My name is Maria Weber, for those that I haven't met before.

I'm going to be doing today's session on M&A fundamentals. As with these fundamentals sessions, we are keeping things pretty basic.

So my aim for today's session is for us to go through just very high level an overview of key M&A concepts.

I'm going to use a couple of slides just to help us through that. Then we're going to spend some time doing a very simple M&A model, but the main principles we need to know are here. And then, yes, stuff can get more complicated, but this is the fundamental bit.

Once we've got that simple M&A model set up, we're then going to use it to do some analysis, and what I'm going to focus on for today is impact on earnings per share. So we're going to look at earnings per share accretion or dilution. We'll then see how much time we've got. I'm definitely not going to take more than an hour, but we'll see if we can then look a little bit at the debt ratios if we've got time, look at premium versus synergy paid, and then I don't think I'll get to return on invested capital. But not next week, because I think there's a break over the Easter period, but on the 10th of April, I think it is, there is a follow-up M&A session that is a bit more advanced, and there you will go into more detail on M&A analysis.

Okay, so we're just laying the groundwork here today.

Okay, so if you scroll down a little once you've clicked in, you'll see there's an empty workout and a full workout. So if I may be going a little bit fast, or you need to drop out of the meeting and come back in, if you want to follow along in the full solution file, you've got that too.

Okay. So please don't be shy to ask questions as we go, either in the main chat or if you don't have access to that, you should have access to the question and answer pod.

Please do ask questions. Okay. So hopefully we are all good to go.

Right.

What I'm going to start with is I said, okay, let's introduce some basic M&A concepts. Right? First of all, I'm talking here about strategic M&A.

So I'm talking about one company buying another company.

I'm not talking about, say, a leveraged buyout where a private equity fund buys another company, they're looking to sell it in a few years.

I'm talking strategic M&A.

Something that's been in the news a lot recently, so it was top of my mind when I was thinking about this session, is the Paramount-Warner Brothers deal.

So you know Netflix was bidding for that as well, and now it seems Paramount has won that. It obviously still has to go through the regulatory hurdles and everything else, but that's the kind of thing that we are talking about here.

Now, first of all, there's got to be strategic rationale for doing a deal. It's not just about the numbers.

Yes, we're looking at the numbers today, but it's always a good idea, especially if you're new to this kind of thing, to look at press releases, look at things like fairness opinions, public disclosures around M&A. So all I did is I just went into Felix, and this is public information.

You don't need to access this only through Felix.

But I looked at Paramount Skydance. So I just typed in the ticker, and then I came to this categorized page with the public announcements and financials.

And here I got the 8-K Paramount to acquire Warner Brothers Discovery, that press release.

And if you want, I can copy this link into the chat.

Okay. If you do want to click into it and have a look at that.

So in this press release, you can see I'm not obviously going to go through the whole thing with you. But first of all, we've got strategic rationale, right? So I mean, they start the very first bullet point talking about how the company is going to be well-positioned, evolving entertainment industry, world-class studios, and there's even more to come if you scroll further down, strategic and financial rationale.

Okay, so decision number one is strategic. Is this a good fit? Then we need to think, okay, let's start looking at the numbers.

So the first thing we need to decide and do a lot of work around is the valuation. What is the buyer going to be paying for this target company? Now, valuation in an M&A context, I mean, the principles are the same as in a non-M&A context in terms of equity value versus enterprise value. But here we're looking not at the unaffected standalone share price, we're looking at an offer price per share.

Now, that in an M&A context would be at a premium, right? Because you want to acquire control of the company, you've got to convince the shareholders to sell, you're looking at synergies. So you offer more than that standalone price.

Now, this is where you do sensitivity analysis.

Before, I mean, I'm looking at a deal announcement that will show the price, but this is a matter of negotiation, looking at what similar deals have been done at recently, so looking at your precedent transactions. But the point is, this would be at a premium.

If it's a publicly listed company, you can observe that premium as a percentage. Now, this Paramount press release doesn't actually put here, I know it was a big premium, but they don't actually put here what the premium is.

But I mean, you could always work it out by going back and looking at the Warner Brothers share before there were rumors of a deal.

So here, Paramount's going to be paying $31 per share, okay, for Warner Brothers.

I just pulled up another deal announcement.

So this one was from last year, and this is a massive deal if it goes ahead. So railway deal in the US, Union Pacific and Norfolk Southern. This is facing tough regulatory hurdles. The regulator of the railways, I forget the name now, in the US has to approve this as well, and I think that's where it's now sitting.

I think they submitted, and then they came back and asked for more information.

So this is another deal announcement that I want to use. And again, I will just share this link.

Let's do that. So if you want to access this, I'll put it in the chatBut like I said, this is public announcements.

I just accessed it through Felix. Here, we've got Union Pacific making an offer for Norfolk Southern.

