Merger Models and Accretion/Dilution: The M&A Interview Essential

Company A buys Company B for $10 billion. Is the deal accretive or dilutive?

This question appears in nearly every investment banking interview. It tests whether you understand the fundamental mechanics of M&A—how deals affect the combined company's earnings per share.

The concept is simple. A deal is accretive if it increases EPS. Dilutive if it decreases EPS. But understanding why requires knowing how purchase prices, financing structures, and earnings interact.

This guide breaks down merger models and accretion/dilution from first principles. The mechanics, the math, the interview questions, and the real-world applications.

---

The Core Concept

What Is Accretion/Dilution?

When Company A acquires Company B:

Accretive: Combined EPS > Acquirer's standalone EPS

Dilutive: Combined EPS < Acquirer's standalone EPS

That's it. The entire concept reduces to one question: Does the deal increase or decrease earnings per share for the buyer's shareholders?

Why It Matters

Accretion/dilution isn't the only way to evaluate M&A. It's not even the most important way. But it matters for several reasons:

Shareholder communication. Public company boards must justify acquisitions to shareholders. "The deal is X% accretive in Year 1" is a tangible metric.

Management incentives. Many executives have EPS-based compensation. Dilutive deals can hurt their pay.

Market reaction. Investors often respond negatively to dilutive deals, at least initially.

Screening tool. Accretion/dilution is a quick sanity check on whether a deal makes financial sense.

The Limitations

Accretion/dilution has real limitations:

Ignores value creation. A deal can be dilutive and still create value if synergies materialize over time.

Short-term focus. Year 1 accretion/dilution may differ from Year 3 or Year 5.

Manipulable. Accounting choices, timing, and financing mix can all affect the result.

Incomplete picture. Strategic rationale, integration risk, and long-term positioning matter more than EPS math.

Smart bankers understand both the mechanics and the limitations.

---

The Basic Math

The Simple Framework

Accretion/dilution analysis compares:

What you get: Target's earnings contribution What you give up: Cost of financing (interest on debt, foregone interest on cash, or new shares issued)

If what you get exceeds what you give up, the deal is accretive.

A Simple Example

Acquirer:

• Net income: $100M
• Shares outstanding: 50M
• EPS: $2.00

Target:

• Net income: $20M
• Purchase price: $300M

Scenario 1: All Cash Deal (Debt Financed)

Cost of financing: $300M × 5% interest × (1 - 25% tax rate) = $11.25M after-tax

Combined net income: $100M + $20M - $11.25M = $108.75M Combined shares: 50M (unchanged) Combined EPS: $108.75M / 50M = $2.175

Accretive by 8.75% ($2.175 vs. $2.00)

Scenario 2: All Stock Deal

Assume acquirer stock trades at $30/share. Shares issued: $300M / $30 = 10M new shares

Combined net income: $100M + $20M = $120M Combined shares: 50M + 10M = 60M Combined EPS: $120M / 60M = $2.00

Break-even (neither accretive nor dilutive)

The Key Insight

The financing method matters enormously.

• Debt financing: You keep all shares but pay interest
• Stock financing: You share earnings with new shareholders
• Cash financing: You lose interest income on cash used

Each has different implications for accretion/dilution.

---

The Drivers of Accretion/Dilution

Driver 1: P/E Arbitrage

This is the most intuitive driver.

The rule: When a high-P/E company buys a low-P/E company with stock, the deal is typically accretive.

Why it works:

• High-P/E buyer: Market values each dollar of earnings highly
• Low-P/E target: Earnings are "cheap"
• When combined, the high-P/E buyer gets more earnings than the dilution from shares issued

Example:

• Buyer P/E: 25x (market values earnings richly)
• Target P/E: 10x (earnings are cheap)
• Stock deal at target's market price

The buyer issues fewer shares (in P/E terms) than the earnings it acquires. Accretive.

The reverse: If a low-P/E buyer acquires a high-P/E target with stock, expect dilution.

