How to Build a Merger Model (Beginner Guide)

What is a Merger Model?

A merger model is a financial model that analyzes the impact of an M&A transaction on the acquiring company's earnings per share. Also called an accretion/dilution model or M&A model, this analysis combines the financial statements of two companies into pro forma combined financials to determine whether the deal creates or destroys value for the acquirer's shareholders.

The core question a merger model answers is straightforward: will the acquirer's EPS increase or decrease after completing the transaction? If EPS increases, the deal is accretive. If EPS decreases, the deal is dilutive. This simple metric drives significant deal decisions because shareholders and boards care deeply about earnings impact.

Beyond the headline accretion/dilution result, merger models also analyze purchase price allocation, goodwill creation, synergy realization, and the optimal mix of cash, stock, and debt to finance the transaction. Investment banking analysts build merger models to advise clients on deal structure, negotiate transaction terms, and present recommendations to boards and shareholders.

For investment banking interviews, merger modeling represents a core technical competency that every candidate must understand. Interviewers expect you to explain the mechanics of accretion/dilution, walk through the key drivers, and discuss how different deal structures affect the analysis. This guide covers everything you need to know to build a merger model from scratch.

The Core Concept: Accretion vs Dilution

Understanding EPS Impact

The fundamental purpose of a merger model is determining whether a transaction is accretive or dilutive to the acquirer's earnings per share. This analysis compares the acquirer's standalone EPS to pro forma EPS after combining with the target.

Accretive deal: Pro forma EPS exceeds acquirer's standalone EPS. The acquisition increases earnings available per share, which is generally viewed positively by shareholders.

Dilutive deal: Pro forma EPS falls below acquirer's standalone EPS. The acquisition decreases earnings available per share, which may concern shareholders unless justified by strategic benefits.

The math is intuitive. When you acquire a company, you are buying its earnings stream. If you pay less for those earnings than your own earnings are valued, the deal is accretive. If you pay more, the deal is dilutive. The payment method matters because stock consideration increases shares outstanding while cash consideration does not.

The Key Drivers

Several factors determine whether a deal is accretive or dilutive:

Relative P/E multiples: If the acquirer trades at a higher P/E than the target, stock deals tend to be accretive. The acquirer is trading expensive currency (high P/E stock) for cheaper earnings (low P/E target). Conversely, if the acquirer has a lower P/E, stock deals tend to be dilutive.

Purchase premium: Higher premiums make deals more dilutive because you are paying more for the same earnings stream. The premium above the target's market value directly affects accretion/dilution math.

Financing mix: Cash deals avoid share dilution but sacrifice interest income on cash used and potentially add interest expense on debt raised. Stock deals preserve cash but increase shares outstanding. The optimal mix depends on relative costs and capital availability.

Synergies: Cost savings and revenue synergies improve pro forma earnings, making deals more accretive. Higher synergies can turn a dilutive deal into an accretive one.

Understanding these drivers helps you anticipate accretion/dilution results before building the model and explain the sensitivity of results to key assumptions.

Step 1: Gather Transaction Assumptions

Acquirer Information

Begin by collecting the acquirer's key financial data:

This information establishes the acquirer's baseline earnings and valuation, which you will compare against pro forma results.

Target Information

Collect parallel information for the target company:

For public targets, you can gather this from SEC filings. For private targets, information comes from management presentations, data rooms, or confidential information memoranda.

Deal Assumptions

Define the transaction structure:

These assumptions drive the entire model. Different financing mixes and synergy levels produce dramatically different accretion/dilution results, which is why sensitivity analysis is essential.

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Step 2: Calculate Purchase Price and Financing

Determining Total Consideration

The total purchase price includes several components beyond the headline equity value:

Equity purchase price = Target shares outstanding × offer price per share (for stock deals) or total cash payment (for cash deals)

Transaction fees typically run 1-3% of deal value for advisory fees plus legal and accounting costs. These are usually expensed rather than capitalized.

Financing fees on new debt issuance are capitalized and amortized over the debt term.

Total consideration = Equity purchase price + transaction fees + financing fees

Structuring the Financing

Determine how the acquirer will fund the purchase price:

Cash on hand: Using existing cash eliminates the need for new financing but sacrifices interest income. Calculate foregone interest as cash used multiplied by the acquirer's reinvestment rate.

New debt: Raising debt adds interest expense but avoids share dilution. Calculate interest expense as new debt multiplied by the cost of debt. Remember to tax-effect the interest expense since interest is tax-deductible.

