Sample Merger Model Video – Advanced Purchase Price Allocation Transcript
In this lesson we’re going to move into the next stage of our merger model, which is looking at the purchase price allocation for the deal and some of the new items that get created in the pro forma balance sheet adjustments.
And just to review our motivation for going through this, why this particular schedule, which I have partially filled out here with all the different items we’re going to look at, just to review why this is such an important part of our merger model, you’ll recall from the fundamentals course and the merger models that we went through there, that when we buy a company it’s not quite as simple as just combining the balance sheets. Because if you look at Microsoft’s balance sheet right here – I’m just going to go to the buyer’s balance sheet down here–you see that of course right now, as of FY 2008, for example, your liability and shareholders’ equity balance matches the total number of assets, so their balance sheet is basically always in balance.
So you’d think that if we could just combine the buyer’s balance sheet, Microsoft’s assets and then their liabilities and shareholder’s equity with Yahoo’s balance sheet everything would be fine.
I’m going to go over to it right here in the operating model. Since Yahoo’s balance sheet is also always in balance, from FY ’06 all the way through FY2012, the forward estimates here, you’d think that we could get away with just combining these balance sheets, but the reason we can’t do that is because it’s not quite that simple. What actually happens in most types of M&A transactions, 99% of M&A deals that are using standard accounting policy, is that the target’s shareholders’ equity number here gets wiped out completely, and so what ends up happening is that Microsoft is effectively paying $30, $40, $50 billion for this company and they’re outlying all that in cash. They might be taking on new debt or issuing stocks, so they’re effectively paying for it in some way, but what happens is that they don’t get all the assets of the company.
What actually happens is that the shareholders’ equity from Yahoo gets wiped out completely.
And so what ends up happening is that we get an imbalance, and our assets no longer equal our liabilities and shareholders’ equity because the shareholders’ equity has been wiped out.
So that’s why we need to make these adjustments. That’s why we need to create new items on here like goodwill and intangibles that help us plug the balance sheet and make sure everything still balances after the transaction is completed.
And you see that on Yahoo’s balance sheet currently they actually already have goodwill and net intangible assets here and these are created for the same exact reasons. They acquired other companies and they needed to plug their balance sheet to make sure it’d still balance. The goodwill and the intangible assets account for the fact that shareholders’ equity is being wiped out and for the fact that what they’re actually paying for a company is usually more than what its assets and liabilities, its balance sheet, suggests that it’s worth.
And if you look at the numbers here, you can see that just by looking at Yahoo’s total number of assets around $11 or $12 billion in ’08, ’09, going to $13, $14 billion in later years as well as its total number of liabilities here which we’ve not calculated explicitly, but we can see that its liabilities are in the $2, $3, $4 billion range, somewhere around in there.
Remember, the shareholders’ equity gets wiped out. You see that basically in this deal we’re going to get a huge surplus because we’re paying around $40 billion for Yahoo, but the total numbers of assets they have is only around $12 billion. The total number of liabilities is only around $2 or $3 billion, so what’s going to happen here is that we have a huge excess of the purchase price over the fair market value of Yahoo according to its balance sheet.
So what we’re going to have to do to account for that is to create a lot of these new items like goodwill and intangibles. We’re also going to be adjusting the values of some of Yahoo’s assets here. So that’s our motivation for going through and creating this schedule.
Go back to this purchase price allocation page now. And I’ll also warn you in advance that this does get tricky. This is definitely one of the trickier parts of putting together a merger model. The rest of it, combining income statements, balance sheets, cash flow statements, things like that, and even setting up some of our scenarios up here, those are okay.
Those do get into some complexity, but with the purchase price allocation we’re going to be dealing with a lot of tax treatment. We’re going to be getting into the details of how an asset purchase versus a stock purchase affects some of these items. So, this does get tricky. This is one of the most difficult parts of putting together a more advanced merger model, but it’s something that comes up all the time in investment banking and you don’t necessarily look at a schedule this complex all the time.
This one is actually more complex than a lot of the merger models that I’ve actually seen in banking and private equity, but it’s good to understand everything that’s on here because if you can get this then you’ll be able to understand anything that you actually do when you start working in banking or private equity.
Now to start with, what I’m going to do here is enter our equity purchase price, and remember, the motivation for doing this is we want to look at how much Microsoft is actually paying for Yahoo and then figure out what their book value is which is basically just the shareholders’ equity number, and then we want to use that to figure out how much of a premium over the book value of Yahoo that they’re actually paying and how much needs to be plugged in on the balance sheet based on that.
