Mergers & Acquisitions,

Accretion / Dilution Modeling

Sunday November 17, 2013

In partnership with:

Alexander Banh Chief Executive Officer

Michael Karp Chief Investment Officer

This presentation is for informational purposes only, and is not an offer to buy or sell or a
solicitation to buy or sell any securities, investment products or other financial product or service,
an official confirmation of any transaction, or an official statement of Limestone Capital Investment
Club. Any views or opinions presented are solely those of the author and do not necessarily
represent those of Limestone Capital.
Table of Contents

1. M&A Overview: In Practice & Theory

a) Types of Transactions
b) Merger Motives
c) Role of Investment Banks
2. Process
a) Buy-Side Process
b) Sell-Side Process
3. Accretion / Dilution
a) Deal Financing: Stock vs. Debt vs. Cash
b) Effects of an Acquisitions
c) Merger Model

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I. M&A Overview
 Types of Mergers & Acquisitions
Strategic vs. Sponsor Acquisitions

STRATEGIC SPONSOR

 Strategic Acquisition: Purchase of an operating  Sponsor Acquisition: Purchase of a business by

business that is in the same industry or a financial sponsor (private equity firm, venture
complements the buyer’s current business capital firm)

ACQUIRER ACQUIRER

TARGET TARGET

Which type of acquirer can afford to pay more?

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 Types of Mergers & Acquisitions
Horizontal, Vertical, Conglomerate Acquisitions
HORIZONTAL
 Acquirer and the target are in the
same industry
 Operating at the same industry
vertical / supply chain level
Barrick / Equinox
 Both of these companies produce
gold and copper
VERTICAL
 May be operating in different
industries
 Operating at different levels of the
same supply chain
AOL / Time Warner
 Conglomerate attempts to diversify
 Most conglomerates have been
 Time Warner supplied content to
consumers through properties like
CNN and Time Magazine
 AOL distributed such information
via its internet service
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CONGLOMERATE
 Acquirer and target are not
necessarily related to each other
volatility in overall corporate
performance by buying unrelated
companies
dismantled as institutional investors
realized they could achieve
diversification’s risk reduction
benefits more efficiently through
realigning their own securities
portfolios and unwilling to pay a
premium for the diversification
efforts of conglomerate managers
 Types of Transactions
Plan of Arrangement vs. Takeover Bids

Plan of Arrangement Takeover Bid

 No actual “plan” is prepared, showing the steps needed to  Offer to acquire outstanding voting or equity securities
close the deal  Bid must be made to all holders of the class with equal
 No direct offer to shareholders consideration
 Requires shareholder approval of two-thirds majority • If bidder increases price, everybody who tendered
(66.67%) gets the benefit of the increased price
 Provides maximum flexibility for structuring  One Stage Process:
(e.g. three-way mergers) • If 90% of shareholders tender, then compulsory
 Useful when: acquisition of the remaining 10%
• Multiple classes of shares involved  Two Stage Process:
• Buying a subsidiary of a publicly traded target • If only two-thirds tender, then move into second
corporation stage process
 Costs more and takes longer • Company must call a shareholder meeting
 Requires court approval • Shareholders will vote to merge / amalgamate,
 Must be a friendly deal requiring two-thirds approval
• Minority shareholders are squeezed out

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 Types of Transactions
Friend Deals vs. Hostile Takeovers, Stock Deals vs. Asset Deals

Benefits of a Friendly Deals Over Hostile Takeover Bids

Hostile Takeover Bid: An attempt to take over a company

Friendly Deal: A business combination that the management
without the approval of the company’s board of directors,
of both firms believe will be beneficial to shareholders, and is
making offers directly to shareholders to gain a controlling
mutually negotiated.
interest.

