Lesson Objective: To construct the Sources and Uses table that details the financing of the transaction and the allocation of the purchase price, and to build the detailed Purchase Price Allocation (PPA) schedule that determines the value of identifiable assets and liabilities and calculates the resulting Goodwill or Bargain Purchase Gain.

In-Depth Notes:

1. The Sources and Uses Table (The Deal’s “Checkbook”):
The Sources and Uses table is a fundamental transaction summary that shows where the money to fund the acquisition is coming from (Sources) and where it is going (Uses).

• Uses of Funds: This represents the total cash required to complete the transaction.

  • Purchase Price for Equity: The total cash or stock value paid to the target’s shareholders for their equity. This is calculated as Offer Price per Share x Target's Diluted Shares Outstanding. (Using diluted shares ensures the acquirer accounts for all outstanding options, warrants, and convertible securities).

  • Repayment of Target’s Existing Debt: The acquirer must typically repay the target’s outstanding debt at the closing of the transaction. This includes senior debt, subordinated debt, and finance leases. If the acquirer assumes the target’s debt (debt assumption), it does not require a cash outflow at closing, but it increases the pro forma leverage of the combined entity.

  • Transaction Fees (Advisory, Legal, and Financing): These are the costs associated with executing the deal.

    • Financial Advisory Fees: Investment banking fees (typically 1% to 3% of the transaction value). Under US GAAP, these are expensed as incurred.

    • Legal and Accounting Fees: Fees for due diligence, contract negotiation, and regulatory filings.

    • Financing Fees: Fees paid to banks for arranging debt financing. These are capitalized (amortized over the life of the debt) under US GAAP and IFRS.

  • Break Fees / Termination Fees: If the target is required to pay a break fee to the acquirer if the deal falls through (or vice versa), this is included as a use of funds.

• Sources of Funds: This represents the cash available to fund the Uses.

  • Cash on Hand: The acquirer’s available cash reserves (minus a minimum cash balance required for ongoing operations).

  • Debt Financing (New Debt): The amount of new bank debt (Term Loans, Revolvers) or bonds issued to fund the purchase. This includes Senior Debt (cheapest, most secure), Mezzanine Debt (higher cost, subordinated), and High-Yield Bonds (most expensive).

  • Equity Financing: Issuance of new shares to fund the transaction. This reduces the need for debt but dilutes existing shareholders.

  • Rollover Equity: The target’s existing management or major shareholders may “roll over” their equity into the new combined entity, meaning they receive stock in the acquirer instead of cash. This reduces the cash required and aligns management’s interests with the new owners.

2. The Sources and Uses Balancing Check:
The fundamental rule of the Sources and Uses table is that Total Sources must equal Total Uses. This is a critical integrity check. If they do not balance, the model is “broken.” In a professional model, this is a built-in =IF(Total_Sources = Total_Users, "Balanced", "ERROR") check.

3. Purchase Price Allocation (PPA):
Under US GAAP (ASC 805) and IFRS (IFRS 3), the acquirer must allocate the purchase price to the identifiable assets acquired and liabilities assumed at their fair market value on the acquisition date.

• The PPA Process:

  • Step 1 – Determine the Purchase Consideration: The total fair value of the consideration transferred (cash paid + fair value of stock issued + fair value of contingent consideration/earn-outs).

  • Step 2 – Identify and Value Assets and Liabilities: All identifiable assets and liabilities of the target are recorded at fair value. This includes:

    • Cash and Cash Equivalents: Fair value equals book value.

    • Accounts Receivable: Fair value is typically the net realizable value (book value minus an allowance for doubtful accounts).

    • Inventory: Fair value may be higher than book value if raw materials prices have increased, or lower if inventory is obsolete.

    • PP&E: Fair value is appraised based on the replacement cost or market value (often significantly higher than book value due to historical cost accounting).

    • Intangible Assets: These are the most complex to value. They must be separately identified if they meet the “separability” or “legal/contractual” criteria. Common intangible assets include:

      • Customer Relationships (valued using the Excess Earnings Method).

      • Trademarks and Brands (valued using the Relief-from-Royalty Method).

      • Technology and Patents (valued using the Multi-Period Excess Earnings Method).

      • Non-Compete Agreements (valued using the With-and-Without Method).

    • Identified Liabilities: All debt, deferred taxes, lease liabilities, and contingent liabilities (e.g., pending lawsuits) are recorded at fair value.

  • Step 3 – Calculate Goodwill (or Bargain Purchase): Goodwill is the “plug” that ensures the accounting equation balances.

    • Goodwill Formula: Goodwill = Purchase Consideration - Fair Value of Identifiable Net Assets Acquired.

    • If Goodwill is Positive: The acquirer paid a premium over the fair value of the identifiable net assets. This premium is recorded as an intangible asset (Goodwill) on the pro forma balance sheet and is not amortized but is tested annually for impairment (under both US GAAP and IFRS).

    • If Goodwill is Negative (Bargain Purchase): This occurs when the purchase price is less than the fair value of the identifiable net assets. Under US GAAP and IFRS, this is recognized as a “Bargain Purchase Gain” in the income statement immediately. This is rare and typically occurs in distress sale scenarios.

4. The Step-Up in Tax Basis (US Tax Code):
An asset purchase (or a 338(h)(10) election on a stock purchase) allows the acquirer to “step up” the tax basis of the target’s assets to their fair market value. This increases the depreciation and amortization tax shield, which is a significant source of value in a deal. The model must calculate the incremental tax benefit of this step-up over the amortization period (typically 15 years for tax purposes under US tax law). In Europe, tax basis step-up rules vary by country; in the UK, a step-up is generally not available for goodwill (unless certain conditions are met), making US deals more tax-advantaged.