So for the equity purchase price, I am going to link up here to our selected scenario, the $42,882 million number in this case. I’m linking to it here under the Selected Scenario column rather than the one of the hard-coded scenario columns because we want this to be able to change if we select a different scenario in this model. I’ll just anchor this as well.
Now for the rest of these items, seller book value and write-off of existing goodwill. So we start running into problems here and you see some of the other items as well. We need to look at PP&E, intangibles, and the problem, if you recall–I’m going to go down to the balance sheet area right now. So we have, so I’ve entered the combined income statement and transaction adjustments up here, we’re going to be filling this in later. I’ve just filled it in for your reference for now so you can see what we’re doing. We’re assuming the transaction closes in FY2009, mid-FY2009 to correspond with Microsoft’s fiscal year ’09, and on the balance sheet what we’re going to be doing is we’re going to be looking at the pre-transaction balance sheet of the buyer and the seller.
So we’re going to have Microsoft’s balance sheet here and then Yahoo’s balance sheet right here. Then we’re going to make some adjustments to it, debits and credits. We’ll be using that to get to a combined balance sheet right here for ’09 and then projecting that forward for 2010 through 2012.
But to get started with this analysis and to figure out what the combined balance sheet for the company’s going to look like and what all of our purchase price allocation has to correspond to, we need to start by filling in these actual items for Microsoft and Yahoo just before the transaction. Now, for Microsoft this is very easy because we can just link back to the Microsoft financials right here and since their fiscal year ends in June 2009 we can just directly link in the ’09 numbers right here.
So I’m going to do that right now. So, cash and cash equivalents, short-term investments from ’09, accounts receivable and these links are all in green because these are direct links to another sheet in our Excel model here. Deferred income taxes, this is a deferred income tax asset in this case.
And then inventory. Then other current assets. So those are Microsoft’s current assets. So that was easy.
But what happens now is we need to get Yahoo’s numbers and you’ll recall that now we’re going to run into a problem because in our inputs page we know that Yahoo’s fiscal year ends December 31st, whereas Microsoft’s ends June 30th. So what we’re going to have to do here is make some adjustments to Yahoo’s numbers to ensure that our balance sheet flows in correct. Now in an ideal scenario what we would do here is we would have a quarterly build for Yahoo, so we list out their financials by quarter for each of these five, six or seven years.
So if we were trying to be truly scientifically detailed here, that’s what we would do. In this case, what I’m going to do instead of trying to do a quarterly model here which is going to be extremely time-consuming and add almost nothing of value here, it’s just going to complicate things and create the need to create all these additional columns without really teaching you anything new. It’s just going to be grunt work.
What I’m going to do instead is just average Yahoo’s ’08 and ’09 numbers to get to a June 30th, ’09, balance sheet for Yahoo. And the reason this works is because fiscal year ’08 for Yahoo ends December 31st. Fiscal year ’09 ends December 31st. So if we average them basically we’re going to get the last half of the ’08 numbers and then the first half of the ’09 numbers, which corresponds exactly to Microsoft’s fiscal year.
So we’re effectively calendarizing Yahoo’s balance sheet here, not really calendarizing it, but sort of adjusting it to match what Microsoft’s fiscal year ends and we’re assuming that each of these items is just going to be the average of the ’08 and the ’09 numbers.
So I’m going to get started with this in the merger model tab right here. So I’ll start with cash and cash equivalents. Go back to Yahoo’s operating model right here. So I’m just going to take these two and then divide by two. Short-term investments I can actually just copy this formula down. Accounts receivable is the next thing on there.
So I’m going to copy this formula down once again with ‘Alt + E + S + F’. Now, deferred income taxes, they don’t have any deferred income taxes under their current assets nor do they have any inventory, so I’m going to enter zero for these numbers for Yahoo. Then for other current assets, I’m going to go back to Yahoo’s operating model right here, and I’m going to count prepaid expenses as the other current assets category. So I’m going to take the ’08 number plus the ’09 number and then divide by two here. So we’re going to add these up and this takes us to the total current assets for Microsoft and for Yahoo right here.
Now I’m not going to go through every single calculation here because it’s very tedious. What I’m going to do instead is actually make the rest of these calculations by directly linking in for Microsoft right here and then by averaging Yahoo’s numbers or by writing a zero if necessary if there’s an item where Microsoft doesn’t have it or if Yahoo doesn’t have it.
