IBIG 04 06 MA Deals Merger Models

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IB Interview Guide, Module 4: M&A Deals and Merger Models

Table of Contents:
Overview & Key Rules of Thumb ....................................................................................... 2
Key Rule #1: Why Buy Another Company? .................................................................... 2
Key Rule #2: Mechanics of EPS Accretion/Dilution...................................................... 12
Key Rule #3: The Purchase Price and Cash/Debt/Stock Mix ........................................ 26
Key Rule #4: Purchase Equity Value, TEV, and Cash-Free, Debt-Free Deals ................ 32
Key Rule #5: How Equity Value and Enterprise Value Change in M&A........................ 41
Key Rule #6: Full Merger Model (60-Minute and 3-Hour Version) .............................. 48
Key Rule #7: M&A Valuation, Value Creation, and the Contribution Analysis ............. 70
Key Rule #8: More Advanced Merger Model Features [OPTIONAL] ............................ 85
Interview Questions ...................................................................................................... 103
M&A Concepts and Overview ................................................................................... 103
Accretion/Dilution Calculations................................................................................. 110
Equity Value, Enterprise Value, and Multiples in M&A Deals .................................... 115
Full Merger Model Mechanics................................................................................... 120
More Advanced Features of Merger Models [OPTIONAL]......................................... 128
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Overview & Key Rules of Thumb

M&A deals and merger models are likely topics in finance interviews, but they’re less important
than accounting, valuation, and DCF analysis for several reasons:
1. Mergers and acquisitions are not relevant for all groups. For example, you don’t work
on M&A deals in the debt capital markets (DCM) or equity capital markets (ECM) groups
in investment banking.
2. They’re also less important in roles like equity research and hedge funds, where you
follow public companies and make investment recommendations.
3. They’re more advanced than the other topics, so they’re less likely to be the subject of
interview questions.
You’ll get at least a few questions on M&A deals if you interview for investment banking roles,
but advanced questions are unlikely unless you have significant work experience.
Basic M&A analysis is simple – it’s easier to explain than 3-statement projection models, for
example.
But interview questions can be quite tricky since many candidates memorize questions and
answers without understanding the underlying concepts.
We start this guide by describing why one company might want to buy another company, and
then we move into simple examples of merger models so you can learn the building blocks.
Then, we look at a merger model for real companies, more advanced features, and other ways
to evaluate deals besides the traditional EPS accretion/dilution analysis.
Key Rule #1: Why Buy Another Company?
A company might buy another company for the same reason that you might buy a book, a video
game, a new car, or a university degree: because you think the item is worth more than what
you’re paying for it.
For example, a university degree might be expensive, but after paying for tuition and
completing the degree, you’ll be able to get jobs that pay much higher salaries.
Even if you take out student loans to pay for the degree, the higher-paying job afterward means
that the degree will pay for itself (well, depending on your university and major…).
It’s the same with companies: it might be expensive to acquire another company, but the
Acquirer will benefit from higher profits and cash flow afterward.
The Acquirer might be able to grow its profits and cash flow to a similar, higher level on its own
– but it would take more time and money to do so independently.
Just like an expensive university degree is a shortcut to higher-paying jobs, an acquisition might
be a shortcut to higher financial performance for a company.
We’ve repeatedly used this formula to describe concepts in this course:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow
Growth Rate < Discount Rate
And you can use this same formula to describe M&A deals and merger models as well.
An Acquirer might want to purchase another company (the “Target”) if the Target’s “asking
price” is less than its Implied Value.
For example, let’s say the Target wants $500 million for its business.
The Acquirer knows the following information about the Target:
• Current Cash Flow = $50 million

• Cash Flow Growth Rate = 4%
• Discount Rate = 12%
The Discount Rate of 12% means that the Acquirer wants its internal projects to deliver at least
a 12% average annualized return.
So, the Target’s Implied Value = $50 million / (12% – 4%) = $625 million.
Therefore, it may be undervalued… but only if the Acquirer’s assumptions are correct!
An Acquirer might be inclined to purchase a Target if:
• The Target’s Asking Price is less than its Implied Value, i.e., the Present Value of its
future cash flows.
• The Acquirer’s expected IRR from the acquisition exceeds its Discount Rate.
You should know that these statements are equivalent: if a Buyer pays less than a Seller’s
implied or intrinsic value, its IRR will exceed the Discount Rate.
These rules are based on finance theory, but in real life, something else enters the equation:
Earnings per Share (EPS).
In theory, companies should care only about their expected future cash flows.
In reality, though, companies must consider both the short-term and long-term effects of
acquisitions.
A company’s shareholders and its Board of Directors care a lot about metrics such as Net
Income and EPS – and how acquisitions might affect them.
Yes, these metrics are quite different from “cash flow,” but many stocks still trade in the short-
term based on changes to Net Income and EPS.
EPS is also important because it reflects all the effects of an acquisition: foregone interest on
cash, interest paid on new debt, and the new shares issued to fund the deal.
So, if a company announces an acquisition that will “boost its long-term cash flows,” but it’s
also expected to result in a huge EPS decrease next year, the market may not react well.
And a sharp decrease in the company’s stock price will annoy shareholders, executives, and the
Board of Directors.
For example, the following sequence often happens in real life:
• Step 1: Company A announces plans to acquire Company B for $100 million. It doesn’t
say anything about EPS at first.
• Step 2: Company A’s share price falls because many investors expect its EPS to decrease
after the deal is complete.
• Step 3: Company A now clarifies its expectations. Its EPS will fall by 10% next year, but it
will increase after that, and its cash flow will also increase.
• Step 4: Investors had expected only a 5% drop in EPS, so they’re disappointed by this
expected decline of 10%. Company A’s share price falls substantially, and the company is
now worth less to its existing investors.
Therefore, companies prefer acquisitions that are accretive to EPS; in other words, acquisitions
that increase their EPS.
For example, if Company A expects to earn $2.00 per share next year, an EPS-accretive deal
might boost its EPS to $2.10 or $2.50.
A deal that’s dilutive to EPS might reduce Company A’s EPS to $1.50, $1.80, or another number
less than $2.00.
These are the two most important financial criteria for deals: the price paid for the Target must
be reasonable, and the deal must have a decent chance of being neutral or accretive to EPS.
In real life, though, no company decides to do a deal based solely on financial criteria.
Instead, the company decides to do a deal and then justifies it using financial criteria.
It’s like a friend who keeps dating horrible people: they date based on whether or not the
person looks like a model – even if the other person also happens to be a serial killer – and then
they find reasons to justify their behavior afterward.
We can divide motivation for acquisitions into financial reasons and fuzzy reasons.
Financial reasons include:
• Consolidation / Economies of Scale: If the biggest and second-biggest companies in the

market combine, they can get better deals with suppliers and save money. Or they can
consolidate departments like accounting and HR, lay off employees, and save money.
• Geographic Expansion: The Buyer operates mostly in Europe, which is a

declining/mature market. It wants to acquire the Seller to expand into Asia and grow
more quickly.
• Gain Market Share: Neither the Buyer nor the Seller is growing because the market is
competitive and highly fragmented, and different companies’ products are similar. But if
the Buyer acquires the Seller, it instantly captures market share.
• Seller is Undervalued: The Seller’s asking price seems attractive because its share price
has fallen significantly; the Buyer sees an opportunity to get a cheap asset.
• Acquire Customers or Distribution Channels: One company could sell more widgets if it
had access to another company’s customers, partners, and salesforce.
• Product Expansion or Diversification: The Acquirer’s core industry is declining, but it

could grow more quickly by purchasing a company in a higher-growth industry.
These count as financial reasons because the Buyer could use numbers or analysis to justify its
decision:
“We can now sell 1,000 more contracts per year to customers in Asia, resulting in EUR 121
million of additional revenue. After expenses, the acquisition will pay for itself within 5 years.”
Here’s a summary:
And then there are fuzzy reasons for acquisitions. For example:
• Intellectual Property / Patents / Key Technologies: The Acquirer wants a cool, shiny
object that the Target has. It can’t determine how much revenue, profit, or cash flow
this shiny object will produce…. but it’s shiny!
• Defensive Acquisition: The Acquirer is afraid of a high-growth competitor, so it acquires

the competitor to prevent the disruption of its main business.
• Acqui-Hire: Recruiting top-notch employees is expensive. Why not shortcut the whole
process by buying an entire, smaller company and hiring everyone like that? This
rationale explains why many small tech startups with almost no revenue are acquired.
• “The Intangibles”: The other company is doing something cool. We’re not cool. Let’s
buy them so that we become cool!
• Office Politics, Ego, and Pride: Let’s buy this company to get bigger! Because bigger is
better! Also, I want to become CEO, and this acquisition will help me get there and
destroy all my rivals.
The process of acquiring another company is complicated and can take anywhere from several
months to several years to complete.
If you’re an investment banker advising a company that wants to sell, here are the steps:
• Step 1: Plan the Process and Create Marketing Materials.

In this step, you’ll meet with the company's management team to learn more about it, set
valuation expectations with the Board of Directors, and prepare the marketing materials.
You’ll create a 5-10-page “Teaser” that summarizes the company, its financial profile, and why
another company might want to acquire it.
For example, maybe your company has recurring cash flow, low capital requirements, and 10-
year contracts that guarantee long-term customers.
You’ll also create a much longer (50-100 page) “Confidential Information Memorandum” (CIM),
also known as an Information Memorandum (IM) or Offering Memorandum (OM), that does
the same thing but in more depth.
Finally, you’ll think about how many Buyers to contact and the timing for contacting them.
• Step 2: Contact the Initial Set of Buyers.

You’ll then start contacting the Buyers, pitching the company, and sending out the Teaser. If a
potential Buyer is interested, you’ll negotiate a Non-Disclosure Agreement (NDA) and send the
CIM, along with more data as the process continues.
Interested buyers will request more information from you, and you’ll have to respond to
questions and address their concerns.
• Step 3: Set Up Management Meetings and Presentations.

Next, you’ll schedule meetings between your company's management team and potential
Buyers who remain interested.
As part of this process, you’ll prepare a “Management Presentation” that highlights the
company’s merits in slide form.
The management team, accompanied by you and other bankers, will deliver this presentation
to each potential Buyer and answer questions afterward.
• Step 4: Solicit Initial and Subsequent Bids from Buyers.
Once you’ve presented the company to all the interested Buyers, you’ll set a deadline for
Indications of Interest (IOIs), also known as Letters of Interest (LOIs) or “bids.”
Each potential Buyer will submit a term sheet outlining its proposed purchase price, the form of
consideration (Cash or Stock), and the additional information it needs to do the deal.
You might pick a winner from this round of bidding, or you might go through multiple rounds.
But at some point, you will select a single winner and start negotiating the deal.
• Step 5: Conduct Final Negotiations, Arrange Financing, and Close the Deal.
The Buyer will conduct final “due diligence” – reviewing your company’s financial statements,
taxes, customer contracts, etc. – at this point.
If everything is fine, the Buyer and Seller, supported by bankers, will negotiate the Definitive
Agreement that defines the deal terms, such as the price, employee retention, treatment of
stock options, and more.
If the Buyer needs to issue Debt or Stock to complete the deal, it will do so at this point. Both
parties will also complete any required regulatory filings.
If all goes well, you’ll announce the deal and wait for it to close. Here’s a summary:
In a buy-side M&A deal, where your bank is helping one company buy another one, the process
is similar, but it’s more about finding companies to acquire.
The company you’re advising doesn’t have to “market itself,” so Step 1 is more about
researching the market and finding the best acquisition targets.
In Step 2, you’ll contact this initial set of potential Sellers, gauge their interest in selling, and
collect information from them.
Steps 3 – 5 proceed as described above, but you’re representing the other party – so you help
the Buyer assess the information that Sellers send and ask follow-up questions.
And then you help the Buyer arrange financing and negotiate the final terms of the deal.
Financing… What Financing?

You know from the accounting and valuation lessons that a company can fund its operations in
two main ways: Debt and Equity (and Preferred Stock, which is similar to Debt).
Just like a company can fund its operations with Debt and Equity, it can also use Debt and
Equity to acquire other companies.
And if the company has excess Cash on its Balance Sheet, it can also use that Cash for
acquisitions.
In a valuation, Debt is cheaper than Equity, up to a point, and the same rule applies here:
companies prefer to fund acquisitions with Debt rather than Equity because Debt is cheaper.
However, if the company has excess Cash, it almost always prefers to use that Cash first
because Cash is even cheaper than Debt (interest rates on Cash are often 0% or close to it).
Using Cash or Debt to pay for another company is straightforward.
With Equity, or Stock, it’s a bit different because the Buyer can use two methods:
1) It can issue new shares to OTHER investors, collect cash from those investors, and use
that cash to pay for the Seller.
2) It can issue shares directly TO the Seller in exchange for the Seller’s shares.
The financial modeling works the same way regardless of the method used: the Seller’s shares
disappear (since it’s no longer an independent entity), and the Buyer’s shares outstanding
increase (assuming that Stock was used to fund the deal).
These additional shares cost the Buyer something for the same reason that stock-based
compensation costs it something: they dilute the company’s existing investors.
For example, if an existing shareholder previously owned 11% of the company, it might own
only 8% or 9% after the company uses Stock to fund an acquisition.
As a result, the investor’s stake in this company just declined, even though the investor didn’t
directly sell any of its stake.
Here’s a summary of the different financing methods in M&A deals:
Mergers vs. Acquisitions

There is no mechanical difference between a “merger” and an “acquisition.” The only
difference is that the Buyer and Seller tend to be closer in size in a merger, while the Buyer
tends to be much bigger in an acquisition.
If the companies are about the same size, the Buyer is unlikely to have enough Cash or enough
Debt capacity to acquire the Seller through one of those.
So, 100% Stock or majority-Stock structures are far more common in mergers.
The ownership split is also far more important in mergers and can be a major negotiating point.
Return to Top.
Key Rule #2: Mechanics of EPS Accretion/Dilution
To assess the financial impact of an M&A deal, you create a merger model in Excel that:
• Summarizes the financial profiles of the Buyer and Seller, including projections and each
company’s Equity Value and Enterprise Value.
• Lists the purchase price, or the amount the Buyer is planning to pay for the Seller, and
the mix of Cash, Debt, and Stock the Buyer will use.
• Includes other key terms of the deal, such as the interest rates on Cash and Debt and
estimates for Synergies – ways to boost combined revenue or reduce costs.
• Shows what the Buyer and Seller look like as a combined entity and how the combined
EPS compares with the Buyer’s standalone EPS.
Besides the shareholder concerns, there is another reason why EPS is the key metric in this
analysis: it’s the only easy-to-calculate metric that captures the deal's FULL impact.
Metrics such as EBITDA and NOPAT do not capture the deal's full financial impact because they
are before Interest Income and Interest Expense and do not reflect the share count.
Even if you were to create new metrics, such as EBITDA per Share or NOPAT per Share, they
would still exclude Net Interest Expense.
The only other metrics that capture the FULL impact of the deal are Free Cash Flow per Share
and Levered Free Cash Flow per Share.
And those metrics are not ideal because they’re affected by many items besides the acquisition,
and no one agrees on the exact definition of Levered FCF.
Here’s the step-by-step process for building a simple EPS accretion/dilution analysis, otherwise
known as a merger model:
Step 1: Get the Financial Stats for the Buyer and Seller
At the minimum, you need each company’s Current Equity Value and Net Income, along with
everything that goes into those calculations: the Current Share Price, Shares Outstanding, Pre-
Tax Income, and Tax Rate.
Here are the assumptions for our very creatively named “Companies A and B”:
Step 2: Determine the Purchase Price and Cash/Debt/Stock Mix

In the section on Precedent Transactions, we mentioned how the Buyer must pay a control
premium to acquire a Seller if it is a public company.
That same concept applies here because we assume that the Buyer pays a control premium to
do the deal.
If the Seller’s share price is currently $5.00, the Buyer might pay $6.00 per share, representing a
20% premium.
A Buyer must pay this control premium because by acquiring 100% of the Seller’s shares, it
changes the supply and demand for those shares – it’s not like going online and buying 23
shares of a multi-billion-dollar company via a personal brokerage account.
Existing shareholders will demand a premium if they’re asked to give up 100% of their
ownership in this company all at once.
In real life, you would value the Seller – Company B – with a DCF, Public Comps, and Precedent
Transactions to make sure this price is reasonable.
You’d also look at comparable deals to verify that the 20% premium is within the range of the
premiums paid in recent transactions.
Here’s our setup for the Equity Purchase Price, also known as the Purchase Equity Value:
The Purchase Equity Value here is $600 million because $5.00 * (1 + 20%) * 100 million shares
= $600 million (or, $500 million * (1 + 20%) = $600 million).
For private companies, the Purchase Price may be based on a multiple of EBITDA, Revenue, or
some other financial metric rather than a premium to the company’s current share price.
Next, you estimate how much of this $600 million Purchase Equity Value can be funded with
Cash, Debt, and Stock.
“But wait!” you say, “Shouldn’t we use the Purchase Enterprise Value for this calculation
instead? Enterprise Value represents the true cost of acquiring the company!”
Yup, that is a common question… so here’s the deal:
In merger models, you start with the Seller’s Purchase Equity Value because at the bare
minimum, the Buyer must pay that much to acquire 100% of the Seller’s shares.
Beyond that, the real price the Buyer pays is NOT necessarily the Purchase Enterprise Value.
We detail this point in one of the next sections, but for now, we’ll just say that the Seller’s Cash
and Debt often stay in place after a deal closes.
Also, items like Unfunded Pensions, Noncontrolling Interests, etc., do not affect the deal
funding, so the “real price” is not necessarily the Purchase Enterprise Value.
Finally, remember the REAL definition of Enterprise Value: the value of Net Operating Assets
to all investors in the company. It’s NOT the “true cost” to acquire the company.
In this simple example, we’re assuming that the Seller’s Cash = the Seller’s Debt, so Purchase
Equity Value = Purchase Enterprise Value.
Once you have the Purchase Price, you estimate the percentages of Cash, Debt, and Stock used
to fund the deal.
You start by using as much of the Buyer’s Cash balance as possible; in most cases, it is the
cheapest method.
Then, if you still need additional funding, you may assume a reasonable amount of Debt.
For example, maybe the Buyer has Debt of $300 million and EBITDA of $100 million for a Debt /
EBITDA ratio of 3x.
Similar companies have Debt / EBITDA ratios between 4x and 5x, so it’s reasonable for the
Buyer to raise an additional $200 million of Debt, taking it to 5x Debt / EBITDA.
It might even be able to go beyond that if the Seller has significant EBITDA as well.
If you still need more funding after that, you then move to Stock.
There are no technical limits on the amount of Stock a Buyer can issue, but most companies
don’t want to give up majority ownership just to acquire another company.
In other cases, companies will issue Stock only up to the level at which a deal remains accretive.
We assumed a mix of 1/3 Cash, 1/3 Debt, and 1/3 Stock in this simple example.
We didn’t perform any of these checks but instead assumed that these percentages all
represented reasonable amounts of Cash, Debt, and Stock for the Buyer.
Once you have that, you can lay out the Cash, Debt, and Stock side-by-side, along with the Cost
of each method:
The Cost of Debt is just like the Cost of Debt in the WACC calculation: it’s the coupon rate the
company would have to pay if it issued additional Debt.
You could estimate it by calculating the YTM of the Buyer’s current Debt or the YTM of peer
companies’ Debt, but you could also use the Buyer’s average interest rate and assume a slight
premium (due to the added risk from the acquisition).
The Cost of Cash is based on the interest rate the company is currently earning on its Cash
balance, which tends to be low.
The company could earn more by investing this Cash in equities or fixed income, but its risk
profile would change.
The Cost of Cash is supposed to be similar to the Risk-Free Rate, so the risk profile of Cash must
be similar to the risk profile of government bonds.
The Cost of Equity is based on Buyer Net Income / Buyer Equity Value, or the reciprocal of the
Buyer’s P / E multiple.
Yes, that’s different from how you calculate the Cost of Equity in the WACC calculation.
It’s different because you are looking at the Cost of Equity in terms of its impact on the
company’s EPS, not the company’s overall Discount Rate (WACC).
WACC is a theoretical concept that companies don’t necessarily prioritize in real life, but every
CFO knows and cares about their Net Income and EPS numbers.
You can think of this type of Cost of Equity as “The Practical Version.”
In most cases, this method still produces higher values than the After-Tax Costs of Debt and
Cash, so the results aren’t necessarily much different.
Neither method is “correct”; they’re different approaches. As we mentioned before,
measuring the Cost of Equity is always subjective, and this is yet another way to do it.
Once you’ve calculated all the Costs, you can calculate the Weighted Cost of Acquisition:
• Weighted Cost of Acquisition = % Cash Used * After-Tax Cost of Cash + % Debt Used *
After-Tax Cost of Debt + % Stock Used * After-Tax Cost of Stock
This Weighted Cost tells you how much the Buyer is “giving up,” in percentage terms, to acquire
the Seller.
You can also calculate Company B’s Yield at this 20% premium.
Its Yield equals its Net Income divided by the Purchase Equity Value, or $30 million / $600
million = 5.0% here.
This “Yield” is how much Company A gets in Net Income for each $1.00 it spends to acquire
Company B.
Whether a deal is accretive or dilutive depends on how the Seller’s Yield compares with the
Weighted Cost of Acquisition.
Here’s how we calculated the Weighted Cost here:
Accretion/dilution follows these rules:
• Weighted Cost of Acquisition < Yield of Seller: Accretive

