If you’re preparing for investment banking interviews, you need to know the mechanics of accretion/dilution cold. Not because companies decide to buy other companies based only on EPS math. They don’t. But because merger models are one of the fastest ways to test whether an M&A idea is even plausible.
The basic question is simple: after the Buyer acquires the Seller, is the Buyer’s earnings per share higher or lower than it would have been on a standalone basis?
If combined EPS is higher, the deal is accretive. If combined EPS is lower, the deal is dilutive. If it’s unchanged, the deal is neutral.
That sounds easy, but the interview trap is that candidates often memorize the labels without understanding the mechanics. The real driver is this: compare what the Seller yields to what the Buyer gives up to fund the acquisition.
Why EPS Is the Core Metric in a Simple Merger Model
A merger model summarizes the Buyer and Seller, lays out the purchase price, shows the cash/debt/stock funding mix, includes deal assumptions such as interest rates and synergies, and calculates what the combined company’s EPS looks like.
EPS matters because it captures more of the deal’s impact than most quick metrics. EBITDA and NOPAT won’t fully work because they come before interest income and interest expense, and they don’t reflect the share count. Even EBITDA per share or NOPAT per share would still miss net interest expense.
Free cash flow per share and levered free cash flow per share could capture the full impact, but they take more time to calculate and tend to be more volatile. So for a simple interview-style model, EPS is the practical metric.
Step 1: Start with the Buyer and Seller’s Financial Profiles
At a minimum, you need each company’s current equity value and net income. To get there, you also need share price, diluted shares outstanding, pre-tax income, and tax rate.
For example, assume Company A is buying Company B.
- Company A share price: $7.00
- Company A diluted shares: 100 million
- Company A equity value: $700 million
- Company A pre-tax income: $100 million
- Company A tax rate: 40%
- Company A net income: $60 million
For Company B:
- Company B share price: $5.00
- Company B diluted shares: 100 million
- Company B equity value: $500 million
- Company B pre-tax income: $50 million
- Company B tax rate: 40%
- Company B net income: $30 million
One subtle point: merger models are based on projected figures in the year after the deal closes. In interviews, people often say “current net income” casually, but the model should really use projected revenue, operating income, pre-tax income, and net income for both companies.
Step 2: Determine the Purchase Price and Funding Mix
If the Seller is public, the Buyer normally needs to pay a control premium. So if Company B trades at $5.00 per share and Company A pays a 20% premium, the offer price is $6.00 per share.
With 100 million shares outstanding, Company B’s purchase equity value is:
Purchase Equity Value = $5.00 × 100 million × (1 + 20%) = $600 million
In real life, you would value the Seller using methodologies such as DCF, public comps, and precedent transactions, and you’d check whether the premium is reasonable versus comparable deals. But for basic merger math, the important point is that the Buyer starts with the Seller’s purchase equity value.
This is where many candidates ask: shouldn’t we use purchase enterprise value because enterprise value is the true cost of acquiring the company?
Not necessarily. In a merger model, you start with purchase equity value because the Buyer needs to pay at least that amount to acquire the Seller’s shares. Enterprise value may be closer to the “true cost” in some cases, but it is not automatically the cash purchase price.
Why? A few reasons:
- The Buyer doesn’t necessarily get all the Seller’s cash. The Seller may keep cash on its balance sheet.
- The Buyer may refinance the Seller’s debt with new debt on similar terms, so existing debt may not increase the upfront cost.
- The Buyer may repay the Seller’s debt using deal funding, in which case debt does increase the amount needed.
- Items like unfunded pensions are murkier because they may cost the Buyer over time but not immediately at closing.
- Transaction fees and integration costs can also add to the upfront funding need.
In the simple Company A / Company B example, assume Company B has no debt and no cash, so purchase equity value equals purchase enterprise value.
Cash, Debt, and Stock: What Does the Buyer Give Up?
Once you have the $600 million purchase price, you decide how much will be funded with cash, debt, and stock.
