Wednesday, March 24, 2010

Why isn't my deal accretive?

I'm building an M&A model for two firms in the same industry and I noticed that the deal I was modeling wasn't accretive. However, the PE for the target was lower (marginally) than the PE of the acquirer and I was using a capitalization structure that was similar for both (both had about the same debt to equity ratios implying similar capital structures). Both also paid about the same interest rate on their debt.

According to simplification and a common interview question, as I mentioned before: buying a high return equity with a low return equity means you should get to "keep the difference". So in this case, when I modeled an acquirer with implied cost of equity lower than the target, I couldn't figure out why my model was telling me the deal was dilutive!

Turns out, I had forgotten about my asset write ups. What I had done was allocated 25% (not sure if this is a reasonable number - I don't have practical experience yet and I also don't have intimate / insider knowledge of the company being modeled) of my good will to writing up intangible assets. What does that mean?

Often a company develops intangible assets (brand value, patents). Companies are generally not allowed to record the value of their own internally developed intangible items on the books (because this would be a very subjective exercise). However, when companies are purchased, the value above book value is recorded as goodwill. Companies can further allocate portions of this good will (not sure the legal or accounting regulations, although I'm sure there are plenty) on the books as intangible assets and amortize them over time.

So what happened in my model? I merged two companies that had similar capital structures and costs of capital (with the target returning *slightly* more), but these synergies were being offset (at least temporarily in the short run) by the increase in D&A expense due to the write up of intangible assets resulting in an apparently dilutive deal.

Note, however, that for an owner with "foresight" (that is to say, not earnings focused), having a higher write up value increases the D&A expense which results in an increase in cash flow (from the tax shield of a non-cash expense) and also reduces debt and interest payments in the long term (model assumes a sweep with a portion of debt financed in a revolver). That is if you can stomach the low to negative earnings results in the short run. The deal would look more dilutive in the short run, but actually be much more accretive in the long run.

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