Merger Model Guide with Questions and
Correct Answers
Why would a company want to acquire another company?✅A company would acquire
another company if it believes it will earn a good return on its investment - either in the
form of a literal ROI, or in terms of a higher Earnings Per Share (EPS) number, which
appeals to shareholders.
There are several reasons why a buyer might believe this to be the case:
• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow more quickly and sees an acquisition as a way to do
that.
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller's customers so it can up-sell and cross-
sell products and services to them.
• The buyer thinks the seller has a critical technology, intellectual property, or
other "secret sauce" it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make
the deal accretive for its shareholders.
Walk me through a basic merger model.✅"A merger model is used to analyze the
financial profiles of 2 companies, the purchase price and how the purchase is made,
and it determines whether the buyer's EPS increases or decreases afterward.
Step 1 is making assumptions about the acquisition - the price and whether it was done
using cash, stock, debt, or some combination of those. Next, you determine the
valuations and shares outstanding of the buyer and seller and project the Income
Statements for each one.
Finally, you combine the Income Statements, adding up line items such as Revenue
and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid
on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate to get
the Combined Net Income, and then divide by the new share count to determine the
combined EPS."
You could also add in the part about Goodwill and combining the Balance Sheets, but
it's best to start with answers that are as simple as possible at first.
What's the difference between a merger and an acquisition?✅There's always a buyer
and a seller in any M&A deal - the difference is that in a merger the companies are
similarly-sized, whereas in an acquisition the buyer is significantly larger (often by a
factor of 2-3x or more).
,Also, 100% stock (or majority stock) deals are more common in mergers because
similarly sized companies rarely have enough cash to buy each other, and cannot raise
enough debt to do so either.
Why would an acquisition be dilutive?✅An acquisition is dilutive if the additional Net
Income the seller contributes is not enough to offset the buyer's foregone interest on
cash, additional interest paid on debt, and the effects of issuing additional shares.
Acquisition effects - such as the amortization of Other Intangible Assets - can also make
an acquisition dilutive.
Is there a rule of thumb for calculating whether an acquisition will be accretive or
dilutive?✅Yes, here it is:
• Cost of Cash = Foregone Interest Rate on Cash * (1 - Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate)
• Cost of Stock = Reciprocal of the buyer's P / E multiple, i.e. E / P or Net
Income / Equity Value.
• Yield of Seller = Reciprocal of the seller's P / E multiple (ideally calculated
using the purchase price rather than the seller's current share price).
You calculate each of the Costs, take the weighted average, and then compare that
number to the Yield of the Seller (the reciprocal of the seller's P / E multiple).
If the weighted "Cost" average is less than the Seller's Yield, it will be accretive since
the purchase itself "costs" less than what the buyer gets out of it; otherwise it will be
dilutive.
Example: The buyer's P / E multiple is 8x and the seller's P / E multiple is 10x. The
buyer's interest rate on cash is 4% and interest rate on debt is 8%. The buyer is paying
for the seller with 20% cash, 20% debt, and 60% stock. The buyer's tax rate is 40%.
• Cost of Cash = 4% * (1 - 40%) = 2.4%
• Cost of Debt = 8% * (1 - 40%) = 4.8%
• Cost of Stock = = 12.5%
• Yield of Seller = = 10.0%
Weighted Average Cost = 20% * 2.4% + 20% * 4.8% + 60% * 12.5% = 8.9%.
Since 8.9% is less than the Seller's Yield, this deal will be accretive.
Wait a minute, though, does that formula really work all the time?✅Nope. There are a
number of assumptions here that rarely hold up in the real world: the seller and buyer
have the same tax rates, there are no other acquisition effects such as new
Depreciation and Amortization, there are no transaction fees, there are no synergies,
and so on.
, And most importantly, the rule truly breaks down if you use the seller's current share
price rather than the price the buyer is paying to purchase it.
It's a great way to quickly assess a deal, but it is not a hard-and-fast rule.
A company with a higher P/E acquires one with a lower P/E - is this accretive or
dilutive?✅Trick question. You can't tell unless you also know that it's an all-stock deal.
If it's an all-cash or all-debt deal, the P / E multiple of the buyer doesn't matter because
no stock is being issued.
If it is an all-stock deal, then the deal will be accretive since the buyer "gets" more in
earnings for each $1.00 used to acquire the other company than it does from its own
operations. The opposite applies if the buyer's P / E multiple is lower than the seller's.
Why do we focus so much on accretion / dilution? Is EPS really that important? Are
there cases where it's not relevant?✅EPS is important mostly because institutional
investors value it and base many decisions on EPS and P / E multiples - not the best
approach, but it is how they think.
A merger model has many purposes besides just calculating EPS accretion / dilution -
for example, you could calculate the IRR of an acquisition if you assume that the
acquired company is resold in the future, or even that it generates cash flows
indefinitely into the future.
An equally important part of a merger model is assessing what the combined financial
statements look like and how key items change.
So it's not that EPS accretion / dilution is the only important point in a merger model -
but it is what's most likely to come up in interviews.
How do you determine the Purchase Price for the target company in an
acquisition?✅You use the same Valuation methodologies we discussed in the
Valuation section. If the seller is a public company, you would pay more attention to the
premium paid over the current share price to make sure it's "sufficient" (generally in the
15-30% range) to win shareholder approval.
For private sellers, more weight is placed on the traditional methodologies.
All else being equal, which method would a company prefer to use when acquiring
another company - cash, stock, or debt?✅Assuming the buyer had unlimited
resources, it would almost always prefer to use cash when buying another company.
Why?
• Cash is cheaper than debt because interest rates on cash are usually under 5%
whereas debt interest rates are almost always higher than that. Thus, foregone interest
on cash is almost always less than the additional interest paid on debt for the same
amount of cash or debt.
