If a Multinational Firm Fails to Effectively Integrate Their Acquisitions, This Can Result in

Investment Banking interview questions: Merger Model (Basic)

You don't need to sympathise merger models as well equally an M&A banker does, but you do need to more than merely the nuts, especially if y'all've had a finance internship or full-fourth dimension job earlier. It's important to know the effects of an acquisition, and sympathise concepts such every bit synergies and why Goodwill & Other Intangibles actually get created. One thing that's not important? Walking through how all 3 statements are affected past an acquisition. In 99% of cases, you lot only intendance about the Income Statement in a merger model (despite rumors to the contrary).

1. Walk me through a basic merger model

"A merger model is used to clarify the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer'due south EPS increases or decreases.

Step 1 is making assumptions about the acquisition - the price and whether it was greenbacks, stock or debt or some combination of those. Next, you make up one's mind the valuations and shares outstanding of the buyer and seller and projection out an Income Argument for each

Finally, y'all combine the Income Statements, adding up line items such every bit Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Involvement Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer's Revenue enhancement Rate to go the Combined Net Income, and then divide by the new share count to make up one's mind the combined EPS."

2. What's the deviation between a merger and an acquisition?

There's e'er a heir-apparent and a seller in whatsoever M&A deal - the difference between "merger' and "acquisition" is more semantic than annihilation. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

three. Why would a company want to acquire another company?

Several possible reasons:

The buyer wants to proceeds marketplace share by buying a competitor.

The heir-apparent needs to grow more quickly and sees an acquisition as a way to do that.

The heir-apparent believes the seller is undervalued.

The heir-apparent wants to acquire the seller'south customers so it can upwardly-sell and cantankerous-sell to them.

The buyer thinks the seller has a critical applied science, intellectual belongings or some other "surreptitious sauce" it tin use to significantly enhance its business organization. The buyer believes information technology tin can achieve significant synergies and therefore make the deal accretive for its shareholders.

4. Why would an acquisition be dilutive?

An acquisition is dilutive if the additional amount of Internet Income the seller contributes is not enough to get-go the buyer's foregone interest on cash, additional interest paid on debt, and the furnishings of issuing additional shares.

Conquering effects - such as amortization of intangibles - can also brand an acquisition dilutive.

5. Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

If the bargain involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, and so compare it confronting the seller's Pre-Taxation Income.

And if information technology'due south an all-stock deal yous tin use a shortcut to appraise whether it is accretive.

But if the deal involves cash, stock, and debt, there's no quick dominion-of-thumb y'all tin can use unless you're lightning fast with mental math.

half dozen. A company with a college P/Due east acquires one with a lower P/Due east - is this accretive or dilutive?

Play a joke on question. Yous can't tell unless you also know that it's an all-stock deal. If it'southward an all-greenbacks or all-debt bargain, the P/E multiples of the buyer and seller don't thing considering no stock is being issued.

Certain, generally getting more earnings for less is good and is more likely to be accretive merely at that place's no difficult-and-fast rule unless it's an all-stock deal.

vii. What is the dominion of thumb for assessing whether an One thousand&A deal will be accretive or dilutive?

In an all-stock deal, if the buyer has a higher P/E than the seller, information technology will be accretive; if the buyer has a lower P/E, it will exist dilutive.

On an intuitive level if y'all're paying more than for earnings than what the market values your own earnings at, y'all can guess that it will be dilutive; and likewise, if you're paying less for earnings than what the market values your own earnings at, you tin guess that information technology would be accretive.

8. What are the complete furnishings of an conquering?

1. Foregone Interest on Cash - The buyer loses the Involvement information technology would have otherwise earned if it uses cash for the acquisition.

two. Additional Interest on Debt - The buyer pays additional Interest Expense if it uses debt.

3. Additional Shares Outstanding - If the buyer pays with stock, information technology must outcome boosted shares.

4. Combined Financial Statements - After the acquisition, the seller's financials are added to the buyer's.

5. Creation of Goodwill & Other Intangibles - These Balance Canvass items that represent a "premium" paid to a company's "fair value" besides become created.

Note: There's actually more than this (see the advanced questions), but this is usually sufficient to mention in interviews.

9. If a company were capable of paying 100% in greenbacks for another company, why would it choose Non to do then?

It might exist saving its cash for something else or it might be concerned well-nigh running low if business organisation takes a turn for the worst; its stock may too be trading at an all-time high and it might be eager to use that instead (in finance terms this would exist "more than expensive" but a lot of executives value having a safety absorber in the course of a large cash balance).

10. Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?

Because the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless information technology combines the company with a complementary portfolio company. Those synergies boost the constructive valuation for the target visitor.

11. Why exercise Goodwill & Other Intangibles become created in an acquisition?

These represent the value over the "fair marketplace value" of the seller that the buyer has paid. Yous calculate the number past subtracting the book value of a company from its equity purchase toll.

More specifically, Goodwill and Other Intangibles correspond things like the value of customer relationships, brand names and intellectual belongings - valuable, only non true financial Assets that show up on the Balance Sheet.

12. What is the divergence between Goodwill and Other Intangible Assets?

Goodwill typically stays the aforementioned over many years and is not amortized. It changes simply if there's goodwill harm (or another acquisition).

Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by striking the Pre-Revenue enhancement Income line.

There'south also a difference in terms of what they each stand for, but bankers rarely become into that level of detail - accountants and valuation specialists worry about assigning each 1 to specific items.

thirteen. Is there anything else "intangible" also Goodwill & Other Intangibles that could also bear upon the combined visitor?

