Accretion dilution model questions?
I have worked on an accretion and dilution model before therefore i definitely expect to be asked about this. So could you guys please help me with any type of accretion dilution questions that you guys have come across before. That would be extremely helpful for me to prepare for my interview. I really appreciate this
Accretion Dilution Model Interview Questions
If you list experience with accretion and dilution models on your resume it is likely you will be asked a few questions on the subject. Here we have a list of our favorite questions and some answers on accretion dilution interview questions from our vast user base of wall street professionals, newbies and hopefuls.
From user breakingbankers
Depending on the firm, the interviewer may pull out the basic financials, set up a scenario where one is acquiring another firm, and ask you if the deal will lead to an increase or decrease in EPS. And you need to walk the interviewer through the logic and mechanics.
A real life example from user idmbanker
I got asked:
If your company's P/E ratio is 12 and you buy a company with P/E ratio of 10 will the deal be accretive or dilutive or do you need more information?
Answer: More information - if it's an all stock deal it will obviously be accretive but if it's not then I need more information
User Newbie_banker gave an example answer of what to say if they replied to the above with "So if it's not an all stock deal, what other factors could make the deal dilutive?":
If it's an all cash deal, PE doesn't really matter. Suppose the cash consideration is 100% debt financed, PF EPS is:Net income (Acquirer) + Net Income (target) + tax effected synergies - tax effected D&A step up - tax effected cost of debt / acquirer shares
From the above equation, it is clear that if net income of target + tax effected synergies > tax effected D&A step up + tax effected cost of debt, the deal is accretive.
After answering many accretion dilution interview questions, user metalasian was asked:
Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?
User Rupert Pupkin added that the most common question he has come across is:
If company A is trading at 9x and company B is trading at 6x should company A buy company B. Then they will ask if it's Accretive or dilutive.
User alexpasch dropped the question:
A - 100M mkt cap, P/E of 10 is merging with B - 60M mkt cap, P/E of 20.To whom is the deal Accretive/dilutive? What is the new P/E of the combined entity? What do the synergies have to be worth for it to be dilutive to neither party?
He then included the answer:
New entity has earnings of $13M and a mkt. cap of $160M, for a P/E of ~12. It is dilutive to A because their EPS goes down. If however, $3M of synergies per year are to be had, then now the company will have a market cap of $160M, and earnings will be $16M, so EPS is constant and it's dilutive to neither party.
For more fantastic questions and answers, feel free to peruse the over 150 comments from our users.
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Depending on the firm, the interviewer may pull out the basic financials, set up a scenario where one is acquiring another firm, and ask you if the deal will lead to an increase or decrease in EPS. And you need to walk the interviewer through the logic and mechanics.
I got asked:
If your company's P/E ratio is 12 and you buy a company with P/E ratio of 10 will the deal be accretive or dilutive or do you need more information?
Answer: More information - if it's an all stock deal it will obviously be accretive but if it's not then I need more information
Reply: Right. So if it's not an all stock deal, what other factors could make the deal dilutive?
If it's an all cash deal, PE doesn't really matter. Suppose the cash consideration is 100% debt financed, PF EPS is:
Net income (Acquirer) + Net Income (target) + tax effected synergies - tax effected D&A step up - tax effected cost of debt / acquirer shares
From the above equation, it is clear that if net income of target + tax effected synergies > tax effected D&A step up + tax effected cost of debt, the deal is accretive.
Above doesn't take into account transaction expenses but arguably it's one time so should not enter the accretion / dilution calcs.
delete
Hi Sir or Madam, could you explain why the all-cash deal can cause more Accretive influence on PF EPS? Thank you!
Additional amortization of intangibles, loss of contracts etc. (negative synergies so to speak), loss of interest income/huge interest expense among others.
Here's one I got asked. Threw me off guard but i was able to work it out.
(after answering the all stock accretive/dilutive question)
Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?
Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.
Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.
There is also a very important assumption being made here which is that the firm you're acquiring has an all equity cap structure. e.g. The firm's Equity value = it's enterprise value = 10x it's earnings. If the firm had a portion that was financed by debt, then you would also have to account for the difference in it's current cost of borrowing vs. whatever new debt you were using to refinance it (in this case at 10% interest).
Chances are, if you just answered based on this assumption, you would still be right. But if you actually explicitly stated it, it would show an even deeper understanding of the concepts of firm value and capital structures in addition to understanding acc/dil.
Newbie_banker, I am not sure I got your reasoning here. How do you express the 15x in terms of debt ?
Could anyone explain this answer?
