Mergers & Acquisitions
FINA 4205e/6205e
Dr. Robert Heller
Class 17
Merger Deals
Basics
Synergies
Accretion/Dilution
Determine valuation of Target
Exchange Ratio
Earnings per share of surviving company
Dilution/Accretion
Highest Offer Price without Dilution in EPS
Influences on changes in EPS
Postmerger P/E Ratio
Fixed Number of Shares vs. Fixed Value
Merger Consequences Analysis
Accretion/(Dilution) Analysis
· Accretion/(dilution) analysis measures the effects of a transaction on a potential acquirer’s earnings, assuming a given
financing structure
– Centers on comparing the acquirer’s earnings per share (EPS) pro forma for the transaction versus on a standalone basis
· If the pro forma combined EPS is lower than the acquirer’s standalone EPS, the transaction is said to be dilutive; conversely,
if the pro forma EPS is higher, the transaction is said to be accretive
· A rule of thumb for 100% stock transactions is that when an acquirer purchases a target with a lower P/E, the acquisition is
accretive
– Concept is intuitive—when a company pays a lower multiple for the target’s earnings than the multiple at which its own
earnings trade, the transaction is de facto accretive
· Transactions where an acquirer purchases a higher P/E target are de facto dilutive
– Sizable synergies, however, may serve to offset this financial convention and result in such acquisitions being accretive
– Transaction-related expenses such as depreciation and amortization, on the other hand, have the opposite effect
· Acquirers target accretive transactions as they create value for their shareholders due to the fact that the market usually
responds favorably
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Merger Consequences Analysis
Accretion/(Dilution) Analysis
· Accretion/(dilution) analysis is usually a key screening mechanism for potential acquirers
– Acquirers do not pursue transactions that are dilutive over the foreseeable earnings projection period due to the potential
destructive effects on shareholder value
– May be exceptions in certain situations
· Key drivers for accretion/(dilution) are purchase price, acquirer and target projected earnings, synergies, and form of
financing, most notably the debt/equity mix and cost of debt
– Calculations must also reflect transaction-related effects pertaining to deal structure, such as the write-up of tangible and
intangible assets
– Maximum accretive effects are served by negotiating as low a purchase price as possible, sourcing the cheapest form of
financing, choosing the optimal deal structure, and identifying significant achievable synergies
· Transaction expenses related to M&A advisory and financing fees may also be factored into accretion/(dilution) analysis
– M&A advisory fees are typically expensed upfront while debt financing fees are amortized over the life of the security
– In many cases, however, transaction fees are treated as non-recurring items and excluded from accretion/(dilution)
analysis, which is the approach we adopt in our analysis
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Merger Consequences Analysis
Accretion/(Dilution) Analysis Steps
· Step I. Enter the acquirer’s standalone projected operating income (EBIT)
· Step II. Add the target’s standalone projected operating income (EBIT)
· Step III. Add expected synergies from the transaction for the projection period
· Step IV. Subtract transaction-related depreciation and amortization expenses (typically associated with writing up the target’s
tangible and intangible assets)
· Step V. Subtract the acquirer’s existing interest expense
· Step VI. Subtract the incremental interest expense associated with the new transaction debt to calculate pro forma earnings
before taxes
· Step VII. Subtract the tax expense at the acquirer’s tax rate to arrive at pro forma combined net income
· Step VIII. In the event stock is used as a portion, or all, of the purchase price, add the new shares issued as part of the
transaction to the acquirer’s existing fully diluted shares outstanding
· Step IX. Divide pro forma net income by the pro forma fully diluted shares outstanding to arrive at pro forma combined
EPS
· Step X. Compare pro forma EPS with the acquirer’s standalone EPS to determine whether the transaction is accretive or
dilutive
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Earnings per share of surviving company
AcquiringCo issues .8333 shares of stock for each share of Target Co’s
stock. That means Acquiror issues 20 million (which it the number of
TargetCo shares) times .8333 shares or 16.666 million new shares issued by
AcquiringCo
Total shares outstanding of the combined companies = 60.0 + 16.666 =
76.666
Post-merger EPS of the combined companies = ($150 + $30)/76.666 = $2.35
What is the percentage accretion (dilution)? polleverywhere
Earnings per share of surviving company
What if the stock price of the AcquiringCo was not $60 per share but is only
$40 per share. What would the exchange ratio be?
