Concept
Cost of equity
Building a Merger or
Accretion/Dilution
model
Determining
Accretion / Dilution for
all Deals
Explanation
Alternative formula to CAPM:
Cost of equity = (Dividends per Share / Share Price) + Growth Rate
of Dividends
Generally not used as not all companies issue dividends. Useful for
companies in industries such as Utilities that issue and grow dividends at
stable, predictable rates.
1% increase/decrease in Discount rate makes far more of an impact that
1% increase/decrease in revenue, revenue growth or EBIT margins
because Discount rate affects everything in the analysis.
A Discount rate difference of 1% impacts analysis far more than a 1%
increase or decrease in Terminal Value because Terminal Value is a large
number and 1% is tiny.
Consolidation eg, four major players in the industry, no. 3 wants to
merge with no. 4 to take on no. 1 and 2 more effectively
Geographical expansion
Undervaluation of sellers business
Economies of scale
View seller as a threat
Gain access to patents, technology etc
Determine purchase price
Determine purchase method (cash, stock, debt)
Project financial profiles and statements of both buyer and seller
Valuation
Tax rates
Revenue
Operating income
Interest Income or (Expense)
Pre-Tax income and Net income
Shares outstanding and EPS
Combine buyer and sellers income statements
Calculate Goodwill and allocate purchase price
Combine balance sheets and adjust for acquisition effects
Adjust the combined income statement for acquisition effects
Calculate accretion/dilution and create sensitivity tables
In an all-stock deal, if buyer has higher P/E than seller, deal is accretive; if
buyer has lower P/E, it will be dilutive.
Eg. If seller has P/E 10x, you get $0.10 for each dollar you pay
(inverse of 10x). If seller has P/E of 8x, you get $0.125 for each dollar
you pay.
First, determine a few key variables:
Cost of cash = Foregone I/R on cash*(1 Buyers tax rate)
Cost of debt = I/R on debt*(1 Buyers tax rate)
Cost of stock = Reciprocal of Buyers P/E multiple
Yield of seller = Reciprocal of sellers P/E multiple
Take weighted average of each of buyers cost, eg. If 100% stock or 5050 stock/cash or 33-33-33 stock/cash/debt/, then compare to Yield of
seller. If it is less, will be accretive.
Note that synergies, new D&A etc are not been accounted for in this
formula, so this is really just a rough way of calculating accretion/dilution.
Cost synergies
LBO
*If buyer is confident about realising synergies, they will use more
cash than stock in the acquisition as they want all synergies to
themselves rather than to share with target.
Foregone interest on cash: buyer loses interest it would have
otherwise earned if it uses cash for acquisition, reducing pre-tax
income, net income and EPS.
Additional interest on debt: buyer pays additional interest expense
if it uses debt, reducing pre-tax income, net income and EPS.
Additional shares outstanding: if buyer pays with stock, it must
issue additional shares, reducing EPS.
Combined financial statements: after acquisition, sellers financial
statements are added to buyers, with few adjustments
Creation of goodwill & other intangibles: these balance sheet
items represent the premium that buyer paid over the sellers
shareholders equity, to ensure B/S balances.
PPE and Fixed asset write-up: you may write up values of these
assets in an acquisition, under the assumption that the market values
exceed the book values
Deferred tax liabilities: normally you write off sellers existing DTLs,
and then create new ones based on Buyers tax rate*(PPE and fixed
asset write-up and newly created intangibles)
Deferred tax assets: in most deals, you write these off completely,
depending on sellers tax situation
Transaction and financing fees: you expense legal and advisory
fees and deduct them from cash and retained earnings at the time of
the transaction, but you capitalise financing fees and then amortise
them over 5-10 years, or as long as newly issued Debt remains on
B/S.
Inter-company accounts receivable and accounts payable: you
may eliminate some of the combined AR and AP balances because
the buyer might owe the seller money and vice versa. Once they are
in the same company, this no longer make sense.
Deferred revenue write-down: accounting rules state you can only
recognise the profit portion of the sellers deferred revenue postacquisition. So you often write own the expense portion of the sellers
deferred revenue over several years in a merger model.
Reduction in force: i.e. laying off employees, getting rid of duplicate
functions
Building consolidation: if both buyer and seller lease buildings in
same city, consolidate into one larger space and save on rent.
