Merger model (basic) Flashcards
(24 cards)
- Walk me through a basic merger model.
A merger model is used to evaluate the financial impact of one company (the buyer) acquiring another (the target). It tells you whether the deal is accretive (increases EPS) or dilutive (decreases EPS) for the buyer.
EPS = earnings per share = net income shares outstanding
Step-by-step:
1. Make purchase assumptions:
* Purchase price for the target (per share or total equity value)
* Form of consideration: Cash, stock, debt, or a mix
2. Project financials for both buyer and target:
* Revenue, Operating Income, Net Income, EPS
3. Combine the Income Statements:
* Add buyer and target revenue and operating expenses
* Adjust for synergies if applicable
* Subtract new interest expense (if using debt), or add interest income saved (if using cash)
4. Adjust for acquisition effects:
* New shares issued if paying with stock
* Amortisation of intangibles and creation of Goodwill
* Deal fees and one-time costs
5. Calculate combined Net Income and divide by new share count:
* Get pro forma EPS
* Compare this to the buyer’s standalone EPS
6. Result = Accretion or Dilution:
* If EPS goes up → Accretive
* If EPS goes down → Dilutive
- What’s the difference between a merger and an acquisition?
Merger:
Two companies combine as equals
Typically involves a “merger of equals”
New entity may take a new name, board, or structure
Example: Company A and Company B merge to form Company AB
Acquisition:
One company (the buyer) purchases another (the target)
The buyer absorbs the target; the target often ceases to exist as a separate entity
Buyer retains control
In practice:
Most “mergers” are actually acquisitions, especially when one company is clearly larger
The term “merger” is often used to make the deal sound more friendly or collaborative
- Why would a company want to acquire another company?
Companies pursue acquisitions to achieve strategic, financial, or operational benefits. Common motivations include:
1. Growth acceleration
Acquire a company to enter new markets, expand geographically, or gain new customers
Faster than growing organically
2. Synergies
Reduce costs by combining operations (cost synergies)
Increase revenue through cross-selling or expanded offerings (revenue synergies)
3. Gaining key assets or capabilities
Acquire technology, intellectual property, talent, or brands they don’t currently have
4. Defensive reasons
Prevent competitors from acquiring the target
Strengthen position in a consolidating industry
5. Financial benefits
The deal may be accretive to EPS
Or improve margins, growth, or return on capital
6. Diversification
Reduce dependence on one market or product
Smooth out earnings or risk profile
- Why would an acquisition be dilutive?
An acquisition is dilutive when the buyer’s Earnings Per Share (EPS decreases after the deal.
Common reasons for dilution:
1. The target’s Net Income is too low
If the acquired company adds less to Net Income than the cost of financing the deal (e.g. new interest expense or new shares), it drags down EPS
2. The purchase price is too high
Overpaying leads to low returns relative to cost, which reduces accretion potential
3. The buyer issues new shares (stock deal)
If the buyer issues a large number of shares, existing shareholders get diluted
Especially dilutive if the buyer has a higher P/E than the target
4. Amortisation of intangible assets
Accounting rules require amortising certain intangibles after acquisition, reducing Net Income and therefore EPS
- Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?
P/E = share price / earnings per share (EPS) = how much are investors willing to pay for $1 of earnings
Yes — there’s a commonly used P/E (Price-to-Earnings) rule of thumb:
If the buyer’s P/E ratio is higher than the target’s, the deal is more likely to be accretive (EPS will increase).
If the buyer’s P/E is lower than the target’s, the deal is more likely to be dilutive (EPS will decrease).
Why this works (in stock deals):
In a stock deal, the buyer is issuing new shares to acquire the target
If the buyer trades at a high P/E, its stock is “expensive” — so issuing new shares is cheap financing
If the target has a lower P/E, the buyer is essentially buying earnings at a discount
→ That tends to increase EPS → accretive
Limitations:
Only applies when the deal is primarily stock-based
Doesn’t account for synergies, debt financing, or non-cash charges like amortisation
Works best when both companies have similar tax rates and accounting standards
- A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?
Generally, its accretive – especially in an all-stock deal.
* This is because the buyer’s stock is highly valid (high P/E) so it can issue fewer shares to acquire a given amount of earnings
* The target’s earnings are “cheaper” (low P/E) so the buyer is acquiring more earnings per dollar than its giving up
o This results in the buyer’s EPS increasing after the deal -> accretive
o Assumptions:
* The deal is stock-financed
* Tax rates, accounting treatment, and synergies don’t distort the outcome
* If the deal includes cash or debt, the P/E rule of thumb may not hold
- What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?
If the buyer’s P/E is higher than the target’s P/E, the deal is more likely to be accretive, especially if it is an all-stock deal
- What are the complete effects of an acquisition?