They say it's $320 per share, and then based on the target's unaffected closing stock price, that is a 25% premium. Oh, sorry, that's based on not the target. The buyer is Union Pacific. Sorry.

So buyer is Union Pacific. It's a 25% premium to Norfolk Southern, who's the target, their 30-day VWAP price. Okay, so there you can see that 25% premium.

Okay, so it's not always going to be 25%.

Like I said, it depends on the market conditions, similar deals, but say like 20% to 50% premiums.

It's not unusual to see. Okay, so that's the first thing.

Now, you are buying the shares, we're assuming, so equity value, but it's also very useful to have enterprise value of the deal, so going over the bridge. Because enterprise value will then allow you to calculate the multiples that the deal is being done at and compare it to recent transactions, and also things like fees are normally calculated based on the enterprise value.

Okay, so we've got the strategic rationale.

We then say, "Right, what's the value? What's the price that's going to be paid?" Next decision is, okay, how is this then going to be financed? And this is what we put into our sources and uses of funds table.

Under the uses of funds, this is what we need money for. We've got the equity purchase price.

I'm buying the shares, what do I need to pay for those shares? Where am I going to get the funding from? Two main sources of finance. We've got debt and equity.

Now, if the buyer is using debt to fund the deal, that means that the target shareholders get cash.

Right? Per share. Because the buyer borrows, gets the cash, and then pays the target.

If equity is issued, what usually happens is it's a share-for-share exchange. So instead of getting cash, what the target would get, the target would get shares in the buyer. But now obviously the buyer would include that target company. So that's a share-for-share exchange.

Now, big deals especially, often use a mix of the two, because if you're familiar with finance, I'm sure you would have heard or thought we would want to use as much debt as we can, right? Because debt is cheaper than equity.

And also, you're not diluting control of the business.

But there is a limit on how much debt you can raise.

You've got to keep an eye on what happens to your credit metrics, right? It's not just about, "Oh, debt's cheap, let's max out the debt." You've got to think about impact on your credit rating, what that would mean for your cost of funding, et cetera.

So big deals, often a mix of the two.

Now, something I wanted to point out.

There's always, I say generally the target company would get shares.

Not always the case, and we can actually see this in the Paramount deal announcement. If I just go back to that Paramount deal, we can see here that Warner Brothers shareholders are getting $31 per share in cash. So if I'm a Warner Brothers shareholder, I'm getting given $31 in cash.

How is Paramount going to be funding this? If we scroll down a little bit more, so down to the transaction highlights, we can see that it's being funded by $47 billion in equity, and then they've got this $54 billion of debt commitments.

Now, that equity is not Paramount shares going to be given to Warner Brothers shareholders. It's not a share-for-share exchange.

Warner Brothers shareholders get cash.

This is Paramount issuing shares, getting the cash, and then giving the cash to the Warner Brothers shareholders. Okay.

So it's not always a share-for-share exchange.

An example where there is a share-for-share exchange happening and a portion being given in cash is this other deal announcement, that Union Pacific Railway deal. So if you look, it's a stock and cash transaction, and if you scroll down again to the transaction details, you can see that the target shareholders would get given one Union Pacific share and $88.82 in cash.

Okay.

So hopefully putting things into context in terms of how a deal can be paid for.

Before we get going with our model, just to note, we're going to see this in our model, that things are a little bit more complicated than the simple sources and uses of funds table because there are other things that we would likely need to take into account.

So we've already talked about the equity purchase price, what we're going to pay for the shares of the target.

But often there are change of control clauses in the debt in the target company, which says if control of this company changes, the debt needs to be repaid. So as part of this transaction, the buyer needs to have enough money to not only pay out the shareholders, but also pay back the debt holders as well. So refinancing the net debt, because if there's any cash in the target, we could then use that to pay off some of the debt. We also need to make sure that the bankers, the lawyers, everyone gets paid their fees, so transaction fees, and then there could be other nuances depending on the kind of deal where you might have to have an operating working capital adjustment, for example.

We'll talk through that in our model in a moment, and other things like pensions, et cetera.On the sources of fund side, we've already spoken about issuing equity and debt. We also could have cash on hand that we want to use.

Right? And then a revolving credit facility typically is not used for very long-term funding, but that would be used for things like this operating working capital adjustment.

And if we go back to that Union Pacific Railway deal announcement, you can see they're paying part with equity, share for share exchange, that's the one share.

Part in cash. Where are they getting this cash from? If you look at the second highlighted paragraph here, the cash portion is funded by a combination of new debt, and they've also got some balance sheet cash on hand that they can use.

Right. Let's now go into the model. Okay, so for those that have just joined, I know some people have just joined us. If you have a Felix subscription, I just want to put the link into the chat.

You can find this document here, M&A MT. Otherwise, please just follow along on screen, ask questions.