 Retention: Targets key management and key employees who would leave in the event of a hostile takeover
 Due Diligence: Bidder needs to conduct extensive due diligence on the target company’s financials to satisfy its own board or
financial backers
• Much more difficult with a hostile takeover as target management will withhold non-public information
 Deal Protection: Special ancillary conditions of the deal can be negotiated between the two companies in a friendly deal
• Break fees, no-shop, go-shop clauses
 Tax Benefits: Only realizable through structured, negotiated transactions
 Regulatory Approval: Government approval is much easier with the cooperation of the target company’s management team

Stock vs. Asset Deals

 Stock deals are by far the most common, where the aggressor purchases the entire entity by buying up all equity ownership
 The option for an asset deal is only available in a friendly negotiated transaction
• A shell firm with a corporate charter remains after the target firm uses the cash to pay back shareholders and debt holders
and “liquidates itself” or use proceeds to “reinvent itself” as a new corporation
 Advantages of an asset deal
• Acquirer is only purchasing the assets that it desires, and keeping only the employees that it needs
• Avoids target firm’s contingent liabilities
• Ability to depreciate purchased assets at purchase value and not historical cost to claim higher capital consumption
allowances

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 Defensive Tactics Against Hostile Takeover Bids1
General Tactics
 Press releases and mailed correspondence to TargetCo’s
shareholders from senior managers of the target company
undermining the bid in attempts to convince shareholders
not to tender shares
 Target management / accountants can nitpick at the
takeover bid for areas where the acquirer failed to meet
regulatory requirements in their documentation
White Knight
 White Knight: Seeking out a firm that management feels
more comfortable handing over control to because of
favourable and negotiated terms
• Even if the white knight is unsuccessful in its
defensive bid, the terms of the deal will still be better
because it bid up the price
Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.
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Poison Pill / Shareholder Rights Plan
 Automatically allowing existing shareholders to buy a
large number of shares in TargetCo at a discounted price,
thus increasing the number of shares the aggressor has to
purchase to gain control of the target
 Makes the takeover more expensive
• Aggressor can concede and start negotiating in the
friendly process, or fight the imposition of poison pill
in media / court
 Poison pills are only effective as a delaying tactic to give
boards time to seek out superior offers
Golden Parachute
 Golden Parachute: Management severance packages
that are triggered upon takeover
• Increases the cost of takeovers, sometimes
prohibitively so
Pac Man
 Target company buying acquirer company, effectively
negating loss of control
 Defensive Tactics Against Hostile Takeover Bids1
Scorched Earth / Crown Jewels
 TargetCo makes itself unattractive to the aggressor
 Crown Jewels: A type of Scorched Earth strategy in
which TargetCo sells off all its attractive assets
• If the acquirer’s original merger motive is to acquire
assets such as oil wells or patents by buying
TargetCo, it can no longer be done since TargetCo
has already sold them off
 Another form of the scorched earth strategy involves
TargetCo spending all the excess cash on its own balance
sheet on acquiring a company that has absolutely nothing
to do with its business model, is unable to realize
synergies, and is just wasting cash
• Makes TargetCo less attractive to acquirer
 Unicorp / Union Gas / Burns Foods Case Study
Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.
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Unicorp / Union Gas / Burns Foods 1986 Case
 Unicorp Canada (P/E firm) made bid to acquire Union Gas
(second largest gas distribution company in Ontario at the
time)
 Union Gas arranged a friendly buyout of Burns Foods (a
meatpacker in a completely unrelated industry) for $125
million as a “scorched earth” strategy
 Unicorp persisted with the takeover
 Unicorp gained control of Union Gas, and subsequently
sold Burns Food back to the Burns family for $65 million
($60 million below the original acquisition price), leading to
a $60 million loss for Union Gas shareholders as the cost
of the failed efforts of the scorched earth strategy
 How do we gauge the probability of a merger’s success?

Silver Lake / Michael Dell Management Buyout of Dell Case Study

 Amended offer price of $13.75 per share in cash consideration, plus payment of a special cash dividend of $0.13 per share, for
total consideration of $13.88 per share in cash

 Why did the share price react in January BEFORE the deal announcement (yellow line)?
 What does the share price reaction on the amendment date mean (orange line)?

Source: Bloomberg
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 How do we gauge the probability of a merger’s success?

