Merger Model Interview Questions: What to Expect (18:38)

Question #1: The Basic Rules

“A company with a P / E multiple of 25x acquires another company for a purchase P / E multiple of 15x. Will the deal be accretive or dilutive?”

ANSWER: You can’t tell unless it’s a 100% Stock deal. If it is, it will be accretive because the Cost of Acquisition is 1 / 25, or 4%, and the Seller’s Yield is 1 / 15, or 6.7%. Since the Seller’s Yield is higher, it will be accretive.

For Cash and Debt deals, or deals with a mix of all three, you’d calculate the Weighted Cost of Acquisition by using Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate) * % Cash + Interest Rate on Debt * (1 – Buyer’s Tax Rate) * % Debt + 1 / (Buyer’s P / E Multiple) * % Stock and compare that to the Seller’s Yield.

Question #2: With Real Numbers

“Let’s say it is a 100% Stock deal. The Buyer has 10 shares at a share price of $25.00, and its Net Income is $10. It acquires the Seller for a Purchase Equity Value of $150. The Seller has a Net Income of $10 as well. Assume the same tax rates for both companies. How accretive is this deal?”

ANSWER: The buyer’s EPS is $10 / 10 = $1.00. It must issue 6 additional shares to do the deal, so the Combined Share Count is 10 + 6 = 16.

Since both companies have the same tax rate and since no Cash or Debt is used, Combined Net Income = $10 + $10 = $20, and Combined EPS = $20 / 16 = $1.25, so the deal is 25% accretive.

Question #3: Equity Value, Enterprise Value, and Valuation Multiples

“What are the Combined Equity Value and Enterprise Value in this same deal? Assume that Equity Value = Enterprise Value for both the Buyer and Seller.”

ANSWER: Combined Equity Value = Buyer’s Equity Value + Value of Stock Issued in the Deal = $250 + $150 = $400.

Combined Enterprise Value = Buyer’s Enterprise Value + Purchase Enterprise Value of Seller = $250 + $150 = $400.

The Combined EV / EBITDA multiple won’t be affected by the mix of Cash, Stock, and Debt, but the P / E multiple will be. It’s 20x here ($400 / $20), but it will change for non-100%-Stock deals.

Question #4: Ranges for the Multiples

“Without doing any math, what ranges would you expect for the Combined EV / EBITDA and P / E multiples, and why?”

ANSWER: They should be somewhere in between the Buyer’s multiples and the Seller’s purchase multiples. It’s almost never a simple average because of the relative sizes of the Buyer and Seller – and for P / E, the purchase method also plays a role.

Question #5: What if the Buyer is Twice as Big?

“What happens if the Buyer is twice as big, i.e. it has an Equity Value of $500 and Net Income of $20?”

ANSWER: The deal becomes *less* accretive because the company making it accretive, the Seller, now has a lower weighting. The Buyer was previously $250 / $400 of the total, but is now only $500 / $650, which is ~63% vs. ~77%, so we’d expect accretion to fall by 10-15%, which it does.

The Combined Multiples will all be closer to the Buyer’s multiples now as well.

Recap, Summary, and Key Principles

Principle #1: If the Seller’s Yield is above the Weighted Cost of Acquisition, it’s accretive; dilutive if the opposite.

Principle #2: Combined Equity Value = Buyer’s Equity Value + Value of Stock Issued in the Deal.

Principle #3: Combined Enterprise Value = Buyer’s Enterprise Value + Purchase Enterprise Value of Seller.

Principle #4: The Combined P / E Multiple is affected by the Cash / Debt / Stock mix, but the Combined EV / EBITDA Multiple is not.

Principle #5: The Combined Multiples will be in between the Buyer’s multiples and the Seller’s purchase multiples – exact numbers depend on sizes of the Buyer and Seller.