IB Vine M&A

On a graph of exchange ratio versus accretion or dilution, what goes on each axis?

Exchange ratio on the x-axis and percentage EPS change on the y-axis.

What shape is the exchange ratio versus accretion curve?

It slopes downward and crosses zero at the break-even exchange ratio.

On the exchange ratio graph, which side of break-even is accretive?

Left of break-even is accretive and right of break-even is dilutive, since a higher exchange ratio means issuing more shares.

What is the break-even exchange ratio equal to?

Target P/E divided by acquirer P/E.

How do higher synergies move the exchange ratio versus accretion curve?

They shift the curve up, so a given exchange ratio produces more accretion.

How does a higher cost of debt move the exchange ratio versus accretion curve?

It shifts the curve down, producing more dilution at any given exchange ratio.

How does a run-up in the acquirer's stock price affect the break-even exchange ratio?

It moves break-even to the left, because a higher acquirer valuation means fewer shares issued for the same purchase price.

Target trades at $20 with a 25 percent premium and has 100 shares. What is the purchase price?

Twenty times 1.25 gives $25 per share, times 100 shares gives $2,500.

A $2,500 purchase price is paid in stock at $100 per acquirer share. How many shares are issued?

Twenty-five shares, which is $2,500 divided by $100.

Acquirer had 100 shares and issues 25 new ones. What is pro-forma target ownership?

Total pro-forma shares are 125, and the target's holders own 25 of those, which is 20 percent.

Acquirer trades at $100 with a 10x P/E and 100 shares. What is its net income and EPS?

EPS is $100 divided by 10, which is $10, and net income is $10 times 100 shares, which is $1,000.

Target trades at $20 with a 20x P/E and 100 shares. What is its net income?

EPS is $20 divided by 20, which is $1, so net income is $1 times 100 shares, or $100.

Combined net income is $1,100 across 125 pro-forma shares. What is pro-forma EPS?

Eleven hundred divided by 125, which is $8.80.

Pro-forma EPS is $8.80 against a standalone EPS of $10.00. How dilutive is the deal?

Eight eighty divided by ten, minus one, gives negative 12 percent, so it is 12 percent dilutive.

How do you calculate the percentage accretion or dilution of a deal?

Divide pro-forma EPS by standalone EPS and subtract one.

Standalone EPS is $10.00 and pro-forma shares are 125. What pro-forma net income breaks even?

Ten times 125 gives $1,250.

Combined net income is $1,100 but $1,250 is needed to break even. What post-tax synergies are required?

One thousand two fifty minus eleven hundred, which is $150.

You need $150 in post-tax synergies at a 40 percent tax rate. What pre-tax synergies does that require?

One fifty divided by one minus 40 percent, which is $150 over 0.6, giving $250.

How do you convert required post-tax synergies into required pre-tax synergies?

Divide the post-tax figure by one minus the tax rate.

Company A has $18 million net income and 6 million shares. What is standalone EPS?

Eighteen divided by six, which is $3.00.

Forty million dollars of debt carries a 20 percent interest rate at a 25 percent tax rate. What is after-tax interest expense?

Forty times 20 percent gives $8 million pre-tax, times one minus 25 percent gives $6 million after tax.

Ten million dollars of pre-tax synergies at a 25 percent tax rate. What is the after-tax figure?

Ten times one minus 25 percent, which is $7.5 million.

A has $18M net income, B has $12.5M, after-tax interest is $6M and after-tax synergies are $7.5M. What is pro-forma net income?

Eighteen plus twelve point five, minus six, plus seven point five, which gives $32 million.

A deal is financed entirely with debt. What happens to the acquirer's share count?

Nothing. No new shares are issued, so the share count is unchanged.

Pro-forma net income is $32 million on 6 million shares against a $3.00 standalone EPS. How accretive is the deal?

Pro-forma EPS is $5.33, so accretion is $2.33 per share, or 77.7 percent.

Buyer has $200mm net income, a 10x P/E, and 1mm shares. What is its share price?

Equity value is 10 times $200 million, which is $2 billion, divided by 1 million shares gives $2,000 per share.

