enterprise Value = $600M + $150M = $750M. Combined EBITDA = $115M. Combined Net Income (assuming same tax rates, no interest effects since 100% Stock) = $50M + $10M = $60M. Combined P/E = $600M / $60M = 10x. Combined TEV/EBITDA = $750M / $115M = ~6.5x.

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

Combined TEV/EBITDA would stay the same because neither Combined Enterprise Value nor Combined EBITDA is affected by deal financing. Combined P/E would change because Combined Equity Value would be only $500M in 100% Cash or Debt deal. Combined Net Income would also change because of Foregone Interest on Cash and Interest Paid on New Debt. In most cases, Combined P/E will be lower in 100% Cash or 100% Debt deal because Combined Equity Value will decrease by greater percentage than Combined Net Income.

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

Enterprise Value-based multiples do not change based on % Cash, Debt, and Stock used because Combined Enterprise Value is not affected by deal financing, and TEV-based metrics (Revenue, EBITDA, EBIT) are also not affected. Equity Value-based multiples do change based on deal financing because Combined Equity Value depends on % Stock Used, and Equity Value-based metrics (Net Income, Free Cash Flow) are affected by 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 Buyer's standalone multiples and Seller's purchase multiples. Combined Equity Value-based Multiples are often in that range too, but don't have to be. Cannot average Buyer's and Seller's multiples because companies could be different sizes. Also cannot use weighted average because proportions of Enterprise Value, EBITDA, and other financial metrics from each company might be different. Combined Multiples will be closer to Buyer's multiples if Buyer is much bigger, but in middle of range if Buyer and Seller are closer in size.

Company A: Enterprise Value $100, Equity Value $80, EBITDA $10, Net Income $4, Tax Rate 50%. Company B: Enterprise Value $40, Equity Value $40, EBITDA $8, Net Income $2, Tax Rate 50%. Calculate TEV/EBITDA and P/E multiples for each company

Company A TEV/EBITDA = $100 / $10 = 10x; P/E = $80 / $4 = 20x. Company B TEV/EBITDA = $40 / $8 = 5x; P/E = $40 / $2 = 20x.

Company A acquires Company B using 100% Cash and pays no premium. Assume 5% Foregone Interest Rate on Cash. What are Combined TEV/EBITDA and P/E multiples?

Combined TEV/EBITDA = Combined Enterprise Value / Combined EBITDA = $140 / $18 = ~7.8x. Combined P/E = Combined Equity Value / Combined Net Income. Combined Equity Value = Acquirer's Equity Value of $80 (no Stock issued). Can add both Net Incomes (same tax rate), so Combined Net Income = $6. But must adjust for Foregone Interest on Cash: Acquirer used $40 Cash, and 5% × $40 = $2. After 50% tax rate, that's $1 reduction in Net Income. Combined Net Income = $5, making Combined P/E = $80 / $5 = 16x.

Company A uses 100% Debt with 10% interest rate to acquire Company B. Again, no premium. What are combined multiples?

Combined TEV/EBITDA remains same at ~7.8x (not affected by deal financing). Combined Equity Value is still Acquirer's Equity Value of $80. Combined Net Income before adjustments = $6, but now must adjust for Interest Paid on New Debt. If Company A uses $40 Debt, it will pay $40 × 10% × (1 – 50%) = $2 in After-Tax Interest. Combined Net Income = $4, making 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?

Real price depends on treatment of Seller's Cash and Debt in deal and transaction fees. If Buyer repays Seller's entire Debt with its Cash or issues Stock to do so, and uses Seller's entire Cash to fund deal, real price will be close to Purchase Enterprise Value (but still not same due to fees). In most cases, Buyer will refinance and replace Seller's existing Debt with same amount of new Debt (doesn't "cost" Buyer anything extra). Seller's existing Cash may be used to fund part of deal or pay transaction fees, but entire balance can't be used due to Seller's minimum Cash requirement. So, "real price" Buyer pays is usually between Purchase Equity Value and Purchase Enterprise Value of Seller.

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

At minimum, need Income Statement projections for both companies over next few years. Ideally, also create simple cash flow projections that track changes in each company's Cash and Debt over same period. Do not need full 3-statement projections for both companies—similar to DCF analysis, cash flow estimates without Balance Sheet projections are fine.

