Building a merger model

A merger model looks intimidating because people picture a 40-tab spreadsheet. It isn't that. It's a short logical chain, and if you can say the chain out loud, you can build the model. Interviewers test the chain, not your Excel speed.

Here's the whole thing: figure out how you're paying for the deal (sources and uses), account for what you bought (purchase accounting and goodwill), stack the two companies' earnings together (combine the income statements), then divide by the new share count to get pro-forma EPS and read off accretion or dilution. Five steps. Learn them in order.

Step 1: Sources and uses

Before anything else, you answer two questions. What does the deal cost, and where's the money coming from? Uses is the spend. Sources is the funding. They must equal.

The biggest use is buying the target's equity: shares outstanding times the offer price per share, which already bakes in a control premium over where the stock traded. But equity isn't the only use. You usually refinance the target's existing debt (lenders often require it on a change of control), and you pay transaction fees: advisory, financing, legal. Those fees are real cash out the door, and beginners forget them.

On the sources side you've got three levers: cash on the balance sheet, new debt raised for the deal, and new stock issued to the seller. The mix you pick drives everything downstream, so hold that thought.

Step 2: Purchase accounting and goodwill

Now you've paid for the target. Accounting demands you record what you got. You mark the target's assets and liabilities to fair value (the write-up), and whatever you paid above the fair value of net identifiable assets becomes goodwill.

$\text{Goodwill} = \text{Equity purchase price} - \text{FMV of net identifiable assets}$

Goodwill isn't a fudge. It's the plug that makes the combined balance sheet balance. You spent, say, $1,000 of equity value on a business whose identifiable assets are worth $700 net of liabilities. The $300 gap has to live somewhere on the asset side or the balance sheet breaks. That $300 is goodwill: what you paid for the brand, the people, the market position, things you can't itemize.

Two second-order effects worth knowing. When you write assets like PP&E and intangibles up to fair value, book value now exceeds tax basis, which creates a deferred tax liability in a stock deal (the write-up isn't tax-deductible, so you owe tax later that the books don't yet show). And you exclude the target's pre-existing goodwill before running this math; you're paying for the business, not their old accounting.

Step 3: Combine the income statements

Stack acquirer and target revenue, costs, and operating income. Then, and this is the step people botch, adjust for the deal itself.

• Synergies: mostly cost synergies (overlapping headcount, closed facilities). Revenue synergies are real but softer, so credible models phase them in and haircut them.
• New interest expense on the acquisition debt you raised in Step 1.
• Forgone interest income on the cash you spent. That cash was earning something; now it isn't.
• Incremental D&A if you wrote up assets, plus intangible amortization.

Run the combined pre-tax number through the acquirer's tax rate to get pro-forma net income.

Step 4: Pro-forma EPS

Net income over shares. The trick is the denominator: it's the acquirer's shares plus any new shares issued to fund the deal. Cash and debt don't change the share count. Stock does.

$\text{Pro-forma EPS} = \frac{\text{Pro-forma net income}}{\text{Acquirer shares} + \text{New shares issued}}$

Step 5: Accretion or dilution

Compare pro-forma EPS to the acquirer's standalone EPS. Higher means accretive. Lower means dilutive. That's the headline number the CFO and board react to.

Quick worked example. Acquirer: $800 net income, 400 shares, so $2.00 EPS. It buys a target earning $200, funded with new debt whose after-tax interest cost is $40. No new shares.

Pro-forma net income = $800 + $200 − $40 = $960. Shares stay at 400. Pro-forma EPS = $960 / 400 = $2.40. EPS climbed from $2.00 to $2.40, so the deal is accretive by 20%. Notice what killed a chunk of it: that $40 of financing cost. Drop it and you'd have printed $1,000 / 400 = $2.50 and overstated the accretion.

One more piece of intuition worth carrying. Combined EV/EBITDA doesn't care how you paid, because enterprise value and EBITDA both ignore capital structure. But EPS very much cares, because the financing mix changes both net income and the share count. That's why accretion/dilution is a financing question as much as a valuation one.