In LBO, FCF refers to Cash flows from operations less Capex
Circular referencing and interest payments: in LBO models you
average the beginning and ending debt balances to determine annual
interest expense, but that also creates a circular reference because
the ending Debt balance depends on how much cash flow you had,
after paying for interest, and interest itself depends on ending debt
balance
What affects IRR?
- Purchase price
- % debt and % equity
- Exit price
- Revenue growth rate, EBITDA margins, interest rates, anything
else that affects cash flow on financial statements
APV
Definitive Agreement
Common Industry
Multiples
Limitations of valuation
techniques
WACC
CAPM
Beta
Unlevering beta
Explanation
- DCF (intrinsic value), Trading Comps + Acquisition comps (relative
valuation)
- LBO in some cases if sponsor is assumed to be backing the deal,
determine if capital structure supports high debt level, sets floor price in
valuing a company.
- We use Sum-of-the-parts to value companies with different business
segments. Each segment is valued using the same valuation
methodologies above.
- DCF: dependent on assumptions, especially around terminal value (if
more than 75% of entire valuation, too dependent on assumptions),
does not reflect actual market price which buyer is willing to pay
- Trading comps: i) finding good comps ii) does not reflect control or
synergy premium
- Acquisition comps: i) may be difficult to find good comps ii)
determining a suitable time frame to search for good acquisition comps
- Project unlevered free cash flows into the future (5 year period on
average or till a steady state)
- Determine the terminal value of the company at end of projection
period, using exit multiple or perpetuity method
- Determine target capital structure in order to arrive at a suitable
WACC
- Discount all future cash flows and terminal value to present day
- We arrive at Enterprise value of the company
- EBIT(1-t) + D&A Capex Changes in Net working capital
- EBITDA Taxes Capex Changes in Net working capital
- Net income + (1-t)*Interest expense + D&A Capex Changes in
Net working capital
- Operating cash flow Capex + After-tax interest expense After-tax
interest income
FCFE = FCFF (1-t)*Interest expense Principal repayment
Or = Operating cash flow Capex Principal repayment
EV = MV of Equity + Net Debt or
EV = MV of Equity + MV Preferred Equity + MV Minority Interest + Net
Debt + Unfunded pension liabilities and other debt-like provisions
WACC = (D/V)*After tax cost of debt + (E/V)*Cost of equity
Cost of debt = risk free rate + corporate credit spread, observable from
market price of debt, or check with DCM teams
Cost of equity relies on CAPM
- WACC represents the opportunity cost of capital or what investors
could earn on another investment with similar risk profile. Commonly
seen as internal hurdle rate.
- Interest is tax deductible, so the overall cost of debt is actually lower
- As leverage increases, WACC with taxes lowers, until it goes beyond
the optimal capital structure, after which costs of financial destress
outweigh benefits of tax shield, resulting in higher WACC (higher cost
of equity demanded by equity holders, higher debt beta).
Expected return on equity = Risk free + Levered Beta*(Market Risk
Premium)
- Measure of how much a stock moves with the market given a
corresponding change in the market. If Beta of a stock is 1.6,
movement in the market by 1% results in a 1.6% change in movement
of the stock price
- Regression coefficient of stock price against market
- Commonly used in finding out beta for private companies
Common multiples
PEG ratio
Accretion / Dilution
analysis
LBO modelling
liabilities
LIFO vs FIFO
Operating leases vs
Capital leases
Calenderisation
Reasons to engage in
M&A
Key M&A considerations
Hostile takeover
defences
- DTA created when assets are being written down, less depreciation or
amortisation expense, higher taxes paid (on book). Opposite happens
for DTL (assets written up)
- In periods of rising prices, FIFO accounting leads to lower COGS and
higher net income. Opposite happens for FIFO.
ROE breakdown
or even retirement.
Purchase Price: Stated as a per-share amount for public
companies.
Form of Consideration: Cash, Stock, Debt
Transaction Structure: Stock, Asset, or 338(h)(10)
Treatment of Options: Assumed by the buyer? Cashed out?
Ignored?
Employee Retention: Do employees have to sign non-solicit or
non-compete agreements? What about management?
Reps & Warranties: What must the buyer and seller claim is true
about their respective businesses?
No-Shop / Go-Shop: Can the seller shop this offer around and try
to get a better deal, or must it stay exclusive to this buyer?
DuPont ROE = (Net income / Pretax income)*(Pretax income /
EBIT)*(EBIT/Sales)*(Sales/Assets)*(Assets/Equity)
Or
Pitchbook content
Information
Memorandum
IPO process
M&A process