How to Build a Merger Model: Purchase Accounting, Financing and Accretion

Step 1 — Purchase price and the consideration mix

Start with the offer: price per share, the premium to the target’s undisturbed share price, and therefore the equity purchase price. Add the target’s net debt to get the transaction enterprise value, which is the figure you compare against precedent transaction multiples.

Then decide the consideration mix — how much cash, how much new debt, how much acquirer stock. This single choice drives most of the accretion outcome, because it determines what the acquirer gives up: cash forgoes interest income, debt adds interest expense, and stock adds shares to the denominator.

A worked case: the target has 40m shares at an undisturbed price of $25. A 30% premium gives $32.50 per share, so equity purchase price is $1.3bn. With $200m of target net debt assumed, transaction enterprise value is $1.5bn.

Step 2 — Sources and uses

Uses: the equity purchase price, the refinancing of any target debt that must be repaid at close, advisory and legal fees, and financing fees. Sources: cash from the acquirer’s balance sheet, new debt by tranche, and the value of acquirer stock issued.

The two fee types are treated differently and this is a routine slip. Advisory and legal fees are expensed — they reduce equity immediately. Financing fees are capitalised as an asset and amortised over the life of the debt, so they hit the income statement gradually.

Sources must equal uses. Build the check here with conditional formatting, because every downstream number depends on it.

Step 3 — Purchase accounting and goodwill

Goodwill is the plug that makes the acquirer’s post-deal balance sheet work: purchase price less the fair value of net identifiable assets acquired. But you cannot calculate it until you have handled the write-ups.

The sequence: eliminate the target’s existing goodwill and existing equity, write identifiable intangible assets up to fair value (brands, customer relationships, developed technology), write up PP&E if the case calls for it, and recognise the deferred tax liability that the write-ups create because the assets are written up for book purposes but not for tax.

A worked case: $1.3bn purchase price; target book equity of $400m; a $250m write-up of identifiable intangibles; a 25% tax rate creating a $62.5m deferred tax liability. Net identifiable assets become $400m plus $250m less $62.5m, or $587.5m. Goodwill is $1.3bn less $587.5m, which is $712.5m.

The written-up intangibles are amortised, and that amortisation is a real, recurring drag on pro forma EPS. Candidates who forget it overstate accretion, sometimes materially.

Step 4 — The pro forma income statement

Combine the two companies line by line, then layer the adjustments. Working down from combined EBIT: add after-tax cost synergies, subtract the new intangible amortisation, subtract incremental interest on acquisition debt, subtract forgone interest income on cash used, and add back any target interest expense on debt that was repaid at close.

Tax the result at the acquirer’s marginal rate, then divide by the new share count — the acquirer’s existing diluted shares plus any shares issued as consideration.

Be disciplined about synergies. Cost synergies are defensible and should be phased rather than applied at full run-rate from day one. Revenue synergies deserve a heavy haircut or exclusion entirely; presenting them at face value is the fastest way to lose a reviewer.

• After-tax synergies, phased — not full run-rate in year one.
• New intangible amortisation, after tax. Frequently omitted and always material.
• Incremental interest on acquisition debt, after tax.
• Forgone interest income on any balance sheet cash used.
• Target interest removed where its debt is refinanced at close.
• Amortisation of capitalised financing fees over the debt life.

Step 5 — Accretion/dilution, and the shortcut that checks it

Pro forma EPS versus the acquirer’s standalone EPS: higher is accretive, lower is dilutive, expressed as a percentage. That is the headline output.

Before trusting the model, check it against the shortcut. For an all-stock deal, compare P/E ratios: if the acquirer trades at a higher P/E than the effective multiple it is paying for the target, the deal is accretive. For cash or debt, compare the after-tax cost of funding to the target’s earnings yield — debt at 6% pre-tax and a 25% tax rate costs 4.5% after tax, so buying a target at 15x (a 6.7% earnings yield) is accretive before any other adjustment.

If the model and the shortcut disagree in direction, the model is wrong somewhere. The shortcut ignores synergies, amortisation and fees, so the magnitudes will differ — but the sign should not.

What accretion does not tell you

Accretion is a statement about the direction of pro forma EPS. It is not a statement about whether value was created, and conflating the two is the most common analytical error in M&A discussion.

An acquirer with a high P/E can buy almost any lower-multiple business and report accretion while paying far more than the target is worth. The value question is separate: is the price below the present value of the cash flows plus achievable synergies? A model that answers only the accretion question has answered the easier half.

The output page should therefore carry both — the accretion percentage and a value view, typically the implied multiple paid against precedent transactions, plus the breakeven synergy figure: how much synergy the deal needs to be value-neutral. That last number is often the most useful thing in the whole model.