Merger Model Guide EXAM Questions With Correct Solutions All Verified By An Expert A+ Graded
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Course
Wall Street Prep
Institution
Wall Street Prep
Why would a company want to acquire another company? - ANS A company would acquire another company if it believes it will earn a good return on its investment - either in the form of a literal ROI, or in terms of a higher Earnings Per Share (EPS) number, which appeals to shareholders.
There ar...
Questions With Correct Solutions All
Verified By An Expert A+ Graded
,Why would a company want to acquire another company? - ANS A company would
acquire another company if it believes it will earn a good return on its investment - either
in the form of a literal ROI, or in terms of a higher Earnings Per Share (EPS) number,
which appeals to shareholders.
There are several reasons why a buyer might believe this to be the case:
• The buyer wants to gain market share by buying a competitor.
K
• The buyer needs to grow more quickly and sees an acquisition as a way to do
that.
C
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller's customers so it can up-sell and cross-
sell products and services to them.
LO
• The buyer thinks the seller has a critical technology, intellectual property, or
other "secret sauce" it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make
the deal accretive for its shareholders.
YC
Walk me through a basic merger model. - ANS "A merger model is used to analyze the
financial profiles of 2 companies, the purchase price and how the purchase is made,
and it determines whether the buyer's EPS increases or decreases afterward.
Step 1 is making assumptions about the acquisition - the price and whether it was done
D
using cash, stock, debt, or some combination of those. Next, you determine the
valuations and shares outstanding of the buyer and seller and project the Income
Statements for each one.
U
Finally, you combine the Income Statements, adding up line items such as Revenue
ST
and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid
on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate to get the
Combined Net Income, and then divide by the new share count to determine the
combined EPS."
You could also add in the part about Goodwill and combining the Balance Sheets, but
it's best to start with answers that are as simple as possible at first.
What's the difference between a merger and an acquisition? - ANS There's always a
buyer and a seller in any M&A deal - the difference is that in a merger the companies
, are similarly-sized, whereas in an acquisition the buyer is significantly larger (often by a
factor of 2-3x or more).
Also, 100% stock (or majority stock) deals are more common in mergers because
similarly sized companies rarely have enough cash to buy each other, and cannot raise
enough debt to do so either.
Why would an acquisition be dilutive? - ANS An acquisition is dilutive if the additional
Net Income the seller contributes is not enough to offset the buyer's foregone interest
on cash, additional interest paid on debt, and the effects of issuing additional shares.
K
Acquisition effects - such as the amortization of Other Intangible Assets - can also make
an acquisition dilutive.
C
Is there a rule of thumb for calculating whether an acquisition will be accretive or
dilutive? - ANS Yes, here it is:
LO
• Cost of Cash = Foregone Interest Rate on Cash * (1 - Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate)
• Cost of Stock = Reciprocal of the buyer's P / E multiple, i.e. E / P or Net
Income / Equity Value.
• Yield of Seller = Reciprocal of the seller's P / E multiple (ideally calculated
YC
using the purchase price rather than the seller's current share price).
You calculate each of the Costs, take the weighted average, and then compare that
number to the Yield of the Seller (the reciprocal of the seller's P / E multiple).
D
If the weighted "Cost" average is less than the Seller's Yield, it will be accretive since
the purchase itself "costs" less than what the buyer gets out of it; otherwise it will be
U
dilutive.
Example: The buyer's P / E multiple is 8x and the seller's P / E multiple is 10x. The
ST
buyer's interest rate on cash is 4% and interest rate on debt is 8%. The buyer is paying
for the seller with 20% cash, 20% debt, and 60% stock. The buyer's tax rate is 40%.
• Cost of Cash = 4% * (1 - 40%) = 2.4%
• Cost of Debt = 8% * (1 - 40%) = 4.8%
• Cost of Stock = = 12.5%
• Yield of Seller = = 10.0%
Since 8.9% is less than the Seller's Yield, this deal will be accretive.
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