Target has $100mm net income at a 20x P/E. What is the purchase price?

Twenty times $100 million, which is $2,000 million.

A $2,000 million purchase is paid in stock at $2,000 per share. How many shares are issued?

One million shares.

Buyer had 1mm shares and issues 1mm more. Combined net income is $300mm. What is pro-forma EPS?

Three hundred million divided by 2 million shares, which is $150 per share.

Standalone EPS is $200 and pro-forma EPS is $150. How dilutive is the deal?

Twenty-five percent dilutive, and EPS falls by $50 per share.

Company A has 25 shares at $40 with a 20x P/E. What are its equity value, net income, and EPS?

Equity value is $1,000, net income is $1,000 divided by 20, which is $50, and EPS is $50 over 25 shares, or $2.00.

Company B has 40 shares at $10 with a 10x P/E. What are its equity value and net income?

Equity value is $400 and net income is $400 divided by 10, which is $40.

Company B has a $400 equity value and is acquired at a 50 percent premium. What is the purchase price?

Four hundred times 1.50, which is $600.

Thirty percent of a $600 purchase is debt at 5 percent pre-tax with a 25 percent tax rate. What is after-tax interest?

Debt is $180, times 5 percent gives $9, times one minus 25 percent gives $6.75.

Twenty percent of a $600 purchase is cash earning 2 percent pre-tax at a 25 percent tax rate. What is the foregone after-tax interest?

Cash used is $120, times 2 percent gives $2.40, times one minus 25 percent gives $1.80.

Fifty percent of a $600 purchase is stock issued at $40 per share. How many new shares?

Three hundred divided by forty, which is 7.5 shares.

NI of $50 and $40, minus $6.75 after-tax interest and $1.80 foregone cash interest. What is pro-forma net income?

Eighty-one dollars and forty-five cents.

Pro-forma net income is $81.45 on 32.5 shares against a $2.00 standalone EPS. Is the deal accretive?

Pro-forma EPS is $2.51, which exceeds $2.00, so the deal is accretive.

A buys B at a $600 price for $40 of net income. What is the effective acquisition P/E?

Six hundred divided by forty, which is 15x.

Why is a deal accretive when the acquirer's P/E exceeds the effective acquisition P/E?

Because the acquirer is buying earnings more cheaply than the market prices its own, so each dollar of acquired earnings is spread over relatively fewer new shares.

Name four ways to structure an acquisition that lowers your leverage ratio.

Fund with cash or equity instead of debt, acquire a company with higher EBITDA, target a company with little or no debt, and generate synergies that raise combined EBITDA.

Besides financing mix, how can you use the target's balance sheet to lower leverage post-acquisition?

Use the target's excess cash to pay down the acquirer's existing debt.

How can deal structure timing help lower a post-acquisition leverage ratio?

Structure earn-outs or deferred payments, which reduce the amount of debt financing needed upfront.

What post-close action can lower a combined leverage ratio?

Divest non-core assets and use the proceeds to pay down debt.

What is the underlying principle for lowering leverage through an acquisition?

Combined EBITDA has to increase by more than combined debt, so the denominator grows faster than the numerator.

Company A has 10 shares at $25 with $10 net income. What is standalone EPS and P/E?

EPS is $1.00 and the P/E is $25 divided by $1.00, which is 25.0x.

A $150 purchase is paid in stock at $25 per acquirer share. How many shares are issued?

Six shares.

Combined net income of $20 across 16 shares against a $1.00 standalone EPS. What is the accretion?

Pro-forma EPS is $1.25, so the deal is 25 percent accretive.

A acquires B for $150 where B has $10 net income. What is the effective target P/E?

Fifteen times.

In an all-stock deal, what is the rule for accretion?

Buying a company at a lower P/E than your own is accretive. Buying at a higher P/E is dilutive.

What is an earn-out?

A provision that pays the seller additional consideration if specified performance targets are met after the acquisition closes.

Why is an earn-out included in a deal structure?

It bridges a valuation gap between buyer and seller, and it incentivizes the seller to maintain growth and stability after closing.