Driver 2: Cost of Financing vs. Yield Acquired

For cash/debt deals, compare:

Cost of financing: After-tax interest rate on debt (or opportunity cost of cash)

Yield acquired: Target's earnings / Purchase price = Target's implied P/E inverse

Rule of thumb:

• If yield acquired > cost of financing → Accretive
• If yield acquired < cost of financing → Dilutive

Example:

• Purchase price: $500M
• Target earnings: $40M
• Yield acquired: $40M / $500M = 8%
• After-tax cost of debt: 4%

You're getting an 8% yield while paying 4% → Accretive

Driver 3: Premium Paid

The premium above market value directly impacts accretion/dilution.

Higher premium → More dilutive (or less accretive)

Why? You're paying more for the same earnings. The yield acquired decreases.

Example:

• Target trades at $200M (10x P/E on $20M earnings)
• No premium: Yield = 10%
• 50% premium ($300M): Yield = 6.7%
• 100% premium ($400M): Yield = 5%

Higher premiums make it harder to achieve accretion.

Driver 4: Synergies

Synergies improve accretion by adding to combined earnings.

Types of synergies:

• Cost synergies (headcount reduction, facility consolidation)
• Revenue synergies (cross-selling, pricing power)

In the model:

• Add estimated synergies to combined net income
• Typically phase in over 1-3 years
• May have costs to achieve (one-time expenses)

Example:

• Deal is 5% dilutive before synergies
• $50M of cost synergies × (1 - 25% tax) = $37.5M after-tax
• If $37.5M > 5% dilution impact, deal becomes accretive

Synergies are often the difference between dilutive and accretive.

---

Building the Merger Model

Step 1: Standalone Projections

Model each company independently:

Acquirer:

• Revenue, EBITDA, Net Income
• Shares outstanding (including dilution from options)
• Current EPS

Target:

• Revenue, EBITDA, Net Income
• Current ownership structure

Step 2: Transaction Assumptions

Define the deal structure:

Purchase price:

• Per-share price or total equity value
• Premium to current market price

Consideration mix:

• % Cash
• % Stock
• % Debt (if buyer issues new debt)

New shares issued (for stock portion):

• Stock consideration / Acquirer share price

Step 3: Financing Assumptions

For cash consideration:

• Source of cash (existing cash vs. new debt)
• Interest rate on new debt
• Foregone interest on cash used

For stock consideration:

• Shares issued
• No direct financing cost (but dilution occurs)

Step 4: Adjustments

Several adjustments affect combined earnings:

Interest expense: On new debt raised

Foregone interest income: On cash used

D&A adjustment: Write-up of target's assets creates additional D&A (reduces earnings)

Synergies: Cost and revenue synergies (add to earnings)

Transaction costs: Advisory fees, financing fees (one-time hit)

Step 5: Combined Income Statement

Acquirer Net Income
+ Target Net Income
+ Synergies (after-tax)
- New Interest Expense (after-tax)
- Foregone Interest Income (after-tax)
- Incremental D&A from Write-ups (after-tax)
= Pro Forma Combined Net Income

Step 6: Calculate Combined EPS

Pro Forma EPS = Pro Forma Net Income / Pro Forma Shares

Pro Forma Shares = Acquirer Shares + New Shares Issued

Step 7: Accretion/Dilution Calculation

Accretion/(Dilution) = (Pro Forma EPS - Standalone EPS) / Standalone EPS

Positive = Accretive Negative = Dilutive

---

Purchase Price Accounting

Why It Matters

When a company is acquired, its assets and liabilities are "written up" (or down) to fair market value. This creates accounting adjustments that affect earnings.

The Key Concepts

Purchase price allocation: The premium paid above book value is allocated to:

1. Identifiable intangible assets (customer relationships, technology, brand)
2. Write-ups of tangible assets to fair value
3. Goodwill (the residual)

Impact on earnings:

• Write-ups to depreciable assets → Higher D&A → Lower earnings
• Amortization of intangibles → Lower earnings
• Goodwill is not amortized (but tested for impairment)

Simplified Treatment

For interview purposes, a simplified approach works:

Assume:

• X% of purchase premium is allocated to identifiable intangibles
• Amortized over Y years
• After-tax impact reduces combined earnings

Example:

• $100M premium paid
• 50% allocated to intangibles ($50M)
• Amortized over 10 years → $5M annual amortization
• At 25% tax rate → $3.75M after-tax earnings reduction

This reduces accretion or increases dilution.