And before I forget, guys, I'm talking about the Paramount deal. Right? If you go to Felix's homepage, you'll see this green banner up at the top.

What's the big deal? We've got a new podcast that two of my colleagues are doing. And I promise you, I'm not just saying it.

I have listened to it, and specifically, the episode on analyzing the Paramount Warner Brothers deal is great. So do yourself a favor. It's free to join, free to listen to.

Have a look. Check out that podcast. It's really, really interesting stuff. Okay. So let's go to our spreadsheet. You'll notice there are loads of exercises here. We've given you the full solutions. You can look through them.

I've just highlighted in yellow the one that we're going to be focusing on, which is M&A Cash Deal 1. Okay, so if we just go to that, what is it? Fourth tab.

Okay, let's just familiarize ourselves a bit with what we need to be doing.

We said, okay, first of all, we need to look at valuation.

So a lot of work would go into analyzing the valuation, but we say, okay, we think a premium of 25% would be fine in this case. You would do sensitivity analysis around this, right? You would run the numbers using different premiums to see what the outcomes would be.

And the way this is formatted is indicating to me it's an assumption, right, that we can play around with. If you go to the Info tab, you can see our formatting key. That light blue background indicates an input and assumption, whereas a blue number is a hard-coded, kind of if you can think of as actual number. Normally, that's for historical numbers, and then the black numbers are formulae. Okay, so first we've got valuation information, and then we go over the bridge, we get enterprise value for the acquisition. We've then got some other assumptions that we're going to need.

So things like synergies, things like how much equity versus debt are we using, interest rates, tax rates, et cetera.

Then we've got the sources and uses of funds table.

Once we've got this, we can now start our analysis.

We are going to focus on, like I said, earnings per share accretion and dilution. We'll talk through that when we get there. And then we can look at other things.

Like I said, hopefully, we'll have time to look at what the debt metrics look like and maybe synergies versus premiums.

But let's start up at the top, and this is not linked to any of those deal announcements I was showing you. Okay? So this is just independent numbers that we are working through.

Right. So we've got the acquirer, we've got the target.

Target's unaffected share price is $4 per share.

We think a premium of 25% is what we could buy this company for. So let's then take the four times 1 plus that 25% to get the offer price or the acquisition price.

So that's $5 per share.

Now, I want to know what's the total amount I'm going to pay for all of the equity, for all of the shares.

I've got the number of shares outstanding of 31, but I need to make a dilution adjustment.

Now, this is not basic fundamentals.

This is getting a little bit more advanced.

But if you are familiar with dilution, I'll do the calculation here with you quickly.

If you're not familiar with it, don't stress.

You can just type in the answer. It's a round number.

If you are interested in learning about this and you do have a Felix subscription, you can find this if you go to Valuation under Investment Banking.

Just if you're interested, if you go to Investment Banking, Valuation, you can find it under Trading Comps. So if you go into Trading Comps, you'll see there's a section on dilution. So diluted number of shares, how to do the dilution calcs. Okay. Let's just do the calc, but you can just type the number in if this is new to you. Okay, so we've got employee stock options outstanding, five of them, five million, whatever. We've got a strike price of three, so that's what employees can buy shares at. So what is the dilutive impact on this? It's effectively the part that are being issued for no value. So I'm going to take the maximum of zero and the share price, which is now the acquisition price, because we're looking at this in an acquisition scenario.

And I just need to make sure that I put brackets around that.

So I'm going to take the difference between theShare price and the strike price, and I'm going to divide that by the share price.

The reason I use that max function is because we only want to include options if they're in the money.

If they're out the money, we don't want to include them.

The answer would then be negative, and it would just give me a zero.

That's what the max function does.

And then we need to multiply by the number of options, and that gives us an answer of two.

So for those of you where this is brand new, please don't stress about it.

Just type in the answer two over here.

It's around two.

But the impact of this is it's not that there's 31 million shares outstanding, it's 31 plus those two extra shares.

Okay, so the diluted number of shares is 33.

Why do we need this? This is okay. We want the total acquisition equity value. We are offering $5 per share, and there are 33 diluted shares outstanding, and so that means a total-- And I've put this in the wrong row again. Okay, I did it in previous session too.

I'm just going to move that down because this is what I've just worked out, the acquisition equity value.

So that's what we would buy out these shares at.

Above that, we have the market cap if there's no deal.

Just looking at things as they are now, what is the market cap of both companies? So let's put this in. We don't actually need it right now, but we'll maybe get to it later with the synergy analysis.

So the buyer has got a share price of 18 with 15 million shares outstanding. And if I copy that across for the target, we can see their market cap's 132. Okay, so I'm paying a premium above that market cap.

So that's the acquisition equity value.

We've said it's useful to have acquisition enterprise value as well, because then you can work out what multiple this is being done at.