- Income Statement effects:
Combined revenue and expenses: Buyer adds the target’s figures
Cost synergies may reduce expenses
New depreciation and amortisation from asset write-ups and intangibles
Interest expense increases if debt is used
Foregone interest income if cash is used
Net Income changes due to all of the above - Balance Sheet effects:
Buyer’s cash balance decreases (if cash is used)
New debt added (if the deal is debt-financed)
Goodwill created: The premium over the target’s net assets
Other intangible assets added and amortised
Target’s assets and liabilities are consolidated into the buyer’s books - Cash Flow Statement effects:
Cash used in acquisition appears under investing activities
Financing flows show new debt or equity issued
Depreciation, amortisation, and interest show up in operating cash flows - EPS impact:
New shares issued (if stock is used) may dilute EPS
Accretion/dilution depends on deal structure, P/E ratios, and synergies - Ownership structure:
If stock is used, existing shareholders are diluted
Target shareholders may become owners of the combined company
- If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?
- To maintain financial flexibility
Keeping some cash on hand allows the buyer to:
Handle future opportunities (e.g. more acquisitions)
Weather downturns or unexpected costs
Using 100% of available cash could weaken liquidity - To preserve credit ratings
If the cash is needed to meet debt obligations, spending it all could hurt the company’s credit rating
This would make future borrowing more expensive - To avoid opportunity cost
The cash may be earning a decent return elsewhere (e.g. invested in the business or securities)
Using it all means giving up those returns - To share risk with target shareholders
If the company offers stock as part of the payment, target shareholders share in future upside (or downside)
This can make negotiations easier or more attractive for the seller - To avoid large tax impacts (especially internationally)
If the cash is held offshore, repatriating it may trigger tax liabilities
- Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?
A strategic acquirer (i.e. a company buying another company) is usually willing to pay more than a private equity firm because it can realise synergies and has longer-term motives.
Key reasons:
1. Synergies
Strategic buyers can generate cost savings (e.g. eliminating duplicate staff or systems) and revenue synergies (e.g. cross-selling)
These synergies increase the value of the target to the buyer
→ So they can afford to pay a higher price
2. Long-term ownership
Strategic buyers plan to hold the business permanently or for the long term, not just to resell it
They may value strategic fit, market expansion, or access to technology
3. No return hurdle
Private equity firms require a minimum IRR (usually 20%+) to make the investment worth it
Strategic buyers don’t have the same return constraints — they can evaluate the deal based on strategic value, not just financial return
4. Can use stock as currency
Strategic acquirers can often use stock instead of cash to fund the deal, which reduces their upfront cost
- Why do Goodwill & Other Intangibles get created in an acquisition?
They are created because the purchase price in an acquisition is usually higher than the fair value of the target’s net assets.
Here’s how it works:
The buyer purchases the target for, say, $500 million
The target’s tangible assets minus liabilities (net assets) are only worth $300 million
The extra $200 million must go somewhere on the Balance Sheet
→ It becomes Goodwill and Other Intangible Assets
What’s included:
Goodwill = the value of intangible things you can’t separate out — brand reputation, customer loyalty, etc.
Other Intangibles = identifiable intangibles like:
Trademarks
Patents
Customer relationships
Technology
These are separately valued and amortised (except Goodwill, which is not amortised but tested for impairment).
- What is the difference between Goodwill and Other Intangible Assets?
Both are non-physical assets created in an acquisition, but they differ in what they represent and how they’re treated in accounting.
Goodwill:
Represents intangible value that cannot be separately identified or valued
Includes:
Brand reputation
Employee expertise
Customer loyalty
Strategic value of the deal
Not amortised
Instead, tested annually for impairment — if the value is no longer justified, the company writes it down
Other Intangible Assets:
Are identifiable and separable from the business
Examples:
Patents
Trademarks
Customer relationships
Technology licences
Amortised over their useful life (e.g. 5–10 years), reducing Net Income annually
- Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?
Yes — there are other intangible factors that don’t go on the Balance Sheet but still impact the success of an acquisition.
Examples of off-balance-sheet intangibles:
1. Cultural alignment (or conflict)
Differences in company culture can affect integration, morale, and productivity
Poor cultural fit is a common reason why mergers fail
2. Management quality
Retaining key leaders from the target company can be critical to post-deal success
3. Employee retention or disruption
Loss of key staff or integration issues can hurt operations and future performance
4. Customer perception
M&A activity may disrupt client relationships or brand loyalty
5. Operational disruption
Combining systems, processes, and teams can slow down the business or create risk
- What are synergies, and can you provide a few examples?
Synergies are the benefits that occur when two companies combine and operate more efficiently or profitably together than they could separately.