• Weighted Cost of Acquisition = Yield of Seller: Neutral
• Weighted Cost of Acquisition > Yield of Seller: Dilutive

In this case, the Weighted Cost of Acquisition is 5.6%, and Company B’s Yield is 5.0%.
Company A is paying more than what Company B is yielding, which makes the deal dilutive.
If the Pre-Tax Cost of Debt decreased to 3.0%, making the Weighted Cost of Acquisition 4.8%,
the opposite would happen:
There’s also a special rule for 100% Stock deals: you can compare the P / E multiples of the
Buyer and Seller (at the Seller’s Purchase Equity Value) to see if the deal is accretive or dilutive.
• 100% Stock Deal, Buyer’s P / E > Seller’s P / E at Purchase Price: Accretive

• 100% Stock Deal, Buyer’s P / E = Seller’s P / E at Purchase Price: Neutral
• 100% Stock Deal, Buyer’s P / E < Seller’s P / E at Purchase Price: Dilutive
In a 100% Stock deal, the Cost of Acquisition is the reciprocal of the Buyer’s P / E multiple.
So, if the Buyer’s P / E is 10x, and the Seller’s Purchase P / E is 5x, then the Buyer’s Weighted
Cost of Acquisition is 1/10, or 10%, and the Seller’s Yield is 1/5, or 20%.
The Buyer is paying less than what the Seller is yielding, so the deal will boost its EPS.
But if the Buyer’s P / E were 10x, and the Seller’s Purchase P /E were 20x, the Buyer’s Weighted
Cost would be 1/10, or 10%, and the Seller’s Yield would be 1/20, or 5%.
The Buyer is paying more than what the Seller is yielding, so the deal will reduce its EPS.
Step 3: Combine Both Companies’ Pre-Tax Incomes and Adjust for the Acquisition Effects
Once you put all the assumptions in place, you add together the Pre-Tax Incomes of the Buyer
and Seller and factor in the acquisition effects:
• Debt: If a Buyer uses Debt, it will have to pay Interest Expense on that Debt in the
future, which will reduce its Pre-Tax Income, Net Income, and EPS.
• Stock: If a Buyer uses Stock, it will have additional shares outstanding in the future,
which will reduce its EPS.
• Cash: If a Buyer uses Cash, it will give up future Interest Income on that Cash, which will
reduce its Pre-Tax Income, Net Income, and EPS. This reduction is called the “Foregone
Interest on Cash.”
Many students think the Foregone Interest on Cash is “an opportunity cost” or “not a real
expense,” but that is incorrect: it IS a true cash cost.
It is a true cash cost because you add together both companies’ projected Pre-Tax Incomes, and
those projected Pre-Tax Incomes already include the expected Interest Income earned on Cash
by both companies.
Let’s say that the Buyer has $200 in projected Pre-Tax Income, and the Seller has $100 in
projected Pre-Tax Income.
The Buyer’s Pre-Tax Income consists of $180 in Operating Income and $20 in Interest Income.
If the Buyer uses Cash to fund the deal and earns $10 less in Interest Income as a result, you
must subtract this $10 in Foregone Interest from the Combined Pre-Tax Income.
If you did not do this, you would be saying that the Buyer still earns $20 in Interest Income –
even though its Cash Balance is much lower than before.
But that’s incorrect: the Buyer won’t be able to earn as much in Interest Income.
Before you combine both companies’ Pre-Tax Incomes and factor in these acquisition effects,
you can set up the analysis so that you see the results at different premiums:
And then you can combine the Pre-Tax Incomes and factor in the acquisition effects:
You calculate “Company A Shares Issued” with (Purchase Equity Value * % Stock) / Company A’s
Share Price.
You should already see one potential problem here: what if the Buyer’s share price changes?
Step 4: Calculate the Combined Net Income and EPS
Next, you take the Combined Pre-Tax Income and multiply it by (1 – Buyer’s Tax Rate) to
calculate the Combined Net Income.
Then, you add the Shares Issued in the deal to the Buyer’s existing share count to get the Total
Shares Outstanding.
The Seller’s shares go away because it no longer exists as an independent entity – Company A
has acquired all of Company B’s shares, removing them from the market.
You then divide the Combined Net Income by the Total Shares Outstanding to determine the
Combined EPS:
Here are the most common questions on this part:
• Should You Use the Buyer’s Tax Rate?

In interviews, case studies, and modeling tests, yes. This is the standard assumption because
the Seller becomes a subsidiary of the Buyer after the deal closes.
In real life, this assumption may not hold up because tax laws are complex; for example, if the
companies are based in different countries, the Seller may still pay taxes based on the rates in
its countries of operation.
• What Happened to the Seller’s Shares?

They are removed from the combined share count because the Seller is no longer an
independent entity after the deal closes.
The shares are removed from the market – it’s the same thing that happens when companies
repurchase shares.
• Is It Correct to Use the Buyer’s Current Share Price to Determine the Shares Issued in
the Transaction?
No, but you do it in simple analyses anyway. The problem is that the Buyer’s share price often
changes between the deal announcement and the deal close.
In a more complex analysis, you might create sensitivity tables that show the outcome across a
range of share prices for the Buyer.
Step 5: Calculate the EPS Accretion/Dilution and Draw Conclusions
In the final step, you calculate EPS accretion/dilution by comparing the Combined EPS with the
Buyer’s Standalone EPS from before the deal took place:
If the Combined EPS is higher than the Buyer’s Standalone EPS, the deal is accretive; if the
Combined EPS is lower, the deal is dilutive; and if it’s the same, the deal is neutral.
Once you have these results, you can use the analysis in real life in a few ways:
1. Deal Screening – You might set up simple models like the one above to screen for
potential acquisitions that make sense for your client. While this simple analysis doesn’t
give you the whole story, it can tell you whether or not a deal is plausible.
2. Pitching Ideas to Clients – You might create this type of analysis and show it to clients or
potential clients to propose deals to them. For example, you might say, “We should
consider talking to Microsoft as a potential Buyer because an acquisition of your
company would be highly accretive, even at a high premium.”
3. Deal Negotiations – As a deal progresses, you might use the output from a merger
model to push for a higher price or superior deal terms. For example, you might say to
the Buyer, “Our client (the Seller) is willing to accept more in Stock and less in Cash if
you agree to raise the price by 5%; even at that level, the deal is accretive for you.”
Companies never “decide” to do deals based on merger models.
They’re supporting tools used to screen ideas, examine potential transactions, and back up deal
negotiations.
Why This Simple Analysis Doesn’t Give You the Whole Story
The section above presented a simplified merger model to teach you the mechanics.
Here are just a few of the oversights in this analysis:
• Share Prices and Tax Rates: As mentioned above, the Buyer’s share price won’t
necessarily stay the same after a deal is announced. And the Combined Tax Rate may
not necessarily be the Buyer’s Tax Rate.
• Purchase Price: We’ve assumed that the purchase price is the Seller’s Purchase Equity
Value. But in real life, the Buyer may refinance the Seller’s Debt and pay for other fees
associated with the deal. Sometimes the Seller can even use a portion of its Cash
balance to fund the deal, further complicating the purchase price. See the next section.
• Synergies: “Synergies” are ways for the Combined Company to boost revenue or cut
costs after the acquisition occurs. For example, maybe the Combined Company no
longer needs 10 separate offices – it can consolidate and move everyone into 8 offices,
which will reduce its rental expense.
Even a modest amount of Synergies ($20 million here) can distort our predictions:
• Other Acquisition Effects: Accounting rules require the Buyer to re-value the Seller’s
Assets and Liabilities when a deal takes place. If the values of Assets like PP&E change,
there might be additional Depreciation or Amortization. In many deals, new items, such
as Other Intangible Assets, also get created.
There are also a few other problems with merger models and EPS accretion/dilution:
1. EPS is Not Always a Meaningful Metric – For example, if the Buyer is a private
company, it probably doesn’t care about its EPS. And if the Buyer has a negative Net
Income, its EPS is not a meaningful metric.
2. Net Income and Cash Flow Are Very Different – Deals that look great based on EPS
might look terrible based on cash flow. This one goes back to why the financial
statements exist: there’s a big difference between accounting profits and cash flows.
3. Merger Models Don’t Capture the Risk of M&A Deals – 100% Cash deals are almost
always accretive. For example, if the Buyer earns 1.0% on its Cash, that’s a 0.75% After-
Tax Cost of Cash. The Seller’s Purchase P / E would have to be above 133x for the deal to
be dilutive!
But it’s very risky to acquire another company. The integration might go wrong, the teams and
cultures might not mesh, there could be legal issues, customers might not like the deal, and so
on – and the analysis doesn’t capture any of these risks.
4. Merger Models Don’t Reflect the Qualitative Factors – You can’t “quantify” cultural fit
or the management teams' ability to work together, for example. But they’re both
critical for deals to be successful.
While it’s important to understand the mechanics of merger models, you also have to
understand their drawbacks and limitations.
Now that you understand the fundamentals, the remaining sections of this guide will delve into
specific aspects of merger models and M&A deals in more detail.
Return to Top.
Key Rule #3: The Purchase Price and Cash/Debt/Stock Mix
This key rule and the next one cover a few “lingering questions” you might have after reading
this guide so far:
• QUESTION #1: What determines the purchase price in an M&A deal? What is the
premium based on? What about prices for private companies?
• QUESTION #2: How does the Acquirer decide on the amount of Cash, Debt, and Stock it
should use to buy the Target? Is it based on simple percentages, or are there restrictions
and guidelines?
• QUESTION #3: How much does an Acquirer "really pay" for a Target? Is it the Purchase
Equity Value or the Purchase Enterprise Value? Something in between? Something else?
This last question is the most complicated one to answer, so please see the next Key Rule for
the full coverage. We’ll address the other two questions here:
QUESTION #1: What Determines the "Purchase Price"?
For public companies, a premium to their current share price (or average price over the past
month, quarter, or year) is required. Otherwise, existing shareholders have no incentive to sell
everything they own.
So, even if the valuation methodologies say that a company is worth $10.00 per share, if this
company is currently trading at $12.00 per share, the Acquirer will have to pay a price greater
than $12.00 per share to buy this company.
The deal can still work if there are enough Synergies to justify this higher price.
EXAMPLE: Let’s say that Company B has a Current Share Price of $33.00, Current Equity Value
of $825 million, and Current Enterprise Value (TEV) of $1.025 billion.
The valuation methodologies say that the company’s Implied Share Price is $35.00 to $45.00.
The premiums paid for companies in this market have been between 15% and 30% over the
past ~3 years.
Therefore, an Offer Price anywhere in this range of ~$38.00 (15% premium) to ~$43.00 (30%
premium) might be reasonable.
However, if the valuation methodologies say that the company's Implied Share Price is only
$20.00 to $30.00, that doesn’t matter.
The Acquirer can’t just go to the Target and say, “Please sell for less than your Current Share
Price – because we think you’re overvalued right now.”
The Acquirer still must pay a premium – more than $33.00 per share – to do this deal.
Since all deals with public Sellers include control premiums, assessing the potential Synergies is
extremely important.
If they’re high enough, these Synergies + the Seller’s Implied Value may still exceed the
Purchase Price, justifying the deal financially.
For private companies, the purchase price is not based on a share-price premium but rather
Revenue, EBITDA, or P / E multiples and the valuation.
For example, if similar companies in this market have been acquired at multiples of 8-12x
EBITDA, then a 10x TEV / EBITDA might be appropriate for a Seller.
You could then back into the Purchase Equity Value once you have the Purchase Enterprise
Value from this multiple.
QUESTION #2: What Determines the Cash, Debt, and Stock Mix in a Deal?
You can base the mix of Cash, Debt, and Stock on simple percentages in a simple model, such as
1/3, 1/3, and 1/3, or 50%, 50%, and 0%.
In reality, though, Acquirers almost always prefer the cheapest purchase method, which is
usually Cash.
If the Acquirer gives up only 1-2% interest on its Cash balance, then almost any M&A deal will
look accretive if it’s completed with 100% Cash.
Once the Acquirer has used all the Cash it can, it will switch to Debt, the next cheapest
acquisition method, up to a certain level, and then it will use Stock for anything past that.
The Cash Limit is usually based on a "minimum Cash balance" that the company needs to keep
its operations running.
Depending on the Acquirer and Target’s sizes, this minimum Cash Balance could be based on
just the Acquirer’s Cash balance or the Acquirer’s Cash + Target’s Cash.
The Debt Limit is usually based on a maximum desired Debt / EBITDA, Debt / Total Capital, or
similar ratio.
For example, maybe the combined company wants to maintain an "investment grade" credit
rating, so it aims to stay at or below 3x Debt / EBITDA.
This ratio should reflect both the Acquirer and Target’s numbers, but if the Acquirer is, say, 10x
or 100x bigger, you might ignore the Target.
And the Stock Limit is murkier because a company could issue, in theory, an unlimited amount
of new Stock… but most companies do not want to do that.
Generally, Acquirers want to maintain control of the combined entity whenever it’s possible to
do so.
For example, if the Acquirer is worth $1 billion, and the Target is worth $1.2 billion, the
Acquirer would not want to issue $1.2 billion of Stock to buy the Target.
If it did that, it would own less than 50% of the combined entity.
Instead, it would use as much Cash and Debt as possible, and then it would switch to Stock for
the remaining portion.
This limit could also be based on EPS accretion/dilution; if the deal turns dilutive with over $500
million of new Stock issued, for example, then maybe that's the limit.
Here are a few examples of how to determine these numbers in a simple merger model where
the Acquirer, Company A, has an Equity Value of $1 billion, and the Target, Company B, has an
Equity Value of $825 million:
Once we have that, we move to the Maximum New Debt Available, which is based on a
maximum Combined Debt / EBITDA of 3.0x:
These are just the “maximum amounts available.” To determine the amounts of Cash and Debt
to use, we use MIN functions to compare them to the Equity Purchase Price:
You can also use this type of analysis to estimate the maximum amount an Acquirer could
spend on a deal.
For example, let’s say the Acquirer has the following profile:
• Current Equity Value: $500 million

• Cash: $200 million; Minimum Cash: $50 million
• Debt: $100 million
• EBITDA: $33 million
• Debt / EBITDA: 3.0x; EBITDA / Interest: 4.1x
• Debt / EBITDA for Comparable Levered Companies: 5.0x; EBITDA / Interest: 2.5x
Without knowing anything about the potential Target, you can already tell a few things:
• Cash: The Acquirer could use a maximum of $150 million in Cash in any deal. This
amount might increase if the Target also has excess Cash.
• Debt: The Acquirer could raise more Debt, but probably not much more than $65
million, since $165 million of total Debt would make its Debt / EBITDA equal 5.0x.
However, it might go above this level if the Target's acquisition boosted its EBITDA (for
example, if the Combined EBITDA increased to $45 million, then the Combined
Company could carry up to $225 million in Debt).
• Stock: It would be very unusual for this company to issue more than $500 million in
Stock in any deal. At that level, existing shareholders would lose control, and the
chances of dilution would increase substantially.
But a much smaller Stock issuance, such as $100 or $200 million, might work.
This quick analysis lets you answer questions such as:
1) “If the Acquire wants to purchase a Target for $400 million, would the deal be feasible?
If so, how would the Acquirer pay for it?”
2) “What’s the biggest deal the Acquirer might be able to complete?”

The answer to the first question is: “Yes, the deal is feasible; the Acquirer would likely use $150
million in Cash, $65 to $100 million in Debt, depending on the acquired company’s EBITDA, and
Stock for the remainder of $150 million to $185 million.”
The second question's answer is more subjective, but the Acquirer could use $150 million in
Cash and perhaps up to $100 – $150 million in Debt, depending on Target’s EBITDA.
The Acquirer’s Current Equity Value is $500 million, so it would probably not issue more Stock
than that.
So, one estimate for the maximum deal size might be $150 million + $150 million + $500 million
= $800 million, but that might be a stretch.
Issuing Stock worth half the company’s Current Equity Value ($250 million) might be a more
realistic maximum and would produce a maximum deal size of $550 million.
Return to Top.
Key Rule #4: Purchase Equity Value, TEV, and Cash-Free, Debt-Free Deals
And now we return to “lingering question #3”:

“How much does an Acquirer ‘really pay’ for a Target? Is it the Purchase Equity Value or the
Purchase Enterprise Value? Something in between? Something else?”
The Acquirer pays neither the Purchase Equity Value nor the Purchase Enterprise Value,
exactly; the amount paid is usually in between the two, depending on the terms of the deal.
However, even this short answer differs based on whether the Target is a public or private
company.
We’ll consider the “public company case” first and then move into private companies and cash-
free, debt-free deals.
The “Real Purchase Price” for Acquisitions of Public Companies
At the minimum, the Acquirer must pay for all the Target’s shares, so the Purchase Equity
Value is always the starting point for the “real purchase price.”
Beyond that, the exact purchase price depends on the treatment of the Target’s Cash and Debt
and the transaction fees (paid to the bankers, lawyers, and other professionals who advise on
the deal).
Factor #1: Treatment of the Seller’s Existing Debt
In theory, Debt should “increase” the purchase price because in most cases, Debt must be
refinanced when a company is acquired (i.e., when a “change of control” takes place).
So, the Acquirer must repay the Target’s Debt using its Cash or replace the Target’s Debt with
the same amount of new Debt.
But these methods are not equivalent.

