Merger Model IB Technical Questions & Answers(GRADED A+)
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Merger Model IB Technical
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Merger Model IB Technical
1. Why would a company want to acquire another company? - ANSWER 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...
Merger Model IB Technical Questions
& Answers(GRADED A+)
1. Why would a company want to acquire another company? - ANSWER 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.
• The buyer needs to grow more quickly and sees an acquisition as a way to do
that.
• 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.
• 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.
Walk me through a basic merger model - ANSWER 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 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.
Finally, you combine the Income Statements, adding up line items such as Revenue 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
, What's the difference between a merger and an acquisition? - ANSWER 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.
Conceptually, what does it mean when an acquisition is accretive or dilutive? - ANSWER 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.
Let's say the buyer has a P/E multiple of 10x, and the seller's P/E is 12x. The buyer's interest rate on
cash is 2% and interest rate on the debt is 8%. The buyer is paying with 30% cash, 20% debt, and 50%
stock. The tax rate is 40%. What's a quick and dirty back of the envelope way to calculate whether
the deal is accretive or dilutive, that's not always 100% accurate. - ANSWER -First, we need to
calculate the cost of cash, debt, and stock in this scenario and compare the weighted average cost of
those 3 things to the yield of the seller. The cost of cash is 2% which needs to be tax effected so 2%
(1-.40%)=1.2%. The cost of debt is 8% which needs to be tax effected so 8% (1-.40%)=4.8%. The cost
of stock, in this case, we are given the buyer's PE multiple of 10x so the cost of the stock is the
reciprocal of that so 10%. If you do the weighted average cost of cash, debt, and stock:
10%*50%=.05 stock
4.8%*20%=.0096 Debt
1.2%*30%=.0036 Cash
Sum of the 3=6.3% which is the cost the deal to the buyer
The yield that the seller is getting is the reciprocal of the seller's P/E multiple so 1/12=8.3%
The cost of the deal is 6.3% compared to the yield of the seller which is 8.3% the transaction is
accretive because you are paying less for what you will get in return
If a company with a higher P/E acquires a company with a lower P/E, is the deal accretive or dilutive?
- ANSWER It depends on if it's an all stock deal, if it is then we know that is an accretive deal because
the buyer is getting more earnings for each dollar that they are using the acquire the other company
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