Accounting, Taxes, and M&A Valuation What Every Investment Banker Needs to Know M&A Accounting • Depending on the characteristics of a merger or acquisition transaction will be accounted for as a: – purchase combination or a – pooling-of-interest (pooling) combination Purchase Method Accounting • Purchase accounting requires the acquirer to record in its financial statements the fair market value of all assets acquired – Both tangible and intangible, and liabilities assumed – The fair value of an asset is generally its market or appraised value, and liabilities are generally valued on a present value basis • Any excess or residual purchase price over the fair value of the net identifiable assets is considered goodwill that must be recorded as an asset and amortized over its useful life or a maximum of 40 years Pooling Method Accounting • The pooling method accounts for a combination of two firms as a union of the ownership interests of the two previously separated groups of stockholders • No sale or purchase is considered to have occurred • The assets and liabilities of the combining firms continue to be carried at their book values, that is, on the basis of their historical costs • Any goodwill carried on the target’s books prior to the merger continues to be carried on the merged firm’s books at its historical cost, but no new goodwill is recognized as a result of the pooling • The stockholders’ equity of the merged firm is recorded at the sum of the book values of the two firms Pooling-of-Interest Treatment • Twelve Criteria For A Pooling of Interests Merger – Attributes of the Combining Companies Autonomous (two-year rule) Independent (10% rule) – Manner of Combining Interests Single transaction (completed in one year following the initiation) Exchange of common stock (90% "substantially all" rule) No equity changes in contemplation of combination (two-year rule) Shares reacquired only for purposes other than combination No change in proportionate equity interests Voting rights immediately exercisable Combination resolved at consummation (no pending provisions) – Absence of Planned Transactions 10 Issuing company does not agree to reacquire shares 11 Issuing company does not make deals to benefit former stockholders 12 Issuing company does not plan to dispose of assets within two years (Source: http://acct.tamu.edu/smith/purpool/apb16_17.htm) Controversy Over Pooling • On September 7, 1999, the FASB issued a draft with four significant changes to existing accounting practice: Use of the pooling-of-interest method would be prohibited The current 40 year maximum amortization period for goodwill would be reduced to 20 years Companies would be required to present separate line items in the income statement for income before taxes and goodwill amortization , and for goodwill amortization net-of-tax basis The current 40-year maximum amortization period for acquired intangible assets (other than goodwill) would be replaced with a presumption that their useful lives are 20 years or less Example: Purchase of Assets • Assume that Acquiror Co buys Target Co for $200,000 in stock • Acquiror Co must then revalue the assets and liabilities of Target Co to their fair values at the date of the acquisition and record any identifiable intangible assets that were not carried on Target’s books • Any difference between the purchase price and the fair value of the net assets would be shown as goodwill arising from the acquisition Assets Cash Target’s Balance Sheet Prior to Acquirer Acquisition Revalued Target’s Balance Sheet Merged Firm $185,000 $6,000 $6,000 $191,000 Accounts Receivables $90,000 $8,000 $8,000 $98,000 Notes Receivable $55,000 $55,000 Inventory $140,000 $10,000 $9,000 $149,000 PPE (net) $250,000 $35,000 $50,000 $300,000 $12,000 $113,000 $113,000 Trademark $15,000 $15,000 Patent $25,000 $25,000 Goodwill Total Assets $720,000 $71,000 $226,000 $946,000 Accounts Payable $90,000 $14,000 $14,000 $104,000 LT Notes Payable $170,000 $15,000 $12,000 $182,000 Shareholders' Equity $460,000 $42,000 $200,000 $660,000 Total Liabilities & Equity $720,000 $71,000 $226,000 $946,000 Liabilities and Equity Example Pooling of Assets • Now the merged firm only recognizes the goodwill that existed prior to the acquisition Assets Cash Target’s Balance Sheet Prior to Acquirer Acquisition Revalued Target’s Balance Sheet Merged Firm $185,000 $6,000 $6,000 $191,000 Accounts Receivables $90,000 $8,000 $8,000 $98,000 Notes Receivable $55,000 $55,000 Inventory $140,000 $10,000 $9,000 $150,000 PPE (net) $250,000 $35,000 $50,000 $285,000 $12,000 $113,000 $12,000 Trademark $15,000 $0 Patent $25,000 $0 Goodwill Total Assets $720,000 $71,000 $226,000 $791,000 Accounts Payable $90,000 $14,000 $14,000 $104,000 LT Notes Payable $170,000 $15,000 $12,000 $185,000 Shareholders' Equity $460,000 $42,000 $200,000 $502,000 Total Liabilities & Equity $720,000 $71,000 $226,000 $791,000 Liabilities and Equity Value from Nothing • Under pooling, the earnings of the merged firm “look better” than under purchase! Purchase Pooling Revenues $500,000 $500,000 COGS $340,000 $340,000 Gross Margin $160,000 $160,000 Depreciation $75,000 $75,000 Amortization $6,825 $300 SGAE $70,000 $70,000 Other $10,000 $10,000 Total Expenses $161,825 $151,550 Net Income -$1,825 $8,450 Expenses Total Amortization uses the straight-line method with zero residual value and a 10-year useful life for patents and trademarks, and goodwill amortized over 40 years Amortization: $6,825 = ($250,000+$15,000)/10 + $113,000/40 Total Amortization uses the straightline method with zero residual value Goodwill amortized over 40 years Amortization is $300 = $12,000/40 Straight-Line method of depreciation with zero residual value and a useful life of years Depreciation: $75,000 = $300,000/4 Tax Considerations • In general, the target’s shareholders pay taxes on the gains or losses immediately when the transaction is concluded, while the acquirer restates the acquired assets at fair market value • The asset write-up increases the amount of depreciation which is valuable for an acquirer in a tax paying status • M&As can be tax-free, whereby the target’s shareholders recognize a loss or gain only if they sell the assets