If an Acquirer repays a Target’s existing Debt using Cash, two things happen:
1) The Target’s projected Interest Expense (and principal repayments) go away.
2) The Acquirer’s projected Interest Income decreases because it has less Cash.
So, in this case, the repayment of the Target’s Debt will increase the “real purchase price.”
The real amount the Acquirer pays will be closer to Purchase Equity Value + Seller’s Debt.
On the other hand, if the Acquirer simply replaces the Target’s existing Debt with new Debt, the
effects are quite different:
1) The Target’s projected Interest Expense still exists, but it might change slightly if the
coupon rate on the new Debt is different.
2) The Acquirer’s projected Interest Income remains the same because it has the same
amount of Cash.
The “real purchase price” in this scenario is closer to the Purchase Equity Value because the
Buyer is not giving up anything for the Target’s Debt.
It doesn’t use Cash to repay it, it doesn’t issue Stock and use the proceeds to repay it, and its
Debt level stays the same.
Sometimes, the Acquirer may assume Target’s existing Debt without repaying or replacing it.
In this case, the Target’s projected Interest Expense and the Acquirer’s projected Interest
Income stay the same.
And, once again, the “real purchase price” is the Purchase Equity Value.
In most M&A deals involving acquisitions of public companies, the Target’s existing Debt is
refinanced and replaced with new Debt in the same amount. So, at most, the Target’s
projected Interest Expense may change slightly.
Here’s a summary:
1. Target’s Debt is Assumed with No Changes: Does not increase the amount the Acquirer
“really pays” for the Target. Interest doesn’t change.
2. Target’s Debt is Repaid with the Acquirer’s Cash: Does increase the amount the
Acquirer “really pays.” Interest changes.
3. Target’s Debt is Replaced with New Debt: Does not increase the amount the Acquirer
“really pays,” but it may slightly affect the Interest.
To track these changes in a merger model, you create a Sources & Uses schedule that shows
the treatment of the Target’s Cash and Debt. Here’s an example:
For this acquisition of a public company, the Cash, Debt, and Stock used are all based on the
Target’s Purchase Equity Value.
The Sources & Uses schedule tells us that the Acquirer is replacing the Target’s existing $250
million of Debt with a new $250 million of Debt, and that the interest rate will be 1% higher.
We can reflect this small interest-rate differential on the Combined Income Statement:
Factor #2: Treatment of the Seller’s Existing Cash

If an Acquirer buys a Target that has $100 million in Cash on its Balance Sheet, it gets that Cash,
reducing the “real purchase price,” right?
No, not necessarily.
Remember that all companies must maintain minimum Cash balances to continue operating.
This minimum Cash balance is a core-business Asset, but as a simplification, we count the entire
Cash balance as non-core when moving from Equity Value to Enterprise Value.
But in real life, this simplification breaks down because the Acquirer can’t necessarily “take” the
Target’s entire Cash balance.
Also, sometimes the Combined Cash Balance is used to fund the deal.
For example, Cash from both companies may be used to pay for the advisory, legal, and
financing fees in the deal.
Therefore, even if an M&A deal is “100% Debt” or “100% Stock,” chances are that at least
some Cash will be used to pay for these fees.
The Target might also use some of its Cash to repurchase its own shares in the deal.
So, when you calculate the Foregone Interest on Cash on the Combined Income Statement, you
should make sure it reflects all uses of Cash from both companies.
We prefer to set a Combined Minimum Cash Balance slightly higher than the actual minimum
to account for the advisory, legal, and financing fees.
If it’s slightly higher, there will be no issues with the Combined Company going below “the real
minimum” after the deal closes.
Here’s what it looks like on the Sources & Uses schedule and the Combined Income Statement:
Factor #3: Unfunded Pensions, Noncontrolling Interests, and Other Components of TEV
In general, components of the Target’s Enterprise Value besides Cash, Debt, and Preferred
Stock do not affect the “real purchase price” in M&A deals.
So, it would be highly unusual for Unfunded Pensions or Noncontrolling Interests or
Capital/Operating Leases to appear in the Sources & Uses schedule.
Yes, they all factor into Enterprise Value, but unlike Debt, they don’t have to be refinanced
when the company’s ownership changes.
This difference explains one major reason why the “real purchase price” is not necessarily the
Target’s Purchase Enterprise Value.
The Bottom Line: The “real purchase price” in an M&A deal is NOT necessarily the Target’s
Purchase Equity Value or Purchase Enterprise Value – in fact, it rarely is.
If the Acquirer repays the Target’s Debt using Cash, the effective price will be closer to the
Purchase Enterprise Value, but the treatment of the Target’s Cash, transaction fees, and other
items will create differences.
When you see language like “Including the assumption of Net Debt” in press releases, that
refers to the Purchase Enterprise Value: Purchase Equity Value + Target’s Debt – Target’s Cash.
But it’s not what the Acquirer actually pays. It’s just a way to calculate purchase multiples such
as TEV / EBITDA.
To determine what the Acquirer truly pays, you must create a Sources & Uses schedule, as
shown above.
Private Companies and Cash-Free, Debt-Free Deals
In theory, everything in the section above could also apply to private companies.
The “starting price” might be the Purchase Equity Value, and then the Target’s Debt and Cash
and the transaction fees would affect how much the Acquirer truly pays.
In practice, however, many acquisitions of private companies are structured as cash-free, debt-
free deals.
The name means what it sounds like: after an Acquirer has purchased a Target, the Target's
Cash and Debt both go to 0.
If the Target’s Debt exceeds its Cash, then the Target uses its entire Cash balance to repay as
much Debt as it can, and the Acquirer repays the rest when it completes the deal.
As a result, the “real purchase price” corresponds to the Purchase Enterprise Value.
If the Target’s Cash balance exceeds its Debt balance, then the Target repays its entire Debt
balance using its Cash.
Then, the Target uses its remaining Cash to issue a "Special Dividend" to shareholders or
repurchase its common stock.
Even if it just keeps the Cash, the effective price is still lower because the Acquirer “gets it.”
It doesn’t matter what the Target does with its remaining Cash because the effective
purchase price is lower in all cases.
In cash-free, debt-free deals, the Purchase Enterprise Value should be based on a multiple of
EBITDA, EBIT, or Revenue since the Target is a private company.
The Combined Cash is based on only the Buyer's Cash because the Seller's Cash is used to fund
the deal and goes to 0 right after it closes.
The Maximum New Debt is based on Max Debt / EBITDA * Combined EBITDA – Buyer's Debt
since the Seller's Debt is repaid in the deal.
And the Cash, Debt, and Stock are based on the Purchase Enterprise Value:
The Sources & Uses schedule uses Purchase TEV + Transaction Fees on the Uses side and the
traditional items on the Sources side:
On the Combined Income Statement, the traditional items, such as Foregone Interest on Cash,
Interest Paid on New Debt, and New Shares Issued, still exist.
However, there are two new items because the Target’s Cash and Debt go away: the Target’s
Lost Interest Income and the Interest Savings on the Target’s Repaid Debt.
For both, we can reverse these lines from the Target’s standalone Income Statement:
This deal structure may seem like a big change, but it’s not that much of a difference.
Think about the net effect vs. the previous setup for a public company:
• Previous Example, Foregone Interest on Cash: $1.5 million per year

• This Example, Foregone Interest on Cash + Target’s Lost Interest Income: $1.6 million
per year
• Previous Example, Interest Paid on New Debt Issued: $13.2 million per year
• This Example, Interest Paid on New Debt, Net of Interest Savings on Repaid Debt:
$13.2 million per year
As a result, the EPS accretion/dilution is barely different under this new deal structure.
In both cases, the Target's existing Debt is replaced with new Debt or kept in place at a
similar interest rate, and about the same amount of Cash is used for deal funding; it's just
divided up differently.
So, in our opinion, cash-free, debt-free deals are “much ado about nothing.”
They seem different, but the EPS impact is minimal, and the assumptions required to set up
cash-free, debt-free deals are more difficult to understand.
There may be other differences for private companies, such as earn-outs (i.e., paying $X now
but $Y later if certain goals are achieved) and tweaking the purchase price based on the
Target's level of Working Capital at the close.
However, those are more advanced topics that we’ll address later in this course/guide.
Return to Top.
Key Rule #5: How Equity Value and Enterprise Value Change in M&A
In the previous section, we mentioned that the “real purchase price” in an M & A deal is neither
the Purchase Equity Value nor the Purchase Enterprise Value of the Target.
It’s usually in between those numbers, depending on the treatment of the Target’s Cash and
Debt.
However, it’s still useful to apply the concepts of Equity Value and Enterprise Value to
acquisitions because they may change based on deal financing and the market’s reaction to
deals.
Different financing methods also affect common valuation multiples such as TEV / Revenue,
TEV / EBITDA, and P / E differently.
Let’s say that the Acquirer, Company A, and the Target, Company B, look like this:
When Company A acquires Company B, the Combined Equity Value is equal to Company A’s
Equity Value plus the market value of any Stock issued to fund the deal.
So, if no Stock is issued, Combined Equity Value = Company A’s Equity Value.
But if it’s a 100% Stock deal, Combined Equity Value = Company A’s Equity Value + Company B’s
Purchase Equity Value.
It’s not that Company B’s value “disappears” – instead, its value is transferred to the Cash,
Debt, and Stock that Company A uses to acquire it.
The Combined Enterprise Value is equal to the Combined Equity Value, plus the Debt (and
other Debt-like Liabilities), minus the Cash (and other non-core-business Assets) of the
Combined Company… including the Cash or Debt used to fund the deal.
But it’s much simpler to write it like this:
Combined Enterprise Value = Acquirer's Current Enterprise Value + Target’s Purchase

Enterprise Value
(NOTE: These formulas reflect only the immediate impact of the deal – afterward, anything
could happen depending on the market’s reaction. Keep reading this section!)
Here’s what happens if Company A uses 100% Debt to acquire Company B for no premium:
But in real life, the Acquirer must pay a control premium for a public Seller. With a 25%
premium, it looks like this:
The Combined Equity Value stays the same – it’s still Company A’s Equity Value – because
Company A doesn’t issue any Stock to fund this deal.
Here’s the math:
• Company A’s Equity Value = $500

• – Combined Cash Balance of $60
• + Combined Debt Balance of $130
• + New Debt of $125

• = Combined Enterprise Value of $695
The Combined Enterprise Value tells you how much the Combined Company’s core business is
worth to all investors, regardless of how the Acquirer funds the deal.
Play around with the numbers in Excel, and you’ll see that the Combined Enterprise Value
remains the same as long as Company A pays the same amount for Company B.
If Company A pays a 25% premium for Company B using 50% Debt and 50% Stock, the
Combined Equity Value changes, but the Combined Enterprise Value stays the same:
Why Enterprise Value Stays the Same: The deal funding “replaces” the Target’s old Equity
Value, so the total amount of capital is preserved.
For example, the Target’s Purchase Equity Value here is $125. That goes away, but it’s replaced
with $62.5 of new Debt and $62.5 of new Stock.
The Combined Enterprise Value initially decreases by $125, but then it increases by $62.5 and
then another $62.5, so it stays the same from beginning to end.
You can also understand this idea by going back to the definition of Enterprise Value: the value
of Net Operating Assets to all investors.
The Net Operating Assets of the Acquirer and Target stay the same because the financing
method changes only the Cash, Debt, and Stock – so Enterprise Value also stays the same.
Since the Combined Enterprise Value stays the same regardless of the financing method,
there’s another important implication as well:
Enterprise Value-based multiples for the Combined Company stay the same regardless of the
financing method.
Enterprise Value-based multiples such as TEV / EBITDA include Enterprise Value in the
numerator and a capital-structure-neutral metric in the denominator.
Enterprise Value does not change based on the financing method, and metrics such as Revenue,
EBIT, and EBITDA do not change based on the financing method, so the numerator and
denominator stay the same regardless of the financing method.
And the additional shares issued don’t matter since these are not per-share metrics.
Here are a few examples of this principle:
The Combined P / E multiple changes because both the Combined Equity Value and the
Combined Net Income change based on the financing method.
The Combined Net Income tends to be lowest for 100% Debt deals because the interest rate on
Debt is far higher than the interest rate on Cash, meaning that the Combined Net Income will
include a higher interest expense and, therefore, decrease by a greater amount.
These concepts are important because many case studies, modeling tests, and interview
questions are based on them.
Here’s a summary of the Combined Enterprise Value, Equity Value, and valuation multiples in
M&A deals:
1. Combined Equity Value = Acquirer’s Equity Value + Market Value of Stock Issued in the
Deal.
2. Combined Enterprise Value = Acquirer’s Enterprise Value + Purchase Enterprise Value of

Target.
3. HOW the Combined Valuation Multiples Change – TEV-based Combined Multiples will
be between the Acquirer’s current trading multiples and Target’s purchase multiples.
Equity Value-based Combined Multiples are usually in this range as well, but they do not
have to be.
4. Combined Enterprise Value-Based Multiples – These will not change regardless of the
financing method because the Combined Enterprise Value isn’t affected by the financing
method, and neither are metrics like Revenue, EBIT, or EBITDA.
5. Combined Equity Value-Based Multiples – These will change based on the financing
method because the Combined Equity Value changes based on the amount of Stock
issued, and the Combined Net Income changes based on the amount of Cash and Debt
used and the interest rates on them.
Finally, remember that these concepts are simplifications that ignore many real-world factors.
For example, Revenue Synergies will affect the Combined TEV / Revenue multiple.
If the Synergies change, then this multiple will change even if the purchase price and financing
method stay the same.
Expense Synergies can make a similar impact on multiples such as Combined TEV / EBITDA, and
acquisition effects such as additional D&A on Asset Write-Ups can also distort these numbers.
When These Rules Go Wrong
Something more basic could also distort these rules: the market may not like the deal.
For example, if Company A announces that it’s acquiring Company B for $125 million, which
reflects a 25% premium, the market might think that Company B is worth only $100 million.
Market participants can’t “take away” Cash or Debt from these companies, but they can sell
Company A’s stock, which will result in a lower stock price for Company A.
If something like this happens, the Purchase Equity Value and Purchase Enterprise Value will
stay the same.
Company A keeps its offer in place, but Company A’s stock price will fall such that the
Combined Equity Value and Combined Enterprise Value are lower by $25 million.
As a result, Company A will have to issue additional shares to do the deal, and the deal will be
less accretive. Here’s a “Before” and “After”:
But if the market suddenly starts doubting this deal and believes that the premium paid for
Company B is unjustified:
The bottom line is that the control premium paid in an M&A deal may not last once the deal is
announced and eventually closes.
If the market likes the deal and believes the Acquirer paid a reasonable price for the Target, the
Acquirer’s share price might stay the same or even go up.
But if not, the Acquirer’s share price will drop to reflect whatever the market thinks the Target
should be worth.
Return to Top.
Key Rule #6: Full Merger Model (60-Minute and 3-Hour Version)
In the previous sections, we covered examples of simplified merger models where we

estimated the purchase price and the Cash / Debt / Stock mix and then used the Weighted Cost
of Acquisition and the Seller’s Yield to predict whether the deals would be accretive or dilutive.
In this section, we’ll walk through a “full merger model” based on a real-life M&A deal: the
Builders FirstSource’s $2.5 billion acquisition of BMC Stock Holdings.
Both companies operated in the building materials and supplies space, a mature industry at the
time of the deal.
The 60-minute and 3-hour versions of this model are not that much different.
The main differences are that the 3-hour version has more supplemental analyses (such as a
quick valuation of BMC), more detail on the Synergies, and more robust formulas.
However, the basic modeling process is nearly the same, so we’re not going to walk through
each version separately.
Instead, we’ll cover both versions here and point out the parts with more detail in the 3-hour
version. Supplemental analyses are covered in the next key rule.
We divide the process of building a merger model into the following eight steps:
1) Project the Financial Statements of the Buyer and Seller – At the minimum, you need
projected Income Statements for the Buyer and Seller and, ideally, simplified Cash Flow
Statements. Full 3-statement models help a bit, but they’re not necessary.
2) Estimate the Purchase Price and Financing Method – You assume a share-price
premium for a public Seller and confirm the price with the valuation methodologies; for
private Sellers, the purchase price is based on a valuation multiple. The Cash / Debt /
Stock mix is based on the minimum combined Cash balance and the maximum
combined Debt balance.
3) Create a Sources & Uses Schedule and Purchase Price Allocation Schedule – These
schedules give more specific details about how much the Buyer is “really paying” (i.e.,
the treatment of the Seller’s Debt), and they describe the other acquisition effects, such
as the new D&A on asset write-ups.
4) Combine the Balance Sheets of the Buyer and Seller (OPTIONAL) – It helps to create a
Combined Balance Sheet because it lets you assess the Combined Company’s capital
structure and whether or not it has reasonable levels of Debt, Equity, and Cash.
However, it’s not required to calculate EPS accretion/dilution or analyze the deal with
other methodologies.
5) Calculate the Synergies (OPTIONAL) – If you have enough information to make detailed
calculations, you can estimate the Revenue Synergies based on cross-selling, up-selling,
and geographic expansion and the Expense Synergies based on employee/building
consolidation. In a simplified model, you can use the company’s internal estimates for
the dollar/euro/GBP/RMB/JPY/other amounts.
6) Combine the Income Statements of the Buyer and Seller and Calculate Accretion /
Dilution – This part is similar to the simplified model: add together the Pre-Tax Incomes
of the Buyer and Seller and adjust for new items, such as Synergies and D&A on asset
write-ups (and the normal effects of using Cash, Debt, and Stock to fund the deal). Then,
calculate the Combined EPS and the accretion/dilution figures.
7) Calculate Cash Flow, Debt Repayment, and Key Metrics and Ratios – To make the
model more accurate, you can project the Combined Company’s cash flow and use that
to determine how much Debt it can repay each year – and how much Cash it generates.
Calculating metrics like Debt / EBITDA and EBITDA / Interest for the Combined Company
also helps you assess the deal's viability. If the Debt has fixed annual principal
repayments and no optional repayments, you might complete this step before the
Income Statement combination.
8) Create Sensitivity Tables – Sensitivity tables let you assess the EPS accretion/dilution
under different scenarios, such as higher or lower purchase prices and Synergy
realization levels.
Here’s each step with screenshots and more detail:
1) Project the Financial Statements of the Buyer and Seller

This step varies by industry and company, but you need projected Income Statements for the
Buyer and Seller and simplified Cash Flow Statements at the minimum.
You don’t need full 3-statement projections; as with the DCF, cash flow is king.
That means you need to forecast the following items:
• Revenue – Ideally based on units sold and average selling price, or on market size and
market share.
• COGS and Operating Expenses – Based on percentages of revenue, employee counts, or

fixed vs. variable costs.
• Net Interest Expense – You must project each company’s Interest Income and Interest
Expense because they might change in the deal.
• Taxes and Net Income – You don’t need these for the Seller, but you do need the
Buyer’s Tax Rate since you will apply it to the Combined Company.
• Major Cash Flow Items – You must project Depreciation & Amortization, the Change in
Working Capital, and other items like recurring Dividends and Deferred Taxes that
impact a company’s cash flow.
We’re not going to paste in the full projections for Builders FirstSource (BLDR) and BMC Stock
Holdings (BMCH), but here’s the projected Income Statement for BLDR:
We assumed percentage growth rates for each of the company’s main segments and made the
expenses percentages of Revenue or linked them to the company’s employee count.
Interest Expense is based on a weighted average coupon rate applied to the company’s Debt
balance, which decreases over time as the company repays Debt principal.
The Cash Flow Statement explains why the Share Count stays the same each year:
We’re setting Stock-Based Compensation, Issuances of Common Stock, and Stock Repurchases
to $0 because we want the share count to stay the same in the projected period.
Otherwise, EPS accretion/dilution becomes less meaningful because the pre-deal share count
keeps changing.
Of course, Stock-Based Compensation still exists as an operating expense. It’s just that, as in the
DCF, we assume that it’s a normal cash expense with this treatment.
The Debt Issuances and Repayments are roughly based on the historical changes in the
company’s Debt and how the company seems to be repaying slightly more than it is issuing
each year.
Once you’ve made these projections for the Buyer, you do the same thing for the Seller.
The Buyer and Seller here are similar, with financial statements that have almost the same line
items, so we’re not going to show screenshots of the Seller’s numbers.
You use the same process to input historical data, do a bit of market research, and project the
future cash flows based on those.
In many M&A situations in real life, you use the management team’s projections rather than
creating your own.
2) Estimate the Purchase Price and Form of Payment

If the Seller is public, you’ll link the purchase price to an Offer Price per Share, which should be
at a premium to the company’s current share price.
You base this control premium on the premiums that similar companies in the market have sold
for recently; if the range is 15% – 30%, you might start at 20% or 25%.
You’ll then check this Offer Price per Share and make sure it’s in-line with the company’s
Implied Share Price as determined by Public Comps, Precedent Transactions, and the DCF.
For private companies, the purchase price is based on a simple TEV / Revenue, TEV / EBITDA, or
P / E multiple, which you pick based on peer companies and the valuation methodologies.
One added complication for public companies is that the purchase price is often framed in
terms of an Exchange Ratio.
For example, if the Exchange Ratio is 0.5x, then the Seller will receive 0.5 new shares from the
Buyer for each of its current shares outstanding.
So, if the Seller currently has 100 million shares and a share price of $8.00, and the Buyer has
200 million shares and a share price of $20.00:
• The Buyer will issue 100 million * 0.5 = 50 million new shares.
• Therefore, the Buyer will pay 50 million * $20.00 = $1 billion for the Seller.
• The Offer Price per Share for the Seller is $20.00 * 0.5 = $10.00.
• $10.00 per share is 25% higher than $8.00 per share, so this is a 25% premium.
In real life, many issues come up with Exchange Ratios because the Buyer and Seller’s share
prices could change significantly before the deal closes.
So, both parties in M&A deals often create restrictions around the number of new shares that
will be issued if the share price changes to X or Y, and they might even change the Exchange
Ratio at different share prices.
For a basic analysis, however, these details are not important (see the section on More
Advanced Merger Model features if you want these details).
Here’s the first part of our assumptions for this BLDR / BMCH deal:
Since this is an acquisition of a public company, we assume that its existing Debt is assumed or
replaced with the same amount of new Debt (i.e., “refinanced”).
Therefore, the funds required for the deal are based on the Purchase Equity Value, and we
assume that a small amount of Cash pays for the Legal, Advisory, and Debt Issuance Fees:
You could simplify this by making Cash, Debt, and Stock simple percentages, but you would
need to check the dollar amounts against the restrictions here.
3) Create a Sources & Uses Schedule and Purchase Price Allocation Schedule
We mentioned earlier that the real amount that a Buyer pays is neither the Purchase Equity
Value nor the Purchase Enterprise Value.
The “real purchase price” depends on the treatment of the Seller’s Debt and Cash as well as the
fees associated with the deal.
To determine this number, you create a “Sources & Uses” schedule.
A Source of Funds is anything that the Buyer uses to pay for the Seller. Cash, Debt, and Stock
are the main Sources.
A Use of Funds is anything that increases the amount that a Buyer must pay for the Seller.
The biggest Use of Funds is the Purchase Equity Value of the Seller.
Debt repayment and legal, advisory, and financing fees are also Uses of Funds because the
Buyer must pay for these items.
If the Buyer assumes the Seller’s Debt or “refinances it” by replacing it with new Debt (what
happens in most public deals), the existing Debt shows up under both Sources and Uses:
How much does the Buyer “really” pay for the Seller in this deal?
We’d say the “real purchase price” is $2.579 billion, which is slightly above the Purchase Equity
Value because of the fees.
The Buyer is not paying anything extra for the Seller’s Debt, so that $336 million does not count
toward the effective price.
The Purchase Price Allocation (PPA) Schedule
Once you’ve created the Sources & Uses schedule, you move onto the Purchase Price
Allocation (PPA) schedule.
You need to set up this schedule because in almost all M&A deals, the Buyer pays a premium to
the Seller’s Book Value (its Common Shareholders’ Equity).
For example, the Buyer might pay $1,000 for the Purchase Equity Value, but the Seller’s
Common Shareholders’ Equity is worth only $700.
This premium is NOT the control premium. The control premium is based on the Market Value
of the Seller’s shares, while this one is based on the Book Value of the Seller.
You should know from the Accounting guides that this premium will result in the Balance Sheet
not balancing, which is a big problem.
To fix this problem, you create two new Assets:
1) Other Intangible Assets, which represent identifiable items that have some value, such
as trademarks, patents, the brand name, and customer relationships; and
2) Goodwill, to represent everything else.