Silver Lake / Michael Dell Management Buyout of Dell Case Study

 Market price and trading volume reactions of the target is a good indicator of the likelihood of the bid’s success
 If TargetCo price immediately jumps above the bid price, investors think the bid is too low and higher competing bids are likely
 If the target price hovers around the bid price, investors think the bid is fair
 If there is no unusual spike in volume, this means that shareholders are sitting on their shares, and unwilling to tender, which
means the likelihood of the bid’s success is low
 If there is a spike in volume on the announcement date, TargetCo shareholders are selling out to merger arbitrageurs, and a
change in control is inevitable

Source: Bloomberg
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 Merger Motives1
Why do companies merge or conduct acquisitions?

Glencore’s 2012 Glencore’s 2013

acquisition of Viterra merger with Xstrata
(US$6.1bn)1 (US$82bn)

Commodities Trading Commodities Trading

Agriproducts Mining Company

1. Glencore Xstrata website

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 Merger Motives1
Why do companies merge or conduct acquisitions?

 Gain market share

• Market / monopoly power
• Glencore has made so many acquisitions over the
years that it has become fully “vertically integrated”
and holds significant market share in all commodities
that it trades
 Fewer organic growth opportunities
 Too much cash on balance sheet
• Common issue for large tech companies
 Seller is undervalued (“cheap”)
 Up-selling and cross-selling opportunities
 Patents, critical technology
• E.g. Google buying Motorola Mobiliity
 Entering new market and / or new country
• CNOOC / Nexen, Petronas / Progress
 Diversification
 Turnaround: Target management is doing a poor job
 SYNERGIES

1. Glencore Xstrata website

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 Merger Motives1
Cost & Revenue Synergies
Cost Synergies
 Easiest to understand, measure,
and predict
 Building consolidation
 Layoffs of redundant support and
administrative staff
 Economies of scale
• Spread fixed overhead over
a large number of units
• More bargaining power
against suppliers
 Vertical Integration
• Disintermediation removes
mark-ups, delivery fees
 Target may have key
competencies, technology, or
infrastructure that can help
reduce the costs of the acquirer
Source: Breaking Into Wall Street
Revenue Synergies
 Cross-sell products to new
customers
 Up-sell products to existing
customers
 Expand into new geographies
 Market / monopoly power
 Revenue synergies are tough to
predict, hard to measure, and at
time intangible
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Other Synergies
 Net Operating Losses
• Bidding firm with past
losses could acquire a
profitable target and then
apply its NOLs
• Profitable bidding firm could
acquire a target that is
losing money, and apply its
NOLs to its own stream of
net income
 Increased Debt Capacity: A
larger, more stable firm can
sometimes get cheaper financing
more easily
 Depreciation: Write up purchase
assets to fair market value,
providing a larger depreciation tax
shield
 Goodwill: Amortization of
goodwill which leads to similar tax
benefits as a greater depreciation
base, but no longer allowed under
IFRS
 Theoretical Underpinnings of Merger Motives & Gains1
Perfect Capital Markets vs. Imperfect Capital Markets

Definitions
 Merger Gain: Situation where as the direct attributable result of the combination of two firms by way of takeover, merger, or
amalgamation, post-combination market value of the resulting enterprise exceeds the sum of the pre-merger market values of the
entity’s constituent firms
 Synergy: Realization of any changes in revenues, expenses, operations, mgmt. policies, risk profile, & future prospects of a
merged firm that results from the merger which causes the post-combination market value of the merged firm to exceed the sum
of the pre-merger market values of its constituent firms
• A synergy is any post-merger development that can create a merger gain
Different merger gains are theoretically possible depending on whether the assumption is made that we operate in perfect
capital markets or imperfect capital markets conditions

PCM Conditions ICM Conditions

1. Price Takers: No one party has influence on the price
2. Equilibrium: Excess demand and supply do not exceed
beyond a transitory moment in time
3. Most investors have and exercise the opportunity to hold
widely diversified portfolios (i.e. only beta risk matters)
4. Dissemination and understanding of corporate and
economic news must be quick enough such that share
prices instantly and unbiasedly reflect all available public
information
5. Homogenous expectations about the uncertain future
1. Imperfect competition in securities market, incl. price
manipulation
2. Persistence of disequilibrium prices
3. Inefficient incorporation of information into security prices
4. Heterogeneous expectations among investors about
security returns
5. Presence of transaction costs and other market frictions
6. Predominance of investors who do not hold widely
diversified portfolios

Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.

