Investment Banking Interview Guide

Access the Rest of the Interview Guide

Table of Contents – Merger Model Questions & Answers

Overview and Key Rules of Thumb ........................................................2

Key Rule #1: Why Buy Another Company? ..........................................3
Key Rule #2: How Does a Merger Model Work?..................................7
Key Rule #3: How Does the Payment Method Affect the Deal? ..... 15
Key Rule #4: Acquisition Effects and Synergies ................................ 20
Key Rule #5: M&A in the Real World.................................................. 23
For Further Learning .............................................................................. 26
Merger Model – Excel Model ................................................................. 27
Merger Model Interactive Quiz ............................................................. 28
Merger Model Questions & Answers – Basic ..................................... 29
Concept and Overview Questions ....................................................... 29
Price and Purchase Methods ................................................................ 33
Acquisition Effects and Synergies........................................................ 39
Real World Scenarios ............................................................................. 42
Merger Model Questions & Answers – Advanced ............................ 44
Purchase Price Allocation and Sources & Uses ................................. 44
Transaction Structures ........................................................................... 48
Net Operating Losses (NOLs) and Deferred Taxes........................... 51
Synergies .................................................................................................. 53
Noncontrolling Interests, Equity Interests, and Divestitures .......... 55
Calendarization and Stub Periods ....................................................... 57
Deal Structures and Legal Points ......................................................... 60
More Advanced Analysis and Special Cases ..................................... 62

1 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Overview and Key Rules of Thumb

The merger model (also known as an

accretion / dilution model or M&A model,
among others) is another topic that’s almost
100% guaranteed to come up in interviews.

The merger model is very common in

investment banking since bankers spend so
much time advising clients on M&A activity, but it also pops up even in roles
like equity research and private equity, because the companies you follow could
always acquire other companies, or be acquired – and you need to understand
how to analyze those scenarios.

The great part about a merger model is that the analysis itself is not terribly
complex – if you already know accounting, you could learn the fundamentals in
about an hour. But at the same time, it’s also very insightful and tells you a lot
about the deal in question.

But many interviewees only memorize selected facts about M&A and merger
models rather than aiming to understand the full picture – which causes
problems in interviews, since interviewers could always come up with new
variations on standard questions.

Here are the 5 most important concepts you need to understand:

1. Why would you buy (or merge with) another company? Merger models
are pointless if you don’t understand this.
2. How does a merger model work? How do you set it up, make
assumptions, combine two companies’ financial statements, and analyze
the result at the end?
3. How do you finance the purchase? There are 3 main methods, and they
all have different trade-offs and effects on the model.
4. What happens immediately after you buy the other company?

2 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

5. What happens in the long-term, and what causes mergers and

acquisitions to be successful or unsuccessful?

Once again, the Excel model that we provide will be huge for understanding
these questions because you’ll see the effects of everything firsthand.

The interactive quiz will also be helpful, but we focus more on concepts there
rather than specific numbers – since conceptual questions are more likely in
interviews.

We’ll start by going through each of these key rules below, and then delve into
the Basic and Advanced questions and answers.

Key Rule #1: Why Buy Another Company?

Everything in finance (and arguably life itself) comes

down to the return on investment.

A company would buy another company if it

believes that it will earn more from the acquisition
than it spends to complete the acquisition.

For example, maybe the buyer is considering acquiring the seller for $500 million.
The buyer has run the numbers, analyzed the seller’s business and its own
business, and concluded that it might earn between $1 billion and $1.2 billion
over the next 10 years by acquiring the seller.

If you do the math in Excel, you’ll see that this is roughly a 15% Internal Rate of
Return (IRR) if you assume $100 million in “additional earnings” each year
afterwards – a good result for most deals.

If the buyer only projected, say, a 5% return from the acquisition, it would be far
less likely to do the deal.

3 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

This explains the buyer’s rationale for pursuing or not pursuing an acquisition –
but investors and analysts tend to focus on Earnings Per Share (EPS) and how
that changes as a result of the acquisition in the near-term (the next 1-2 years).

EPS is simply Net Income / Shares

Outstanding, and depending on the price
the buyer pays, the seller’s pre-tax profits,
and the purchase method, it may go up,
go down, or be about the same afterward.

In a merger model, you usually focus on

EPS accretion / dilution (accretion = the
buyer’s EPS goes up, dilution = the buyer’s
EPS goes down) and figure out whether the deal will increase or decrease EPS, or
have no impact.

Before you start thinking about that, though, you need to understand more about
why a buyer might want to acquire a seller. In other words, what could cause the
buyer to earn a good return on investment, or (perhaps) boost its Earnings Per
Share?

We can divide the rationale for buying a company into “financial reasons” and
“fuzzy reasons.”

Financial Reasons for Acquisitions

In mature markets, consolidation often motivates M&A activity. For example,

there might be 4 major players in the market and the 3rd largest company wants
to acquire the 4th largest company to take on the #1 and #2 companies more
effectively.

With these types of deals, it’s usually obvious that the acquisition will yield a
good return on investment or otherwise boost EPS because both businesses are
mature and predictable.

4 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Sometimes geography plays a role in deals as well – the

buyer is based in North America, but the seller’s
customer base is in Europe and so they could expand by
growing geographically.

Besides gaining market share, a buyer might also be

motivated to acquire a seller because it needs to grow
more quickly and sees a faster-growing, smaller company
as a solid way to achieve that goal. All else being equal, investors value higher-
growth companies more highly.

Sometimes the company in question might be undervalued – or at least be

viewed as undervalued – in which case the buyer might also be interested.

At the right price almost any deal would yield a good return, so a specific
company’s valuation can motivate M&A activity as well.

The buyer might also be motivated to gain the seller’s customers – maybe it
estimates that it could up-sell higher-priced products or services to 20% of the
seller’s customers, or cross-sell some of its own products, which results in
significantly more revenue and profit for them.

There’s a lot of guesswork involved with this type of reasoning, which takes us
into our next category for acquisitions: fuzzy reasons.

Fuzzy Reasons for Acquisitions

Bankers would like to claim otherwise, but plenty of acquisitions happen for
completely irrational reasons.

In fact, massive acquisitions (anything worth over $50 billion USD) are often
driven almost entirely by ego, politicking, and sometimes a sense of “destiny”
(Of course we should buy them! It’s our destiny to be the biggest company ever!).

5 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

The cross-selling and up-selling motivation above usually qualifies for this
category, because there’s no way to know in advance what the uptake will be or
how much these efforts will add to the bottom-line.

Other reasons include:

• The seller has a particularly important technology, patent, or other

intellectual property that the buyer
views as essential.
• The seller poses a threat, whether real
or imagined, to the buyer’s business
and the buyer wants to make a
defensive acquisition.
• The seller has amazing employees and
the buyer is willing to pay a premium
just to get these employees (an “acqui-
hire,” common with tech start-ups).
• Although the seller is not projected to yield a good ROI or boost EPS in
the near-term, the buyer thinks that there are intangible benefits that will
materialize in the very long-term.

These reasons are much more common in research & development-driven

industries such as technology and biotech, and much less common in old-school,
asset-based industries like manufacturing.

Here’s the key takeaway: a buyer will only acquire a seller if it believes that it
will gain something from the deal – it will earn more from the acquisition than
what it’s spending on the acquisition.

Mergers vs. Acquisitions

The only difference between a “merger” and an “acquisition” is that in a merger,

the buyer and seller are about the same size, whereas in an acquisition the buyer
is significantly bigger (usually at least 2-3x bigger by revenue or market cap).

6 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Mechanically, they work exactly the same way and there is no difference in a
merger model regardless of whether the deal is classified as a merger or an
acquisition.

There are certain transaction structures and purchase methods that may differ
depending on whether it’s a merger or acquisition, which we’ll get into in the
questions and answers below, but the mechanics are the same.

There are also differences between acquiring over 50% of a company and less
than 50% of a company, but we’ll address that in the Advanced Questions and
Answers below.

Key Rule #2: How Does a Merger Model Work?

You can divide a merger model into an 8-step process – we’ll briefly go through
the steps here, and then look at a few of the steps in more detail below.

Step 1: Determine the Purchase Price

You do this the same way you value any other company: you would use a
combination of Public Comps, Precedent Transactions, and the DCF (and
possibly other methodologies) to come up with a reasonable price.

If it’s a public company you come up with a per-share purchase price; if it’s a
private company you might assume an Implied Equity Value based on the
valuation. The example below is for a public company, where we’ve assumed a
premium to the seller’s share price:

Step 2: Determine the Purchase Method

7 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Once you’ve determined the price for the seller, you need to figure out how to
pay for it: cash, stock, or debt.

• Cash: Just like normal cash in your bank account. Cold, hard money that
you can immediately withdraw and use to pay for something. The
downside is that you give up interest that you could have earned on that
cash, which is known as the foregone interest on cash.
• Debt: Similar to a mortgage, student loan debt, or auto debt in real life:
you take out a loan and pay interest on that loan, also repaying the
principal to the lenders over time.
• Stock: Sort of like “trading in” your existing car or house when you go to
buy a new one. You’re using the value of an existing asset – your
company – to buy something else. The downside is that you’ll get
additional shares outstanding, which will reduce your Earnings Per
Share and may upset investors.

Some deals will involve just one of these, but many deals use 2 or 3 of these
methods (e.g. 20% cash, 40% debt, 40% stock).

The method you use depends on how much cash you can afford to use, how
much debt or stock you can afford to issue, the structure of recent deals in the
market, and what the company’s upcoming plans are (Expanding? Buying a new
factor? Raising debt?).

You would determine the interest rates for cash and debt based on what’s
happening in the market and prevailing interest rates at the time of the deal.

Buyers generally prefer to pay with 100% cash, if possible – it’s the cheapest
option since the interest rate on cash is lower than the interest rate on debt. The
“cost” of issuing equity depends on the P / E multiples of the buyer and seller
(more on this below), but it is almost always more expensive than cash or debt.

8 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Step 3: Project the Financial Profiles and Statements of the Buyer and Seller

This one comes straight from the 3-statement models that you’ve created for the
buyer and seller. Here’s what you need at the bare minimum:

• Valuation – Share Price, Shares Outstanding, and Equity Value and

Enterprise Value.
• Tax Rates – You’ll need the buyer’s tax rate when combining the Income
Statements in the next step.
• Revenue – Kind of a big deal on the Income Statement…
• Operating Income – You don’t need all the items in between revenue and
operating income on the Income Statement. If you have them, great, but
revenue and operating income are the most important ones.
• Interest Income / (Expense) – You need these to calculate Pre-Tax Income.
• Pre-Tax Income and Net Income – Self-explanatory.
• Shares Outstanding and EPS – You need these to calculate EPS and
accretion / dilution at the end.