We’ve covered the rationale for these items in the Accounting lessons, so we’re not going to re-
hash everything here.
This process still happens in real M&A deals, but the Buyer must also re-value all the Seller’s
Assets and Liabilities when the deal closes and write them up or down to their “fair market
values.”
For example, perhaps the Seller purchased a building for $1,000 five years ago. This building will
be listed on the Seller’s Balance Sheet at $1,000 minus Accumulated Depreciation.
If the Accumulated Depreciation is $100, the building will be $900 on the Balance Sheet.
When the Buyer reviews this building and researches the local market, it concludes that the
building is worth $1,100.
Therefore, the Buyer will record a “write-up” of $200 to reflect this fair market value.
There might also be write-ups for Inventory and other items, but PP&E write-ups are the most
common ones because the value of real estate often increases over time.
In addition to these Asset write-ups, you also write down a Seller’s existing Deferred Tax
Assets (DTAs) and Deferred Tax Liabilities (DTLs) in most M&A deals.
These items were created due to temporary differences between Cash Taxes and Book Taxes
that will eventually reverse.
But in an M&A deal, items set to reverse “eventually” must reverse upon deal close.
So, the differences are reconciled, the existing DTAs and DTLs are wiped out, and a new DTL
may be created if there’s a write-up of PP&E or Other Intangible Assets.
Depreciation & Amortization on these items are not deductible for cash-tax purposes, but the
company still records the D&A on its book financial statements.
Therefore, the Cash Taxes the company pays to the government will be higher than the Book
Taxes it records on its Income Statement.
A Deferred Tax Liability means that the company expects to pay higher Cash Taxes than Book
Taxes in the future, which corresponds to this scenario.
Over time, the DTL will decrease as the company pays those higher Cash Taxes, and eventually,
it will reach $0 once the write-ups have been fully depreciated or amortized:
Advanced Note: The treatment for these items differs in Asset Purchases and 338(h)(10) deals
– please see the section on More Advanced Merger Model Features.
Here’s the Purchase Price Allocation schedule for the BLDR / BMCH deal:
Asset write-ups reduce the Goodwill Created because they increase the Assets side of the
Balance Sheet, which means less Goodwill is needed. Liability write-downs also reduce the
Goodwill Created because they make the L&E side of the Balance Sheet smaller.
Liability write-ups and new Liabilities, such as the new DTL, increase the Goodwill Created
because they do the opposite. Asset write-downs, similarly, increase Goodwill Created.
4) Combine the Balance Sheets of the Buyer and Seller (OPTIONAL – SKIPPED IN 60-MINUTE
MODEL)
The Balance Sheet combination is simple if you’ve set up the Sources & Uses and Purchase Price
Allocation schedules correctly.
You add together the Balance Sheets of the Buyer and Seller as of the deal close date (the end
of FY 20 here), and you reflect the Cash, Debt, and Stock used in the deal, write up or down
various Assets and Liabilities, and write down the Seller’s Common Shareholders’ Equity:
And then on the Liabilities & Equity side:
If the post-transaction Balance Sheet does not balance, then you’ve done something wrong and
must review your work to find the mistake.
One trick is to review the S&U and PPA schedules and check off each item there as it appears on
the Combined Balance Sheet.
Everything except for the Equity Purchase Price and Allocable Purchase Premium should appear
once and only once in these “Pro-Forma Adjustments” columns.
5) Calculate the Synergies (OPTIONAL – SIMPLIFIED IN 60-MINUTE MODEL)

Synergies represent ways for 1 + 1 to equal 3 rather than 2 in M&A deals.
For example, the Buyer’s standalone Revenue is $1,000, and the Seller’s standalone Revenue is
$500.
But after they merge, the Revenue of the Combined Company is $1,600 rather than $1,500
because the Buyer can sell some of its products to the Seller’s customers, and vice versa.
There may also be Expense Synergies related to headcount reductions, building consolidation,
and better deals with suppliers (due to volume discounts).
In simple models, you might rely on each company’s estimates for Synergies and include them
as lump-sum numbers:
If you have more time and information, you might create more detailed estimates.
For example, in the 3-hour merger model, we assume Revenue Synergies in the BLDR / BMCH
deal based on increases to their overlapping business segments:
And the Expense Synergies are linked to specific reductions in the employee counts at both
companies, with the Merger & Integration Costs as a percentage of these SG&A Cost Savings:
Once you’ve estimated these Synergies, you can also value them with a simple DCF, which uses
a Long-Term Growth Rate of 1% and Discount Rate of 11% (the Buyer’s WACC) here:
The most common mistakes with Synergies include:

1) Failing to include Merger & Integration or Realization Costs. Realizing synergies costs
money over several years as the combined company restructures, and the model must
reflect that. These costs may appear on the Income Statement, Cash Flow Statement, or
both statements.
2) Failing to include additional COGS and Operating Expenses that correspond to the
Revenue Synergies – selling extra products and services costs money!
3) Using nonsensical logic, such as assuming that the Combined Operating Expenses can be
reduced by 50%+ in a single year. As a rule of thumb, single-digit-percentage reductions
are more plausible.
Once you have the Synergies and Merger & Integration Costs set up, you can combine the
Buyer and Seller's Income Statements in the next step.
6) Combine the Income Statements of the Buyer and Seller and Calculate Accretion / Dilution
This step is straightforward if you’ve set up everything properly in the previous steps.
The 3-hour and 60-minute versions are similar, but the 3-hour version uses more complex
formulas that handle more cases in a few spots, and it shows more detail for the Revenue and
Expense categories.
In both cases, though, we prefer to start with the bottom section of the Cash Flow Statement
to reflect the principal repayments on the New Debt used to fund the deal.
This changing Debt balance means that the Interest Expense will change each year.
If there are no required principal repayments, then you can skip this step and return after
you’ve finished the Combined Income Statement:
We could have skipped this formula and used a much simpler version with a 1% principal
repayment of the original balance each year (as in the 60-minute version).
Here’s the Income Statement combination, section by section:
It’s not necessary to show all the Revenue categories here; you could just add together Total
Revenue for both companies and then put the Revenue Synergies below that figure.
Here, we use formulas such as the following for the new Depreciation and Amortization:
= – MIN(Intangibles_Writeup / Intangibles_Amortization_Period, Intangibles_Writeup – All
Amortization So Far)
These formulas handle Amortization Periods of 1-4 years rather than 5+ years, but we could
skip them and use simple division as well (as in the 60-minute version).
Next, we calculate the Combined Pre-Tax Income by factoring in the Net Interest Income from
the Buyer and Seller, the Foregone Interest on Cash, and the Interest Paid on New Debt:
This “Pro-Forma EPS” metric makes the deal look far better than it is, but many companies
calculate it and present deals using this metric.
There are many problems with “Pro-Forma EPS,” including the fact that there’s no standard
definition, but you should understand the basic idea because you’ll see it in many M&A deals.
7) Calculate Cash Flow, Debt Repayment, and Key Metrics and Ratios
You do not need full Cash Flow Statement projections for both companies, but you do need to
project the major, recurring line items on the Cash Flow Statement: D&A, the Change in
Working Capital, CapEx, and so on.
In this case study, we did have Cash Flow Statement projections for both companies, so the
combination was simple: add everything together and include the acquisition effects and new
line items.
In this case, the Combined Cash Flow Statement projections are not that useful because the
New Debt principal repayments are low, and the Cash balance increases by a huge amount.
These projections would be more important if:
1) The New Debt principal repayments were more complex;
2) The New Debt allowed for optional repayments; or
3) If the company were in danger of falling below its minimum Cash balance.
The New Debt reduction just means that the company’s Interest Paid on New Debt decreases
each year, as shown above on the Combined Income Statement.
Once you’ve set up this schedule and linked everything properly, you can calculate the Key
Metrics and Ratios.
These aren’t required, but they do help you draw conclusions about other aspects of the deal,
such as:
• Does the Combined Company use too much Debt? Or could it use more Debt?
• Is the Combined Company growing more quickly or more slowly than the Buyer and
Seller as standalone entities?
• How much of an impact do the Synergies make on the Combined Company’s margins?
Here are the metrics we analyzed for this deal:
8) Create Sensitivity Tables

With the entire model finished, we can now analyze the deal with different purchase prices,
different mixes of Cash, Debt, and Stock, and different Synergy realization levels using
sensitivity tables.
Here are a few examples that measure accretion/dilution of Year 1 and Year 2 Pro-Forma EPS:
A few notes:
1) These specific tables are not that useful because the main question in this deal is not the
Exchange Ratio or purchase price, but the financing: 100% Stock vs. a mix of Cash, Debt,
and Stock.
2) Another problem is that we’re not sensitizing the Buyer’s Share Price, partially because
we’ve set up this model in a simplified way and ignored the real way the Exchange Ratio
works.
We can address the first issue by building sensitivity tables with a 100% Stock mix, such as this
one:
The second issue, with the Buyer’s Share Price, is more difficult to address without changing the
model significantly (see the section on More Advanced Features).
Finally, remember that just because an M&A deal is accretive doesn’t mean it’s a good idea.
Accretion/dilution analysis, like valuation and DCF modeling, is a way to screen for companies
and check whether a deal makes some financial sense.
But no one in the history of human civilization has ever said, “Aha! This deal is accretive.
Therefore, let’s stop everything and acquire this company right away!”
Return to Top.
Key Rule #7: M&A Valuation, Value Creation, and the Contribution Analysis
There are many ways to evaluate a merger or acquisition, and an EPS accretion/dilution analysis
isn’t necessarily the best choice in all scenarios.
Accretion/dilution makes the most sense when the Buyer and Seller are fairly close in size and
have positive EPS and cash flow, and when the deal is motivated by financial reasons rather
than “fuzzy reasons.”
But in many M&A deals, one or more of those conditions is false.
Another problem is that not all Buyers care about EPS.
All companies have Earnings per Share figures because all companies record something for Net
Income, and all companies – even private ones – have shares outstanding.
But if the Buyer is private or its EPS is extremely negative, then the results of an EPS
accretion/dilution analysis won’t be meaningful.
Also, even if the Buyer and Seller are both similarly sized public companies with positive EPS,
additional analyses can help if it’s a 100% Stock or majority-Stock deal.
If that’s the case, the post-deal ownership and the deal’s impact on the Buyer’s share price
matter a lot, which is why you often use the Contribution Analysis and the Value Creation
Analysis.
Here are some alternative methods for evaluating M&A deals:
Qualitative / “Strategic” Analysis
This method is relevant in many acquisitions of small tech and biotech startups.
These small companies have no profits, no cash flow, and almost no revenue, so acquisitions
are not based on financial criteria such as multiples or EPS accretion/dilution.
Instead, the rationale comes down to:
1) Potential for Extremely High Growth – For example, if Small Biotech Firm B discovers a
cure for skin cancer, then Big Pharma Company A might become the most valuable
healthcare company in the world if it acquires this smaller firm.
2) Defensive Acquisition / Fear of Competition – If Big Social Media Company A perceives

a new, high-growth social media company to be a threat, it might acquire it because of
the strong network effects. If it doesn’t act quickly, the smaller company might grow
virally and disrupt the bigger company’s entire business!
There isn’t much in-depth financial analysis in these deals, but you might justify them with
back-of-the-envelope math.
For example, maybe each user of Smaller Social Media Company is worth $1.00 per year, and it
has 100 million users currently.
But its userbase could grow to 500 million in a few years, so Big Social Media Company A
decides to offer $300 million to acquire it – more than what the company is currently worth,
but less than what it might be worth in the future.
M&A Valuation
You can value a company as a standalone entity, and you can also value it in the context of an
M&A transaction.
You can then compare its implied value (plus the value of potential Synergies) to the Offer Price
to determine whether or not the Buyer is getting a good deal.
We’re not going to repeat all the steps for a DCF here, but the UFCF projections for the example
deal’s Seller – BMC Stock Holdings – look like this:
We simply extend the 5-year projections for the company another 5 years into the future so
that the DCF shows a 10-year projection period.
The Discount Rate (WACC) is between 8% and 9%, based on comparable public companies, the
baseline Terminal FCF Growth Rate is 1%, and the baseline Terminal EBITDA Multiple is 6.7x.
For reference, the Seller’s share price just before this deal was announced was $32.22.
Here’s the output of the DCF sensitized with different Discount Rate and Terminal Value
assumptions:
The quick conclusion is that the Seller seems slightly overvalued as a standalone entity.
It’s not a huge differential; it might be overvalued by 5-15% depending on the assumptions.
So, if the Buyer pays a standard premium in the 10-30% range, it will need to realize fairly
substantial Synergies for the Offer Price to make sense.
We previously valued the Synergies using the Acquirer’s WACC of 11% and found they were
worth approximately $1.2 billion. At the Seller’s WACC, they would be worth closer to $1.7
billion.
If we compromise and say the Synergies are worth about $1.5 billion, then:
• Seller’s Implied Equity Value from DCF: $2.0 billion

• Present Value of Synergies: $1.5 billion
• Equity Purchase Price: $2.5 billion
Since the Implied Equity Value + PV of Synergies is much higher than the Equity Purchase Price,
this deal seems like a clear “win” from a valuation perspective.
However, that assumes that 100% of the Revenue and Expense Synergies are realized without
any cost overruns or delays, and that they continue indefinitely into the future.
If only 50% of the Total Synergies are realized, then the valuation is much closer to a
“breakeven” level.
IRR vs. Discount Rate (WACC)

If you’ve already set up a DCF to value a Seller, you’ve projected and valued the possible
Synergies, and you’ve calculated WACC for the Buyer and Seller, you might as well take the next
step and set up an IRR vs. Discount Rate analysis.
The idea here is simple: the Discount Rate represents the Buyer’s expected annualized returns,
and the IRR represents the annualized returns that the Buyer will earn on the deal.
Therefore, if the IRR exceeds the Discount Rate, the deal is a good one; if not, the deal is not.
The idea is simple, but there are several issues with this analysis:
1) Which Discount Rate Do You Use? Probably not the Seller’s, but do you use the Buyer’s
Discount Rate or a “weighted average” rate?
2) Do You Use UFCF and WACC or LFCF and Cost of Equity? We prefer UFCF and WACC
because the DCF already uses UFCF and WACC, and Levered DCFs tend to create
consistency issues.
3) To Whom Do You Attribute the Synergies? Does the Buyer or Seller get the credit? Or is
the credit split between the Seller and Buyer? Or do you just ignore this issue?
Since IRR vs. Discount Rate is a “back of the envelope” analysis, we keep it simple and use the
Buyer’s WACC, but sensitize it down to a lower number closer to the Seller’s WACC.
And we assume that the After-Tax Cash Flow from Synergies is “part of the Seller’s package”
because the Buyer wouldn’t be able to realize these Synergies without the Seller.
Here’s our analysis, which extends directly from the DCF:
From the sensitivities, the conclusion is that this acquisition’s IRR seems likely to exceed the
11% Discount Rate, even at higher purchase prices – as long as 80%+ of the expected Synergies
are realized:
Like the other analyses around this deal, this one depends on whether or not we believe the
Buyer’s Synergy estimates.
Relative Contribution Analysis

Another way to assess mergers and acquisitions is the Relative Contribution Analysis.
The idea is simple: if the Acquirer contributes 80% of the Combined Company’s Revenue,
EBITDA, and other financial metrics, will it own 80% of the Combined Company afterward?
If it owns less than 80%, then perhaps it is paying too much for the Target; if it owns more than
80%, then perhaps it is paying too little for the Target.
In this analysis, you sum up the Acquirer and Target's financials across a range of metrics and
calculate the percentages that each one contributes.
So, if the Acquirer contributes an average of 75%, and the Target contributes 25%, then the
Acquirer might be justified in owning 75% of the Combined Company.
Based on that, you might suggest a purchase price that results in the Acquirer owning 75% and
the Target owning 25% of the Combined Company.
The Contribution Analysis is most relevant for:
• 100% Stock Deals – In these deals, all purchase price changes directly affect ownership
since the Buyer is issuing shares to the Seller.
• “Mergers of Equals” (MOE) Deals – These transactions almost always use 100% Stock
because the Buyer and Seller are about the same size.
• Private Company M&A Deals – Private Buyers don’t care about EPS as much as public
Buyers, so the Contribution Analysis is the most relevant methodology in 100% Stock
deals.
• Majority-Stock Deals – If the Buyer uses at least 50% Stock, the Contribution Analysis
could still be meaningful because the Combined Company's ownership will change
substantially if the purchase price changes.
This analysis isn’t relevant for 100% Cash or 100% Debt deals because the Seller won’t have any
ownership in the Combined Company.
You start this analysis by summing up the relevant metrics for the Acquirer and Target and
calculating the Contribution Percentage for each one:
Then, you calculate the Combined Pro-Forma Enterprise Value for each metric based on the
Acquirer’s Current Enterprise Value and its Contribution Percentage.
So, if the Acquirer’s Current Enterprise Value is $3 billion, and it contributes 75% of the
Revenue, then the Combined Pro-Forma Enterprise Value is $3 billion / 75%, or $4 billion.
That $4 billion represents what the Combined Enterprise Value “should be” for this new
company once the deal closes.
Here’s an example:
For Equity Value-based metrics, such as Net Income, you take the Acquirer’s Current Equity
Value and divide by its Contribution Percentage to determine the Combined Pro-Forma Equity
Value.
Then, to go from Combined Pro-Forma Enterprise Value to Equity Value (or the reverse), you
subtract (or add) the “bridge” items:
Once you have the Combined Pro-Forma Values for each metric, you can calculate the Target’s
Implied Value for each one.
To do that, take the Combined Pro-Forma Enterprise Value and subtract the Acquirer’s Current
Enterprise Value:
You can then move to the Target’s Implied Equity Value by subtracting the normal items in the
Equity Value to Enterprise Value bridge, shown in cells D8:D12 in the screenshot above.
These numbers tell you what the Equity Purchase Price “should be” in the deal, based on the
percentages of financial metrics the Target contributes to the Combined Company.
You can then divide by the Target’s share count to get the Purchase Price per Share, and you
can divide that by the Acquirer’s current share price to get the Implied Exchange Ratio:
You can now create graphs to illustrate the Contribution Percentages vs. the Ownership
Percentage:
The most useful graph is the one that compares the Buyer’s Offer Price to the Seller’s Implied
Share Price from the Contribution Analysis:
From these graphs and the data above, it appears that the Acquirer is paying far too much for
the Target, at least if it funds this deal with 100% Stock.
However, there are a few caveats:
1) These analyses do not include Synergies – And as you saw in the previous section,
Synergies, even ones that are partially credited to the Target, can change the analysis
dramatically.
2) This deal won’t necessarily be 100% Stock – In fact, we recommend against 100% Stock
and advise the Acquirer to use a mix of Cash, Debt, and Stock instead. In that case, these
findings are less relevant because the Target’s ownership percentage will be far lower.
If the deal absolutely must be 100% Stock, then the Contribution Analysis would be more
important, and we might also include Synergies.
If it still produced Implied Offer Prices that were far different from the initially proposed Offer
Price, then the Acquirer and Target might re-negotiate the price based on those numbers.
Value Creation Analysis
You can also evaluate an M&A deal by assessing whether or not it might increase the
Acquirer’s share price.
In a previous section of this guide, we stated these two rules:
1. Combined Equity Value = Acquirer’s Equity Value + Market Value of Stock Issued in
Deal.
2. Combined Enterprise Value = Acquirer’s Enterprise Value + Purchase Enterprise Value of