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 Theoretical Underpinnings of Merger Motives & Gains1
Merger Motives Capable of Creating Merger Gains in PCM & ICM

Merger Motives Capable of Creating Merger Gains in Perfect and Imperfect Capital Markets
1. Increase Market Power: Monopoly or monopsonic power
2. Cost Reduction through Economies of Scale: Decentralization, managerial specialization, elimination of duplicate activities).
Economies of scope (Coca-Cola), Canadian banks takeover of trust & mutual fund managers
• It is unlikely that Canadian deals will lead to significant economies of scale due to the small size of the Canadian market
3. Vertical Integration
4. Complementary Strengths & Resources
5. Improved Management & Efficiency: Eliminated conflict of interest when Joe Segal owned both Zellers & Fields, Zellers
acquiring Fields eliminated competition between the two companies
6. Gaining Access to Scarce Resources: Property rights, government licenses, new technologies, natural resources, non- public
information
7. Other Strategic & Defensive Benefits: Cisco 1990’s acquisition spree, IBM purchase of Lotus, Disney & Pixar both defensive
and strategic theme park synergies with Pixar characters
8. Reduction in Beta Risk: In PCM environment, almost all merger related sources of corporate risk have no relevance or can be
duplicated without cost by investors
• PCM risk reduction merger gains occur when managers use control over operations of the merged firm to implement more
conservative risk averse strategies and policies such that prospective beta risk of merged firm is less than weighted
average of the pre-merger betas of constituent firms
9. Tax Savings: TLCF, CCAs, tax shelter laws by entering into lines of business with more favourable tax laws (Valeant & Biovail)
10. Financial Benefits: In PCM, reduction in bankruptcy risk is of no value as long as there are no costs associate with bankruptcy.
• Real costs of going bankrupt such as legal fees, fire sale liquidation losses, produce merger gain, since reduction of
bankruptcy costs is not possible through investors manipulating the markets by themselves

PCM merger gains happen only if the combination of merged firms can achieve some benefit that individual investors
could not have achieved on their own through manipulation of their own personal security portfolios

Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.

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 Theoretical Underpinnings of Merger Motives & Gains1
Merger Motives Capable of Creating Merger Gains in ICM Only

Merger Motives Capable of Creating Merger Gains in Imperfect Capital Markets Exclusively

1. Sales & Earnings Variability Risk Reduction via Diversification

• There is little evidence supporting existence of conglomerates & may be valued at a discount to total market value of
component firms
• A big firm containing a bunch of unrelated business leads to management inefficiency
• Conglomerates cannot move in and out of investments as easily as individual investors can
• Investors’ reliance on accurate accounting information, and the uncertainty associated with conglomerates’ financial
statements means blurred disclosure
• Conglomerates sell at discount to full break up value because upon divestiture, the firm has to pay capital gains taxes on
gains from constituent firms
2. Financial Advantages
• Moving the acquired firm towards its optimal debt ratio = increased debt subsidy for debt financing
• Better ability to set dividend policy to the share-value-maximizing level
• Access to funds, lower transaction costs w/ issuances, more media & ibanking attention
• Cash transfer within a conglomerate between a cash cow business unit to a cash-strapped one with high growth
3. Presence of Bargains or Inflated Share Prices
• Disequilibrium Prices: the market price of the target can be less than true intrinsic value, with gains accruing to
acquiring firm when the target realizes its intrinsic value
• Liquidation Value: When the market value of the target firm is below the combined value of constituent assets, the
acquirer can realize merger gains by selling bits and pieces of the target firm off post-acquisition

PCM merger gains happen only if the combination of merged firms can achieve some benefit that individual investors
could not have achieved on their own through manipulation of their own personal security portfolios
Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.
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 Theoretical Underpinnings of Merger Motives & Gains1
Merger Motives Capable of Creating Merger Gains in ICM Only

Merger Motives Capable of Creating Merger Gains in Imperfect Capital Markets Exclusively

