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Investment Banking interview questions: Merger Model (Basic)

You lot don't need to sympathize merger models equally well every bit an M&A banker does, but y'all do need to more than than just the basics, peculiarly if you've had a finance internship or total-fourth dimension job earlier. It's of import to know the furnishings of an conquering, and understand concepts such as synergies and why Goodwill & Other Intangibles actually get created. I matter that'south non important? Walking through how all 3 statements are afflicted by an acquisition. In 99% of cases, you only intendance virtually the Income Statement in a merger model (despite rumors to the contrary).

i. Walk me through a bones merger model

"A merger model is used to analyze the fiscal profiles of 2 companies, the purchase toll and how the purchase is fabricated, and determines whether the buyer's EPS increases or decreases.

Stride ane is making assumptions about the acquisition - the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and projection out an Income Statement for each

Finally, you combine the Income Statements, adding up line items such equally Revenue and Operating Expenses, and adjusting for Foregone Interest on Greenbacks and Interest Paid on Debt in the Combined Pre-Taxation Income line; you use the buyer's Tax Charge per unit to get the Combined Net Income, and and so separate by the new share count to determine the combined EPS."

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

There's always a buyer and a seller in any Grand&A deal - the deviation betwixt "merger' and "acquisition" is more semantic than anything. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

iii. Why would a company desire to acquire another company?

Several possible reasons:

The heir-apparent wants to gain market share past buying a competitor.

The buyer needs to grow more rapidly and sees an conquering as a way to exercise that.

The heir-apparent believes the seller is undervalued.

The buyer wants to acquire the seller'south customers so it tin can up-sell and cross-sell to them.

The buyer thinks the seller has a disquisitional technology, intellectual holding or some other "secret sauce" it tin employ to significantly enhance its business. The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

four. Why would an acquisition exist dilutive?

An conquering is dilutive if the boosted amount of Net Income the seller contributes is non enough to offset the buyer's foregone interest on cash, additional involvement paid on debt, and the effects of issuing additional shares.

Acquisition effects - such as amortization of intangibles - can too make an acquisition dilutive.

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

If the deal involves just cash and debt, you can sum upwardly the interest expense for debt and the foregone interest on greenbacks, then compare information technology confronting the seller's Pre-Tax Income.

And if it's an all-stock deal you lot can use a shortcut to assess whether information technology is accretive.

But if the bargain involves cash, stock, and debt, at that place'due south no quick rule-of-thumb you can employ unless yous're lightning fast with mental math.

6. A company with a higher P/E acquires one with a lower P/E - is this accretive or dilutive?

Play a joke on question. You can't tell unless y'all also know that information technology's an all-stock deal. If it's an all-cash or all-debt bargain, the P/East multiples of the buyer and seller don't matter considering no stock is being issued.

Sure, more often than not getting more earnings for less is practiced and is more probable to be accretive but at that place'south no difficult-and-fast rule unless it's an all-stock deal.

7. What is the rule of thumb for assessing whether an M&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/Eastward, information technology volition be dilutive.

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

eight. What are the complete furnishings of an acquisition?

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

2. Boosted Interest on Debt - The heir-apparent pays additional Interest Expense if it uses debt.

3. Boosted Shares Outstanding - If the buyer pays with stock, it must outcome additional shares.

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

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

Annotation: There's actually more than than this (see the avant-garde questions), but this is usually sufficient to mention in interviews.

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

It might be saving its cash for something else or it might be concerned about running low if concern takes a turn for the worst; its stock may also be trading at an all-time loftier and information technology might be eager to apply that instead (in finance terms this would be "more expensive" but a lot of executives value having a safety cushion in the form of a large cash balance).

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

Because the strategic acquirer can realize revenue and price synergies that the private equity business firm cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effective valuation for the target company.

eleven. Why do Goodwill & Other Intangibles become created in an acquisition?

These correspond the value over the "fair market value" of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its disinterestedness purchase price.

More specifically, Goodwill and Other Intangibles represent things like the value of customer relationships, brand names and intellectual property - valuable, but not true financial Assets that prove up on the Balance Sheet.

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

Goodwill typically stays the same over many years and is non amortized. It changes just if there'due south goodwill impairment (or some other acquisition).

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

In that location's also a divergence in terms of what they each correspond, but bankers rarely go into that level of item - accountants and valuation specialists worry about assigning each one to specific items.

13. Is at that place anything else "intangible" as well Goodwill & Other Intangibles that could also impact the combined company?

