820 likes | 836 Views
Definition of Terms Used in Mergers and Overview. Merger and Acquisition Background. A few terms that will be used throughout the course. Mergers and Acquisitions are valuation and capital budgeting problems, but:
E N D
Merger and Acquisition Background • A few terms that will be used throughout the course. • Mergers and Acquisitions are valuation and capital budgeting problems, but: • The value of synergies and management strategy in M&A are difficult to quantify with financial models • Costs and benefits of a merger can be measured in various different ways (DCF Valuation, Equity IRR, EPS changes, credit quality, NPV) • Accounting, tax, and regulatory issues can be complex in modeling (goodwill, tax step-ups, re-financing) • Methods of quantifying the costs and benefits of M&A with financial model • Merger or consolidation; performance of combined company in terms of EPS and credit quality (as well as DCF of target company) • Acquisition; model the rate of return earned assuming that the company will be re-sold after a holding period and evaluate EPS effects (as well as DCF of target company)
Merger Terms • Synergy • Increase in revenue and/or decrease in expense and/or decrease in capital expenditure that occurs because two companies operate as one. • Premium • Increase in target share price from before the merger to after the merger • Dilution/Accretion • Effect of merger or acquisition on earnings per share or some other measure – accretion is increase from merger and decrease is dilution.
Premium • .
Synergy and Premium NRG Price: $22/Share 264 million shares NRG Market Cap: $5,810 Million Premium: $2.1 Billion 37% of $5,810 Million After Tax Synergies $1 bill - $1.8 billion Less: Costs 360 Net Synergies $720 – 1,440 million
Earnings Analysis Should Include Constraint of Credit Rating • .
Merger Terms • Purchase Accounting • Purchase accounting is normally used in M&A. Assets and liabilities are measured at fair value rather than original cost and the common equity of the company is eliminated. Alternative method is pooling of interests. • Goodwill • Asset arising from purchase accounting that arises from the difference between equity that was on the balance sheet and equity that is paid for the company. • Minority Interest • The share of the company (assets and income) that is not owned by shareholders of the corporation.
Merger Terms • Consideration: • How the payment is made for the equity value of the target company. This can be share exchange, cash, preferred stock, option or other creative forms of financing. • Uses and Sources of Funds in Acquisition • Uses of funds include consideration and fees and may include repayment of existing debt. Sources are debt, equity (public offering or share exchange), surplus cash of target etc. Sources can also include the sale of business units. • Purchase Price Allocation: • In an stock purchase, can elect to have the transaction treated as an asset purchase implying a step-up in value
Merger Terms – Example Amount paid for the equity of the target What the equity holders of the target receive Includes debt of the target
Merger Terms • Exchange Ratio and Share Exchange • The number of shares received for the new merged firm that will be received for existing shares of the target. The starting point for evaluation should be the relative share prices before the merger. • Transaction Multiples • Financial ratios such as the price to earnings ratio, the market to book ratio and the enterprise value to EBITDA ratio that are computed from the amount paid for other transactions. Transaction multiples contrast with public company multiples. • Transaction Value • Enterprise value (equity value plus net debt (market value) plus the transaction fees
Floating Collar When the acquirer share price increases, then the exchange ratio declines To evaluate the band in exchange ratio, could adjust the sources and uses of funds statement When the acquirer share price declines, the exchange ratio increases
Definitions of Success • Accounting • Earnings Accretion is Success • Earnings Dilution is Failure • Economics • Net present value of free cash flow • Net Present Value of Synergies > Premium is Success • Net Present Value of Synergies <= Premium is Failure • Finance • Compute the Equity IRR with Exit Multiples over Holding Period • Stock Price Increases Relative to Comparable Companies
Alternative Methods of Analysis • There are alternative methods for analysis of an acquisition, all of which have advantages and disadvantages: • Discounted Cash Flow • Compute DCF of Target on Standalone Basis • Add after-tax PV of Synergies • Acquisition Model • Compute Equity Cash Flow with Actual Financing Structure • Evaluate Equity IRR and Variation in Equity IRR • Integrated Merger Model • Compute the Effect of Acquisition on EPS and Other Ratios • Evaluate Credit Ratios and EPS Changes
Accretion Objective Mergers Premium received by target company and added benefits if continue interest in the new company EPS Accretion from the perspective of acquiring company
