In this tutorial, you’ll learn why Goodwill exists and how to calculate Goodwill in M&A deals and merger models – both simple and more complex/realistic scenarios.
How To Calculate Goodwill In M&A Deals And Merger Models
Hello and welcome to another tutorial video. As you can see this time round we're going to go over how to calculate goodwill in M&A deals and murder models why it exists and show you a few simple examples of how this works. Now this one does not actually come directly from a reader or watch your question but it comes from the fact that I was looking at this channel the other day and I realized that we had videos on topics like negative goodwill or bargain purchases and also topics like purchase price allocation for non-controlling interests but we don't have anything specifically on a former basic topic which is how to calculate goodwill in the first place. Also even though it's a fairly basic topic we actually get a surprising number of questions about it despite the fact that there's detailed coverage in our guides and courses. There are lots of articles on mine on Investopedia Wikipedia. Other sources like that. It still seems to cause a fair amount of confusion. So here goes our explanation starting with why goodwill exists and a simple example. Once we go through that then we'll look at a slightly more complex example and some added complexities that can come up in this calculation in real life with more advanced models. So why does goodwill exist. The short answer is that goodwill is an accounting construct that exists because it emanates deals buyers almost always pay more than what the sellers balance sheets are worth.
So if you look at roughly assets minus liabilities and say that's the value of a seller's balance sheet to acquire the Sillars equity a buyer is almost always going to pay more than that number. Now the buyer gets all the seller's assets and liabilities. So when this happens when it pays more than what the seller's balance sheet is worth that makes its balance sheet go out of balance. When a deal closes we create goodwill to fix this imbalance and ensure that assets equals liability plus equity on the combined balance sheet. The basic calculation for goodwill is that it equals the equity purchase price and the deal minus the seller's common shareholders equity. That's what goes away in the deal plus the sellers existing goodwill that also goes away. And then you add or subtract other adjustments to the seller's balance sheet. Let's go through a very simple example an excel so you can see what this looks like visually. We're going to say here that a buyer pays a thousand dollars in cash for the seller and the seller has fifteen hundred dollars in assets 600 in liabilities and common shareholders equity of 900. So let's go into excel and see what this looks like. Here is our target company right here. We have cash of 200 accounts receivable 300p.p. of 1000 and so total assets equals 1500. And then on the liability side they have debt of 400 accounts payable of 200 equity of 900 and so liabilities plus equity equals 1500. And our balance sheet for the seller balances.
Now the buyer is going to pay a thousand dollars for the equity purchase price for the seller right here and if we look at the acquirers balance sheet which is similar to the targets just a whole lot bigger because the buyer is a bigger entity and we simply combined the acquirer and Target's balance sheets as is so we just go in and literally add up each item cash accounts receivable PPD accounts payable debt and so on if we just do this the balance sheets actually balance. But of course that's not what happens in an MBA deal anemone deal we have to reflect the fact that the seller's common shareholders equity is written down and the fact that we spend cash or debt or stock to acquire the seller. So here we'll keep it simple and just say that we are spending 1000 dollars in cash to acquire the seller and a link to that 1000 up there. Now in our combined column over here we take the acquirers numbers plus the target's numbers plus these transaction adjustments. And so we end up with 700 of cash right here. Now what also happens is that on the other side we need to wipe out the sellers shareholders equity so we can just link to that and reverse it directly. And so you can see the problem right here. Our balance sheet goes out of balance because our asset side here goes up by 500. But then our liabilities equity side goes up by 600. Now if we had paid exactly 900 for the target instead so exactly matching its common shareholders equity then we would not have gotten this problem because in that scenario the asset side would go to 7600 and the liabilities that Woodside would go up to seven thousand six hundred.
And so to fix this issue I'll change it back to 1000 for now to fix this issue we create something called goodwill and it follows that exact same formula that I showed you before we take our equity purchase price. The 1000 right there and then we subtract the sellers common shareholders equity because that gets written down in the deal that reduces the that he's not quite.