So, what you should do now, if you want to get some practice doing this, is you should go in and link in the rest of Microsoft’s items and then Yahoo’s items and be sure to average each one and be sure to either put zero if it doesn’t exist or to actually take it into account if it does exist on the Microsoft or Yahoo balance sheets respectively.
So you can pause this video right now and then come back once you’ve done that and then I’m going to resume this by showing you what the completed pre-transaction balance sheets for Microsoft and for Yahoo look like that so that you can check yours against my work and make sure that everything matches up.
Okay. So now hopefully you have Microsoft and Yahoo’s separate balance sheets from right before the transaction closes here. Microsoft’s is from their FY2009. Yahoo’s is the average of their ’08 and ’09 balance sheets.
A couple things to point out here. Yahoo doesn’t have any deferred income taxes and inventory, so those are both zero. We already went over that. There are not capitalized financing fees yet because this is going to be something that will be created in the transaction depending on whether or not Microsoft raises debt.
Net PP&E just flows in, equity and other investments, goodwill and intangibles all flow in directly.
Yahoo does not have any deferred income tax assets. This is actually not 100% true. We’ve just sort of listed their deferred income tax assets under other long-term assets here. It’s not a huge deal, because you’ll see with the way we allocate purchase price and do that calculation that we don’t really need to have deferred income tax assets. We can also work with this on the liabilities side and make sure everything works out like that.
Other long–term assets, I’ve just combined two items here. If you look back at Yahoo’s balance sheet, I’ve combined the long-term debt investments and then the other long-term assets line item here into one.
For current liabilities, this is all pretty straightforward. Accounts payable, accrued expenses all flow in. Yahoo has no explicit deferred income taxes spelled out under current liabilities. Short-term deferred revenue just flows in and then it has nothing for other.
Refinanced debt, term loan A and high yield debt are all zero because these are created or paid off in the transaction. For the debt refinanced number here, you’ll recall that we’re assuming zero for basically all the scenarios here and so what we would do here is if this were not zero, if this were some other number then we would actually take into account Yahoo’s existing balance sheet debt here instead, and we would link the debt refinanced calculation to that rather than just having the zero number here.
What would happen on this balance sheet when we go to combine it is that whatever debt they have that actually gets refinanced or paid off would just go to zero and then we would record some kind of entry for that. We wouldn’t necessarily do it in a separate line item like this. In all likelihood we would probably have an item on Yahoo’s balance sheet around the separated balance sheets here called debt or short–term debt or debt paid off in transactions, something like that, but in this case, again, it’s zero, so we’re just going with this assumption for now.
Term loan A and high–yield debt here, these are both going to be created in the transaction should Microsoft use debt, so these are all zero.
Long-term revenue just flows in directly. Deferred tax liabilities, other long-term liabilities all flow in directly.
Minority interests, so this one we’ll get into later. For now we’re going to be assuming that Microsoft just assumes Yahoo’s existing minority interests so they don’t have to pay them off or anything. For shareholders’ equity again, just pretty much flows in directly. So, your balance sheet should come out to $11,992 million for assets for Yahoo and then $11,992 million for liabilities and shareholders’ equity.
It doesn’t quite balance here with our balance check, but it comes out to ($0) which actually means there’s some kind of decimal point that’s off, but this is close enough. This is actually a very common scenario with merger models and anything like an LBO model where you have complex balance sheet adjustments. In a lot of cases, there will be some kind of decimal that doesn’t exactly match because of rounding errors, so don’t freak out if you see this. Keep in mind that as long as it’s a zero-ish number then you’re probably fine.
It’s probably just a matter of rounding and something there being off.
So with that in place, now let’s go to the top and start filling in our purchase price allocation and the pro forma balance sheet adjustments. So first thing we’re going to do here is subtract the seller’s book value, so Yahoo’s book value. In this case the book value is just referring to assets minus liabilities so it’s really just Yahoo’s shareholders’ equity, so I’m just going to fill in that. And remember, the reason we’re doing this is we’re assuming in this transaction that Yahoo’s shareholders’ equity gets wiped out completely.
The other thing we want to do here is also write-off Yahoo’s existing goodwill in this transaction. So I’m going to go down and link in their goodwill. And the reason we’re doing this, this is just kind of a standard thing that you do in any type of M&A deal like this, whether it’s an asset purchase or stock purchase. You typically assume that the seller’s goodwill is completely written off and it’s replaced with new goodwill.
The reason you’re doing this because you don’t want to be double counting it. So if we were to not take this into account, for example, then we would be assuming that the allocable purchase premium is lower than it should be.