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

S&U schedule is important because it tells you how much Buyer really pays for Seller. Purchase Equity Value and Purchase Enterprise Value can be deceptive. In S&U schedule, you add up total cost of acquiring company on Uses side (its shares, any refinanced Debt, transaction fees) and show amount of Cash, Debt, and Stock used to pay for everything on 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 Cash-Free, Debt-Free deal, Seller's existing Cash and Debt balances both go to 0 immediately after deal closes. If Debt > Cash, Seller uses Cash to repay as much Debt as it can, then Buyer repays rest when completing deal. If Cash > Debt, Seller repays entire Debt using Cash, then uses remaining Cash to issue special dividend, repurchase shares, or reduce Equity Value. In these deals, purchase price usually based on multiple like TEV/EBITDA or TEV/Revenue (Seller is private). S&U schedule based on Purchase Enterprise Value on Uses side rather than Purchase Equity Value, and "Refinanced" or "Assumed/Replaced" Debt not shown because Seller's Debt always goes to 0. Usually means additional New Debt on Sources side is used to repay Seller's existing Debt.

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

Main purpose is to estimate Goodwill that will be created in deal. Goodwill exists because Buyers often pay far more for companies than their Balance Sheets suggest they're worth (Purchase Equity Value exceeds acquired company's Common Shareholders' Equity). When this happens, Combined Balance Sheet will go out of balance because Seller's CSE is written down to $0, but total Cash, Debt, and Stock used exceeds CSE written down. So, estimate new Goodwill with this schedule, factor in write-ups of Assets (PP&E, Intangibles), and include other acquisition effects such as creation of Deferred Tax Liabilities and write-offs of existing DTLs and DTAs.

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

A DTL represents expectation that Cash Taxes will exceed Book Taxes in future. DTLs get created because Depreciation & Amortization on Asset Write-Ups is not deductible for cash-tax purposes in Stock Purchase (M&A deal where Buyer purchases all Seller's shares and acquires everything Seller has). As result, Buyer will pay more in Cash Taxes than Book Taxes until Write-Ups are fully depreciated/amortized. Each time Buyer pays more in Cash Taxes than Book Taxes, DTL decreases until it eventually reaches 0.

Acquirer purchases Target for $1B Equity Purchase Price. Target has $600M in CSE and no existing Goodwill. Acquirer plans to write up Target's PP&E and Other Intangibles by $100M. Walk me through Purchase Price Allocation, assuming 25% tax rate

"Allocable Purchase Premium" = Equity Purchase Price – CSE + Target's existing Goodwill = $1B – $600M + $0 = $400M. PP&E and Other Intangibles increase by $100M, so subtract this (need less Goodwill to balance). Purchase Premium down to $300M. Create DTL corresponding to write-ups = $100M × 25% = $25M, and add it (increase on L&E side means more Goodwill needed on Assets side). So, $325M of Goodwill gets created, along with Asset Write-Ups of $100M and new DTL of $25M.

What happens if an Acquirer purchases another company for $1B Equity Purchase Price, but Target's CSE is $1.5B? Assume no write-ups or other adjustments

"Negative Goodwill" cannot exist per IFRS and U.S. GAAP rules. Record $500M difference as Extraordinary Gain on Income Statement, increasing Pre-Tax Income and Net Income. On CFS, Net Income is higher, reverse this Extraordinary Gain (non-cash), and reverse additional Book Taxes via positive adjustment in Deferred Taxes line. Initial Balance Sheet combination works same way, but don't record any Goodwill; just add all Target's Assets and Liabilities to Acquirer's and reflect Cash, Stock, and Debt used. Increased Net Income (due to Extraordinary Gain) flows into CSE, and DTL changes based on adjustment in Deferred Tax line. Cash does not change because Extraordinary Gain is non-cash and company's Cash Taxes stay same.

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

Reflect Cash, Debt, and Stock used in deal; create new Goodwill; write up Assets (PP&E, Other Intangibles); reflect Seller's assumed or refinanced Debt; show any new DTLs and write-offs of existing DTLs and DTAs. Write down Seller's CSE and reflect transaction and financing fees (transaction fees deducted from CSE, financing fees deducted from Book Value of New Debt). Other adjustments may include: reduce combined Accounts Receivable or Payable to reflect intercompany receivables/payables; write down Deferred Revenue after transaction (companies can recognize only profit portion of Seller's Deferred Revenue following deal).

