Merger models and accretion/dilution, explained
A merger model asks one question: does the buyer's earnings per share (EPS) go up (accretive) or down (dilutive) after the deal? You combine both companies' net income, adjust for synergies, new interest and lost interest on cash, then divide by the new share count.
The shortcut: compare the cost of each funding source with the target's earnings yield (its net income ÷ purchase price). Stock costs the buyer's earnings yield (1 ÷ its P/E). Debt costs its after-tax interest rate. Cash costs the after-tax interest it would have earned. If what you pay for is cheaper than what you buy, the deal is accretive.
M&A questions
Basic
Why would a company acquire another company?
A strong answer covers
- Growth: new markets, products or customers
- Synergies: cost savings or revenue gains
- Acquire technology or talent
- Defensive reasons or using excess cash
Basic
What's the difference between a merger and an acquisition?
A strong answer covers
- Acquisition: one company buys another
- Merger: two companies combine, often of similar size
- Legally the line is blurry
- Most deals are acquisitions in practice
Intermediate
Walk me through a merger model.
A strong answer covers
- Project both companies' financials
- Determine price and mix of cash, stock and debt
- Combine income statements with synergies, interest and new shares
- Calculate pro forma EPS and accretion or dilution
Intermediate
How does a buyer decide between paying with cash, stock or debt?
A strong answer covers
- Cost of each: forgone interest, after-tax interest, earnings yield
- Buyer's balance sheet and leverage capacity
- Whether the buyer's stock is richly valued
- Target shareholders' preferences and tax implications
Intermediate
What are synergies, and why are cost synergies valued more than revenue synergies?
A strong answer covers
- Value created by combining the companies
- Cost synergies: removing overlap, more control and certainty
- Revenue synergies depend on customers and are harder to achieve
- Investors and banks often discount revenue synergies heavily
Intermediate
A client wants to buy a competitor at a 35% premium. Walk me through how you'd tell them whether that price makes sense.
A strong answer covers
- Value the target standalone with comps, precedents and a DCF
- Estimate realistic synergies and their timing, net of integration costs
- Compare premium paid to PV of synergies
- Check accretion/dilution and the buyer's leverage capacity
Intermediate
Walk me through a sell-side M&A process from mandate to signing.
A strong answer covers
- Prep: teaser, CIM, buyer list, model
- First round: NDAs, indications of interest
- Second round: management presentations, data room, LOIs
- Negotiate the purchase agreement, sign, then close after approvals
Intermediate
What is a fairness opinion, and why does a board want one?
A strong answer covers
- Banker's opinion that the price is fair from a financial point of view
- Based on valuation analyses like comps, precedents and DCF
- Helps the board show it met its fiduciary duty
- Not a recommendation to shareholders on how to vote
Intermediate
What's the difference between a stock purchase and an asset purchase?
A strong answer covers
- Stock purchase: buy the shares, take on all liabilities
- Asset purchase: pick specific assets and liabilities
- Asset deals can give the buyer a tax step-up
- Sellers usually prefer stock deals
Intermediate
What is a break-up fee and why do deals include them?
A strong answer covers
- Paid if one side walks away under certain conditions
- Target fee compensates the buyer for its time and costs
- Reverse fee protects the target if the buyer can't close
- Usually a few percent of deal value
Advanced
Buyer P/E 15x, target P/E 25x, all-stock deal. Accretive or dilutive, and what could change that?
A strong answer covers
- Dilutive: the buyer pays 25x earnings with stock that trades at only 15x
- Buyer's earnings yield (6.7%) is above target's (4%)
- Synergies could offset the dilution
- Using cash or debt could make it accretive
Advanced
How does purchase price allocation work in an acquisition?
A strong answer covers
- Target's assets and liabilities written up to fair value
- Intangibles like customer relationships identified
- Remaining excess becomes goodwill
- Write-ups create new D&A and deferred tax liabilities
Advanced
A board receives an unsolicited bid. How would you advise them?
A strong answer covers
- Compare price to standalone value (DCF, comps, precedents)
- Consider premium, certainty of financing and regulatory risk
- Explore alternatives: other bidders, staying independent
- Fiduciary duty to maximize shareholder value
Advanced
Why might a buyer's stock fall when it announces an acquisition, even if the deal is accretive?
A strong answer covers
- Market thinks the buyer overpaid or synergies are unrealistic
- Accretion can come from cheap financing, not value creation
- Integration risk, added leverage or dilution from new shares
- Signals management sees few organic growth options
Advanced
A CEO asks whether to sell the company now or wait two years. How would you frame the advice?
A strong answer covers
- Compare today's offer value to a risk-adjusted standalone plan
- Consider market conditions, financing environment and buyer appetite
- Weigh execution risk of the plan against certainty of a deal
- Shareholder considerations and fiduciary duty
Advanced
Walk me through how you'd value synergies.
A strong answer covers
- Split into cost and revenue synergies
- Apply probability and phase-in timing
- Subtract integration costs
- Value with a multiple or DCF and compare to the premium paid
Advanced
Why might an all-stock deal be accretive in year one but destroy value long term?
A strong answer covers
- Accretion is an accounting result, not value creation
- Buyer may overpay relative to intrinsic value
- Synergies may not materialize
- Integration problems and culture clashes
Quick quiz (5 questions)
Buyer P/E 20x, target P/E 15x, all-stock deal. The deal is:
- Accretive ✓
- Dilutive
- Neutral
- Impossible to tell
The buyer uses expensive currency (high P/E) to buy cheaper earnings.
The 'cost' of issuing stock in a merger model is measured by:
- The buyer's dividend yield on its current shares
- Buyer's earnings yield (1 ÷ P/E) ✓
- The buyer's interest rate on new borrowing
- The target's share price divided by its earnings
New shares claim a slice of earnings equal to the inverse of P/E.
New debt at 8% interest with a 25% tax rate has an after-tax cost of:
- 8%
- 6% ✓
- 2%
- 10%
8% × (1 − 25%) = 6%.
A buyer pays all cash it was earning 4% on, with a 25% tax rate. The after-tax cost of that cash is:
- 4%
- 3% ✓
- 1%
- 25%
Forgone interest after tax: 4% × (1 − 25%) = 3%.
Buyer P/E 12x pays for a target at 16x in an all-stock deal. With no synergies, the deal is:
- Accretive
- Neutral
- Dilutive ✓
- Impossible to tell
The buyer's stock is cheaper than the earnings it buys, so EPS falls.
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