Objectives of Model Overview Section • Provide a general understanding of M&A models as background for subsequent sections • Read through actual models to gain general familiarity with transaction • Understand why and sheets and modules are added in models • Find key components of common to M&A models • How M&A models can be used to evaluate the benefits and costs of a transaction with alternative structures. • M&A Accounting • M&A Financing • M&A Synergies • Target Valuation • Model Assumptions
Accounting for Acquisitions (Majority Stake) • Purchase Accounting • Assets of acquired firm must be reported at fair market value • Goodwill is created – difference between purchase price and estimated fair market value of net assets • Goodwill no longer has to be amortized – assets are essentially marked-to-market annually and goodwill is adjusted and treated as an expense if the market value of the assets has decreased • Pooling of interests • Pooling accounting is meant to reflect situations in which there is no ownership change, but the uniting of business interests
Accounting for Acquisitions (Alternative Stakes) • Consolidation • When the investor controls more than 50% of the voting shares • Line by line consolidation of financial statements • Eliminate inter-company transactions • Minority interest • Equity Method • Investor holds between 20% and 50% of a company • Investment stated at net asset value • Dividends received treated as adjustment to investment • Earnings recorded as percent of companies earnings • Fair Value Method • Investor holds less than 20% • Dividends treated as income
Purchase Accounting • Cash and Accounts Receivable • Generally valued at carrying values prior to the acquisition • Marketable Securities • Net realizable value • Inventories • Replacement cost; eliminate LIFO reserves • Property plant and equipment • Booked at fair market value • Accounts payable and accrued expenses • Carrying values prior to acquisition • Debt • Value at current interest rates • Intangible Assets (Customer listes etc.)
Treatment of Goodwill • Goodwill -- The intangible assets of the acquired firm arising from the acquiring firm paying more for them than their book value. • Formerly, goodwill could not be amortized for more than 40 years for “financial accounting purposes.” and goodwill charges are generally deductible for “tax purposes” over 15 years. • Now Goodwill is amortized only when determined that there has been a permanent “impairment” (Thus, firm has some discretion in when it is recognized as an expense) • Impairment of goodwill is not tax deductible (for tax purposes, can still amortize goodwill) • Kitchen Sink Quarter: Digging through their vaults, dredging anything that looked shaky, and writing it off – getting it over with.
Steps in Goodwill Calculation to Compute Goodwill • Step 1: • Purchase Price of Equity less Book Value of Target • Step 2: • Add Transaction Cost (Like increase in the purchase price that is capitalized) • Step 3: • Deduct asset write-ups (Like increase in the book value of equity of the target) • Step 4: • Add liability write-ups (Like reduction in the book value of equity of the target)
Steps in Purchase Allocation and Write-Up • Begin with Purchase Price – Enterprise Value • Equity Consideration • Plus: Existing Debt and Fees • Less: Surplus Cash Used • Subtract • Existing Net working Capital (Other than surplus cash) • Net Other Assets and Other Liabilities • Existing Value of Fixed Assets • Goodwill (Value as Zero) • Equals • Asset Write-up
Goodwill GW = Equity Purchase price – Book Value of Target + Fees Allowed – Asset Write-ups + Liability Write-ups Using Abbreviations GW = EqPrice – BVeq + Fees – Write-up Or since BVeq = Existing Assets – Debt + Net WC GW = EqPrice – Existing Assets + Ex Debt – Net WC - Write-up Purchase Price Purchase price is the amount of the fixed assets plus the net goodwill (analogous to the enterprise value) Using Abbreviations PP = EqPrice + Debt + Fees = Existing Assets + Write-up + Goodwill + Net WC GW = PP - Existing Assets - Write-up - Net WC Goodwill and Purchase Price Allocation
Goodwill versus Intangible Assets – Tyco Example • If intangible assets are created, then subsequent earnings are affected. Consider the example of Tyco: • By minimizing or marking down the value of intangible assets and maximizing or marking-up, goodwill, Tyco can inflate its earnings. The earnings lift comes because Tyco can treat the goodwill differently from real assets, which under accounting rules lose value over time. • In addition, if Tyco sells the assets it has marked down at the time of the acquisition, it can make a larger profit. • Over the last three years, Tyco has spent about $30 billion on acquisitions and created the same amount of goodwill.
Goodwill Calculation Example • Compute goodwill and goodwill amortization as a function of purchase price of the target company. Book value of equity plus net asset write-ups Separately add deferred taxes and fees
Example of Purchase Price Allocation • This example shows how the balance sheet is reconciled with valuation of assets at market values and use of goodwill.