3. Presence of Bargains or Inflated Share Prices (…cont’d)

• Different risk aversion of acquirer and target shareholders: If acquirer has a lower cost of capital, what is fairly
valued to the target shareholders will be a bargain to the acquirer
• Disturbance theory of mergers: In period of significant change in economic conditions, valuation differences are
especially prevalent
• Bargains: Arise from acquisition of small, closely held companies with low volume, such that the true value has not been
fully priced into the stock due to lack of interest or knowledge from the market
• Bankruptcy: Firms are likely to sell at bargain prices when they have gone bankrupt or owners want to sell out quickly for
personal reasons (such as management wanting to retire)
• Investment Canada Act / Net Benefits Test: Artificially segments corporate acquisitions market such that Canadian
firms can buy firms at prices lower than they would otherwise have had to pay, and foreign firms need to pay a higher
premium
4. Accounting Magic
• The acquiring buying a firm with a lower P/E than its own through a share exchange offer
• Presumes that investors only focus on accounting numbers, and that they must price stocks according to a simplistic
formula (stock price = EPS x P/E), AND that aggressor P/E multiple will not change materially as a result of the merger
• When one firm acquires another, the market often mistakenly applies the acquiring firm’s higher P/E multiple to the whole
merged firm, rather than using a weighted average of the P/E multiples of the pre merger firms

“While• the motive of conducting an acquisition to “secure assets at a bargain” is a legitimate one, it is not likely that
sufficiently large undervaluations exist to make bargain hunting a dominant motive because it would be eliminated with the
takeover premium paid to shareholders. Firms are not able to identify bargains any better than the market in general, so
benefits of a genuine bargain acquisition are overrated.”

Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.

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 Why do most mergers and acquisitions destroy value?

Value Destruction
 About two thirds of mergers and acquisitions destroy value
 From 1980 to 2001, acquisitions resulted in an average of 1 – 3% decline in acquirer share price, or $218 billion of value
transferred from acquirers to sellers (McKinsey & Co.)

Reasons Why Mergers Fail1

 Management egos
• Managing a bigger company means bigger Overpaid (1994)
bonuses if compensation is tied to equity
 Diversification results in loss of management focus
CEO Power Struggle (1995)
 Acquirer paid too much for target
 Unsuccessful at integrating disparate corporate
cultures leading to attrition of key personnel CEO Power Struggle (1997)
 Managers focusing too intently on cost-cutting measures
to neglect day-to-day business, resulting in lost
customers Systems Integration (1998)
 Easy to overestimate synergies
• Synergies are often not enough to overcome Overpaid (2001)
control premium and financing / transaction fees
• Synergies take time to realize
 Winner’s curse Unsuccessful Integration (2005)
• When an attractive target is put into play,
competing bidders often enter and bid up the price
Horrible Timing (2007)
• Potential merger gains become slimmer

Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.

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 Role of Investment Bankers in M&A
Strategic M&A Advisory

How do investment bankers add value to M&A transactions?

 Structure of Transaction  Tax Consequences

• Plan of arrangement, takeover bid, amalgamation • Creation of goodwill
 Consideration • Transaction structure and consideration will affect
• Cash, shares, preferred shares, warrants, special taxes
warrants  Execution
 Offer / Bid Price • M&A process can be lengthy
• Requires a full suite of valuation work • Many legal procedures need to be followed
 Deal Terms • Due diligence
• Break fee, reverse break fee, go-shop clause, right  Regulation
to match • Certain deals must be carefully structured to
• Are options assumed by buyer, cashed out, or maintain compliance with anti-trust, national
ignored? interest, and other legal issues
• Mgmt lock-up agreements, for board of directors, • Many large deals get blocked by the government
large shareholders • How can the acquirer avoid restrictive regulatory
legislation preventing the deal from passing?

Investment banks can add a great deal of strategic value compared to more transaction oriented situations like equity or
debt issuances. Many investment banks focus exclusively on M&A as their niche.

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 Role of Investment Bankers in M&A
Strategic M&A Advisory

How do investment bankers add value? How does a firm choose an investment bank?

