Merger Model: Cash, Debt, and Stock Mix (19:58)

How Do You Determine the Cash / Stock / Debt Mix in an M&A Deal?

Very common interview question, and you also need to know it for what you do on the job.

3 ways to fund a company, and to fund acquisitions of other companies: use cash on-hand, borrow the money from other entities (debt), or issue equity (stock) to new investors.

But how does a buyer in an M&A deal decide whether it should use…

50% debt and 50% stock vs.
33% debt, 33% stock, and 33% cash vs.
50% cash and 50% debt vs….

And the list goes on.

Easiest: Think about the “cost” of each method, start with the cheapest method, use the most of THAT method that you can, and then move to the next cheapest method, and continue like that.

GENERALLY:

Cheapest: Cash, since interest rates on cash are lower than interest rates on debt, and tend to be low in general.

Next Cheapest: Debt, since it is still cheaper than equity and since interest paid on debt is tax-deductible.

Most Expensive: Stock, since the Cost of Equity tends to exceed the Cost of Debt… in theory and in practice.

To Compare Them: Look at the “After-Tax Yields”… for debt and cash, just take the Interest Rate and multiply by (1 – Buyer’s Tax Rate).

Stock: Take the buyer’s Net Income and divide by its Equity Value (or “flip” its P / E multiple).

SO: Always start with cash, use the most you can, then move to debt, use the most you can, and finish up with stock.

Cash – How Much is “The Most You Can?”

Easy: Company has minimal cash and can’t use anything, or it has a huge cash balance and can use all of it.

More Common Case: Look at the company’s “minimum” cash balance and use the excess cash above that to fund the deal.

EX: Company has $500 million in cash right now, but its minimum cash balance to keep operating is $200 million…

So it can use $300 million of its cash to fund the deal.

How to Determine: Can be tough, but sometimes companies disclose it…

…or you can look back at historical cash balances and make a guesstimate based on that (what was its lowest cash balance in past years?).

Debt – How Much Can You Use?

So let’s say you’ve now used $300 million of cash to fund the deal… but it’s a deal for $1 billion total.

How much debt can you use to fund the remainder? $700 million? $300 million? $500 million?

Easiest Method: Calculate the key credit stats and ratios for the combined company – for example:

Total Debt / EBITDA
Net Debt / EBITDA
EBITDA / Interest Expense

And see what amount of debt makes these look “reasonable”, in line with historical figures and also figures for comparable companies.

EX: Let’s say that if the company uses $500 million of debt, its Debt / EBITDA is 4x.

Historically, it has been around 2-3x, and no peer company is levered at more than 3.5x.

If that’s the case, we’d say that 3.5x – 4.0x is probably the “maximum” (whatever amount of debt that means).

Here: We have the Debt / EBITDA and other ratios for the Men’s Wearhouse / Jos. A. Bank peer companies.

Stock – Now What?

Often used as the “method of last resort” because:

A) It tends to be the most expensive method for most companies.

B) Most acquirers don’t like giving up ownership and diluting existing shareholders unless absolutely necessary.

So in this example, if we’ve used $300 million of cash and $500 million of debt, we’re still not quite at $1 billion… need an extra $200 million, which we can get by issuing stock.

# of Shares = $200 million / Buyer’s Share Price.

Technically, there’s no real “limit,” but it would be very odd for a company to give up more than, say, 50% ownership to another company… unless they’re very close in size.

Exceptions:

Buyer has an exceptionally high P / E multiple (Amazon) – stock might be the cheapest!

Buyer wants to do a tax-free deal (Google / YouTube) and it’s much bigger anyway, so won’t make a difference.

Companies are similarly sized – stock might always be necessary because cash/debt are implausible (mergers of equals).

Summary

Which purchase method do you use?

MOST relevant when companies are closer in size… doesn’t make much difference when the buyer is 100x or 1000x bigger than the seller.

Order:

1. Cash – Any excess cash above the company’s minimum cash balance.

2. Debt – To the upper range of the Debt / EBITDA of comparables (and other metrics).

3. Stock – For any remaining funding that’s required; ideally give up well under 50% ownership.