We're also going to need it for our fees.

So let's now go over the bridge. So we've got the equity value.

We know to go from equity to enterprise value.

We add debt, we subtract cash, other financial assets.

So that's like adding net debt. So I'm going to add the net debt.

And then there's also a pension fund deficit, which is a debt-like item. I'm going to add that on.

And I get enterprise value for the transaction of 225.

We've then got the separate working capital adjustment that we'll come to in a moment.

Okay, any questions, please don't be shy to ask either in the main chat or in the Q&A pod.

Okay, we need this equity value, and we're going to need the enterprise value to work out fees to do our sources and uses of funds.

Let's start with the use of funds. What do we need money for? Okay, I need to buy the shares, equity value.

So there, it's that equity value, right? The acquisition equity value. So that's first thing I need money for.

Then we are assuming that there is a change of control clause.

You are going to have to refinance the net debt of the target.

Or maybe there's not a change of control clause and you want to refinance the net debt if you can. Sometimes it's hard to do that, but in this case, we are going to refinance that net debt.

So I need to come up with an additional 40 million to pay off the debt.

Then this is not going to be in every single case, but if there's something like a pension deficit, so certain types of pension schemes that guarantee a certain outcome to the members, if they are in deficit, okay, that's a financial liability. And the pensions regulator might say, "As part of doing this deal, you need to top that up.

You need to put some money into the pension plan." And so in this case, we've got a pension top-up, pension deficit adjustment of 20.

So we need more money for that.

And then this working capital adjustment won't always happen.

But in this example, if you think of it as working capital fluctuates throughout the year, if we've agreed the deal, and then it takes a while for the deal to actually close and for the money to change hands.

If at the time of closing, there's a higher than normal level of working capital, we're going to have to pay a bit more for that.

Okay? It's like buying a car where the gas tank is full, pay a little bit extra for that. And so that's what we've illustrated here.

We've got this working capital adjustment of 10.

So this is all uses of funds. I need the funding for this at closing.

And then finally, we've got the fees, which we are assuming is going to be, I nearly said 5%, that would be great.

Half a percent of enterprise value.

So paying the lawyers, the bankers.

So I've got acquisition enterprise value, and I've got the fees.

So that's 1.1. And then we can total all of that up to get our total need for funds. That's our total uses of funding.Now we need to think about how we are actually going to finance this.

First up, we have got a revolving credit facility.

Like I said, you would typically not use an RCF for something like a big acquisition, but what we could use this for is our working capital adjustment.

So I'm going to fund the money that I need for the working capital with a revolver.

Next we've got debt funding, but we haven't actually figured out what that is yet, because what we do have here is an assumption in row 20 that we're going to finance 30% of the equity purchase price with equity. Now be careful if you are new to this, there's equity floating around, right, all over the place.

We've got equity over here, equity, and we've got the word equity over here.

It's two completely different things.

Equity on the left-hand side is what am I paying the target shareholders, right? So this is like that $31 that Paramount is paying Warner Brothers.

That's on the left-hand side here.

On the right-hand side is me as Paramount, how much equity am I going to be issuing to get the funding to pay for the deal, right? So that's what's on the right-hand side over here.

So we've said, okay, equity funding is going to be 30%, so go up and link to your assumption because we want to be able to play around with all of this, so we're not hard coding 30%, and that's going to be 30% of this equity purchase price.

Shareholders, I'm going to fund 30% of that purchase with equity, which means that the debt I'm going to raise or that I need to raise is the balancing figure.

We're going to take that total 236.1 and we're going to subtract the amount we've already got from the revolver and the amount that we are going to get from equity, and that means debt funding of 176.6. So that is our plug in this model.

And let's just do a check to see that our total sources equals the total uses, which it does.

Now, not all models might be like this.

Other models might first work out the amount of debt we can raise, and then the equity would be the plug.

You've got to make sure that this debt amount is actually achievable, that this is not going to be so big that it pushes then the company into, say, non-investment grade, unless that's part of the plan and people would be happy with that, but for a public company, you normally want to try and maintain your credit rating.

Yeah, but like I say, there's always exceptions.

And actually interestingly, if you have been following the Paramount, Warner Brothers deal, if I'm not mistaken, I think I remember reading Paramount's debt got downgraded because of this big debt burden they're taking on to do the deal.

They're raising a massive amount of debt, and so I think Fitch downgraded them. Okay, and please correct me someone if I am wrong, if you have more information in the chat, but I think I recall reading that quite recently. Okay. So guys, we have got the beginnings now of our analysis. We know what we want to pay, are the money that we need in our uses of funds, and then where we're going to get that funding from.

Any questions? Just going to take a pause, take a sip.

