Introduction

Mergers and acquisitions (M&A) present companies with an opportunity to achieve growth, synergy, and competitive advantages. However, not all mergers and acquisitions are a financially smart decision. The merger model, also known as the accretion/dilution model is an essential tool used to analyse the financial impact of these transactions.

While the intricacies of merger models and accretion/dilution analysis represent a more advanced topic typically encountered in investment banking, these concepts can still surface in interviews, especially for higher-level roles like MBA Associate or more specialized groups. Understanding these elements demonstrates a deep comprehension of how mergers and acquisitions impact financial performance and shareholder value, showcasing your readiness to tackle complex financial scenarios and contribute meaningfully to strategic decision-making processes.

Synergies

Why do companies engage in M&A in the first place? One word: synergies.

• Cost synergies

• ‍Revenue synergies

• Strategic synergies

Cost Synergies

Cost synergies refer to the reductions in operating costs that are anticipated after the merger of two companies. These savings result from increased efficiencies within the newly combined entity. Cost synergies are one of the three primary types of synergies, the other two being revenue and financial synergies.

These emerge from lowered expenses due to enhanced efficiencies, which can involve eliminating redundant functions, leveraging economies of scale, and optimizing supply chain operations. Types of cost synergies include:

• ‍Workforce Reductions: Mergers often lead to layoffs due to overlapping roles. For instance, if two companies have large sales teams in the same regions, some positions may become redundant. Conversely, if the companies complement each other geographically, workforce reductions might not be necessary. Example: Both companies have separate administrative teams. Post-merger, these teams are consolidated, reducing headcount and related expenses.

• ‍Technological Advancements: When one company possesses proprietary technology that enhances operational efficiency, integrating this technology can result in significant cost savings for the merged entity. For example, if one company has advanced IT systems, the other company can benefit from these efficiencies post-merger. Example: Company A has developed an advanced logistics software that streamlines operations. By implementing this technology across the combined entity, Company B can also reduce its logistics costs.

• ‍Supply Chain Efficiencies: Cost savings can be achieved through improved supply chain management. A merger can provide access to better supply chain relationships and lower input costs. Additionally, the increased size of the combined company can lead to a stronger bargaining position with suppliers, further reducing costs. Example: Company B has strong relationships with suppliers, securing lower raw material costs. The merged company leverages these relationships to reduce overall procurement costs.

• ‍Research and Development (R&D) Synergies: If one company has developed a component or technology that complements the other company's products, the merger can eliminate the need for the second company to develop this technology independently. This results in substantial R&D cost savings. Example: Company A has a proprietary component that enhances the efficiency of Company B’s products. Instead of investing in R&D to develop a similar component, the merged entity uses Company A’s existing technology, saving on development costs.

Measuring Cost Synergies:

• Comparable Transactions: Analyzing similar past M&A deals to estimate potential savings.

• ‍Bottom-Up Analysis: Examining each company's internal operations to identify specific areas for cost reduction and efficiency gains.

Key Takeaway: Cost synergy refers to the reduction of costs achieved through enhanced efficiencies following the merger of two companies. These savings can manifest in various ways, such as workforce reductions, technological upgrades, supply chain optimizations, and improved research and development processes.

Revenue Synergies

Revenue synergies refer to the potential for increased revenue resulting from the merger of two companies. These synergies can enhance the combined company's sales and market presence through various strategies and opportunities.

Here are some common types of revenue-enhancing synergies achieved through mergers:

• ‍Property and Patents: Access to additional intellectual property, such as patents, can enable the merged company to develop superior and more competitive products. These enhanced products can attract higher revenue by offering greater value to customers. e.g., a new smart security system could use Company X's motion detection technology and Company Y's real-time alert algorithms to provide users with more accurate and timely security updates.

• ‍Complementary Products: When two merging firms produce complementary products, they can bundle these products to boost sales. e.g.,if one company specializes in hardware and the other in software, their combined offerings can create a more comprehensive product line that appeals to a broader customer base, driving increased sales through cross-selling opportunities.

• ‍Geographic and Customer Diversification: Merging companies with different geographic footprints and customer bases can capitalize on expanded market access. The combined firm can leverage its broader geographic and demographic reach to attract new customers and increase sales. e.g., a merger between a company with a strong presence in North America and another with a significant market share in Europe can result in enhanced revenue by tapping into each other's established markets.

By effectively implementing these revenue synergies, the merged company can achieve higher sales, greater market penetration, and an improved competitive position in the industry.

Key Takeaway: While cost synergies focus on reducing expenses, revenue synergies aim at increasing sales and market opportunities through combined resources and capabilities.

Strategic Synergies

Strategic synergies refer to those synergies that enable companies to achieve certain strategic objectives that enhance their competitive position, market presence, and long-term growth.

These synergies are often realized through market share expansion, growth acceleration, improved valuation, and defensive strategies:

• ‍Market Share Expansion: Merging two companies can significantly increase their combined market presence and competitiveness. By uniting their strengths, the merged entity can achieve a larger market share, making it a more formidable competitor in the industry. e.g., two regional retail chains merge to form a national brand, creating a combined leading brand to compete with other regional players.