Also, someone asked me about accretion/dilution giving me 3 parameters 1/ interest rate is 5% 2/ P/E of acquirer > P/E target 3/ P/E of acquirer is 10x
What do you say to your client? Should he acquire the target with debt or shares?
invert the ratios again and think of it as an "equity earnings yield" vs a "cost of debt." you are going to raise $1 of debt that costs you x and you will use that $1 of debt to acquire $1 of the target's equity which will earn you y. if y>x, i.e., the acquired equity earns you more than the cost of the debt, then the deal is accretive.
10% interest rate after tax is 6.5%. for every $1 of debt you raise, you will pay $0.065 in interest. now compare that cost to the earnings generated by the target's equity. invert the target PE of 10x and you get 1/10=10%. So every $1 of target equity acquired at 10x PE will generate $0.100 in earnings. So, if you raise a dollar of debt that costs you 6.5 cents and use the debt proceeds to buy a dollar of equity that will earn you 10 cents, your net result is positive 3.5 cents. Every dollar of the target's equity that the acquirer buys using debt will increase the acquirer's earnings by 3.5 cents. The acquirer's equity share count is not changing because this is an all debt transaction, so earnings per share is increasing, i.e., the transaction is accretive to EPS.
That is a great question, thanks for posting. I guess it is okay to ignore the purchase premium in the answer?
Newbie, that's right. When I answered I forgot the tax shield, but the point of the question was whether or not you'd recognize that the debt was essentially a multiple of its interest rate.
So, when I answered I said that the deal would be neutral, given that you're issuing a 10x interest rate debt for 10x PE firm - again, not completely correct, but showed that I understood the underlying concept and wasn't reciting an answer from the vault guide
how does "1 / after-tax cost of debt" give you a relevant PE multiple? can anyone explain that? thanks!
wow thank you so much, this is really informative, please keep it coming
is that all the questions they wiill ask you about accretion dilution?
please keep it coming guys
That's what she said.
^^ good one - havent heard that in a while :D
Folks,
Can someone post the top 10 questions that could be asked on Accretion/Dilution analysis?
(Or am'I asking too much of spoonfeeding from you guys ?)
V
bump
Merger Model: http://www.ibankingprep.com/
Also, please confirm/correct my understanding of your answers:
A/ An acquisition is accretive... If debt financing: Target’s earnings yield (E/P) > post-tax cost of debt If shares financing: Buyer’s P/E > Target’s P/E
B/ If both financing options are Accretive: you get the highest accretion with the lowest of the two following costs: Buyer’s earnings yield and post-tax cost of debt.
Am I right?
Thanks you so much for your help!
bump, can we have more clarification on this stuff?
There's two ways of looking at this:
First, by P/E. For an all stock deal, if a big P/E acquires little P/E, then it's accretive. As the acquirer, you're paying less per dollar of earnings than the market values your own earnings. Read that a couple times to really let it sink in. For all cash (debt) deal, the effective "P/E" of the debt is 1/(after-tax cost of debt), which represents how much debt the market is willing to give the acquirer for each dollar of interest it pays. If this is greater than the P/E of the target, then it's accretive.
Second, by the "cost" of your financing vs the "yield" you get, which is what yoursrohan just said before me.
P/E and earnings yield are inverses of each other.
Hi guys,
Most of the time this is a good discussion. However, 2 things: 1) I think what's most important about EPS accretion/dilution is to know that it should absolutely not matter. It is commonly assumed that the market gets easily fooled by holding the P/E ratio of the acquirer constant. But think about it: If in a share swap the P/E ratios of the acquirer and the target differ substantially, should the legal structure alone (A takes over B or the other way around) decide whether there is a large value creation or destruction: No! Damodaran also explains it in his blog:http://aswathdamodaran.blogspot.mx/2012/12/acquisition-accounting-i-acc…
There are a few empirical studies out there testing whether the market gets fooled. Only one study (Andrade, 1999) finds a statistically significant outperformance (CAR) of accretive vs. dilutive deals, but the effect is quite low! Damodaran suggests the right thing: the accretion/dilution analysis belongs to the dustbin.
2) If you get still interviewed about it, I think it is quite helpful to understand the matter mathematically. Pls find it below - unfortunately, I cannot post it as a pic and I created it with the Word formula tool, so it may look a little confusing at first sight. A is the acquirer, B is the target, E = earnings, P = Market cap, S = shares, i = interest rate, t = tax rate, _A refers the variable to the acquirer, _B to the target.
