How do you test whether an M&A deal is accretive or dilutive?

Q: What is the yield method in accretion/dilution analysis?

The yield method compares the target's earnings yield (1/P/E) against the acquirer's cost of capital. For all-stock deals, if the acquirer's P/E exceeds the target's P/E at the offer price, the deal is accretive. For debt-financed deals, compare the target's earnings yield to the after-tax cost of debt.

Q: What is the EPS method in a merger model?

The EPS method calculates pro forma earnings per share after the deal by combining both companies' net income, adjusting for after-tax interest on new debt, lost interest on cash, D&A from write-ups, and synergies, then dividing by pro forma shares outstanding. If pro forma EPS exceeds the acquirer's standalone EPS, the deal is accretive.

Q: How do you calculate the weighted cost of acquisition in a mixed deal?

Multiply the stock portion by the acquirer's earnings yield (1/P/E) and the debt portion by the after-tax interest rate, then sum them. For example, a 50/50 stock-debt deal with a 20x P/E acquirer and 6% debt at 25% tax gives a weighted cost of (0.5 x 5%) + (0.5 x 4.5%) = 4.75%. The deal is accretive if the target's yield exceeds this.

Q: Why should you not use WACC or CAPM in accretion/dilution analysis?

In accretion/dilution, the cost of equity is the inverse of the acquirer's P/E ratio, not CAPM. CAPM calculates a theoretically correct discount rate for DCF valuation, while accretion analysis asks whether issuing stock dilutes or enhances EPS. Discussing beta and risk-free rates in an accretion question signals framework confusion.

Master the Yield Method and EPS Method for investment banking interviews. Learn why using CAPM for accretion is a fatal error, how to avoid the "bootstrapping earnings" trap, and the exact formulas to answer "is this deal accretive" correctly every time.

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Accretion / Dilution Framework

Every M&A deal is a trade. If the earnings you buy exceed what you paid, the acquisition is accretive. If not, it's dilutive.

Two testing methods: Yield Method (compare returns vs. costs) and EPS Method (compare earnings per share before vs. after). Both are core to merger model analysis.

Quick Reference

Deal Type	Accretive If...
All-Stock	Target P/E (at offer price) < Acquirer P/E
All-Cash/Debt	Target earnings yield > after-tax borrowing cost
Mixed	Target earnings yield > weighted cost of acquisition
EPS Test	Pro forma EPS > prior EPS

Yield Method

Flip the target's P/E to get earnings yield:

Earnings Yield = \frac{1}{P/E}

20x P/E = 5% yield. Compare this against your acquisition currency cost.

All-Stock Deals

Pay with your own shares. Compare P/E ratios using the target's P/E at the offer price, not its current trading price.

Rule: Target P/E (at offer price) < Acquirer P/E → Accretive

Example:

Acquirer P/E = 25x (4% yield)
Target P/E = 15x (6.7% yield)
Trading 4% for 6.7%. Accretive.

A 25x P/E means the market values your earnings richly—each dollar of your earnings "buys" more. Swapping those expensive shares for a company trading at 15x yields more earnings per dollar of value given up.

Account for deal premiums: if the target trades at 10x but you pay a 50% premium, the effective P/E is 15x.

All-Cash / All-Debt Deals

Fund the acquisition with borrowed money. Compare target yield to after-tax interest cost.

After-Tax Cost of Debt = Interest Rate \times (1 - t)

Rule: Target earnings yield > after-tax cost of debt → Accretive

Example:

Target P/E = 12x (8.3% yield)
After-tax debt cost = 4.5%
Buying 8.3% with 4.5% money. Accretive.

Borrowing at 4.5% to buy something returning 8.3% is arbitrage. For cash-funded deals, the cost is foregone after-tax interest income:

Cost of Cash = Interest Rate \times (1 - t)

Cash acquisitions are typically accretive—interest rates on cash (3-4%) fall below company yields (5-10%).

Mixed Deal Structure

Most deals combine stock and debt. Calculate the Weighted Cost of Acquisition.

Do not use WACC or CAPM. For accretion analysis, cost of equity equals the inverse of the Acquirer's P/E.

Weighted Cost = (% Stock \times \frac{1}{Acquirer P/E}) + (% Debt \times Rate_{debt} \times (1 - t))

Rule: Target earnings yield > Weighted Cost → Accretive

Example: 50/50 stock and debt.

Acquirer P/E: 20x (Cost = 5%)
Debt Interest: 6% (Tax rate 25% → Cost = 4.5%)

Weighted Cost = (0.5 \times 5%) + (0.5 \times 4.5%) = 4.75%

Target Yield above 4.75% = Accretive.

Average the costs of your two currency types based on spending allocation.

WACC vs. Accretion

Context	Cost of Equity	Application
DCF Valuation	CAPM: $R_{f} + β \times ERP$	Discounting future cash flows
Accretion/Dilution	Inverse P/E: $1/ P/E$	Comparing acquisition cost to earnings yield

DCF estimates what a company is worth using a theoretically correct discount rate. Accretion analysis asks whether the deal makes each share earn more or less. The "cost" of issuing stock is your current earnings yield.

Discussing beta and risk-free rates in an accretion question signals framework confusion.

EPS Method

The method used in actual merger models. Calculate pro forma earnings per share after the deal.

Pro Forma EPS = \frac{Combined Net Income \pm Adjustments}{Pro Forma Shares}

Rule: Pro Forma EPS > Prior EPS → Accretive

Numerator adjustments:

Add: Target net income, after-tax synergies
Subtract: After-tax interest on new debt, after-tax D&A from write-ups, lost interest on cash

Denominator adjustments:

Add: New shares issued (stock deals)

For statement flow mechanics, see the guide on 3 Financial Statements.

After the deal, each share of your stock either generates more earnings or less. More = shareholders are better off. "Accretive" means each slice of the pie got bigger.

Method Comparison

Yield Method = return vs. cost. Conceptually cleaner. Answers "is this acquisition a good trade?"

EPS Method = shareholder perspective. Analysts build merger models around it. Management compensation ties to it. Answers "did my shares get more valuable?"

Both give the same directional answer. Buying earnings at 5% with capital costing 8% fails both tests.

LBO Considerations

In a Leveraged Buyout, PE funds maximize debt because:

Debt sits on target's balance sheet, not theirs
Interest is tax-deductible
Equity returns get leveraged up

Debt is cheap money that someone else (the target) repays. Loading 5% debt to buy a business returning 15% amplifies your equity return beyond 15%.

For debt paydown and IRR mechanics, see Paper LBOs.

Core Principle

For EPS calculation reference, see M&A Math Cheat Sheet: EPS Method.

Both methods answer one question:

Is the return on what you're buying greater than the cost of getting it?

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Frequently Asked Questions

What is the yield method in accretion/dilution analysis?

What is the EPS method in a merger model?

How do you calculate the weighted cost of acquisition in a mixed deal?

Why should you not use WACC or CAPM in accretion/dilution analysis?