 Special Situations  Relationship business

• Buying firm after bankruptcy or restructuring
 Deloitte acquiring Monitor  Strategic expertise can play a role
• Insider bids (protection of minority shareholders) • Certain banks are strong in certain sectors
• Reverse mergers
• Three-way mergers  Can banks compete by lowering their price?
• Most banks have competitive pricing and similar fee
 Fairness Opinion structures
• Independent valuation to determine if offer price is • Decision to hire an advisor is rarely based on fees
fair, associated with lower fees for the bankers
• Most Boards of Directors require a fairness opinion  Buy Side Advisory
before approving the deal • Ease of and terms of financing offered by each bank
is an important decision criteria
 Other
• Spinoffs / divestitures  Stapled Financing Package
• Acquisitions / divestitures of specific assets, • The sell side advisor provides financing for buyers
especially in oil and gas, mining, real estate (Scotia • Buyers no longer need to scramble for last minute
Waterous, Brookfield Financial) financing
• Hostile Defense
 Is our company undervalued?
 Are we vulnerable to a raider?

Investment banks can add a great deal of strategic value compared to more transaction oriented situations like equity or
debt issuances. Many investment banks focus exclusively on M&A as their niche.

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 Role of Investment Bankers in M&A
Buy Side vs. Sell Side

Buy Side vs. Sell Side Good Case Studies to Read Up On

 Investment banks can advise on the buy side or sell side
 Buy Side: Advising the acquirer / aggressor / bidder
• Helps buyer determine the right bid and deal terms
• Can be complex with multiple bidders or with hostile
takeover
• Takes 16 – 36 weeks
• Takes another 3 – 4 months to close after
announcement
 Sell Side: Advising the seller / target
• See previous slide

Sell Side, Strong Side?

 Investment bankers are paid a small portion of the total
fee up front (work fee)
 The bulk of the fee is not paid until the deal is closed and
approved by regulatory bodies
 Sell side advisory roles have much higher chance of
closing than buy side advisory roles
 When a company is being sold, they are being sold for a
good reason, and there is a high likelihood that they will
be sold
 On the buy-side, if there are multiple bidders, and the
bank advises only one bidder, then it may not be
successful

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II. M&A Process
 Buy Side Process

 Analyze competitive landscape

 Identify potential targets
Assessment  Find key issues to address:
(4 – 8 weeks) • Pensions, contingent liabilities, off balance sheet items, inside ownership, unusual equity
structures, special warrants
 Build out acquisition timetable, most of which have the tendency to be optimistic

Contacting  Contact potential target candidates

Targets &  Negotiate a confidentiality agreement (CA)
Valuation  Perform preliminary valuation on target, including trading comparables, precedent transactions,
discounted cash flow analysis, accretion / dilution model, LBO floor valuation
(4 – 8 weeks)

Pursuing the  Send letter of intent (LOI) with details of initial offer
Deal & Due  Conduct due diligence: Create data room, analyze products and services, analyze the company and
industry, assess the company’s financials, identify contingent liabilities, conferences with management,
Diligence auditors, lawyers, site visits
(4 – 10 weeks)  Finish valuation

 Finish due diligence

Definitive  Arrange, negotiate and execute definite agreement
Agreement & • Board must approve transaction for it to be considered “friendly”
Closing  Provide financing, unless stapled financing package in place
(4 – 10 weeks)  Conduct any required filings and announce deal
 Seek shareholder and regulatory approval, deal may take another 3-4 months before official close

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 Sell Side Process
 When a firm wishes to sell itself, it will usually either:
• Contact an investment bank with which it has a strong relationship
Find An Advisor • Contact an investment bank which has strategic expertise in the company’s sector
(1 – 2 weeks) • Invite multiple investment banks to a beauty contest
 During a beauty contest, multiple investment banks will present their qualifications, expertise, proposed strategy, key issues,
and universe of buyers to the firm

 Identify seller’s objectives and determine appropriate sale process: broad or narrow auction?
 Broad Auction: Contact many potential buyers, more bidders usually means a higher price
Preliminary • Risks leaking competitive information, and there is also a higher chance that the process itself will be leaked, which
Assessment interferes with the deal itself and the morale of employees
(2 – 4 weeks) • Often the best option if the public is already expecting a sale
 Strategic Review: When a company announces they are doing this, usually means a broad auction
 Narrow Auction: Contact a few strategic buyers to prevent the leaking of competitive information

