Accretion and Dilution Analysis + Questions

Read the previous post on Diluted Shares Outstanding

Accretion/Dilution analysis refers to analyzing whether an M&A deal actually adds value to the buyer. In accretion/dilution analysis, P/E and EPS are the most important metrics

  • Accretive deal
    • Represents a deal where the profits of the acquisition outweigh the costs
  • Dilutive deal
    • Represents a deal where the costs of the acquisition outweigh the profits
There are 2 approaches to conducting accretion/dilution analysis in interview questions:
  1. Comparing the cost of capital with the seller's yield
  2. Comparing the pre-acquisition EPS with pro forma EPS
Some formulas to keep in mind:
PE = Share Price / EPS
PE = Equity Value / Net Income
EPS = Net Income / No. Shares Outstanding

1. Costs of Capital Approach:
  • Cost of Cash = Foregone Interest Rate on Cash * (1 - Buyer's Tax Rate)
  • Cost of Debt = Interest Rate on New Debt * (1 - Buyer's Tax Rate)
  • Cost of Equity = Reciprocal of the Buyer's PE Multiple (Net Income / Equity Value)
Weighted Average Cost of Acquisition = (% Cash * Cost of Cash) + (% Debt * Cost of Debt) + (% Stock * Cost of Stock)

Seller's Yield = 1 / Seller's Purchase PE Multiple
  • If weighted cost < seller's yield, the deal will be accretive
  • If weighted cost > seller's yield, the deal will be dilutive
Example Question: A company with a P/E multiple of 25x acquires another company for a purchase P/E multiple of 15x. Will the deal be accretive or dilutive?
  • First, ask the interviewer if the deal is an all-stock deal.
    • Rule of thumb for all-stock deals:
      • Buyer's PE > Seller's PE: Accretive
      • Buyer's PE < Seller's PE: Dilutive
  • If it is an all-stock deal, this is accretive as the buyer has a higher PE (25x) than the seller (15x).
  • Assuming it is NOT an all-stock deal, use Costs of Capital Approach:
    • Cost of Acquisition = 1 / 25 = 4%
    • Seller's Yield = 1 / 15 = 6.7%
    • Since seller's yield > cost of acquisition, deal is accretive

2. Pro Forma EPS Approach:
  • If the question asks for how accretive/dilutive a deal is, or what is the % accretion/dilution of the deal, we can't use the Costs of Capital approach since you can't figure out the EPS change
  • Pro Forma EPS Approach rule of thumb:
    • EPS after > EPS before: Accretive
    • EPS after < EPS before: Dilutive
Steps:
  1. Calculate Pro Forma Net Income
    • Begin with the Acquirer’s Net Income, add the Acquired Target Earnings and Synergies, and subtract Interest Expense and Foregone Interest Income. As mentioned above, be sure to calculate all items on an After-Tax Basis.
  2. Calculate Pro Forma Shares
    • Start with the acquirer's shares and add any new shares issued to the target (diluted shares outstanding method in previous post)
  3. Calculate Pro Forma EPS
    • Pro Forma Net Income / Pro Forma Shares
Example Question: Assume a 100% Stock deal. The Buyer has 10 shares outstanding at a share price of $25, and its Net Income is $10. It acquires the Seller for a Purchase Equity Value of $150. The Seller has a Net Income of $10 as well. Assume the same tax rates for both companies. How accretive is this deal?
  • Pro Forma Net Income = $10 + $10 = $20
  • Pro Forma Shares = 10 + (150 / 25) = 16
  • Pro Forma EPS = $20 / 16 = 1.25
  • The deal is 25% accretive

Interview Questions:

1. Company A (with $200 in earnings; P/E ratio of 10x; 50 shares outstanding) acquired company B (with $50 in earnings; P/E ratio of 15x; 40 shares outstanding). Company A paid a 33.3% premium and financed the deal with 50% debt and 50% stock Assume the cost of debt is 5% and the tax rate is 20%
(1) What is the purchase equity value of company B?
(2) Is this deal going to be accretive or dilutive?
(3) What is the pro forma Net Income, EPS, and by what percent is it accretive or dilutive?
  • 1) What is the purchase equity value of company B?
    • Equity Value of Company B:
      • Knowing that P/E = Equity Value / Net Income
      • 15 = EqV / 50
      • EqV = 750
    • Applying a 33% premium, purchase equity value = 997.5 ≈ $1000
  • 2) Is this deal going to be accretive or dilutive?
    • Weighted Average Cost of Acquisition = (% Cash * Cost of Cash) + (% Debt * Cost of Debt) + (% Stock * Cost of Stock)
    • Remember that the deal is financed with 50% debt and 50% stock, so $500 debt and $500 stock
    • Cost of Cash = 0.05 * (1-0.2) = 0.04 = 4%
    • Cost of Stock = 1 / 10 = 10%
    • WACA = 0.5 * 4% + 0.5 * 10% = 7%
    • Seller's Yield = 1 / 15 = 6.7%
    • Deal is dilutive
  • What is the pro forma Net Income, EPS, and by what percent is it accretive or dilutive?
    • Pro Forma Net Income = 200 + 50 = $250; 250 - [(500*0.05) * (1-0.2)] = 230
    • New share issuance = equity financing / A's share price 
      • = 500 / $40 = 12.5
    • 50 + 12.5 = 62.5 total shares
    • Pro Forma EPS = 230 / 62.5 = 3.68
    • EPS before = 200 / 50 = 4
    • EPS after = 3.68
    • 8% Dilutive
2. Walk me through a sell-side M&A process
  • Win the mandate
  • Plan the process and create marketing materials
  • Contact the initial set of buyers
  • Set up management meetings and presentations
  • Solicit initial and subsequent bids from buyers
  • Conduct final negotiations, arrange financing, and close the deal
3. Why would a company want to buy another company?
  • If they think they will be better off after the acquisition takes place and that the acquisition will create value
4. What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?
  • Cash is usually the cheapest, quickest option. The con is the opportunity cost the fund has for something else in the future
  • Debt is normally cheaper than stock but more expensive than cash. The con is that additional debt makes future debt issuances more difficult and expensive
  • Stock can be used quickly and is an option for companies that can't take on additional debt and don't have excess cash to use. The con is that it can dilute existing shareholders
5. Buyer has P/E multiple of 8x Seller has a P/E multiple of 10x. Buyer earns 4% interest on cash and pays 6% interest on debt. The tax rate is 30%. Buyer is paying for seller with 20% cash, 20% debt, and 60% stock. Is this deal going to be accretive or dilutive?
  • Dilutive
6. Company A buys Company B using 100% debt. Company B has a P/E multiple of 10x Company A has a P/E multiple of 15x. What interest rate is required on the debt to make the deal dilutive? (Assuming 40% tax rate)
  • 16.7%
7. Company A has a P/E of 10x, which is higher than the P/E of Company B. The interest rate on debt is 5%. If Company A has 40% tax rates, should Company A use debt or stock for the most accretion?
  • Both sources will be accretive, but debt is much cheaper than stock so should use debt.
8. Company A has a P/E of 10x, a Debt Interest Rate of 10%, a Cash Interest Rate of 5%, and a tax rate of 40%. Company A wants to acquire Company B at a purchase P/E multiple of 16x using 1/3 Stock, 1/3 Debt, and 1/3 Cash. Will the deal be accretive?
  • Dilutive






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