We want to take this into account to reflect the fact that the existing goodwill on Yahoo’s balance sheet already represents some type of premium to its value according to the balance sheet. So I’m going to take the equity purchase price, subtract seller book value and then add in the write-off of the goodwill here. So you have about $36 billion purchase premium to allocate to PP&E and intangible assets.
Now, to determine how much goodwill actually gets created here, we need to take into account a couple different calculations. So I’m going to start with the write-up of PP&E, plants, property and equipment here. The reason we’re doing this is because typically what happens is in a transaction like this, usually on the seller’s balance sheet, Yahoo’s balance sheet, and also on Microsoft’s balance sheet, but we’re not doing it here. We’re only looking at the seller’s balance sheet. What happens is that the market value of PP&E, and then the book value, what’s on their balance sheet, tends to diverge over time if it’s been around long enough.
So in this case, this net PP&E number on Yahoo’s balance sheet is likely lower than what its market value is because generally land gets more valuable over time and buildings do depreciate, but usually in a purchase like this you assume that there’s a write-up to the PP&E. So we’re reflecting the fact that over time the book value and the actual market value of PP&E have drifted apart, and we’re going to fix that by assuming a write-up to Yahoo’s net PP&E value here.
And there are a number of different ways you can do this. To actually get the real numbers, typically you would speak with accountants or you’d go through them, and they would give you an estimate. In this case, we’re just going to assume 10% here.
Now you don’t have to assume this as a percentage of the actual PP&E number. Sometimes you might just assume a percentage of the allocable purchase premium goes to the PP&E write-up. It doesn’t really matter as long as you’re consistent and as long as you make sure that everything you’re allocating here is less than the allocable purchase premium. So, in other words, as long as you make sure that all these items actually add up to this number, the $37 billion, then you can really do whatever you want here.
Now for the PP&E write-up amount I’m going to take this 10% number and then multiply by Yahoo’s existing PP&E, so the $1.8 billion.
I’m going to just anchor both of these to make sure there’s no shifting around if we copy this elsewhere. So we have a PP&E write-up of around $180 million.
Now, for the depreciation period, for the book years and the tax years here, this is referring to something that’s a bit subtle. I’m going to go back to Yahoo’s operating model here. I’m going to go down to their PP&E schedule so we can take a look at what we did before here.
So it looks like the useful lives of these things, it varies, between 5 and 10 years. Buildings have 25 years, but it looks like for the most part these are between 5 and 10 years for equipment, leasehold improvements, furniture, those types of things. And what this is really telling us is that in terms of our accounting, our book value here, it tells us that we should probably be assuming something in this range of 5 to 10 years for the book value for the depreciation of these new assets.
So I’m going to go back to merger model page right here. So for the depreciation period for book purposes here I’m just going to enter eight because it’s sort of in the middle of this range. Again, for something like this, truthfully. In a real deal, we would speak with accountants, and they would give us this information. We would just plug it into our model.
Now, the depreciation years for tax purposes here, so, what this is referring to is the fact that for book purposes, for accounting purposes, typically we record one value for depreciation, but then for tax purposes we actually look at a different schedule, and we have both a tax value and a book value for pretty much all the items on the balance sheet. Now it doesn’t actually matter that much for most of them, but for the items on here, so the assets, intangible assets, goodwill, things like that, the tax value versus the book value actually matter quite a bit.
So what we’re going to say in this case for the depreciation years for tax purposes is we’re just going to say six years. And the reason I’m doing this is because often companies will depreciate assets faster for tax purposes than they will for book purposes for obvious reasons.
If they can depreciate it more quickly for tax purposes, then that means they have a higher tax deduction from a faster depreciation. So that’s sort of why they do it. There are a number of ways you could do this. You could assume something different from straight line depreciation as well (i.e. an accelerated depreciation method such as sum-of-years-digit or double-declining balance for instance), but this is simply the assumption that we’re going to go with for now.
I’ll footnote this by saying companies often assume faster depreciation for tax purposes.
Now, for the yearly depreciation expense here, we have the book value and the tax value. The reason we have this split is because, again, we have different depreciation periods for both of them, and so we’re going to have different yearly expenses for the book value versus the tax value.
Now for the book value it doesn’t matter what type of transaction we have, regardless of whether it’s an asset purchase or a stock purchase or 338(h)10 election up here. For accounting values, these are all the same.
So we’re not going to link this to our transaction type at all. It’s always going to be basically the $181 million PP&E write-up amount divided by the eight years, the book period right here.
So we’ll take the $181 million and just divide by this “8” number. So we get $23 million per year in depreciation for book purposes.
