Investment Banking - M&a and Initial Public Offerings - Fin 573 MOOC 2 Module 3

Investment Banking:M&A and initial Public Offerings
Professor Jim Bertram & Professor Rob Metzger
Module 3: Merger Consequences Analysis
Table of Contents
Lesson 3-1: Merger Consequences Analysis .....................................................................................2
Accretion/Dilution ................................................................................................................................................. 2
Lesson 3-2: Building an Accretion/Dilution Model ...........................................................................6

Building an Accretion/Dilution Model Part 1 ........................................................................................................ 6
Building an Accretion/Dilution Model Part 2 ...................................................................................................... 12
1
Lesson 3-1: Merger Consequences Analysis
Accretion/Dilution
The merger consequences analysis, also known as the Accretion Dilution analysis,
measures the impact on earnings per share of an acquisition. Assessing whether the
transaction increases or decreases EPS, as well as the related creditors statistics. This
analysis enables a strategic buyer to fine-tune the ultimate amount that it can pay for a
transaction, as well as helping it assess what is the best way to finance and structure
the deal. As we will see in a detailed build-out in another session. The key inputs into
this analysis are, what is the purchase price of the company? What are the target
company's projections? What are the forms of financing? And what is the deal
structure?
2
Before we get into the details of how to prepare the Merger Consequences analysis,
let's first discuss what is meant by the words accretion and dilution. Accretion is the
concept that after factoring in both the economic and accounting impact of a particular
acquisition transaction, the acquiring company's earnings per share goes up as
compared to its standalone EPS projection. On the other hand, the term dilution refers
to a situation where the company's earnings per share goes down after measuring the
impact of an acquisition. It's important to note that this is not focused on the impact of
prior results, but instead is focused on the impact of projected results in the current year
and the first few years after the transaction. Basically, shareholders want to know if the
deal will be EPS accretive on a go-forward basis since the share price is theoretically a
sum of the present value of all future cash flows of the company. Let's take a quick look
at an accretion dilution analysis and the conclusions we draw. Later, we will walk
through a full accretion dilution model from scratch.
3
Our starting point is to calculate the buyer standalone projected earnings per share. In
this instance, $4.45 per share. This is our baseline EPS. Our objective is to see if after
factoring in the impact of the transaction, both positive and negative, whether pro forma
projected net income after the deal is more or less than this baseline. If it is more then
the transaction is accretive. If it is less, it is dilutive. To arrive at pro forma projected net
income we sum the following, the buyers projected net income 44468, the targets
projected net income 6540, and the after-tax impact of transaction adjustments. These
transaction adjustments includes synergies that we expect to happen from the
combination, the cost of incremental debt we take out to complete the transaction,
including interest expense, forgone interest income and financing fee amortization and
the amortization of transaction intangibles.
4
To be discussed in detail in a little while. We sum up all of these items on a pre-tax

basis and tax effected by the marginal tax rate to arrive at an after-tax amount. Then we
aggregate the seller projected net income, the buyer projected net income, and after-tax
adjustments to arrive at pro forma projected net income. We then take this number and
divide it by the number of fully diluted shares outstanding after the transaction to arrive
at pro forma EPS. In this example, for 441 per share. Since for 441 per share is less
than our standalone EPS of 445 per share. This transaction is dilutive. If the pro forma
EPS was greater than 445 per share, it would have been accretive .
5
Lesson 3-2: Building an Accretion/Dilution Model
Building an Accretion/Dilution Model Part 1
This session covers the detailed steps of how to build an accretion dilution model.
Before we dig in, let's review the main concept behind accretion dilution or what is
known as a merger consequences analysis.
6
As a refresher, the merger consequences analysis measures the impact on earnings