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

The outset refers to any Enquiry & Evolution projects that were purchased in the acquisition but which have non been completed still. The logic is that unfinished R&D

projects crave significant resource to complete, and as such, the "expense" must exist recognized equally part of the conquering.

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

xiv. What are synergies, and tin can you provide a few examples?

Synergies refer to cases where two + 2 = 5 (or 6, or 7...) in an acquisition. Basically, the heir-apparent gets more value than out of an acquisition than what the financials would predict.

There are two types: acquirement synergies and cost (or expense) synergies.

Revenue Synergies: The combined visitor tin can cross-sell products to new customers or up-sell new products to existing customers. It might also be able to expand into new geographies as a result of the deal.

Toll Synergies: The combined company can consolidate buildings and authoritative staff and can lay off redundant employees. Information technology might also be able to shut downwards redundant stores or locations.

15. How are synergies used in merger models?

Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue - this additional Revenue then flows through the rest of the combined Income Statement.

Toll Synergies: Commonly you reduce the combined COGS or Operating Expenses by this corporeality, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.

16. Are revenue or cost synergies more important?

No one in M&A takes acquirement synergies seriously considering they're so hard to predict. Toll synergies are taken a bit more seriously because information technology's more than straightforward to see how buildings and locations might be consolidated and how many redundant employees might exist eliminated.

That said, the chances of whatever synergies really being realized are nearly 0 then few take them seriously at all.

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

Bold the buyer had unlimited resources, information technology would always prefer to utilize cash when ownership another company. Why?

• Cash is "cheaper" than debt because interest rates on greenbacks are usually nether 5% whereas debt interest rates are almost ever college than that. Thus, foregone interest on greenbacks is almost always less than additional involvement paid on debt for the same amount of greenbacks/debt.

• Cash is also less "risky" than debt because at that place'southward no chance the heir-apparent might fail to heighten sufficient funds from investors.

• It'south hard to compare the "cost" directly to stock, simply in general stock is the about "expensive" way to finance a transaction - remember how the Cost of Equity is nigh always higher than the Cost of Debt? That aforementioned principle applies hither.

• Cash is also less risky than stock because the buyer's share toll could change dramatically one time the acquisition is announced.

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

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

You would also expect at "Debt Comps" for companies in the same industry and encounter what types of debt and how many tranches they have used.

19. How do you make up one's mind the Purchase Price for the target company in an acquisition?

You utilize the aforementioned Valuation methodologies we already discussed. If the seller is a public visitor, you would pay more attention to the premium paid over the current share price to brand sure information technology's "sufficient" (generally in the 15-30% range) to win shareholder approval.

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

20. Permit's say a visitor overpays for another visitor - what typically happens subsequently and can you lot give whatever recent examples?

There would exist 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 acquisition goes, there might be a big goodwill damage accuse later on if the visitor decides it overpaid.

A recent example is the eBay / Skype bargain, in which eBay paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and eBay later on concluded up writing downwardly much of the value and taking a large quarterly loss equally a result.

21. A buyer pays $100 meg for the seller in an all-stock bargain, but a twenty-four hours later the market decides it'due south simply worth $l million. What happens?

The heir-apparent'southward share toll would fall by whatsoever per-share dollar corporeality corresponds to the $50 million loss in value. Note that it would not necessarily exist cut in half.

Depending on how the deal was structured, the seller would effectively only exist receiving half of what it had originally negotiated.

This illustrates one of the major risks of all-stock deals: sudden changes in share cost could dramatically bear upon valuation.

22. Why do most mergers and acquisitions fail?

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

Many deals are also done for the incorrect reasons, such as CEO ego or pressure from shareholders. Whatsoever deal done without both parties' best interests in mind is likely to fail.

23. What role does a merger model play in bargain negotiations?

The model is used as a sanity check and is used to examination diverse assumptions. A company would never decide to exercise a bargain based on the output of a model.

It might say, "Ok, the model tells united states this deal could work and be moderately accretive -it's worth exploring more."

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

Emotions, ego and personalities play a far bigger office in 1000&A (and any type of negotiation) than numbers do.

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

The almost common variables to look at are Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies. Sometimes yous as well expect at different operating sensitivities, like Revenue Growth or EBITDA Margin, but it's more mutual to build these into your model as different scenarios instead.

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

- prepared by breakingintowallstreet.com and mergersandinquisitions.com.