Have a super day for SA at BB coming up... Doing some prep for M&A questions, and was confused a bit on a simple "rule of thumb" question
For 100% stock deals we can compare the acquirer's P/E to the target's P/E to determine if it is accretive or dilutive.
For 100% debt deals we can compare acquirers 1/[cost of debt*(1-tax rate)] to the target's P/E to determine if it is accretive or dilutive.
My question is: what exactly does 1/[cost of debt(1-tax rate)] represent in this context? Why are we able to compare it to the target's P/E in order to determine if the deal is accretive or not? Is 1/[cost of debt(1-tax rate)] considered the P/E of debt???
Someone pls help
Hi Hardo_69, any of these topics helpful:
You're welcome.
It’s a quick tool for rough comparisons being made. The P/E as an equity ratio is indirectly proportional to cost of equity via taking reciprocal. The tax-effected cost of debt is indirectly proportional to some ratio for the debt financing via taking reciprocal. In effect you use debt to finance the m&a instead of equity so that is your capital cost.
I think you would actually just use the after tax cost of debt for the example you're providing with 100% debt. This would give you the cost of capital for using debt to finance the transaction and you're comparing it to the reciprocal of the P/E multiple which a proxy for earnings yield of the target. The reason this makes sense is because if your after tax cost of debt is 5% and you're acquiring a company with a P/E multiple of 10x (earnings yield = 10%) then you can see that you're using a capital source with a 5% cost to buy something that is going to yield you 10% and thus the deal is accretive. The reciprocal of after tax cost of debt in this situation would be 20% and would make the deal appear to be dilutive, but that would be an incorrect conclusion.
This is the answer.
You're finding relative Cost of Capital for comparison sake.
I agree with this. I find it more intuitive to look at the a/t cost of debt vs. the earnings yield. You could take the inverse of the a/t cost of debt. That would give you the "PE" of debt. But that is not that intuitive, to me at least.
Thank you guys. This helped a lot. So what I am getting is that the target/offer P/E can be flipped and used as a proxy for sellers earnings yield.
Then on the buyer side we can take P/E for stock or 1/after-tax cost of debt, and then use the reciprocal of that as the cost of capital for the acquisition.
So they are both representative of the same relationship just represented differently, correct?
Would also want to say that in my interviews for SA at BB banks I never had anything on M&A come up that required you to figure out the cost of acquisition. But to be clear you're NOT taking the reciprocal of the after-tax cost of debt and you are taking the reciprocal of the target's P/E in the all debt scenario. If it's all stock you DO take the reciprocal of the Buyer's P/E ratio because then you're comparing earnings yields. In the case of the all-stock question, though, you don't even need to take the reciprocals as you can just figure it out from their P/E multiples at face value.
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