per share of an acquisition. Assessing whether the transaction increases or decreases
the buyer's EPS as well as the related credit statistics. This analysis enables a strategic
buyer to fine tune the ultimate amount that it can pay for a transaction as well as helping
it assess what is the best way to finance and structure the deal. As we will see in a
detailed buildout in a few minutes, the key inputs into this analysis are what is the
purchase price of the company, what are the target company's projections, what are the
forms of financing, and what is the deal structure.
7
Before I open up an accretion dilution spreadsheet template and begin to build the
model, I'd like to review the steps that we will follow. Step 1, enter the acquirer's
standalone net income and EPS. Step 2, add the target's standalone net income. Step
3, analyze the transaction. Step 4, calculate after-tax transaction adjustments, expected
synergies, transaction-related depreciation and amortization expenses, incremental
interest expense associated with the new transaction debt, the tax rate, which is the
buyer's marginal tax rate.
8
Step 5, sum number 1, 2, and 4 to arrive at a pro forma combined net income. Step 6,
calculate pro forma fully diluted shares outstanding. For an all-cash deal, this will be the
same number of shares as the buyer had prior to the transaction. But for a stock or
partial stock deal, we'll add in the new shares to the current fully diluted shares to arrive
at pro forma shares. Step 7, divide pro forma net income by the pro forma fully diluted
shares outstanding to arrive at pro forma combined earnings per share. Step 8,
compare pro forma earnings per share to standalone earnings per share. If pro forma
earnings per share is higher, the transaction is accretive. If it is negative, the transaction
is dilutive. Let's open up the spreadsheet and begin to build it. Conceptually, what we're
doing is taking the buyer and target's financial projections and combining them into a
single analysis.
9
However, due to GAAP accounting as well as the economics of the M&A transaction
itself, it isn't just as easy as 1 plus 1 equals 2. But nevertheless, our starting point is the
buyer's and seller's standalone financial statements. At a minimum, a historical income
statement for the past 12 months projected income statements for the next one to two
years as well as the year-end historical balance sheet. As you can see in our template,
this has been completed in a summary fashion and has been prepopulated. As with
other templates, it is important to not modify the model structure, e.g., adding rows,
changing labels, etc. as these spreadsheets feed into other parts of the model and
could create issues if there are modifications. Instead, it is better to make notes of how
you confirmed the source data to fit into the model construct. Here, we can see that the
buyer's revenues are projected to grow 12 percent in 2021. Gross margins are constant
as we gain some efficiency on our SG&A. We work our way down to the net income line
and result in approximately 45 million of net income in 2020 and 56 million in 2021.
Below the income statement is the historical 1231 2020 balance sheet, again, in
summary fashion.Moving to the next tab, target financial statements, we will do the
same thing as we did with the buyer's historical financial statements. You'll note that the
format is exactly the same, but the amounts are typically much smaller. In this instance,
it's about one third of the buyer's size. Oftentimes you'll find that the sellers are growing
faster, but the margins are not quite as high. This is attributable to the fact that the seller
is oftentimes a higher growth business that has not yet reached at steady-state margins.
Again, this is a rule of thumb, not an absolute.
10
Now that we have our standalone financials for the buyer and seller, we'll turn to the
accretion dilution assumptions in the next lesson.
11
In the previous lesson, we created the historical and projected financial statements for
both the buyer and the target. Once this is done, we now turn our attention to building
out the assumptions tab.
12
Once we have the historical and projected financial statements loaded for the buyer and
the target, we can now begin to build out the assumptions tab. We start with what the
buyer is paying for the target in terms of enterprise value. It's typical to think of this as
an equity purchase price per share, calculated as a premium to the current market price
or to simply take the target EPS and multiply it by the current PE and putting a premium
on that. In this instance, we take an EPS of 654 share and multiply it by a PE of 15
times to get at a $98.10 per share purchase price. Then we added on a 30 percent
control premium, which is a very representative premium if you look at thousands of
transactions over a long period of time. Once we have the purchase price per share, we
multiply it by the number of fully diluted shares outstanding to arrive at the equity
purchase price. Then we add debt and subtract cash to arrive at the enterprise value.
From there we look at how we are going to pay for the target; cash, stock, or a
combination thereof. If we are using cash, what is the split between cash on hand and
new borrowings? For the new borrowings, we make assumptions about origination fees
and interest rate. Whereas for the cash on hand, we focus on the interest rate on the
cash balances. We'll see how we use this later in this session. After we figure out the
purchase price and determine how we will pay for it, I move down to the sources and
uses table on the bottom of this spreadsheet. Here I start with the uses. The primary
ones being payment to equity holders and payment of outstanding debt and fees. The
amount paid to equity holders is simply the equity purchase price or 127,530. The target
does not have outstanding debt, so that amount is zero.
13
The total fees are the combination of financing fees on new debt plus the fees paid to
bankers, lawyers, and accountants. We see that assumption above called non-financing
