CFA Level II Exam · Corporate Restructuring

Exchange Ratio and Cash vs Stock Merger Financing

Updated 7 October 2026 · Fact-checked

The exchange ratio is the number of acquirer shares offered for each target share, equal to the offer price per target share divided by the acquirer's share price. Post-merger EPS equals combined earnings, adjusted for financing costs and synergies, divided by acquirer shares plus new shares issued. Compare it with the acquirer's standalone EPS to see accretion or dilution.

Understand Deal Financing and Exchange Ratio Analysis

When a company buys another, it must pay in cash, in its own shares, or in a mix. The choice decides who bears risk, who keeps the gains, and what happens to EPS.

In a cash offer, target shareholders receive a fixed amount per share. Their gain is the premium over the target's pre-deal price. They have no further stake in the combined firm. The acquirer's shareholders keep all the synergies, pay the premium, and carry all the risk that the deal fails to create value.

In a stock offer, target shareholders receive acquirer shares and become owners of the combined firm. The exchange ratio sets how many acquirer shares each target share receives. Target holders now share in the synergies and also in the risk. The value they receive moves with the acquirer's share price, unless the terms are fixed in value rather than in ratio. A fixed exchange ratio leaves the value uncertain, so target holders bear the share-price risk. A fixed value deal adjusts the ratio so the value stays constant. In that case the acquirer's existing shareholders bear the share-price risk, through a variable number of shares issued and so a variable amount of dilution.

EPS effects come from simple arithmetic. In a stock deal, the acquirer adds new shares to the denominator and adds the target's earnings to the numerator. In a cash deal, shares do not change, but earnings fall by the after-tax cost of the cash used. That cost is after-tax interest if you borrow, or after-tax interest income lost if you use cash on hand.

Accretion is not value creation. EPS can rise simply because the acquirer has a higher P/E than the price it pays for the target. The exam tests whether you can compute EPS correctly and then explain who gains and who bears the risk.

Key formulas to remember

Exchange ratio: Exchange ratio = offer price per target share ÷ acquirer share price; Shares issued = exchange ratio × number of target shares. Offer price is the price you read from the vignette, not the target's current price.
Post-merger EPS (stock deal): EPS = (acquirer earnings + target earnings + after-tax synergies) ÷ (acquirer shares + new shares issued); Use net income figures, not EBIT. Add synergies only if the vignette gives them.
Post-merger EPS (cash deal): EPS = (acquirer earnings + target earnings + after-tax synergies − after-tax financing cost) ÷ acquirer shares; After-tax financing cost = cash paid × rate × (1 − tax rate). The rate is the borrowing rate, or the forgone interest rate on cash.
Target holders' ownership in combined firm: Ownership = new shares issued ÷ (acquirer shares + new shares issued); This is the share of combined value and synergies that target holders receive in an all-stock deal.
Premium paid: Premium = offer price − target standalone price; premium % = premium ÷ target standalone price; This is the target shareholders' gain in a cash deal.
Gain split: Acquirer gain = synergies − premium paid; target gain = premium paid (cash deal); In a stock deal, target gain = ownership share × combined value − target standalone value.
Accretion test (stock deal): EPS accretive if acquirer P/E > offer price ÷ (target EPS + after-tax synergies per target share); Equivalent to the target's earnings yield at the offer price exceeding the acquirer's earnings yield. With no synergies, the denominator is just target EPS. With synergies, you must add the after-tax synergies per target share to target EPS, or the test is wrong. If in doubt, recompute EPS in full.
Accretion test (cash deal): EPS accretive if (target earnings + after-tax synergies) ÷ cash paid > after-tax financing rate; Target earnings yield at the price paid versus the after-tax cost of funds. With no synergies, use target earnings alone.

How to solve Deal Financing and Exchange Ratio Analysis questions

Use the same sequence for every item set on deal financing. Pull the data from the vignette before you calculate anything.

1Identify the consideration: all cash, all stock, or a mix. For a mix, split the offer value into the cash part and the stock part.
2List the data: acquirer and target shares, EPS or net income, share prices, offer price, synergies, tax rate and financing rate.
3For the stock part, compute the exchange ratio (offer price ÷ acquirer price) and new shares issued (ratio × target shares).
4For the cash part, compute cash required and the after-tax financing cost (cash × rate × (1 − tax)).
5Build combined earnings: acquirer earnings + target earnings + after-tax synergies − after-tax financing cost.
6Divide by post-deal shares (acquirer shares + new shares issued) to get post-merger EPS.
7Compare with acquirer standalone EPS. Higher is accretive, lower is dilutive.
8Answer the qualitative part: who bears the risk, who shares synergies, and what the premium is. Check your answer agrees with the direction implied by P/E or earnings yield.

Quickest way: Earnings-yield shortcut for accretion or dilution

When to use it: Use it when the question asks only whether EPS rises or falls, or to check the direction of a full calculation. It does not give the EPS level.

Stock deal with no synergies: compute the offer P/E (offer price ÷ target EPS) and compare with acquirer P/E. Lower offer P/E than acquirer P/E means accretive.
Cash deal with no synergies: compute target earnings ÷ cash paid and compare with the after-tax cost of funds. Higher earnings yield means accretive.
If after-tax synergies are given, add them to target earnings before testing. For a stock deal, use offer price ÷ (target EPS + after-tax synergies per target share) as the offer P/E. For a cash deal, use (target earnings + after-tax synergies) ÷ cash paid. If this feels unsafe, recompute EPS in full.
Pick the option that matches the direction, then calculate the exact EPS only if the number is asked.

