Break into Wall Street Technical preparation
M&A and merger models
M&A questions test whether you can judge a deal the way a board would: why buy, what it does to earnings per share, what the acquirer is really paying for, and how a sell-side process gets to a signed agreement.
What you must know
- Why companies buy
To grow faster than they could alone, to enter a new market, product or geography, to gain technology or talent, to cut costs through scale, or to remove a competitor. Sellers sell because owners want liquidity, a sponsor needs to exit, or the business is worth more inside a larger group. A good answer always comes back to whether the combined company is worth more than the two apart, net of the price paid.
- Accretion and dilution
A deal is accretive if the buyer's pro forma earnings per share, usually for the next full year, are higher than before, and dilutive if lower. Pro forma net income is the two companies' net income, less the after-tax cost of funding, plus after-tax synergies, less new amortisation of acquired intangibles. Pro forma shares are the buyer's shares plus any new shares issued.
- The cost of each currency
Cash costs the interest it would have earned, after tax. Debt costs its interest rate, after tax. Stock costs the buyer's earnings yield, the inverse of its P/E. Compare each with the target's earnings yield at the purchase price: if the target yields more than the funding costs, the deal is accretive before synergies.
- Synergies
Cost synergies come from removing overlap: duplicated head offices, procurement savings, combined plants. Revenue synergies come from cross-selling or pricing power. Markets trust cost synergies more because management controls them. Both take time to arrive and usually need one-off integration costs first.
- Purchase price allocation
The buyer records the target's identifiable assets and liabilities at fair value, which usually writes up fixed assets and recognises intangibles such as customer relationships, brands and technology. Whatever the price exceeds those net assets by is goodwill. Written-up assets are depreciated or amortised, which reduces future earnings; goodwill is not amortised under US GAAP or IFRS and is tested for impairment instead. A deferred tax liability usually arises too, which practice handles in more detail than an interview needs.
- The sell-side auction
Preparation: the bank and the seller build a model, a teaser, a confidential information memorandum and a buyer list. First round: buyers sign confidentiality agreements, receive the memorandum and submit non-binding indications of interest. Second round: a shortlist gets management presentations, the data room and a draft purchase agreement, and submits binding bids with their markup. Then the seller negotiates with the preferred bidder, signs, and closes after regulatory and shareholder approvals.
Worked example
Accretion and dilution: cash, debt or stock
The buyer earns $100 of net income on 100 shares, so EPS is $1.00, and trades at $20, a P/E of 20x. It pays $150 for a target earning $10, a P/E of 15x. Tax is 25%. Cash earns 4% before tax, new debt costs 6% before tax, and new shares are issued at $20. No synergies or fees.
| Line | All cash | All debt | All stock |
|---|---|---|---|
| After-tax cost of funding | 3.0% | 4.5% | 5.0% |
| Buyer net income | $100.00 | $100.00 | $100.00 |
| Target net income | +$10.00 | +$10.00 | +$10.00 |
| After-tax interest lost or paid on $150 | −$4.50 | −$6.75 | $0.00 |
| Pro forma net income | $105.50 | $103.25 | $110.00 |
| Shares (new shares: 150 ÷ 20) | 100.0 | 100.0 | 107.5 |
| Pro forma EPS | $1.0550 | $1.0325 | $1.0233 |
| Change in EPS | +5.50% | +3.25% | +2.33% |
The target's earnings yield at the price paid is 10 ÷ 150, about 6.7%. Every currency costs less than that, so every structure is accretive, and the cheapest currency, cash, is the most accretive. Cash: $150 × 4% × 0.75 = $4.50. Debt: $150 × 6% × 0.75 = $6.75. Stock: 1 ÷ 20 = 5.0%.
Practice
Answer out loud first, then check. Mark each card; the ones to review come back first next time.
Why would a company acquire another company?
Because the combination should be worth more than the two companies apart, by more than the premium paid. The usual reasons are faster growth, entry into a new market or product, buying technology or talent, cost savings from scale, and market position. Sometimes it is defensive, to stop a competitor getting an asset. And sometimes the reasons are weaker, such as empire building, which is why boards and shareholders test the price so hard.
Likely follow-up: Why do many acquisitions destroy value?
Walk me through a merger model.
Start with the buyer's and the target's projected net income and share counts, the purchase price and how it is funded: cash, new debt, new shares or a mix.
Combine the net income, subtract the after-tax interest lost on cash or paid on new debt, add after-tax synergies and subtract new amortisation from the purchase price allocation. Divide by the buyer's shares plus any new shares to get pro forma EPS, and compare it with the buyer's standalone EPS to see whether the deal is accretive or dilutive.
Likely follow-up: Which line do bankers flex most to make a deal look accretive?
A buyer with $1.00 of EPS, 100 shares and a P/E of 20x buys a target earning $10 for $150, all in cash earning 4% before tax, with a 25% tax rate. Accretive or dilutive?
The cash would have earned $150 × 4% = $6 before tax, $4.50 after tax. Pro forma net income is $100 + $10 − $4.50 = $105.50, on the same 100 shares, so EPS is $1.055: 5.5% accretive.
The shortcut: the after-tax cost of cash is 3%, the target's earnings yield at that price is 10 ÷ 150, about 6.7%, so it has to be accretive.
