I am scratching my head for this question - Company A is buying company B either in 100% cash or in 100% debt. If forgone interest for cash is 5% and before tax debt interest rate is 10%. Tax rate is 40%. Which acquisition will be dilutive and which will be Accretive?
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Cost of Debt = Coupon/YTM x (1-Tax Rate) Cost of Debt = 10 * .6 Cost of Debt = 6%
Yah lxwarr30! I agree with you that cost of debt is 6%. Other point is that debt financing will provide a tax shield of 10% * Debt * 40%. So will the debt financing be accretive then? How do we come to conclude that cash financing be a dilutive then?
the tax shield is what is making the cost of debt 6% instead of 10%. They are the same point.
the method of financing is just one factor that determines if a transaction is accretive or not.
in this scenario, the cost of financing is either the lost 5% of income on cash or the 6% after-tax cost of debt. so using cash would be cheaper here, but would not necessarily mean the transaction would be accretive. that would depend on factors outside your scenario (P/E ratios between the two companies primarily).
If I have a P/E for company A (buyer) = 11 and P/E for company B (seller) = 10 (suppose), how that is going to have effect on cash financing? What effect P/E is going to have in the acquisition?
Here's my thought.
In both deals, number of shares outstanding does not change. So the focus is on post-acquisition earnings.
In 100% cash deal, you lose 5% interest income, so your bottom line is down by 5%(1-40%)Transaction Value
In 100% debt deal, you incur 10% interest expense, so your bottom line is down by 10%(1-40%)Trx Value
Based on this, both are dilutive, but debt deal is more dilutive than cash deal.
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