Here’s a simple example of Income Statement projections:

9 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

You don’t truly “need” projections for the Balance Sheet and Cash Flow
Statement, but you should at least have the Balance Sheets for the buyer and
seller from just before the acquisition closes.

Step 4: Combine the Buyer and Sellers’ Income Statements

This is straightforward: you just add

together everything on the Income
Statements down to the Pre-Tax
Income line.

Then, you multiply the Combined Pre-

Tax Income by (1 – Buyer’s Tax Rate)
to get to the Combined Net Income –
this is a very important point because
many people do this incorrectly and
multiply by the Seller’s Tax Rate or
some type of “combined” Tax Rate,
both of which are wrong.

Finally, you add new shares issued to

the buyer’s shares outstanding, and
divide Net Income by that new share
count to determine EPS.

Note that you do not add in the seller’s shares outstanding – they are all wiped
out in the acquisition, and go away completely.

Step 5: Calculate Goodwill and Allocate the Purchase Price

When a buyer acquires a seller, the seller’s shares outstanding disappear

completely and its Shareholders’ Equity is also wiped out and goes to $0 –
because it no longer exists as an independent entity.

10 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

However, that creates a problem when we combine the Balance Sheets of the
buyer and seller – consider the following scenario:

• The buyer has $10,000 in Assets, $8,000 in Liabilities, and $2,000 in

Shareholders’ Equity.
• The seller has $1,000 in Assets, $800 in Liabilities, and $200 in
Shareholders’ Equity.
• The buyer pays $500 for the seller, using 100% cash.

We add the Liabilities, so the combined total is $8,800, and we wipe out the
sellers’ Shareholders’ Equity so the total is still $2,000. Liabilities & Equity =
$10,800.

Now, on the other side, we add Assets from both companies, which gets us to
$11,000… except the buyer has used $500 in cash to purchase the seller, so its
Assets side is only $10,500. The Balance Sheet is out of balance!

When this happens, we need to create an Asset called Goodwill (and a related
Asset called Other Intangible Assets) to account for the premium that a buyer
has paid above the seller’s Shareholders’ Equity.

In this case, the purchase price is $500 but the seller’s Shareholders’ Equity is
only $200 – so we would create $300 in Goodwill (and/or Other Intangible Assets)
to account for that premium, and we’d add that new $300 Asset to the combined
Balance Sheet on the Assets side.

11 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Now the Balance Sheet would balance properly since the Assets side is $10,800,
which matches the Liabilities & Equity side.

There are other effects in an acquisition as well – for example:

• We often adjust the value of the seller’s PP&E and possibly other Assets.
• We usually “reset” the seller’s existing Goodwill and write it down to $0.
• We create Deferred Tax Liabilities due to the adjustments to PP&E and
other Assets, and we may write off the seller’s existing Deferred Tax
Liabilities.

And the list goes on – we cover this in more detail in the Advanced Questions
and Answers section below.

Here’s the key takeaway: you adjust a bunch of items on the Balance Sheet in a
merger model, and you need to create Goodwill (and Other Intangible Assets) to
plug the holes and represent the premium that a buyer pays over a seller’s
Shareholders’ Equity.

The difference between Goodwill and Other Intangible Assets is that Goodwill is
not amortized and therefore doesn’t change unless there’s an Impairment charge,

12 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

whereas Other Intangible Assets amortize over time, reflecting how they
“expire.”

Step 6: Combine the Balance Sheets and Adjust for Acquisition Effects

This is fairly straightforward because you are mostly just adding together all the
relevant line items. Here’s what you do in each section:

• Current Assets: You add

most of these items, and
subtract any Cash the
buyer uses to acquire the
seller.
• Long-Term Assets: You
adjust the PP&E value up
or down, and also adjust
the values of Goodwill
and Other Intangible
Assets depending on the
previous step.
• Current Liabilities: You
add everything here,
perhaps adding or
subtracting Debt if the
buyer uses Debt to
acquire the seller or pays
off the seller’s Debt.
• Long-Term Liabilities: You add most items here, but you add or subtract
Debt if the buyer uses Debt to acquire the seller or pays off the seller’s
Debt; you may also adjust the Deferred Tax Liability.
• Shareholders’ Equity: You wipe out the seller’s Shareholders’ Equity, but
add the dollar value of new shares issued by the buyer.

Step 7: Adjust the Combined Income Statement for Acquisition Effects

13 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Here are the key items that you adjust for on the Income Statement:

• Synergies: If you’ve assumed

revenue or expense synergies,
you need to reflect them here.
• Depreciation & Amortization:
If you’ve assumed changes to
PP&E or you’ve created Other
Intangible Assets, you need to
reflect the new D&A expense
on the combined Income
Statement.
• Foregone Interest on Cash: If
the buyer uses cash to acquire
the seller, this equals Cash Used
* Interest Rate.
• Interest Paid on New Debt: If
the buyer uses debt to acquire
the seller, this equals Debt Used
* Interest Rate.
• Shares Outstanding: If the buyer issues shares to raise the funds to
acquire the seller, the new number here equals Old Buyer Shares
Outstanding + Number of Shares Issued in Deal.

See the diagram above for a visual example of what all these items would look
like, and how they impact the EPS at the bottom.

Step 8: Calculate Accretion / Dilution and Create Sensitivity Tables

To calculate Accretion / Dilution, you compare the new, Combined Earnings Per
Share (EPS) number to the buyer’s old, projected EPS number from before the
acquisition.

14 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

If the buyer was projected to have an EPS of $1.00 prior to the acquisition, but the
combined company, post-acquisition, is projected to have $1.10 EPS, that’s 10%
accretion. If they only have $0.90 EPS post-acquisition, that’s 10% dilution.

You don’t stop with this number – normally you create sensitivity tables that
allow you to analyze the change in EPS at different purchase prices, transaction
structures, and purchase methods.

For example, you might see how the EPS changes when you buy a company with
30% cash, 40% cash, 50% cash, and 60% cash, at purchase prices ranging from
$500 million to $600 million. There’s an example below for the deal we’ve been
referencing in this guide:

This type of table lets you better assess whether or not the deal still “works”
under different assumptions.

Key Rule #3: How Does the Payment Method Affect the Deal?

The two sections above give you the high-level overview of why a company
might buy another company, and how to model an acquisition.

It’s important to understand those, but you also need to understand the trade-
offs behind different methods of financing an acquisition.

15 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Let’s start with the obvious: if a buyer pays more for a seller, the deal will be
more dilutive (or less accretive), assuming that the mix of cash/stock/debt stays
the same.

A deal will generally be dilutive if the amount of extra Pre-Tax Income the seller
contributes is not enough to offset the foregone interest on cash, the cash paid on
Debt, and the effects of issuing shares. Here’s an example:

• It’s a 50 / 50 cash / debt deal.

• The seller contributes $100 in Pre-Tax Income.
• The buyer pays $80 in Interest on Debt.
• The buyer gives up $25 in Foregone Interest on Cash.
• This will be dilutive because the buyer gains $100 in Pre-Tax Income, but
loses $105.

When you add a stock issuance to the mix t’s more difficult to assess, but there is
a rule of thumb even for that (keep reading).

The buyer almost always prefers to use 100% cash when acquiring a seller
because cash is cheaper than debt – and unlike issuing stock, it doesn’t require
the buyer to give up any ownership to the seller.

Sellers also tend to prefer cash because it’s less risky than equity (the buyer’s
share price might plummet immediately after the deal is announced, reducing
the purchase price).

However, the buyer is constrained because it may not have enough cash available
to complete the purchase; it might have also earmarked the cash for other
purposes, such as hiring more employees.

So if it needs to use debt and/or stock, it has to assess how much it can
reasonably use. On the debt side, it will look at the percentages of debt used in
recent, similar deals, as well as what its Leverage Ratio (Total Debt / EBITDA)
will be, and whether or not it can reasonably meet its interest payments.

16 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

For stock issuances, it will look at how much ownership it’s giving up and how
much it’s diluting existing shareholders.

For example, if it currently has 90 million shares outstanding but it’s issuing 30
million shares to acquire another company, that’s bound to make investors
question whether they want to give up 25% of the company to the seller.

Share price is also a factor when issuing stock. A buyer will always prefer to
issue stock when its shares are trading at high levels. If its share price were $100,
for example, it only has to issue half as many shares as it would if its share price
were $50 – and issuing half as many shares results in less dilution.

Rules of Thumb for Merger Models

Now we’re about to make your life – and your interviews – easier
by providing 2 rules of thumb that you can use to estimate
accretion / dilution for all scenarios.

Rule #1: 100% Stock Deals and P / E Multiples

This one is simple: in an all-stock deal, if the buyer has a higher P / E than the
seller, the deal will be accretive; if the buyer has a lower P / E, it will be
dilutive.

Think of it like this: P / E = Equity Value / Net Income.

If the buyer’s Equity Value is $100 and its Net Income is $10, its P / E is 10x. If
you bought it, you’d be getting $0.10 in earnings for each dollar you pay for it
(flip the P / E, so 1 / 10 = 10%).

If the seller’s Equity Value is $80 and its Net Income is $10, its P / E is 8x. There,
you’d be getting $0.125 in earnings for each dollar you pay for the seller (flip
the P / E, so 1 / 8 = 12.5%).

17 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

You get “more for your money” with the seller because its P / E multiple is lower.
Since the buyer would get more for each dollar invested in the seller than what
it’s currently earning for each dollar invested in itself, this acquisition is accretive.

This is a simplification. This rule assumes that the buyer and seller have the
same tax rates, that there’s no premium paid for the seller over its current share
price, and that there are no other acquisition effects such as Depreciation &
Amortization from Asset Write-Ups.

So this rule rarely holds up in the real world. However, if the seller’s P / E is
higher than the buyer’s P / E, you can be almost 100% certain that the deal will
be dilutive.

Rule #2: How to Determine Accretion / Dilution for All Deals

Now we’ll show you a cool trick for determining accretion / dilution in all
scenarios. First, let’s define a few 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 (ideally, the P /E
multiple at the purchase price for the deal)

To determine whether a deal is accretive or dilutive, simply calculate the

weighted “cost” for the buyer and compare it to the Yield of the Seller. If the
Buyer’s Cost exceeds the Seller’s Yield, it’s dilutive. Otherwise, it’s accretive.

