Merger Model

What is a Merger Model?

Investment bankers and M&A professionals primarily use a merger model. A detailed analysis of the prospective combination of the two companies is carried out. The goal is to ascertain whether or not there exist benefits to an amalgamation.

A merger model is an information-intensive tool. It is based on several assumptions and tailored to incorporate the specific characteristics of the subject companies to provide as realistic results as possible. A merger model can be considered as a feasibility study that is carried out beforehand to ensure the success of amalgamations. Corporations hire investment professionals and valuation specialists to determine the consequent value of the resultant merged entity. It would be only on the green signal of the investment bankers that the corporations would consider further action viable.

MERGER MODEL

Factors Considered in Merger Models

Method of Discharge of Purchase Consideration

The fundamental sources of funding an acquisition are shares, debt, and cash. The foremost consideration that the acquiring companies have in mind while issuing a consideration is whether it would lead to accretion (increase in EPS) or dilution (decrease in EPS). It also must ensure that the company does not take on more debt than it can sustain in the process. The company must also be conscious of not giving away such amounts of cash to jeopardize its liquidity. An ideal discharge combination would be any mix of cash, debt, and stocks that satisfy the long-term goals of the company.

The following example shall provide a better understanding

Co. A, an acquiring company, is in the process of taking over Co. B (target company).

 AB
No of Shares7,50,0005,00,000
Market price per share$5$2.5
12% Debentures (Nom Val $1 each) $200,000

The board of Co. A resolves to discharge the PC in the following manner:

  • To issue 1 share in Co A for every 10 shares held
  • To issue a 15% debenture for every 2 shares held
  • Pay cash for the balance
  • To pay off the existing debenture holders at par by issuing 15% debentures in Co. A

Based on this, the purchased consideration would look something like this:

 Market Value of B (500,000* $2.5)$1,250,000
lessEquity Shares Issued (500,000/10 * $5)($250,000)
 Balance$1,000,000
LessDebentures Issued (500,000/2 * $1)($250,000)
 Balance discharged with cash$750,000

It is important to remember that only the debentures issued to the common stockholders form a part of the purchase consideration—the debentures issued to the existing bondholders of Co. B are considered separately.

Also Read: Acquisition

Intangibles

As seen in the above example, the purchase consideration discharged exactly matches the company’s worth. However, in many cases, that may not be the case. The consideration may be more or less than its fair value in practice. This may be for several reasons. The acquiring companies may be fine with paying a premium for firms with high synergy benefits or with valuable assets on their books. Conversely, a sick unit or a firm undergoing turmoil may be sold off at much below its fair value. Such scenarios give rise to intangibles on the balance sheet.

The below-mentioned key must be remembered:

Consideration > Net Asset Value = Goodwill
Consideration < Net Asset Value = Adjustment to Capital Reserve

The following example will clarify the idea.

Go through the following balance sheet of Co. X

Equity & Liabilities$Assets$
Equity Share Capital6,00,000Fixed Assets7,50,000
Reserve2,50,000Investments50,000
8% Debentures3,00,000Receivable2,00,000
  Bank1,50,000
 11,50,000 11,50,000

The FMV of the fixed assets is calculated to be $900,000. Therefore, the net worth of assets and liabilities of Co. X is $(900,000 +50,000 +200,000 +150,000-300,000) 1,000,000.

Co. Y (acquiring co) paid $1,200,000 for the assets of Co. X. Therefore, goodwill of $200,000 will reflect on Co Y’s balance sheet.

Synergies

One of the biggest motivations to initiate a merger is synergies of scale that arise only due to strategic amalgamations. Synergies refer to the abnormal benefit that would accrue to a company by virtue of which it is positioned significantly ahead of its competitors. The revenues earned by the merged entity shall be greater than the combined revenue of each of the single entities had the merger not taken place. Such is the impact of an effective and well-thought-out merger. There are two broad categories of mergers that lead to synergies:

Vertical Merger

It occurs when a player acquires another player in the same channel but is placed at a different point. For example, a merger with a manufacturer, distribution channel, or consumer of a product is a vertical merger. This kind of merger model brings about cost efficiency, prevents redundancy of operations, and aids in making a company self-sufficient.

