What is the accretion/dilution formula, and what changes between a cash-financed deal and a stock-financed deal in the pro forma share count and pro forma net income?

What the interviewer is actually testing

"Walk me through a merger model" is the single most comprehensive M&A technical question: it requires you to have internalized every prior lesson in this module and sequence them correctly under pressure, live, usually without a whiteboard beyond what you draw yourself.

What a strong answer signals:

• You build in the correct order: purchase price and offer structure, then sources & uses, then PPA, then the combined income statement, then pro forma EPS and accretion/dilution, then sensitivities. Jumping straight to "accretive or dilutive" without the scaffolding reads as pattern-matched, not understood.
• You know which lines are non-negotiable inputs versus derived outputs. Offer premium and financing mix are assumptions the deal team chooses; goodwill, incremental D&A, and pro forma EPS are consequences that fall out of those assumptions.
• You can do the paper version cold: a simplified all-cash or all-stock deal, computing accretion/dilution by hand in under two minutes, the same muscle as the paper LBO.
• You connect mechanics to judgment. A model that shows 8% year-one accretion doesn't end the conversation: you should immediately ask (or volunteer) whether that accretion survives a synergy haircut, what it does to leverage, and whether accretion is even the right lens versus IRR/NPV on the price paid.

Common follow-ups: "Which is more accretive, cash or stock, all else equal, and why?" (cash: no share dilution, and lost interest income is usually cheaper than the target's earnings yield); "What's the one number you'd want before doing anything else?" (the target's P/E relative to the acquirer's, for a stock deal, or the cost of the incremental debt relative to the target's earnings yield, for a cash/debt deal); "Why might a board approve a dilutive deal?" (strategic rationale, growth/TAM expansion, defensive necessity, or synergies not yet in the model but expected to close the gap within an agreed timeline).

A candidate who can narrate this whole flow smoothly, then pivot immediately to "but here's why accretion isn't the full picture," is showing exactly the blend of mechanical fluency and judgment elite boutiques hire for.

Common traps

Trap 1: Starting the walkthrough with accretion/dilution instead of the purchase price. Candidates jump to "is it accretive" before establishing the offer price, financing, and PPA that the accretion math depends on.

Say it out loud: "I'd build this in order: first the purchase price and offer structure, then sources and uses, then the purchase price allocation, then the combined income statement, and only then pro forma EPS and accretion or dilution: each stage depends on the one before it."

Trap 2: Forgetting the treasury stock method when computing diluted shares at the new offer price. A higher offer price pulls more options into the money, increasing diluted share count and equity purchase price versus using the pre-deal share count.

Say it out loud: "I'd re-run the treasury stock method at the offer price, not the current price: a premium can bring options into the money that were previously out of the money, which increases the effective share count I'm paying for."

Trap 3: Treating sources and uses as an afterthought rather than a hard constraint. Sources must equal uses to the dollar; candidates sometimes describe financing loosely without tying it back to the exact purchase price plus fees plus refinancing needs.

Say it out loud: "Uses are the equity purchase price, any target debt refinanced, and transaction fees; sources are however I've said I'm funding it (cash, new debt, new equity) and those two totals have to tie exactly."

Trap 4: Applying 100% of assumed synergies in year one. Real integration takes time; models that show full run-rate synergies immediately overstate near-term accretion.

Say it out loud: "I'd phase synergies in (maybe 40% in year one, 75% in year two, 100% by year three) rather than assuming full run-rate synergies land immediately, since integration takes time and the model should reflect that."

Trap 5: Ignoring lost interest income on cash used, or forgetting to net the refinancing benefit. Cash used to fund the deal isn't free: it stops earning interest income; and if target debt is refinanced at a different rate, that delta belongs in the model too.

Say it out loud: "Using cash isn't free: I'd lose the interest income that cash was earning, so the P&L impact of a cash deal is that forgone interest income net of tax, not zero. And if I'm refinancing the target's debt, I'd net the rate difference against the new acquisition debt's cost."

Trap 6: Conflating accretion/dilution with value creation. A deal can be accretive to EPS and still be value-destructive (overpaying, wrong strategic rationale, excessive leverage), or dilutive and still be the right deal strategically.

Say it out loud: "Accretion and dilution measure the near-term EPS mechanics of the deal, not whether it creates value: I'd also want to see the price paid against a DCF or comps-based fair value, the leverage impact, and the strategic rationale before calling this a good deal."