Tricky technical question
Can anyone help me with this?
Question I found online: Company A has $40 in earnings and 10 shares outstanding, and buys company B which has $25 in earnings and 5 shares outstanding. The purchase price is 12X earnings, paid with cash using debt at 6% interest. Tax rate is 40%. What is the accretion per share?
Associated answer: Eventually figured it out....65-18(interest expense)+7.2(tax shield)=$54.2, divided by 10 shares=$5.42, minus original EPS 4=$1.42 accretion per share.
I can't quite follow where the answer is getting its numbers.
Also wanted to ask how this question could be phrased with other considerations involved. Like % cash or % equity in the consideration
The way this works is as follows:
65 = consolidated earnings of A and B, 40 + 25. Assumes no synergies. 18 = incremental interest expense equal to 6% of 300, which is the given purchase price of 12x on B's earnings of 25. 7.2 = reduction in tax expense, given 40% tax rate applied to a reduction of $18 in pretax income from interest.
Pro forma net income = 40 + 25 - (0.06 * (1-0.4) * 300), hope that makes it clear. Since you funded the acquisition entirely with debt, shares outstanding is still 10, so new EPS is $5.42.
Another way you could think about this is: you are buying an asset for $300 using debt, and your post-tax cost of debt is 3.6%. In return you are getting an earnings yield of ~8.33% (1/12, the inverse of the purchase multiple) and so your accretion is equal to the spread between these two times the value of the generating asset, namely (8.33% - 3.6%) * 300 = 4.73% * 300 = 14.2. Since there are 10 shares outstanding accretion per share is $1.42.
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