M&A Interview Questions for Finance

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The primary difference between a merger and an acquisition lies in the relative size and structure of the companies involved, though both fall under the broader category of M&A (mergers and acquisitions).

1. Merger: In a merger, two companies of approximately equal size come together to form a new, combined entity. This often involves a more balanced partnership where both companies agree to combine their operations, assets, and resources. Mergers are typically seen as a mutual decision where both companies contribute equally to the new entity.
2. Acquisition: In an acquisition, one company (the buyer) is significantly larger and acquires control over the other (the seller). The acquiring company absorbs the target company, and the target typically loses its independence. Acquisitions can be either friendly (with mutual agreement) or hostile (where the target company resists the acquisition).

In essence, the distinction is semantical—in both cases, one company is taking control of the other. The key difference is that mergers usually occur between companies of similar size, while acquisitions typically involve a larger company buying a smaller one.

A company may merge with another for several key reasons:

1. Synergies: Mergers often create cost and revenue synergies by reducing costs and expanding market reach.
2. Market share expansion: Merging with a competitor allows a company to increase market share and strengthen its position in the industry.
3. Diversification: Mergers help a company diversify into new markets or industries, reducing risks tied to its core business.
4. Access to new technology: Merging provides access to new technologies or capabilities that can drive growth, especially in tech and pharma sectors.
5. Tax benefits: Mergers can offer tax advantages, such as utilizing tax loss carryforwards to offset future taxable income.

A merger model is a financial model used to evaluate the potential impact of a merger or acquisition on the combined company. 

It forecasts how the transaction will affect the financial statements, including earnings per share (EPS), valuation, and synergies (both revenue and cost synergies). The model helps determine whether the deal will be accretive or dilutive to the acquirer's earnings.

A merger is accretive when the earnings per share (EPS) of the combined company increases. This typically happens if:

• The acquiring company purchases the target at a price lower than its earnings yield.
• Cost synergies (e.g., reduced expenses) or revenue synergies (e.g., increased sales) significantly improve the combined company's profitability.

In these cases, the merger adds more earnings than the cost of the transaction, making the deal accretive.

A merger is dilutive when the earnings per share (EPS) of the combined company decreases. This can happen if:

• The additional Net Income from the target isn’t enough to offset:
  • Foregone interest on cash,
  • Additional interest on debt, or
  • Dilution from issuing new shares.
• Amortization of intangibles (e.g., goodwill) reduces the combined company's profitability.

In these cases, the cost of the acquisition outweighs the earnings generated by the target company, making the deal dilutive.

To quickly determine if an acquisition will be accretive or dilutive, you can use these methods based on the deal structure:

1. Cash and Debt Deal: Compare the interest expense on debt and the foregone interest on cash to the seller's Pre-Tax Income. If the interest cost exceeds the seller’s income, the deal is likely dilutive; if the seller’s income exceeds the interest cost, the deal is likely accretive.
2. All-Stock Deal: Compare the EPS of the acquirer with the combined EPS to determine if the deal adds or dilutes earnings.
3. Cash, Stock, and Debt Deal: No quick rule exists for this structure; a detailed analysis of interest costs, stock issuance, and changes in EPS is required.

This simplified breakdown provides a clear approach to quickly assessing deal impact.

Synergies refer to the concept where the value created by a merger or acquisition is greater than the sum of the individual companies' values. Essentially, 2 + 2 = 5 (or even more), meaning the combined company is more valuable than the two separate entities based on the financials.

There are two main types of synergies:

1. Revenue synergies: These occur when the combined company can cross-sell products to new customers or up-sell additional products to existing customers. The merger may also allow for geographic expansion, enabling the company to enter new markets or regions.
2. Cost synergies: These occur when the combined company can reduce costs through consolidation of operations, such as combining administrative staff, closing redundant offices, or eliminating duplicative functions. This can also include cutting down on redundant locations or stores.

Cost synergies are generally more important than revenue synergies in M&A because they are easier to predict. Cost synergies, like consolidating buildings or eliminating redundant staff, are more tangible and straightforward. 

In contrast, revenue synergies, such as cross-selling or market expansion, are harder to estimate and often seen as speculative. However, the likelihood of synergies being fully realized is low, so many in M&A don’t place significant weight on them.

In a merger model, synergies are used to adjust the financial projections of the combined company to reflect the value created through the merger.

1. Revenue synergies: These are typically added to the Revenue figure for the combined company. You then assume a certain margin on this additional revenue, and this extra revenue flows through the rest of the Income Statement, increasing the overall profitability of the combined entity.
2. Cost synergies: These are usually reflected as reductions in COGS (Cost of Goods Sold) or Operating Expenses for the combined company. Lower expenses boost Pre-Tax Income, which in turn increases Net Income and Earnings Per Share (EPS). This makes the deal more accretive, meaning it adds value to the acquirer's earnings.

Most mergers and acquisitions fail due to:

• Difficult integration and realization of synergies: Merging and integrating companies is complex, and realizing synergies (cost and revenue) is often harder than expected.
• Improper motivations: Many deals are driven by CEO ego, shareholder pressure, or short-term goals, rather than a clear, strategic fit.
• Lack of mutual benefit: Deals that don't prioritize the best interests of both companies often fail due to misalignment or poor communication.