Cash vs Stock vs Debt: How to Calculate the Cost of Each Funding Source in M&A

If you're prepping for investment banking interviews, you will almost certainly hear some version of this question: "Which is cheapest for an acquirer: cash, debt, or stock?"

The quick answer: cash is usually cheapest, debt is next, and stock is usually the most expensive. But "usually" is doing a lot of work in that sentence, and interviewers love to test whether you know why. This post walks through how to calculate each cost, how to compare them in a real deal, and how to answer the question in a way that sounds like you've actually built a merger model.

Why the Cost of Funding Matters in M&A

When a company buys another company, it has to pay for it somehow. The three main options are:

• Cash already sitting on the balance sheet
• Debt raised from lenders or bond investors
• Stock issued to the target's shareholders or to the market

Each option has a "cost" that hits the acquirer's earnings. That cost is the key to the most common merger model question of all: will this deal be accretive or dilutive to the acquirer's EPS?

If you can calculate the cost of each funding source in your head, you can answer accretion/dilution questions in about 30 seconds without building a full model.

The Cost of Each Funding Source

1. Cost of Cash = Forgone Interest × (1 − Tax Rate)

Cash isn't free. If a company spends $1 billion of cash on an acquisition, it loses the interest it was earning on that cash.

Formula:

After-tax cost of cash = Interest rate on cash × (1 − Tax rate)

You apply the tax adjustment because interest income is taxable. Losing $30 million of interest income doesn't reduce net income by $30 million. It reduces it by $30 million minus the taxes you would have paid on it.

Example: cash earns 3%, tax rate is 25%.

• 3% × (1 − 0.25) = 2.25%

2. Cost of Debt = Interest Rate × (1 − Tax Rate)

When you borrow money, you pay interest. Since interest expense is tax-deductible, the true cost to net income is lower than the headline rate.

Formula:

After-tax cost of debt = Interest rate on new debt × (1 − Tax rate)

Example: new debt costs 7%, tax rate is 25%.

• 7% × (1 − 0.25) = 5.25%

Debt costs more than cash because lenders charge more than what you earn parking money in safe, short-term instruments.

3. Cost of Stock = Inverse of the Acquirer's P/E Ratio

This one trips people up. When you issue new shares, you don't pay interest. Instead, you give away a slice of future earnings to new shareholders. That's the cost.

Formula:

Cost of stock = Acquirer's Net Income ÷ Acquirer's Equity Value = 1 ÷ Acquirer's P/E

This is also called the earnings yield.

Example: acquirer trades at $50 per share with EPS of $2.50.

• P/E = $50 ÷ $2.50 = 20x
• Cost of stock = 1 ÷ 20 = 5%

No tax adjustment here, because the P/E is already based on after-tax net income.

The Shortcut: Compare Funding Cost to the Target's Yield

Here's where it all comes together. To figure out if a deal is accretive or dilutive, compare:

• The weighted cost of funding (what the acquirer gives up), and
• The target's yield = Target's Net Income ÷ Purchase Price = 1 ÷ Target's P/E at the purchase price

The rule:

• If target yield > weighted cost of funding → the deal is accretive
• If target yield < weighted cost of funding → the deal is dilutive

In plain English: if what you're buying earns more than what you're paying for it, EPS goes up.

Worked Example: Same Deal, Three Funding Choices

Let's put real numbers on this.

Acquirer:

• 100 million shares outstanding
• Share price: $50
• Net income: $250 million (EPS = $2.50, P/E = 20x)
• Interest earned on cash: 3%
• Interest rate on new debt: 7%
• Tax rate: 25%

Target:

• Net income: $40 million
• Purchase price (equity): $1,000 million
• Purchase P/E = 25x, so target yield = 4%

Our funding costs from above:

Now let's prove the shortcut actually works by running the full EPS math.

All-Cash Deal

• Forgone interest: $1,000M × 3% = $30M pre-tax, or $22.5M after tax
• Combined net income: $250M + $40M − $22.5M = $267.5M
• Shares: still 100M
• New EPS: $2.675 vs. $2.50 → accretive ✅

All-Debt Deal

• Interest expense: $1,000M × 7% = $70M pre-tax, or $52.5M after tax
• Combined net income: $250M + $40M − $52.5M = $237.5M
• Shares: still 100M
• New EPS: $2.375 vs. $2.50 → dilutive ❌

All-Stock Deal

• New shares issued: $1,000M ÷ $50 = 20M shares
• Combined net income: $250M + $40M = $290M
• Total shares: 120M
• New EPS: $2.417 vs. $2.50 → dilutive ❌

The full math matches the shortcut every time. That's why bankers (and interviewers) love it.