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

Revenue Synergies: assume Seller can sell products to some of Buyer's customer base. If Buyer has 100,000 customers, 1,000 might buy widgets from Seller. Each widget costs $10, that's $10,000 extra Revenue. Must also factor in COGS and OpEx for extra sales. If each widget's cost is $5, Combined Company earns only $5,000 extra Pre-Tax Income. Expense Synergies: assume Combined Company can close certain offices or lay off redundant employees (IT, accounting, HR). If Combined Company has 10 offices, management might feel only 8 required after merger. If each office costs $100,000/year, 2 × $100,000 = $200,000 in Expense Synergies, boosting Combined Pre-Tax Income by $200,000.

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

First, many models don't include costs associated with Revenue Synergies—even if Buyer or Seller can sell more products/services, those extra sales cost something (must include extra COGS and OpEx). Second, realizing Synergies takes time. Even if company expects $10M in "long-term synergies," won't realize all in Year 1; might take years, percentage realized increases gradually each year. Finally, realizing Synergies costs money. Always "integration costs" associated with deal, and certain types of Synergies (like headcount reductions) cost even more due to severance costs for employees.

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

Create a "mini" Cash Flow Statement. Eliminate most of Financing and Investing sections (except CapEx and potentially Dividends), but keep most of Cash Flow from Operations section. Similar to what you do in DCF to project Unlevered FCF, but here you're projecting company's Free Cash Flow (which deducts Net Interest Expense). Must include Net Interest Expense because it directly affects company's ability to repay Debt and generate Cash; purpose is different from DCF since you're not valuing company but tracking its Cash and Debt balances.

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

Easiest approach is to count it as cash operating expense. Just as in DCF, SBC is problematic because it increases company's diluted share count and reduces its value to existing shareholders. But difficult to estimate this impact since would have to project company's share price and SBC details. Also, much easier to analyze M&A deals if each company's standalone share count stays same each year. So, easiest NOT to add back SBC as non-cash expense on standalone and combined CFS. That way, it's effectively cash operating expense, and each company's share count stays same (assuming Stock Issuances and Repurchases 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 Acquirer could use more Debt to fund deal or if it's using too much Debt. Sometimes deceptive to look at Debt/EBITDA immediately after deal closes because Combined Company can de-lever rapidly by paying off Debt. Even if Debt/EBITDA jumps to high level like 5x or 6x, if it can repay Debt and bring it down to 2x or 3x in few years, might be able to use more Debt to fund initial deal.

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

This gets confusing because there's no universal definition of Pro-Forma EPS. Most companies calculate it by adding back non-cash expenses created in M&A deal, primarily Amortization of Intangibles and Depreciation of PP&E Write-Ups, and some also add back Restructuring or Merger/Integration Costs (logic: they're "non-recurring"). Then, calculate 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 true costs of acquisitions.

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

One problem is it's not clear if you should use Buyer's Discount Rate, Seller's, or weighted average of the two. If Buyer and Seller's Discount Rates are significantly different, results could change dramatically. Other problems relate to treatment of Synergies and Terminal Value of Synergies. Depending on whether Buyer or Seller gets "credit" for Synergies, IRR could change significantly. Also questions about whether "Terminal Value" for Synergies is justified, given they probably won't last forever. Similar to EPS accretion/dilution, 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 Contribution Analysis, add up Buyer and Seller's financial metrics (Revenue, EBITDA) and determine percentage Buyer and Seller "contribute" to each combined metric. Then, estimate Pro-Forma Combined Enterprise Value based on Buyer's Enterprise Value / Buyer's Contribution Percentage for relevant metric. Example: if Buyer's Enterprise Value is $1,500 and it contributes 75% of Combined Revenue, Pro-Forma Combined Enterprise Value based on Revenue = $1,500 / 75% = $2,000. Subtract Buyer's Enterprise Value from this to get Seller's Implied Enterprise Value, subtract items in TEV bridge to get Implied Equity Value. Divide by share count to get Implied Offer Price. Compare this Implied Offer Price to actual Offer Price to determine if Buyer paying appropriate price.

