Investment Banking Technical Q - M&A
(Reposted as prior one did not gain enough traction) **Questions:
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?
2.) 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?
**Answers
1.) *0.1 x 0.5 + (0.5)(1-0.4)x = 0.083, so cost of debt has to be 11%
2.) 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*
Isn't making the equation equal to 0.083 something that will make the deal accretive? Wouldn't you also have to add the earnings of company B to the 4M and 250k?
For 1, I think you're good - it is neither accretive nor dilutive. What you are doing here is setting the Earnings "cost" equal to the earnings "gain". So, P/E= 10 means that you have an earnings yield of 10%, so you are 'paying' 10% for every share issued. You then weight-average this with the after tax cost of debt (x) to understand what "earnings" you are giving up, both in earnings yield from the equity and interest payments from the debt, in exchange for what earnings you are getting, which is 12 PE, or 8.3% Earnings yield. When you set it equal, it means the deal is neither accretive nor dilutive.
For 2....this question, and your answer are very confusing. I think it's because you don't understand how the consideration for a deal works - in a transaction, the target's shares get wiped out. The only additional shares we have are the ones we issue. This misunderstanding is fucking everything up, starting with your valuation, so I'm just gonna redo this.
As I understand the prompt, Company B has 500k shares outstanding and is being purchased for $15 a share, valuing the firm at $7,500k. Company A is using 40% stock and 60% debt to finance the deal. Company A's stock is $25.
40% Equity * $7,500k = $3,000k paid in equity 60% Debt * $7,500k = $4,500k paid in debt
Equity portion -> $3,000k / $25 Company A share price = 120,000 new shares issued
Debt portion -> $4,500 * 6% * (1-40%) = $162k Interest
Pre Transaction EPS = $4,000k/1,000k shares = $4 / share (you got this piece right)
PF EPS = ($4,000k + $1,000k + $250k - $162k)/(1,000k+ 120k) = $4.07
Accretive by $0.07/Share