What About a Mixed Deal?

Most real deals use a combination. Just weight the costs.

Example: 50% debt, 50% stock.

• (50% × 5.25%) + (50% × 5.00%) = 5.125%

Since 5.125% is above the 4% target yield, the deal is still dilutive. If you swapped some of that debt for cash, the weighted cost would drop and you might flip it to accretive.

When the "Usual" Ranking Breaks

Here's the part that separates good answers from great ones. The order cash < debt < stock is a tendency, not a law.

A High P/E Makes Stock Cheap

Imagine the acquirer trades at 40x earnings. Its cost of stock is 1 ÷ 40 = 2.5%. That's cheaper than our 5.25% after-tax cost of debt.

This is exactly why richly valued companies (think fast-growing tech names) often use their stock as acquisition currency. Their shares are "expensive" in the market, which makes them cheap to issue.

Low Interest Rates Make Debt Cheap

When borrowing rates are very low, the after-tax cost of debt can drop below the cost of stock even for companies with moderate P/E ratios. That's one reason debt-funded deals tend to look more attractive in low-rate environments.

Cash Is Only Cheapest If You Have It

The cost of cash looks great on paper, but most companies don't have enough excess cash to fund a large deal, and they need to keep some on hand to run the business.

Accounting Cost vs. Economic Cost: The Nuance Interviewers Love

There's an important distinction you should be ready to explain.

The inverse P/E is not the true cost of equity. It's a shortcut for measuring the impact on EPS. In corporate finance terms, the real cost of equity is usually estimated with CAPM, and it's almost always higher than the cost of debt, because equity holders take more risk and get paid last.

So two statements can both be true:

• In an accretion/dilution analysis, stock can look cheaper than debt if the acquirer has a high P/E.
• In an economic sense, equity is generally the most expensive form of capital.

If you mention this distinction unprompted, you'll sound like someone who understands the concepts rather than someone who memorized a formula.

Beyond the Numbers: Other Factors That Drive the Choice

The cheapest option on a spreadsheet isn't always the one a company picks. Bankers also weigh:

• Leverage and credit ratings: too much new debt can trigger a rating downgrade and raise future borrowing costs.
• Risk sharing: with stock, target shareholders share in the upside and downside of the combined company. With cash, they walk away with certainty.
• Ownership and control: issuing lots of shares dilutes existing shareholders' voting power.
• Signaling: paying in stock can suggest management thinks its shares are fully valued. Paying in cash can signal confidence.
• Seller taxes: target shareholders who receive stock can often defer taxes in properly structured deals, while cash is generally taxable right away.
• Deal size: for a huge acquisition, the acquirer may simply need all three sources to get to the purchase price.

What the Shortcut Ignores

Keep in mind that the yield comparison is a simplification. A full merger model also accounts for:

• Synergies (cost savings or revenue gains)
• Transaction and financing fees
• New D&A and amortization from writing up the target's assets and creating new intangibles
• Differences in tax rates between acquirer and target

For interview purposes, the shortcut is perfect. Just be ready to say "this ignores synergies, fees, and purchase accounting adjustments" if pushed.

How to Answer This in an Interview

Here's a clean, confident answer you can adapt:

"To compare funding sources, I'd look at the after-tax cost of each. The cost of cash is the forgone interest income times one minus the tax rate. The cost of debt is the interest rate on new debt times one minus the tax rate. The cost of stock is the inverse of the acquirer's P/E, or its earnings yield. Typically cash is cheapest, then debt, then stock, but that can change. A company with a very high P/E might find stock cheaper than debt. To test accretion or dilution, I'd compare the weighted cost of funding to the target's yield, which is the inverse of its purchase P/E. If the target's yield is higher, the deal is accretive."

That answer covers the formulas, the ranking, the exception, and the application. That's everything they're looking for.

Key Takeaways

• Cost of cash = interest rate on cash × (1 − tax rate)
• Cost of debt = interest rate on debt × (1 − tax rate)
• Cost of stock = 1 ÷ acquirer's P/E
• Usual ranking: cash < debt < stock, but a high P/E or low interest rates can change it
• Accretion test: if the target's yield (1 ÷ purchase P/E) beats the weighted cost of funding, the deal is accretive
• Know the nuance: inverse P/E is an EPS shortcut, not the true economic cost of equity

Practice this with a few different sets of numbers until you can do it in your head. Change the acquirer's P/E, bump interest rates up and down, and watch how the answer shifts. Once it clicks, you'll be ready for any accretion/dilution question an interviewer throws at you.