Okay, let's move on then. Before we go into the earnings per share analysis, one of the things we're actually going to need for the earnings per share analysis is to know how many shares are going to be outstanding after the deal. So where you see this word pro forma, all pro forma means is just after the deal, what are things going to look like? So if I start off and say, "Okay, well, how many shares does the buyer have outstanding at the moment?" We've got that up at the top here.

They've got 15 million shares outstanding at the moment.

So those shares aren't going anywhere.

But then what we need to look at is we need to look at this equity funding over here and say, "That equity funding, how many shares does that represent?" We are saying we are going to issue equity to the value of 49.5 in total.

Well, how many shares do I need to issue to make up that total? I need to divide by the value of one share, and that's what we have in row six. And remember, this is the buyer issuing their shares, right? So I use the buyer's share price, and that gives me 2.8.

Like I said, those shares could be issued as part of a share-for-share exchange, so like that railway deal where each shareholder of the target is getting one share in the acquirer plus an amount of cash, or Paramount deal, they're just issuing those shares for cashOkay? And then they're going to give the cash to the Warner Brothers shareholders. Either way, there's going to be more shares outstanding in the buyer. So total shares outstanding is going to be 17.8.

And then something that's useful to do is to just do a ownership analysis after the deal to say, okay, well, the acquirers shareholders, they before owned 100% of the acquirer, but now because we're issuing shares, they are going to own 84.5% of the combined entity after the deal, and then the remainder will be, if it's a share-for-share exchange, owned by the target company shareholders.

And this you might want to look at and say, okay, well, I know there's certain thresholds, like if you go below 75%, you can't pass special resolutions. If you go below 50%, you actually don't control the company anymore.

So just keeping an eye on that.

Okay, we are now ready to move on to looking at the earnings per share bit. I'm going to leave this relative PE analysis. That's a bit more advanced and I imagine something that you will look at in the next session. If not, though, you do have the answer.

This is just a very quick, high-level way to determine if the deal is going to be accretive or dilutive, but there's some caveats that come with it.

Okay, so I'm going to go and actually do the accretion and dilution analysis.

So what is accretion or dilution? We are comparing two sets of earnings per share.

I'm not actually interested in the past, the actual, right? I don't care what has happened last year.

I'm interested in the forecast. So year one, year two, year three.

Say, at least the next three years.

I want to compare what is the buyer's earnings per share on a stand-alone basis. If they don't do this deal, me as a shareholder in the buyer, what is my earnings per share expected to be going forward? I then want to compare that to the pro forma earnings per share after the deal, because as directors, you're coming to me and you're saying, "Cool, we want to buy this other company." I'm now thinking as a shareholder, okay, well if you don't buy the other company, this is the earnings per share I'm expecting going forward. If you do buy the company, what's the earnings per share expected to be going forward? And as a shareholder, I would obviously be happy if there is an increase after the deal.

So that's what we call accretion. Dilution, other way around.

There's a decrease after the deal.

Now, I think I looked in the Warner Brothers press release, or not Warner Brothers, Paramount.

I didn't see them refer to EPS accretion. Okay? I don't think I saw it in this press release, but if you look in that railway press release, Union Pacific, you can see here under the transaction details, they say, "The transaction is expected to be accretive," so increase to Union Pacific, that's the buyer, "the adjusted earnings per share in the second full year after closing the deal, and then rising to high single-digit accretion thereafter." Okay, so they do mention this in their press release.

Let's have a look at how we calculate that.

To calculate earnings per share, I need two things.

I need total earnings, so I need pro forma combined earnings, and I need the pro forma number of shares outstanding after the deal. We already have the pro forma number of shares outstanding.

We just calculated it.

Pro forma number of shares outstanding is that 17.8.

It's the original 15 plus what's being issued to do the deal.

So we're seeing the financing impact come through.

If equity is used, increase in the number of shares.

I'm going to press F4 to lock onto that because I'm going to want to copy this right. I think what I'll do is I'll just do year one properly and show my formula on the right-hand side, and then when we're done, we copy to the right. Okay, so we've already got one part of calculating pro forma earnings per share. So the next part we need is, okay, what's pro forma net income? That's going to start by simply adding the two companies together. This is the net income of the target on a stand-alone basis. This is the net income of the acquirer on a stand-alone basis. And that we've got above.

For the buyer, remember, both of these are stand-alone.

No deal. Right? You carry on going as you are.

We've got an earnings per share forecast, and we've got a weighted average shares outstanding. So number of shares, that's what WASO stands for, weighted average shares outstanding.

And net income would then be the earnings per one share times the number of shares.

I can then select that and copy it to the right.

I'm going to do exactly the same thing for the target on a stand-alone basis.

So earnings per one share times the number of shares to give me total earnings.

Let's bring that down into our calculation below.

So I've got the net income of the buyerI'll just do it for the first year, and I've got the target's net income.