18 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Let’s look at a few examples of this rule in action:

• The buyer has a P / E multiple of 12x and the seller’s P / E multiple is 10x.
The foregone interest rate on cash is 4% and the interest rate on new debt
is 8%. The buyer’s tax rate is 40%.
• Cost of Cash = 4% * (1 – 40%) = 2.4%
• Cost of Debt = 8% * (1 – 40%) = 4.8%
• Cost of Stock = 1 / 12 = 8.3%
• Yield of Seller = 1 / 10 = 10.0%

In this case, this rule tells us that the acquisition will be accretive regardless of
the cash / stock / debt mix used – because none of the buyer’s costs exceed the
Yield of the Seller.

But look what happens if we have slightly different numbers:

• The buyer’s P / E multiple is 8x and the seller’s P / E multiple is 12x now.

Everything else is the same.
• Cost of Cash = 4% * (1 – 40%) = 2.4%
• Cost of Debt = 8% * (1 – 40%) = 4.8%
• Cost of Stock = 1 / 8 = 12.5%
• Yield of Seller = 1 / 12 = 8.3%

In this case, the after-tax costs of debt and cash are less than the Seller’s Yield of
8.3%, so a 100% debt acquisition or a 100% cash acquisition would both be
accretive.

However, the buyer’s Cost of Stock is greater than the Yield of the Seller now,
so a 100% stock acquisition would be dilutive.

You can combine these rules to estimate what would happen in other scenarios,
such as a 50/50 cash/stock deal, or a 33/33/33 cash/stock/debt deal – just calculate
the weighted average cost.

19 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

One interesting implication of this rule: cash is not necessarily the cheapest way to
acquire a company.

For example, if the buyer has an extremely high P / E multiple of 100x, the
reciprocal would be 1%. And that 1% might very well be lower than the after-tax
cost of cash for them (ex: 4% * (1 – 40%) = 2.4%.

The only problem with this shortcut is that it doesn’t account for other
acquisition effects – synergies, new D&A, and so on. Use it to quickly estimate
what a deal will look like on a non-synergy, cash-only basis, rather than as a
universal law.

Another big problem (we cover this in the Excel file and tutorial) is that this
doesn’t account for the premium paid for the seller, unless you use the purchase
price for the Seller’s Yield rather than its current share price.

Example: The seller’s Net Income is $100 million and its market cap is $1 billion,
so its P / E is 10x and its current Yield is 1 / 10, or 10%. However, if the buyer
pays $1.5 billion for the seller, its Effective Yield would only be $100 million /
$1.5 billion, or 6.7%.

This is really important to factor in for “real deal” scenarios, and you can review
the Excel file and tutorial there for more details there.

Key Rule #4: Acquisition Effects and Synergies

What happens after an acquisition is equally as important as important as how

you acquire a company in the first place.

Questions on this topic are much more likely if you’ve had full-time work
experience already or you have more advanced knowledge from other sources.

But just to be complete, we’ll discuss a few of the key points here (there’s more
coverage in the Advanced Questions and Answers toward the end).

20 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Basic Acquisition Effects

Here are the 5 key acquisition effects that you need to know – these are fair game
even for entry-level interviews:

1. Foregone Interest on Cash – The buyer loses the Interest it would have
otherwise earned if it uses cash for the acquisition – so that reduces its Pre-
Tax Income, Net Income, and EPS.
2. Additional Interest on Debt – The buyer pays additional Interest Expense if
it uses debt, which reduces its Pre-Tax Income, Net Income, and EPS.
3. Additional Shares Outstanding – If the buyer pays with stock, it must issue
additional shares, which will reduce its EPS.
4. Combined Financial Statements – After the acquisition, the seller’s financial
statements are added to the buyer’s, with a few adjustments.
5. Creation of Goodwill & Other Intangibles – These Balance Sheet items
represent the premium that the buyer paid over the seller’s Shareholder’s
Equity, and are required to ensure that the Balance Sheet balances.

You can calculate the impact of the first 3 effects using the rule outlined above:
for the first two, multiply the interest rate by (1 – Buyer’s Tax Rate), and for the
impact of issuing stock, flip the P / E multiple of the buyer.

More Advanced Acquisition Effects

Then there are a few additional effects that you see in more advanced merger
models. These are unlikely to come up in entry-level interviews, but there’s no
such thing as being overly prepared:

• PP&E and Fixed Asset Write-Ups – You may write up the values of these
Assets in an acquisition, under the assumption that the market values
exceed the book values.
• Deferred Tax Liabilities – Normally you write off the seller’s existing
DTLs, and then create new ones based on Buyer’s Tax Rate * (PP&E and
Fixed Asset Write-Up and Newly Created Intangibles). See the Advanced
Questions for more.

21 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

• Deferred Tax Assets – In most deals, you write these off completely,
depending on the seller’s tax situation; see the Advanced section.
• Transaction and Financing Fees – You expense legal and advisory fees and
deduct them from Cash and Retained Earnings at the time of the
transaction, but you capitalize financing fees and then amortize them 5-10
years, or as long as newly issued Debt remains on the Balance Sheet.
• Inter-Company Accounts Receivable and Accounts Payable – You may
eliminate some of the combined AR and AP balances because the buyer
might owe the seller money and vice versa. Once they’re the same
company, this no longer makes sense.
• Deferred Revenue Write-Down – Accounting rules state that you can
only recognize the profit portion of the seller’s Deferred Revenue post-
acquisition. So you often write down the expense portion of the seller’s
Deferred Revenue over several years in a merger model.

Another important feature in more advanced merger models is the treatment Net
Operating Losses (NOLs) and book vs. cash taxes; see the Advanced section for
more on those.

Revenue and Expense Synergies

By combining forces, two companies may earn more revenue than if they simply
added together their separate revenues, or they may pay fewer expenses as a
result of consolidation.

You could model revenue synergies by assuming a price increase or by

assuming additional volume sold.

For example, maybe as a result of acquiring

Company B, Company A can add new features to
its products that result in customers paying $105
rather than $100 for each unit – you could then
multiply that difference by the units sold each
year to estimate the annual revenue synergies.

22 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Revenue synergies are rarely taken seriously in practice because it’s impossible
to predict how successful these types of up-sell / cross-sell efforts will be.

Expense synergies are much more grounded in reality, and are easier to estimate.
The two most common expense synergies:

• Reduction in Force: This is a nice way of saying, “Lay off employees.”

Often, two companies will have redundant employees in administrative
functions – accounting, bookkeeping, marketing, and so on, and they can
reduce expenses by eliminating
redundant positions.
• Building Consolidation: If the buyer
and seller both lease buildings in the
same city, it makes sense to consolidate
into one larger space and save on rent –
or in the case of owned buildings, save
on loan payments and property taxes.

You might estimate expense synergies by finding, for example, that each
employee costs $100,000 per year, including salary, benefits, and other
compensation, and then assuming that 5% of the workforce can be cut.

5% represents 30 employees, so that is a savings of $3 million per year.

Key Rule #5: M&A in the Real World

Understanding merger models is great, but you also need to grasp how they
work in real life and how bankers and other financiers actually use them.

First off, realize that no deal ever happens because of the output of an Excel
model.

Financial modeling gives you an idea of whether a deal might be viable, or

whether a company might be undervalued or overvalued, for example, but no

23 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

one would ever say, “Aha! This deal is 12% accretive according to my Excel
model! Let’s do it!”

Merger models are used more for supporting evidence in negotiations and M&A
discussions – not as a way to make decisions in the first place.

Acquisitions Gone Bad

Another harsh fact of life is that most M&A deals fail. It’s tough to merge two
completely different organizations, and there are many factors that could lead to
failure:

• Integration Difficulties – On paper it might

have seemed like a great move, but in
practice integrating two separate employee
bases, supply chains, retail networks, and so
on can prove incredibly difficult. And if
companies can’t integrate properly, the deal
will fail.
• Cultural Differences – While bankers like
to think otherwise, a company is more than just revenue and profit in
Excel. If two companies have radically different cultures (e.g. one is very
relaxed and casual and one is stuffy and uptight), it will be challenging, if
not impossible, for employees to work together successfully.
• Poor Rationale – Perhaps the original reason that the buyer gave to justify
the acquisition made no sense in the first place. It sounds crazy, but huge
deals really do happen for poor-to-nonexistent reasons. And when it
becomes clear that the original reasoning made no sense, the deal works
out poorly for everyone.
• Synergy Failures – Maybe the buyer acquired the seller to access its
wonderfully lucrative customer base… only to find that the customer base
does not, in fact, want any of its products. Whoops.

Overpaying for Companies

24 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Another common “failure” scenario happens when the buyer overpays for the
seller.

To see examples of this, just look up hyped tech start-up M&A deals and you’ll
see examples of absurd multiples or companies with 0 revenue and profit being
acquired for tens or hundreds of millions (or billions) of dollars.

In these cases, enormous Goodwill & Other Intangible Asset balances get
created… and afterward, there are often Impairment Charges and Write-Downs
as the buyer re-assesses what the seller was really worth.

Maybe they record $500 million of Goodwill initially, but then they re-assess it in
1-2 years and record a $100 million Impairment Charge, which reduces (book)
Pre-Tax Income, Net Income, and Goodwill.

Sometimes the impact is more immediate as well – for example, if a public

company is acquiring another company using a significant amount of stock, the
market almost always has a strong reaction to news of any deal.

If the buyer pays $100 million worth of stock for the seller but the market
believes the seller is only worth $80 million, the buyer’s stock price will
inevitably fall once the deal is announced.

Its share price would not fall by 20% necessarily, but rather by the per-share
amount that corresponds to this $20 million difference in value.

Example: The buyer is worth $1 billion, has 100 million shares outstanding, and
its current share price is $10.00. It wants to issue 10 million shares to acquire the
seller for $100 million.

But if the market believes that the seller is only worth $80 million rather than
$100 million, the buyer’s share price might fall to $9.81 (implying a total value of
$1.08 billion) to reflect this lower value.

25 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Moral of the Story: There are many ways for M&A deals to fail and to have
disastrous consequences after the fact.

This is why it’s so important to use sensitivities to analyze deal scenarios such as
different purchase prices, synergy levels, cash/stock/debt combinations, and
more. You want to ensure that even in the worst case scenario, the deal won’t be a
complete disaster.

Hardly anyone ever thinks about these dangers in real life because they’re
incentivized to get deals done at any cost.

For Further Learning

The rules above are a great start, but sometimes you need more: if you’re in this
position, click here to check out our Financial Modeling Fundamentals course.

