Breaking Into Wall Street

Merger Model Walkthrough: Combining the Income Statements (19:25)

You’ll learn how to combine the Income Statements and calculate EPS accretion/dilution in this lesson, including support for “switches” on the revenue and expense synergies and more flexible formulas for the debt repayment and new depreciation and amortization lines.



What is a Merger Model?

Merger Model Definition: In a merger model, you combine the financial statements of the buyer and seller in an acquisition, reflect the effects of the acquisition, such as interest paid on new debt and new shares issued, and calculate the combined Earnings per Share (EPS) of the new entity to determine whether or not the deal is viable.

You can build a fairly simple merger model that takes 30-60 minutes (or even less time), or one that takes hours or days to complete, depending on the complexity and requirements.

In this tutorial and walkthrough, we’ll look at one small part of a moderately complex merger model – one that might take a few hours to build, if you already have a template and much of the data filled in.

Specifically, we’ll walk through the Income Statement combination in a merger model here, since it’s one of the most important steps in the entire process.

How To Build a Merger Model In 8 Steps

We normally divide a merger model into the following 8-step process:

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 Form of Payment – 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 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 in other ways.

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 Cost Synergies based on employee/building/supplier consolidation. In a simplified model, you can make lump-sum estimates.

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 – or how much Cash it generates. Calculating metrics like Debt / EBITDA and EBITDA / Interest for the Combined Company also helps you assess the viability of the deal. 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.

As you can see, not all of these steps are required; steps 4 and 5 are optional, and even steps 7 and 8 could be optional if you’re pressed for time, or you lack the required information.

To illustrate step 6 – the Income Statement Combination – we’ll use Builders FirstSource’s $2.5 billion acquisition of BMC Stock Holdings as the example deal.

We already have 3-statement projections for each company, and we’ve already set up the purchase price, deal financing, and synergies. Here’s a quick summary:

Merger Model Assumptions

  • Equity Purchase Price: $2.5 billion
  • Seller’s Debt: Refinanced and replaced so that the total Debt balance and coupon rate stay the same
  • % Cash: 15%
  • % Debt: 47%
  • % Stock: 38%

This differs from the real deal, which was financed with 100% Stock, because we want to illustrate all the potential acquisition effects on the Combined Income Statement.

There’s also a bit of extra cash used here to cover the transaction fees:

Merger Model Assumptions

We also set up a purchase price allocation schedule to calculate the Goodwill created in the deal, as well as the asset write-ups and new Deferred Tax line items:

Purchase Price Allocation

If you want to learn more about why these items get created, see our tutorial on Deferred Tax Liabilities in M&A deals.

Next, we estimated the Synergies in this deal “off-screen,” mostly by using Builders FirstSource’s numbers as a guide: around $80 million in Year 1, $110 million in Year 2, and $140 million in Year.

Those represent Cost Synergies, or cost savings from firing employees and consolidating buildings, so we also added Revenue Synergies in our version of this model.

These might come from the fact that both companies can expand geographically and sell to different customers in different regions once the deal is done.

Merger Model – Combined Income Statement Walkthrough

We prefer to start the Combined Income Statement with the bottom of the Combined Cash Flow Statement, or the “Combined Cash Flow Projections” if you lack full Cash Flow Statement for both companies.

We do this because if Debt is used to fund the deal, it’s helpful to track required principal repayments to determine how that New Debt balance changes over time (since it will affect the Interest Expense as well).

If there are no principal repayments, or the New Debt only allows for optional repayments, then you can skip this step and return after you’ve finished the Combined Income Statement:

Combined Cash Flow Statement - Bottom

We could have skipped this complex formula and used a much simpler version that assumed a 1% principal repayment of the original balance each year as well.

The Income Statement combination is fairly simple: we literally add together the corresponding line items, such as Revenue, COGS, and SG&A, for the Buyer and Seller.

And in a few cases, we make adjustments based on the merger model assumptions and acquisition effects.

Here’s the Combined Income Statement, section-by-section:

Combined Income Statement - Revenue and COGS

It’s not necessary to show all the Revenue categories here; you could just add together Total Revenue for both companies and then include the Revenue Synergies.

The next section of the merger model, for Combined Operating Expenses, is similar, but it has more acquisition effects from the Synergies and the new Depreciation & Amortization on the written-up assets:

Combined Income Statement - Operating Expenses

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 only 1-4 years rather than 5+ years, but we could skip them and use a simple division in the model as well.

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:

EPS Accretion Dilution

The EPS accretion / dilution here is a standard part of any merger model: add together the Pre-Tax Incomes of the Buyer and Seller, and then adjust for acquisition effects, such as Synergies, Foregone Interest on Cash, and Interest Paid on New Debt.

That will result in the Combined Pre-Tax Income.

Then, multiply by (1 – Buyer’s Tax Rate) to get the Combined Net Income, and then divide by the Share Count, which equals the Buyer’s Shares + New Shares Issued in the Deal.

The Seller’s shares go away because it no longer exists as an independent entity when the deal closes.

What Does This Merger Model Mean?

Broadly speaking, companies want deals to be EPS-accretive because it’s easier to win approval for such deals, and shareholders tend to react better when the deal is expected to increase the company’s EPS.

EPS is a key metrics in M&A because it’s the only quick-to-calculate number that reflects all the primary effects of the acquisition: Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.

Of course, EPS does not tell the whole story.

Plenty of deals could be accretive to the Buyer’s EPS but still be terrible deals!

You can use the analysis as supporting evidence for or against deals, but no company ever “decides” to make an acquisition just because it’s likely to be EPS-accretive.

You might also look at the Contribution Analysis, the Value Creation Analysis, or a simple DCF-based valuation of the Seller to judge the quantitative merits of the deal.

We cover those analyses in the full courses on this site.

One Final Note: Pro-Forma EPS

This “Pro-Forma EPS” metric in the screenshot above makes the deal look far better than it actually is, but many companies calculate it and present deals using this metric.

In short, “pro-forma” numbers like this one attempt to remove “one-time” and “non-cash” acquisition effects, such as the new D&A and the merger & integration costs here.

The problem is that “pro-forma” numbers are too good to be true: if the Combined Company expects to realize Synergies, it needs to pay to restructure and set up the company to achieve those Synergies.

So, we do not think the Pro-Forma EPS calculations are particularly sound, but you should understand the basic idea because you’ll see it many M&A deals.