fees as a percentage of enterprise value. The sum of these items are the uses of cash
to complete the transaction. Then we move to the left, to the sources. Starting with the
buyer debt, cash on hand used to fund the transaction both from the target and from the
buyer, and then the equity issued. The equity issued is the plug. We start with the debt
and cash and then know that the rest needs to be financed with equity. Note that in
many strategic deals we use just debt and cash on hand, so there's not always an
equity plug as there would be in an LBO.
14
Once we complete sources and uses, I move back up to the top portion and complete
the tax rate assumption, the synergies assumption,and the intangible amortization
assumption.The first two of these are pretty straightforward.
The tax rate is the marginal tax rate and the synergy assumption is typically about 10
percent or so of the SG&A expenses of the target. The intangible amortization
assumption is a little more complicated. In essence, the purpose of this is to assess how
15
much intangible assets are created by the transaction and to assess how much of this is
allocated to what is known as identifiable intangibles versus goodwill. Identifiable
intangibles are things like patents, trademarks, and customer lists, which aren't physical
assets but can be amortized over their useful life. These items are specifically valued
and their useful life can be calculated. As a simple rule of thumb for this analysis, we will
use a 30 percent allocation and amortize these items over a blended seven-year useful
life. In real life, a company would hire an accounting firm that would do a study to figure
this out with a lot of precision. Goodwill is the difference between the total amount of the
excess purchase price and the identifiable intangibles. This amount is recorded on the
balance sheet as a long-term asset and does not get amortized. Instead, each year the
buyer will perform what is known as an impairment test on the business acquired to see
if the value of the acquired company is more or less than it was when the transaction
was consummated. If the answer is more, then the goodwill remains on the balance
sheet. If it is less, then the difference between the current valuation and the original
valuation reduces the goodwill balance on the balance sheet with an equal amount of
an impairment loss taken through the income statement. Upon completion of the
transaction assumptions and the sources and uses table, we can now perform the
accretion-dilution analysis and then adjust the balance sheet of the combined company.
16
Let's start with the accretion dilution analysis. First, I'll navigate to the accretion dilution
analysis template. As a reminder, the accretion dilution analysis is focused on
determining whether the buyers earnings per share goes up or down after factoring in
the earnings of the target and the impact of the accounting and financing adjustments.
It's a simple yes, no question. If the post-deal earnings are higher then it is accretive,
but if they are less, then it is dilutive. To answer this question we start with the buyers
earnings per share on a standalone basis, which is a poll from the buyer's financial
statement tab. This is the baseline against which we measure the post-deal earnings
per share. Let's start with the buyer standalone earnings per share off of that tab. Both
for '20 and 2021. Pull in their diluted shares outstanding of 10,000 each year to
calculate net income of 44,468 and 55,915. We'll then look at the targets net income,
which is 64,540 in 2020 and 8,640 in 2021. We'll then move into the transaction
adjustments to combine net income. The positive adjustments are going to be EBIT
synergies. Again, this is a reminder, these are cost savings that we obtained by putting
the two companies together. It's calculated as a percentage savings of the targets
Sg&a. We'll get this off of our assumptions tab.Twenty-two 10 which is 10 percent in
2020 and then 2,570 in 2021. We then have to look at the costs related to the financing
of the transaction. This is going to be a combination of cost on debt that we take out as
well as interest that we forgo by using cash on hand. We'll calculate these as follows.
On the interest expense on the incremental debt, we'll take the amount of money that
we borrowed to fund the transaction. In this instance, 88,936. We'll multiply that by our
annual interest rate. In this instance is four percent. It's going to be that same amount in
17
both 2020 and 2021. We then look at what we call forgone interest income. We only
have forgone interest income in instances where we use cash on hand to finance a
portion of the transaction. Here we'll go to our uses table and see that we use 5,000
cash of target purchased. In our historical income statement, as well as in our projected
income statement, we have that cash still on the balance sheet earning interest. Since
we're using that to fund the transaction, we need to adjust for that. I'll take the 5,000
times in this instance, 0.5 percent. Since we don't earn my very much on cash in the
bank. That's forgone interest income. Again, this is interest income that was in our
historical financial statements, as well as our projected financial statements that we
have to adjust out because we're using cash to fund a portion of the transaction. Then
the last piece of the acquisition capital expense is going to be what we call amortization
of financing fees. When we borrow money from the bank, they charge us a fee. We pay
for it at the time of the transaction, but we amortize it over the life of the borrowings.
Here we'll go to our assumptions tab, and identify that we have 2,668 of amortized
financing fees, which is three percent of the amount of debt that we took out. We
amortize that over a five-year period, or 534 each year both in 2020 and 2021. The last
piece of our transaction adjustments are going to be what we call incremental
amortization of transaction intangibles. If we go back to our assumptions tab, up to the
top right, will see that we calculate our intangible asset amortization. We start with our
