Merger Model Example: Accretion/Dilution with a Financing Mix
The simple accretion test asks one thing: does EPS go up if you print stock to buy a target? A real merger model adds the part that actually decides deals — how you pay for it: part stock, part cash and debt, with real after-tax interest.
Why this matters
What a merger model adds to the simple test
The classic all-stock accretion/dilution question strips financing away: you issue shares equal to the offer value divided by your share price, add the two companies' earnings, and see whether EPS rises. It is a great warm-up, but no banker structures a deal that way. Real acquirers pay with a mix — some stock, some cash raised from the balance sheet or new debt.
That mix changes the math in two places. The stock portion still dilutes by issuing new shares. But the cash/debt portion carries an interest cost, and because interest is tax-deductible, only the after-tax cost reduces pro-forma net income. So a fuller merger model has two dilution levers working against the target's added earnings: new shares in the denominator and after-tax interest in the numerator.
This guide walks one clean example end to end — a 60% stock, 40% cash/debt deal — then covers the P/E intuition and the mistakes interviewers love to probe. After that, a graded modeling test hands you fresh numbers every attempt.
Worked example
One deal, start to finish
The inputs
- Acquirer net income$500M
- Acquirer shares250M
- Acquirer share price$50
- Target net income$50M
- Offer (equity purchase price)$1,000M
- Financing mix60% stock / 40% cash-debt
- Interest rate on cash/debt5%
- Tax rate40%
Step 1 — Standalone EPS and the split
Start with what the acquirer earns today, then split the $1,000M offer into its two funding buckets:
Stock consideration = 1,000 × 60% = $600M
Cash/debt consideration = 1,000 × 40% = $400M
Step 2 — New shares from the stock portion
Only the stock slug issues shares. Divide it by the acquirer's share price:
New shares = 600 / 50 = 12M shares
Step 3 — After-tax interest on the cash/debt portion
The $400M cash/debt slug costs 5% in interest, but the tax shield claws part of that back, so use the after-tax cost:
After-tax interest = 400 × 0.05 × 0.60 = $12M
Note the pre-tax interest was $20M; the 40% shield saves $8M, leaving a $12M drag on net income.
Step 4 — Pro-forma net income, shares, and EPS
Combine the earnings, subtract the after-tax financing cost, and divide by the larger share count:
Pro-forma shares = 250 + 12 = 262M
Pro-forma EPS = 538 / 262 ≈ $2.05
Step 5 — Accretion or dilution
Compare pro-forma EPS to the $2.00 standalone figure:
The target added $50M of earnings against just 12M new shares and a $12M after-tax interest cost — so the deal lifts EPS by roughly 2.7%. Shift the mix toward more cash/debt or a higher interest rate and that cushion shrinks fast.
The intuition
It all comes back to yields
Every merger model is a contest of yields. The target throws off an earnings yield — its net income divided by the price you pay. Here that is 50 / 1,000 = 5%. Each way of funding the deal has its own cost: the stock slug costs the acquirer's earnings yield (the inverse of its P/E), and the cash/debt slug costs the after-tax interest rate.
The acquirer trades at $50 on $2.00 of EPS — a 25x P/E, or a 4% earnings yield. Because the target yields 5% and the stock you issue only "costs" 4%, funding with stock is accretive. The debt slug costs 5% × (1 − 40%) = 3% after tax, which is also below the target's 5% yield, so that portion accretes too. Both levers point the same way, which is why the deal lands comfortably positive.
Flip any of those relationships and the sign can flip. A lower-P/E acquirer (a higher earnings yield than the target) dilutes on the stock portion. A pricier target (lower earnings yield) or a higher borrowing rate can push the cash/debt portion into dilution. The whole model is just weighing the target's earnings yield against a blended cost of your financing mix.
Watch out
Common mistakes
Forgetting to tax-effect the interest
The single most common slip is subtracting the full pre-tax interest from pro-forma net income. Interest is deductible, so only the after-tax cost — interest × (1 − tax rate) — actually reduces earnings. Using $20M instead of $12M here would understate accretion by more than a full percentage point and can wrongly turn an accretive deal dilutive.
Splitting stock and cash incorrectly
New shares come from the stock portion only, and interest comes from the cash/debt portion only. Issuing shares on the whole $1,000M offer, or charging interest on the entire purchase price, double-counts one lever and drops the other. Always split the consideration first, then apply each cost to its own bucket.
Ignoring foregone interest on cash
If the cash portion comes from the acquirer's own balance sheet rather than new debt, there is still a cost: the after-tax interest that cash was earning is now gone. Treating balance-sheet cash as "free" overstates accretion. Swap the borrowing rate for the after-tax yield you forfeit, and the dilution from the cash slug reappears.
Comparing to the wrong baseline
Accretion is measured against the acquirer's standalone EPS, not against the combined net income or the target's EPS. Anchor to the $2.00 the acquirer would have earned alone, then judge whether the $2.05 pro-forma figure is higher or lower. Mixing up the baseline flips the interpretation even when the arithmetic is right.
FAQ
Frequently asked questions
What is a merger model and how is it different from a simple accretion test?
A merger model works out what the acquirer's pro-forma earnings per share look like after buying a target. The simple accretion test assumes an all-stock deal with no financing cost. A fuller merger model adds a financing mix — part stock, part cash/debt — and charges after-tax interest on the cash/debt portion. That interest cost drags pro-forma net income, so the same deal can flip from accretive to dilutive depending on how it is funded.
Why do you use after-tax interest instead of the full interest cost?
Interest expense is tax-deductible, so the real hit to net income is the interest cost net of the tax shield. If you borrow $400M at 5%, that is $20M of pre-tax interest, but at a 40% tax rate the shield saves $8M, leaving a $12M after-tax cost. Using the full $20M would overstate the dilution and understate accretion.
How does the stock-versus-cash split change accretion or dilution?
The stock portion dilutes by issuing new shares; the cash/debt portion dilutes through after-tax interest. Which lever hurts more depends on the acquirer's share price versus its borrowing rate. When a stock trades at a high P/E (a low earnings yield), issuing shares is cheap relative to earnings, and paying with more stock tends to be more accretive. When debt is cheap after tax, a bigger cash/debt slug can be more accretive instead.
What is the P/E intuition behind an accretive deal?
For the stock-funded portion, a deal is accretive when the acquirer's P/E is higher than the P/E it is paying for the target's earnings. A high-P/E acquirer issues relatively few shares per dollar of target earnings acquired, so EPS rises. Add financing and the same idea holds against the after-tax cost of debt: if the target's earnings yield beats the after-tax cost of the cash/debt you use, that slug is accretive too.
What is foregone interest and why does it matter in a merger model?
If the acquirer funds the cash portion from its own balance-sheet cash rather than new debt, it gives up the after-tax interest that cash was earning. That foregone interest is a real cost to pro-forma net income even though no new debt is raised. In this walkthrough we treat the cash/debt slug as carrying an interest cost; if you fund with existing cash, swap the borrowing rate for the after-tax yield you lose.
Now build it under a timer
Reading a worked example is one thing — grinding the financing mix, after-tax interest, and accretion under a clock is another. Run the graded merger-model test with fresh numbers every attempt, or start from the simpler all-stock accretion build.