A Primer on Merger Consequences Analysis

Merger Consequences Analysis, also known as affordability analysis, is used to determine what an acquirer
could afford to pay for a potential target. The affordability analysis is performed in the pre-transaction phase to: (i)
evaluate the effect of the transaction on shareholder value, (ii) validate whether the EPS for the acquirer will
increase or decrease post-transaction and (iii) evaluate the impact of the transaction on the credit profile of the
acquirer. Both the acquirer and target will perform this analysis. The acquirer’s objective is to determine how
much it can pay while the target is focused on how much it could potentially receive. This analysis does not
reflect the fair or appropriate price for an acquisition but addresses the maximum price that the acquirer can afford
to pay considering certain financial constraints and parameters.
Merger Consequences Analysis for publicly traded companies is often referred to as accretion/dilution analysis.
This analysis helps quantify the impact a combination of the two companies will have on the combined
consolidated earnings. In other words, will the newly combined company report stronger EPS than the acquirer on
a standalone basis in the years following the transaction?
Another affordability question that this analysis seeks to validate, this time, focusing on financial risk, is how much
new debt the acquirer can borrow without adversely affecting its credit profile and/or credit rating.
The analysis requires evaluating how all the costs and benefits (pro forma impact) of a transaction impact the
acquirer. Therefore, one way to approach the analysis is to divide it into three steps:
Step 1: Structure the Terms of the Transaction
Step 2: Calculate the Transaction Adjustments
Step 3: Analyze the Pro Forma Impact

Step 1: Structure the Terms of the Transaction

Determine the offer price per share
The first assumption is to determine a price per share that the acquirer will offer the target in exchange for
ownership. Although we can’t determine what price the acquirer can afford to pay just yet, we can make
preliminary assumptions on the target’s valuation expectations based on public comparables, acquisition
comparables, and DCF analyses.
The offer price is typically higher than the target’s share price and is expressed as a percentage premium.
Another way of thinking about it is the extra amount which the acquirer is willing to pay in order to gain control
of the target. Historically, control premiums have averaged around 20-40%, but are influenced by both
macroeconomic conditions as well as transaction specifics (i.e. the nature of the transaction (hostile or
friendly), expected synergies, and the type of consideration paid).
Decide on consideration mix
The next step is assessing if the acquirer can raise the funds necessary to complete the transaction. The
three typical forms of consideration are stock, borrowed funds (or debt) and excess cash from the acquirer’s
balance sheet. When issuing stock, the acquirer is issuing new shares of its own stock which they then
exchange for shares of the target. In other words, the acquirer is matching the value of the offer price with its
own shares. The consideration mix will be influenced by financial constraints and parameters.

Step 2: Calculate the Transaction Adjustments

Balance sheet adjustments and goodwill
When combining the acquirer and the target, there is more to do than summing the assets and liabilities. One
of the key adjustments to the balance sheet is accounting for the impact of the financing consideration and
transaction costs. The incremental debt and/or equity used to fund the purchase price is debited or credited to
the balance sheet of the acquirer. Also, certain transaction fees (i.e. advisory fees) are either immediately
expensed while others (i.e. financing costs) are deferred and amortized over time.
Since the acquirer is assuming all the target’s balance sheet items (not just purchasing shares), the target’s
assets and liabilities must be restated to their fair market value. If the value offered to the target is greater
than the market value of the assets (net of existing goodwill and liabilities), the residual amount is allocated to
goodwill. The accounting for these adjustments is called “purchase accounting” or “acquisition method”.

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 Step 2: Calculate the Transaction Adjustments – continued
Basics of “purchase accounting”
Offer Value Offer Value
Goodwill
Excess
Purchase
Price Write – up to fair Write – up to fair
market value market value

Net Identifiable Net Identifiable Net Identifiable

Assets Assets Assets
of Target of Target of Target

Phase 1 Phase 2 Phase 3

Phase 1: Calculate the excess purchase price. Simply take the offer value and subtract the book value of the
target’s net identifiable assets.

Net Identifiable Assets = Assets – Existing Goodwill – Liabilities – Noncontrolling Interest

Phase 2: Determine the fair market value.

Typically, a professional appraiser will use cash Purchase Price Allocation
flow analysis, comparables analysis, and other Offer Value 10,450.0
valuation techniques to estimate the fair market Less: Net identifiable assets of target (235.0)
value of the target’s assets. Any adjustment Excess purchase price for allocation 10,215.0
needed to restate book value to fair value is called Less: Fixed asset write-up(a) (2,043.0)
a write-up and will be reflected on the combined Less: Indefinite life intangibles write-up(b) (1,532.2)
balance sheet. A common modeling technique is Less: Definite life intangibles write-up(c) (1,021.5)
to estimate the write-up as a percentage of the Plus: Deferred tax liability (d) 1,746.8
excess purchase price for allocation. The write-up Goodwill Created 7,365.0
percentages will vary from industry to industry. You
(a) Fixed asset write-up: 10,215.0 x 20.0% = 2,043.0
can review the merger documents of precedent
transactions to try and analyze historical write-up (b) Indefinite life intangibles write-up: 10,215.0 x 15.0% = 1,532.2
amounts as a percentage of the purchase price (c) Definite life intangibles write-up: 10,215.0 x 10.0% = 1,021.5
and use that as a preliminary assumption. (d) Deferred tax liability = SUM(write-ups) x acquirer tax rate (38.0%)