Now, for tax purposes, this is where it starts to get tricky, but basically what happens here is that in an asset purchase the buyer assumes a step-up in the tax basis on all these assets.
So, in other words, the buyer has both a tax balance sheet and then the GAAP balance sheet. The GAAP balance sheet is simply what you see down here right below, what’s actually recorded in their filings and on their books. So this is what you see.
And on this version of the balance sheet, the book (i.e. GAAP) version of the balance sheet, you always record the asset step-ups, step-downs, the write-up and the write-downs to the existing book value on here. So you’re always going to record those numbers.
But on the tax version of the balance sheet, which I have not laid out here because it doesn’t really matter except for a few items, on the tax version of the balance sheet it works differently depending on what type of transaction you have.
Now for an asset purchase or a 338(h)10 election that’s treated like an asset purchase for accounting purposes, what happens is that the depreciation from this new PP&E write-ups, the newly-created depreciation from the write-up of this PP&E is tax deductible.
So when we look at our pre-tax income and then get to our cash taxes paid, how much the company’s actually paying out in taxes, then this number’s going to be if we have an asset purchase or a 338(h)10 election. And the reason that happens in those deals and why it doesn’t happen in a stock purchase is because in an asset purchase this write-up is actually recorded for tax purposes, whereas in a stock purchase the buyer assumes the seller’s existing taxes. And so even if there’s a step-up like this, a write-up amount then the buyer keeps going with the seller’s original tax basis (i.e. ‘carryover’ or ‘rollover’ of seller’s existing tax basis in asset). So they’re, so this is not recognized for tax purposes in a stock deal.
Again, the rules here do get a bit confusing and I don’t really have a concrete reason for why this happens. These are just kind of the rules. This is how they’ve always done it, and this is just how it works in an accounting perspective.
So what I’m going to do here for the yearly depreciation expense on a tax basis is I’m going to link to the transaction type here. So if this is an asset deal or a 338(h)10 election then we’re going to take the PP&E write-up amount and divide by the number of tax years here. Otherwise, if it’s a stock purchase then we’re going to assume zero.
And this pattern will be repeating itself throughout the rest of the schedule for purchase price allocation and pro-form balance sheet adjustments so it’s a good idea to get this in your head now because you’ll see it cropping up here in goodwill and also with the intangible asset allocation.
So for the write-up of PP&E, again, remember that we’re looking at book values for this goodwill created here. So we’re not going to worry about the difference between an asset purchase and a stock purchase for adding in all these items. The asset purchase versus the stock purchase only matters for the tax purposes.
So we’re going to look at a tax schedule later on, but keep in mind that for book purposes you can do this exactly the same way regardless of whether it’s an asset deal or it’s a stock deal.
So for the write-up of the PP&E we’re going to link in this $181 million number right here. Now the next thing I want to do is look at the intangible asset write-up here.
So I’m going to link in this excess purchase price to allocate. This is just referring to the allocable purchase premium. Now you remember before that I said there are a couple different ways you could determine the PP&E write-up amount, the intangible asset write-up amount. Now before when we looked at the PP&E amount I assumed a write-up as a percentage of Yahoo’s base PP&E number.
In this case we’re going to do something different. We’re going to assume that a certain percentage of this purchase price gets allocated to intangibles. And what’s really going on here if you look at Yahoo’s balance sheet is that in the course of this purchase they’ve probably accrued additional intangible assets over time, but they haven’t been properly recorded on the balance sheet because the balance sheet just reflects the book value of what they have. It doesn’t reflect the actual fair market value.
So what we’re doing in a transaction like this, we always need to write up the intangible assets to the actual fair market value.
Now to actually do this, to make this calculation for real, if you want to be perfectly precise you would typically call in an accountant or auditor or someone else such as a business appraiser who would actually go in and look at the individual assets, measure them and get very technical. Usually in a merger model though you just make a very simple assumption here, we’re going to assume a percentage allocated to intangibles or a percentage write-up over the original intangible amount. So in this case I’m going to say 20% of the excess purchase premim gets allocated to intangibles, which means that when we multiply the 20% times the $37 billion number here, we have an intangibles write-up of around $7.5 billion here.
So what this means is when we combine our balance sheets, we’re going to be adjusting Yahoo’s net intangibles assets item here, the $295 million, and actually adding around $7 billion to it. And this’ll show up on the combined balance sheet, so effectively Microsoft is getting this huge new $7 or $8 billion intangible asset.