(polleverywhere)
Earnings per share of surviving company
What if the stock price of the AcquiringCo was not $60 per share but was
only $40 per share. What would the exchange ratio be?
Answer – AcquiringCo would issue ____
How many new shares of AcquiringCo would be issued in the merger?
(polleverywhere)
Earnings per share of surviving company
What if the stock price of the AcquiringCo was not $60 per share but was only $40 per
share. What would the exchange ratio be?
Answer – AcquiringCo would issue
How many new shares of AcquiringCo would be issued in the merger?
That means AcquiringCo issues
Total shares outstanding of the combined companies =
What is the percentage accretion/(dilution) as a result of the merger? (polleverywhere)
Earnings per share of surviving company
What if the stock price of the AcquiringCo was not $60 per share but was only $40 per share. What
would the exchange ratio be?
Answer – AcquiringCo would issue
How many new shares of AcquiringCo would be issued in the merger?
That means issues
Total shares outstanding of the combined companies =
What is the percentage dilution/accretion as a result of the merger. (polleverywhere)
EPS of the Acquiror after the merger =
$2.50 per share before the merger, and ____per share after is a
Determine valuation of Target
Exchange Ratio
Earnings per share of surviving company
Dilution/Accretion
Dilution in EPS – Projected for several years
Influences on changes in EPS
Postmerger P/E Ratio
Fixed Number of Shares vs. Fixed Value
Note the depreciation and
amortization which may
result from the merger, and
that it impacts the
calculation of EPS of the
acquirer after the merger.
Note we are calculating this
for five year projection
period – an acquisition can
be dilutive for LTM EPS, or
the next year, but then be
accretive – so maybe the deal
should be done even if
dilutive originally.
Note also interest expense,
standalone and incremental
Determine valuation of Target
Exchange Ratio
Earnings per share of surviving company
Dilution/Accretion
Breakeven Synergies
Highest Offer Price without Dilution in EPS
Influences on changes in EPS
Postmerger P/E Ratio
Fixed Number of Shares vs. Fixed Value
Breakeven Synergies Calculation
The bottom section shows the pre-tax
synergies necessary to make the transaction
breakeven (i.e., neither accretive nor dilutive).
In the event the transaction is dilutive in a
given year, this analysis determines the
amount of pre-tax synergies necessary to
make pro forma EPS neutral to standalone
EPS. Similarly, in the event the transaction is
accretive, the analysis determines the synergy
cushion before the transaction becomes
dilutive.
Look at 2012. Is the merger dilutive
or accretive to EPS based on 2012?
What additional amount in EPS do
we need to breakeven, that is have no
dilution or accretion?
What amount in $$$ (not EPS) do we
need to have no dilution or accretion
- start with after tax amount.
What is that amount pre-tax?
Note the last line “Required Synergies to
Breakeven/(Cushion). That is the Additional Pre-tax
synergies to breakeven.
Breakeven Synergies Calculation
The bottom section shows the pre-tax synergies
necessary to make the transaction breakeven (i.e.,
neither accretive nor dilutive). In the event the
transaction is dilutive in a given year, this analysis
determines the amount of pre-tax synergies
necessary to make pro forma EPS neutral to
standalone EPS. Similarly, in the event the
transaction is accretive, the analysis determines
the synergy cushion before the transaction
becomes dilutive.
Look at 2012. Is it dilutive or accretive? Dilutive
What additional amount in EPS do we need to
breakeven, that is have no dilution or accretion? $0.15
per share.
What amount in $$$ (not EPS) do we need to have no
dilution or accretion start with after tax amount.
$0.15 times 207.1 shares O/S = $31.065 million
Note the last line “Required Synergies to Breakeven/(Cushion).” What is that amount pre-tax? $31.065/(1-.38) = $50.1
And the “Additional Pre-Tax synergies to Breakeven” million [The difference vs. $49.1 is rounding we don’t
see)
That is the Additional Pre-tax synergies to breakeven.
Breakeven Synergies Calculation
The bottom section shows the pre-tax
synergies necessary to make the transaction
breakeven (i.e., neither accretive nor dilutive).
In the event the transaction is dilutive in a
given year, this analysis determines the
amount of pre-tax synergies necessary to
make pro forma EPS neutral to standalone
EPS. Similarly, in the event the transaction is
accretive, the analysis determines the synergy
cushion before the transaction becomes
dilutive.