You receive a $50 discount as a Breaking Into Wall Street member, and you get 20
hours of video tutorials along with several bonus case studies on real M&A
deals and leveraged buyouts.

It has been one of our most popular courses year after year, and it’s a great way
to extend your knowledge of merger models, practice with real case studies
based on M&A deals involving large companies, and prepare for interviews
more intensively.

26 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Merger Model – Excel Model

This file will be very useful for understanding how different variables, such as
interest rates, profit margins, and P / E multiples, impact the output of a merger
model.

This one is not quite as useful for understanding the merger model concept, but
we’ve been through that in detail above.

Play around with these assumptions, tweak the numbers, and see how
everything changes as a result – and what the results tell you about M&A deals
in real life.

You can get the full model right here:

• United / Goodrich – Merger Model (Excel) and Video Tutorial

27 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Merger Model Interactive Quiz

The interactive quiz here is more extensive than what we provide in other
sections of the guide, because merger models are a deep topic and there are
many different angles to cover.

There aren’t quite as many “calculation” questions because conceptual questions

on merger models are more likely in interviews.

Once again, this quiz is divided into sections on Basic and Advanced questions.
For entry-level interviews you should focus on the Basic questions. The
Advanced questions address M&A in-depth, but many interviewers won’t even
know all the material covered in this quiz.

• Basic Merger Model Quiz

• Advanced Merger Model Quiz

28 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Merger Model Questions & Answers – Basic

It’s no longer enough to know the basic concept behind a merger model and how
you can use cash, debt, and stock to acquire a company.

Especially now that more interview prep resources are available, interviewers
have started asking twists and variations on common questions.

So even if the concepts are “basic,” the explanations and rationale behind each
answer may be far from “basic.”

We address the most common topic areas in this section and go through dozens
of example questions with detailed explanations for each one.

Concept and Overview Questions

1. Why would a company want to acquire another company?

A company would acquire another company if it believes it will earn a good

return on its investment – either in the form of a literal ROI, or in terms of a
higher Earnings Per Share (EPS) number, which appeals to shareholders.

There are several reasons why a buyer might believe this to be the case:

• The buyer wants to gain market share by buying a competitor.

• The buyer needs to grow more quickly and sees an acquisition as a way to do
that.
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller’s customers so it can up-sell and cross-
sell products and services to them.
• The buyer thinks the seller has a critical technology, intellectual property, or
other “secret sauce” it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make
the deal accretive for its shareholders.

29 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

2. Walk me through a basic merger model.

“A merger model is used to analyze the financial profiles of 2 companies, the

purchase price and how the purchase is made, and it determines whether the
buyer’s EPS increases or decreases afterward.

Step 1 is making assumptions about the acquisition – the price and whether it
was done using cash, stock, debt, or some combination of those. Next, you
determine the valuations and shares outstanding of the buyer and seller and
project the Income Statements for each one.

Finally, you combine the Income Statements, adding up line items such as
Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash
and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the
buyer’s Tax Rate to get the Combined Net Income, and then divide by the new
share count to determine the combined EPS.”

You could also add in the part about Goodwill and combining the Balance Sheets,
but it’s best to start with answers that are as simple as possible at first.

3. What’s the difference between a merger and an acquisition?

There’s always a buyer and a seller in any M&A deal – the difference is that in a
merger the companies are similarly-sized, whereas in an acquisition the buyer is
significantly larger (often by a factor of 2-3x or more).

Also, 100% stock (or majority stock) deals are more common in mergers because
similarly sized companies rarely have enough cash to buy each other, and cannot
raise enough debt to do so either.

4. Why would an acquisition be dilutive?

An acquisition is dilutive if the additional Net Income the seller contributes is not
enough to offset the buyer’s foregone interest on cash, additional interest paid on
debt, and the effects of issuing additional shares.

30 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Acquisition effects – such as the amortization of Other Intangible Assets – can

also make an acquisition dilutive.

5. Is there a rule of thumb for calculating whether an acquisition will be

accretive or dilutive?

Yes, here it is:

• 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 (ideally calculated
using the purchase price rather than the seller’s current share price).

You calculate each of the Costs, take the weighted average, and then compare
that number to the Yield of the Seller (the reciprocal of the seller’s P / E
multiple).

If the weighted “Cost” average is less than the Seller’s Yield, it will be accretive
since the purchase itself “costs” less than what the buyer gets out of it; otherwise
it will be dilutive.

Example: The buyer’s P / E multiple is 8x and the seller’s P / E multiple is 10x.

The buyer’s interest rate on cash is 4% and interest rate on debt is 8%. The buyer
is paying for the seller with 20% cash, 20% debt, and 60% stock. The buyer’s tax
rate is 40%.

• Cost of Cash = 4% * (1 – 40%) = 2.4%

• Cost of Debt = 8% * (1 – 40%) = 4.8%
• Cost of Stock = 1 / 8 = 12.5%
• Yield of Seller = 1 / 10 = 10.0%

Weighted Average Cost = 20% * 2.4% + 20% * 4.8% + 60% * 12.5% = 8.9%.

31 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Since 8.9% is less than the Seller’s Yield, this deal will be accretive.

6. Wait a minute, though, does that formula really work all the time?

Nope. There are a number of assumptions here that rarely hold up in the real
world: the seller and buyer have the same tax rates, there are no other acquisition
effects such as new Depreciation and Amortization, there are no transaction fees,
there are no synergies, and so on.

And most importantly, the rule truly breaks down if you use the seller’s current
share price rather than the price the buyer is paying to purchase it.

It’s a great way to quickly assess a deal, but it is not a hard-and-fast rule.

7. A company with a higher P/E acquires one with a lower P/E – is this
accretive or dilutive?

Trick question. You can’t tell unless you also know that it’s an all-stock deal. If it’s
an all-cash or all-debt deal, the P / E multiple of the buyer doesn’t matter because
no stock is being issued.

If it is an all-stock deal, then the deal will be accretive since the buyer “gets”
more in earnings for each $1.00 used to acquire the other company than it does
from its own operations. The opposite applies if the buyer’s P / E multiple is
lower than the seller’s.

8. Why do we focus so much on accretion / dilution? Is EPS really that

important? Are there cases where it’s not relevant?

EPS is important mostly because institutional investors value it and base many
decisions on EPS and P / E multiples – not the best approach, but it is how they
think.

32 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

A merger model has many purposes besides just calculating EPS accretion /
dilution – for example, you could calculate the IRR of an acquisition if you
assume that the acquired company is resold in the future, or even that it
generates cash flows indefinitely into the future.

An equally important part of a merger model is assessing what the combined

financial statements look like and how key items change.

So it’s not that EPS accretion / dilution is the only important point in a merger
model – but it is what’s most likely to come up in interviews.

Price and Purchase Methods

1. How do you determine the Purchase Price for the target company in an
acquisition?

You use the same Valuation methodologies we discussed in the Valuation

section. If the seller is a public company, you would pay more attention to the
premium paid over the current share price to make sure it’s “sufficient”
(generally in the 15-30% range) to win shareholder approval.

For private sellers, more weight is placed on the traditional methodologies.

2. All else being equal, which method would a company prefer to use when
acquiring another company – cash, stock, or debt?

Assuming the buyer had unlimited resources, it would almost always prefer to
use cash when buying another company. Why?

• Cash is cheaper than debt because interest rates on cash are usually under 5%
whereas debt interest rates are almost always higher than that. Thus,
foregone interest on cash is almost always less than the additional interest
paid on debt for the same amount of cash or debt.
• Cash is almost always cheaper than stock because most companies’ P / E
multiples are in the 10 – 20x range… which equals a 5-10% “Cost of Stock.”

33 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

• Cash is also less risky than debt because there’s no chance the buyer might
fail to raise sufficient funds from investors, or that the buyer might default.
• Cash is also less risky than stock because the buyer’s share price could
change dramatically once the acquisition is announced.

3. You said “almost always” above. So could there be cases where cash is
actually more expensive than debt or stock?

With debt this is impossible because it makes no logical sense: why would a bank
ever pay more on cash you’ve deposited than it would charge to customers who
need to borrow money?

With stock it is almost impossible, but sometimes if the buyer has an extremely
high P / E multiple – e.g. 100x – the reciprocal of that (1%) might be lower than
the after-tax cost of cash. This is rare. Extremely rare.

4. If a company were capable of paying 100% in cash for another company,

why would it choose NOT to do so?

It might be saving its cash for something else, or it might be concerned about
running low on cash if business takes a turn for the worst.

Its stock may also be trading at an all-time high and it might be eager to use that
“currency” instead, for the reasons stated above: stock is less expensive to issue if
the company has a high P / E multiple and therefore a high stock price.

5. How much debt could a company issue in a merger or acquisition?

You would look at Comparable Companies and Precedent Transactions to

determine this. You would use the combined company’s EBITDA figure, find the
median Debt / EBITDA ratio of the companies or deals you’re looking at, and
apply that to the company’s own EBITDA figure to get a rough idea of how
much debt it could raise.

34 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

You could also look at “Debt Comps” for similar, recent deals and see what types
of debt and how many tranches they have used.

6. When would a company be MOST likely to issue stock to acquire another

company?

1. The buyer’s stock is trading at an all-time high, or at least at a very high

level, and it’s therefore “cheaper” to issue stock than it normally would be.
2. The seller is almost as large as the buyer and it’s impossible to raise
enough debt or use enough cash to acquire the seller.

7. Let’s say that a buyer doesn’t have enough cash available to acquire the
seller. How could it decide between raising debt, issuing stock, or some
combination of those?

There’s no simple rule to decide – key factors include:

• The relative “cost” of both debt and stock. For example, if the company is
trading at a higher P / E multiple it may be cheaper to issue stock (e.g. P /
E of 20x = 5% cost, but debt at 10% interest = 10% * (1 – 40%) = 6% cost.
• Existing debt. If the company already has a high debt balance, it likely
can’t raise as much new debt.
• Shareholder dilution. Shareholders do not like the dilution that comes
with issuing new stock, so companies try to minimize this.
• Expansion plans. If the buyer expands, begins a huge R&D effort, or buys
a factory in the future, it’s less likely to use cash and/or debt and more
likely to issue stock so that it has enough funds available.

8. Let’s say that Company A buys Company B using 100% debt. Company B
has a P / E multiple of 10x and Company A has a P / E multiple of 15x. What
interest rate is required on the debt to make the deal dilutive?

• Company A Cost of Stock = 1 / 15 = 6.7%

• Company B Yield = 1 / 10 = 10.0%

35 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Therefore, the after-tax Cost of Debt must be above 10% for the acquisition cost to
exceed Company B’s Yield.