Similarly, for the net PP&E what we’re going to be doing is adding the buyer’s net PP&E to the seller’s, Yahoo’s, and then also factoring in the additional PP&E write-up that we had over Yahoo’s actual amount right here.
Now for the amortization period for intangible assets here, once again we have this split between book and tax and it’s kind of the same story as we had with deprecation and PP&E above where for book purposes, regardless of the deal, regardless of whether it’s a stock deal, an asset deal or a 338(h)10 election, for book purposes we treat it the same way.
For tax purposes, that’s where it gets tricky and that’s where we have to do something different depending on the type of transaction it is.
For book purposes, usually we make an assumption of around five years for the intangibles amortization right here. I’m going to go with five. For tax purposes, there’s a rule if you look in the tax code for transactions, which I’m not going to get into here because it’s quite boring and because you really don’t want to go through all the detail, I’m just going to tell you what the rule is. The rule is that for tax purposes you amortize goodwill and other intangible assets over the course of 15 years in a transaction like this, so we’re going to enter 15 here.
I’m just going to footnote this and say “per revised tax code for transactions.”
Now for the yearly amortization expense. For book purposes we’re just going to take the intangible write-up amount and then divide by the amortization period for the book number here. For the tax expense here, so how much we can actually amortize and deduct for tax purposes, this one actually amortizes more slowly than we saw with the asset write-up above. So this one we had an accelerated depreciation schedule for tax purposes. For the intangible write-up here we have a slower amortization schedule for tax purposes.
So once again I’m going to link to the transaction type, this TYPE custom named variable right here. I’m going to say if it equals zero, so if it’s an asset deal or a 338(h)10 election, then we’re going to take the intangibles write-up amount right here and then divide by the period of 15 years. So otherwise if it’s a stock deal then we’re going to say zero.
So that’s how we calculate these amortization and depreciation expenses depending on whether it’s a stock deal, an asset deal, and for book (i.e. GAAP) and tax purposes.
Okay. So now that we have all that in place we can enter our new deferred tax liability that’s being created in this transaction here. Now when we went through the intangible asset write-up and the fixed asset write-up up here, we said how that in an asset purchase these new charges, these new depreciation expense for the asset write-up and then the new amortization expense for the intangible asset write-up are both tax deductible in an asset deal, but not tax deductible in a stock deal.
So if you think about what this means for our deferred tax liability, so what’s really happening here is that effectively in an asset purchase transaction here or a 338(h)10 transaction here, the combined company here, their tax rate will be effected by the presence of these new items, but in a stock purchase it won’t be.
So what ends up happening instead is that in a stock purchase we have to record these gains, the intangible write-up amount and then the fixed asset PP&E write-up amount here, we have to record these and assume that they’re going to be paying taxes on these at some point in the future.
So what we’re going to do for the deferred tax liability formula, the rule for this one is that, again, in an asset purchase or 338(h)10 election, this is zero, because we don’t have any deferred tax liability created in those, because in those scenario the buyer’s tax basis in these newly acquired assets on its tax books matches what’s on the GAAP books and so there’s no difference between what they owe in cash taxes and what they owe in book taxes. But for a stock purchase there is that difference and so we’re going to create a deferred tax liability to account for that.
So the formula for this one, we’re going to go back to the transaction type here. We’re going to say if TYPE named variable equals zero, so if it’s an asset purchase or 338(h)10 election deal, we’re going to say that we have zero for the deferred tax liability, but if it’s a stock purchase we’re going to say that the deferred tax liability is equal to the intangible write-up amount plus the PP&E write-up amount all multiplied by the buyer’s effective tax rate.
So effectively it becomes the total write-up amount here for fixed and intangible assets times the buyer’s tax rate, and this is because in the long-term they’re going to have to be paying taxes based on the buyer’s tax rate because we’re dealing with the combined company here.
So that’s what our new deferred tax liability will be. It comes out to $2.2 or $2.3 billion here.
So let’s start adding in some of these numbers now. So the write-up of intangibles here, which is the $7.5 billion number, then we have the write-off of seller’s existing deferred tax liability.
So, another rule for the purchase price allocation and pro-form balance adjustments here is that with any type of M&A deal we are required to write-down the entire value, that is write-off the entire value, of the seller’s existing deferred tax liabilities.
So in this case we’re going to go down to Yahoo’s balance sheet, and we have these deferred tax liabilities right here, that’s the only liabilities related item for deferred taxes.
So we’re just going to take the $261 million right here and assume that this entire value is written down to zero in this transaction.