Types of synergies:
1. Cost synergies (most common)
Result from eliminating duplicate costs or improving efficiency
Examples:
* Layoffs of overlapping staff (e.g. HR, Finance)
* Combining office space or infrastructure
* Streamlining supply chains
* Consolidating IT systems or vendors
2. Revenue synergies
Result from increased sales or pricing power due to the deal
Examples:
* Cross-selling products to each other’s customers
* Expanding into new markets using combined distribution
* Offering bundled services or better pricing
3. Financial synergies (less common)
Improved access to capital or lower borrowing costs
Potential to use tax losses from one company to offset profits in the other
- How are synergies used in merger models?
In a merger model, synergies are added to the combined company’s financials to reflect the expected benefits of the acquisition — and they directly affect whether the deal is accretive or dilutive.
1. Cost synergies
Reduce combined operating expenses
Increase Net Income and EPS
Typically included as a line item under operating costs or added directly to EBITDA
2. Revenue synergies
Increase Revenue in the combined Income Statement
May improve margins and Net Income
Often modelled more cautiously (harder to quantify and realise)
Impact:
Higher earnings from synergies → higher pro forma EPS → increases chance of deal being accretive
Also impacts the purchase price justification, since the buyer can afford to pay more if synergies are large
Accounting treatment:
Synergies are not shown as a standalone line on the Balance Sheet or Cash Flow Statement
They affect earnings indirectly by altering the Income Statement components
- Are revenue or cost synergies more important?
Cost synergies are generally more important in M&A models — especially when assessing whether a deal is accretive or dilutive.
Why cost synergies matter more:
* More predictable and achievable
* It’s easier to cut overlapping costs (e.g. layoffs, facilities, suppliers) than it is to guarantee new sales
* Direct impact on profitability
* Cost synergies flow straight to the bottom line → increase Net Income and EPS
* Quick to implement
* Can often be realised shortly after closing the deal
Why revenue synergies are less relied upon:
* Harder to quantify
* It’s difficult to predict whether customers will actually buy more or cross-sell opportunities will materialise
* Slower to realise
* May take months or years to show up in results
* Often considered “upside optionality” rather than a base case input
- All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?
All else being equal, a company would prefer to use cash.
Why cash is preferred:
* Cheapest form of financing
o No interest payments like debt
o No dilution like stock
o If the buyer has excess cash earning low returns, using it for a deal is more efficient
* Less risky for the seller
o Cash is certain and immediate, unlike stock, which can fluctuate in value
* No ongoing obligations
o Unlike debt, there’s no need to repay anything or meet interest payments
Why not stock?
* Dilutes existing shareholders
* Risky for sellers (they’re now partly exposed to the buyer’s stock performance)
Why not debt?
* Adds interest expense
* Increases financial risk
* Can limit future borrowing capacity or hurt credit ratings
- How much debt could a company issue in a merger or acquisition?
The amount of debt a company can issue in an M&A deal depends on its financial profile and what lenders believe it can safely repay.
Key factors lenders consider:
1. Leverage ratios
* Most important is Debt / EBITDA
* Typical range:
o 2–3× for conservative companies
o 4–6× for more aggressive, leveraged buyouts
* If the buyer’s combined Debt / EBITDA exceeds these levels, lenders may not approve additional borrowing
2. Interest coverage
* Measured as EBITDA / Interest Expense
* Lenders want to ensure the company can cover interest payments comfortably (e.g. at least 3× coverage)
3. Industry norms
* Some sectors (e.g. utilities, infrastructure) can support more debt
* Others (like tech or cyclical businesses) may require lower leverage
4. Cash flow stability
* Companies with recurring, predictable cash flows can safely take on more debt
* Volatile businesses face tighter debt limits
5. Credit rating considerations
* Issuing too much debt may lower the company’s credit rating, making future borrowing more expensive
- How do you determine the Purchase Price for the target company in an acquisition?
The purchase price is determined based on a combination of valuation analysis, negotiation, and deal dynamics.
1. Valuation methods:
* Public Comparables
o What are similar companies trading at (e.g. EV/EBITDA, P/E)?
* Precedent Transactions
o What have similar companies been acquired for?
* DCF Analysis
o What is the intrinsic value of the target based on projected cash flows?
* These methods give a valuation range to guide pricing.
2. Premiums analysis (if target is public):
* Acquirers usually offer a premium over the current share price (often 20–40%) to:
o Encourage shareholders to sell
o Reflect synergies or control value
3. Strategic fit and synergies:
* If the acquirer expects significant synergies, it may justify paying a higher price
* A better strategic fit = more willingness to pay up
4. Competitive dynamics:
* In a bidding war or auction, the price may rise above valuation benchmarks
* If the buyer is the only interested party, it may offer less
- Let’s say a company overpays for another company – what typically happens afterwards and can you give any recent examples?