10% / (1 – 40%) = 16.7%, so we can say “above approximately 17%” for the
answer. That is an exceptionally high interest rate, so a 100% debt deal here
would almost certainly be accretive instead.

9. Let’s go through another M&A scenario. Company A has a P / E of 10x,

which is higher than the P / E of Company B. The interest rate on debt is 5%. If
Company A acquires Company B and they both have 40% tax rates, should
Company A use debt or stock for the most accretion?

• Company A Cost of Debt = 5% * (1 – 40%) = 3%

• Company A Cost of Stock = 1 / 10 = 10%
• Company B Yield = Higher than 10% since its P / E multiple is lower

Therefore, this deal will always be accretive regardless of whether Company A

uses debt or stock since both “cost” less than Company B’s Yield.

However, Company A will achieve far more accretion if it uses 100% debt
because the Cost of Debt (3%) is much lower than the Cost of Stock (10%).

10. This is a multi-part question. Let’s look at another M&A scenario:

• Company A: Enterprise Value of 100, Market Cap of 80, EBITDA of 10, Net
Income of 4.
• Company B: Enterprise Value of 40, Market Cap of 40, EBITDA of 8, Net
Income of 2.

First, calculate the EV / EBITDA and P / E multiples for each one.

• Company A: EV / EBITDA = 100 / 10 = 10x, P / E = 80 / 4 = 20x.

• Company B: EV / EBITDA = 40 / 8 = 5x, P / E = 40 / 2 = 20x.

36 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

11. Good. Now, Company A decides to acquire Company B using 100% cash.
Company A does NOT pay any kind of premium to acquire Company B. What
are the combined EBITDA and P / E multiples?

In this scenario, Company B’s Market Cap gets wiped out because it no longer
exists as an independent entity, and Company A’s cash balance decreases
because it has used its cash to acquire Company B.

So, the Combined Market Cap = 80. Previously, A had 20 more Debt than Cash,
and B had the same amount of Cash and Debt.

To get real numbers here, let’s just say that A had 60 of Debt and 40 of Cash.
Afterward, the Debt remains at 60 but all the cash is gone because it used the
Cash to acquire B. We don’t need to look at B’s numbers at all because its Cash
and Debt cancel each other out.

So the Combined Enterprise Value = 80 + 60 = 140. It is no coincidence, of course,

that Combined Enterprise Value = Company A Enterprise Value + Company B
Enterprise Value. That is how it should always work in an acquisition where
there was no premium paid for the seller.

You add the EBITDA and Net Income from both companies to get the combined
figures. This is not 100% accurate because Interest Income changes for Company
A since it’s using cash and because the tax rates may be different, but we’re
going to ignore those for now since the impact will be small:

• Combined EV / EBITDA = 140 / (10 + 8) = 140 / 18 = 7.8x.

• Combined P / E = 80 / (4 + 2) = 80 / 6 = 13.3x.

12. Now, let’s say that Company A instead uses 100% debt, at a 10% interest
rate and 25% tax rate, to acquire Company B. Again, Company A pays no
premium for Company B. What are the combined multiples?

Once again, Company B’s Market Cap gets wiped out since it no longer exists as
an independent entity.

37 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

So Combined Market Cap = 80.

The combined company has 40 of additional Debt, so if we continue with the

assumption that A has 60 of Debt and 40 of Cash the Enterprise Value is 80 + 60 +
40 – 40 = 140, the same as in the previous example (Important: Regardless of the
purchase method, the combined Enterprise Value stays the same).

The Combined EBITDA is still 18, so EV / EBITDA = 140 / 18 = 7.8x.

But the combined Net Income has changed. Normally, Company A Net Income +
Company B Net Income = 6…

But now we have 40 of debt at 10% interest, which is 4, and when multiplied by
(1 – 25%), equals 3. So Net Income falls to 3, and Combined P / E = 80 / 3 = 26.7x.

13. What was the point of this scenario and these questions? What does it tell
you about valuation multiples and M&A activity?

There are a few main takeaways from this exercise:

1. Regardless of the purchase method (cash, stock, debt, or some

combination of those), the Combined Enterprise Value for the new entity
stays the same.
2. Company B’s Market Cap (and the book version of it – Shareholders’
Equity) always gets wiped out when it is acquired (technically, whenever
the acquisition is for over 50% of Company B).
3. Regardless of the purchase method, the Combined EV / EBITDA multiple
does not change because Combined Enterprise Value always stays the
same and because the Combined EBITDA is not affected by changes in
interest or additional shares outstanding.

14. Why would a strategic acquirer typically be willing to pay more for a
company than a private equity firm would?

38 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Because the strategic acquirer can realize revenue and cost synergies that the
private equity firm cannot unless it combines the company with a
complementary portfolio company. Those synergies make it easier for the
strategic acquirer to pay a higher price and still realize a solid return on
investment.

Acquisition Effects and Synergies

1. What are the effects of an acquisition?

1. Foregone Interest on Cash – The buyer loses the Interest it would have
otherwise earned if it uses cash for the acquisition.
2. Additional Interest on Debt – The buyer pays additional Interest Expense
if it uses debt.
3. Additional Shares Outstanding – If the buyer pays with stock, it must
issue additional shares.
4. Combined Financial Statements – After the acquisition, the seller’s
financial statements are added to the buyer’s.
5. Creation of Goodwill & Other Intangibles – These Balance Sheet items
that represent the premium paid to a seller’s Shareholders’ Equity also get
created.

There’s more to it than this (see the Advanced section), but this is usually
sufficient to mention in interviews.

2. Why do Goodwill & Other Intangibles get created in an acquisition?

These represent the amount that the buyer has paid over the book value
(Shareholders’ Equity) of the seller. You calculate the number by subtracting the
seller’s Shareholders’ Equity (technically the Common Shareholders’ Equity)
from the Equity Purchase Price.

Goodwill and Other Intangibles represent the value of customer relationships,

employee skills, competitive advantages, brand names, intellectual property, and
so on – valuable, but not physical Assets in the same way factories are.

39 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

3. What is the difference between Goodwill and Other Intangible Assets?

Goodwill typically stays the same over many years and is not amortized. It
changes only if there’s Goodwill Impairment (or another acquisition).

Other Intangible Assets, by contrast, are amortized over several years and affect
the Income Statement by reducing Pre-Tax Income.

Technically, Other Intangible Assets might represent items that “expire” over
time, such as copyrights or patents, but you do not get into that level of detail as
a banker – it’s something that accountants and auditors would determine post-
acquisition.

4. What are some more advanced acquisition effects that you might see in a
merger model?

• PP&E and Fixed Asset Write-Ups – You may write up the values of these
Assets in an acquisition, under the assumption that the market values
exceed the book values.
• Deferred Tax Liabilities and Deferred Tax Assets – You may adjust these
up or down depending on the asset write-ups and deal type.
• Transaction and Financing Fees – You also need to factor in these fees
into the model somewhere.
• Inter-Company Accounts Receivable and Accounts Payable – Two
companies “owing” each other cash no longer makes sense after they’ve
become the same company.
• Deferred Revenue Write-Down – Accounting rules state that you can
only recognize the profit portion of the seller’s Deferred Revenue post-
acquisition. So you often write down the expense portion of the seller’s
Deferred Revenue over several years in a merger model.

You do not need to know all the details for entry-level interviews, but you
should be aware that there are more advanced adjustments in M&A deals.

40 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

5. What are synergies, and can you provide a few examples?

Synergies refer to cases where 2 + 2 = 5 (or 6, or 7…) in an acquisition. The buyer

gets more value than out of an acquisition than what the financials would
otherwise suggest.

There are 2 types: revenue synergies and cost (or expense) synergies.

• Revenue Synergies: The combined company can cross-sell products to new

customers or up-sell additional products to customers. It might also be able to
expand into new geographies as a result of the deal.
• Expense Synergies: The combined company can consolidate buildings and
administrative staff and can lay off redundant employees. It might also be
able to shut down redundant stores or locations.

6. How are synergies used in merger models?

• Revenue Synergies: Normally you add these to the Revenue figure for the
combined company and then assume a certain margin on the Revenue (all
additional Revenue costs something) – this additional Revenue then flows
through the rest of the combined Income Statement, and you reflect the
additional expenses as well.
• Expense Synergies: Normally you reduce the combined COGS or
Operating Expenses by this amount, which in turn boosts the combined
Pre-Tax Income and Net Income, increasing the EPS and making the deal
more accretive.

7. Are revenue or expense synergies more important?

Revenue synergies are rarely taken seriously because they’re so hard to predict.
Expense synergies are taken a bit more seriously because it’s more
straightforward to see how buildings and locations might be consolidated and
how many redundant employees might be eliminated.

41 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Real World Scenarios

1. Let’s say a company overpays for another company – what happens

afterward?

A high amount of Goodwill & Other Intangibles would be created if the purchase
price is far above the Shareholders’ Equity of the target. In the years following
the acquisition, the buyer may record a large Goodwill Impairment Charge if it
reassesses the value of the seller and finds that it truly overpaid.

2. A buyer pays $100 million for the seller in an all-stock deal, but a day later
the market decides that it’s only worth $50 million. What happens?

The buyer’s share price would fall by whatever per-share dollar amount
corresponds to the $50 million loss in value. It would not necessarily be cut in
half.

Depending on the deal structure, the seller would effectively only receive half of
what it had originally negotiated.

This illustrates one of the major risks of all-stock deals: sudden changes in share
price could dramatically impact the valuation (there are ways to hedge against
that risk – see the Advanced section).

3. Why do most mergers and acquisitions fail?

M&A is “easier said than done.” In practice it’s very difficult to acquire and
integrate a different company, realize synergies, and also turn the acquired
company into a profitable division.

Many deals are also done for the wrong reasons, such as the CEO’s massive ego
or pressure from shareholders. Any deal done without both parties’ best
interests in mind is likely to fail.

4. What role does a merger model play in deal negotiations?

42 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

The model is used as a sanity check and as a way to test various assumptions. A
company would never decide to do a deal because of the output of a model.

It might say, “OK, the model tells us this deal could work and would be
moderately accretive – it’s worth exploring in more detail.”

It would never say, “Aha! This model predicts 21% accretion – we should have
acquired this company yesterday!”

Emotions, ego and personalities play a far bigger role in M&A than numbers do.

5. What types of sensitivities would you look at in a merger model? What

variables would you analyze?