Now we also may have to take into account the write-down on their deferred tax assets. Now, in this case, it looks like Yahoo doesn’t have any, but remember, this is not completely accurate. They actually do have net operating losses which is really what deferred tax assets are referring to. They’re really net operating losses, and they’re just recorded under other long-term assets here.
Now the actual calculation for this gets tricky and it depends on their NOLs, the purchase price, the tax schedule, so for right now I’m going to leave this one blank and I’m going to footnote it and say that we’re filling this one in later based on the tax schedule. So I’m just going to change this to blue for now.
Footnote it and say “we’ll fill in later based on tax NOL schedule”. So you have that. And then we need to take into account our new deferred tax liability right here. So let’s add up all these items to see how much new goodwill actually gets created in this deal.
So take the purchase premium minus the write-up of PP&E, minus the write-up of intangibles. Subtract the write-off of deferred tax liabilities. Add in the write-down of existing deferred tax assets and then add in the new deferred tax liability. So we get $31 billion of goodwill being created.
Now if you’re wondering why we subtract some of these items and add the others, if you think about the way the balance sheet works and the fact that goodwill represents a plug, this becomes pretty clear. So on the assets side of the balance sheet we have the PP&E and intangibles, and if you think about what’s going on here, if we have additional PP&E or additional intangibles being created here, then that means we need less in the way of goodwill because those are both on the assets side of the balance sheet down here.
And so when we go in to fill in and plug in this transaction and account for the fact that all the shareholders’ equity has been wiped out, if we have a greater number for the PP&E and for the intangible assets then that means we can have a lower number for our goodwill because these are all on the assets side of the balance sheet.
But for the other items on here, so the write-off of existing deferred tax liabilities, we’re subtracting this one because it also means we need less goodwill because our liabilities and shareholders’ equities side of the balance sheet is going to go down.
So if that side goes down then we need less of a plug, less goodwill here to fill in everything and to take into account premium paid over Yahoo’s assets and liability values here.
Likewise, for the write-down of existing deferred tax assets here, since this is a write-down, we’re decreasing the total number of assets on our combined balance sheet and so that means that we need more goodwill, more of a plug to fill this in.
Deferred tax liability, so we’re adding this one because, again, we have an increase to our liabilities and shareholders’ equity side on the balance sheet and so we need more goodwill, we need more of a plug to fill this in. And so that’s kind of the rationale for how we get to goodwill here.
Now you used to actually do more than this. Under the old accounting rules which were revised in 2008, you used to actually take into account more and you used to also figure in the transaction fees and the financing fees into this calculation, but we no longer do that. The goodwill allocation is now based solely on the equity purchase price of the company.
So keep that in mind. In some older models you may still see people doing this, but it’s technically wrong now. You’re supposed to only use the equity purchase price and the other items that we went through here. Basically anything that is directly coming from the balance sheet that does not relate to transaction fees or anything like that.
Now to fill in the period here for the goodwill for the book and tax purposes. So, for book purposes we’re going to say ‘N/A’ here because goodwill is never amortized, regardless of the transaction type.
I’m just going to footnote this. “Goodwill never amortized for book accounting purposes.” And instead of amortizing goodwill what we do here is just check it for impairment each year, but we’re not going to build that into the model because that’s a one-time event and because we need accountants or auditors or business appraisers to fill in that kind of information.
For the tax years here, as with intangible assets, the rule for acquisitions like this is that intangibles and goodwill are both amortized over 15 years, so we’re going to enter the 15.
And then for the yearly goodwill expense here, so for the book value we’re going to enter zero because goodwill is never amortized for book purposes. Now for the tax expense, again, the rule is similar to what we have for intangible asset write-up and for the fixed asset write-up here where if it’s an asset deal then we do amortize the goodwill, so we have a yearly expense, but if it’s a stock deal then we don’t do that. We have zero for our goodwill amortization expense for tax purposes if the transaction is structured as a stock deal. And those are just the rules of accounting.
This is why buyers usually prefer an asset purchase because they get all these tax deductions that you see right here, whereas sellers will almost always prefer a stock purchase because they get to get rid of all their liabilities, the ones they don’t want, and because tax treatment is more favorable for them. But you see right here how we’re going to get into a lot of tax deductions for the buyer and you see exactly why they would prefer an asset purchase rather than a purchase of stock in most cases.
So for this one the formula is going to be if TYPE named variable equals zero, so if this is an asset purchase, then what we want to do is take the goodwill created and then divide by the goodwill period of years here. Otherwise, if it’s a stock purchase we want to set this to zero.