Horizontal Merger

This refers to a competitive merger strategy where firms at the same level but in different industries shake hands. The fundamental rationale behind a horizontal merger is to pool resources with your competition or contemporary to eliminate peer-to-peer competition. A fast-food company incorporating a desserts chain is an example of the same.

The following merger model based on synergies will further clarify the concept:

ParticularsABC Co.XYZ Co.
Revenues ($)8,00,0004,00,000
Cost of Goods Sold(COGS) ($)6,00,0002,40,000
EBIT ($)2,00,0001,60,000
Expected Growth Rate6%8%
Cost of Capital10%12%

It is a situation of a vertical merger, and combining the two firms will create economies of scale in the form of effective integration of the supply chain. This will reduce the cost of goods sold from 70% to 65% of revenues. The tax rate applicable is 40%.

Let us have a look at how synergies cause a difference in valuation before and after the merger.

Before Merger

FCF to ABC Co = (800,000- 600,000) * 0.6

= $120,000

Value of Firm = 120,000 * 1.06/ 0.1-0.06

= $3,180,000

FCF to XYZ Co = (400,000-240,000) * 0.6

= $ 96000

Value of firm = 96,000 * 1.08/0.12-0.08

= $ 2,592,000

From above the combined value without merger works out to be (3,180,000 + 2,592,000) = $5,772,000

After Merger

After merger, the COGS reduce to 65% of revenue.

Combined Revenue = (800,000 + 400,000) $1,200,000

COGS = 65% of $1,200,000

=$780,000

EBIT to Combined Firm = (1,200,000 – 780,000) $420,000

Post tax FCF = 420,000 * 60%

=$252,000

WACC (Already Computed) = 11%

Weighted average growth rate (Already Computed) = 7%

Therefore, value of merged firm:

252,000 * 1.07 / 0.11-0.07

= $6,741,000

Therefore, increase in Valuation post-merger ($6,741,000- $5,772,000) is $969,000

Steps in Constructing a Merger Model

Literally speaking, the steps involved in a merger model are vast and elaborate. Initiating and concluding an amalgamation of two giant corporations is a mammoth task and entails a multitude of minute steps. There is no margin for error, so the IB professionals must carefully scan each parameter. This write-up makes an effort to narrow down the complex procedure and briefly discuss the basic steps involved.

Step 1: Company Profiling

Growth opportunities available in the market must be scanned. The acquiring company must determine the dimension in which it wants to expand- horizontally, vertically, or laterally. It must also set objectives in terms of partnership it seeks via the merger- strategic, financial, or cost-effectiveness.

Step 2: Identify target M&A candidates

Out of the vast universe of potential takeovers available, the company must boil down to the best few. Based on the objective statement drafted in the above step, it must determine the firms that best align with it. It must also inquire whether such companies are open to a sale.

Step 3: Conduct Valuation

Carry out a valuation study that may be based on variables such as forecasted cash flows, customer base, synergy benefits, patent monopoly, PE multiples, etc. There are no prescribed criteria to value a company. However, buyouts normally do not occur unless the seller offers a premium over the existing value of the target. In the absence of the same, there is absolutely no incentive to sell.

Step 4: Determine Goodwill and Purchase Consideration

Once the preliminary surveying is done and valuations have been determined, a buyout price is offered to the target. The seller must tailor an optimum mix of common stocks and cash for the shareholders of the target. Moreover, an important consideration for the seller is to ensure that only such a number of stocks are issued, which does not dilute its prevailing EPS.

Step 5: Adjust balance sheets and income statements for acquisition effects

This is a simple procedure and requires a line-by-line addition of various items in the books of an acquirer. If the assets and liabilities of the target company are revalued, they are required to be recorded at such revalued figures. Along the way, adjustments are also made for goodwill or reserves that arise during such a merger. Additionally, deferred tax assets (liabilities), as the case may be, are offset against one another to offer a consolidated picture.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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