M&A and Merger Models

What a merger model answers

A merger (accretion / dilution) model asks: after buying the target, will the acquirer's earnings per share go up or down? Public acquirers care because investors track EPS, and the model also shows ownership, credit metrics and how much synergy the deal needs.

Walk through a merger model

1. Project both companies' income statements and standalone EPS.
2. Set the purchase price — offer price per share (current price + premium) × target diluted shares, plus any target debt refinanced and fees.
3. Sources and uses — fund the price with cash on hand, new debt, new acquirer stock, or a mix.
4. Purchase price allocation — write target assets up to fair value, create new intangibles, record a deferred tax liability on the write-ups, and plug the remainder as goodwill.
5. Combine the income statements and adjust: forgone interest on cash, new interest on debt, extra D&A on write-ups and intangibles, and synergies — all tax-effected.
6. Pro forma EPS = pro forma net income ÷ (acquirer shares + new shares issued). Compare with the acquirer's standalone EPS.
7. Sensitivities — purchase premium, cash / stock mix, synergies, interest rates.

Goodwill with numbers

Purchase equity price 500. Target book equity 300. PP&E written up by 50; at a 25% tax rate this creates a deferred tax liability of 12.5.

Goodwill = 500 − (300 + 50 − 12.5) = 162.5

Goodwill is not amortised under US GAAP or IFRS; it is tested for impairment. An impairment signals the buyer overpaid.

Why acquire?

• Growth that the buyer cannot achieve organically.
• Synergies — cost (overlapping headcount, facilities, procurement) and revenue (cross-selling, pricing).
• Market share, new products, technology or talent.
• Diversification or vertical integration.

Cost synergies are more credible and are valued more by investors; revenue synergies are harder to achieve and usually phased in.

Cash, stock or debt?

From the acquirer's view, cash is usually cheapest (low interest income forgone), then debt (after-tax interest), then stock (earnings yield of the acquirer, 1 ÷ P / E, often the most expensive and dilutes ownership). Stock makes sense when the acquirer's shares are richly valued, the balance sheet cannot take more debt, or the seller wants to share in the upside.

Why strategics can pay more than PE

Strategic buyers can count on synergies and often have a lower cost of capital and a longer horizon, so they can justify a higher price than a sponsor constrained by a target IRR.

Interview answer template

"Project both companies, set the purchase price and how it is funded, allocate the price to assets and goodwill, combine the income statements adjusting for interest, new D&A and synergies after tax, and divide pro forma net income by the new share count. If pro forma EPS is above the acquirer's standalone EPS, the deal is accretive."

The shortcut every interviewer expects

Compare the after-tax cost of each funding source with the target's earnings yield at the purchase price.

Target yield = 1 ÷ purchase P / E (the P / E the acquirer is paying, including the premium).

If the weighted cost of funding is below the target yield, the deal is accretive (before synergies and new D&A).

For an all-stock deal this collapses to a simple rule: accretive if the acquirer's P / E is higher than the purchase P / E of the target.

Worked example

Acquirer: net income 100, 100 shares, EPS 1.00, share price 20.00 → P / E 20x (stock cost 5%). Target: net income 40, purchase price 600 → purchase P / E 15x (yield 6.7%). Funding: 50% stock, 50% new debt at 8%, tax rate 25% (debt cost 6%).

Shortcut: weighted cost = 0.5 × 5% + 0.5 × 6% = 5.5% < 6.7% → accretive.

Check with numbers:

• New shares: 300 ÷ 20.00 = 15
• After-tax interest: 300 × 8% × (1 − 25%) = 18
• Pro forma net income = 100 + 40 − 18 = 122
• Pro forma shares = 115
• Pro forma EPS = 122 ÷ 115 = 1.061, about 6% accretive

Break-even synergies

If a deal is dilutive, how much pre-tax synergy is needed to break even?

Break-even pre-tax synergies = (standalone EPS × pro forma shares − pro forma net income) ÷ (1 − t)

Suppose instead pro forma net income were 110 with 115 shares. Required net income = 1.00 × 115 = 115; shortfall 5; pre-tax synergies = 5 ÷ 0.75 ≈ 6.7.

Other things that make a deal dilutive

• Paying a high premium (low target yield).
• New D&A on written-up assets and amortisation of new intangibles.
• Transaction fees financed with debt, and higher interest rates.
• Issuing stock when the acquirer's P / E is low.

Accretion is not value creation

An accretive deal can still destroy value if the buyer overpays relative to the target's intrinsic value, and a dilutive deal can create value if synergies arrive later. Say this unprompted — it shows judgement.

Interview checklist

1. State the cost of each funding source after tax.
2. Compare with the target's yield at the offer price.
3. Mention synergies and new D&A as adjustments.
4. Offer to verify with a quick pro forma EPS calculation.