So right now we’ve set this to a stock purchase above in the transaction type so all these values are coming out to zero.
Now the last thing we want to do on here is account for the deferred revenue write-down.
Now the reason we need to take this into account this is not really a balance sheet adjustment per se because it actually happens after the transaction, so it happens in usually the first, second or third year of the transaction after it’s closed, but I’m still putting it in here because it relates to balance sheet items.
The reason we have to write-down deferred revenue in a transaction like this is because in a lot of cases, depending on the way the company has collected cash from its customers and then recorded it or deferred it on its balance sheet, we could end up in a situation where we double-count the deferred revenue.
So, for example, if it’s deferred revenue that’s collecting for a service and the service has already been performed but they still have it on their balance sheet as deferred revenue, then we could end up in a situation where the buyer gets it and now it records the deferred revenue as well, but it’s also recording the actual revenue from the seller for performing that service. So we end up effectively double counting that revenue.
Now the details here get tricky and again, for this one, investment bankers never actually estimate this. You would call in accountants to actually look at the deferred revenue balances, to look at all the detail behind their balance sheets and when they recorded what to get an estimate here. What we’re going to do for now though is just assume a certain percentage of this is written down over a certain number of years.
So for the seller deferred revenue, I’m going to go down to Yahoo’s balance sheet once again and I’m just going to assume there’s short-term deferred revenue for this one. The reason is because we actually have two balances here, long-term and short-term deferred revenue, but the majority is under short-term deferred revenue and so we’re just going to pay attention to that one and assume that the entire write-down occurs there.
In reality, you might have it under both short-term and long-term here, but it’s more likely to get the double counting phenomenon of recording too much revenue with the short-term deferred revenue.
For the percent fair value, again, you would really need to get accountants’ input for this one, but we’re going to go with 50%. So we’re essentially assuming that 50% of this balance is what the real fair value should be, so we’re assuming that about half of this would be potentially double counted in the transaction unless we actually wrote it down over the course of some time here.
So we’re going to multiply the percent fair value times the seller’s deferred revenue, and then for the write-down period here, actually, for deferred revenue write-downs the standard is to assume that everything goes away within the course of a year, so we’re just going to say one year for the write-down period. Again, this does depend on the input of accountants and auditors and sometimes you go beyond this, but usually in most merger models, most advanced complex merger models like the one we’re creating here, you make an assumption of one year for the write-down period for deferred revenue.
And then finally, for the yearly deferred revenue expense what we’re going to do here is just take the deferred revenue write-down and then divide by the number of years.
This one does not depend on whether it’s a stock deal or asset deal or anything like that or a 338(h)10 election, you always have a deferred revenue write-down and it’s always the same amount regardless of the transaction structure here. So that’s an overview of how we set up our pro-form of balance sheet and how we allocate our purchase price to establish how much goodwill is actually created in this transaction.
Now you’ll, if you’ll remember the balance sheet adjustments that we went through in the goodwill and intangibles that we looked at for our more simplified model, you’ll see that there’s a lot more complexity here. So we have asset write-ups, intangibles, deferred tax liabilities and assets that we have to take into account. We haven’t even taken some of those into account yet, but actually the basic idea is the same. Goodwill is still created when we pay more for a company than what its balance sheet tells us it’s really worth.
So actually the basic concept here is not too much different. Really the complexity comes from the fact that we have multiple new items being created and from the fact that depending on whether it’s a stock deal or asset deal or 338(h)10 deal, we have different treatment for the books and for the taxes for this transaction.
If we wanted to test out some of what we did we could change this transaction type here to an asset or 338(h)10 deal. The accounting treatment for both those is the same, which is why I’ve combined them to the same switch up there.
And now we see that as expected just to check our work we have a yearly depreciation expense for our asset write-up, we have the amortization expense for tax purposes, for the intangible asset write-up. We have no deferred tax liability because the buyer is getting the stepped-up tax basis here, so we don’t have a liability being created, and then we have a tax deductible yearly goodwill expense. Deferred revenue stays exactly the same. So that’s how we know that our model is flowing through correctly here. I’m going to go back and change it to a stock deal for now.
So that’s an overview of how we go through and allocate our purchase price and how we start making some of our balance sheet adjustments. In the next lesson we’re actually going to combine the balance sheets of Yahoo and Microsoft. We’re going to take into account all these adjustments, and you’ll see in a real complex scenario like this how exactly you add in all the different items, which items you subtract, and how you actually take into account all these adjustments for the pro forma combined balance sheet.
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