---

Interview Questions

Basic Questions

"Is this deal accretive or dilutive?"

Walk through the framework:

1. Compare what you get (target earnings) vs. what you give up (financing cost or shares)
2. Calculate combined EPS
3. Compare to standalone EPS

"What makes a deal accretive?"

Three main factors:

1. Acquiring lower P/E company with stock (P/E arbitrage)
2. Target earnings yield > cost of financing (for cash deals)
3. Synergies that boost combined earnings

"When would a company do a dilutive deal?"

Strategic reasons may override EPS impact:

• Long-term value creation exceeds short-term dilution
• Strategic necessity (competitive positioning, technology)
• Synergies expected to make it accretive over time
• Target is faster-growing (EPS catch-up expected)

Intermediate Questions

"Walk me through a merger model."

Structure your answer:

1. Model acquirer and target standalone
2. Define transaction assumptions (price, mix)
3. Calculate financing costs
4. Make accounting adjustments (interest, D&A)
5. Add synergies
6. Combine income statements
7. Calculate pro forma EPS
8. Compare to standalone for accretion/dilution

"How does financing mix affect accretion/dilution?"

Debt vs. stock depends on:

• Cost of debt (after-tax interest rate)
• Acquirer's P/E (implied cost of equity)

If after-tax debt cost < earnings yield on acquirer stock, debt is more accretive than stock.

Example:

• After-tax cost of debt: 4%
• Acquirer P/E: 20x → Earnings yield: 5%

Debt costs 4%, stock "costs" 5% → Debt is cheaper, more accretive.

"How do synergies affect the analysis?"

Synergies add to combined earnings:

• $50M pre-tax synergies × (1 - tax rate) = after-tax impact
• Added to pro forma net income
• Typically phased in over 1-3 years

Can convert a dilutive deal to accretive.

Advanced Questions

"The acquirer has a P/E of 15x and the target has a P/E of 20x. Is an all-stock deal accretive or dilutive?"

Quick analysis:

• Buyer P/E < Target P/E
• Buyer is issuing "cheap" stock to buy "expensive" earnings
• Each share issued gives away more earnings than acquired
• Dilutive

"How much in synergies would you need to make this deal accretive?"

Work backwards:

1. Calculate pro forma dilution (in $ terms)
2. Synergies needed = Dilution / (1 - tax rate)

Example:

• Deal is $10M dilutive (after-tax)
• Tax rate: 25%
• Pre-tax synergies needed: $10M / 0.75 = $13.3M

"What's the break-even P/E for an all-stock deal?"

In an all-stock deal with no synergies:

• Break-even occurs when acquirer P/E = Target P/E (at purchase price)
• If buyer P/E > Target P/E → Accretive
• If buyer P/E < Target P/E → Dilutive

---

Quick Mental Math

The 1% Rule

For back-of-envelope analysis:

For debt-financed deals:

• If target's earnings yield > after-tax cost of debt → Accretive
• Every 1% difference ≈ 1% accretion/dilution (roughly)

Example:

• Target yield: 8% (1/12.5x P/E)
• After-tax debt cost: 4%
• Spread: 4%
• Rough accretion: ~4%

Quick Stock Deal Analysis

For all-stock deals:

Accretion % ≈ (Buyer P/E - Target P/E at purchase price) / Target P/E

This is approximate but directionally useful.

Example:

• Buyer P/E: 20x
• Target P/E at purchase price: 15x
• Rough accretion: (20 - 15) / 15 = 33%

(Actual math is more complex, but this gives direction.)

Break-Even Calculations

Break-even premium for stock deal:

If buyer and target have same P/E, any premium creates dilution. The break-even premium is 0%.