• ‍Growth Acceleration: Acquiring new products, technologies, or customer bases through a merger can accelerate the growth trajectory of the combined company. This strategic synergy allows the merged entity to enter new markets, expand its product offerings, and leverage the complementary strengths of both companies. e.g., a software company that acquires a startup with innovative AI technology. The acquisition enables the software company to integrate advanced AI capabilities into its existing products, offering new features and attracting more customers, thereby accelerating growth

• ‍Valuation Enhancement: Mergers can enhance shareholder value by integrating a smaller company that trades at a discount into a larger platform. By incorporating the undervalued company's operations into a larger, more established business, the combined entity can unlock significant value and improve overall market valuation. e.g., if large e-commerce platform acquires a smaller niche online retailer that trades at a lower valuation due to limited market reach. By integrating the smaller retailer into its extensive platform, the larger company enhances the retailer's competitive positioning, leading to an immediate uplift of its valuation.

• ‍Defensive Strategies: Mergers can also serve as a defensive strategy to prevent competitors from gaining control of strategic assets. By acquiring key companies or technologies, the merged entity can secure its market position and protect itself from potential competitive threats. e.g., a leading telecommunications company acquires a smaller competitor with valuable 5G technology patents. This defensive move prevents rivals from accessing these strategic assets and strengthens the acquiring company's technological capabilities.

Key Takeaway: Strategic synergies represent the broader, more qualitative motivations behind mergers and acquisitions, beyond the direct financial benefits of revenue and cost synergies. While not always quantifiable (like cost or revenue synergies), these strategic considerations are key drivers of M&A activity.

Merger Model

A merger model is a financial analysis tool used to evaluate the impact of combining two companies on the acquirer’s earnings per share (EPS). This model is critical in investment banking, equity research, and corporate finance, as it helps stakeholders understand whether a merger or acquisition will be accretive (increase EPS) or dilutive (decrease EPS).

Key Takeaway: EPS accretion/dilution helps shareholders determine if acquiring a target company will increase their earnings per share. A deal is accretive if the pro forma EPS is higher than the standalone EPS and dilutive if it is lower. Pro forma net income combines the acquirer’s net income, the target’s net income, and transaction effects such as post-tax synergies and added interest from new debt.

How Does a Merger Model Work

A merger model typically involves the following steps:

Step 1 | Determine the Purchase Price

‍Use valuation methods such as comparable company analysis, precedent transactions, and discounted cash flow (DCF) analysis to determine a fair price for the target company.

• Transaction Details: Input the basic details about the transaction, namely the target company’s purchase price, and any transaction fees..

Step 2 | Determine the Purchase Method

‍Decide whether to use cash, debt, or stock to finance the acquisition.

• ‍Financing Assumptions: Detail the interest rates on any new debt, the terms of any new equity issued, and the cash on hand used for the acquisition.,

Step 3 | Project Financial Statements

‍Forecast the financial statements of both the acquiring and target companies.

• Income Statements: Forecast the revenue, cost of goods sold, operating expenses, and taxes for both the acquirer and the target.

• ‍Balance Sheets: Project the assets, liabilities, and equity items for both companies.

• Cash Flow Statements: Forecast cash flows from operating, investing, and financing activities.

Step 4 | Combine Financial Statements

‍Merge the income statements, balance sheets, and cash flow statements of both companies.

• Income Statement Combination: Add together the revenues, expenses, and net income of both companies, adjusting for synergies and other effects of the acquisition.

• ‍Balance Sheet Combination: Sum the assets, liabilities, and equity of both companies, adjusting for the impact of the transaction.

• Cash Flow Statement Combination: Combine the cash flows from both companies, considering any new debt or equity raised and transaction-related costs.

Step 5 | Calculate Goodwill and Purchase Price Allocation

‍Account for the premium paid over the book value of the target company.

• Purchase Price Allocation: Allocate the purchase price to the target’s assets and liabilities, with any excess recorded as goodwill.

• ‍Goodwill Calculation: Subtract the fair value of the net identifiable assets from the purchase price to determine the goodwill.

Step 6 | Adjust for Acquisition Effects

‍Include adjustments such as synergies, new depreciation and amortization, and financing costs.

• Depreciation and Amortization: Adjust for new depreciation and amortization expenses resulting from the purchase price allocation.

• ‍Interest Expense: Include interest expenses from any new debt raised to finance the acquisition.

• Synergies: Estimate potential costs savings and revenue enhancements and incorporate the estimated synergies into the combined financials.

Step 7 | Calculate Accretion/Dilution

‍Compare the combined EPS to the acquirer’s standalone EPS to determine if the deal is accretive or dilutive.

• Pro Forma EPS: Calculate the pro forma EPS by dividing the combined net income by the new share count.

• ‍Standalone EPS: Compare the pro forma EPS to the acquirer’s standalone EPS to determine if the deal is accretive or dilutive.