Yes. You could also take a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off.

The start refers to any Research & Development projects that were purchased in the acquisition but which accept not been completed yet. The logic is that unfinished R&D

projects require significant resources to complete, and as such, the "expense" must exist recognized as function of the acquisition.

The second refers to cases where the seller has collected cash for a service but not yet recorded it equally revenue, and the heir-apparent must write-downward the value of the Deferred Revenue to avoid "double-counting" revenue.

14. What are synergies, and can yous provide a few examples?

Synergies refer to cases where two + 2 = 5 (or half-dozen, or 7...) in an conquering. Basically, the buyer gets more value than out of an conquering than what the financials would predict.

There are ii types: revenue synergies and toll (or expense) synergies.

Acquirement Synergies: The combined company tin can cross-sell products to new customers or up-sell new products to existing customers. Information technology might too be able to expand into new geographies equally a result of the deal.

Cost Synergies: The combined company tin can consolidate buildings and administrative staff and can lay off redundant employees. It might likewise be able to close down redundant stores or locations.

15. How are synergies used in merger models?

Revenue Synergies: Normally you add these to the Revenue effigy for the combined visitor and then assume a certain margin on the Revenue - this additional Revenue then flows through the residuum of the combined Income Argument.

Cost Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Revenue enhancement Income and thus Net Income, raising the EPS and making the deal more accretive.

16. Are acquirement or cost synergies more than important?

No one in Chiliad&A takes acquirement synergies seriously because they're so difficult to predict. Toll synergies are taken a chip more seriously considering it'southward more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.

That said, the chances of any synergies actually beingness realized are well-nigh 0 so few accept them seriously at all.

17. All else being equal, which method would a company prefer to use when acquiring another company - cash, stock, or debt?

Bold the buyer had unlimited resources, it would always prefer to use cash when ownership another company. Why?

• Cash is "cheaper" than debt because interest rates on cash are unremarkably under 5% whereas debt involvement rates are almost always higher than that. Thus, foregone interest on cash is virtually always less than additional interest paid on debt for the same amount of greenbacks/debt.

• Cash is besides less "risky" than debt because there's no take chances the buyer might neglect to raise sufficient funds from investors.

• It'due south difficult to compare the "cost" direct to stock, but in general stock is the near "expensive" way to finance a transaction - remember how the Cost of Equity is nigh always higher than the Cost of Debt? That same principle applies here.

• Greenbacks is too less risky than stock considering the buyer's share price could change dramatically in one case the acquisition is announced.

18. How much debt could a company issue in a merger or acquisition?

More often than not you would look at Comparable Companies/ Precedent Transactions to make up one's mind this. You would use the combined company's LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of whatsoever companies you lot're looking at, and apply that to your own EBITDA figure to get a crude idea of how much debt you lot could heighten.

Yous would also wait at "Debt Comps" for companies in the same industry and run into what types of debt and how many tranches they accept used.

19. How do you decide the Purchase Price for the target company in an acquisition?

You use the same Valuation methodologies we already discussed. If the seller is a public company, you lot would pay more than attention to the premium paid over the current share price to make sure it'due south "sufficient" (more often than not in the 15-xxx% range) to win shareholder approval.

For private sellers, more weight is placed on the traditional methodologies.

20. Let's say a company overpays for another visitor - what typically happens afterward and can you give whatsoever contempo examples?

There would be an incredibly high amount of Goodwill & Other Intangibles created if the toll is far above the fair market value of the company. Depending on how the conquering goes, at that place might be a big goodwill impairment charge afterward if the company decides it overpaid.

A contempo example is the eBay / Skype deal, in which eBay paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and eBay subsequently ended upwards writing downward much of the value and taking a large quarterly loss every bit a issue.

21. A heir-apparent pays $100 million for the seller in an all-stock bargain, merely a day subsequently the market place decides it'southward only worth $fifty 1000000. What happens?

The buyer's share price would fall past whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would non necessarily be cut in half.

Depending on how the bargain was structured, the seller would finer only be receiving half of what information technology had originally negotiated.

This illustrates i of the major risks of all-stock deals: sudden changes in share toll could dramatically touch valuation.

22. Why do most mergers and acquisitions fail?

Like so many things, M&A is "easier said than done." In practice it's very hard to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable sectionalization.

Many deals are likewise done for the incorrect reasons, such as CEO ego or pressure from shareholders. Any deal done without both parties' all-time interests in mind is likely to fail.

23. What part does a merger model play in deal negotiations?

The model is used as a sanity check and is used to test various assumptions. A company would never decide to exercise a deal based on the output of a model.

Information technology might say, "Ok, the model tells us this deal could work and be moderately accretive -it's worth exploring more than."

It would never say, "Aha! This model predicts 21% accretion - we should definitely acquire them now!"

Emotions, ego and personalities play a far bigger role in M&A (and any blazon of negotiation) than numbers exercise.

24. What types of sensitivities would you look at in a merger model? What variables would yous wait at?

The most common variables to look at are Purchase Price, % Stock/Cash/Debt, Acquirement Synergies, and Expense Synergies. Sometimes y'all also look at different operating sensitivities, similar Acquirement Growth or EBITDA Margin, but it'southward more common to build these into your model equally different scenarios instead.

You lot might expect at sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Cost vs. Price Synergies, Purchase Price vs. Revenue Synergies, or Purchase Price vs. % Cash (so on).

- prepared by breakingintowallstreet.com and mergersandinquisitions.com.

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Source: https://finexecutive.com/en/news/_investment_banking_interview_questions_merger_model_basic_2_4_2015

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