Break-even interest rate for debt deal:

Interest rate that makes deal neutral:

• Break-even rate = Target earnings yield × (1 + tax rate)

If target yields 8% and tax is 25%:

• Break-even pre-tax rate = 8% / 0.75 = 10.7%

Below that rate → Accretive. Above → Dilutive.

---

Real-World Considerations

Accretion/Dilution ≠ Value Creation

A deal can be:

• Accretive and value-destroying (overpaid, even if math works)
• Dilutive and value-creating (synergies take time to materialize)

EPS impact is a metric, not the goal. Value creation is the goal.

Multi-Year Analysis

Year 1 accretion/dilution tells an incomplete story.

What changes over time:

• Synergies phase in
• Debt gets paid down
• Growth rates differ between acquirer and target
• Purchase accounting adjustments diminish

A dilutive deal in Year 1 may be accretive by Year 3.

Cash EPS vs. GAAP EPS

Some analyses use "Cash EPS" that adds back:

• Amortization of intangibles
• Other non-cash charges

This provides a cleaner operating view but differs from reported GAAP EPS.

Different Share Price Scenarios

Stock deals lock in an exchange ratio, not a fixed dollar value.

Fixed exchange ratio: Target shareholders get X shares of acquirer per share held. Deal economics shift with acquirer's stock price.

Collar: Exchange ratio adjusts within a range to provide price protection.

Model both buyer and target stock price sensitivities.

---

Common Mistakes

Modeling Errors

Forgetting tax effect on interest. Interest is tax-deductible. Use after-tax cost.

Ignoring purchase accounting. Asset write-ups create D&A that reduces earnings.

Incorrect share count. Include dilution from options, convertibles on both sides.

Missing foregone interest. If cash is used, the acquirer loses interest income.

Conceptual Errors

Equating accretion with value creation. They're different concepts.

Ignoring strategic rationale. EPS math is one input, not the decision.

Forgetting synergies. Many deals only make sense with synergies.

Over-relying on Year 1. Multi-year analysis often tells a different story.

---

Practice Problem

Given:

• Acquirer: $500M net income, 100M shares, $50 stock price
• Target: $60M net income, 20M shares, $30 stock price
• Deal: Acquirer buys target at $40/share (33% premium)
• Consideration: 50% cash (debt at 5%), 50% stock
• Tax rate: 25%
• $30M pre-tax synergies

Calculate accretion/dilution.

Solution:

Step 1: Purchase price

• $40/share × 20M shares = $800M total

Step 2: Financing mix

• Cash/debt: $400M
• Stock: $400M / $50 = 8M new shares issued

Step 3: Financing costs

• Interest: $400M × 5% = $20M pre-tax
• After-tax: $20M × (1 - 25%) = $15M

Step 4: Combined earnings

• Acquirer: $500M
• Target: $60M
• Less interest: -$15M
• Plus synergies: $30M × (1 - 25%) = $22.5M
• Combined: $567.5M

Step 5: Combined shares

• 100M + 8M = 108M

Step 6: Pro forma EPS

• $567.5M / 108M = $5.25

Step 7: Accretion/dilution

• Standalone EPS: $500M / 100M = $5.00
• Accretion: ($5.25 - $5.00) / $5.00 = 5.0%

The deal is 5% accretive.

---

The Bottom Line

Accretion/dilution analysis is fundamental to M&A. It answers a simple question: Does the deal increase or decrease earnings per share?

The core mechanics:

• Compare earnings acquired vs. cost of financing
• Stock deals depend on relative P/E ratios
• Debt deals depend on earnings yield vs. interest cost
• Synergies improve accretion

For interviews:

• Know the framework cold
• Be able to do quick mental math
• Understand the drivers (P/E arbitrage, cost of financing, synergies)
• Recognize limitations (EPS ≠ value creation)

Master this, and you'll handle one of the most common technical questions in M&A interviews. More importantly, you'll understand how bankers actually think about deal economics.