Likely follow-up: And if the buyer paid entirely in stock at $20 a share?
In an all-stock deal, what is the quick test for accretion?
Compare P/E ratios. If the buyer's P/E is higher than the P/E it pays for the target, the deal is accretive, before synergies and fees. A buyer at 20x paying 15x is buying earnings more cheaply than its own shares are valued, so it gains EPS. Paying 25x would be dilutive. The test only holds for all-stock deals with no synergies or extra amortisation.
Likely follow-up: Why does it only hold for all-stock deals?
Which is cheapest to use: cash, debt or stock?
Usually cash, then debt, then stock. Cash only costs the after-tax interest it would have earned, which tends to be low. Debt costs its after-tax interest rate. Stock costs the buyer's earnings yield, the inverse of its P/E, and also gives away a share of all future upside. The order can change: a buyer with a very high P/E can find its stock cheaper than debt, and debt capacity and ratings put a limit on borrowing.
Likely follow-up: Why might a seller prefer to be paid in stock?
If a deal is accretive, is it a good deal?
Not necessarily. EPS accretion is an accounting result. A buyer with a high P/E can make almost any lower-multiple purchase accretive with its stock, even if it overpays. The better test is whether the return on the price paid, including realistic synergies, exceeds the buyer's cost of capital, and whether the combined company creates value. Conversely, a dilutive deal can be sensible if it buys faster growth.
Likely follow-up: What return would you compare with the cost of capital?
What are synergies, and which kind do investors trust more?
Synergies are the extra value from combining: cost synergies from removing duplicated functions, procurement and facilities, and revenue synergies from cross-selling, wider distribution or pricing. Investors trust cost synergies more, because management controls them and they are easier to measure. Revenue synergies depend on customers behaving as planned, so they are often discounted heavily or left out of the base case.
Likely follow-up: How would you value $50 a year of cost synergies?
The buyer pays $300 in stock at $20 a share for a target earning $10. Buyer EPS is $1.00 on 100 shares, tax 25%. How many pre-tax synergies do you need to break even?
The buyer issues 300 ÷ 20 = 15 new shares, so there are 115 shares. Pro forma net income without synergies is $110, so EPS is about $0.957: dilutive.
To get back to $1.00, net income must reach $115, so after-tax synergies of $5 are needed, which is $5 ÷ 0.75, about $6.7 before tax.
Likely follow-up: Is $6.7 of synergies plausible for a target earning $10?
What is goodwill, and how is it created in an acquisition?
Goodwill is the purchase price less the fair value of the target's identifiable net assets. Example, ignoring deferred taxes: the buyer pays $150 for a target with $60 of book net assets, writes up fixed assets by $10 and recognises $30 of intangibles such as customer relationships, so identifiable net assets are $100 and goodwill is $50.
The intangibles are amortised over their lives, which reduces EPS. Goodwill is not amortised under US GAAP or IFRS; it is tested for impairment.
Likely follow-up: Why do merger models add back acquired amortisation in adjusted EPS?
Walk me through a sell-side M&A process.
Preparation: the bank works with the seller on positioning, a financial model, a teaser, a confidential information memorandum and a list of buyers.
First round: interested buyers sign confidentiality agreements, review the memorandum and submit non-binding indications of interest. Second round: a shortlist gets management meetings, data room access and a draft purchase agreement, and submits binding offers with their markup. The seller then negotiates with the preferred bidder, signs, and the deal closes after regulatory and other approvals.
Likely follow-up: Why would a seller choose a targeted process with three buyers over a broad auction?
Why run an auction rather than negotiate with a single buyer?
Competition. Several bidders push the price up and improve terms, and the process gives the board evidence that it got the best value, which matters for its duties to shareholders. The costs are time, the risk of a leak unsettling staff, customers and competitors, and more information shared with rivals. A negotiated sale is quicker and more confidential, and fits when one buyer is clearly the natural owner.
Likely follow-up: What protections does a buyer seek once it has signed?
What is the difference between a fixed exchange ratio and a fixed value in a stock deal?
With a fixed exchange ratio, each target share receives a set number of buyer shares, so the target's shareholders bear the risk that the buyer's share price moves before closing. With a fixed value, the number of shares adjusts so the target receives a set dollar amount, and the buyer bears the risk of issuing more shares if its price falls. Collars limit either effect within a band.
Likely follow-up: Which would you want as the seller, and when?
What other effects of a deal show up in a merger model besides funding and synergies?
New depreciation and amortisation from writing up assets and recognising intangibles, which reduce pro forma earnings. Financing fees, often amortised over the life of the debt. One-off integration and transaction costs. Any refinancing of the target's debt. Changes in the tax rate. And foregone interest on the target's cash, if it is used.
Likely follow-up: Which of these do analysts usually exclude from adjusted EPS?
Common mistakes
- Forgetting to tax the interest: lost interest income and new interest expense both move net income after tax.
- Using the P/E shortcut on a cash or debt deal. It only works for all-stock deals with no other adjustments.
- Treating accretion as proof that a deal creates value.
- Counting revenue synergies at full value and from day one.
- Saying goodwill is amortised. Under both US GAAP and IFRS it is tested for impairment.
- Describing the auction without the order of documents: teaser, confidentiality agreement, memorandum, indications of interest, data room, binding bids.