Share deal: The EPS after the merger equals: (1) (E_A+E_B)/(S_A+P_B/P_AS_A )=(E_A+E_B)/(S_A (1+P_B/P_A )) To be accretive, the EPS after the merger needs to be bigger than the aquirer's pre-deal EPS: (2) (E_A+E_B)/(S_A (1+P_B/P_A ))-E_A/S_A >0 (3) (E_A+E_B)/(S_A (1+P_B/P_A ))-(E_A (1+P_B/P_A ))/(S_A (1+P_B/P_A ))>0 (4) (E_B-E_AP_B/P_A )/(S_A (1+P_B/P_A ))>0 (5) (E_BP_B/P_B -E_AP_B/P_A )/(S_A (1+P_B/P_A ))>0 The key equation follows: The earnings yield of the target needs to be bigger than that of the aquirer: (6) (P_B (E_B/P_B -E_A/P_A ))/(S_A (1+P_B/P_A ))>0 In terms of P/E ratio: (7) (P_B (1/(P_B/E_B )-1/(P_A/E_A )))/(S_A (1+P_B/P_A ))>0
Debt-financed deal: Post-merger EPS - Pre-merger EPS >0: (8) (E_A+E_B-P_Bi(1-t_A))/S_A -E_A/S_A >0 (9) (E_B-P_Bi(1-t_A))/S_A >0 (10) (E_BP_B/P_B -P_Bi(1-t_A))/S_A >0 Key equation: The earnings yield of the target needs to be higher than the after-tax cost of debt: (11) (P_B (E_B/P_B -i(1-t_A )))/S_A >0 (12) (P_B (1+P_B/P_A )(E_B/P_B -i*(1-t_A )))/(S_A (1+P_B/P_A ))>0
When comparing the accretion gain of the stock deal with that of the debt-financed deal, it is important to notice that a stock deal is punished for the issue of new shares: (13) ((E_B/P_B -E_A/P_A )-(1+P_B/P_A )(E_B/P_B -i*(1-t_A )))/(S_A (1+P_B/P_A ))>0
I hope this solves all the questions posted here.
Need some accretion/dilution questions (Originally Posted: 02/02/2011)
So I was foolish enough to put on my resume that I had experience with accretion/dilution analysis from my previous internship, and I've been getting grilled on it ever since.
To prep for some upcoming interviews, can you guys please post some good accretion/dilution questions that you'd ask someone interviewing for an SA position?
they will basically just ask you if company A is trading at 9x and company B is trading at 6x should company A buy company B. Then they will ask if it's Accretive or dilutive.
This is the most common question I came across concerning this.
A - 100M mkt cap, P/E of 10 is merging with B - 60M mkt cap, P/E of 20.
To whom is the deal Accretive/dilutive? What is the new P/E of the combined entity? What do the synergies have to be worth for it to be dilutive to neither party?
^^^Answers:
New entity has earnings of $13M and a mkt. cap of $160M, for a P/E of ~12. It is dilutive to A because their EPS goes down. If however, $3M of synergies per year are to be had, then now the company will have a market cap of $160M, and earnings will be $16M, so EPS is constant and it's dilutive to neither party.
Can you please explain how you reach to each number? How did you get $13M, $160M and P/E of 12?
isn't this wrong? because the market cap of B should be wiped out.
The key is to remember that it's based off of earnings per share, not P/E. So, if a higher P/E acquires a lower P/E, it is Accretive, not dilutive.
thanks! any more?
a
eps=net income/fully diluted shares
a
correct me if i'm wrong, but i recall reading somewhere that only in an all-stock deal can you guarantee that if the buyer has a higher p/e, the deal will be Accretive--if the buyer's paying in all cash or all debt, p/e multiples don't matter.
yes, the example given assumes that this is an all stock deal. the stock of the acquirer at 10x PE is "cheap" relative to the stock of the target which is "expensive" at 20x PE. so think of this as buying something expensive (the 20x company). since your stock is relatively cheap at 10x, you will have to fork over more shares to cover the expensive 20x purchase price and that makes the deal dilutive.
Those questions are too easy. Here are some tougher ones: 1. A company with a PE of 10 buys a company with a PE of 12 with 50% debt and 50% equity. Assume a 40% tax rate. What would be the cost of debt to make this neither Accretive nor dilutive?
1) 1/9 2) dilutive?
Sorry for bumping. But can anyone give me some intuition behind the rule (stock deal is accretive when P/E buyer > P/E buyer)
Look at it from this point of view.. Assume both have the same net income and no. of shares o/s, the firm with a higher PE has to issue lesser number of shares v/s. the firm with a lower PE... hence the proforma Net income will be double but the denominator (# of shares) will not.. hence Accretive for the acquiror..
Was wondering if anyone knew how to set up the two problems VanillaThunder12 posted
Maverickz, I think the correct way to set these up is as follows:
0.1 x 0.5 + (0.5)(1-0.4)x = 0.083, so cost of debt has to be 11%
Company A EPS before the acquisition:
$4M/1M shares = 4 EPS.
Company A EPS after acquisition:
($4,000,000 + $250,000 - $405 000*)/1,500,000** = 3.1 EPS
Therefore, the deal is dilutive.