The most common variables to analyze are Purchase Price, % Stock/Cash/Debt,

Revenue Synergies, and Expense Synergies. Sometimes you also look at
different operating sensitivities, like Revenue Growth or EBITDA Margin, but it’s
more common to build these into your model as different scenarios instead.

You might look at sensitivity tables showing the EPS accretion/dilution at

different ranges for the Purchase Price vs. Cost Synergies, Purchase Price vs.
Revenue Synergies, or Purchase Price vs. % Cash (and so on).

6. If the seller has existing Debt on its Balance Sheet in an M&A deal, how do
you deal with it?

You assume that the Debt either stays on the Balance Sheet or is refinanced (paid
off) in the acquisition. The terms of most Debt issuances state that they must be
repaid in a “change of control” scenario (i.e. when a buyer acquires over 50% of a
company), so you often assume that the Debt is paid off in a deal.

That increases the price that the buyer needs to pay for the seller.

43 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

7. Wait a minute. If you use Cash or Debt to acquire another company, it’s clear
how you could use them to pay off existing Debt… but how does that work
with Stock?

Remember what happens when a company issues shares: it sells the shares to
new investors and receives cash in exchange for them. Here, they would do the
same thing and issue a small portion of the shares to 3rd party investors rather
than the seller to raise the cash necessary to repay the debt.

The buyer might also wait until the deal closes before it issues additional shares
to pay off the debt. And it could also use cash on-hand to repay the debt, or
refinance the debt with a new debt issuance.

Merger Model Questions & Answers – Advanced

You should study this section only if you have significant experience working on
M&A deals and advising buyers and sellers, because these questions are
advanced and not terribly likely to come up in interviews.

We are including them here because anything is fair game, especially if you’ve
listed specific M&A transactions on your resume / CV and have gone into detail
on your role in them.

A few of these questions are extremely advanced to the point of obscurity and
go beyond what most junior bankers in the industry would even know.

But then, you signed up for this guide because you wanted the most
comprehensive interview prep resource around, right?

Purchase Price Allocation and Sources & Uses

1. What’s the purpose of Purchase Price Allocation in an M&A deal? Can you
explain how it works?

44 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

The ultimate purpose is to make the combined Balance Sheet balance.

This harder than it sounds because many items get adjusted up or down (e.g.
PP&E), some items disappear altogether (e.g. the seller’s Shareholders’ Equity),
and some new items get created (e.g. Goodwill).

To complete the process, you look at every single item on the seller’s Balance
Sheet and then assess the fair market values of all those items, adjusting them
up or down as necessary.

So if the buyer pays, say, $1 billion for the seller, you figure out how much of
that $1 billion gets allocated to each Asset on the Balance Sheet.

Goodwill (and Other Intangible Assets) serves as the “plug” and ensures that
both sides balance you’ve made all the adjustments. Goodwill is roughly equal to
the Equity Purchase Price minus the seller’s Shareholders’ Equity and other
adjustments.

2. Explain the complete formula for how to calculate Goodwill in an M&A deal.

Goodwill = Equity Purchase Price – Seller Book Value + Seller’s Existing

Goodwill – Asset Write-Ups – Seller’s Existing Deferred Tax Liability + Write-
Down of Seller’s Existing Deferred Tax Asset + Newly Created Deferred Tax
Liability + Intercompany Accounts Receivable – Intercompany Accounts Payable

A couple notes here:

• Seller Book Value is just the Shareholders’ Equity number (technically, the
Common Shareholders’ Equity number).
• You add the Seller’s Existing Goodwill because it is “reset” and written
down to $0 in an M&A deal.
• You subtract the Asset Write-Ups because these are additions to the
Assets side of the Balance Sheet – Goodwill is also an asset, so effectively
you need less Goodwill to “plug the hole.”
• Normally you assume 100% of the Seller’s existing DTL is written down.

45 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

• The seller’s existing DTA may or may not be written down completely
(keep reading this section).
• You add Intercompany Accounts Receivable because they go away, which
reduces the Assets side; the opposite applies for Intercompany AP.

3. Why do we adjust the values of Assets such as PP&E in an M&A deal?

Because often the fair market value is significantly different from the Balance
Sheet value. A perfect example is real estate – usually it appreciates over time,
but due to the rules of accounting, companies must depreciate it on the Balance
Sheet and show a declining balance over time to reflect the allocation of costs
over a long time period.

Investments, Inventory, and other Assets may have also “drifted” from their fair
market values since the Balance Sheet is recorded at historical cost for companies
in most industries (exceptions, such as commercial banking, do exist).

4. What’s the logic behind Deferred Tax Liabilities and Deferred Tax Assets?

We go into this in more detail in the upcoming section on Deferred Taxes and
NOLs.

The basic idea is that you normally write down most of the seller’s existing DTLs
and DTAs to “reset” its tax basis, since it’s now part of another entity.

And then you may create new DTLs or DTAs if there are Asset Write-Ups or
Write-Downs and the book and tax Depreciation and Amortization numbers
differ.

If there are write-ups, a Deferred Tax Liability will be created in most deals since
the Depreciation on the write-ups is not tax-deductible, which means that the
company will pay more in cash taxes; the opposite applies for write-downs and
there, a Deferred Tax Asset would be created.

See the section on NOLs and Deferred Taxes for more details.

46 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

5. How do you treat items like Preferred Stock, Noncontrolling Interests, Debt,
and so on, and how do they affect Purchase Price Allocation?

Normally you build in the option to repay (or in the case of Noncontrolling
Interests, purchase the remainder of) these items or assume them in the Sources
& Uses schedule.

If you repay them, additional cash/debt/stock is required to purchase the seller.

However, that choice does not affect Purchase Price Allocation.

You always start with the Equity Purchase Price there, which excludes the
treatment of all these items.

Also, you only use the seller’s Common Shareholders’ Equity in the PPA schedule,
which excludes Preferred Stock and Noncontrolling Interests.

6. So do you use Equity Value or Enterprise Value for the Purchase Price in a
merger model?

This is a trick question because neither one is entirely accurate. The PPA
schedule is based on the Equity Purchase Price, but the actual amount of
cash/stock/debt used is based on that Equity Purchase Price plus the additional
funds needed to repay debt, pay for transaction-related fees, and so on.

That number is not exactly “Enterprise Value” – it’s something in between

Equity Value and Enterprise Value, and it’s normally labeled “Funds Required”
in a model.

7. How do you reflect transaction costs, financing fees, and miscellaneous

expenses in a merger model?

47 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

You expense transaction and miscellaneous fees (such as legal and accounting
services) upfront and capitalize the financing fees and amortize them over the
term of the debt.

Expensed transaction fees come out of Retained Earnings when you adjust the
Balance Sheet (and Cash on the other side), while Capitalized Financing Fees
appear as a new Asset on the Balance Sheet (and reduce Cash immediately) and
are amortized each year according to the tenor of the debt.

In reality, you pay for all of these fees upfront in cash. However, since financing
fees correspond to a long-term item rather than a one-time transaction, they’re
amortized over time on the Balance Sheet. It’s similar to how new CapEx
spending is depreciated over time.

None of this affects Purchase Price Allocation. These fees simply increase the
“Funds Required” number discussed above, but they make absolutely no impact
on the Equity Purchase Price or on the amount of Goodwill created.

8. How would you treat Debt differently in the Sources & Uses table if it is
refinanced rather than assumed?

If the buyer assumes the Debt, it appears in both the Sources and Uses columns
and has no effect on the Funds Required.

If the buyer pays off Debt, it appears only in the Uses column and increases the
Funds Required.

Transaction Structures

1. What are the main 3 transaction structures you could use to acquire another
company?

The 3 main structures are the Stock Purchase, Asset Purchase, and 338(h)(10)
Election.

48 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Note that Stock Purchases and Asset Purchases exist in some form in countries
worldwide, but that the 338(h)(10) Election is specific to the US – however, there
may be equivalent legal structures in other countries.

Here’s how they differ:

Structure: Stock Purchase Asset Purchase 338(h)(10) Election

Buyer Acquires: All Assets and Only Certain All Assets and
Liabilities + Off- Assets and Liabilities + Off-
Balance Sheet Liabilities of the Balance Sheet
Items Seller Items
Seller Pays Entire Purchase Entire Purchase Entire Purchase
Taxes On: Price Price PLUS (Total Price PLUS (Total
Value Assigned Value Assigned to
to All Assets – All Assets – Book
Book Value of All Value of All
Assets) Assets)
Assets Written No Yes Yes
Up on Tax
Balance Sheet?
Can Buyer No Yes Yes
Deduct New
D&A from
Written-Up
Assets for Tax
Purposes?
Creates DTL? Yes No No
Most Common Public companies Private Private companies,
For: and large private companies, divestitures,
companies divestitures, distressed public
distressed public companies
companies
Favored By: Sellers Buyers Both

49 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Part of the reason that both parties favor the 338(h)(10) structure is that buyers
typically agree to pay more to compensate sellers for the favorable tax treatment
they receive.

2. Would a seller prefer a Stock Purchase or an Asset Purchase? What about the
buyer?

A seller almost always prefers a Stock Purchase to avoid double taxation and to
dispose of all its Liabilities

The buyer almost always prefers an Asset Purchase so it can be more careful
about what it acquires and to get the tax benefit from being able to deduct D&A
on Asset Write-Ups for tax purposes.

However, it’s not always possible to “pick” one or the other – for example, if the
seller is a large public company only a Stock Purchase is possible in 99% of cases.

3. Why might a company want to use 338(h)(10) when acquiring another

company?

A Section 338(h)(10) election blends the benefits of a Stock Purchase and an Asset
Purchase:

• Legally it is a Stock Purchase, but accounting-wise it’s treated like an

Asset Purchase.
• The seller is still subject to double-taxation – capital gains on any Assets
that have appreciated and on the proceeds from the sale.
• But the buyer receives a step-up tax basis on the new Assets it acquires,
and it can depreciate and amortize them so it saves on taxes.

Even though sellers still get taxed twice, buyers will often pay more in a
338(h)(10) deal because of the tax-savings potential.

It’s particularly helpful for:

50 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

• Sellers with high NOL balances (more tax-savings for the buyer because
this NOL balance will be written down completely – so more of the excess
purchase price can be allocated to Asset Write-Ups).
• Companies that have been S-corporations for over 10 years – in this case
they do not have to pay taxes on the appreciation of their Assets.

The requirements to use 338(h)(10) are complex and it cannot always be used.

For example, if the seller is a C Corporation it can’t be applied; also, if the buyer
is not a C Corporation (e.g. a private equity firm), it also can’t be used.