Company A has $100M net income, 100M shares, and a 20x P/E. What are EPS, share price, and equity value?

EPS is $1.00, share price is $1.00 times 20, which is $20, and equity value is $2 billion.

Company B trades at $10 with 50M shares and $100M net income. What is its P/E?

Equity value is $500 million, so the P/E is $500 million over $100 million, which is 5x.

How do you calculate an exchange ratio?

Divide the target's share price by the acquirer's share price.

Target trades at $10, acquirer at $20, and the target has 50M shares. How many new shares are issued?

The exchange ratio is 0.50, so 50 million times 0.50 gives 25 million new shares.

Combined net income of $100M plus $100M plus $175M synergies across 125M shares. What is pro-forma EPS?

Three hundred seventy-five million divided by 125 million, which is $3.00.

Standalone EPS is $1.00 and pro-forma EPS is $3.00. How accretive is the deal?

Accretive by $2.00 per share.

Company A has $1,000 equity value with $100 net income, Company B has $2,000 equity value with $50 net income. What are their P/Es?

Company A is 10x and Company B is 40x.

A 10x P/E acquirer buys a 40x P/E target in stock. What must happen for the deal to be accretive?

The effective seller's yield has to exceed 10 percent, which is the acquirer's earnings yield, so you need enough after-tax synergies to lift the acquired earnings above 10 percent of the purchase price.

What is the earnings yield of a company, and why does it matter in M&A?

It is the inverse of the P/E ratio. It represents the return the buyer earns on the purchase price, and it is what you compare against the after-tax cost of financing.

Company A has a $200m market cap at a 20x P/E with 100m shares. What are its net income and EPS?

Net income is $200 million over 20, which is $10 million, and EPS is $10 million over 100 million shares, which is $0.10.

A 5 percent pre-tax cost of debt at a 20 percent tax rate. What is the after-tax cost?

Five percent times one minus 20 percent, which is 4 percent.

A target has a 10x P/E and the after-tax cost of debt is 4 percent. Is the all-debt deal accretive?

Yes. The target's earnings yield is 10 percent, which exceeds the 4 percent after-tax cost of debt, so the deal is accretive before any synergies.

What is the general rule for accretion in an all-debt deal?

The deal is accretive if the target's earnings yield exceeds the after-tax cost of debt.

Net income of $10m plus $10m, plus $4m after-tax synergies, minus $4m after-tax interest, on 100m shares. What is pro-forma EPS?

Pro-forma net income is $20 million, divided by 100 million shares gives $0.20, versus $0.10 standalone.

How do you calculate an acquirer's cost of equity from its P/E?

Take the inverse of the P/E. A 20x P/E implies a 5 percent cost of equity.

A deal is half debt at a 4 percent after-tax cost and half equity at a 5 percent cost. What is the blended cost?

Fifty percent times 4 percent plus 50 percent times 5 percent, which is 4.5 percent.

Why does mixing equity into an all-debt deal reduce accretion here?

Because the acquirer's cost of equity of 5 percent is higher than its 4 percent after-tax cost of debt, so the blended acquisition cost rises toward the target's yield.

What does accretion or dilution actually measure?

The immediate impact of a deal on the acquirer's earnings per share.

What does accretion indicate about the price a buyer is paying?

That the buyer is acquiring earnings at a lower cost than its own earnings multiple implies.

What does accretion or dilution fail to capture?

Strategic value, longer-term synergies, and growth. That is why companies sometimes pursue deals that are dilutive on day one.

A stock trades at $20 with $2 EPS. What are the P/E and the implied cost of equity?

The P/E is 10x and the implied cost of equity is one over 10, which is 10 percent.

A 5 percent coupon at a 40 percent tax rate. What is the after-tax cost of debt?

Five percent times one minus 40 percent, which is 3 percent.

A debt-funded share repurchase where the after-tax cost of debt is 3 percent and the cost of equity is 10 percent. Accretive or dilutive?

Accretive. The company is retiring 10 percent cost equity using 3 percent cost debt, so EPS rises.

What is the general rule for whether a debt-funded share repurchase is accretive?

