Merger Model: How to Build a Pro Forma Combined Company
A mid-size industrial buyer pays $800M for a smaller manufacturer, financed half with stock and half with debt. The merger model traces that $800M through the deal's financing structure, purchase price allocation, and pro forma adjustments to answer one question: what does the combined company earn per share?
Key takeaway: A merger model starts with sources and uses to lay out the financing, allocates the purchase price between identifiable assets and goodwill, and layers in pro forma adjustments for new interest expense, depreciation write-ups, and synergies. The output is combined EPS, which determines whether the deal is accretive or dilutive.
The Deal
Buyer:
| Amount | |
|---|---|
| Net Income | $160M |
| Shares Outstanding | 80,000,000 |
| Share Price | $50 |
| EPS | $2.00 |
Target:
| Amount | |
|---|---|
| EBITDA | $100M |
| Net Income | $50M |
| Book Value of Net Assets | $300M |
The buyer offers $800M for the target, an 8.0x EBITDA multiple. The deal is financed 50% with newly issued stock and 50% with new debt at a 5% interest rate. The combined tax rate is 25%.
Sources and Uses
The sources and uses table shows where the money comes from and where it goes:
| Sources | Amount | Uses | Amount |
|---|---|---|---|
| New Equity (shares) | $400M | Purchase Price | $800M |
| New Debt | $400M | ||
| Total Sources | $800M | Total Uses | $800M |
The equity portion: the buyer issues $400M / $50 = 8 million new shares to the target's shareholders. The debt portion: the buyer borrows $400M from lenders, adding it to the balance sheet.
Sources must equal uses. In more complex deals, the table would include refinancing the target's existing debt, paying advisory fees, and tapping the buyer's existing cash. Here the structure is straightforward: two sources fund the purchase price.
Purchase Price Allocation
Under acquisition accounting, the buyer records the target's assets and liabilities at fair value, not book value. The difference between the purchase price and the fair value of identifiable net assets is goodwill.
The target's book value of net assets is $300M. An independent appraisal identifies $80M in fair value adjustments: the target's equipment and customer relationships are worth $80M more than book value.
Book Value of Net Assets: $300M
+ Fair Value Adjustments: $80M
Fair Value of Net Assets: $380M
Goodwill: $800M - $380M = $420M
The buyer's balance sheet records $380M in identifiable net assets and $420M in goodwill. Goodwill represents the portion of the purchase price that cannot be assigned to any specific asset: the target's market position, workforce, and expected synergies.
The $80M in write-ups creates new depreciation and amortization expense. If the written-up assets have a 10-year remaining useful life:
Additional D&A = $80M / 10 = $8M per year
After-Tax Cost = $8M x (1 - 0.25) = $6M per year
This $6M annual charge reduces the combined company's earnings. Goodwill is not amortized but is tested for impairment annually.
Pro Forma Adjustments
Three adjustments bridge the gap between combined standalone earnings and pro forma earnings:
New interest expense. The $400M in acquisition debt at 5% adds $20M in annual interest:
Interest Expense = $400M x 5% = $20M
After-Tax Cost = $20M x (1 - 0.25) = $15M
Depreciation step-up. The $80M in asset write-ups generates $8M in additional annual D&A:
After-Tax Cost = $8M x (1 - 0.25) = $6M
Cost synergies. Management projects $24M in annual pre-tax savings from consolidating facilities and eliminating redundant roles:
After-Tax Benefit = $24M x (1 - 0.25) = $18M
Summarizing the three adjustments:
| Adjustment | Pre-Tax | After-Tax |
|---|---|---|
| New interest expense | -$20M | -$15M |
| Depreciation step-up | -$8M | -$6M |
| Cost synergies | +$24M | +$18M |
| Net Adjustment | -$4M | -$3M |
The $18M in after-tax synergies more than covers the $15M in after-tax interest, but the $6M depreciation step-up leaves a net drag of $3M on combined earnings.
Combined Earnings
Starting with standalone earnings and applying the adjustments:
Buyer Net Income: $160M
+ Target Net Income: $50M
Combined Standalone: $210M
- After-Tax Interest: $15M
- After-Tax D&A Step-Up: $6M
+ After-Tax Synergies: $18M
Pro Forma Net Income: $207M
Dividing by the new share count:
Pro Forma Shares: 80M + 8M = 88M
Pro Forma EPS: $207M / 88M = $2.35
The buyer's standalone EPS is $2.00. Pro forma EPS is $2.35, a 17.5% increase. The deal is accretive.
Without synergies, pro forma net income drops to $189M:
Pro Forma NI (no synergies): $210M - $15M - $6M = $189M
Pro Forma EPS: $189M / 88M = $2.15
The deal remains accretive at $2.15, a 7.5% increase over standalone. The target's $50M in earnings more than covers the $21M in after-tax deal costs (interest plus the D&A step-up). Synergies widen the margin but are not required to make the financial case.
Why Merger Models Matter
Merger models appear throughout investment banking and corporate development:
- Deal evaluation: Banks build merger models to test whether a proposed acquisition is accretive or dilutive under different financing structures and synergy assumptions. The model is the quantitative foundation of the recommendation to the board.
- Financing decisions: The split between stock and debt in the sources and uses determines both the dilution to existing shareholders and the leverage added to the balance sheet. The model quantifies that tradeoff across different mixes.
- Synergy accountability: When a deal is dilutive before synergies, the model shows exactly how much savings are needed to break even. This creates concrete targets for the integration team rather than vague commitments.
- Board presentations: The pro forma EPS walk, from standalone through each adjustment to the combined figure, is a standard element of every deal presentation. It gives the board a clear path through the financial impact.
Conclusion
A merger model builds the combined company's pro forma earnings by layering financing costs, accounting adjustments, and synergies on top of standalone results. The sources and uses table structures the deal, purchase price allocation creates goodwill and depreciation step-ups, and the pro forma adjustments determine whether the deal is accretive or dilutive.
For how the P/E relationship between buyer and target drives accretion and dilution, see our guide on accretion/dilution analysis. For the market multiples that benchmark the purchase price, see our guide on comparable company analysis. For how the underlying business is valued before the deal, see our guide on DCF valuation.
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