Net Operating Losses (NOLs) and Deferred Taxes

1. How do you take into account NOLs in an M&A deal?

You apply Section 382 to determine how much of the seller’s NOLs are usable
each year.

• Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past

3 Months’ Adjusted Long-Term Rates

So if our Equity Purchase Price were $1 billion and the highest adjusted long-
term rate were 5%, then we could use $1 billion * 5% = $50 million of NOLs each
year.

If the seller had $250 million in NOLs, then the combined company could use $50
million of them each year for 5 years to offset its taxable income.

Here’s a link to these adjusted long-term rates.

2. Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get
created in M&A deals?

51 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

These get created when you write up assets – both tangible and intangible – and
when you write down assets in a transaction. An asset write-up creates a
deferred tax liability, and an asset write-down creates a deferred tax asset.

You write down and write up assets because their book values – what’s on the
Balance Sheet – often differ substantially from their “fair market values.”

An asset write-up creates a deferred tax liability because you’ll have a higher
Depreciation expense on the new asset, which means you save on taxes in the
short-term – but eventually you’ll have to pay them back, so you get a liability.

The opposite applies for an asset write-down and a deferred tax asset.

3. How do DTLs and DTAs affect the Balance Sheet Adjustments in an M&A
deal?

You take them into account with everything else when calculating the amount of
Goodwill & Other Intangibles to create on your pro-forma Balance Sheet. The
formulas are as follows:

• Deferred Tax Asset = Asset Write-Down * Tax Rate

• Deferred Tax Liability = Asset Write-Up * Tax Rate

So let’s say you were buying a company for $1 billion with 50% cash and 50%
debt, and you had a $100 million asset write-up and a tax rate of 40%. In addition,
the seller has total Assets of $200 million, total Liabilities of $150 million, and
Shareholders’ Equity of $50 million.

Here’s what would happen on the combined company’s balance sheet (ignoring
transaction and financing fees):

• First, you simply add the seller’s Assets and Liabilities (but NOT
Shareholders’ Equity – it is wiped out) to the buyer’s to get your “initial”
Balance Sheet. Assets are up by $200 million and Liabilities are up by $150
million.

52 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

• Then, Cash on the Assets side goes down by $500 million.

• You have an Asset Write-Up of $100 million, so Assets go up by $100
million.
• Debt on the Liabilities & Equity side goes up by $500 million.
• You get a new Deferred Tax Liability of $40 million ($100 million * 40%)
on the Liabilities & Equity side.
• Assets are down by $200 million total and Liabilities & Shareholders’
Equity are up by $690 million ($500 + $40 + $150).
• So you need Goodwill & Intangibles of $890 million on the Assets side to
make both sides balance.

4. Could you get DTLs or DTAs in an Asset Purchase?

No, because in an Asset Purchase the book basis of assets always matches the tax
basis. DTLs and DTAs get created in Stock Purchases because the book values of
Assets are written up or written down, but the tax values are not.

5. How do you factor in DTLs into forward projections in a merger model?

You create a book vs. cash tax schedule and figure out what the company owes
in taxes based on the Pre-Tax Income on its books, and then you determine what
it actually pays in cash taxes based on its NOLs and its new D&A expenses (from
any Asset Write-Ups).

Anytime the “cash” tax expense exceeds the “book” tax expense you record this
as a decrease to the Deferred Tax Liability on the Balance Sheet; if the “book”
expense is higher, then you record that as an increase to the DTL.

Synergies

1. Can you give me an example of how you might calculate revenue synergies?

“Sure. Let’s say that Company A sells 10,000 widgets per year in North America
at an average price of $15.00, and Company B sells 5,000 widgets per year in
Europe at an average price of $10.00. Company A believes that it can sell its own

53 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

widgets to 20% of Company B’s customers, so after it acquires Company B it will

earn an extra 20% * 5,000 * $15.00 in revenue, or $15,000.

It will also have expenses associated with those extra sales, so you need to reflect
those as well – if it has a 50% margin, for example, it would reflect an additional
$7,500, rather than $15,000, to Operating Income and Pre-Tax Income on the
combined Income Statement.”

This last point about expenses associated with revenue synergies is important
and one that a lot of people forget – there’s no such thing as “free” revenue with
no associated costs.

2. Should you estimate revenue synergies based on the seller’s customers and
the seller’s financials, or the buyer’s customers and the buyer’s financials?

Either one works. You could assume that the buyer leverages the seller’s products
or services and sells them to its own customer base – but typically you assume an
uplift to the seller’s average selling price, or something else that the buyer can do
with the seller’s existing customers.

You approach it that way because the buyer, as a larger company, can make
more of an immediate impact on the seller than the seller can make on the buyer.

3. Walk me through an example of how to calculate expense synergies.

“Let’s say that Company A wants to acquire Company B. Company A has 5,000
SG&A-related employees, whereas Company B has around 1,000. Company A
calculates that post-transaction, it will only need about 800 of Company B’s
SG&A employees, and its existing employees can take over the rest of the work.
To calculate the Operating Expenses the combined company would save, we
would multiply these 200 employees that Company A is going to fire post-
transaction by their average salary, benefits, and other compensation expenses.”

4. How do you think about synergies if the combined company can consolidate
buildings?

54 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

If the buildings are leased, you assume that both lease expenses go away and are
replaced with a new, larger lease expense for the new or expanded building. So
in that case it is a simple matter of New Lease Expense – Old, Separate Lease
Expenses to determine the synergies.

If the buildings are owned, it gets more complicated because one or both of them
will be sold, or perhaps leased out to someone else. Then you would have to look
at Depreciation and Interest savings, as well as additional potential income if the
building is rented out.

5. What if there are CapEx synergies? For example, what if the buyer can
reduce its CapEx spending because of certain assets the seller owns?

In this case, you would start recording a lower CapEx charge on the combined
Cash Flow Statement, and then reflect a reduced Depreciation charge on the
Income Statement from that new CapEx spending each year.

You would not start seeing the results until Year 2 because reduced Depreciation
only comes after reduced CapEx spending. This scenario would be much easier to
model with a full PP&E schedule where you can adjust the spending and the
resulting Depreciation each year.

Noncontrolling Interests, Equity Interests, and Divestitures

1. What happens when you acquire a 30% stake in a company? Can you still
use an accretion / dilution analysis?

You record this 30% as an “Investment in Equity Interest” or “Associate

Company” on the Assets side of the Balance Sheet, and you reduce Cash to
reflect the purchase (assuming that Cash was used). You use this treatment for
all ownership percentages between 20% and 50%.

55 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

You can still use an accretion / dilution analysis; just make sure that the new Net
Income reflects the 30% of the other company’s Net Income that you are entitled
to.

2. What happens when you acquire a 70% stake in a company?

For all acquisitions where over 50% but less than 100% of another company gets
acquired, you still go through the purchase price allocation process and create
Goodwill, but you record a Noncontrolling Interest on the Liabilities side for the
portion you do not own. You also consolidate 100% of the other company’s
statements with your own, even if you only own 70% of it.

Example: You acquire 70% of another company using Cash. The company is
worth $100, and has Assets of $180, Liabilities of $100, and Equity of $80.

You add all of its Assets and Liabilities to your own, but you wipe out its Equity
since it’s no longer considered an independent entity. The Assets side is up by
$180 and the Liabilities side is up by $100.

You also used $70 of Cash, so the Assets side is now only up by $110.

We allocate the purchase price here, and since 100% of the company was worth
$100 but its Equity was only $80, we create $20 of Goodwill – so the Assets side is
up by $130.

On the Liabilities side, we create a Noncontrolling Interest of $30 to represent the

30% of the company that we do not own. Both sides are up by $130 and balance.

3. Let’s say that a company sells a subsidiary for $1000, paid for by the buyer in
Cash. The buyer is acquiring $500 of Assets with the deal, but it’s assuming no
Liabilities. Assume a 40% tax rate. What happens on the 3 statements after the
sale?

56 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Income Statement: We record a Gain of $500, since we sold Balance Sheet Assets
of $500 for $1,000. That boosts Pre-Tax Income by $500 and Net Income by $300
assuming a 40% tax rate.

Cash Flow Statement: Net Income is up by $300, but we subtract the Gain of
$500 in the CFO section, so cash flow is down by $200 so far. We add the full
amount of sale proceeds ($1000) in the CFI section, so cash at the bottom is up by
$800.

Balance Sheet: Cash on the Assets side is up by $800, but we’ve lost $500 in
Assets, so the Assets side is up by $300. On the other side, Shareholders’ Equity
is also up by $300 due to the increased Net Income.

In this scenario, you’d also have to go back and remove revenue and expenses
from this sold-off division and label them “Discontinued Operations” on the
financial statements prior to the close of the sale.

4. Now let’s say that we decide to buy 100% of another company’s subsidiary
for $1000 in cash. This subsidiary has $500 in Assets and $300 in Liabilities,
and we are acquiring all the Assets and assuming all the Liabilities. What
happens on the statements immediately afterward?

Income Statement: No changes.

Cash Flow Statement: We record $1000 for “Acquisitions” in the CFI section, so
cash at the bottom is down by $1000.

Balance Sheet: Cash is down by $1000 on the Assets side, but we add in the
subsidiary’s Assets of $500, so this side is down by $500 so far. We also create
$800 worth of Goodwill because we bought this subsidiary for $1000, but (Assets
Minus Liabilities) was only $200. So the Assets side is up by $300. The other side
is up by $300 because of the assumed Liabilities, so both sides balance.

Calendarization and Stub Periods

57 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

1. What’s the purpose of calendarization in a merger model?

You need to make sure that the buyer and seller use the same fiscal years post-
transaction. Normally you change the seller’s financial statements to match the
buyer’s.

If the buyer’s fiscal year ends on December 31 and the seller’s ends on June 30,
for example, you would have to take quarter 3 (Jan – Mar) and quarter 4 (Apr –
Jun) from the seller’s most recent fiscal year and then add quarters 1 (Jul – Sep)
and 2 (Oct – Dec) from the seller’s current fiscal year to match the buyer’s current
fiscal year.

The second point here is that you may also need to create a stub period from the
date when the deal closes to the end of the buyer’s current fiscal year.

For example, if the deal closes on September 30 but the buyer’s fiscal year ends
on December 31, the buyer and seller are still one combined company for that 3-
month period and you need to account for that, normally via a separate “stub
period” right before the start of the first full fiscal year as a combined entity.

2. Let’s say that the buyer’s fiscal year ends on December 31, the seller’s fiscal
year ends on June 30, and the transaction closes on September 30. How would
you create a merger model for this scenario?