Okay, so we've consolidated in that sense.

We've brought the two companies together.

But what we haven't considered yet is the deal impact.

And the first thing we need to think about is what about synergies? Synergies are created by two companies coming together. That's the definition of synergies.

So by definition, synergies are not captured in the standalone net incomes of the two businesses because you bring them together, and that's then when you have these cost savings that weren't built in, or higher revenues than you had forecast because now you've got cross-selling between the companies, et cetera.

Now, not all press releases indicate the synergies, but I think both of these ones that I pulled do indicate synergies, and Paramount are forecasting a massive amount of synergy. I think it's $6 billion.

Where are we? There we go. If you go to transaction highlights for the Paramount-Warner Brothers deal, $6 billion in synergies. Okay? And they say, where's that going to come from? Technology integration, efficiencies, et cetera. So it's a question whether that is actually going to be achieved, but that's what they're disclosing.

So $6 billion of synergies, and then I think Union Pacific also disclosed further up. There we go. For shareholders, $2.75 billion in annualized synergy. Okay. Now, obviously it depends on the sizes of the companies. You can't really compare the $6 billion and $2.75 billion because they're obviously different sizes, underlying companies, but we can see these numbers in the press release.

Okay, so in our case, we are forecasting synergies. If you go up to our assumptions, we see five.

Important to remember, whenever you're doing earnings per share analysis, it is after tax. So we need to take the five synergies on a post-tax basis.

We've got a tax rate of 30%, and so we're going to have to multiply that five by one minus 30%.

So let's go pick that up and just make sure you're using your dollar signs consistently here so that when we copy to the right, everything stays where we want it to. So I've got synergy of five, and I'm going to multiply by one minus 30% because the tax authorities are going to take 30% of whatever I make.

So I'm left with 70.

So lock on to that. So after-tax synergies of 3.5.

Now we're keeping things very basic here, but guys, do you agree this is a little bit unrealistic? Because we are forecasting that you are going to achieve the full amount of synergy in the first year after acquisition.

And synergies often take a while to be fully realized, right? It's not just going to be day one, acquisition happens, all of a sudden, all the cost savings are made, the sales have come through.

So normally what you would see in a more detailed model is the synergies building up to what's called the run rate, if you hear of run rate synergies. So building up to the run rate of 100%. So for example, in year one, you could have, say, 20% of that $5 million being achieved. Year two, you've got 50% being achieved, and then year three, you've got the 100% being achieved.

Okay, so here we're just saying from year one, it's all there.

So simplified, but you get the idea.

We've got one more adjustment to make before we can add up our total earnings.

And we're now thinking, okay, we've got the buyer standalone, the target standalone earnings, we've added them together.

Not encapsulated in those earnings is synergy, so we add that on after tax.

Then we have to think about, what about interest? If I am funding this deal with debt, there's going to be additional interest that is not captured in the standalone businesses because I'm raising more debt.

So we've got to make this interest adjustment.

So let's go pick up, first of all, the debt numbers.

I'm going to put everything in brackets because we're going to have to multiply by the interest rate.

So we're going to our sources of funds, and I'm saying, right, I'm adding on this RCF of 10. I'm going to press F4 to lock onto that.

I'm also adding on that long-term debt figure of 176.6, and I'm pressing F4 again to lock onto that.

So I've got the two on the right-hand side, my sources of funds.

But what about the fact that I am repaying the target's debt? Do you agree, included in that target's net income of 9.2, there's interest expense in there, but if I repay that debt, the interest expense will disappear.

So I'm going to subtract the debt of the target that I'm repaying. So I come up here and I'm subtracting that 27. Can you see it's on the other side of the sources and uses table? I'm repaying that debt. So I press F4, I'm locking onto everything.

So that's the adjustment to debt. The extra I'm adding minus what I'm actually repaying, that's sitting in the target.

Then I need to multiply that by the interest rate because we're doing an income statement and I want the interest impact.

So we're going to come up here and find the interest rate of 5% in row 21, lock onto thatAnd again, don't forget, after tax, we're looking at earnings per share, bottom line of the income statement, what belongs to shareholders, and that is definitely after tax. So we've got to take one minus the tax rate of 30%, lock onto that.

And just when you thought we were finished, we are not, because we've got one more adjustment we need to make, and that is, I want to make this a negative.

I want to show that it's an expense.

So synergy is a good thing, increases the earnings.

This, on balance, additional interest is going to decrease the earnings of the businesses.

And now we can do our total.

So I've got the pro forma net income after the deal for year one expected to be 26.5.

We've already got the number of shares outstanding after the deal.

And now I can work out, well, what's that on a per share basis? Total income divided by number of shares, and that gives me 1.49 for the first forecast year.

I then say, okay, for the acquirer shareholders, if they don't buy this other company, what were they expecting for next year as earnings per share? If you look in row 45, the buyer shareholders were expecting 1.26.

