Enterprise Value and M&A Financing method confusion
Hi All,
I got asked this question in an interview and remain confused till date -
Acquirer A: EV = 2000, Equity = 2000
Target T: EV=1000, Equity = 1000
A buys T paying 50% premium, what happens to combined EV, Equity and Net Debt based on 1) 100% cash deal, 2) 100% debt deal and 3) 100% Stock deal
For 1) I said, Combined EV= A+T = 2000+1000 = 3000, and Equity= A's equity = 2000; so Net debt = 1000, but what happens to the 50% premium?
for 3) I said Combined EV is still 3000, but Eq is now 2000+1500 = 3500, so net debt is -500 but how can net debt change if 100% stock deal?
Can anyone please shed some light? Many thanks!
Hey buddy.
I think the way to look at it is the following:
Acquires offers 50% premium meaning it will have to pay 1500 (1000*(1+50%)). Hence it will need to finance it with existing cash, raise more debt or issue equity worth of 1500.
In the first scenario, the acquirer uses existing cash, so the equity of A does not change (obviously you have to assume no market price effect, so equity stays the same as you are not issuing more shares). But as the acquirer pays 1500 in cash to acquire T, its net debt goes up by 1500. So you have acquirer's equity at 2000, 1500 net debt = 3500 EV, then for the combined EV you add the net debt of the target which is 0, so the combined EV is 3500
2) 100% debt deal, the mechanics here is the same as if it was 100% cash deal, because when you raise 1500 in additional debt, the net debt or EV does not change. And for the same above reasons equity does not change too, but after A buys T for 1500, the net debt increases by 1500 (as in the 1 part), so at the end you have the same things = EV = 2000 (acquirers equity) + 1500 (net debt) + 0 (net debt of the target) = 3500
3) Here the equity obviously increases as the acquires issues stock worth 1500. When new shares are issued, equity increases by 1500, but EV of the acquirer stays the same as cash also increases by 1500. After A acquires T, you have equity of 3500, net debt of 0, net debt of the target is also 0. So combined EV is 3500.
I might have missed something so take it with the grain of salt. Let me know if any questions. Would also appreciate if someone could confirm if my logic is correct
your calculations definitely makes sense , but Just wondering where does the equity of the target go to for question 2? or do you assume the cash paid disappears because you pay off the shareholders for the target? hence there won't be any equity nor debt to account for?
on a simple basis, shouldn't it be EV = 2000 (acquirers equity) + 1500 (net debt) + 0 (net debt of the target) + 1500 (Equity of target)
Equity of the target in an acquisition always gets wiped out. So you only have the equity of the acquirer which changes only if you issue more shares or stock price changes. Also net debt of the target is 0 in this question but you need to add it to get combined EV
This makes sense too because EV should be irrespective of cap structure, right?
Exactly. EV is the same for all cases. The difference is just how you finance the business.
Interested in an answer so I'll try my best, but not quite sure so feel free to correct
1) Financing phase: no debt nor equity raised, but 1500 assumed existing cash, so for EV to equal Eq, there is existing 1500 of debt
Eq = 2000 // EV = Eq + D - existing cash = 2000 + 1500 - 1500 = 2000
Post deal:
Eq = 2000 - 1500 (cash lost) + 1000 (new asset) = 1500 // EV = Eq + D = 1500 + 1500 = 3000
2) Financing phase: Debt
Eq = 2000 (raising debt is neutral) // EV = Eq + New D - New cash = 2000 + 1500 - 1500 = 2000
Post deal:
Eq = 2000 - 1500 (cash lost) + 1000 (new asset) = 1500 // EV = Eq + New D = 1500 + 1500 = 3000
3) Financing phase: Equity raising
Eq = 2000 + 1500 (new equity) = 3500 // EV = Eq - cash = 3500 - 1500 = 2000
Post deal:
Eq = 3500 - 1500 (cash lost) + 1000 (new asset) = 3000 // EV = Eq = 3000
Why would equity fall in the first two scenarios? Thats just not correct
To me, it decreases due to the premium paid over market value, it is equity holders' loss. This value destruction will be compensated if synergies are created.
Combined EV stays the same as these are just financing options with no impact on companies' operating businesses
Many thanks Guys,
I believe Trnt is correct, EV is always A+B= 3000 irrespective of financing method or premium paid. The premium affecting the equity is the confusing part here. The VP said, Equity is 1500 as premium is paid, which is equity holders loss.
I am still a bit confused with the +1000 new asset (as Target equity is wiped out after transaction) but your overall totals make sense.
Trnt is 100% wrong. He is right though that EV is the same for all cases (see my answer).
That’s the point, premium doesn’t effect equity value directly. I mean of course the market may think it’s too much and sell the stock, but you ignore the markets impact in such questions, because if you consider how markets react - they can react in any way. Price of the stock can also rise if investors believe there is a lot of synergies and premium is worth. In this question equity only moves when more stock is issued as stock price stays constant. Equity value only changes if stock price change or of number of shares changes. It’s as simple as that. There is nothing more behind it.
Premium is extra cash that is paid over the economic value of the company, you might expect that the combined value increase due to synergies but this is not an hypothesis here at this stage. It is equivalent to a deal paid without premium + cash being lost (or dividend issued), this second part must have an impact on equity. I am open to counter-argument but here it seems obvious that extra cash paid for no extra value has an impact of equity. Maybe try to stretch your reasoning with very high premium paid for near 0 equity value and it appears that it must have an impact on value, which is not an anticipation of market reaction (not the topic indeed).
Dude you need to refresh your accounting. Paying premium is very different to just cash dividend (which indeed decreases equity). The reason why it is completely different is because when A pays premium over fair value of net assets of the target, the asset called goodwill is created which indicates some intangible assets of the target. So its not like wasting cash on nothing accounting wise. Yes probably equity value of the combined should fall in theory due to very high premium paid but it purely depends on investor reaction.
A premium is not additional paid over economic value. It is premium paid over the current share price, which is what the current marketplace thinks the standalone price of company T’s stock is.
It is very reasonable that both the acquiring firm and the marketplace will think that the combined firm due to synergies is worth paying the premium. And it is very unreasonable to think that any firm with self-interested shareholders would ever approve an acquisition where they just flush $500 down the toilet.
Even if there aren’t synergies like increased sales or cost efficiencies, the acquisition could be justified by decreasing competition in their industry so company A increases market power. Regardless, it strains credulity that a company focused on maximizing value would ever willingly pay more for something than it’s worth, and that shareholders and bankers would approve of that.
I think you need to refresh the meaning of/formula behind net debt.
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