Target.
These principles help answer case study questions and do quick math in interviews, but, like
many simple rules, they don’t always hold up in real life.
Immediately after an acquisition is announced, there’s a good chance that the Combined Equity
Value and Combined Enterprise Value will change as described above.
But after that, almost anything could happen.
For example:
• What if the Combined Company’s FCF Growth Rate slows down after the acquisition
closes? Its value will likely decrease.
• What if the Combined Company’s margins increase because it realizes higher-than-

expected Synergies after the deal closes? Its value will likely increase.
• What if the market likes this Combined Company a lot more than the Buyer and Seller
as standalone entities, and demand for the Combined Company’s shares pushes up its
stock price?
To account for these possibilities, you could use a Value Creation Analysis to estimate the
valuation multiples the Combined Company might trade at.
In a Value Creation Analysis, you start by finding larger companies in the same industry that
trade at higher multiples because of “greater scale,” higher growth rates, a more favorable
market position, or some other factor.
For this deal, we selected two larger companies: Carrier Global Corporation [CARR] and W.W.
Grainger, Inc. [GWW].
At the time of the transaction, each one had an Enterprise Value between $20 billion and $40
billion, with Revenue in the $10-20 billion range.
Also, they conveniently happened to trade at higher valuation multiples – particularly the TEV /
Revenue multiple.
We added up the Acquirer and Target’s standalone figures, including Synergies in the first full
combined year, to put all the financial profiles side-by-side:
It’s questionable how much closer the Acquirer + Target are to CARR and GWW here; yes,
they’re bigger as a combined entity, but they’re still far away in terms of EBITDA.
In the next step, we averaged the Revenue and EBITDA multiples of CARR and GWW and then
applied those multiples to the Combined Company:
Yes, you read that correctly: we’re assuming that the Combined Company will trade at
significantly higher Revenue and EBITDA multiples because… magic?
OK, not magic – because “it’s more similar to these two larger, public companies in the
industry.”
The Value Creation Analysis is highly speculative, which is why most people don’t take it
seriously.
It can be important in certain industries, such as REITs, where larger companies might trade at
higher multiples, but it’s a stretch to use this methodology here.
Continuing with the analysis, we added Cash and Non-Core Assets and subtracted Debt and
Preferred Stock to move from Implied Enterprise Value to Implied Equity Value:
The “Combined Entity – Implied Share Price” here represents this Combined Implied Equity
Value divided by (Acquirer’s Share Count + Shares Issued to Fund the Deal).
The results for the TEV / Revenue multiples seem so unbelievable that we ignore them.
The results for the TEV / EBITDA multiples also show a substantial increase in the Acquirer’s
share price, but it’s closer to the “believable zone.”
We can then sensitize these results based on the Combined TEV / EBITDA Multiple, the Year 1
Synergies, the Exchange Ratio, and other assumptions:
The conclusion is that if there’s even modest multiple expansion – if the Combined Company
goes from a 7.5x forward TEV / EBITDA multiple to an 8.2x or 8.8x multiple – then the Acquirer’s
share price will increase after the deal closes.
But if the Combined Multiple stays the same as the Acquirer or Target’s standalone multiples,
then the Acquirer’s share price will decrease.
The Synergies make some difference, but this entire analysis comes down to the credibility of
this “multiple expansion” (we’re skeptical).
Return to Top.
Key Rule #8: More Advanced Merger Model Features [OPTIONAL]
This last section of this guide is optional because it covers topics are unlikely to come up in
interviews or case studies.
You sometimes encounter these more advanced features on the job, but you still use simple
models in many cases due to time pressure.
So, if you have limited time or you’re interviewing for internships or entry-level roles, you
should skip this part of the guide.
Exchange Ratios, Collars, Earn-Outs, and Other Purchase Price Variations

We’ve been acting as if there’s only one “Purchase Price,” and that the Buyer instantly decides
on the exact percentages of Cash, Debt, and Stock to use.
But the reality is not so simple: for example, the Purchase Price might consist of an upfront
payment and then an additional payment in the future if the Seller achieves certain goals.
Also, as covered in the full merger model walkthrough, deals with a Stock component are often
priced based on an Exchange Ratio rather than a specific Stock percentage.
This structure can create problems if the Buyer’s share price changes significantly between the
announcement and the deal close, so dealmakers use structures known as collars and
variations such as fixed and floating exchange ratios to solve these issues.
Exchange Ratios and Collars
One problem with any M&A deal funded by Stock is the risk that both parties assume because
of possible changes in the Buyer’s share price.
For example, if the Buyer plans to issue 100 shares at its current share price of $10.00 for a
purchase price of $1,000, that purchase price will drop to $900 if the Buyer’s share price drops
to $9.00.
So, rather than offering a fixed percentage of Stock, many Buyers offer a fixed number of
shares (allowing the purchase price to vary) or a fixed price (allowing the shares issued to vary).
The “fixed number of shares” option is called a Fixed Exchange Ratio.
For example, in a deal with a 2:1 Fixed Exchange Ratio where the Seller has 10 million shares,
the Buyer will always issue 20 million shares to acquire the Seller.
If the Buyer’s share price increases from $10.00 to $15.00 or falls from $10.00 to $5.00, the
Seller will still receive 20 million shares – so the purchase price could be anywhere from $100
million to $300 million.
However, the Seller’s ownership won’t change: if the Buyer originally had 100 million shares
outstanding, the post-deal share count will always be 120 million. So, the Seller will own ~16.7%
of the Combined Company regardless of the Buyer’s share price.
A Floating Exchange Ratio is the opposite: the Seller always receives the same purchase price
but a different number of shares, depending on the Buyer’s share price.
For example, both parties might agree on a price of $220 million. The Buyer’s share price is
initially $11.00, so it has to issue 20 million shares to the Seller (~16.7% ownership).
But if the Buyer’s share price increases to $12.00, now it will issue ~18.3 million shares (~15.5%
ownership). And if its share price decreases to $10.00, it will issue 22 million shares (~18.0%
ownership).
The Buyer tends to favor a Fixed Exchange Ratio if it wants to limit dilution and prefers
certainty around the number of new shares issued.
Sometimes, the market interprets a Fixed Exchange Ratio as a sign that the Buyer is not
confident in the value of its shares, so there may be a negative signaling effect.
The Seller tends to favor a Floating Exchange Ratio if it believes the Buyer’s Stock Price will fall:
it will get the same price, but it will own a higher percentage of the combined company.
To compromise, the Buyer and Seller can use a collar to establish a Fixed Exchange Ratio within
certain share-price ranges and a Floating Exchange Ratio within others.
For example, a Fixed Exchange Ratio with a collar might be structured like this:
• Buyer’s Share Price Between $50.00 and $60.00: The Seller always gets 10 million of the
Buyer’s shares, so its ownership percentage is fixed, but the effective purchase price
ranges from $500 million to $600 million.
• Buyer’s Share Price Above $60.00: The Seller gets a maximum price of $600 million, so
it will receive fewer shares if the Buyer’s share price increases (e.g., 7.5 million shares if
the Buyer’s share price reaches $80.00).
• Buyer’s Share Price Below $50.00: The Seller gets a minimum price of $500 million, so it
will receive more shares if the Buyer’s stock price falls (e.g., 12.5 million shares if the
Buyer’s share price falls to $40.00).
Another option is a Floating Exchange Ratio with a collar, which might be structured like this:
• Buyer’s Share Price Between $50.00 and $60.00: The Seller always gets an effective
purchase price of $550 million. So, it receives 11 million shares when the Buyer’s share
price is $50.00 and ~9.2 million shares when the Buyer’s share price is $60.00.
• Buyer’s Share Price Above $60.00: The Seller gets a minimum of ~9.2 million shares, so
its ownership stays the same, but the purchase price could climb to much higher levels.
• Buyer’s Share Price Below $50.00: The Seller gets a maximum of 11 million shares, so its
ownership stays the same, but the purchase price could fall to much lower levels if the
Buyer’s share price falls significantly.
These structures let the Buyer and Seller reduce the risk of 100% Stock deals.
For example, if the Seller’s main concern is its ownership in the combined entity, it could
negotiate for a Floating Exchange Ratio with a collar to ensure that its ownership is always
within a specific range.
But if its main concern is the purchase price, it might prefer a Fixed Exchange Ratio with a collar
– to ensure that the purchase price always stays within a specific range.
Here’s what these structures look like in the Builders FirstSource / BMC Stock Holdings deal:
The justifications for a Fixed Exchange Ratio with a collar vs. a Floating Exchange Ratio with a
collar differ, but in general, a collar is most useful when:
• The Seller is moderately sized relative to the Buyer – maybe ~10-30% of its size. So, it’s
not a Merger of Equals, but it’s also not a tiny acquisition.
• The parties want the risk protection of a Cash deal and the tax benefits of a Stock deal.
• It’s a cross-border deal with different currencies involved (collars can also reduce FX risk
if the offer price is based on one currency).
• The Buyer’s share price has been volatile, or the Buyer and Seller strongly disagree
about the future direction of the Buyer’s share price.
• The deal is a competitive auction, and one Buyer wants to stand out by offering
attractive deal terms.
• The deal will take a long time to close. A 100% Stock deal that takes 12 months to close
because of regulatory requirements is much riskier than one that takes only 2-3 months
to close.
Earn-Outs and Deferred Consideration

Here’s a simple example of a Purchase Price that includes an Earn-Out:
“We’ll pay $100 million for your company now, and if you achieve EBITDA of $20 million in two
years, we’ll pay you an additional $50 million then.”
A Purchase Price with an Earn-Out for a biotech startup might be:
“We’ll pay you $100 million for your company now, and if your drug makes it to Phase 3 clinical
trials within two years, we’ll pay you an additional $50 million.”
The Buyer pays some amount upfront and an additional amount in the future based on
whether or not the Seller achieves certain goals.
Earn-Outs are common in acquisitions of private companies – especially with tech, biotech, and
pharmaceutical startups, where the Buyer and Seller might disagree about the Seller’s
prospects.
If the Buyer believes the Seller is worth $100 million, and the Seller believes it is worth $200
million, they could use a structure like the one above to compromise: “We’ll pay you the $100
million upfront, and if you perform well over the next few years, we’ll pay you the additional
$100 million.”
In most cases, Buyers cannot use Earn-Outs in acquisitions of public Sellers because
shareholders usually demand upfront compensation.
Earn-Out structures can get complex, and real-life deals often include multiple performance
tiers with different deferred compensation in each tier.
On the financial statements, the Buyer records an Earn-Out as a “Contingent Consideration”
Liability, and it adjusts the value of this Liability over time.
If the probability of paying the Earn-Out decreases, the Buyer records the change as a positive
on the Income Statement because the Buyer is more likely to save money in the future.
The opposite happens if the payout probability increases: it’s a negative on the Income
Statement, and it increases the Contingent Consideration on the Balance Sheet.
These adjustments are all non-cash, so the Buyer reverses them in the non-cash adjustments
section of the Cash Flow Statement.
Also, these adjustments do not affect the Cash Taxes, so the Buyer will reverse any additional
taxes or taxes saved on the Income Statement within the Deferred Tax line on the CFS.
When that happens, the Buyer’s DTA or DTL will change accordingly.
So, when the Buyer adjusts the value of the Contingent Consideration, Equity, the Contingent
Consideration, and the DTA or DTL will change, but Cash will not change.
If the Buyer finally pays the Earn-Out to the Seller, it records the cash outflow in the Cash Flow
from Financing section and reduces the Liability to $0.
If the Earn-Out period expires and the Seller’s financial performance does not qualify it for
payment, the Buyer writes down this Contingent Consideration Liability to $0.
This write-down is shown as a positive on the Income Statement, it’s reversed on the Cash Flow
Statement, and the additional taxes from the IS are reversed on the CFS.
Once again, only the Contingent Consideration, Equity, and DTA or DTL will change.
Here’s what the Purchase Price Allocation schedule looks like when there’s a $50 million Earn-
Out in a deal:
Earn-Outs increase the Goodwill Created because they boost the L&E side of the Balance Sheet,
meaning that more Goodwill is needed to balance the change on the Assets side.
However, Earn-Outs do not affect the Sources & Uses schedule because they don’t change the
price, fees, or funding mix for the initial deal.
Here’s what the Income Statement and Cash Flow Statement might look like following the
deal’s close:
Mergers, Tender Offers, and Stock vs. Asset vs. 338(h)(10) Deals
So far, we’ve been assuming that all M&A deals work the same way: the Buyer makes an offer
to acquire the Seller, and then it uses Cash, Debt, and Stock to fund the acquisition.
All the Seller’s shares disappear, and the Buyer gets all the Seller’s Assets and Liabilities, plus all
its off-Balance Sheet items.
But in real life, there are different deal structures as well as different methods of executing
deals.
Two deal-execution methods are mergers and tender offers.
In a merger, the Buyer’s Board of Directors and the Seller’s Board agree on a price, negotiate
the purchase agreement, and announce the deal, and then shareholders vote to approve or
reject the transaction.
In a tender offer, the Buyer proposes an offer price directly to the Seller’s shareholders, and
each shareholder decides whether or not to sell their shares for that price.
Decades ago, Buyers used tender offers mostly in hostile takeovers, but now they use them
mostly for speed.
It’s faster to execute a tender offer because the Buyer doesn’t need to negotiate a long
agreement with the Seller, but the control premium also tends to be higher because the Buyer
must convince individual shareholders to sell.
The Buyer is not obligated to pay for the shares until a set number have been tendered, which
reduces the risk of paying for some shares but not completing the deal.
Mergers are more common when the Seller initiates the M&A process and when the Buyer
wants to negotiate for a lower price, even if it means a more time-consuming deal.
Stock vs. Asset vs. 338(h)(10) Deals
Just like there are multiple ways to negotiate a deal, there are also multiple ways to structure a
deal.
The main two methods are known as Stock Purchases and Asset Purchases.
These terms do NOT refer to the form of consideration, so “Stock Purchase” does NOT mean
that the Buyer issues new shares to complete the deal.
In a Stock Purchase, the Buyer purchases all the Seller’s shares outstanding and gets all its
Assets, Liabilities, and off-Balance Sheet items.
In an Asset Purchase, the Buyer purchases only selected Assets of the Seller and assumes only
selected Liabilities. And it gets only the off-Balance Sheet items listed in the agreement.
100% Cash deals, 100% Debt deals, and 100% Stock deals could all be structured as either Stock
Purchases or Asset Purchases.
These two structures exist worldwide and work similarly under U.S. GAAP and IFRS, but specific
details, such as the tax treatments, may differ from country to country.
Asset Purchases are far more common for divestitures and acquisitions of smaller, private
companies; they’re difficult to use when acquiring large, public Sellers.
Buyers tend to favor Asset Purchases because:

1) They let Buyers pick and choose exactly what they get in deals, which reduces risk; and
2) Assets are written up for both Book and Tax purposes, meaning that Buyers can deduct the
D&A on Asset Write-Ups for cash-tax purposes and that no new DTL is created.
There are other differences as well: for example, Goodwill amortizes for tax purposes, and this
Goodwill Amortization is cash-tax-deductible in Asset Purchases.
But in Stock Purchases, Goodwill doesn’t amortize at all, and the new D&A created in the deal is
not cash-tax deductible.
One disadvantage of an Asset Purchase – for the Seller – is that the Seller’s shareholders must
pay taxes on the purchase price plus the Gains on its Net Assets.
And one disadvantage for the Buyer is that the Seller’s Net Operating Losses (NOLs) are written
down 100% and may not be used by the Buyer after the deal closes.
Sellers tend to prefer Stock Purchases because:
1) Their shareholders pay taxes based on only the Purchase Price, which means the taxes
are almost always lower.
2) There’s less post-transaction risk because the Buyer acquires everything the Seller has
(Assets, Liabilities, and off-Balance Sheet items), so any issues with those items become
the Buyer’s responsibility.
3) Stock Purchases are faster to execute than Asset Purchases because the Buyer and
Seller don’t need to specify the treatment of every single Asset and Liability.
To compromise, Buyers and Sellers can use a 338(h)(10) election to treat a Stock Purchase like
an Asset Purchase.
The 338(h)(10) election is specific to the U.S. tax code, so you don’t need to know about it if
you’re in another region; however, similar structures may exist in other countries.
In a 338(h)(10) deal, the Buyer purchases all the Seller’s shares and gets all its Assets, Liabilities,
and off-Balance Sheet items, but taxes work the same as they do in an Asset deal.
So, the new D&A on Asset Write-Ups is deductible for cash-tax purposes, no new DTL gets
created, and Goodwill, Other Intangible Assets, and NOLs follow the same treatment as in Asset
Purchases.
338(h)(10) deals have additional requirements as well; for example, the Buyer must be a C
corporation, the Seller must be domestic, and only certain types of Sellers qualify.
Here’s a summary:
Structure: Stock Purchase Asset Purchase 338(h)(10) Election

Buyer Acquires: Only Certain All Assets and
All Assets and Liabilities
Assets and Liabilities + Off-
+ Off-Balance Sheet
Liabilities of the Balance Sheet
Items
Seller Items
Seller Pays Taxes Purchase Price PLUS (Value Assigned to
On: Purchase Price Net Assets in Deal – Book Value of Net
Assets)
Assets Written Up
on Tax Balance No Yes
Sheet?
Can Buyer Deduct
New D&A on Asset
No Yes
Write-Ups for Cash-
Tax Purposes?
Creates New DTL? Yes No
Goodwill & Other Not amortized for tax Amortization is tax-deductible;
Intangibles: purposes and not cash- amortized over 15 years for cash-tax
tax-deductible purposes
Allowable Annual Equity Purchase Price *
NOL Usage: Maximum of Past 3
None
Months’ Adjusted Long-
Term Rates
Off-Balance Sheet MAX(0, NOL Balance –
NOL Write-Down: Allowable Annual Usage
100%
* # Years Until
Expiration)
Write-Down of NOL MAX(0, NOL Portion –
Portion of DTA: Allowable Annual Usage
100%
* Buyer’s Tax Rate * #
Years Until Expiration)
Most Common Public companies and Private companies, divestitures, and
Sellers: large private companies distressed public companies
Favored By: Sellers Buyers Both
Net Operating Losses (NOLs) in Different Deal Structures

We summarized the treatment of the Seller’s NOLs in the table above, but it’s worth explaining
in more detail with a few sample numbers here.
In Asset Purchases and 338(h)(10) deals, the Seller’s NOLs are written down 100% and cannot
be used at all post-transaction. In Stock Purchases, the Buyer can use some amount of the
Seller’s NOLs each year, but it may have to write down a portion of the total balance.
Let’s say the Seller has $100 million in off-Balance Sheet NOLs, which are represented as $25
million within its Deferred Tax Asset since it has a 25% tax rate.
The Buyer pays an Equity Purchase Price of $1 billion for the Seller.
In an Asset Purchase or 338(h)(10) deal, the Buyer writes down the $25 million of NOLs within
the DTA and the entire $100 million off-BS number, and the Buyer cannot utilize any of the
Seller’s NOLs in the future.
But in a Stock Purchase, this full write-down does not happen, and the Buyer can use a limited
amount of NOLs annually.
For U.S.-based Buyers, the following rule applies:
• Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past 3 Months'
Adjusted Long-Term Rates
The rules vary in different countries, and you can find them with a quick Google search in most
cases.
These “Adjusted Long-Term Rates” are linked to prevailing yields on government bonds in the
Buyer’s country.
So, if the past three months had “Adjusted Long-Term Rates” of 1.2%, 1.0%, and 1.5%, the
Buyer could apply a maximum of $1 billion * 1.5% = $15 million in NOLs each year.
In this case, therefore, the Buyer could use the Seller’s $100 million NOL balance over ~7 years
and utilize the entire balance to reduce its Cash Taxes.
No write-down is required because the Buyer can use the Seller’s entire NOL balance before it
expires.
As the Buyer uses these NOLs, the off-Balance Sheet figure will decline by $15 million per year,
and the portion within the DTA will decline by $15 million * 25% = $3.75 million per year.
By contrast, if these NOLs were set to expire in 3 years, the Buyer could not use the entire
balance.
In that case, the Buyer could use only $45 million of the NOLs, which corresponds to $11.25
million of the DTA balance.
So, the Buyer, in the initial transaction, would have to write down $55 million of the off-BS NOL
balance and $13.75 million of the DTA balance.
After that initial write-down, the off-Balance Sheet NOLs would decrease by $15 million per
year, and the DTA would decrease by $3.75 million per year.
To summarize, here’s an example of how everything on the Income Statement and Cash Flow
Statement differs in a Stock Purchase vs. an Asset or 338(h)(10) deal:
Stock Purchase – Book vs. Cash Taxes Asset / 338(h)(10) Purchase – Book vs. Cash Taxes
In this example, the combined company’s Cash balance finishes at a higher level in the Asset or
338(h)(10) deal because the Buyer can deduct the new D&A for cash-tax purposes.
The Seller’s NOLs are written down, so the Buyer loses that benefit, but the tax advantages of
the D&A treatment outweigh this loss.
If the Seller has a huge NOL balance, both parties might prefer a Stock Purchase, but if the
NOL balance is smaller or non-existent, an Asset Purchase or 338(h)(10) election might offer
more benefits for the Buyer.
The exact structure rarely makes a big difference in a merger model unless the deal is unusual
(e.g., the Seller has a massive amount of NOLs, or the Seller’s Assets are written up by a huge
percentage).
But it’s still good to be familiar with these deal structures because they could come up in more
advanced interviews and on the job.
Acquisitions for Less Than 100% of Companies
A Buyer doesn’t “have to” acquire 100% of a Seller: it could acquire 10%, 40%, 70%, or any
other percentage.
Most interview questions and case studies relate to 100% acquisitions, so we have focused on
them in this guide.
Acquisitions for less than 100% of other companies are treated differently depending on
whether the percentage acquired is over 50% or under 50%.
We covered this topic extensively in the More Advanced Accounting guide and the
corresponding lessons, so please refer to that – we’re not going to repeat it here.
In short, if the Buyer acquires less than 50% of the Seller, an “Equity Investment” or “Associate
Company” is created, and the financial statements are not consolidated.
There are a few small adjustments for Percentage Owned * Seller’s Net Income and Percentage
Owned * Seller’s Dividends, but nothing else.
If the Buyer acquires more than 50% but less than 100% of the Seller, the financial statements
are consolidated 100%, new Goodwill is created, and a Noncontrolling Interest on the L&E side
is created.
This Noncontrolling Interest represents the portion of the Seller that the Buyer does not own,
i.e., Seller’s Market Value at Time of Deal * (1 – Buyer’s Ownership Percentage in Seller ).
It changes over time based on the Seller’s Net Income and Dividends and any changes in the
Buyer’s ownership of the Seller.
For more details, including screenshots and full walk-throughs of the entire process in both
cases, please see the More Advanced Accounting guide.
Private Companies
The mechanics of merger models are similar regardless of whether the Buyer, Seller, or both,
are private.
You still allocate the Purchase Price, create a Sources & Uses schedule, make the same Balance
Sheet adjustments, combine the Income Statements, create a Combined Cash Flow Statement,
and so on.
The main differences relate to the transaction assumptions and the focus of the analysis:
• Purchase Price: It’s based on a multiple of EBITDA, Revenue, or another financial metric
rather than a share-price premium. You then back into the Purchase Equity Value from
the Purchase Enterprise Value.
• Form of Consideration: If the Buyer is private, it probably can’t issue Stock to do the
deal. Exceptions apply for certain private-to-private deals and large and well-known
private Buyers (e.g., Ikea or Cargill).
Also, Earn-Outs are common in acquisitions of private Sellers, while they’re rare for
public Sellers.
Sometimes the Seller must maintain a targeted level of Working Capital as well, and the
Buyer may end up paying more (or less) based on the actual vs. targeted Working
Capital.
• Deal Type: “Cash-Free, Debt-Free” deals are common for private Sellers. This term
means that the Seller’s existing Cash and Debt both go to 0 immediately after the deal
closes, which means that the Sources & Uses schedule is based on the Purchase
Enterprise Value rather than the Purchase Equity Value.
See the section on Cash-Free, Debt-Free Deals for more.
• Deal Structure: The Buyer is more likely to use an Asset Purchase or 338(h)(10) election
for a private Seller because there’s more risk related to the company’s Assets, Liabilities,
and off-Balance Sheet items.
• Meaningful Analysis: EPS accretion/dilution is the same if the deal involves a public
Buyer and private Seller, but it’s less meaningful if the Buyer is private.
It’s not that private companies “don’t have EPS” – all companies earn Net Income and
have shares outstanding, so all companies have EPS figures.

