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Investment Banking interview questions: Merger Model (Bones)

Yous don't need to understand merger models besides as an Thousand&A banker does, simply you do demand to more than just the nuts, especially if you've had a finance internship or total-fourth dimension task earlier. It's important to know the effects of an acquisition, and sympathize concepts such equally synergies and why Goodwill & Other Intangibles actually become created. I thing that'south not important? Walking through how all 3 statements are affected by an conquering. In 99% of cases, you lot only care about the Income Statement in a merger model (despite rumors to the reverse).

1. Walk me through a basic merger model

"A merger model is used to analyze the financial profiles of 2 companies, the buy price and how the buy is made, and determines whether the buyer's EPS increases or decreases.

Pace one is making assumptions about the acquisition - the price and whether it was cash, stock or debt or some combination of those. Next, you decide the valuations and shares outstanding of the buyer and seller and project out an Income Argument for each

Finally, you combine the Income Statements, calculation upward line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; yous apply the buyer's Tax Rate to become the Combined Net Income, and so separate by the new share count to determine the combined EPS."

2. What'south the difference between a merger and an conquering?

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

3. Why would a company want to acquire some other company?

Several possible reasons:

The buyer wants to gain market share past buying a competitor.

The heir-apparent needs to grow more than apace and sees an acquisition every bit a style to do that.

The buyer believes the seller is undervalued.

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

The buyer thinks the seller has a critical technology, intellectual property or some other "surreptitious sauce" it can use to significantly enhance its business concern. The buyer believes it can achieve significant synergies and therefore brand the deal accretive for its shareholders.

4. Why would an acquisition be dilutive?

An acquisition is dilutive if the boosted amount of Cyberspace Income the seller contributes is not enough to kickoff the heir-apparent's foregone interest on cash, boosted interest paid on debt, and the effects of issuing additional shares.

Conquering effects - such as amortization of intangibles - can too make an conquering dilutive.

5. Is there a dominion of thumb for computing whether an conquering will be accretive or dilutive?

If the deal involves just cash and debt, you lot can sum up the interest expense for debt and the foregone interest on cash, and so compare information technology against the seller's Pre-Tax Income.

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

But if the deal involves cash, stock, and debt, at that place's no quick dominion-of-thumb yous can use unless you're lightning fast with mental math.

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

Trick question. Yous can't tell unless y'all also know that it'southward an all-stock deal. If it'south an all-cash or all-debt deal, the P/E multiples of the buyer and seller don't matter because no stock is existence issued.

Sure, mostly getting more earnings for less is good and is more likely to be accretive but there'due south no hard-and-fast dominion unless information technology's an all-stock deal.

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

In an all-stock bargain, if the heir-apparent has a higher P/Due east than the seller, it volition be accretive; if the heir-apparent has a lower P/E, information technology will be dilutive.

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

eight. What are the complete furnishings of an acquisition?

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

2. Additional Interest on Debt - The buyer pays additional Interest Expense if information technology uses debt.

3. Additional Shares Outstanding - If the heir-apparent pays with stock, it must event additional shares.

4. Combined Financial Statements - Afterward the conquering, the seller's financials are added to the buyer'south.

five. Creation of Goodwill & Other Intangibles - These Remainder Canvass items that represent a "premium" paid to a company'due south "fair value" also get created.

Notation: In that location's actually more than than this (encounter the avant-garde questions), but this is usually sufficient to mention in interviews.

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

Information technology might be saving its greenbacks for something else or information technology might be concerned about running depression if concern takes a turn for the worst; its stock may also exist trading at an best loftier and it might be eager to utilize that instead (in finance terms this would exist "more than expensive" but a lot of executives value having a safe cushion in the form of a large greenbacks balance).

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

Considering the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies heave the effective valuation for the target visitor.

11. Why practise Goodwill & Other Intangibles get created in an conquering?

These represent the value over the "fair market value" of the seller that the heir-apparent has paid. You calculate the number by 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, make names and intellectual property - valuable, merely not true financial Assets that show up on the Balance Sail.

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

Goodwill typically stays the same over many years and is not amortized. It changes merely if at that place'south goodwill impairment (or another conquering).