Step 8 | Perform Sensitivity Analysis

Analyse how changes in key assumptions impact the results.

• Key Assumptions: Identify the key assumptions that could impact the accretion/dilution analysis, such as the purchase price, financing terms, and synergies.

• ‍Scenario Analysis: Test different scenarios to understand how changes in these assumptions affect the deal’s outcome.

Accretion / Dilution

The choice around acquisition financing will directly affect accretion / dilution analysis.

The acquisition can be financed through:

• Cash: Using available cash reserves.

• ‍Debt: Borrowing funds to finance the acquisition.

• Stock: Issuing new shares to the target company's shareholders.

When a buyer pays a higher price for a seller, the deal tends to be more dilutive (or less accretive), assuming the mix of cash, stock, and debt remains unchanged. Broadly speaking, a deal becomes dilutive if the additional Pre-Tax Income from the seller does not offset the costs associated with the acquisition, such as foregone interest on cash, interest paid on debt, and the impact of issuing new shares.

For example, consider a deal financed 50% with cash and 50% with debt:

• The seller contributes £1,000 in Pre-Tax Income.

• The buyer incurs £900 in Interest on Debt.

• The buyer forgoes £300 in Interest on Cash.

Result: The deal is dilutive because the buyer gains £1,000 in Pre-Tax Income but loses £1,200 in associated costs.

When stock issuance is involved, the assessment becomes more complex, but there are general rules of thumb to guide the evaluation.

To make your life easier during interviews, let's examine how accretion / dilution is calculated on the various scenarious.

Stock-Financing Deals

Look at P/E multiples! This rule is straightforward: in an all-stock deal, if the buyer's Price-to-Earnings (P/E) ratio is higher than the seller's, the deal will be accretive. Conversely, if the buyer's P/E is lower, the deal will be dilutive.

Here's why:

• P/E Ratio Definition: P/E = Equity Value / Net Income.

• Example: If the buyer has an Equity Value of £100 and Net Income of £10, its P/E is 10x. This means you're getting £0.10 in earnings for each pound you invest (1 / 10 = 10%).

• Seller's Scenario: If the seller has an Equity Value of £80 and Net Income of £10, its P/E is 8x. This gives you £0.125 in earnings for each pound invested (1 / 8 = 12.5%).

Since the seller offers a higher return per pound invested (due to a lower P/E multiple), the acquisition is accretive. However, this rule simplifies reality. It assumes equal tax rates, no premium paid for the seller, and no other acquisition effects like Depreciation & Amortization from Asset Write-Ups. Despite these simplifications, if the seller’s P/E is higher than the buyer’s, the deal will almost certainly be dilutive.

All Other Deals

Here, the "quick and dirty" method to determine accretion or dilution in any scenario by calculating the weighted "cost" for the buyer and comparing it to the seller’s yield.

Key Variables:

• Cost of Cash: Foregone Interest Rate on Cash * (1 - Buyer Tax Rate)

• ‍Cost of Debt: Interest Rate on Debt * (1 - Buyer Tax Rate)

• Cost of Stock: Reciprocal of the Buyer’s P/E multiple (i.e., E/P or Net Income/Equity Value)

• ‍Yield of Seller: Reciprocal of the Seller’s P/E multiple (preferably at the purchase price for the deal)

To determine if a deal is accretive or dilutive:

• ‍Firstly, you calculate the weighted "cost" for the buyer.‍

• Secondly, you compare this cost to the Seller’s Yield.‍

• Finally, if the Buyer’s Cost exceeds the Seller’s Yield, the deal is dilutive. Otherwise, it is accretive.

Pecking Order Theory

According to the Pecking Order Theory in corporate finance, companies prioritize their sources of financing based on the principle of least resistance or cost. The hierarchy is as follows:

• ‍#1 Cash: Companies prefer to use internal funds (retained earnings) first, as they incur no additional costs and do not dilute ownership.‍

• #2 Debt: If internal funds are insufficient, companies then turn to debt, which is generally cheaper than equity and does not dilute ownership.‍

• ‍#3 Equity: As a last resort, companies issue new equity, which is typically more expensive due to higher required returns from investors and dilutes existing shareholders' ownership.

When considering debt, buyers evaluate:

• Recent similar deals and the percentages of debt used.

• The Leverage Ratio (Total Debt / EBITDA) and the feasibility of meeting interest payments.

For stock issuances, buyers assess:

• The percentage of ownership being transferred to the seller and the dilution impact on existing shareholders.

• Market conditions and share price levels. Buyers prefer issuing stock when their shares are trading at high levels to minimize the number of shares issued and reduce dilution.

Conclusion

It is key to understand the impact of M&A. After all, that is what drives it in the first place. By leveraging strategic, revenue, and cost synergies, companies can achieve significant growth and competitive advantages. A well-constructed merger model helps in evaluating the financial impact of these transactions, ensuring that stakeholders can make informed decisions. Additionally, considering the trade-offs between different financing methods can optimize the benefits of M&A deals.