Stock issuance: Issuing shares avoids cash outflow but dilutes existing shareholders. Calculate new shares issued as equity consideration divided by acquirer's stock price.

Most deals use a combination of financing sources. The optimal mix balances several factors: maintaining target credit ratings, minimizing dilution, preserving financial flexibility, and meeting any regulatory requirements.

Example Calculation

Consider an acquisition with $1 billion equity purchase price:

Annual interest expense on new debt: $300 million × 5% = $15 million pre-tax After-tax interest expense (at 25% tax rate): $15 million × (1 - 0.25) = $11.25 million

Foregone interest on cash (assuming 3% reinvestment rate): $500 million × 3% × (1 - 0.25) = $11.25 million after-tax

These financing costs reduce pro forma earnings and must be incorporated into accretion/dilution analysis.

Step 3: Purchase Price Allocation

Understanding Goodwill

When an acquirer pays more than the fair value of net identifiable assets, the excess is recorded as goodwill on the combined balance sheet. This accounting treatment is required under acquisition accounting (ASC 805).

Goodwill represents intangible value including brand recognition, customer relationships, assembled workforce, and expected synergies that cannot be separately identified and valued.

Fair Value Adjustments

Purchase price allocation requires stepping up target assets to fair value. Common adjustments include:

Property, plant, and equipment: Appraised value may differ from book value, particularly for real estate or specialized equipment.

Intangible assets: Identify and value customer relationships, technology, trade names, and other intangibles not on the target's balance sheet.

Inventory: Step up to fair value, which may create temporary margin compression as higher-cost inventory flows through cost of goods sold.

Deferred revenue: Write down to fair value representing remaining fulfillment costs, which reduces revenue recognition post-close.

These adjustments affect pro forma earnings through changed depreciation, amortization, and temporary purchase accounting effects.

Example Purchase Price Allocation

Goodwill created: $800 million - $500 million = $300 million

The $100 million in fair value adjustments will generate additional depreciation and amortization expense that reduces pro forma earnings.

Step 4: Model Synergies

Types of Synergies

Synergies are the value created by combining two companies that would not exist if they remained separate. Properly modeling synergies is critical because they often determine whether a deal is accretive or dilutive.

Cost synergies are generally more credible and achievable than revenue synergies. Models typically give full credit to cost synergies while applying haircuts to revenue synergy assumptions.

Timing and Costs

Synergies do not appear immediately. Most models assume synergies phase in over two to three years as integration progresses:

Achieving synergies requires integration costs including severance payments, facility closure costs, systems integration expenses, and consulting fees. These one-time costs should be modeled separately from ongoing synergy benefits.

Synergy Impact on Accretion/Dilution

Synergies improve pro forma earnings, making deals more accretive (or less dilutive). For accretion/dilution analysis, add after-tax synergies to combined net income:

A deal that is 5% dilutive before synergies might become 3% accretive with $50 million in annual cost synergies. This explains why synergy assumptions are among the most scrutinized elements of merger analysis.

Step 5: Build Pro Forma Income Statement

Combining the Companies

The pro forma income statement adds together the two companies' financials with adjustments for transaction effects:

Pro Forma Revenue = Acquirer revenue + Target revenue + Revenue synergies

Pro Forma Operating Expenses = Acquirer expenses + Target expenses - Cost synergies + D&A from fair value step-ups

Pro Forma Operating Income = Pro forma revenue - Pro forma operating expenses

Pro Forma Interest Expense = Acquirer interest + Target interest + New debt interest - Interest income foregone on cash used

Pro Forma Pre-Tax Income = Operating income - Interest expense

Pro Forma Net Income = Pre-tax income × (1 - Tax rate)

Calculating Pro Forma EPS

With pro forma net income calculated, determine pro forma EPS:

Where pro forma shares = Acquirer shares outstanding + New shares issued to target shareholders

Compare pro forma EPS to acquirer standalone EPS to determine accretion or dilution:

A positive percentage indicates accretion; negative indicates dilution.

Step 6: Sensitivity Analysis

Key Variables to Test

Merger models require sensitivity analysis around key assumptions because small changes can flip deals from accretive to dilutive. Build sensitivity tables testing:

Purchase price sensitivity: How does accretion/dilution change at different premium levels? This helps negotiate appropriate deal terms.

Financing mix sensitivity: Compare all-cash, all-stock, and various mixed scenarios. Identify the optimal structure given current conditions.