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

There'southward also a difference in terms of what they each represent, just bankers rarely get into that level of detail - accountants and valuation specialists worry about assigning each i to specific items.

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

Yes. You lot could also have a Purchased In-Process R&D Write-off and a Deferred Acquirement Write-off.

The first refers to any Research & Development projects that were purchased in the acquisition but which have non been completed yet. The logic is that unfinished R&D

projects require meaning resources to consummate, and as such, the "expense" must exist recognized as part of the acquisition.

The 2d refers to cases where the seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-downward the value of the Deferred Revenue to avoid "double-counting" acquirement.

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

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

There are 2 types: revenue synergies and price (or expense) synergies.

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

Cost Synergies: The combined company can consolidate buildings and authoritative staff and tin 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 yous add these to the Revenue figure for the combined visitor so assume a certain margin on the Revenue - this additional Revenue and so flows through the rest of the combined Income Statement.

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

xvi. Are revenue or cost synergies more than important?

No one in G&A takes revenue synergies seriously because they're so hard to predict. Toll synergies are taken a scrap more seriously considering it's 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 existence realized are most 0 so few have 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 heir-apparent had unlimited resource, it would always prefer to utilize cash when buying another company. Why?

• Greenbacks is "cheaper" than debt because involvement rates on cash are usually nether 5% whereas debt interest 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 cash/debt.

• Cash is also less "risky" than debt considering there'due south no chance the buyer might fail to enhance sufficient funds from investors.

• Information technology'southward hard to compare the "cost" straight to stock, only in general stock is the most "expensive" fashion to finance a transaction - remember how the Toll of Equity is almost ever higher than the Price of Debt? That same principle applies hither.

• Greenbacks is also less risky than stock considering the buyer's share price could modify dramatically once the conquering is announced.

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

Generally you lot would expect at Comparable Companies/ Precedent Transactions to determine this. You would employ the combined company'southward LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of any companies y'all're looking at, and apply that to your ain EBITDA effigy to get a rough idea of how much debt you could heighten.

Y'all would also wait at "Debt Comps" for companies in the same industry and see what types of debt and how many tranches they have used.

nineteen. How do you determine the Purchase Price for the target company in an acquisition?

You use the same Valuation methodologies nosotros already discussed. If the seller is a public company, you lot would pay more attending to the premium paid over the current share price to make sure it's "sufficient" (generally in the 15-xxx% range) to win shareholder approval.

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

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

There would be an incredibly high amount of Goodwill & Other Intangibles created if the toll is far above the fair marketplace value of the company. Depending on how the acquisition goes, there might be a large goodwill impairment accuse later on if the visitor decides it overpaid.

A contempo example is the eBay / Skype bargain, in which eBay paid a huge premium and extremely loftier multiple for Skype. Information technology created excess Goodwill & Other Intangibles, and eBay subsequently ended upwardly writing downwards much of the value and taking a large quarterly loss as a result.

21. A buyer pays $100 million for the seller in an all-stock bargain, only a day later the market decides information technology's only worth $50 1000000. What happens?

The buyer's share price would fall past whatever per-share dollar corporeality corresponds to the $l million loss in value. Annotation that it would not necessarily be cut in one-half.

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

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

22. Why do most mergers and acquisitions fail?

Like so many things, Yard&A is "easier said than washed." In practice it's very difficult to learn and integrate a different company, actually realize synergies and also plow the acquired company into a assisting division.

Many deals are besides done for the incorrect reasons, such as CEO ego or force per unit area from shareholders. Whatsoever deal done without both parties' best interests in mind is probable to fail.

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

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

It might say, "Ok, the model tells usa this deal could piece of work and be moderately accretive -it'south worth exploring more."

Information technology would never say, "Aha! This model predicts 21% accretion - we should definitely learn them now!"

Emotions, ego and personalities play a far bigger role in K&A (and whatever type of negotiation) than numbers do.

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

The most common variables to look at are Purchase Price, % Stock/Cash/Debt, Acquirement Synergies, and Expense Synergies. Sometimes you also expect at different operating sensitivities, similar Revenue Growth or EBITDA Margin, but information technology'south more common to build these into your model as unlike scenarios instead.

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

- prepared past 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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