It is accretive whenever the after-tax cost of debt is below the company's earnings yield, which is the inverse of its P/E.

Buyer P/E is 10x and seller P/E is 12x. Is an all-stock deal automatically dilutive?

Usually yes, because the buyer is paying a higher multiple than its own, but synergies or other factors can offset the difference.

What is the most immediate quantitative test of whether an acquisition succeeded?

EPS accretion or dilution. Did pro-forma EPS increase relative to standalone.

How do you use stock price performance to judge an acquisition?

Compare the acquirer's post-deal stock price to its pre-announcement price and to a relevant index. Underperformance suggests value destruction.

How do you use ROIC to judge whether an acquisition created value?

Compare the return on invested capital from the acquisition to the company's WACC. If ROIC is below WACC, the deal destroyed value.

Besides EPS, stock price, and ROIC, name three ways to judge acquisition success.

Whether projected cost and revenue synergies were actually realized, whether revenue and margin trends beat standalone projections, and whether customers and employees were retained after close.

Why does post-close attrition signal a failed acquisition?

High customer or employee turnover indicates integration problems, and both erode the earnings base the deal was priced on.

A target has a 20x P/E. What is its earnings yield?

One over twenty, which is 5 percent.

A target's earnings yield is 5 percent. At what after-tax cost of debt does an all-debt deal break even?

At exactly 5 percent.

A target's earnings yield is 5 percent and the tax rate is 25 percent. What is the breakeven pre-tax cost of debt?

Five percent divided by one minus 0.25, which is 6.67 percent.

In an all-debt deal, is the acquirer's own P/E relevant to whether the deal is accretive?

Not directly, since no shares are issued. It only matters for measuring the impact on the acquirer's per-share metrics.

Fifty million dollars of operating cost synergies at a 25 percent tax rate. What is the cash flow impact?

Pre-tax income rises $50 million, and the after-tax benefit is $37.5 million, which flows through as an increase in cash from operations.

Fifty million dollars of CapEx synergies at a 25 percent tax rate. What is the cash flow impact?

Cash flow from investing improves by the full $50 million. There is no immediate tax impact, because capital expenditure is not expensed.

Why are CapEx synergies worth more per dollar than operating cost synergies?

Because operating cost savings are taxed before reaching cash flow, while a reduction in capital expenditure is a full dollar of cash saved with no immediate tax effect.

Fifty million dollars each of operating cost and CapEx synergies at 25 percent tax. What is the total Year 1 cash flow impact?

Thirty-seven point five million from operations plus fifty million from investing, giving $87.5 million.

Conventionally, who is expected to pay more, a strategic or a financial buyer?

A strategic buyer, because it can realize synergies that a financial buyer generally cannot.

How does leverage let a financial buyer outbid a strategic?

Private equity sponsors use significantly more debt, and higher leverage amplifies equity returns, so the sponsor can pay a higher total price and still clear its return hurdle.

How can portfolio synergies let a sponsor outbid a strategic?

If the sponsor already owns a company in the same or an adjacent sector, it can realize synergies much like a strategic through a buy-and-build strategy.

How can auction dynamics push a financial buyer above a strategic bid?

Multiple financial buyers competing in the same process can drive the price above what a single strategic buyer is willing to pay.

What is dry powder pressure and how does it raise sponsor bids?

Sponsors with large amounts of uninvested capital approaching the end of an investment period may pay more simply to deploy it before the window closes.

How can a public strategic's discipline let a sponsor win a deal?

Public strategics face shareholder scrutiny and stay conservative on price to avoid EPS dilution, while a private sponsor faces far less public pressure on short-term accretion.

Six hundred million dollars buys 60 percent of a company's equity. What is total implied equity value?

Six hundred divided by 0.60, which is $1,000 million.

Equity value is $1,000M and debt is $100M. What is enterprise value?

Eleven hundred million dollars.

Enterprise value is $1,100M against $50M of EBITDA. What is the multiple?

Twenty-two times.

Company A has $25 net income and 10 shares. What is standalone EPS?

Two dollars and fifty cents.