Synergy sensitivity: What synergy level is required for the deal to be accretive? How sensitive are results to synergy timing assumptions?

Interest rate sensitivity: If financing with debt, how do different rate scenarios affect results?

Building Sensitivity Tables

Create two-way sensitivity tables showing accretion/dilution across combinations of key variables. For example:

Purchase price vs. synergies: Rows show different premium levels, columns show different synergy amounts, cells show resulting accretion/dilution percentage.

Cash % vs. stock %: Holding total price constant, show how different financing mixes affect EPS impact.

These tables help clients and deal teams understand the range of potential outcomes and make informed decisions about transaction structure.

Understanding how to present and interpret sensitivity analysis is essential for accretion/dilution interview questions.

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Common Interview Questions

Walk Through Building a Merger Model

"Start with transaction assumptions including purchase price, financing mix, and synergies. Calculate the purchase consideration and how it will be funded across cash, debt, and stock. Perform purchase price allocation to determine goodwill. Build pro forma financials by combining the two companies and adjusting for financing costs, foregone interest, and synergies. Calculate pro forma EPS and compare to acquirer standalone EPS to determine accretion or dilution."

What Makes a Deal Accretive vs Dilutive?

"The key driver is the relationship between what you pay for earnings and what your own earnings are worth. If the acquirer's P/E is higher than the target's effective P/E (including premium), stock deals tend to be accretive because you're exchanging expensive currency for cheaper earnings. Cash deals are accretive if the target's earnings yield exceeds the after-tax cost of financing. Synergies improve accretion by adding earnings without adding shares."

How Do Synergies Affect Accretion/Dilution?

"Synergies increase pro forma net income without increasing shares outstanding, so they make deals more accretive. A deal that's dilutive before synergies can become accretive once synergy benefits are included. This is why synergy assumptions are heavily scrutinized, because aggressive synergy projections can make almost any deal appear accretive on paper."

Why Might a Company Pursue a Dilutive Deal?

"Short-term dilution may be acceptable if the deal creates long-term strategic value. Reasons include: acquiring critical technology or capabilities, eliminating a competitor, gaining market share in attractive markets, defensive moves to prevent a competitor from acquiring the target, or expected future accretion once synergies fully materialize. Management must articulate a compelling strategic rationale to justify near-term dilution."

Common Mistakes to Avoid

Modeling Errors

Several technical mistakes frequently appear in merger models:

Forgetting to tax-effect adjustments: Interest expense, synergies, and other adjustments must be calculated on an after-tax basis since they affect pre-tax income.

Double-counting synergies: If synergies are already reflected in projections, do not add them again as a separate line item.

Ignoring purchase accounting effects: Fair value step-ups create additional D&A that reduces pro forma earnings.

Miscounting shares: Ensure you correctly calculate new shares issued based on the stock consideration and acquirer's share price.

Forgetting foregone interest: Cash used for the acquisition was previously earning interest income that is now lost.

Conceptual Errors

Beyond mechanics, avoid these conceptual mistakes:

Assuming accretion equals value creation: A deal can be accretive but still destroy value if the acquirer overpays. Accretion/dilution is one metric, not the complete picture.

Ignoring integration risk: Models assume clean execution, but integration challenges can prevent synergy realization and create unexpected costs.

Using unrealistic synergies: Aggressive synergy assumptions make any deal look attractive. Credible models use conservative, well-supported synergy estimates.

Key Takeaways

Conclusion

Building a merger model requires combining technical financial modeling skills with strategic understanding of deal dynamics. The mechanics follow a logical flow: gather assumptions, structure financing, allocate purchase price, model synergies, build pro forma financials, and analyze accretion/dilution. Each step involves judgment calls about assumptions that significantly impact results.

For investment banking interviews, you must understand both the how and the why of merger modeling. Being able to build a model is necessary but not sufficient. Interviewers expect you to explain why deals are accretive or dilutive, how different structures affect results, and what strategic considerations might justify accepting short-term dilution.

The best way to develop merger modeling proficiency is practice. Build models using public transaction announcements, varying assumptions to see how results change. This hands-on experience develops the intuition that allows you to anticipate results and explain dynamics clearly in interviews.

Merger modeling connects directly to understanding how synergies drive M&A value and how acquirers think about what makes an attractive acquisition target. Mastering these interconnected concepts prepares you for the full range of M&A questions you will face in investment banking interviews.