purchase price of equity or 127,530, we subtract out our book value which we get from
the target's balance sheet and get excess purchase price of 97,530. We've identified
that 30 percent of those will be allocated to identifiable intangibles or 29,259. We'll
amortize those over their useful life, which is a blended number. But in this instance,
seven years, which will result in 4,180 of incremental annual amortization. If we go back
to our accretion dilution analysis we'll pull in that number 4,180 into each year and that's
a negative adjustmentOur total pre-tax adjustments are going to be, some of our
positive EBIT synergies, less the negatives of interest expense, forgone interest
income, amortization of financing fees, and incremental amortization of transaction
intangibles. This results in total negative pre-tax adjustments of 6,086 in 2020 and 5,726
in 2021. We then need to tax effect these. We're going to tax effect these by taking our
pre-tax adjustments times our tax rate. Our tax rate is going to be taken directly off of
our assumptions tab, which is the marginal tax rate of 25 percent.
18
You can see that we derive an income tax benefit of 1,521 in 2020 and 1,431 in 2021.
We sum up the total pre-tax adjustments and the tax benefit to get to a negative
adjustment to net income of 4,564 in 2020 and 4,294 in 2021. Now we'll calculate our
proforma combined results. We calculate net income, which is the sum of the 44,468,
the 6,540 and the negative 4,564 to get to 46,443. We do the same thing in 2021 by
taking 55,915, 8,640 and negative 4,294 to come up with proforma net income of
60,260 in 2021 and 46,443 in 2020. We then need to calculate our diluted shares
outstanding. We have 10,000 at the time of the transaction, or the buyer has 10,000
when they do the deal. But then we have to go to our sources and uses table and look
and see if we used any equity to finance a transaction. We'll pull up the assumptions tab
again. You'll see that we did issue 38,259 of equity. We have to calculate the number of
shares that we actually issue to arrive at a 38, 259 amount. The way that we do this is
we'll go back to our accretion dilution tab and we'll say, how much equity did we issue
divided by what is the price per share of the buyer at the time of the transaction in this
instance at $50 per share. That results in 765 shares issued. That's going to be the
same in each year. Then we've calculated a proforma EPS of $4.31 in 2020 and $5.60
in 2021. Then what we'll do is we'll compare that against the results that we had on a
standalone basis and ask ourselves that question, is it higher or lower? The 4.31 is
$0.13 lower than our 445. That shows that we have dilution in 2020 of three percent or
$0.13 per share. However, in the forward year 2021, the 560 is more than the 559. We
can conclude that in that year, the transaction is accretive or positive by 0.1 percent. We
can also go back and we can calculate what are the number of synergies that we would
need in order to break even or what we call a neutral accretion dilution. The model will
calculate that for you. It'll show you that it's 2,634 for 2020 and since it's a positive, we
19
wouldn't need to calculate that for 2021. This is how we go about calculating accretion
dilution and going through that process.
20
Once we've identified whether or not the transaction is accretive or dilutive, we now can
move to the balance sheet and make some transaction adjustments. Those transaction
adjustments are going to fit into three categories. First, accounting for the cash and debt
components of the financing. Second, recording the goodwill and the amortizable
intangibles. And then third, adjusting the equity for the transaction. First on the cash
side, remember that we used 5,000 of the target's cash to complete the financing and
so we just simply remove that or -5,000. Number two, we took out debt to fund a good
portion of the transaction. So we are going to bring debt under the balance sheet of 88,
936. And when we took out the debt we also incurred financing fees.
21
And we pay those fees at the time of the deal but we're going to capitalize them and
amortize them over the life of the loan.
The second thing that we're going to do is we're going to record the identifiable and
tangible assets as well as the goodwill. So we'll go back up to our assumptions analysis,
where we calculated the amount of the excess purchase price that we allocate to
identifiable and tangibles. Which in this instance is 30% or 29 to 59 and we recorded
22
that as an asset. And the remainder of that amount or 70% is going to be identified as
goodwill or 68 to 71. The last adjustments that we're going to make are going to be to
the equity line. First, we need to eliminate the targets book value at 30,000. Number
two, we're going to issue equity,To fund the transaction, here is 38 to 59.
And the third piece that flows through the equity component is the amount of the non
financing transaction expenses.
23
So if we go back into the cell, we're going to adjust out,

Go to our Assumptions tab, the 4,665 of total fees and we're going to deduct from that
the amount of amortizable financing fees that we capitalized. So that will be a direct
reduction to our equity balance.And when we do that, we come up with a balance sheet
that balances 353,198 both in assets and as well as liabilities and shareholder's equity.
24

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Investment Banking:M&A and initial Public Offerings

Professor Jim Bertram & Professor Rob Metzger

Module 3: Merger Consequences Analysis

Lesson 3-2: Building an Accretion/Dilution Model ...........................................................................6

Lesson 3-1: Merger Consequences Analysis

To be discussed in detail in a little while. We sum up all of these items on a pre-tax

Lesson 3-2: Building an Accretion/Dilution Model

Building an Accretion/Dilution Model Part 1

As a refresher, the merger consequences analysis measures the impact on earnings

So if we go back into the cell, we're going to adjust out,

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