It’s just that private companies care less about EPS than public companies do.
You’ll focus more on the Seller's valuation and other methods to evaluate the deal, such
as the Contribution Analysis or the IRR vs. Discount Rate.
• Accounting Adjustments: Before you can value a private Seller or build a merger model
for it, you may have to adjust its financial statements and make sure they conform to
U.S. GAAP or IFRS standards.
But this step depends heavily on the type of Seller: if it has $1 billion in revenue and
thousands of employees, its financial statements should already be in good shape.
But if it’s a barbershop with four employees, you’ll need to sharpen your pencil.
Calendarization and Stub Periods
We’ve been assuming that M&A deals always close at the end of the Buyer’s fiscal year and that
Buyers and Sellers have the same fiscal years (e.g., ones that end on December 31st).
In real life, both assumptions are often false:
• The Buyer’s fiscal year might end on June 30th, but the Seller’s fiscal year might end on
December 31st.
• The deal might close on September 30th or August 14th or another random date in
between those two.
The first problem is easier to deal with: you always use the Buyer’s fiscal year in merger
models.
If the Buyer’s fiscal year ends on June 30th but the Seller’s ends on December 31st, you’d take
the results from the last six months of the Seller’s fiscal year and add them to the ones from the
first six months of its next year.
You would then combine those results with those from the Buyer’s fiscal year since they cover
the same period (January 1st – December 31st).
You build many merger models on a quarterly basis, so in practice, this may not be too difficult:
add up the quarters such that the calendar periods match up.
The second problem with irregular closing dates is more annoying to deal with.

If the deal closes between fiscal years or quarters, you have to create a combined stub period
in the model.
For example, if the deal closes on August 14th, and you’re building a quarterly model, you’d
have to create a stub period that shows the Buyer and Seller’s results from August 14th to
September 30th.
It will be almost impossible to get results for that exact period because you normally project
entire quarters, so you might just divide the projected results for the July 1st – September 30th
quarter by 2.
Then, the first “full” combined quarter will run from October 1st to December 31st.
Combining stub Income Statements and Cash Flow Statements doesn’t take too much effort,
but it’s annoying to project Balance Sheets for these types of irregular dates.
You can’t just divide items by a simple integer because the Balance Sheet is a snapshot in time.
So, you’d have to take the Balance Sheet from June 30th, “roll it forward” based on the IS and
CFS results between July 1st and August 14th, and link the Balance Sheet items to that.
It’s a tedious process that adds little value, and you could simplify, use quarterly end dates, and
get similar results.
Also, even if the acquisition closes on an irregular date, the Buyer, Seller, and investors tend to
focus on the first full year of the combined results.
Return to Top.

Interview Questions
Merger models and M&A deals can get complex, but most interview questions on these topics
are simple and relate to the rationale for deals and the basic calculations.
Interviewers are unlikely to ask about the more advanced topics, such as the treatment of NOLs
in M&A deals. They’re far more likely to ask tricky questions about simpler subjects, such as
how Enterprise Value and valuation multiples change after an acquisition.
Therefore, the interview questions in this guide reflect that reality. You need to know the
fundamentals very well because the “difficult questions” relate to the core topics rather than
the more advanced points.
M&A Concepts and Overview
Questions about accretion/dilution and the calculations in M&A deals could come up, but
you’re also likely to get questions about the concepts and companies’ motivations for acquiring
other companies.
If you don’t understand these questions, your interviewers will never even reach the more
advanced topics.
1. Why might one company want to buy another company?

One company might want to buy another company if it believes it will be better off after the
acquisition takes place. For example:
• The Seller’s asking price is less than its Implied Value, i.e., the Present Value of its
future cash flows.
• The expected IRR from the acquisition exceeds the Buyer’s Discount Rate.
Buyers often acquire Sellers to save money via consolidation and economies of scale, to expand
geographically or gain market share, to acquire new customers or distribution channels, and to
expand their products and services.
Synergies, or the potential to combine and reduce expenses through departmental
consolidation or to boost revenue through additional sales, also explain many deals.
Deals may also be motivated by competition, office politics, and ego.

2. How can you analyze an M&A deal and determine whether or not it makes sense?
The qualitative analysis depends on the factors above: could the deal help the company expand
geographies, products, or customer bases, give it more intellectual property, or improve its
team?
The quantitative analysis might include a valuation of the Seller to see if it’s undervalued, as
well as a comparison of the expected IRR to the Buyer’s Discount Rate.
Finally, EPS accretion/dilution is important in most deals because Buyers prefer to execute
accretive deals, i.e., ones that increase their Earnings per Share (EPS). The Board of Directors is
more likely to approve of accretive deals, and investors also like accretive deals more than
dilutive ones.
3. Walk me through a merger model (accretion/dilution analysis).

In a merger model, you start by projecting the financial statements of the Buyer and Seller.
Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the
deal. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate
the true cost of the acquisition and its after-effects.
Then, you combine the Balance Sheets of the Buyer and Seller, reflecting the Cash, Debt, and
Stock used, new Goodwill created, and any write-ups and write-downs. You then combine the
Income Statements, reflecting the Foregone Interest on Cash, Interest Paid on New Debt, and
Synergies. If the New Debt balance changes over time, the Interest Paid on New Debt should
reflect that.
The Combined Net Income equals the Combined Pre-Tax Income times (1 – Buyer’s Tax Rate),
and to get the Combined EPS, you divide that number by (the Buyer’s Existing Share Count +
New Shares Issued in the Deal).
You calculate the accretion/dilution by taking the Combined EPS, dividing it by the Buyer’s
standalone EPS, and subtracting 1 to make it a percentage.
4. Why might an M&A deal be accretive or dilutive?

A deal is accretive if the extra Pre-Tax Income from a Seller exceeds the cost of the acquisition
in the form of Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer only
$70 in additional Interest Expense, and the Buyer doesn’t issue any new shares, the deal will be
accretive because the Buyer’s Earnings per Share (EPS) will increase.
A deal will be dilutive if the opposite happens. For example, if the Seller contributes $100 in
Pre-Tax Income, but the deal costs the Buyer $130 in additional Interest Expense, and its share
count remains the same, its EPS will decrease.
5. How can you tell whether an M&A deal will be accretive or dilutive?
You compare the Weighted Cost of Acquisition to the Seller’s Yield at its Purchase Price.
• Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate)

• Cost of Debt = Interest Rate on New Debt * (1 – Buyer’s Tax Rate)
• Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e., Net Income / Equity Value.
• Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase
Equity Value.
Weighted Cost of Acquisition = % Cash Used * Cost of Cash + % Debt Used * Cost of Debt + %
Stock Used * Cost of Stock.
If the Weighted Cost is less than the Seller’s Yield, the deal will be accretive; if the Weighted
Cost is greater than the Seller’s Yield, the deal will be dilutive.
6. Why do you focus so much on EPS in M&A deals?

Because it’s the only easy-to-calculate metric that also captures the FULL impact of the deal –
the Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.
Although metrics such as EBITDA and Unlevered FCF more accurately approximate cash flow
and the value of the company’s core business, they don’t reflect the deal’s full impact because
they exclude Net Interest and the effect of new shares.
7. How do you determine the Purchase Price in an M&A deal?

If the Seller is public, you assume a premium to the Seller’s current share price based on the
average premiums for similar deals in the market (usually between 10% and 30%). You can then
use the DCF, Public Comps, and other valuation methodologies to cross-check this figure.

The Purchase Price for private Sellers is based on the standard valuation methodologies, and
you usually link it to a multiple of EBITDA, EBIT, or Revenue since private companies don’t have
easy-to-determine share prices.
If the Buyer expects to realize significant Synergies, it is often willing to pay a higher premium
for the Seller because the Present Value of the Synergies might exceed this premium to the
Seller’s current market value.
8. What are the advantages and disadvantages of each purchase method (Cash, Debt, and
Stock) in M&A deals?
Cash tends to be the cheapest option; most companies earn little Interest Income on it, so they
don’t lose much by using it to fund deals. It’s also the fastest and easiest to close Cash-based
deals.
The downside is that using Cash limits the Buyer’s flexibility if it needs the funds for something
else soon.
Debt is normally cheaper than Stock but more expensive than Cash, and deals involving Debt
take more time to close because of the need to market the new Debt to investors.
Debt also limits the Buyer’s flexibility because additional Debt makes future Debt issuances
more difficult and expensive.
Stock tends to be the most expensive option, though it can sometimes be the cheapest (on
paper) if the Buyer trades at an extremely high P / E multiple.
It dilutes the Buyer’s existing investors, but it also prevents the Buyer from paying an additional
cash expense for the deal.
In some cases, the Buyer can also issue Stock more quickly than it can issue Debt.
Finally, the Seller's tax implications are different: its shareholders are not taxed immediately if
they receive shares from the Buyer, but they do pay taxes immediately if they receive cash
proceeds for their shares (corresponding to Cash and Debt).
9. How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?
Since Cash is cheapest for most Acquirers, they’ll use all the Cash they can before moving to the
other funding sources. So, you might assume that the Cash Available equals the Acquirer’s

current Cash balance minus its Minimum Cash balance. You may also include the Target’s Cash
balance if it is significant.
After that, Debt tends to be the next cheapest option. An Acquirer might be able to raise Debt
up to the level where its Debt / EBITDA and EBITDA / Interest ratios remain in-line with those of
peer companies.
So, if it’s levered at 2x EBITDA now, and similar companies have 4-5x Debt / EBITDA, it might be
able to raise Debt up to that level. Again, you may also factor in the Target’s Debt and EBITDA if
they are significant.
Finally, there’s no strict limit on the amount of Stock an Acquirer might issue, but few
companies would issue enough to give up control of the company, and some Acquirers will
issue Stock only up to the point at which the deal turns dilutive.
10. Which purchase method does a Seller prefer in an M&A deal?

The Seller has to balance taxes with the certainty of payment and potential future upside.
To a Seller, Debt and Cash are similar because they mean immediate payment, but also
immediate capital gains taxes for the shareholders and no potential upside if the Buyer’s share
price increases. But there’s also no risk if the Buyer’s share price decreases.
Stock is more of a gamble because the Seller could end up with a higher price if the Buyer’s
share price increases, but it could also get a lower price if the Buyer’s share price drops. The
Seller’s shareholders also avoid immediate taxes with Stock since they pay taxes only when
they sell their shares.
So, the preferred method depends on the Seller’s confidence in the Buyer: Cash and Debt are
better with higher uncertainty, while Stock may be better with large, stable Buyers.
11. What’s the impact of each purchase method in an M&A deal, and how do you estimate
the Cost of each method?
The Foregone Interest on Cash represents the Cost of Cash. The Acquirer loses future projected
Interest Income by using Cash to fund a deal. The Interest Expense on New Debt represents the
Cost of Debt.
For both of these, you take the interest rate and multiply by (1 – Acquirer’s Tax Rate) to
estimate the after-tax costs.

The Cost of Stock is represented by the additional shares created in a deal and how those
shares reduce the Combined Company’s EPS. It’s equal to the reciprocal of the Acquirer’s P / E
Multiple, i.e., Acquirer’s Net Income / Acquirer’s Equity Value.
12. Isn’t the Foregone Interest on Cash just an “opportunity cost”? Why do you include it?
No, it’s not just an “opportunity cost” because the Acquirer’s projected Pre-Tax Income already
includes the Interest Income that the company expects to earn on its Cash balance!
So, if an Acquirer expects $90 in Operating Income and $10 in Interest Income for a total of
$100 in Pre-Tax Income, its projected Pre-Tax Income will fall if it uses Cash to fund the deal.
13. Isn’t it a contradiction to calculate the Cost of Stock by using the reciprocal of the
Acquirer’s P / E multiple? What about the Risk-Free Rate, Beta, and the Equity Risk Premium?
It’s not a contradiction; it’s just a different way of measuring the Cost of Equity.
The “Reciprocal of the P / E Multiple” method measures the Cost of Equity in terms of EPS
impact, while the CAPM method measures it based on the stock’s expected annualized returns.
Neither method is “correct” because you use them in different contexts.
In most cases, regardless of the method you use, Stock will be the most expensive funding
source for a company.
14. Why might an Acquirer choose to use Stock or Debt even if it could pay for the Target
with Cash?
The Acquirer might not necessarily draw on its entire Cash balance if, for example, much of the
Cash is in overseas subsidiaries or otherwise restricted.
Also, the Acquirer might be preserving its Cash for a future expansion plan or Debt maturity.
Finally, if the Acquirer is trading at high multiples, such as a 100x P / E multiple, it might be
cheaper to use Stock to fund the deal.
15. Are there cases where EPS accretion/dilution is NOT important? What else could you look
at?

Yes, there are many cases where EPS accretion/dilution is less important or irrelevant.
For example, if the Buyer is private, or it already has negative EPS as a standalone entity, it
won't care about whether the deal is accretive or dilutive.
It also makes little difference if the Buyer is far bigger than the Seller (e.g., 10x – 100x its size).
Besides EPS accretion/dilution, you can also analyze the deal's qualitative merits, compare the
IRR to the Discount Rate, and value the Seller + Synergies and compare that to the Equity
Purchase Price.
Finally, you can create a Contribution Analysis to look at how much the Buyer and Seller
"contribute" to each financial metric and then compare the contribution percentages to their
respective ownership percentages.
Value Creation Analysis, to determine how the Buyer’s share price will change after the deal
closes, may also be useful in certain contexts, such as if the Buyer + Seller together will
resemble a larger, more valuable public company in the market.
16. How does a merger differ from an acquisition?

There’s no mechanical difference in a merger model or the other analyses because there’s
always a Buyer and Seller in any M&A deal.
The difference is that in a merger, the companies are closer in size, while the Buyer is
significantly larger than the Seller in an acquisition.
100% Stock or majority-Stock deals are also more common in mergers because similarly sized
companies can rarely use Cash or Debt to acquire each other.
You’ll also place more weight on the Contribution Analysis and Value Creation Analysis methods
in mergers because 100% Stock deals are so common.
17. What are the main PROBLEMS with merger models?

First, EPS is not always a meaningful metric. Second, Net Income and cash flow are quite
different, so EPS-accretive deals might be horrible from a cash-flow perspective.
Third, merger models don’t capture the true risk inherent in M&A deals. 100% Cash deals
almost always look accretive, even though the integration process might go wrong, legal issues
might arise, and customers or shareholders might revolt.

Fourth, merger models often fail to consider what might happen if the Buyer or Seller’s share
prices change significantly before the deal closes – especially in 100% Stock deals.
Finally, merger models don’t capture the qualitative aspects of a deal, such as cultural fit or
management’s ability to work together.
Return to Top.
Accretion/Dilution Calculations
Questions about accretion/dilution math can be surprisingly tricky.

They’re also far more common than questions about advanced topics because all bankers are
familiar with accretion/dilution, but not as many know the specifics of 338(h)(10) deals.
1. Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Will the deal be accretive?
You can’t tell unless you know that it’s a 100% Stock deal.
If it is a 100% Stock deal, then it will be accretive because the Buyer’s P / E is higher than the
Seller’s, indicating that the Buyer’s Cost of Acquisition (1 / 25, or 4%) is less than the Seller’s
Yield (1 / 15, or 6.7%).
2. Walk me through the full math for the deal now.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net
Income is $10.
It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of
$10 as well. Assume the same tax rates for both companies. How accretive is this deal?
Company A’s EPS is $10 / 10 = $1.00.
To do the deal, Company A must issue 6 new shares since $150 / $25.00 = 6, so the Combined
Share Count is 10 + 6 = 16.
Since no Cash or Debt were used and the tax rates are the same, the Combined Net Income =
Company A Net Income + Company B Net Income = $10 + $10 = $20.

Therefore, the Combined EPS is $20 / 16 = $1.25, so it’s accretive by 25%.
3. Company A now uses Debt with an Interest Rate of 8% to acquire Company B. Is the deal
still accretive? At what interest rate does it change from accretive to dilutive?
The Weighted Cost of Acquisition is 8% * (1 – 25%), or 6%, so the deal is still accretive because
that Cost is less than the Seller’s Yield of 6.7%.
For the deal to turn dilutive, the After-Tax Cost of Debt would have to exceed 6.7%. Since 6.7%
/ (1 – 25%) = 8.9%, the deal would turn dilutive at an interest rate >= 8.9%.
4. What are the Combined Equity Value and Enterprise Value in this deal?
Assume that Equity Value = Enterprise Value for both the Buyer and Seller and use 100%
Stock funding.
Combined Equity Value = Buyer’s Equity Value + Market Value of Stock Issued in the Deal =
$250 + $150 = $400.
Combined Enterprise Value = Buyer’s Enterprise Value + Purchase Enterprise Value of Seller =
$250 + $150 = $400.
5. How do the Combined TEV / EBITDA and P / E multiples change if the deal financing
method changes?
The Combined TEV / EBITDA stays the same regardless of the financing method, but the
Combined P / E multiple will change based on the Stock issued and the Cash and Debt used.
The Stock issued affects the Combined Equity Value, and the Cash and Debt used affect the
Combined Net Income because of the Foregone Interest on Cash and Interest Paid on New
Debt.
6. Without doing any math, what range would you expect for the Combined P / E multiple?
The Combined P / E multiple should be between the Buyer’s P / E multiple and the Seller’s
Purchase P / E multiple, so between 25x and 15x here.