*Debt issued = ($15 x 500,000 shares/0.4) x 0.6 = $11,250,000 interest = $11,250,000 x 0.06 x (1-0.4) = $405,000
**1,000,000 shares + 500,000 issued
Please correct me if I am wrong.
Can you elaborate on #1?
should you include B's earnings when calculate post merger earnings?
Wouldn't you also have to add the earnings of company B to the 4M and 250k?
Private companies - accretion/dilution question (Originally Posted: 09/01/2010)
I was asked the following question -
Company A intends to acquire company B. Both are completely private firms and do not have any shares trading on any of the exchanges.
Would you conduct accretion/dilution analysis and what would be the issues ?
I answered yes - I would conduct accretion/dilution analysis.
But for the issues ... I think I was not confident so ....
What do you guys think ? Is accretion/dilution analysis for private companies similar to the accretion/dilution analysis for public companies ? What if the acquirer is public and target is private ? Or if acquirer is private and target is public (a reverse merger) ?
-V
Hi,
Firstly, you should stop stressing out about your past interview questions. Just brush up on what you need to know for next time.
Generally, Accretion/Dilution modelling is a fundamental analysis performed at the outset of all proposed M&A transactions, irrespective of whether the companies are listed or unlisted - So, well done, your answer "Yes", is correct.
As to the reasoning, in order to ascertain whether a proposed M&A deal will enhance shareholder value, a relatively simple analysis focuses on whether the EPS of the Acquiring Entity is greater post merger than it was prior to the merger. If so, this is an Accretive deal, and generally, it should be encouraged/pursued. If EPS post merger is lower than EPS pre merger, the deal is dilutive, and generally, discouraged.
Accretion/Dilution modelling is also useful in analysing and determining the best way to structure the consideration (purchase price), ie, via cash, scrip or debt (in the case of a LBO). This decision will impact upon the EPS post merger. Eg, if the Acquiring Entity has a lower P/E ratio than the Target and payment is made via scrip with no premium paid for the target, this merger will be dilutive as the Acquiring Entity will have to issue more stock to acquire the Target relative the increase in earnings contributed by the Target. Further consideration regarding cash payment is that the Acquiring Entity will forgo interest earnings on that cash amount, and in the case of debt, the Acquiring Entity will incur more interest expenses.
In addition, you should also consider other factors that result from a merger that may impinge of Accretion/Dilution analysis, such as the syngergies created by the mergers, economies of scale and scope, growth projections, increased capacity, reduction in competition.
A word of warning - the Accretion/Dilution analysis is only a theoretical model used for analysing the impact of an M&A deal on the EPS of the Acquiring Entity post merger. It only takes into account the pro-forma combined earnings for 1 or 2 years. This is unrealistic, as we know that companies are going concerns, and longer term projections may be necessary, esp where there may be integration delays and lagged impacts on the pro-forma earnings.
Hope this helps. Sorry about the rant, but Accretion/Dilution analysis is very important in all M&A deal analyses, irrespective of whether the companies are listed or unlisted.
Thank you very much - mbas3497
We can only conduct Accretive/Dilutive analysis for public acquirers. the absence of share count for private acquirers prevents us from computing EPS, which is integral to Accretive/dilutive analysis. Public or private status of target does not matter. For private targets, it is impossible to determine purchase price per share as share count is not available. Instead, we utilize lump sum purchase EV for private targets. Besides, we don't have access to F/S of private companies unless our team has been engaged by them. Hope this helps.
Tough Accretion Dilution Questions (Originally Posted: 12/15/2014)
Hey guys, was wondering if anyone walk me through how to answer these questions:
A company with a PE of 10 buys a company with a PE of 12 with 50% debt and 50% equity. Assume a 40% tax rate. What would be the cost of debt to make this neither Accretive nor dilutive?
Company A has a share price of $25 and 1,000,000 shares outstanding buys Company B with 40% equity paying $15/share with 500,000 shares outstanding. Company A has a net income of $4,000,000 and company B has a net income of $1,000,000, cost of debt is 6% (40% tax rate), there is $250,000 (after tax) in hard synergies. Is this Accretive or dilutive? By how much?
Was hoping someone would know how to answer these
You are going to want the PE of the debt to equal 14 so the PE that you basically outlay to buy the company is 12 (50%10 + 50%14). So just work backwards to find the cost of debt that makes the PE = 14.
This is just manipulating numbers and understanding ratios. You should at least post your thought process then someone on here can say if you are in the right or wrong direction.
VandelayIndustries,
1) I'm not very clear on why there would be a separate PE for debt and equity. Can this problem be solved with the available info?
2) I think this one would be old EPS $4, new EPS ($5mm+250k-6%(1-40%)4.5mm)/(1mm+120K), meaning (old earnings + synergies - after tax interest expense)/(old share count + new shares issued). Is that right?