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

In Value Creation Analysis, assume Buyer + Seller combined will trade at higher valuation multiples, in-line with multiples of larger public companies in sector. Calculate Combined Enterprise Value based on those higher multiples, subtract all TEV bridge items (and reflect Cash and Debt used in deal) to get Combined Equity Value, divide by Combined Share Count to get Implied Share Price for entity. If this share price higher than Acquirer's standalone share price, deal "created value". This analysis is highly speculative because no guarantee Buyer + Seller combined will magically trade at higher multiples; most relevant if deal represents clear case of Companies #2 and #3 in market combining to compete with Company #1. Less relevant when market is highly fragmented, and Buyer + Seller together still doesn't resemble larger companies.

Why do Buyers tend to prefer Asset Purchases, and Sellers tend to prefer Stock Purchases?

In Asset Purchases, Buyers can pick and choose exact Assets to acquire and exact Liabilities to assume, reducing transaction risk. Buyers can also deduct D&A on Asset Write-Ups for cash-tax purposes in Asset Purchase, reducing tax burden after deal closes. Sellers prefer Stock Purchases because Asset Purchases leave them with more risk after deals close and because they must pay taxes on entire purchase price PLUS Gains recorded on their Net Assets in Asset Purchase.

What's the advantage of a 338(h)(10) election for a U.S.-based Buyer?

In 338(h)(10) Election, Buyer and Seller choose to treat Stock Purchase as if it were Asset Purchase for tax purposes. Buyer still acquires all Assets, Liabilities, and off-Balance Sheet items of Seller, but can also deduct D&A on Asset Write-Ups for cash-tax purposes. Seller's entire NOL balance is also written down (as in standard Asset Purchase). 338(h)(10) deals can help Buyers and Sellers compromise and reach agreement more quickly since they combine elements favored by Buyers and Sellers in Asset and Stock Purchases.

If a Seller has a massive NOL balance, should the Buyer use a Stock Purchase, Asset Purchase, or 338(h)(10) election to acquire it?

Buyer should use Stock Purchase because NOLs are written down 100% in Asset Purchase and 338(h)(10) deals, so Buyer cannot use any of Seller's NOLs in those deal structures.

Walk me through what happens in Stock Purchase deal where Buyer pays Equity Purchase Price of $2B for Seller, and Seller has off-BS NOL balance of $400M. NOLs expire in 5 years. Assume Long-Term Adjusted Rates for past 3 months were 0.5%, 0.7%, 1.0% and Buyer's Tax Rate is 25%

If off-BS NOL balance is $400M, portion within DTA should be ~$100M at 25% tax rate. Buyer allowed to use MAX(0.5%, 0.7%, 1.0%) × $2B = $20M per year. NOLs expire in 5 years, meaning Buyer can use 5 × $20M = $100M total. Therefore, Buyer will write down $300M of off-BS NOLs and $75M of NOLs within DTA when transaction closes. Remaining off-BS NOL balance will be $100M, NOL portion within DTA will be $25M. After that, Buyer will use $20M of NOLs each year to reduce cash-taxable income, so off-BS balance declines by $20M/year. DTA portion declines by $5M/year until both on-BS and off-BS NOL balances reach $0 at end of Year 5.

How do these numbers change in an Asset Purchase?

In Asset Purchase, Net Operating Losses (both off-Balance Sheet and on-Balance Sheet versions) are written down to $0, and Buyer can't use any of Seller's NOLs.

Why would a Buyer and Seller agree to an Earn-Out in an M&A deal?

They might agree to Earn-Out if they disagree about Seller's future financial performance and can't agree on upfront price. Example: Buyer thinks Seller will grow at 5% per year, but Seller believes 15% per year. As compromise, Buyer might offer Seller upfront cash plus additional compensation if it achieves certain financial goals (like reaching $100M revenue or $20M EBITDA in 2 years). Earn-Outs also used to incentivize executives and key employees at Seller to stay at new company after deal closes.

Buyer acquires Seller for Equity Purchase Price of $1B. It also promises additional $200M in 2 years if Seller reaches $100M EBITDA by then. Seller's CSE is $600M, no existing Goodwill, Buyer plans to write up Assets for $100M. Assume 25% tax rate and Stock Purchase. Walk me through Purchase Price Allocation

First, subtract Seller's CSE from Equity Purchase Price, resulting in Allocable Purchase Premium of $400M. Buyer writes up Assets for $100M, which reduces Premium because less Goodwill is needed. Down to $300M. DTL will be created because of write-ups, estimate at $100M × 25% = $25M. This DTL will increase Premium because more Goodwill must balance this DTL on other side. Up to $325M. Next, record $200M Earn-Out as "Contingent Consideration" on L&E side, increasing amount of Goodwill required. End up with total of $525M in Goodwill from this deal.

