Interview Question - Merger
Assume all-stock deal.
If Company A has a P/E of 10x and it acquires Company B which has a P/E of 10x as well, the deal will have no affect. Easy.
However, in an interview the interviewer asked me what would happen if Company A had no debt, while company B has 20% debt ratio. If Company A acquires company B, will it be Accretive, dillutive, or no affect if Company A wants to maintain a 0% debt ratio? He said it would be Accretive. Could someone please explain this? Thanks!
Someone please correct me if I'm wrong here, but if we're assuming a stock for stock deal then we're assuming that the stock issued will only cover the purchase price of the target's equity, while the net debt of the target will be paid for / refinanced using new debt / cash from the acquirer.
Since debt and cash are now being utilized in our sources of cash here, and the post-tax cost of debt will likely be lower than our implied cost of equity (calculated as the inverse of our 10x PE mult), then we know that on a weighted basis Company A's total cost of capital to acquire Company B will be lower than Company A's cost of equity. This also implies Company A's cost of capital will be lower than Company B's cost of equity, since it's stated earlier that both companies have equal P/Es. Since Company A's cost of capital is lower than Company B's cost of equity (which can be thought of as the return we'll expect to receive from Company B's earnings), then we'll consider this deal Accretive.
edit: I came to dilutive as well.
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