Walk me through a merger model at a high level.
Model answer
A merger model takes two standalone companies, combines them at a deal price and financing structure, and outputs the pro forma financials and accretion / dilution to the acquirer's EPS.
Four main blocks.
Block one: standalone projections. Build or import 3-5 year financial projections for the acquirer and target separately — income statement, balance sheet, cash flow statement. Both companies' standalone numbers are the starting point for everything that follows.
Block two: deal assumptions and sources and uses. Inputs: purchase price (per share, premium to unaffected, total equity value), deal structure (cash / stock / mixed), financing mix (new debt at a specified rate, equity issuance at the acquirer's price), assumed transaction fees, and any refinancing of target debt. Sources and uses balances total uses — equity purchase price plus refinanced debt plus fees — against sources — new debt, new equity, and cash on hand.
Block three: purchase accounting. Allocate the purchase price across the target's assets and liabilities at fair value, identify intangibles to be created, calculate goodwill as the residual. Determine new amortization expense from the intangibles. Handle the deferred tax liability on any non-tax-deductible step-up.
Block four: pro forma combination and accretion / dilution. Combine the standalone income statements line by line. Layer adjustments: add expected cost synergies (after-tax, phased in over 1-3 years), add interest expense on new debt (after-tax), subtract interest income on cash used (after-tax), subtract incremental D&A and amortization from the step-ups (after-tax). Calculate pro forma net income. Add new shares issued to acquirer's standalone share count to get pro forma diluted shares. Pro forma EPS equals pro forma net income divided by pro forma shares. Compare to standalone acquirer EPS — that's the accretion or dilution.
Final outputs: accretion / dilution by year, pro forma leverage and credit metrics, breakeven synergy required to make the deal accretive, sensitivity tables across price, financing mix, and synergies. The MD wants three numbers: year-1 accretion, year-3 accretion, pro forma leverage.