A merger is the combination of two businesses, while an acquisition is the purchase of the ownership of one business by another. Mergers & Acquisitions models (M&A) involve analysis for scenarios in which one company (the Buyer) proposes to offer cash or its own shares in order to purchase the shares of another company (the Seller or the Target).
Reasons for M&As
M&A may increase the value for the buyer by creating an important value driver known as Synergies (ways to increase profit / earnings through an acquisition), among other reasons.
Various reasons can lead to an M&A transaction:
- Revenue Synergies: Increase and diversify revenues / market share by the acquisition of new and / or complementary product and service offerings
- Operational Synergies: Increase production capacity / operational efficiency / expertise through acquisition of workforce / facilities / knowhow.
- Cost Synergies: Decrease of costs through economies of scale
- Financial Synergies: Reduction of financial risk and potentially lower borrowing costs.
M&A AnalysisThe primary goal of an M&A Analysis is to determine if the buyer’s earnings per share (EPS) will increase or decrease because of the merger.
An increase in expected EPS from a merger is called Accretion (and such an acquisition is called an Accretive Acquisition), and a decrease in expected EPS from a merger is called Dilution (and such an acquisition is called a Dilutive Acquisition).
An M&A Model consists of the following key outputs:
- Analysis of Accretion/Dilution on EPS
- Balance Sheet Impact
- Deal Synergies
- Cash / Stock Consideration and Impact
- Goodwill creation and other Balance Sheet adjustments
- Transaction fees
Evaluation of an M&A DealA set of questions help in the evaluation of a potential M&A transaction, for example:
Publicly traded stock or privately held?
Insider ownership or sizable portion of the company’s shares in the open market?
- Strategic Buyer (potential synergies to be considered)?
- Financial Sponsor (firm looking for an attractive return via a Leveraged Buyout)?
- Privately negotiated sale or auction?
- Hostile or friendly takeover?
Acquisition Consideration (Cash or Equity)?
Premiums paid for Comparable Transactions?
The M&A Model
The basic phases to build an M&A Model are presented below (A to E):
A. Purchase Price & ConsiderationThe Buyer intends to benefit from the transaction by increasing the value available to its existing shareholders. By acquiring enough shares to gain control of the Target company, the buyer is willing to pay a Control Premium, which is the price paid above market value for a Target public company in order to gain control of the company.
A critical component to evaluating an M&A transaction is to determine how much of a Control Premium should be paid for the Target. One method is to look at recent Precedent Transactions to determine how much of a premium has been paid for ownership of other, similar companies in recent M&A transactions. Other methods to determine the Purchase Price include Comparable Company Analysis, and Discounted Cash Flow Analysis.
The above methods lead to a range of Purchase Prices and Control Premiums for the Target, which will then enable the management of both the Buyer and Target (along with their respective M&A teams / advisors) to argue for and agree upon a precise price/premium. Another important issue is the type of consideration being offered to the Target’s shareholders. The Buyer can offer Cash or Shares of the Buyer’s common stock or a combination of both as the consideration for the Purchase Price.
B. Transaction Assumptions
Important assumptions parameters affecting the deal are presented below:
- Current Share Price & Number of Shares Outstanding for the Buyer
- Current valuation information for the Target
- Expected Offer Price/ Control Premium for the Seller in the proposed transaction
- Cash / Stock proportion of consideration
- M&A transaction fees (Restructuring Fees)
- Financing Fees from new Equity and/or Debt issuance
- Expected interest rate on new Debt
For more details, check our M&A Model Template.
C. Sources & Uses
The Sources & Uses section of an M&A Model contains the information regarding flow of funds in an M&A transaction—specifically, where the money is coming from and where it is going.
Sources of Funds is the amount of money raised through various equity and debt instruments, as well as from cash owned by the Buyer, to fund the purchase of the Target.
Uses of Funds shows the cash that is going out to purchase the Target, as well as various fees needed to complete the transaction.
The total Sources of Funds must always exactly match with the total Uses of Funds.
Goodwill is an asset that arises on an acquiring company’s Balance Sheet whenever it acquires a Target for a price that exceeds the Book Value of Net Tangible Assets (i.e., Total Tangible Assets – Total Liabilities) on the Target’s Balance Sheet. As part of the transaction, some portion of the acquired assets of the Target will often be “written
up”. This increase in asset valuation will appear as an increase in Other Intangible Assets on the Buyer’s balance sheet.
Goodwill is a Long-Term Asset but is never depreciated or amortized unless an Impairment is found. That is, if it is determined that the value of the acquired entity clearly becomes lower than what the original Buyer paid for it. In that case, a portion of the Goodwill will be “written off” as a one-time expense (i.e. Goodwill will be decreased by an amount equal to the amount of the Impairment charge).
E. Accretion/Dilution AnalysisAfter the transaction has closed, the Buyer will own all the assets, as well as the financial performance (Profit/Loss), of the Target company. Accretion/Dilution Analysis is used to determine how the Target’s financial performance will affect the Buyer’s Earnings Per Share.
As we discussed earlier, a transaction is accretive if the buyer’s expected future EPS increases because of the acquisition. On the other hand, the transaction would be dilutive if the buyer’s expected future EPS declines because of the acquisition. Thus, it is important to estimate the Accretion/Dilution potential from a deal before the Buyer can agree to the proposed transaction.
For more detail on building an M&A model, please see our M&A Model Template.