You would need to create quarterly financial statements for both the buyer and
sell for the September 30 – December 31 period, and you would show that as the
first “combined” period in the merger model.

So you would combine the Income Statements, Balance Sheets, and Cash Flow
Statements for that 3-month period, and then keep them combined for the rest of
the time after that (adjusting the seller’s financial statements to match the fiscal
year of the buyer, as in the example above).

58 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Normally you do not care much about accretion / dilution for stub periods like
this, so you would just calculate it for the first full fiscal year after the transaction
close.

3. Does anything change if the transaction closes on March 31 instead?

The only difference is that now you need a 9-month stub period rather than a 3-
month stub period.

So you would need to find or create financial statements for Q4 of the seller’s
fiscal year ending June 30, and then Q1 and Q2 for the next year.

You would also take the last 3 quarters of the buyer’s fiscal year and combine the
statements from that period with the seller’s, taking into account all the normal
acquisition effects for that period.

4. What if the deal closes on a more “random” date, like August 17?

There are a couple options here; you could attempt to “roll-forward” the
financial statements to this date in between quarterly end dates. For example,
you might create an August 17 Balance Sheet by looking at the Balance Sheet as
of June 30 and the Balance Sheet as of September 30 and averaging them (since
August 17 is roughly in the middle).

For the Income Statement and Cash Flow Statement, you could just take the July
1 – September 30 quarterly numbers and multiply by (43 / 90) since 43 days of the
quarter will pass in the “combined” period between August 17 and September 30.

The main problem is that this method creates a lot of extra work, because now
you have to roll forward all the statements to this random date, figure out the
numbers from that date to the end of the quarter, and then add additional
quarters until the end of the buyer’s fiscal year.

So in practice, you usually assume a cleaner close date in merger models unless
you need 100% precision for some reason.

59 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Deal Structures and Legal Points

1. What is an exchange ratio and when would companies use it in an M&A

deal?

An exchange ratio is an alternate way of structuring a 100% stock M&A deal, or

any M&A deal with a portion of stock involved.

Let’s say you were going to buy a company for $100 million in a 100% stock deal.
Normally you would determine the number of shares to issue by dividing the
$100 million by the buyer’s stock price.

With an exchange ratio, by contrast, you would tie the number of new shares to
the buyer’s own shares – so the seller might receive 1.5 shares of the buyer’s
shares for each of its shares, rather than shares worth a specific dollar amount.

Buyers might prefer to do this if they believe their stock price is going to decline
post-transaction – sellers, on the other hand, would prefer a fixed dollar amount
in stock unless they believe the buyer’s share price will rise after the transaction.

2. Isn’t there still some risk with an exchange ratio? If the stock price swings
wildly in one direction or the other, the effective purchase price would be very
different. Is there any way to hedge against that risk?

Yes. You can use something called a collar, which guarantees a certain price
based on the range of the buyer’s stock price to the seller’s stock price. Here’s an
example:

Suppose that we had a 100% stock deal with a 1.5x exchange ratio, i.e. the seller
receives 1.5 of the buyer’s shares for each 1 of its own shares. The buyer’s share
price is $20.00 and the seller has 1,000 shares outstanding. Right now, it’s worth
$30,000 (1,000 * 1.5 * $20.00) to the seller. Here’s how we could set up a collar:

• If the buyer’s share price falls below $20.00 per share, the seller still
receives the equivalent of $20.00 per buyer share in value. So if the buyer’s

60 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

share price falls to $15.00, now the seller would receive 2,000 shares
instead.
• If the buyer’s share price is between $20.00 and $40.00 per share, the
normal 1.5x exchange ratio is used. So the value could be anything from
$30,000 to $60,000.
• If the buyer’s share price goes above $40.00 per share, the seller can only
receive the equivalent of $40.00 per buyer share in value. So if the buyer’s
share price rises to $80.00, the seller would receive only 750 shares instead.

Collar structures are not terribly common in M&A deals, but they are useful for
reducing risk on both sides when stock is involved.

3. Walk me through the most important terms of a Purchase Agreement in an

M&A deal.

There are dozens, but here are the most important points:

• Purchase Price: Stated as a per-share amount for public companies; just a

number (the Equity Purchase Price) for private companies
• Form of Consideration: Cash, Stock, Debt…
• Transaction Structure: Stock, Asset, or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-
compete agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about
their respective businesses?
• No-Shop / Go-Shop: Can the seller “shop” this offer around and try to get
a better deal, or must it stay exclusive to this buyer?

4. What’s an Earnout and why would a buyer offer it to a seller in an M&A

deal?

An Earnout is a form of “deferred payment” in an M&A deal – it’s most common

with private companies and start-ups, and it is highly unusual for public sellers.

61 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

It is usually contingent on financial performance or other goals – for example, the

buyer might say, “We’ll pay you an additional $10 million in 3 years if you can
hit $100 million in revenue by then.”

Buyers use it to incentivize sellers to continue to perform well and to discourage

management teams from taking the money and running off to an island in the
South Pacific once the deal is done.

More Advanced Analysis and Special Cases

1. Normally we create Goodwill because we pay more for a company than

what its Shareholders’ Equity says it’s worth. But what if the opposite happens?
What if we paid $1000 in Cash for a company, but its Assets were worth $2000
and its Liabilities were worth $800?

First off, you would reverse any new write-ups to Assets to handle this scenario
the easy way, if possible. So if we had Asset Write-Ups of $300 then it would be
easy to simply reverse those and make it so the Assets were only worth $1700,
which would result in positive Goodwill instead.

If it is not possible to do that – e.g. there were no Asset Write-Ups or they cannot
be reversed for some reason – then we need to record a Gain on the Income
Statement for this “Negative Goodwill.”

In this case, the company’s Shareholders’ Equity is $1200 but we paid $1000 for it,
so we do the following:

Income Statement: Record a Gain of $200, boosting Pre-Tax Income by $200 and
Net Income by $120 at a 40% tax rate.

Cash Flow Statement: Net Income is up by $120, but we subtract the Gain of
$200, so Cash is down by $80 so far. Under CFI we record the $1000 acquisition,
so Cash at the bottom is down by $1080.

62 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

Balance Sheet: Cash is down by $1080. But we have $2000 of new Assets, so the
Assets side is up by $920. On the other side, Liabilities is up by $800 and
Shareholders’ Equity is up by $120 due to the increased Net Income, so both
sides are up by $920 and balance.

2. What if Shareholders’ Equity is negative?

Nothing is different. You still wipe it out, allocate the purchase price, and create
Goodwill.

3. How would an accretion / dilution model be different for a private seller?

The mechanics are the same, but the transaction structure is more likely to be an
Asset Purchase or 338(h)(10) Election; private sellers also don’t have Earnings Per
Share so you would only project down to Net Income on the seller’s Income
Statement.

Note that accretion / dilution makes no sense if you have a private buyer because
private companies do not have Earnings Per Share.

4. Explain what a contribution analysis is and why we might look at it in a

merger model.

A contribution analysis compares how much Revenue, EBITDA, Pre-Tax Income,

Cash, and possibly other items the buyer and seller are “contributing” to
estimate what the ownership of the combined company should be.

Example: Let’s say that the buyer is set to own 50% of the new company and that
the seller will own 50%. But the buyer has $100 million of revenue and the seller
has $50 million of revenue – a contribution analysis would tell us that the buyer
“should” own 66% instead because it’s contributing 2/3 of the combined revenue.

It’s most common to look at this with merger of equals scenarios, and less
common when the buyer is significantly larger than the seller.

63 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

5. How would I calculate “break-even synergies” in an M&A deal and what

does the number mean?

To do this, you would set the EPS accretion / dilution to $0.00 and then back-
solve in Excel to get the required synergies to make the deal neutral to EPS.

It’s important because you want an idea of whether or not a deal “works”
mathematically, and a high number for the break-even synergies tells you that
you’re going to need a lot of cost savings or revenue synergies to make it work.

6. Normally in an accretion / dilution model you care most about combining

both companies’ Income Statements and Balance Sheets. But let’s say I want to
combine all 3 financial statements – how would I do this?

1. Always combine the buyer’s and seller’s Balance Sheets first (remember to
wipe out the seller’s Shareholders’ Equity).
2. Make the necessary Pro-Forma Adjustments (cash, debt, stock,
goodwill/intangibles, etc.).
3. Project the combined Balance Sheet using standard assumptions for each
item (see the Accounting section of the guide).
4. Combine and project the Income Statement.
5. Then, project the Cash Flow Statement and link everything together as
you normally would with any other 3-statement model. You can usually
just add items together here, but you may eliminate some of the seller’s
investing or financing activities depending on what the buyer wants to do.

You never combine the Income Statement or Cash Flow Statement from before the
acquisition closes. You only look at the combined statements immediately after
the acquisition and into future years.

7. How do you handle options, convertible debt, and other dilutive securities
in a merger model?

64 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

The exact treatment depends on the terms of the Purchase Agreement – the
buyer might assume them or it might allow the seller to “cash them out” if the
per-share purchase price is above the exercise prices of these dilutive securities.

If you assume that they’re exercised, then you calculate dilution to the Equity
Purchase Price in the same way you normally would – the Treasury Stock
Method for options, and the “if converted” method for convertibles.

8. Can you explain what “Pro Forma” numbers are in a merger model?

This gets confusing because there are contradictory definitions. The simplest one
is that Pro Forma numbers exclude certain non-cash acquisition effects:

• Amortization of Newly Created Intangibles

• Depreciation of PP&E Write-Up
• Deferred Revenue Write-Down
• Amortization of Financing Fees

Some people include all of these, other people include only some of these, and
companies themselves report numbers in different ways. Excluding
Amortization of Intangibles is the most common adjustment here.

While a lot of companies report numbers this way, the concept itself is flawed
and inconsistent because companies themselves already include existing non-
cash charges like Depreciation, Amortization, and Stock-Based Compensation.
To make things even more confusing, some people will also add back some or all
of those items as well.

9. If you’re looking at a reverse merger (i.e. a private company acquires a

public company), how would the merger model be different?

Mechanically, it’s similar because you still allocate purchase price, combine and
adjust the Balance Sheets, and combine the Income Statements, including
acquisition effects.

65 / 66
 Investment Banking Interview Guide

Access the Rest of the Interview Guide

The difference is that accretion / dilution is not meaningful if it’s a private

company because it doesn’t have an EPS number; so you would place more
weight on a contribution analysis, or even on something like the IRR of the
acquisition.

66 / 66