Since Company A is larger than Company B, we would expect the Combined P / E multiple to be
closer to Company A’s multiple of 25x.
7. Now assume that Company A is twice as big financially, so its Equity Value is $500, and its
Net Income is $20. Will a 100% Stock deal be more or less accretive?
The deal will be less accretive.
The intuition is that Company A’s P / E remains the same, but it’s significantly bigger, so the
higher-yielding Company B provides less of a boost to Company A’s EPS.
The Combined P / E multiple will still be between 15x and 25x, but it will be even closer to 25x
because Company A has a greater weighting in the combined company.
8. Now, do the math. What is the accretion/dilution in a 100% Stock deal with a $150
Purchase Equity Value for Company B? Feel free to write down the numbers.
The Buyer previously represented $250 / $400, or 63%, of the total company, but now it
represents $500 / $650, or 77%, of the total company, so we’d expect the accretion to fall by
around 10-15%.
Company A’s share price is now $50.00, it still has 10 shares outstanding, and its Equity Value is
$500. Its EPS is $20 / 10 = $2.00.
To acquire Company B, Company A must issue 3 additional shares since $150 / $50.00 = 3.
Since both companies have the same tax rate and no Cash or Debt was used, you can add the
Net Income figures: Combined Net Income = $20 + $10 = $30.
The new share count is 10 + 3 = 13, and $30 / 13 = $2.31. This is about 15% higher than the
Buyer’s standalone EPS ($0.15 is 15% of $1.00, and $0.30 is 15% of $2.00).
So, it’s about 10% lower than the 25% accretion when Company A was smaller.
9. Company A has a P / E of 10x, a Debt Interest Rate of 8%, a Cash Interest Rate of 4%, and a
Tax Rate of 25%.
It wants to acquire Company B at a purchase P / E multiple of 16x using 1/3 Stock, 1/3 Debt,
and 1/3 Cash. Will the deal be accretive?

Company A’s After-Tax Cost of Stock is 1/10, or 10%, its After-Tax Cost of Debt is 8% * (1 – 25%)
= 6%, and its After-Tax Cost of Cash is 4% * (1 – 25%) = 3%.
Company B’s Yield is 1 / 16, or 6.25% (mental math: 1 / 4 = 25%, and 1 / 8 = 12.5%, so 1 / 16 =
6.25%).
The Weighted Cost of Acquisition is 10% * 1/3 + 6% * 1/3 + 3% * 1/3 = 3.33% + 2% + 1% =
6.33%.
Since the Weighted Cost is slightly above Company B’s Yield, the deal will be dilutive.
10. Company A acquires Company B using 100% Debt. Company B has a purchase P / E
multiple of 12x, and Company A has a P / E multiple of 15x.
What interest rate on Debt is required to make the deal dilutive?
Company B’s Yield is 1 / 12, or 8.3%, so the After-Tax Cost of Debt must be above 8.3% for the
deal to be dilutive.
Assuming the company has a tax rate of 25%, 8.3% / (1 – 25%) = 11.1%, which you can round to
“Around 11%.”
That is a high interest rate for most companies, so a 100% Debt deal would almost certainly be
accretive.
11. Company A has an Equity Value of $1,000 and a Net Income of $100. Company B has a
Purchase Equity Value of $2,000 and a Net Income of $50.
For a 100% Stock deal to be accretive, how much in Synergies must be realized?
Company A’s P / E is $1,000 / $100 = 10x, so its Cost of Stock is 10%. Company B’s P / E is
$2,000 / $50 = 40x, so its Yield is 1 / 40, or 2.5%.
Therefore, without Synergies, this deal would be highly dilutive.
For the deal to turn accretive, Company B’s Yield must exceed 10%. That means that its
Purchase P / E multiple must be below 10x, which means its Net Income must be above $200.
So, there must be $150 in After-Tax Synergies for this deal to be accretive. At a 25% tax rate,
that means at least $200 in Pre-Tax Synergies.

12. An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million,
Net Income of $50 million, and a Debt / EBITDA of 2x. Peer companies have a median Debt /
EBITDA of 4x.
It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller
has a Net Income of $30 million, EBITDA of $50 million, and no Debt.
What’s the best way to fund this deal? Use the Combined EBITDA figures in the calculations.
The Acquirer would prefer to use its Cash balance to do this deal, but $50 million is likely close
to the minimum Cash balance for a company of this size, so Cash financing is unlikely.
The Acquirer’s P / E multiple is 20x, so its Cost of Stock is 1 / 20, or 5%.
That’s a fairly low Cost of Stock, so there’s a chance that the company’s After-Tax Cost of Debt
might be higher.
However, there’s no information on the Cost of Debt, so our best guess is that Debt is still
cheaper than Stock.
The company could afford to boost its Debt / EBITDA from 2x to 4x since peer companies have
leverage in that range.
The Combined Company has $150 million in EBITDA, and 4 * $150 million = $600 million.
The Acquirer has $200 million in Debt, and the Target has no Debt, so the Acquirer could afford
to issue $400 million in new Debt to fund the deal.
The remaining $100 million could be issued in Stock. If the Acquirer used part of its Cash
balance or the Target’s Cash balance, the $100 million Stock portion would be reduced.
13. An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50
million, Net Income of $25 million, and Debt / EBITDA of 3x.
Similar companies in the market have Debt / EBITDA ratios of 5x.
What’s the BIGGEST acquisition this company might be able to complete?
You can’t answer this question precisely without knowing the Target’s Net Income and EBITDA,
but you can make a rough estimate.

The Acquirer couldn’t use its entire Cash balance to fund a deal, but it might be able to use a
substantial portion of it, such as $50 million, since its Cash balance would then equal its annual
EBITDA.
It could afford to use leverage up to 5x EBITDA, which means that it could use $100 million in
additional Debt to fund a deal (since it currently has $150 million of Debt, or 3 * $50 million).
That number might change based on the Target’s Debt and EBITDA as well.
There’s no limit on how much Stock the company could issue, but it would be unlikely to issue
so much that it lost control of the company.
Therefore, the likely maximum is around $500 million of Stock, and a more realistic level might
be about half its Current Equity Value ($250 million), or whatever amount turns the deal
dilutive.
So, a reasonable answer might be: “In theory, the Acquirer might be able to fund a deal for up
to $650 million. But unless it wanted to issue a massive amount of Stock, the maximum realistic
level would be closer to $400 to $650 million.”
Return to Top.
Equity Value, Enterprise Value, and Multiples in M&A Deals
Questions about Equity Value and Enterprise Value in M&A deals are less common than ones
on accretion/dilution, but they’re still important because they often act as “add-on” questions.
If you get the accretion/dilution question correct, the interviewer might follow up and ask you
to describe what happens to Equity Value, Enterprise Value, and valuation multiples.
1. An Acquirer with an Equity Value of $500 million and Enterprise Value of $600 million buys
another company for a Purchase Equity Value of $100 million and a Purchase Enterprise Value
of $150 million.
What are the Combined Equity Value and Enterprise Value?
The Combined Enterprise Value equals the Enterprise Value of the Buyer plus the Purchase
Enterprise Value of the Seller, so it’s $600 million + $150 million = $750 million.
You can’t determine the Combined Equity Value because it depends on the deal financing:
Combined Equity Value = Acquirer’s Equity Value + Market Value of Stock Issued in Deal.

If it’s a 100% Stock deal, the Combined Equity Value will be $500 million + $100 million = $600
million, but if it’s 100% Cash or Debt, the Combined Equity Value = $500 million.
If the % Stock is between 0% and 100%, the Combined Equity Value will be between $500 and
$600 million.
2. How do the Combined Equity Value and Enterprise Value change based on the deal
financing?
The Combined Enterprise Value is not affected by the deal financing: it’s always equal to the
Buyer’s Enterprise Value plus the Purchase Enterprise Value of the Seller.
The Combined Equity Value equals the Buyer’s Equity Value plus the Market Value of Stock
Issued in the Deal, which could range from $0 up to the Purchase Equity Value of Seller.
So, in a 100% Stock deal, the Combined Equity Value = Buyer’s Equity Value + Purchase Equity
Value of Seller.
3. Wait, you’re saying that in a 100% Cash or Debt deal, the Seller’s Equity Value just
“disappears.” How is that possible?
The Seller’s Equity Value doesn’t “disappear” – it’s transformed into the Cash used or Debt
issued by the Buyer in the deal.
The Combined Enterprise Value calculation demonstrates this point: both companies’
Enterprise Values still exist after the deal, so no value is “lost” along the way.
4. Wait a minute, you’re also saying that the purchase premium the Acquirer pays for the
Target lasts after the deal closes? How is that possible?
The purchase premium does not necessarily “last” because it depends on the market’s reaction
to the deal.
If the market believes the Target's premium was justified, then the rules about Combined
Equity Value and Combined Enterprise Value will hold up.
However, if the market believes the Acquirer overpaid for the Target, the Acquirer’s share price
will fall to reflect the amount by which it overpaid – whether that means the entire purchase
premium, part of the premium, or more than the premium.

5. Let’s say an Acquirer has an Equity Value of $500 million and an Enterprise Value of $600
million. The Acquirer has 100 million shares outstanding at $5.00 per share.
The Target has an Equity Value of $100 million and an Enterprise Value of $150 million, and
the Acquirer pays a 30% premium to acquire the Target in a 100% Stock deal.
A few months after the deal is announced, the market loses faith in the deal and believes the
30% premium is no longer justified.
What happens to the Combined Equity Value and Enterprise Value immediately after the deal
is announced and several months after, when the market loses faith in the 30% premium?
Immediately after, Combined Equity Value = $500 million + $130 million = $630 million since it’s
a 100% Stock deal.
Combined Enterprise Value = $600 million + $180 million = $780 million.
When the market loses faith in this 30% premium, the Acquirer’s share price will fall, such that
its Eq Val and TEV both fall by $30 million.
So, its share price will fall to $4.70, and the Combined Equity Value will decrease to $600 million
because the Acquirer’s Equity Value is now only $470 million.
Combined Enterprise Value = $570 million + $180 million = $750 million, so it is also down by
this $30 million premium.
6. How does that last answer change if the Acquirer uses 100% Debt or Cash instead?
The Combined Enterprise Value changes the same way in both steps: initially, it’s $780 million,
but then it falls to $750 million as the Acquirer’s share price falls.
The Combined Equity Value is initially only $500 million in a 100% Debt or 100% Cash deal
because no Stock is issued. When the Acquirer’s share price falls, the Combined Equity Value
drops to $470 million.
7. An Acquirer with an Equity Value of $500 million and an Enterprise Value of $600 million
has Net Income of $50 million and EBITDA of $100 million.

The Target, with a Purchase Equity Value of $100 million and a Purchase Enterprise Value of
$150 million, has Net Income of $10 million and EBITDA of $15 million.
What are the Combined P / E and TEV / EBITDA multiples in a 100% Stock deal? Assume the
same tax rates for the Acquirer and Target.
The Combined Equity Value in a 100% Stock deal is $500 million + $100 million = $600 million,
and the Combined Enterprise Value is $600 million + $150 million = $750 million.
The Combined EBITDA is $115 million, and the Combined Net Income, assuming the same tax
rates and no interest effects since it’s a 100% Stock deal, is $50 million + $10 million = $60
million.
Therefore, the Combined P / E multiple is $600 million / $60 million = 10x, and the Combined
TEV / EBITDA multiple is $750 million / $115 million = ~6.5x.
8. How would those Combined Multiples change in a 100% Cash or Debt deal?
The Combined TEV / EBITDA multiple would stay the same because neither the Combined
Enterprise Value nor the Combined EBITDA is affected by the deal financing.
The Combined P / E multiple would change because the Combined Equity Value would be only
$500 million in a 100% Cash or Debt deal.
The Combined Net Income would also change because of the Foregone Interest on Cash and
Interest Paid on New Debt.
In most cases, the Combined P / E multiple will be lower in a 100% Cash or 100% Debt deal
because the Combined Equity Value will decrease by a greater percentage than the Combined
Net Income.
9. How do the Combined Multiples change based on the deal financing?

Enterprise Value-based multiples do not change based on the % Cash, Debt, and Stock used
because the Combined Enterprise Value is not affected by the deal financing, and TEV-based
metrics such as Revenue, EBITDA, and EBIT are also not affected by it.
Equity Value-based multiples do change based on the deal financing because the Combined
Equity Value depends on the % Stock Used, and Equity Value-based metrics such as Net Income

and Free Cash Flow are affected by the Foregone Interest on Cash and Interest Paid on New
Debt.
10. What are the possible ranges for the Combined Multiples after a deal takes place?
Combined Enterprise Value-based Multiples will be between the Buyer’s standalone multiples
and the Seller’s purchase multiples.
Combined Equity Value-based Multiples are often in that range as well, but they do not have to
be (see the next question for an example).
You cannot average the Buyer’s multiples and the Seller’s purchase multiples to determine the
Combined Multiples because the companies could be different sizes.
You also cannot use a weighted average because the proportions of Enterprise Value, EBITDA,
and other financial metrics from each company might be different.
The Combined Multiples will be closer to the Buyer’s multiples if the Buyer is much bigger, but
they’ll be in the middle of the range if the Buyer and Seller are closer in size.
11. Consider this M&A scenario:
• Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income
of $4, and Tax Rate of 50%.
• Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of
$2, and Tax Rate of 50%.
Calculate the TEV / EBITDA and P / E multiples for each company.
Company A TEV / EBITDA = $100 / $10 = 10x; P / E = $80 / $4 = 20x.
Company B TEV / EBITDA = $40 / $8 = 5x; P / E = $40 / $2 = 20x.
12. Company A acquires Company B using 100% Cash and pays no premium to do so. Assume
a 5% Foregone Interest Rate on Cash.
What are the Combined TEV / EBITDA and P / E multiples?
Combined TEV / EBITDA = Combined Enterprise Value / Combined EBITDA = $140 / $18 = ~7.8x.

Combined P / E = Combined Equity Value / Combined Net Income.

The Combined Equity Value is the Acquirer’s Equity Value of $80 since no Stock was issued.
We can add both companies’ Net Incomes since they have the same tax rate, so the Combined
Net Income is $6. But we have to adjust for the Foregone Interest on Cash as well.
The Acquirer used $40 in Cash, and 5% * $40 = $2. After the 50% tax rate, that’s a $1 reduction
in Net Income.
So, the Combined Net Income is $5, which makes the Combined P / E = $80 / $5 = 16x.
13. Now, let’s say that Company A instead uses 100% Debt with a 10% interest rate to acquire
Company B.
Again, Company A pays no premium for Company B. What are the combined multiples?
The Combined TEV / EBITDA multiple remains the same at ~7.8x because it is not affected by
the deal financing.
The Combined Equity Value is still the Acquirer’s Equity Value of $80.
The Combined Net Income before adjustments is $6, but now we must adjust for the Interest
Paid on New Debt.
If Company A uses $40 of Debt to acquire Company B, it will pay $40 * 10% * (1 – 50%), or $2, in
After-Tax Interest.
So, the Combined Net Income is $4, which makes the Combined P / E = $80 / $4 = 20x.
Return to Top.
Full Merger Model Mechanics
Ironically, questions about the “full merger model” tend to be easier than the questions above
about accretion/dilution, Enterprise Value, and valuation multiples.
That’s because the process of building a complete merger model is straightforward, and the
numbers are too complicated for mental math.
So, as with the first section, these questions tend to be more conceptual.

1. Why is the “real purchase price” in an M&A deal NOT equal to the Seller’s Purchase Equity
Value or Purchase Enterprise Value?
The real price depends on the treatment of the Seller’s Cash and Debt in the deal and the
transaction fees.
If the Buyer repays the Seller’s entire Debt balance with its Cash balance or it issues Stock to do
so, and it uses the Seller’s entire Cash balance to fund the deal, the real price will be close to
the Purchase Enterprise Value (but still not the same due to fees).
In most cases, the Buyer will refinance and replace the Seller’s existing Debt with the same
amount of new Debt, but that does not “cost” the Buyer anything extra.
And the Seller’s existing Cash may be used to fund part of the deal or pay for transaction fees,
but the entire balance can’t be used because of the Seller’s minimum Cash requirement.
So, the “real price” the Buyer pays is usually in between the Purchase Equity Value and
Purchase Enterprise Value of the Seller.
2. What information do you need from the Buyer and Seller to create a full merger model?
At the minimum, you need Income Statement projections for both companies over the next few
years. Ideally, you will also create simple cash flow projections that track the changes in each
company’s Cash and Debt over the same period.
You do not need full 3-statement projections for both companies – similar to a DCF analysis,
cash flow estimates without Balance Sheet projections are fine.
3. Why is a Sources & Uses schedule important in a full merger model?

The Sources & Uses (S&U) schedule is important because it tells you how much the Buyer really
pays for the Seller.
The Purchase Equity Value and Purchase Enterprise Value can be deceptive for the reasons
outlined above.
But in the S&U schedule, you add up the total cost of acquiring the company on the Uses side –
its shares, any refinanced Debt, and the transaction fees – and then you show the amount of
Cash, Debt, and Stock that will be used to pay for everything on the Sources side.

4. How does a Cash-Free, Debt-Free deal for a private Seller differ from a standard M&A deal
for a public Seller?
In a Cash-Free, Debt-Free deal, the Seller’s existing Cash and Debt balances both go to 0
immediately after the deal closes.
So, if Debt > Cash, the Seller uses its Cash balance to repay as much Debt as it can, and then the
Buyer repays the rest when it completes the deal.
If Cash > Debt, then the Seller repays its entire Debt balance using its Cash, and then it uses the
remaining Cash to issue a special dividend to shareholders, repurchase shares, or do something
else to reduce its Equity Value.
In these types of deals, the purchase price is usually based on a multiple such as TEV / EBITDA
or TEV / Revenue rather than a share-price premium because the Seller is private.
Also, the Sources & Uses schedule is based on the Purchase Enterprise Value on the Uses side
rather than the Purchase Equity Value, and “Refinanced” or “Assumed/Replaced” Debt is not
shown because the Seller’s Debt always goes to 0 after the deal closes.
In most cases, this deal structure simply means that the additional New Debt on the Sources
side is used to repay the Seller’s existing Debt.
5. What’s the purpose of a Purchase Price Allocation schedule in a merger model?

The main purpose is to estimate the Goodwill that will be created in a deal.
Goodwill exists because Buyers often pay far more for companies than their Balance Sheets
suggest they are worth; in other words, the Purchase Equity Value exceeds the acquired
company’s Common Shareholders’ Equity (CSE).
When this happens, the Combined Balance Sheet will go out of balance because the Seller’s CSE
is written down to $0, but the total amount of Cash, Debt, and Stock used in the deal exceeds
the CSE that was written down.
So, you estimate the new Goodwill with this schedule, factor in write-ups of Assets such as
PP&E and Intangibles, and include other acquisition effects such as the creation of Deferred Tax
Liabilities and changes to existing Deferred Tax items.
6. Why do Deferred Tax Liabilities get created in many M&A deals?

A Deferred Tax Liability, or DTL, represents the expectation that Cash Taxes will exceed Book
Taxes in the future.
DTLs get created because the Depreciation & Amortization on Asset Write-Ups is not deductible
for cash-tax purposes in a Stock Purchase (i.e., an M&A deal structured such that the Buyer
purchases all the Seller’s shares and acquires everything the Seller has).
As a result, the Buyer will pay more in Cash Taxes than Book Taxes until the Write-Ups are fully
depreciated/amortized. Each time the Buyer pays more in Cash Taxes than Book Taxes, the DTL
decreases until it eventually reaches 0.
7. An Acquirer purchases a Target for a $1 billion Equity Purchase Price. This Target has $600
million in Common Shareholders’ Equity and no existing Goodwill.
The Acquirer plans to write up the Target’s PP&E and Other Intangible Assets by $100 million.
Walk me through the Purchase Price Allocation, assuming a 25% tax rate.
The “Allocable Purchase Premium” equals the Equity Purchase Price minus the Common
Shareholders’ Equity plus the Target’s existing Goodwill, so $1 billion – $600 million + $0 = $400
million.
The PP&E and Other Intangible Assets increase by $100 million, so you subtract this figure
because it means you’ll need less Goodwill to make the Balance Sheet balance. So, the
Purchase Premium is down to $300 million.
Then, you create a Deferred Tax Liability that corresponds to these write-ups. It’s equal to $100
million * 25%, or $25 million, and you add it because an increase on the L&E side means that
more Goodwill will be needed on the Assets side.
So, $325 million of Goodwill gets created, along with Asset Write-Ups of $100 million and a new
Deferred Tax Liability of $25 million.
8. What happens if an Acquirer purchases another company for a $1 billion Equity Purchase
Price, but the Target’s Common Shareholders’ Equity is $1.5 billion?
Assume there are no write-ups or other adjustments.
“Negative Goodwill” cannot exist per the rules of IFRS and U.S. GAAP.