- Goodwill is created — and later impaired
* If the buyer pays more than the target’s fair value, the extra is recorded as Goodwill
* If the deal doesn’t deliver expected benefits, that Goodwill may be written down, reducing Net Income - EPS and shareholder value can suffer
* If the acquisition is dilutive and doesn’t add enough profit, it lowers EPS
* Shareholders may lose confidence, and the stock price may fall - Integration issues arise
* Mismatched cultures, systems, or leadership can prevent synergies from being realised - Debt load increases (if deal is debt-financed)
* Interest payments may strain cash flow
* Credit ratings may fall, making future borrowing more expensive - Management credibility takes a hit
* Analysts and investors may question the leadership’s judgment
Example:
Microsoft’s $7.6B write-down of Nokia (2015)
Microsoft acquired Nokia’s phone business for $7.2B
The deal failed to revive its mobile strategy
Microsoft later wrote down nearly the entire value of the acquisition, resulting in massive Goodwill impairment
- A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it’s only worth $50 million. What happens?
This means the combined company’s stock price fell significantly after the deal was announced or closed — and the value of the deal dropped as a result. Even though the buyer “paid” $100M in stock, the actual value of what the seller received has dropped to $50M, because the stock price fell — illustrating that in all-stock deals, the deal value is tied to share price performance.
1. The target shareholders lose value
* They received stock worth $100M at the time of the deal
* But now that stock is worth $50M, so they’ve effectively lost half their value
2. The buyer’s shareholders are also affected
* The buyer issued shares (diluting its own shareholders)
* But the market has reacted negatively — possibly due to:
o Overpayment
o Doubts about synergies
o Fear of integration issues
o Concerns about future performance
3. The market has “repriced” the combined company
* The stock price drop reflects investor sentiment that the deal destroyed value
* This is common when deals are seen as poorly timed or overpriced
- Why do most mergers and acquisitions fail?
Most M&A deals fail to achieve their intended goals, often due to integration issues, overpayment, or unrealistic expectations.
Top reasons M&A deals fail:
1. Poor integration
* Operational, cultural, and technological integration is often harder than expected
* Differences in company culture, systems, or leadership can disrupt performance
2. Overpaying for the target
* If the buyer pays too much based on overestimated synergies or future growth, the deal destroys shareholder value
* Overpayment leads to Goodwill impairments and lower returns
3. Unrealised synergies
* Cost and revenue synergies are often too optimistic
* Companies may fail to achieve them due to execution challenges or misaligned products/customers
4. Strategic mismatch
* The deal may look good on paper but lack real strategic logic
* “Empire building” acquisitions often fail to add value
5. Disruption and employee turnover
* Key people may leave post-acquisition
* Staff morale and productivity may decline
6. Market or regulatory pushback
* Markets may react negatively if the deal is seen as risky
* Regulators may delay, alter, or block the deal entirely
- What role does a merger model play in deal negotiations?
A merger model is a key tool in M&A negotiations because it helps both parties understand the financial impact of the deal — especially on EPS (Earnings Per Share), valuation, and affordability.
Key roles of the merger model:
1. Test accretion/dilution
* The model shows whether the deal will increase or decrease the buyer’s EPS
* EPS impact is often a headline metric in M&A and may influence shareholder support
2. Support pricing and structure discussions
* Helps the buyer decide:
o What it can afford to pay
o Whether to use cash, stock, or debt
o What mix creates the most attractive outcome (financially and strategically)
3. Quantify synergies
* Shows how cost or revenue synergies affect the deal outcome
* Can be used to justify a higher purchase price or to pressure the seller if synergies are needed for accretion
4. Inform negotiation tactics
* The buyer may present a model to the seller to justify a lower offer
* The seller may run its own version to argue for a higher price
5. Communicate value to shareholders and boards
* Cleanly summarises whether the deal:
o Is accretive
o Creates long-term value
o Can be financed reasonably
* Helps management secure internal and external approval
- What types of sensitivities would you look at in a merger model? What variables would you look at?
Sensitivity analysis in a merger model tests how changes in key assumptions affect accretion/dilution, EPS, and overall deal value. It helps assess the risk and flexibility of the deal structure.
Key variables to sensitise:
1. Purchase Price / Offer Premium
* Test the impact of paying more or less for the target
* Higher price → more dilution (unless fully offset by synergies)
2. Synergies (cost or revenue)
* Vary the amount and timing of expected synergies
* Shows how much the deal relies on synergy realisation to be accretive
3. Form of Consideration (Cash vs. Stock vs. Debt)
* Test different financing mixes to see how they affect:
o EPS
o Interest expense or savings
o Share dilution
4. Interest Rates (on cash and debt)
* Adjust interest earned on cash used or interest paid on new debt
* Higher rates = more impact on EPS and deal feasibility
5. Target’s operating performance
* Change assumptions around the target’s:
o Revenue growth
o Margins
o Net income
