Basic Merger Model Interview Questions for Finance

A merger model is a financial analysis used to evaluate the impact of an acquisition, particularly on the buyer’s Earnings Per Share (EPS). It helps determine whether a deal is accretive or dilutive. The process typically follows these steps: 

1. Set transaction assumptions.
Start by defining the deal terms: purchase price and payment method (cash, stock, debt, or a mix). Estimate expected synergies if applicable.

2. Project financials and combine the income statements. 
Project the standalone income statements for both companies. Then combine them by adding revenue and operating expenses, adjust for foregone interest on cash and new interest on debt, and apply the buyer’s tax rate to calculate the combined net income.

3. Calculate the EPS impact.
Divide the combined net income by the new share count, including any new shares issued. Compare this to the buyer’s standalone EPS to determine if the deal is accretive (new EPS is higher) or dilutive (new EPS is lower). 

An acquisition is dilutive when the seller’s net income doesn’t fully offset the negative financial effects for the buyer. Specifically, it’s dilutive if:

• The seller’s net income is lower than the buyer’s foregone interest income (if cash is used),
• The interest expense on new debt is high (if debt is used), or
• A large number of new shares are issued (if stock is used), reducing EPS.

In addition, non-operating effects like the amortization of intangibles can reduce net income and contribute to dilution.

It depends on how the deal is financed.

1. Cash and Debt Deal: You can estimate the impact by comparing the seller’s pre-tax income to the buyer’s cost of funding.

• Add the foregone interest on cash and the interest expense on new debt.
• If the seller’s pre-tax income is higher than the combined cost, the deal is likely accretive.

2. All-Stock Deal: There’s a common shortcut. 

• If the buyer’s P/E ratio is higher than the seller’s, the deal is generally accretive.
• If the buyer’s P/E is lower, it’s dilutive.

3. Mixed Consideration (Cash, Stock, Debt): There’s no reliable shortcut. You'd need to model the deal or do quick estimates across all funding sources.

There are several strategies a buyer can use to turn a potentially dilutive deal into an accretive one:

1. Realize cost synergies by reducing overlapping expenses, such as SG&A or headcount to boost combined net income and improve EPS.

2. Improve the deal structure.

• Using cash instead of issuing new shares (if the buyer has excess cash and low opportunity cost) can reduce dilution.
• Raising low-interest debt instead of equity can also help, especially if the cost of debt is lower than the earnings yield of the target.

3. Negotiate a lower purchase price for the target to increases the earnings acquired per dollar spent, and improve accretion.

4. Delay or phase certain costs such as integration costs or non-critical investments to temporarily support EPS in the near term.

5. Reduce the effective tax rate by using the buyer’s tax structure to offset the target’s earnings and increase combined net income.

The key difference lies in how the buyer pays for the acquisition:

1. Cash Deal

• The buyer uses its own cash or raises debt to fund the purchase.
• It leads to no dilution, but the buyer loses interest income on that cash or takes on interest expense from new debt.
• Cash deals are usually seen as less risky for the seller (they get paid upfront) and often lead to faster closings.

2. Stock Deal

• The buyer issues new shares to pay for the target.
• This dilutes existing shareholders, which can lower the buyer’s EPS unless the target contributes enough net income to offset the dilution.
• It’s often preferred when the buyer has a high stock valuation or wants to preserve cash.

In short, cash deals affect the balance sheet, while stock deals affect the share count and EPS. The optimal structure depends on the buyer’s financial position, cost of capital, and strategic goals.

Many deals often involve a mix of cash, stock, and debt. The impact depends on the proportion of each and how each funding source affects the buyer’s financials.

Using debt in a deal affects the merger model in several key ways:

1. Interest expense: New debt adds interest expense, which reduces the combined pre-tax income and net income, potentially making the deal more dilutive to EPS.

2. Risk and leverage: It increases the buyer’s leverage and financial risk, which can affect credit ratings and future borrowing capacity.

3. No dilution: Unlike issuing stock, debt doesn’t dilute existing shareholders, so if the seller generates strong income, the deal can be EPS-accretive despite the added interest cost.

To estimate debt capacity in a merger, you'd typically use a market-based approach:

1. Leverage Benchmarking

• Look at comparable companies or precedent transactions to find the typical Debt/EBITDA ratios in the industry.
• Multiply that median ratio by the combined company’s LTM EBITDA to estimate a reasonable debt amount.

2. Debt Comps

• Analyze recent debt issuances by similar companies to understand the typical capital structure, including types of debt (e.g., term loans, high-yield bonds) and the number of tranches.

This gives you a practical estimate of what lenders would likely support in a real deal context.

Synergies are used to reflect the potential performance improvements from combining two companies, and they directly impact the combined income statement:

1. Revenue Synergies

• These are added to the top line of the combined company.
• You then apply an assumed profit margin to the incremental revenue, and the resulting income flows through to net income and boosts EPS.

2. Cost Synergies

• These reduce the combined operating expenses or COGS.
• This increases pre-tax income, which leads to higher net income and a more accretive impact on EPS.

PPA determines how the purchase price is allocated across the target’s assets and liabilities. It affects the balance sheet and income statement by:

• Creating intangibles and goodwill, which may be subject to amortization or impairment.
• Impacting depreciation and amortization expenses, which in turn affect net income and EPS.

Modeling these correctly is important for assessing true accretion/dilution.