So, in this situation, you record this $500 million difference as an Extraordinary Gain on the
Income Statement, which increases Pre-Tax Income and Net Income.
On the Cash Flow Statement, Net Income is higher, and you reverse this Extraordinary Gain
because it’s non-cash. You also reverse the additional Book Taxes paid on it via a positive
adjustment in the Deferred Taxes line item on the CFS.
The initial Balance Sheet combination still works the same way, but you don’t record any
Goodwill; you just add all the Target’s Assets and Liabilities to the Acquirer’s and reflect the
Cash, Stock, and Debt used to fund the deal.
The increased Net Income (due to the Extraordinary Gain) flows into Common Shareholders’
Equity, and the DTL changes based on the adjustment in the Deferred Tax line item.
Cash does not change because the Extraordinary Gain is non-cash and the company’s Cash
Taxes stay the same.
9. What are the main adjustments you make when combining the Balance Sheets in an M&A
deal?
You reflect the Cash, Debt, and Stock used in the deal, create new Goodwill, write up Assets
such as PP&E and Other Intangibles, and reflect the Seller’s assumed or refinanced Debt. You
also show any new Deferred Tax Liabilities and the write-offs of existing DTLs and DTAs.
Then, you write down the Seller’s Common Shareholders’ Equity and reflect transaction and
financing fees (transaction fees are deducted from CSE, and financing fees are deducted from
the Book Value of the New Debt).
These are the most common adjustments, but there are others; for example, you might reduce
the combined Accounts Receivable or Accounts Payable to reflect intercompany receivables or
payables, and you might write down Deferred Revenue after the transaction closes because
companies can recognize only the profit portion of the Seller’s Deferred Revenue following a
deal.
10. Give me an example of how you might estimate Revenue and Expense Synergies in an
M&A deal.
With Revenue Synergies, you might assume that the Seller can sell its products to some of the
Buyer’s customer base.

So, if the Buyer has 100,000 customers, 1,000 of them might buy widgets from the Seller. Each
widget costs $10.00, so that is $10,000 in extra Revenue.
There will also be COGS and Operating Expenses associated with these extra sales, so you must
factor those in as well. For example, if each widget's cost is $5.00, then the Combined Company
will earn only $5,000 in extra Pre-Tax Income.
With Expense Synergies, you might assume that the Combined Company can close a certain
number of offices or lay off redundant employees, particularly in functions such as IT,
accounting, and HR.
For example, if the Combined Company has 10 offices, management might feel that only 8
offices will be required after the merger.
If each office costs $100,000 per year, there will be 2 * $100,000 = $200,000 in Expense
Synergies, which will boost the Combined Pre-Tax Income by $200,000.
11. Why do many merger models tend to overstate the impact of Synergies?
First, many merger models do not include the costs associated with Revenue Synergies. Even if
the Buyer or Seller can sell more products or services after the deal occurs, those extra sales
cost something, so you must also include the extra COGS and OpEx.
Second, realizing Synergies takes time. Even if a company expects $10 million in “long-term
synergies,” it won’t realize all of them in Year 1; it might take years, and the percentage realized
will increase gradually each year.
Finally, realizing Synergies costs money. There will always be “integration costs” associated
with a deal, and certain types of Synergies, such as headcount reductions, will cost even more
due to severance costs for employees.
12. How do you calculate the Combined Company’s Debt repayment capacity in a merger
model?
You do this by creating a “mini” Cash Flow Statement.
You eliminate most of the Financing and Investing sections (except for CapEx and potentially
Dividends), but you keep most of the Cash Flow from Operations section.

It’s similar to what you do in a DCF to project Unlevered Free Cash Flow, but you’re projecting
the company’s Free Cash Flow – which deducts Net Interest Expense – here.
You have to include the Net Interest Expense because it directly affects a company’s ability to
repay Debt and generate Cash; the purpose is different from that of a DCF since you’re not
valuing a company but instead tracking its Cash and Debt balances.
13. How should you treat Stock-Based Compensation (SBC) in a merger model?
The easiest approach is to count it as a cash operating expense. Just as in a DCF, SBC is
problematic because it increases the company’s diluted share count and, therefore, reduces its
value to existing shareholders.
But it’s difficult to estimate this impact since you would have to project the company’s share
price and details of the SBC to do that. Also, it’s much easier to analyze M&A deals if each
company’s standalone share count stays the same each year.
So, it’s easiest NOT to add back SBC as a non-cash expense on the standalone and combined
Cash Flow Statements.
That way, it’s effectively a cash operating expense, and each company’s share count stays the
same (assuming that Stock Issuances and Repurchases are also set to 0, which they should be).
14. Why might you calculate metrics such as Debt / EBITDA and EBITDA / Interest for the
Combined Company in an M&A deal?
These metrics tell you whether the Acquirer could use more Debt to fund the deal or if it’s using
too much Debt to fund the deal.
Sometimes, it’s deceptive to look at a number like Debt / EBITDA immediately after a deal
closes because the Combined Company can de-lever rapidly by paying off Debt.
So, even if its Debt / EBITDA jumps up to a high level, such as 5x or 6x, if it can repay Debt and
bring it down to 2x or 3x in a few years, it might be able to use more Debt to fund the initial
deal.
15. How do Pro-Forma EPS and Pro-Forma accretion/dilution from the standard, or
IFRS/GAAP-compliant, figures?

This one gets confusing because there’s no universal definition of Pro-Forma EPS.
But most companies calculate it by adding back non-cash expenses created in an M&A deal,
primarily the Amortization of Intangibles and the Depreciation of PP&E Write-Ups, and some
also add back Restructuring or Merger/Integration Costs – under the logic that they are “non-
recurring.”
Then, they calculate the Combined Net Income based on this “Pro-Forma” Pre-Tax Income with
these line items added back.
Many companies report Pro-Forma EPS and calculate accretion/dilution based on these figures,
but you should be skeptical because these numbers tend to understate the true costs of
acquisitions.
16. Suppose that you set up an IRR vs. Discount Rate analysis to judge the merits of an M&A
deal. Why might you not be able to take the results of this analysis literally?
One problem with this analysis is that it’s not clear if you should use the Buyer’s Discount Rate,
the Seller’s, or a weighted average of the two. Therefore, if the Buyer and Seller's Discount
Rates are significantly different, the results could change dramatically.
Other problems relate to the treatment of the Synergies and the Terminal Value of the
Synergies. Depending on whether the Buyer or Seller gets “credit” for the Synergies, the IRR
could change significantly.
There are also questions about whether or not a “Terminal Value” for Synergies is justified,
given that they probably won’t last forever. Similar to EPS accretion/dilution, the IRR vs.
Discount Rate analysis is useful, but only one way to judge M&A deals.
17. Walk me through a Contribution Analysis for a 100% Stock M&A deal.
In a Contribution Analysis, you add up the Buyer and Seller's financial metrics, such as Revenue
and EBITDA, and determine the percentage the Buyer and Seller “contribute” to each combined
metric.
Then, you estimate the Pro-Forma Combined Enterprise Value based on Buyer’s Enterprise
Value / Buyer’s Contribution Percentage for the relevant metric.

For example, if the Buyer’s Enterprise Value is $1,500, and it contributes 75% of the Combined
Revenue, the Pro-Forma Combined Enterprise Value based on Revenue is $1,500 / 75% =
$2,000.
You then subtract the Buyer’s Enterprise Value from this number to get the Seller’s Implied
Enterprise Value, and you subtract the items in the TEV bridge to get its Implied Equity Value.
Then, you divide by its share count to get the Implied Offer Price. You can then compare this
Implied Offer Price to the actual Offer Price in the deal to determine whether the Buyer is
paying an appropriate price.
18. How does the Value Creation Analysis in M&A deals work, and when is it appropriate?
In a Value Creation Analysis, you assume that the Buyer + Seller as a combined entity will trade
at higher valuation multiples, in-line with the multiples of larger public companies in the sector.
You calculate the Combined Enterprise Value based on those higher multiples, subtract all the
TEV bridge items (and reflect the Cash and Debt used in the deal) to get the Combined Equity
Value, and divide by the Combined Share Count to get the Implied Share Price for this entity.
If this share price is higher than the Acquirer’s standalone share price, the deal “created value.”
This analysis is highly speculative because there’s no guarantee that the Buyer + Seller
combined will magically trade at higher multiples; it’s most relevant if the deal represents a
clear case of Companies #2 and #3 in the market combining to compete with Company #1.
It’s less relevant when the market is highly fragmented, and the Buyer + Seller together still
does not resemble larger companies.
Return to Top.
More Advanced Features of Merger Models [OPTIONAL]
All the questions here are OPTIONAL.

Interviews have shifted away from these topics and toward trickier questions about the
fundamentals.
These more advanced topics are good to know if you’ve had significant IB/PE work experience,
such as working on several M&A deals from start to finish, but they’re not important if you’re
interviewing for entry-level roles.

1. Why do Buyers tend to prefer Asset Purchases, and Sellers tend to prefer Stock Purchases?
In Asset Purchases, Buyers can pick and choose the exact Assets they want to acquire and the
exact Liabilities they want to assume, which reduces transaction risk.
Buyers can also deduct D&A on Asset Write-Ups for cash-tax purposes in an Asset Purchase,
which reduces their tax burden after the deal closes.
Sellers tend to prefer Stock Purchases because Asset Purchases leave them with more risk after
deals close and because they must pay taxes on the entire purchase price PLUS the Gains
recorded on their Net Assets in an Asset Purchase.
2. What's the advantage of a 338(h)(10) election for a U.S.-based Buyer?

In a 338(h)(10) Election, the Buyer and Seller choose to treat a Stock Purchase as if it were an
Asset Purchase for tax purposes.
So, the Buyer still acquires all the Assets, Liabilities, and off-Balance Sheet items of the Seller,
but it can also deduct D&A on Asset Write-Ups for cash-tax purposes.
The Seller’s entire NOL balance is also written down (as in a standard Asset Purchase).
338(h)(10) deals can help Buyers and Sellers compromise and reach an agreement more quickly
since they combine the elements favored by Buyers and Sellers in Asset and Stock Purchases.
3. If a Seller has a massive NOL balance, should the Buyer use a Stock Purchase, Asset
Purchase, or 338(h)(10) election to acquire it?
The Buyer should use a Stock Purchase because NOLs are written down 100% in Asset Purchase
and 338(h)(10) deals, so the Buyer cannot use any of the Seller’s NOLs in those deal structures.
4. Walk me through what happens in a Stock Purchase deal where the Buyer pays an Equity
Purchase Price of $2 billion for the Seller, and the Seller has an off-Balance Sheet NOL balance
of $400 million. The NOLs expire in 5 years.
Assume that the Long-Term Adjusted Rates for the past three months were 0.5%, 0.7%, and
1.0% and that the Buyer’s Tax Rate is 25%.

If the off-BS NOL balance is $400 million, the portion within the DTA should be approximately
$100 million at a 25% tax rate.
The Buyer is allowed to use MAX(0.5%, 0.7%, 1.0%) * $2 billion, or $20 million, per year.
The NOLs expire in 5 years, which means the Buyer can use 5 * $20 million = $100 million total.
Therefore, the Buyer will write down $300 million of the off-BS NOLs and $75 million of the
NOLs within the DTA when the transaction closes.
The remaining off-BS NOL balance will be $100 million, and the NOL portion within the DTA will
be $25 million.
After that, the Buyer will use $20 million of the NOLs each year to reduce its cash-taxable
income, so the off-BS balance will decline by $20 million per year.
The DTA portion will decline by $5 million per year until both the on-BS and off-BS NOL
balances reach $0 at the end of Year 5.
5. How do these numbers change in an Asset Purchase?

In an Asset Purchase, the Net Operating Losses – both the off-Balance Sheet and on-Balance
Sheet versions – are written down to $0, and the Buyer can’t use any of the Seller’s NOLs.
6. Why would a Buyer and Seller agree to an Earn-Out in an M&A deal?

They might agree to an Earn-Out if they disagree about the Seller’s future financial performance
and, therefore, can’t agree on an upfront price.
For example, the Buyer might think the Seller will grow at only 5% per year, but the Seller
believes it will grow at 15% per year.
As a compromise, the Buyer might offer the Seller upfront cash, along with additional
compensation if it achieves certain financial goals, such as reaching $100 million in revenue or
$20 million in EBITDA in 2 years.
Earn-Outs are also used to incentivize executives and key employees at the Seller to stay at the
new company after the deal closes.

7. A Buyer acquires a Seller for an Equity Purchase Price of $1 billion. It also promises an
additional $200 million in 2 years if the Seller reaches $100 million in EBITDA by then.
The Seller’s Common Shareholders’ Equity is $600 million, it has no existing Goodwill, and the
Buyer plans to write up Assets for a total of $100 million. Assume a 25% tax rate and a Stock
Purchase deal structure and walk me through the Purchase Price Allocation.
First, you subtract the Seller’s CSE from the Equity Purchase Price, which results in an Allocable
Purchase Premium of $400 million.
The Buyer writes up Assets for $100 million, which reduces that Premium because less Goodwill
is needed. So, it’s down to $300 million.
A Deferred Tax Liability will be created because of these write-ups, which we can estimate at
$100 million * 25% = $25 million. This DTL will increase the Premium because more Goodwill
must balance this DTL on the other side. So, we’re up to $325 million.
Next, we have to record the $200 million Earn-Out as “Contingent Consideration” on the L&E
side, increasing the amount of Goodwill required.
So, we end up with a total of $525 million in Goodwill from this deal.
8. In Year 1, the Buyer believes the Seller is far less likely to reach $100 million in EBITDA in 2
years, so it reduces the value of the Contingent Consideration Liability by 30%.
Walk me through the three statements.
$200 million * 30% = $60 million, so the Contingent Consideration will fall by $60 million.
However, this change will be recorded as a POSITIVE on the Income Statement because it’s a
Liability write-down.
So, Pre-Tax Income on the Income Statement will be up by $60 million, and Net Income will be
up by $45 million at a 25% tax rate.
On the CFS, its Net Income is up by $45 million, but this Change in Contingent Consideration
was non-cash, so you reverse it and subtract the $60 million.
Also, the company’s Cash Taxes are not affected by this line item, so you reverse the $15
million in extra taxes and record a positive $15 million in the Deferred Income Taxes line.
At the bottom, Cash is unchanged because +$45 – $60 + $15 = $0.

On the Balance Sheet, Cash is unchanged, but the Deferred Tax Asset is down by $15 million, so
the Assets side is down by $15 million.
On the L&E side, the Contingent Consideration is down by $60 million, but CSE is up by $45
million due to the increased Net Income, so the L&E side is also down by $15 million, and both
sides balance.
9. In Year 2, the Buyer realizes it was wrong and reverses this change. Then, at the end of
Year 2, the Seller achieves its goals and reaches $100 million in EBITDA.
Walk me through the financial statements when the Earn-Out is paid out to the Seller. Ignore
the Reversal of the Earn-Out Write-Down and walk through ONLY the payout.
When the Earn-Out is paid to the Seller, there are no changes on the Income Statement. The
$200 million cash outflow is recorded within Cash Flow from Financing on the CFS, so Cash is
down by $200 million at the bottom.
On the Balance Sheet, Cash is down by $200 million, so the Assets side is down by $200 million,
and the Contingent Consideration also declines by $200 million, so the L&E side is also down by
$200 million, and the Balance Sheet balances.
10. What's the difference between Fixed and Floating Exchange Ratios, and which one do
Buyers prefer?
With a Fixed Exchange Ratio, the Seller receives a constant number of shares. For example, the
Buyer might agree to issue two new shares for each one of the Seller’s shares. The Seller’s
ownership will stay the same regardless of the Buyer’s share price, but the purchase price will
change.
With a Floating Exchange Ratio, the Seller receives a fixed purchase price but a variable number
of shares. For example, the Buyer might agree to pay $200 million to the Seller, but that means
10 million shares if the Buyer’s share price is $20.00 and 40 million shares if the Buyer’s share
price is $5.00.
Buyers care the most about avoiding dilution in M&A deals, so a Buyer tends to favor the Fixed
Exchange Ratio if it’s not confident of its future share price. But if the Buyer is reasonably
confident that its share price will rise, it might favor a Floating Exchange Ratio so that it issues
fewer shares.

11. Why might a Buyer and Seller agree to a collar in a 100% Stock deal?
100% Stock deals present risk for both Buyers and Sellers: the Buyer could dilute its
shareholders by a huge amount if its share price falls, while the Seller could receive fewer
shares than expected if the Buyer’s share price rises.
A collar lets both parties compromise and reduce the risks by establishing a Fixed Exchange
Ratio within a certain range of Buyer share price, with Floating Exchange Ratios outside that
region. It might also be set up in the opposite way, with a Floating Exchange Ratio in a certain
range and Fixed Exchange Ratios outside that range.
Sellers can be assured of receiving a fixed purchase price or a fixed number of shares within a
range of share prices for the Buyer, while Buyers can limit either the dilution or the effective
purchase price.
12. What are example terms for a Fixed Exchange Ratio with a collar in an M&A deal?
This structure means that the Seller gets a fixed number of shares within a certain share price
range for the Buyer.
So, the purchase price will vary within that range, and above or below that range, the purchase
price is fixed, but the shares received by the Seller will vary.
For example:
• Buyer’s Share Price Between $50.00 and $60.00: The Seller always gets 10 million of the
Buyer’s shares.
• Buyer’s Share Price Above $60.00: The Seller gets a maximum price of $600 million, and
the shares issued vary based on the Buyer’s share price.
• Buyer’s Share Price Below $50.00: The Seller gets a minimum price of $500 million, and
the shares issued vary based on the Buyer’s share price.
13. What would change in a merger model if the deal closed on an irregular date, such as
August 15th?

You would “roll forward” the Balance Sheets for both companies to August 15th and combine
them on that date, ensuring that the Purchase Price Allocation and Sources & Uses schedules
are also based on that date.
You would also create a “stub period” for the Combined Income Statement and Cash Flow
Statement to show what happens between August 15th and the end of the companies’ first
quarter (or first year) as a combined company.
Even with an irregular closing date and a stub period, you tend to focus on the first full year of
combined results in a merger model because EPS accretion/dilution means more over an entire
year than it does over a stub period or a single quarter.
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Access the Rest of the IB Interview Guide

IB Interview Guide, Module 4: M&A Deals and Merger Models

Overview & Key Rules of Thumb

Key Rule #1: Why Buy Another Company?

• Current Cash Flow = $50 million

• Consolidation / Economies of Scale: If the biggest and second-biggest companies in the

• Geographic Expansion: The Buyer operates mostly in Europe, which is a

• Product Expansion or Diversification: The Acquirer’s core industry is declining, but it

• Defensive Acquisition: The Acquirer is afraid of a high-growth competitor, so it acquires

• Step 1: Plan the Process and Create Marketing Materials.

• Step 2: Contact the Initial Set of Buyers.

• Step 3: Set Up Management Meetings and Presentations.

• Step 4: Solicit Initial and Subsequent Bids from Buyers.

Financing… What Financing?

Mergers vs. Acquisitions

Key Rule #2: Mechanics of EPS Accretion/Dilution

Step 2: Determine the Purchase Price and Cash/Debt/Stock Mix

Accretion/dilution follows these rules:

• Weighted Cost of Acquisition < Yield of Seller: Accretive

• Weighted Cost of Acquisition > Yield of Seller: Dilutive

• 100% Stock Deal, Buyer’s P / E > Seller’s P / E at Purchase Price: Accretive

Here are the most common questions on this part:

• Should You Use the Buyer’s Tax Rate?

• What Happened to the Seller’s Shares?

Here are just a few of the oversights in this analysis:

Key Rule #3: The Purchase Price and Cash/Debt/Stock Mix

• Current Equity Value: $500 million

2) “What’s the biggest deal the Acquirer might be able to complete?”

And now we return to “lingering question #3”:

But these methods are not equivalent.

Factor #2: Treatment of the Seller’s Existing Cash

• Previous Example, Foregone Interest on Cash: $1.5 million per year

Combined Enterprise Value = Acquirer's Current Enterprise Value + Target’s Purchase

• Company A’s Equity Value = $500

• + New Debt of $125

2. Combined Enterprise Value = Acquirer’s Enterprise Value + Purchase Enterprise Value of

In the previous sections, we covered examples of simplified merger models where we

1) Project the Financial Statements of the Buyer and Seller

• COGS and Operating Expenses – Based on percentages of revenue, employee counts, or

2) Estimate the Purchase Price and Form of Payment

2) Goodwill, to represent everything else.

And then on the Liabilities & Equity side:

5) Calculate the Synergies (OPTIONAL – SIMPLIFIED IN 60-MINUTE MODEL)

The most common mistakes with Synergies include:

8) Create Sensitivity Tables

2) Defensive Acquisition / Fear of Competition – If Big Social Media Company A perceives

• Seller’s Implied Equity Value from DCF: $2.0 billion

IRR vs. Discount Rate (WACC)

Relative Contribution Analysis

2. Combined Enterprise Value = Acquirer’s Enterprise Value + Purchase Enterprise Value of

• What if the Combined Company’s margins increase because it realizes higher-than-

Key Rule #8: More Advanced Merger Model Features [OPTIONAL]

Exchange Ratios, Collars, Earn-Outs, and Other Purchase Price Variations

Earn-Outs and Deferred Consideration

Buyers tend to favor Asset Purchases because:

Structure: Stock Purchase Asset Purchase 338(h)(10) Election

Net Operating Losses (NOLs) in Different Deal Structures

See the section on Cash-Free, Debt-Free Deals for more.

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M&A Concepts and Overview

1. Why might one company want to buy another company?

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