Phase 3: Calculate Goodwill. Now that you have allocated the excess purchase price to specific assets, the
"residual" goes to goodwill. Goodwill is the excess purchase price over the fair market value of net identifiable
assets acquired.
Note: A deferred tax liability is generated as a result of the incremental depreciation and amortization
from the write-ups. A temporary timing difference arises from this disconnect between when taxes are
reported as opposed to when they’re actually paid.
This is an advanced tax concept and should be discussed in detail with an experienced tax advisor.
Income statement (pre and post-tax) adjustments
There are a few core transaction adjustments that most merger models account for. They are:
(a) Incremental interest expense from new debt issued to finance the transaction
(b) Synergies
▪ Additional cash flows or cost savings resulting from the combination of two similar businesses, divided
into two categories: incremental revenue or cost savings
(c) Additional depreciation and amortization expense resulting from the asset write-ups
(d) Adjusting for forgone interest income on the cash off the existing balance sheet used to finance the
acquisition
(e) New shares issued as part of the transaction consideration
After-tax
Acquirer’s Target’s “Incremental
Calculate pro forma EPS by combining the Pro Forma Net Income + Net Income +/- Adjustments”
=
two companies’ net incomes and then accounting for all EPS
Acquirer’s New
+
incremental adjustments. Shares Outstanding Shares Issued

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 Step 3: Analyze the Pro Forma Impact
Income statement impact – accretion / (dilution)
One of the central questions is whether the deal will be accretive or be a benefit to the acquirer’s bottom-line.
By calculating pro forma EPS, or the estimated EPS post-transaction, we can compare the combined
business’s earnings to the acquirer’s on a standalone basis.
Pro Forma EPS > Acquirer’s Standalone EPS: ▲ Accretive
Pro Forma EPS < Acquirer’s Standalone EPS: ▼ Dilutive
Pro Forma EPS = Acquirer’s Standalone EPS: EPS neutral
It is also common to analyze the incremental synergies required to keep EPS neutral or to “breakeven”. This
is particularly helpful if the deal appears dilutive. It gives you a sense of the amount of synergies that are
needed before there is no negative impact on EPS. In the example below, 221.2 of synergies are needed in
the first projected year to make the transaction EPS neutral (Pro Forma EPS = Acquirer’s standalone EPS). In
FYE+3, the transaction is accretive by 0.03. This creates a “cushion” of 39.0 pre-tax earnings. The cushion
refers to the amount of synergies that do not have to be realized while still maintaining a neutral EPS impact.
FYE+1 FYE+2 FYE+3 Calculating Pre-Tax Synergies:
EPS Accretion / (Dilution)
Pro Forma EPS 2.83 3.18 3.53
x Pro Forma shares outstanding
Acquirer Stand-Alone EPS 3.00 3.25 3.50
= Net income accretion / (dilution)
Accretion / (Dilution) ÷ (1 - Tax rate)
EPS Accretion / (Dilution) (0.17) (0.07) 0.03 = Pre-tax (cushion) / synergies to
EPS Accretion / (Dilution) - % (5.7%) (2.1%) 0.7%
Pre-tax (cushion) / synergies to breakeven 221.2 91.1 (39.0)
breakeven

Balance sheet impact – pro forma leverage

One key metric to analyze on the balance sheet is the Debt / EBITDA leverage ratio. This gives an indication
of whether the combined company will be able to meet its principal obligations. One of the primary concerns
of an acquirer is if the acquisition debt raised could cause the rating agencies, such as Standard and Poor’s, to
either place the ratings on watch or immediately downgrade their current credit rating.

Calendarizing Different Fiscal Year Ends Between Target and Acquirer

If the target and acquirer are on different fiscal year ends, you will need to adjust the target’s projections to reflect
the same year-end as the acquirer. Because the balance sheet is a snapshot in time, there is generally no need
for adjustments since the most recently reported information reflects the assets the acquirer will be taking over.

In the example below, the acquirer’s fiscal year end is December while the targets is September. Only 75% of the
target’s FYE+1 overlaps with FYE+1 of the acquirer’s. 25% of FYE+2 overlaps as well.

FYE FYE + 1 FYE + 2 To match

FYE +fiscal
3 year ends the following
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
math must be done to the target:
FYE + 1 Acquirer
FYE + 1 Target = 2.20 75% x 2.20 = 1.65
FYE + 2 Target = 2.40 25% x 2.40 = 0.60
Calendarized FYE+1 1.65 + 0.60 = 2.25

“Adjusted EPS” or “Cash EPS”

This removes the impact of the additional non-cash D&A resulting from the write-ups of PP&E and intangibles. It
is important to understand that neither “Cash EPS” nor “Adjusted EPS” are GAAP terms, so the methodology for
calculating them will vary from industry to industry, and perhaps even from company to company.

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 Conclusion
There is no right answer when doing Merger Consequences Analysis. A merger model is simply a tool to
measure the financial impact of a transaction on the acquirer’s financial statements. Therefore, it is commonly
referred to as a secondary valuation methodology. Accretion/dilution is primarily an affordability analysis and
does not reflect any value creation. Just because a deal is EPS accretive, doesn’t mean it is a good deal. There
are many other factors influencing the quality of a transaction, including, but not limited to, strategic rationale and
integration success. How much an acquirer can pay may differ from the amount they should pay or how much
they will pay. Generally, shareholders do not prefer dilutive transactions; however, if the transactions are
expected to generate enough value to become accretive in a reasonable time (i.e. within 3 years), a proposed
combination could be justified.

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