 Contact potential buyers


Find An Advisor
Negotiate and execute confidentiality agreements
First Round  Send out Confidential Information (1 – 2 weeks)
Memorandums (CIM) and initial bid procedures letter
 Prepare management presentation, build data room, negotiate stapled financing package if needed
 Receive initial bids, and filter buyers to second round
 Facilitate Management Presentations: Mgmt. brings bankers to presentations to add legitimacy
 Facilitate Due Diligence: Site visits, open up data room to buyers
Second Round  Send out final bid procedures letter and create a draft of the definitive agreement
 Buyers make final bids

 Evaluate final bids, negotiate with top bidders, and select the winning bidder, which may not always be the highest bidder
• Other factors like deal terms, type of consideration, future plans are also important factors to consider to ensure that
the buyer is willing to cooperate with existing management’s vision to lead to a smooth transition
Negotiations &
 Arrange for fairness opinion (if needed), receive board approval and execute definitive agreement
Closing  Announce Transaction
 Closing: Shareholder approval, regulatory approval, financing, and closing
 May take 3-4 months for acquisition to officially
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III. Accretion / Dilution Analysis
 Financing Takeovers – Choice of Consideration
Stock vs. Cash Consideration

Benefits of Stock Consideration Benefits of Cash Consideration

 Good if the acquirer’s stock is doing well
• Many stock acquisitions by tech companies before
tech bubble burst
 Better for tax
• With cash acquisition, capital gain is immediately
taxable
• With stock, these capital gains can be deferred
 Beneficial for acquirer if it is cash strapped and does not
have excess cash leftover
 Cash is generally cheaper than equity
• The opportunity cost of balance sheet cash is
forgone interest on cash
• Typically 1%, while cost of equity is usually double
digits
• Debt is also generally cheaper than stock
 Good for confident buyers
• With cash, buyer retains 100% of the benefit since
acquiring shareholders own all of the entity’s shares
• Target shareholders will NOT receive the acquirer’s
shares in exchange for their own
 Less uncertainty
• Stock offers are usually made with an exchange
ratio and have no fixed value
• Stock price could fluctuate before tendering of
shares
• Cash is a fixed value (assuming no currency risk)
 Better if stock of acquirer is weak
• Cash is more common in economic downturns
 Will result in better profitability ratios
• However, liquidity ratios will decline

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 Financing Takeovers – Choice of Consideration
Stock vs. Cash Consideration

Buy Side Considerations of Share Exchange vs. Cash1

 Canadian law does not permit bids contingent upon the acquirer’s securing financing and requires bidder to have adequate
financing arrangements before the bid is made

 Factors distinguishing between cash & share exchange:

• Willingness to Share Gains: If cash is used to finance takeover, target firm’s shareholders do not participate in synergy
related gains except to the extent that it has been priced into the offering price
• Disclosure: Cash offer lower level of disclosure, while a share exchange offer requires an offering memorandum and
takeover bid circular
• Ownership Control: Cash transaction does not change ownership control position of aggressor
• Tax Considerations: If TargetCo shareholders have embedded capital gains tax in their shares, they will prefer to do share
exchange and get the aggressor’s shares in return for tendering their own to avoid “tax deferred roll over” if they took cash
or debt
 Institutional shareholders non-taxable & indifferent
• Non-Tax Shareholder Preference: Institutional investors (that owned shares in TargetCo) prefer to receive cash, if they
are concerned that the takeover will not create added value, but shares if they think the aggressors’ shares will increase in
market value
• Market Value of Aggressor Firm’s Shares: If the aggressor’s shares are overvalued, it will want to trade its own shares as
“currency” of the transaction for TargetCo’s shares (will get more shares of TargetCo per share it gives up)
• Need for Approval of Aggressor Firm’s Shareholders: In an all cash transaction, the management of the aggressor does
not need shareholder approval
 In a share exchange, management also does not need shareholder approval, as long as shares issued does not exceed the authorized
maximum share capital
 Many firms have a clause in the IPO prospectus that gives management unlimited authorized maximum share capital

Source: Cannon, William. “The Analysis of Mergers and Acquisitions”, 2013.