Example of Purchase Price Allocation Begin with Consideration for the equity and then add the debt assumed to derive purchase price. Net purchase price is the consideration paid (including fees) plus the net debt Allocate the purchase price to fixed assets and net working capital. The remainder is goodwill
Bargain Purchase and Negative Goodwill • Negative goodwill is allocated to reduce the pro-rata values assigned to purchased assets excluding cash, financial assets, accounts receivable, inventories and other assets held for sale. • If all of the negative goodwill cannot be absorbed, then record income.
Restructuring Charges in Business Combinations Restructuring charges • Costs associated with the exit or disposal of activities. • Fall into three main classes: • One-time benefits provided to employees being involuntarily terminated. • Costs of terminating contracts. • Costs of moving employees or consolidating operations.
Restructuring Charges in Business Combinations (continued) If restructuring costs provide future benefits to the combined company– • They are not recognized as a liability on the transaction date. • Instead, they are recognized as expenses in the future periods when they are incurred. • The fair value of target’s preexisting restructuring liabilities recognized by the acquirer at the acquisition date and included as part of the target’s total liabilities for the calculation of transaction goodwill.
Case Exercise • Given two standalone models • Determine the combined ratios • Assume two private companies • Assume no synergies in initial case • Use template model with titles
Analysis with Consolidation Analysis • Alternative synergies • Alternative purchase prices • Alternative debt and equity issues • Alternative asset write-up and write-down policies • Alternative dividend policy
How M&A Models are Put Together • An M&A Model Accepts • Corporate models from both companies (with financial statements) • Purchase price for target company • Financing of purchase • Transaction costs and synergies • M&A Model Outputs • Financial performance of new company (EPS and financial ratios) • Credit quality of new company (credit quality ratios of new company)
Inputs, Outputs and Valuation in Standalone Corporate Models • Inputs to Derive Free Cash Flow • Capital Expenditures • Revenues • Expenses • Debtors and Creditors • Tax Rates • Plant Life • Calculations are simple: Revenues – Expenses – Working Capital Movement, net of tax • Inputs to Derive Net Cash Flow • Debt to Capital • Interest Rates • Debt Repayment • Dividends • Net cash flow is: Operating Cash – Interest – Debt Repayment – Dividends • The basic structure of corporate models are easy to understand without being a modelling expert • The balance sheet must balance – by far the most effective check on calculations
Goodwill Calculation • Goodwill is computed as the amount paid for equity less the equity book value. • Goodwill is lowered from asset write-ups (increases in book value) and eliminations of deferred tax (reductions in liabilities). • Goodwill is increased from asset write-downs, deferred tax asset elimination and transaction fees that are effectively a reduction in purchase price.
Pro-forma Balance Sheet • Purpose: establish the initial balance sheet for modeling. Existing book equity of the target company should be eliminated. All of the other adjustments including goodwill, debt and equity issues and retirements and asset write-ups are from the sources and uses and the goodwill analysis.
Basic Merger Points • The market for corporate control is efficient • Easy deals that add value are difficult to find • Most successful deals are from highly disciplined deal making such as General Electric • Better deals come from: • Believable and unique synergies • Lower price premiums • Smaller companies in related businesses (not diversification) • ROIC and Related Industry • Better run acquirers (higher ROI relative to the industry average) • Same Industry – asset base is similar so you would expect the same ROIC This implies that you should compute the ROIC and understand differences
Example of Merger Analysis -- J.P. Morgan • The elements of J.P. Morgan's analyses included: • Assessing the potential value creation as a result of the merger; • Assessing the sharing of the combined pro forma entity given the historical and forecast contributions of each company, and the sharing of the potential value creation; • Testing the results on pro-forma Exxon earnings per share for the potential accretion/dilution of earnings for the next 3 years; and, • Checking the premium to be paid by Exxon in the merger against market precedent.
Successful M&A • Characteristics of successful M&A transactions: • Focus on quickly improving operating performance (revenue synergies are difficult to achieve; cost synergies are more believable) • Extract investment within five years • Created incentives for top management • Concentrate on cash flow rather than earnings • Personal wealth involved in the deal • Value investing (low P/E) rather than glamour investing (high multiples) • Paying with cash has had more success than issuing shares through share exchange • M&A as a way to use excess cash has not been successful