And then I compare and I say, okay, the 1.49 if there is a deal, versus the 1.26 if there's no deal.

Subtract one because I just want the percentage change, and that gives me an 18.5% accretion.

So that is very good, especially in the first year after closing.

Often what you would see is maybe a bit of dilution until the synergies fully come through. Okay, but in this case, this is looking good. If I select all of that and copy it to the right, let's see if we've done this properly.

Okay, if you're seeing those accretion numbers, okay, 18.5, 24, 26, that's correct. You do have the solution files, if not, but obviously please ask questions if anything is unclear.

Okay, so on this metric, this isn't the only metric, because you could achieve EPS accretion by just structuring the deal well by using a lot of debt, which is cheap.

Right? But there's got to be strategic reasons, et cetera.

So it doesn't mean, oh, just because you see EPS accretion in a deal, it's a brilliant deal.

Okay, but on this metric, looking at what's expected to happen to the EPS, this seems to be a good deal. Now, you would run sensitivity around this, right? Think about what do we think would happen if we played around with that premium? Okay, if we instead of 25% had to go up to a 50% premium, do you agree the EPS accretion would be worse? Because we're going to have to issue more debt, which means more interest. We're going to issue more shares, which means more shares outstanding, more equity. So if I change that to 50%, and we come down and have a look at what's happened, the deal's still accretive, but we can see the numbers are a lot lower than before. Okay? We would also think of things like, oh, what would happen if the interest rate changed? If the company was more risky because now we're using actually a bit too much debt. That would have an impact.

This would also have an impact. What happens if I can't raise so much debt and I need to raise not 30% equity financing? What if I needed to raise 60% equity financing? What would that do to the earnings per share accretion dilution? Okay, now, all of this, I mean, I'm doing one by one and going to look, but this is what a data table, a sensitivity table would do, right? Showing different outcomes with different assumptions.

Okay. So guys, that is EPS accretion, or in this case, not dilution.

We do have a little bit of time, so if there are questions, please ask, but if there's not questions with the time we've got, I'm going to have a quick look at working out the pro forma debt metrics.

So looking at debt to EBITDA, thinking about, okay, before the acquisition is done, what is the debt in the buyer of 300 relative to the buyer's EBITDA? So that's 1.9 times. We know the higher this ratio, the more risky, right? Because that's more debt relative to the earnings, the EBITDA.

We can do this for the target as well.

But typically, it's at the buyer level that the debt will be raised.

Now let's calculate, okay, what's debt going to be after the deal? What's EBITDA going to be after the deal? Well, EBITDA after the deal is going to be the buyer's EBITDA and the target's EBITDA, and then don't forget about the synergies.

If you're being conservative here, you could leave the synergies out, but we say let's include the synergies here.

So I'm going to go up and I need to pick the five pre-tax synergy, right? Because I'm EBIT before interest and tax.

And that's also why I don't take interest into account, right? So I just add the synergy pre-tax, I'm before interest and taxes.

So there's pro forma EBITDAAnd then to get pro forma debt, I've got the debt in the acquirer, that's not going anywhere, plus the debt in the target, but that debt of the target is being refinanced. So I want my model to be flexible because what if it's not refinanced, then this will change.

So I add it in because it's there, and then I take it out because I'm refinancing it, and then I've got to add the debt on the right that I'm adding to fund the deal, the $10+ the $176.6.

And that gives me $486.6 total debt after the deal.

And so what is that as a metric? Debt to EBITDA is 2.7 times. So we can see quite a big jump for the acquirer, right? 1.9 times to 2.7 times.

You would need to have a look at similar companies in the industry. What kind of levels do they have, debt to EBITDA? What credit ratings do they have? It's not to say that the rating agencies will immediately downgrade you if there's a plan to delever quickly, if you've maybe got a history of doing M&A where you have delevered quickly, but this is something that you would keep an eye on. If you start going above, say, three times, I mean, it's different for different industries, but there we would start saying, "Okay, leverage is getting high." And like I said, I think I showed you, Paramount's adding a lot of debt.

So if you look here in the Paramount deal, their net debt to EBITDA, taking synergy into account, is going to be 4.3 times.

Which is pretty high, but can you see they said there's a clear path to investment-grade credit metrics within three years of closing.

Okay. And I think the Union Pacific, they're also going to raise a bit of debt.

They're going to have debt to EBITDA of 3.3 times, and they say they're prioritizing maintaining a strong balance sheet and investment-grade credit rating. Okay? But ultimately, I mean, it's up to the credit rating agencies.

You've got to convince them that this would work.

Okay.

I am going to squeeze every last second that I've got here. I don't want to say I'm going to squeeze every last bit of joy out of your Friday because that is just too negative. Okay? Let's just use our last little bit of time together.

