Walk me through a merger model.
A merger model tests whether a deal raises or lowers the buyer's EPS. Set the price and financing mix, combine income statements, adjust for lost interest on cash, new debt interest, synergies and new amortization, add new shares, then compare pro forma EPS with standalone.
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Example answer
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A merger model shows what an acquisition does to the buyer's earnings per share. You're basically putting the two companies together. First, the purchase price and how it's paid. Second, I combine the two income statements. Third, the deal adjustments. You adjust for things like interest and synergies. Fourth, I divide pro forma net income by the new share count and compare that with the buyer's standalone EPS. If it's higher, the deal is accretive. If it's lower, it's dilutive.
What holds it back
The four steps are in the right order, but each is only a heading. It never says which adjustments come from cash, debt or stock, so the interviewer can't tell whether you could build it.
A merger model shows what an acquisition does to the buyer's earnings per share. I build it in four steps. First, the purchase price and how it's paid. I take the offer price per share times the target's diluted shares, then split the total between cash, new debt and new stock. Second, I combine the two income statements. I add the target's revenue and costs to the buyer's, down to pre-tax income. Third, the deal adjustments. Cash used means the buyer loses the interest it was earning. New debt means new interest expense. New stock means more shares. I also add synergies. Then I tax the adjusted pre-tax income to get pro forma net income. Fourth, I divide pro forma net income by the new share count and compare that with the buyer's standalone EPS. If it's higher, the deal is accretive. If it's lower, it's dilutive.
A merger model shows what an acquisition does to the buyer's earnings per share. I build it in four steps. First, the purchase price and how it's paid. I take the offer price per share times the target's diluted shares, then split the total between cash, new debt and new stock. Second, I combine the two income statements. I add the target's revenue and costs to the buyer's, down to pre-tax income. Third, the deal adjustments. Cash used means the buyer loses the interest it was earning. New debt means new interest expense. New stock means more shares. I also add synergies. And I subtract amortization of any intangibles written up in the deal. Then I tax the adjusted pre-tax income to get pro forma net income. Fourth, I divide pro forma net income by the new share count and compare that with the buyer's standalone EPS. If it's higher, the deal is accretive. If it's lower, it's dilutive. A quick example at a 25% tax rate. The buyer earns $200 million on 100 million shares, so standalone EPS is $2.00, and its stock is at $30. The target earns $40 million and costs $600 million, paid half with debt at 6% and half with stock. The debt costs $18 million of interest, or $13.5 million after tax. The stock is 10 million new shares. Cost synergies of $10 million are $7.5 million after tax. Pro forma net income is 200 plus 40, minus 13.5, plus 7.5, which is $234 million. Over 110 million shares that's about $2.13, so the deal is about 6.4% accretive. I'd also run it without the synergies, since they're the least certain input. That gives about $2.06, so the deal is still accretive. I left out the intangible amortization and fees to keep the math short, and both would pull the number down.
The numbers, step by step
All figures in millions except per share. The tax rate is 25%, and the $600 purchase price is paid half with 6% debt and half with stock at $30.
- Buyer's standalone EPS$200 net income ÷ 100 shares
- $2.00
- After-tax interest on new debt$300 × 6% × (1 − 25%)
- $13.5 million
- New shares issued$300 of stock ÷ $30 a share
- 10 million
- After-tax synergies$10 × (1 − 25%)
- $7.5 million
- Pro forma net income$200 + $40 − $13.5 + $7.5
- $234 million
- Pro forma EPS$234 ÷ (100 + 10) shares
- $2.127, or about $2.13
- Accretion$2.127 ÷ $2.00 − 1
- about 6.4%
- Pro forma EPS without synergies($234 − $7.5) ÷ 110 shares
- about $2.06
What the interviewer listens for
- Do you start with the purchase price and how it's financed?
- Do you tie each adjustment to cash, debt or stock?
- Do you tax the adjustments before you get to net income?
- Do you end by comparing pro forma EPS with the buyer's standalone EPS?
- Can you run simple numbers without getting lost?
Common mistakes
- Adding the two companies' net income and dividing by the two share counts added together.The target's old shares disappear, and only the shares the buyer issues are new.
- Forgetting to tax the adjustments.New interest and synergies are pre-tax numbers, so each has to be multiplied by one minus the tax rate.
- Using the target's current market value as the purchase price.The buyer pays a premium, and the offer price is what gets financed.
- Walking through a DCF or an LBO by habit.A merger model answers one question, which is what happens to the buyer's EPS.
More finance technicals
- What are synergies, and which kind would you trust more?
- Would a buyer rather pay for an acquisition with cash, debt or stock?
- Walk me through a sell-side M&A process.
- Why would one company want to acquire another?
- How do you tell whether an acquisition is accretive or dilutive?
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