Required Synergies to Breakeven (Cushion) equals
(- (EPS accretion/(dilution) x pro forma fully diluted shares) /(1 – tax rate))
In our example (-$0.15 x 207.1)/(1- .38) = $50.1
Synergies needed to break even
If tax rate is 38%, what are the pretax synergies needed (cushion) to
breakeven from EPS standpoint based on pro forma calculations?
(Polleverywhere)
Determine valuation of Target
Exchange Ratio
Earnings per share of surviving company
Dilution/Accretion
Highest Offer Price without Dilution in EPS
Influences on changes in EPS
Postmerger P/E Ratio
Fixed Number of Shares vs. Fixed Value
Influences on changes in EPS
The degree of change in EPS of the Acquirer influenced by:
1. The differential in P/E ratios (between the acquirer and target).
2. The relative size of the two firms as measured by earnings.
Determine valuation of Target
Exchange Ratio
Earnings per share of surviving company
Dilution/Accretion
Highest Offer Price without Dilution in EPS
Influences on changes in EPS
Postmerger P/E Ratio
Fixed Number of Shares vs. Fixed Value
Post merger P/E ratios
Bootstrapping Earnings per Share
Bootstrapping EPS refers to the corporation's ability to increase its EPS through the
purchase of other companies.
These earnings were prevalent during the third merger wave of the late 1960s. During
this time, the market was not efficient in its valuation of conglomerates. These
conglomerates were able to experience an increase in EPS and stock prices simply by
acquiring other firms.
The third merger wave stretched from the mid-1950s to 1969, and
peaked during the “go-go” boom of 1962-1969, when 60 percent of all
mergers were of the conglomerate type. Medium-size companies that
often got started in the rapidly expanding electronics industry or military
contracting or both gobbled up firms in unrelated industries.
International Telephone and Telegraph, Ling-Temco-Vought, Gulf and
Western, and Litton Industries all made unrelated acquisitions totaling $1
billion or more. https://monthlyreview.org/2001/05/01/mergers-
concentration-and-the-erosion-of-democracy/
Post merger P/E ratios
Bootstrapping Earnings per Share
Bootstrapping EPS refers to the corporation's ability to increase its EPS through the
purchase of other companies.
Two conditions are necessary for bootstrapping EPS to occur:
1. The P/E ratio must not decline following the merger. This implies that the market must be willing to
apply at least the premerger P/E ratio after the merger. If the market decides that the combined firm is not as
valuable, per dollar of earnings, there may be a market correction and the P/E ratio may fall. In the third
merger wave, the market was slow to reevaluate the growing conglomerates and apply a lower P/E ratio.
2. The acquirer must have a higher P/E ratio than the target. If these two conditions prevail, companies
with higher P/E ratios can acquire companies with lower P/E ratios and experience growth in EPS. This
gives the acquiring company an incentive to continue with further acquisitions and have even greater
increase in EPS. The process will continue to work as long as the stock market continues to value the
acquiring company with the same P/E ratio. This occurred during the late 1960s. The movement came to an
end when the market corrected itself as it questioned many of the acquisitions that appeared to lack
synergistic benefits.
Postmerger P/E Ratio
If the market is efficient, bootstrapping EPS is not possible. The postmerger P/E ratio will be a weighted
average of the premerger P/E ratios
Determine valuation of Target
Exchange Ratio
Earnings per share of surviving company
Dilution/Accretion
Highest Offer Price without Dilution in EPS
Influences on changes in EPS
Postmerger P/E Ratio
Fixed Number of Shares vs. Fixed Value
Fixed Number of Shares vs Fixed
Value
A buyer in a stock-for-stock transaction can offer either a fixed number of shares in its
company or a specific dollar value.
When the number of shares is fixed, its value can vary as the stock price of the acquirer
varies. The value the seller receives and the buyer provides then varies depending on
movements in the bidder's stock price.
A buyer, however, can simply offer a fixed value, and the actual number of shares may
vary as the stock price of the acquirer varies. The uncertainty caused by a fixed
number of shares can be reduced through a collar agreement. Such an agreement
usually stipulates that if the stock price goes above or below a certain value, there will
be an adjustment in the exchange ratio.
Fixed Value Examples