In Year 1, Buyer believes Seller is far less likely to reach $100M EBITDA in 2 years, so it reduces value of Contingent Consideration Liability by 30%. Walk me through the three statements

$200M × 30% = $60M, so Contingent Consideration will fall by $60M. However, this change recorded as POSITIVE on Income Statement (Liability write-down). Pre-Tax Income up by $60M, Net Income up by $45M at 25% tax rate. On CFS, Net Income up $45M, but this Change in Contingent Consideration was non-cash, so reverse it and subtract $60M. Company's Cash Taxes not affected by this line item, so reverse $15M in extra taxes and record positive $15M in Deferred Income Taxes line. At bottom, Cash unchanged (+$45 – $60 + $15 = $0). On Balance Sheet, Cash unchanged, but DTA down by $15M, so Assets side down $15M. On L&E side, Contingent Consideration down $60M, but CSE up $45M due to increased Net Income, so L&E side also down $15M, and both sides balance.

In Year 2, Buyer realizes it was wrong and reverses this change. Then, at end of Year 2, Seller achieves goals and reaches $100M EBITDA. Walk me through financial statements when Earn-Out is paid out to Seller. Ignore Reversal of Earn-Out Write-Down and walk through ONLY the payout

When Earn-Out is paid to Seller, no changes on Income Statement. $200M cash outflow recorded within Cash Flow from Financing on CFS, so Cash down $200M at bottom. On Balance Sheet, Cash down $200M, so Assets side down $200M, and Contingent Consideration also declines by $200M, so L&E side also down $200M, and Balance Sheet balances.

What's the difference between Fixed and Floating Exchange Ratios, and which one do Buyers prefer?

With Fixed Exchange Ratio, Seller receives constant number of shares. Example: Buyer might agree to issue 2 new shares for each one of Seller's shares. Seller's ownership stays same regardless of Buyer's share price, but purchase price will change. With Floating Exchange Ratio, Seller receives fixed purchase price but variable number of shares. Example: Buyer might agree to pay $200M to Seller, but that means 10M shares if Buyer's share price is $20 and 40M shares if Buyer's share price is $5. Buyers care most about avoiding dilution in M&A deals, so Buyer tends to favor Fixed Exchange Ratio if not confident of future share price. But if Buyer reasonably confident share price will rise, might favor Floating Exchange Ratio so it issues fewer shares.

Why might a Buyer and Seller agree to a collar in a 100% Stock deal?

100% Stock deals present risk for both Buyers and Sellers: Buyer could dilute shareholders by huge amount if share price falls, while Seller could receive fewer shares than expected if Buyer's share price rises. Collar lets both parties compromise and reduce risks by establishing Fixed Exchange Ratio within certain range of Buyer share price, with Floating Exchange Ratios outside that region. Might also be set up opposite way, with Floating Exchange Ratio in certain range and Fixed Exchange Ratios outside that range. Sellers assured of receiving fixed purchase price or fixed number of shares within range of share prices for Buyer, while Buyers can limit either dilution or effective purchase price.

What are example terms for a Fixed Exchange Ratio with a collar in an M&A deal?

This structure means Seller gets fixed number of shares within certain share price range for Buyer. Purchase price will vary within that range, and above or below that range, purchase price is fixed, but shares received by Seller will vary. Example: Buyer's Share Price Between $50 and $60: Seller always gets 10M of Buyer's shares. Buyer's Share Price Above $60: Seller gets maximum price of $600M, shares issued vary based on Buyer's share price. Buyer's Share Price Below $50: Seller gets minimum price of $500M, shares issued vary based on Buyer's share price.

What would change in a merger model if the deal closed on an irregular date, such as August 15th?

Would "roll forward" Balance Sheets for both companies to August 15th and combine them on that date, ensuring Purchase Price Allocation and Sources & Uses schedules also based on that date. Would also create "stub period" for Combined Income Statement and Cash Flow Statement to show what happens between August 15th and end of companies' first quarter (or first year) as combined company. Even with irregular closing date and stub period, tend to focus on first full year of combined results in merger model because EPS accretion/dilution means more over entire year than it does over stub period or single quarter.