In practice, you’d often start with cash because it’s usually the cheapest funding source. Then you’d use a reasonable amount of debt, based on leverage capacity. For example, if the Buyer has $300 million of debt and $100 million of EBITDA, its Debt / EBITDA is 3x. If comparable companies are at 4x to 5x, the Buyer might be able to raise another $200 million of debt and move to 5x.
If cash and debt are not enough, the Buyer can issue stock. There are fewer hard limits on stock issuance, but companies usually don’t want to give up majority ownership. Some will issue stock only up to the point where the deal still remains accretive.
For this example, use a simple one-third mix:
- Cash: 33.3%
- Debt: 33.3%
- Stock: 33.3%
So Company A uses $200 million of cash, issues $200 million of debt, and issues stock for the remaining $200 million.
The Weighted Cost of Acquisition
Each funding source has a cost.
The cost of debt is the interest rate the Buyer would pay on new debt. You estimate it using the yield to maturity or coupon rates on the Buyer’s existing debt, or similar debt from peer companies.
The cost of cash is the interest rate the Buyer earns on cash. This tends to be low and is supposed to resemble a risk-free rate because cash has a low-risk profile.
The cost of stock is different from the cost of equity in WACC. For accretion/dilution, the practical cost of equity is:
Buyer Net Income / Buyer Equity Value
That’s the reciprocal of the Buyer’s P / E multiple. In this example, Company A has $60 million of net income and $700 million of equity value, so its cost of equity is 8.6%.
Assume:
- Pre-tax cost of cash: 3.0%
- Pre-tax cost of debt: 6.0%
- Tax rate: 40%
- After-tax cost of cash: 1.8%
- After-tax cost of debt: 3.6%
- Cost of stock: 8.6%
The weighted cost of acquisition is:
% Cash × After-Tax Cost of Cash + % Debt × After-Tax Cost of Debt + % Stock × Cost of Stock
With the one-third mix, Company A’s weighted cost is about 4.7%.
Compare That Cost to the Seller’s Yield
Now calculate Company B’s yield at the purchase price:
Seller Yield = Seller Net Income / Purchase Equity Value
Company B has $30 million of net income and a $600 million purchase equity value, so:
$30 million / $600 million = 5.0%
This is the cleanest shortcut in accretion/dilution math:
- Weighted cost of acquisition < Seller yield: accretive
- Weighted cost of acquisition = Seller yield: neutral
- Weighted cost of acquisition > Seller yield: dilutive
Here, Company A’s weighted cost is 4.7%, and Company B’s yield is 5.0%. Company A is paying less than what Company B is yielding, so the deal should be accretive.
If the pre-tax cost of debt rose to 10.0%, the weighted cost might increase to around 5.5%. Then Company A would be paying more than Company B is yielding, and the deal would become dilutive.
The Special Rule for 100% Stock Deals
For a 100% stock deal, you can use a simpler P / E comparison.
- Buyer P / E > Seller P / E at purchase price: accretive
- Buyer P / E = Seller P / E at purchase price: neutral
- Buyer P / E < Seller P / E at purchase price: dilutive
Why does this work? In a 100% stock deal, the cost of acquisition is the reciprocal of the Buyer’s P / E. The Seller’s yield is the reciprocal of the Seller’s purchase P / E.
If the Buyer trades at 10x P / E and the Seller’s purchase P / E is 5x, the Buyer’s cost is 10% and the Seller’s yield is 20%. The Buyer is paying less than it receives, so the deal is accretive.
If the Buyer trades at 10x and the Seller’s purchase P / E is 20x, the Buyer’s cost is 10% and the Seller’s yield is 5%. Now the Buyer is paying more than it receives, so the deal is dilutive.
Step 3: Combine Pre-Tax Income and Add Acquisition Effects
After setting the purchase price and funding mix, combine the Buyer’s and Seller’s pre-tax income and adjust for the acquisition effects.
- Debt: new debt creates interest expense, reducing pre-tax income, net income, and EPS.
- Stock: new shares increase the share count, reducing EPS.
- Cash: cash used in the deal reduces future interest income. This is called foregone interest on cash.
Don’t dismiss foregone interest on cash as “just an opportunity cost.” In this analysis, it is treated as a real cost because the projected pre-tax income for the Buyer already includes expected interest income on cash.
