Cash, Debt or Stock? How the Merger Model Financing Mix Drives Accretion/Dilution

"Would you pay for this acquisition with cash or stock?" sounds like a judgement call. In a merger model interview it is a maths question. Plenty of candidates answer "cash, because it's cheaper" and stop, and an interviewer can break that answer by changing one number. The cash, debt and stock mix sets how much of its earnings the buyer gives up to fund the deal. Set that cost against the earnings the target brings in and you have your accretion/dilution answer.

Accretion/dilution in a merger model compares two yields

The interview shortcut skips the full model and compares two percentages.

The first is the target yield: the target's net income divided by the equity purchase price. Buy a company for $400m that earns $25m and your yield is 6.25%. That is the inverse of the P/E you pay, so use the offer price with the premium included. (If P/E feels shaky, start with valuation multiples explained.)

The second is the after-tax cost of the money you use to pay. If the target yield beats the weighted cost of funding, the deal is accretive. If it falls short, it is dilutive.

The after-tax cost of cash, debt and stock

Cash on hand. Spend cash and you lose the interest it was earning. Cost of cash = interest rate on cash × (1 - tax rate). Cash earns less than debt costs, so it tends to be the cheapest source, but you can spend only the excess above the minimum balance the business needs.

New debt. Cost of debt = interest rate × (1 - tax rate), because interest is tax-deductible. Interview maths assumes the full deduction.

New stock. Shares carry no interest, but new shareholders take a slice of the combined profit. The cost of stock is the buyer's earnings yield: net income divided by market capitalisation, or 1 ÷ the buyer's P/E. A buyer on 20x earnings pays 5% on every dollar of stock it issues, with no tax adjustment, since net income already sits after tax.

For a mixed deal, weight the three: (% cash × cost of cash) + (% debt × cost of debt) + (% stock × cost of stock).

An illustrative example with round numbers

The figures are invented and ignore synergies, fees and amortisation of new intangibles. The buyer earns $100m on 100m shares priced at $20, so EPS is $1.00 and the P/E is 20x. It pays $400m of equity for a debt-free target earning $25m. Tax is 25%, cash earns 4% and new debt costs 8%.

Now check it the long way. Spending the cash gives up $16m of interest, $12m after tax, so net income is 100 + 25 - 12 = $113m. New debt costs $32m of interest, $24m after tax, leaving $101m. Stock keeps the full $125m but issues $400m ÷ $20 = 20m new shares.

Illustrative figures from the example above. EPS before the deal is $1.00.

The ranking matches the yields: stock beat debt. The textbook order of cash, then debt, then stock assumes the after-tax cost of debt sits below the buyer's earnings yield, and here 6% debt against 5% stock reverses it. The last row drops the buyer to 12x, or $12 a share. Stock now costs 8.3%, above the 6.25% target yield, so the deal needs 33.3m new shares and turns dilutive.

The P/E rule of thumb and its limits

In an all-stock deal, if the buyer's P/E is higher than the P/E it pays for the target, the deal is accretive. If lower, dilutive. It is the yield comparison in another form. The rule breaks in four places:

• Mixed consideration. It covers stock only. Once cash or debt enters, use the weighted cost.
• The wrong target P/E. Pay a 30% premium for a target trading at 15x and you are paying 19.5x.
• Items outside the maths. Synergies push towards accretion. Fees, amortisation of written-up assets and costlier refinancing of the target's debt push the other way.
• A one-year accounting test. A buyer can show accretion by acquiring slow-growing earnings with expensive stock and still destroy value.

Choosing the mix beyond EPS

Lenders cap debt through leverage and interest cover, and stock hands over ownership and can signal that the buyer's board thinks its shares are rich. Sellers weigh the certainty of cash against exposure to the buyer's share price, which is why stock deals come with negotiated exchange ratios and sometimes collars (see exchange ratios: fixed, floating and collars).

A 40-second answer to say out loud

"Cash costs the after-tax interest it would have earned, debt costs the after-tax interest on the new borrowing, and stock costs the buyer's earnings yield, one over its P/E. I weight those by the mix and compare the result with the target's yield, its net income over the equity price paid. If the target yield is higher, the deal is accretive; if lower, dilutive. Cash tends to be cheapest, but a high-P/E buyer can find stock cheaper than debt, so I check the numbers before assuming the order."

The follow-ups to have ready

"Buyer at 12x, target bought at 18x, all stock. Accretive or dilutive?" Dilutive. Stock costs 1/12, about 8.3%, and the target yields 1/18, about 5.6%.

"The deal is dilutive. How do you fix it?" Pay less, find synergies, or shift to funding whose after-tax cost sits below the target yield.

"Why does the mix change combined P/E but not combined EV/EBITDA?" EBITDA sits above interest, and enterprise value counts debt, cash and equity together, so shifting between them moves neither. Net income sits below interest and gets divided by the share count, so both move with the mix. (EBIT vs EBITDA vs net income covers the difference.)

"If a deal is accretive, is it a good deal?" Not on that evidence alone. Accretion measures next year's EPS. Value depends on paying less than the target is worth to the buyer, synergies included, and that is a DCF question.

How to make it stick this week

1. Rebuild the example on paper without looking. Then change one input at a time (buyer P/E to 12x, debt rate to 6%, price to $500m) and predict the direction before you calculate.
2. Say the 40-second answer aloud with a timer, then have someone fire the follow-ups in random order.
3. Read one real deal. Use EDGAR full-text search to find a merger filing that mentions "accretive to earnings per share", note how the buyer paid, and work out which source cost the most.

More free material is in the Knowledge Base, and new pieces land in IBB Insights.