Common mistakes in Deal Financing and Exchange Ratio Analysis

Using the target's current price instead of the offer price when computing the exchange ratio.
Both prices appear in the vignette, and the target price is the one most visible.
Fix: The ratio is offer price ÷ acquirer price. Use the current target price only to compute the premium.
Using pre-tax interest in a cash deal funded by debt.
Candidates compute interest and forget that it is tax deductible.
Fix: Always multiply financing cost by (1 − tax rate) when adjusting net income.
Adding new shares in a cash deal, or forgetting them in a stock deal.
Candidates apply one template to both forms of consideration.
Fix: Cash deal: shares unchanged, earnings reduced. Stock deal: shares increase, no financing cost.
Treating an accretive deal as a value-creating deal.
EPS rising feels like a gain for shareholders.
Fix: Accretion can come from a P/E difference alone. Value creation requires synergies exceeding the premium.
Saying target shareholders keep the risk in a cash deal.
Mixing up who owns the combined firm after closing.
Fix: In cash, target holders are paid out and bear no further risk. The acquirer's holders bear all the risk and keep all the synergies. In stock, both groups share them.
Dividing by the wrong ownership base when finding target holders' stake.
Candidates divide new shares by the acquirer's original shares.
Fix: Divide new shares by total post-deal shares (original plus new).

Worked examples

Example 1

Vignette: Acquirer A has 100 million shares, net income of $400 million (EPS $4.00) and a share price of $60. Target T has 40 million shares, net income of $100 million (EPS $2.50) and a share price of $30. A offers $36 per T share, paid entirely in A shares. No synergies are expected.

Q1. The exchange ratio is closest to: A. 0.60 B. 0.83 C. 1.20

Q2. Post-merger EPS is closest to: A. $4.00 B. $4.03 C. $4.17

Show the solution

Q1: Exchange ratio = offer price ÷ acquirer price = 36 ÷ 60 = 0.60. The 0.83 option uses 30 ÷ 36 and the 1.20 option uses 36 ÷ 30, both wrong.
Q2: New shares issued = 0.60 × 40 million = 24 million.
Combined earnings = 400 + 100 = $500 million, with no synergies.
Post-deal shares = 100 + 24 = 124 million.
Post-merger EPS = 500 ÷ 124 = $4.03, above the standalone $4.00, so the deal is accretive.
Check: acquirer P/E = 60 ÷ 4 = 15. Offer P/E = 36 ÷ 2.50 = 14.4. A lower offer P/E than acquirer P/E agrees with accretion.

Answer: Q1: A (0.60). Q2: B ($4.03), accretive. Target holders own 24 ÷ 124, about 19.4%, of the combined firm.

Example 2

Vignette: Use the same companies. Now A offers $36 per T share in cash, totalling $1,440 million, funded entirely by new debt at 6% with a tax rate of 25%. No synergies are expected.

Q1. Post-merger EPS is closest to: A. $4.35 B. $4.14 C. $5.00

Q2. Which statement is correct? A. Target shareholders share in the synergies from the deal. B. Acquirer shareholders bear all of the risk that synergies are not realised. C. Target shareholders receive a value that falls if the combined firm performs badly.

Show the solution

Q1: Cash needed = 40 million × 36 = $1,440 million.
Pre-tax interest = 1,440 × 6% = $86.4 million.
After-tax interest = 86.4 × (1 − 0.25) = $64.8 million.
Combined earnings = 400 + 100 − 64.8 = $435.2 million.
Shares are unchanged at 100 million, so EPS = 435.2 ÷ 100 = $4.35 (above $4.00, accretive).
Check: target earnings yield = 100 ÷ 1,440 = 6.9%. After-tax cost of debt = 4.5%. Yield above cost, so accretive.
Q2: In a cash deal, target holders receive a fixed price and exit, so A and C are wrong. The acquirer's holders keep all synergies and bear the risk, so B is correct.

Answer: Q1: A ($4.35, accretive, more than the $4.03 under the stock offer). Q2: B.

Exam tips

Read the consideration type first. It tells you whether to change shares, earnings, or both.
Quote or circle the tax rate and financing rate. Many errors come from ignoring them.
When a question asks who benefits or bears risk, answer in terms of who owns the combined firm after closing.
Expect distractors that use the wrong price in the ratio or pre-tax interest. Check which price and which earnings figure each option uses.
Use the P/E or earnings-yield comparison to confirm the direction of your EPS answer before you move to the next question.

Deal Financing and Exchange Ratio Analysis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Deal Financing and Exchange Ratio Analysis: frequently asked questions

How do I calculate the exchange ratio in a merger?

Divide the offer price per target share by the acquirer's share price. Multiply the ratio by the number of target shares to get the new acquirer shares issued.

When is a stock deal accretive to EPS?

With no synergies, it is accretive when the acquirer's P/E is higher than the price paid divided by target EPS. In other words, the acquirer uses highly valued shares to buy cheaper earnings. If synergies exist, include them in the combined earnings and recompute.

Why does a cash deal leave shareholders with more risk?

Target holders are paid a fixed amount and leave. The acquirer's holders keep all the upside from synergies but also absorb any shortfall. In a stock deal, target holders share both.

Do I include interest in post-merger EPS for a debt-funded cash deal?

Yes, as after-tax interest deducted from combined earnings. If the cash comes from existing balances, deduct the after-tax interest income lost instead.