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 Accretion / Dilution

What is accretion / dilution? Effects of an Acquisition

 Accretion: If pro forma (combined) EPS of the merged
company is greater than the acquirer’s original EPS
 Dilution: If pro forma (combined) EPS of the merged
company is less than the acquirer’s original EPS
Acquirer P/E of 10x, Target P/E of 5x, Accretive?
 What is the consideration?
• Assume all stock
 This transaction is accretive
• In an all stock deal, the transaction is accretive if the
P/E of the target is less than the P/E of the acquirer
• You are paying for a company that is generating
more earnings than you are per dollar of stock price
• Your shareholders are paying less for $1 of earnings
than you would normally
• Your EPS will thus go up if you buy their relatively
underpriced stock with your own relatively
overpriced stock
 Note: we have not accounted for financing fees,
transaction fees, or synergies
 Depends on the consideration
 Foregone interest on cash
• Opportunity cost of balance sheet cash used in the
transaction is lost interest income
 Interest on debt
• If leverage is used, additional interest expense will
be charged to the acquirer
 Additional shares outstanding
• If consideration is a share exchange, acquirer will
have to issue additional shares from treasury
 Combined Financial Statements
 Creation of Goodwill and other intangibles
• Write up target’s assets from historical cost to fair
value
• Goodwill represents the premium over this amount
(approximately)

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 Accretion / Dilution

All-Cash Acquisition
 If a deal is financed only through cash and debt, there is a shortcut for calculating accretion / dilution
 If: interest expense for debt + foregone interest on cash < target’s pre-tax income, then acquisition is accretive
 Think of it as: pre-tax cost of financing being used < pre-tax income being consolidated with your own
 Assumes no synergies, transaction fees, financing fees
 Complete equation:

Accretive if: Transaction Fees + Financing Fees + Interest Expense On Debt + Foregone Interest On Cash
<
Target’s Pre-Tax Income + Synergies

Mix of Stock & Cash Consideration

 There are no shortcuts for finding accretion / dilution for acquisitions that use a mix of cash and stock
• Must build merger model
 Advantages of using a merger model:
• Intrinsic valuation allows you to understand break-even syneries, key variables, as well as bull, base, and bear case
scenarios
 Disadvantages of using a merger model:
• Using precedent transactions may provide a more objective view, since there is less room for manipulation
• Difficult to model out synergies, transition costs, effect on corporate culture and employee morale

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Accretion / Dilution
Merger Model Walkthrough

Steps to a M&A Accretion / Dilution Model

1. Input purchase price assumptions (% cash, % stock, % debt)

2. Build stand-alone income statement and balance sheet for acquirer AND target

3. Allocate purchase price to the writing-up of assets to fair value, the creation of new goodwill, and
transaction fees

4. Build a sources and uses of capital table to calculate the necessary amount of sponsor equity needed
to fill the gap

5. Make adjustments to the target’s balance sheet based on Step 3

6. Create pro forma post-merger balance sheet and income statement, making adjustments for any
synergies or new debt / interest expenses

7. Calculate post-merger fully diluted shares outstanding

8. Did EPS increase? Sensitize analysis to purchase price, % stock / cash / debt, revenue synergies, and
expense synergies

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 Accretion / Dilution
Advanced Merger Model Concepts

Deferred Tax Liabilities Goodwill

 Writing up target’s assets to fair value creates  We write up the target’s assets from historical
deferred tax liabilities (DTLs) cost to fair market value
 On your books, it seems like you don’t have to  We then have to account for any DTLs created
pay as much tax, since you are writing up your
assets up and increasing your depreciation base
 In reality, you still have to pay the same amount of Equity Purchase Price
tax less: Seller's Book Value
• Naturally, the government does not let you Premium Paid Over Book
reduce taxes by writing up the target’s add: Seller's Existing Goodwill
assets after an acquisition
less: Asset Write-Ups
 There will be a discrepancy between your books less: Seller's Existing DTL
and the taxes you actually pay add: Writedown of Seller's Existing DTA
 This discrepancy creates a DTL add: Newly Created DTL
• DTL = Asset Write-Up x Tax Rate Merged Company Goodwill

Almost never asked in interviews.

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