If the Buyer’s projected pre-tax income includes $20 of interest income, but it uses cash in the acquisition and now earns $10 less, you must subtract that $10 from combined pre-tax income. Otherwise, you’d be pretending the Buyer still earns interest on cash it no longer has.
For Company A and Company B, the combined pre-tax income starts with $100 million from Company A and $50 million from Company B. Then subtract foregone interest on cash and interest expense on new debt. If there are synergies, you add them as well, but the simple shortcut above assumes no synergies.
Step 4: Calculate Combined Net Income and EPS
Next, tax-effect combined pre-tax income using the Buyer’s tax rate. In interview models and simple case studies, this is the standard assumption because the Seller becomes a subsidiary of the Buyer after the deal closes.
Then calculate total shares outstanding:
- Start with the Buyer’s existing diluted shares.
- Add new shares issued in the transaction.
- Do not include the Seller’s shares because the Seller is no longer an independent public company.
The shares issued are calculated as:
Shares Issued = Purchase Equity Value × % Stock Used / Buyer Share Price
In this example, Company A issues stock for one-third of the $600 million purchase price, or $200 million. At a $7.00 share price, it issues about 28.6 million shares.
One caveat: using the Buyer’s current share price is not perfect. The Buyer’s share price could change between announcement and close. In a more detailed model, you would create sensitivity tables across a range of Buyer share prices.
Step 5: Compare Combined EPS to Standalone EPS
Finally, divide combined net income by total diluted shares to calculate combined EPS. Then compare it to the Buyer’s standalone EPS.
Company A’s standalone EPS is:
$60 million / 100 million shares = $0.60
If combined EPS is above $0.60, the deal is accretive. If it’s below $0.60, the deal is dilutive. If it equals $0.60, it’s neutral.
That’s the full mechanical loop: purchase price, funding mix, interest effects, share issuance, combined net income, combined EPS.
How Bankers Actually Use This Analysis
Simple merger models are useful, but not because they deliver a final “do the deal” answer. They support decisions and conversations.
- Deal screening: You can quickly test whether potential acquisitions make sense for a client.
- Pitching ideas: You might show a client that a certain Buyer could acquire them accretively, even at a meaningful premium.
- Deal negotiations: You can use the model to argue for a higher price or a different mix of cash, debt, and stock.
For example, a Seller might accept more stock and less cash if the Buyer agrees to raise the price, especially if the deal still remains accretive for the Buyer.
Why Simple Accretion/Dilution Can Mislead You
The shortcut is useful, but it does not give you the whole story.
First, share prices and tax rates can change. The Buyer’s stock price might not stay flat from announcement to closing, and the combined tax rate may not equal the Buyer’s tax rate in real life.
Second, the purchase price may be more complicated than purchase equity value. The Buyer might refinance debt, repay debt, pay transaction fees, or account for other items. Sometimes the Seller’s cash balance can also affect funding.
Third, synergies can change the result. Even modest cost savings can turn a deal from dilutive to accretive. If the combined company can consolidate offices, reduce rent expense, or cut other costs, the EPS impact improves.
Fourth, acquisition accounting can create additional effects. The Buyer must reassess the value of the Seller’s assets and liabilities. Changes in asset values can create additional depreciation or amortization, and new intangible assets may be created.
There are also broader limitations:
- EPS is not always meaningful. A private acquirer may not care much about EPS. A company with negative net income may not care either.
- Net income and cash flow are different. A deal can look good on EPS and still look bad on cash flow.
- Merger models do not capture M&A risk. Integration can fail, teams may not mesh, legal issues can emerge, and customers may dislike the deal.
- Qualitative factors matter. Cultural fit and management alignment can be critical, but you cannot measure them cleanly in a merger model.
That’s why the best interview answer isn’t just “accretive” or “dilutive.” It’s: “Based on the simple EPS math, the deal is accretive because the Seller’s yield exceeds the Buyer’s weighted cost of acquisition. But I’d also want to examine synergies, purchase accounting, funding capacity, cash flow impact, and integration risk.”
That answer shows you understand both the spreadsheet and the deal.