Walk through a merger model

A merger model answers one question: if Company A buys Company B, do Company A's shareholders end up better or worse off in the short term?

The usual measure is earnings per share. If it rises, the deal is accretive. If it falls, it is dilutive.

This is a sequencing question. The interviewer already knows how the model works. What they want is to hear you lay out the steps in the right order, at the right level of detail, in about two minutes.

The mistake nearly everyone makes is jumping straight to the answer. Earnings per share is the output. Everything interesting happens in the four steps before it.

Step 1: Transaction assumptions

Everything starts here. Before any maths, you need to know the shape of the deal.

Purchase price. What you are paying for the target, usually expressed per share or as a total.

The premium. How much above the target's current share price you are offering. Buyers almost always have to pay extra to persuade shareholders to sell — typically 20 to 40 percent above the undisturbed price.

Consideration mix. How you are paying. Cash from the balance sheet, new debt, your own shares, or a combination. This choice has a bigger effect on the answer than almost anything else.

Interest rate on new debt. If you are borrowing, what does it cost?

Synergies. Savings or extra revenue from combining the two businesses. Cost synergies — one head office instead of two — are easier to defend than revenue synergies, which often do not materialise.

Fees. Advisers, banks and lawyers all get paid.

Expected closing date. Deals take months to complete.

Step 2: Sources and uses

A short table showing where the money comes from and what it pays for. The two sides must tie.

Uses: the equity purchase price, repaying any target debt that has to be refinanced, and fees.

Sources: new debt, cash on hand, and the value of any shares issued.

This step takes thirty seconds and shows you understand that deals have to be funded. Skipping it is a small but noticeable gap.

Step 3: Purchase price allocation

This is the accounting step, and it is the one candidates rush. It is also where most follow-up questions come from, so it is worth understanding properly.

Here is the problem it solves.

When you buy a company, you do not just record "we spent $1 billion." Accounting rules require you to say what you bought. So you go through the target's assets and record each at what it is really worth today.

Writing assets up

The target's balance sheet shows assets at what they cost long ago. Their real value now is often higher.

A factory bought for $50 million twenty years ago might be worth $120 million today. There may also be assets not on the balance sheet at all — brand names, customer relationships, patents. These are called identifiable intangible assets.

You revalue everything to fair value. That is called writing up the assets.

The consequence: extra depreciation

Higher asset values mean higher depreciation and amortisation charges going forward. Those charges reduce reported profit.

This is why an acquisition can dent earnings even when the underlying business is doing fine. It is one of the standard adjustments in a merger model.

Goodwill

Now the leftover.

You paid $1 billion. You have allocated, say, $700 million to identifiable assets at fair value. What about the other $300 million?

That becomes goodwill. It represents the things you paid for that you cannot point at — the workforce, the reputation, the expectation that the two businesses are worth more together.

Goodwill = purchase price − fair value of identifiable net assets acquired

Goodwill sits on the balance sheet. For US public companies it is not amortised — instead it is tested each year, and if the business turns out to be worth less than you paid, you write it down. That is called an impairment.

The deferred tax liability

One more piece, and mentioning it will distinguish you immediately.

You wrote assets up for accounting purposes. But tax authorities often do not accept that write-up. So for tax purposes, depreciation stays based on the old, lower values.

That means your accounting profit and your taxable profit fall out of line for years. Accounting says higher depreciation, tax says lower.

That difference gets recorded at closing as a deferred tax liability — essentially a note saying "we will owe more tax later than our accounts suggest." It unwinds gradually over the life of the assets.

Step 4: Combine the income statement

Now you build the combined company.

• Add both companies' revenues and costs
• Add synergies
• Add the extra depreciation and amortisation created by the write-ups
• Add interest on new debt
• Subtract interest income lost on any cash you spent
• Tax the whole thing at the acquirer's tax rate

That gives you combined net income.

Step 5: Build the new share count

Acquirer's existing shares, plus any new shares issued to pay for the deal.

New shares = (stock portion of the purchase price) ÷ (acquirer's share price)

Step 6: Work out accretion or dilution

Combined net income divided by combined shares gives you the new earnings per share.

Compare it to what the acquirer earned per share on its own. Higher is accretive, lower is dilutive.

Step 7: Say what you would test

Do not stop at the answer. Name what you would flex:

• Purchase price. How much can you pay before it turns dilutive?
• Synergy level. And specifically, breakeven synergies — the amount needed to make EPS exactly unchanged. This is often the most useful single output.
• The funding mix. Cash, debt and stock have very different costs, and changing the mix can flip the answer.
• Credit statistics. If you borrowed heavily, is the combined company's debt load still safe?

How this differs from an LBO

Worth being able to state clearly, because interviewers ask.

A merger model is about a company buying another company. The buyer is strategic — it already operates in the industry. The question is whether earnings per share goes up.

An LBO model is about a financial buyer with no operations of its own. The question is what percentage return they earn over five years.

Different buyers, different motives, different outputs.

Saying it out loud

"You start with the transaction assumptions — purchase price and premium, how much is cash, stock and debt, the interest rate, synergies and fees.

Then sources and uses, showing how the deal gets funded.

Then purchase price allocation. You write the target's assets up to fair value, record a deferred tax liability where the write-up is not tax deductible, and whatever is left over becomes goodwill. The write-ups create extra depreciation that reduces future earnings.

Then you combine the income statements — add both businesses, layer in synergies, add the new depreciation and interest, subtract interest income lost on cash used, and tax it at the acquirer's rate.

Then build the new share count including any shares issued, divide, and compare earnings per share to standalone.

And I would sensitise the price, the synergies and the funding mix, and look at breakeven synergies — the level needed to make the deal EPS-neutral."

What the interviewer is really checking

Can you sequence?

Someone who has built one of these knows assumptions come before funding, funding before allocation, allocation before combining. Someone who has not tends to start at earnings per share and work backwards.

Do you understand purchase price allocation?

This is where the follow-ups live: where goodwill comes from, why write-ups create extra depreciation, why a deferred tax liability appears. Rushing this step invites all three.

Which tax rate?

The acquirer's, on the combined company. A quick question with a quick right answer.

Can you connect it to accretion/dilution?

They are the same question at different levels of detail. Moving comfortably between the full build and the P/E shortcut shows you understand rather than recite.

Do you know how much to include?

Part of what is being tested is editorial judgment — knowing what belongs in two minutes and what to save for the follow-up.

Common mistakes

Starting at earnings per share.

That is the output. Start with the assumptions.

Skipping sources and uses.

Thirty seconds, and it shows you know deals need funding.

Getting goodwill wrong.

It is the leftover after allocating the price to identifiable assets at fair value — not simply price minus book equity, though that shortcut sometimes gets used loosely.

Forgetting the deferred tax liability.

Where an asset write-up is not tax deductible, a DTL gets recorded. Mentioning it sets you apart immediately.

Using the target's tax rate.

The combined company pays the acquirer's rate.

Ignoring fees.

Advisory fees are usually expensed. Financing fees are capitalised and spread over the life of the debt.

Forgetting interest income lost on cash used.

Same omission as in a standalone accretion/dilution question, and just as visible.

Stopping at "so it is accretive by 3 percent."

Without sensitivities and breakeven synergies, you have given the number but not the judgment.