You've got the answer for this, but let's quickly do the synergy versus premium paid. Okay? So acquisition equity value, if we go up to the top, it's that yellow number we highlighted, right? I'm paying $165 for the equity.

What's the market cap before looking at this acquisition? And that's the number just above that. It's $132.

Okay, so that's the market cap, and then I compare it to what I'm actually paying. And the difference between that or those two-- Oh, I nearly created a circular reference there, okay? Is $33. So that's the premium above the market cap that I'm paying for the equity.

Now what I want to do is I want to compare that and say, "Okay, I'm paying extra above the stand-alone value of the company. What is the synergy that I think I'm going to get from this deal?" Because if I'm paying less than the synergy I think I'm going to get, then that's great. Right? I'm creating some value. So let's now put a value on the synergy.

To do that, I'm going to do a discounted cash flow effectively.

Now, I've got the WACC of the target, let's say, because if we assume synergies are in the target, WACC of the target, and then this risk premium is debatable. I mean, how much risk premium do I add? You would probably rather do a sensitivity analysis around the synergies, apply a bit of a haircut to the synergies.

But the rationale, at least behind adding this premium, is to say the synergies are more uncertain than the other forecast cash flows of the business, because synergies by nature are more risky.

So I'm just increasing the discount rate to 10%.

Okay, that's the rationale behind it, synergies being more uncertain, so higher discount rate to reflect that.

Now, I'm not doing a full DCF where each year I'm going to be discounting, then calculating the terminal value. I would need to do that if the synergies were different in each year building up to the run rate. Right? We've said in our example, we kept it very simple. We just said the synergies are achieved from day one effectively.

So what I'm actually doing is a terminal value calculation.

Right? So if I take the synergies after tax now, because I do want this on a post-tax basis, that's going to be the value to me. So that's the three and a half post-tax synergy.

If you've done some valuation terminal value calculation, you know you take your cash flow and you multiply it by one plus the growth rate, and then you divide it by WACC minus the growth rate.

Now, we're being conservative here in that we are assuming no growth rate in synergies. You could build in, say, inflation.

We're saying no growth rate. So do you agree that one plus G disappears because that becomes zero, so that's now gone? And WACC minus G disappears. Well, the minus G at least.

So all you need to do is you just need to divide by WACC.

So that three and a half divided by the WACC, I'm doing a perpetuity valuation here, and I'm saying today, the present value of those synergies into the future foreverIt's going to be 35 in today's terms.

And now what's the value created or destroyed? Well, I'm getting value of 35 by buying this other company. I'm creating value of 35, and I compare that to the premium I'm paying above the kind of standalone value of that business.

And so it's positive, which indicates the value I'm getting is more than the premium I'm paying. So that is value created.

If it were the other way around, it would be value destroyed.

And guys, that, with three minutes to go, is where I'm going to wrap up. Okay, I see I have a question in the Q&A pod admin related. I'll definitely answer that if I can in a moment. Let's just quickly wrap up.

If we have a quick summary of what we've talked about today.

First thing I think I would emphasize, if you're kind of new to finance world or even if you're not, but I suppose if you're not, you would be looking at this stuff anyway. But if you're new or if you're a student, read deal announcements. These are public documents for public companies.

So we looked at two deal announcements.

Also look at things like fairness opinions, et cetera.

Honestly, this podcast is great. Go watch the one or listen to it. I think there's a YouTube version and a podcast-only version.

Listen to the one Paramount deal being analyzed. Super interesting.

So gaining that awareness. Then what we did, we did a simple model.

We said you need to work out what you're going to pay.

Then you need to do your sources and uses of funds.

It's not just about what you're going to pay for the equity.

There's other things that need to be funded. How are you going to finance that? Debt, equity, maybe excess cash if you have that lying around.

We then used that information to do a bit of analysis and we said, "Okay, what is expected to happen to the earnings per share?" And so the forecast earnings per share of the two companies are brought together.

And then you say, "What about synergies? What about financing impact? Is there going to be additional interest? Are there going to be additional shares outstanding because of the equity we've issued?" And then you compare EPS after the deal versus before the deal.

You also then need to think about the amount of debt being added onto the business and what impact that could have on credit ratings.

And then we did a quick analysis to compare the premium we're paying with the value of the synergies. Remember, all of this stuff is assumptions.

You would want to test this, do sensitivity analysis, et cetera.

But hopefully now you have a better understanding of a simple merger model.

Okay, so thank you very much for attending.

I see that I have got a couple of comments in the chat.

Okay, so I think I'm going to stop the recording now, though, because I think these things are admin related. But thanks very much for attending.

I hope to see you on future sessions.

Enjoy the rest of your day, and also have a wonderful weekend.

So thanks. Just going to stop the recording and then I'll address the couple of questions I've got.