they receive in payment from the acquirer Qualifying for Tax Free Treatment: Mergers The shareholders of the target have to retain a continuing equity interest in the acquirer The interest must be substantial in relation to the net assets of the target • These two rules have been interpreted to mean that the target shareholders have to receive at least 50 percent of their payment in stock of the acquirer Qualifying for Tax Free Treatment: Acquisitions All payment to the shareholders of the target has to be in the form of voting stock The acquirer must obtain at least 80 percent of the voting stock of the target Valuing Acquisitions • Despite 30 years of evidence demonstrating that most acquisitions not create value for the acquiring company, both the number and the volume of deals have been increasing from year to year • You need to understand however the several meanings of the word “value.” It Depends on What You Mean by Value • Intrinsic value – NPV of the future cash flows of the target irrespective of any acquisition – Conrail’s intrinsic value was around $71 per share when it was acquired • Market value – The market adds a premium that incorporates the probability that the target firm be acquired – Conrail stock price jumped to $85.13 the day the first bid by CSX was announced • Purchase price – A.k.a :anticipated takeout value.” How much the acquiror must pay to get the target • Synergy value – The NPV of the future cash flows that result from integration • Value gap – The difference between the intrinsic value and the purchase price Valuing Synergies • Types of synergies: – Cost savings – Revenue enhancements – Process improvements – Financial engineering – Tax benefits Valuation Assumptions • Capital structure assumption – The capital structure assumption should not be reflective of the financing used to buy the target per se, but should reflect the degree to which owning the target incrementally affects your debt capacity Valuation Assumptions Continued • Pre-Tender Offer Strategy – The target firm’s stock price will exceed the present value of the firm’s future cash flows if it reflects the possibility that the firm may eventually be taken over at a premium – Toeholds: Bidder buys shares in the open market prior to making the tender offer • Can buy up to 5% and then have a window in which to notify the markets that a tender offer will be forthcoming At that point open market purchases must cease Target Firm Stock Prices Around a Tender Offer Total value about 27% Information leakage: about 10% out of 27% [...]... firm may eventually be taken over at a premium – Toeholds: Bidder buys shares in the open market prior to making the tender offer • Can buy up to 5% and then have a window in which to notify the markets that a tender offer will be forthcoming At that point open market purchases must cease Target Firm Stock Prices Around a Tender Offer Total value about 27% Information leakage: about 10% out of 27% ... has to be in the form of voting stock 2 The acquirer must obtain at least 80 percent of the voting stock of the target Valuing Acquisitions • Despite 30 years of evidence demonstrating that most acquisitions do not create value for the acquiring company, both the number and the volume of deals have been increasing from year to year • You need to understand however the several meanings of the word... Treatment: Mergers 1 The shareholders of the target have to retain a continuing equity interest in the acquirer 2 The interest must be substantial in relation to the net assets of the target • These two rules have been interpreted to mean that the target shareholders have to receive at least 50 percent of their payment in stock of the acquirer Qualifying for Tax Free Treatment: Acquisitions 1 All payment... How much the acquiror must pay to get the target • Synergy value – The NPV of the future cash flows that result from integration • Value gap – The difference between the intrinsic value and the purchase price Valuing Synergies • Types of synergies: – Cost savings – Revenue enhancements – Process improvements – Financial engineering – Tax benefits Valuation Assumptions • Capital structure assumption... from Nothing • Under pooling, the earnings of the merged firm “look better” than under purchase! Purchase Pooling Revenues $500,000 $500,000 COGS $340,000 $340,000 Gross Margin $160,000 $160,000 Depreciation $75,000 $75,000 Amortization $6,825 $300 SGAE $70,000 $70,000 Other $10,000 $10,000 Total Expenses $161,825 $151,550 Net Income -$1,825 $8,450 Expenses Total Amortization uses the straight-line method... with zero residual value and a 10-year useful life for patents and trademarks, and goodwill amortized over 40 years Amortization: $6,825 = ($250,000+$15,000)/10 + $113,000/40 Total Amortization uses the straightline method with zero residual value Goodwill amortized over 40 years Amortization is $300 = $12,000/40 Straight-Line method of depreciation with zero residual value and a useful life of 4 years... gains or losses immediately when the transaction is concluded, while the acquirer restates the acquired assets at fair market value • The asset write-up increases the amount of depreciation which is valuable for an acquirer in a tax paying status • M& As can be tax-free, whereby the target’s shareholders recognize a loss or gain only if they sell the assets they receive in payment from the acquirer Qualifying... structure assumption should not be reflective of the financing used to buy the target per se, but should reflect the degree to which owning the target incrementally affects your debt capacity Valuation Assumptions Continued • Pre-Tender Offer Strategy – The target firm’s stock price will exceed the present value of the firm’s future cash flows if it reflects the possibility that the firm may eventually... of the word “value.” It Depends on What You Mean by Value • Intrinsic value – NPV of the future cash flows of the target irrespective of any acquisition – Conrail’s intrinsic value was around $71 per share when it was acquired • Market value – The market adds a premium that incorporates the probability that the target firm be acquired – Conrail stock price jumped to $85.13 the day the first bid by CSX