Correct Answers
Why would a company want to acquire another company?✅A company would acquire
another company if it believes it will earn a good return on its investment - either in the
form of a literal ROI, or in terms of a higher Earnings Per Share (EPS) number, which
appeals to shareholders.
There are several reasons why a buyer might believe this to be the case:
• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow more quickly and sees an acquisition as a way to do
that.
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller's customers so it can up-sell and cross-
sell products and services to them.
• The buyer thinks the seller has a critical technology, intellectual property, or
other "secret sauce" it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make
the deal accretive for its shareholders.
Walk me through a basic merger model.✅"A merger model is used to analyze the
financial profiles of 2 companies, the purchase price and how the purchase is made,
and it determines whether the buyer's EPS increases or decreases afterward.
Step 1 is making assumptions about the acquisition - the price and whether it was done
using cash, stock, debt, or some combination of those. Next, you determine the
valuations and shares outstanding of the buyer and seller and project the Income
Statements for each one.
Finally, you combine the Income Statements, adding up line items such as Revenue
and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid
on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate to get
the Combined Net Income, and then divide by the new share count to determine the
combined EPS."
You could also add in the part about Goodwill and combining the Balance Sheets, but
it's best to start with answers that are as simple as possible at first.
What's the difference between a merger and an acquisition?✅There's always a buyer
and a seller in any M&A deal - the difference is that in a merger the companies are
similarly-sized, whereas in an acquisition the buyer is significantly larger (often by a
factor of 2-3x or more).
,Also, 100% stock (or majority stock) deals are more common in mergers because
similarly sized companies rarely have enough cash to buy each other, and cannot raise
enough debt to do so either.
Why would an acquisition be dilutive?✅An acquisition is dilutive if the additional Net
Income the seller contributes is not enough to offset the buyer's foregone interest on
cash, additional interest paid on debt, and the effects of issuing additional shares.
Acquisition effects - such as the amortization of Other Intangible Assets - can also make
an acquisition dilutive.
Is there a rule of thumb for calculating whether an acquisition will be accretive or
dilutive?✅Yes, here it is:
• Cost of Cash = Foregone Interest Rate on Cash * (1 - Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate)
• Cost of Stock = Reciprocal of the buyer's P / E multiple, i.e. E / P or Net
Income / Equity Value.
• Yield of Seller = Reciprocal of the seller's P / E multiple (ideally calculated
using the purchase price rather than the seller's current share price).
You calculate each of the Costs, take the weighted average, and then compare that
number to the Yield of the Seller (the reciprocal of the seller's P / E multiple).
If the weighted "Cost" average is less than the Seller's Yield, it will be accretive since
the purchase itself "costs" less than what the buyer gets out of it; otherwise it will be
dilutive.
Example: The buyer's P / E multiple is 8x and the seller's P / E multiple is 10x. The
buyer's interest rate on cash is 4% and interest rate on debt is 8%. The buyer is paying
for the seller with 20% cash, 20% debt, and 60% stock. The buyer's tax rate is 40%.
• Cost of Cash = 4% * (1 - 40%) = 2.4%
• Cost of Debt = 8% * (1 - 40%) = 4.8%
• Cost of Stock = = 12.5%
• Yield of Seller = = 10.0%
Weighted Average Cost = 20% * 2.4% + 20% * 4.8% + 60% * 12.5% = 8.9%.
Since 8.9% is less than the Seller's Yield, this deal will be accretive.
Wait a minute, though, does that formula really work all the time?✅Nope. There are a
number of assumptions here that rarely hold up in the real world: the seller and buyer
have the same tax rates, there are no other acquisition effects such as new
Depreciation and Amortization, there are no transaction fees, there are no synergies,
and so on.
, And most importantly, the rule truly breaks down if you use the seller's current share
price rather than the price the buyer is paying to purchase it.
It's a great way to quickly assess a deal, but it is not a hard-and-fast rule.
A company with a higher P/E acquires one with a lower P/E - is this accretive or
dilutive?✅Trick question. You can't tell unless you also know that it's an all-stock deal.
If it's an all-cash or all-debt deal, the P / E multiple of the buyer doesn't matter because
no stock is being issued.
If it is an all-stock deal, then the deal will be accretive since the buyer "gets" more in
earnings for each $1.00 used to acquire the other company than it does from its own
operations. The opposite applies if the buyer's P / E multiple is lower than the seller's.
Why do we focus so much on accretion / dilution? Is EPS really that important? Are
there cases where it's not relevant?✅EPS is important mostly because institutional
investors value it and base many decisions on EPS and P / E multiples - not the best
approach, but it is how they think.
A merger model has many purposes besides just calculating EPS accretion / dilution -
for example, you could calculate the IRR of an acquisition if you assume that the
acquired company is resold in the future, or even that it generates cash flows
indefinitely into the future.
An equally important part of a merger model is assessing what the combined financial
statements look like and how key items change.
So it's not that EPS accretion / dilution is the only important point in a merger model -
but it is what's most likely to come up in interviews.
How do you determine the Purchase Price for the target company in an
acquisition?✅You use the same Valuation methodologies we discussed in the
Valuation section. If the seller is a public company, you would pay more attention to the
premium paid over the current share price to make sure it's "sufficient" (generally in the
15-30% range) to win shareholder approval.
For private sellers, more weight is placed on the traditional methodologies.
All else being equal, which method would a company prefer to use when acquiring
another company - cash, stock, or debt?✅Assuming the buyer had unlimited
resources, it would almost always prefer to use cash when buying another company.
Why?
• Cash is cheaper than debt because interest rates on cash are usually under 5%
whereas debt interest rates are almost always higher than that. Thus, foregone interest
on cash is almost always less than the additional interest paid on debt for the same
amount of cash or debt.
