2/8/10

I have worked on an accretion and dilution model before therefore i definitely expect to be asked about this. So could you guys please help me with any type of accretion dilution questions that you guys have come across before. That would be extremely helpful for me to prepare for my interview. I really appreciate this

Accretion Dilution Model Interview Questions

If you list experience with accretion and dilution models on your resume it is likely you will be asked a few questions on the subject. Here we have a list of our favorite questions and some answers on accretion dilution interview questions from our vast user base of wall street professionals, newbies and hopefuls.

From user @breakingbankers

Depending on the firm, the interviewer may pull out the basic financials, set up a scenario where one is acquiring another firm, and ask you if the deal will lead to an increase or decrease in EPS. And you need to walk the interviewer through the logic and mechanics.

A real life example from user @idmbanker

I got asked:

If your company's P/E ratio is 12 and you buy a company with P/E ratio of 10 will the deal be accretive or dilutive or do you need more information?

Answer: More information - if it's an all stock deal it will obviously be accretive but if it's not then I need more information

User @Newbie_banker gave an example answer of what to say if they replied to the above with "So if it's not an all stock deal, what other factors could make the deal dilutive?":

If it's an all cash deal, PE doesn't really matter. Suppose the cash consideration is 100% debt financed, PF EPS is:

Net income (Acquirer) + Net Income (target) + tax effected synergies - tax effected D&A step up - tax effected cost of debt / acquirer shares

From the above equation, it is clear that if net income of target + tax effected synergies > tax effected D&A step up + tax effected cost of debt, the deal is accretive.

After answering many accretion dilution interview questions, user @metalasian was asked:

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

User @Rupert Pupkin added that the most common question he has come across is:

If company A is trading at 9x and company B is trading at 6x should company A buy company B. Then they will ask if it's Accretive or dilutive.

User @alexpasch dropped the question:

A - 100M mkt cap, P/E of 10 is merging with B - 60M mkt cap, P/E of 20.

To whom is the deal Accretive/dilutive? What is the new P/E of the combined entity? What do the synergies have to be worth for it to be dilutive to neither party?

He then included the answer:

New entity has earnings of $13M and a mkt. cap of $160M, for a P/E of ~12. It is dilutive to A because their EPS goes down. If however, $3M of synergies per year are to be had, then now the company will have a market cap of $160M, and earnings will be $16M, so EPS is constant and it's dilutive to neither party.

For more fantastic questions and answers, feel free to peruse the over 150 comments from our users.

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Comments (169)

2/8/10

Depending on the firm, the interviewer may pull out the basic financials, set up a scenario where one is acquiring another firm, and ask you if the deal will lead to an increase or decrease in EPS. And you need to walk the interviewer through the logic and mechanics.

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7,548 questions across 469 investment banks. The WSO Investment Banking Interview Prep Course has everything you'll ever need to start your career on Wall Street. Technical, Behavioral and Networking Courses + 2 Bonus Modules. Learn more.

2/8/10

I got asked:

If your company's P/E ratio is 12 and you buy a company with P/E ratio of 10 will the deal be accretive or dilutive or do you need more information?

Answer: More information - if it's an all stock deal it will obviously be accretive but if it's not then I need more information

Reply: Right. So if it's not an all stock deal, what other factors could make the deal dilutive?

2/8/10
mdedrick:

I got asked:

If your company's P/E ratio is 12 and you buy a company with P/E ratio of 10 will the deal be accretive or dilutive or do you need more information?

Answer: More information - if it's an all stock deal it will obviously be accretive but if it's not then I need more information

Reply: Right. So if it's not an all stock deal, what other factors could make the deal dilutive?

If it's an all cash deal, PE doesn't really matter. Suppose the cash consideration is 100% debt financed, PF EPS is:

Net income (Acquirer) + Net Income (target) + tax effected synergies - tax effected D&A step up - tax effected cost of debt / acquirer shares

From the above equation, it is clear that if net income of target + tax effected synergies > tax effected D&A step up + tax effected cost of debt, the deal is accretive.

Above doesn't take into account transaction expenses but arguably it's one time so should not enter the accretion / dilution calcs.

3/12/17

Hi Sir or Madam, could you explain why the all-cash deal can cause more Accretive influence on PF EPS? Thank you!

2/8/10

Additional amortization of intangibles, loss of contracts etc. (negative synergies so to speak), loss of interest income/huge interest expense among others.

2/8/10

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

2/8/10
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

2/8/10
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

There is also a very important assumption being made here which is that the firm you're acquiring has an all equity cap structure. e.g. The firm's Equity value = it's enterprise value = 10x it's earnings. If the firm had a portion that was financed by debt, then you would also have to account for the difference in it's current cost of borrowing vs. whatever new debt you were using to refinance it (in this case at 10% interest).

Chances are, if you just answered based on this assumption, you would still be right. But if you actually explicitly stated it, it would show an even deeper understanding of the concepts of firm value and capital structures in addition to understanding acc/dil.

7/23/10
Newbie_banker:

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Newbie_banker,
I am not sure I got your reasoning here. How do you express the 15x in terms of debt ?

2/24/11
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

Could anyone explain this answer?

Also, someone asked me about accretion/dilution giving me 3 parameters
1/ interest rate is 5%
2/ P/E of acquirer > P/E target
3/ P/E of acquirer is 10x

What do you say to your client? Should he acquire the target with debt or shares?

2/24/11
Rastignac:
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

Could anyone explain this answer?

Also, someone asked me about accretion/dilution giving me 3 parameters
1/ interest rate is 5%
2/ P/E of acquirer > P/E target
3/ P/E of acquirer is 10x

What do you say to your client? Should he acquire the target with debt or shares?

there are a few considerations here (accretion/dilution, pro forma leverage restrictions and targeted credit ratings...does the acquirer want to remain investment grade, do target shareholders prefer cash consideration to stock, what will the pro forma equity ownership look like in a stock deal), but to get at only the accretion/dilution question you should look at this in the same way we looked at the first question in my previous post, i.e., compare P/E ratios or their inverses.

cost of debt is 5% and will be ~3.3% after tax. this is very cheap financing and it will be hard to beat this by financing through issuing equity.

flip the acquirer P/E and you get 10% earnings yield. if the acquirer issues equity shares to complete the acquisition, he is paying with a currency that yields/costs 10%. if the acquirer uses debt to fund the acquisition, he is paying with a currency that yields/costs 3.3%. debt is the cheaper financing source so if your only consideration is which deal is more Accretive, you would use debt.

target PE is less than acquirer PE, so target earnings yield is greater than 10%. one dollar of acquirer equity yields/costs less than one dollar of target equity will yield/earn for the acquirer. thus, a stock acquisition would be Accretive to earnings.

both debt and stock deals are Accretive with the debt deal being more Accretive. so you would do all debt except for the fact that you might not be able to get that much leverage, you might want to maintain a high credit rating and doing all debt would lower it, or you just might not want all that debt for some other reason (e.g., you aren't comfortable operating the company with that much debt).

Best Response
2/24/11
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

invert the ratios again and think of it as an "equity earnings yield" vs a "cost of debt." you are going to raise $1 of debt that costs you x and you will use that $1 of debt to acquire $1 of the target's equity which will earn you y. if y>x, i.e., the acquired equity earns you more than the cost of the debt, then the deal is accretive.

10% interest rate after tax is 6.5%. for every $1 of debt you raise, you will pay $0.065 in interest. now compare that cost to the earnings generated by the target's equity. invert the target PE of 10x and you get 1/10=10%. So every $1 of target equity acquired at 10x PE will generate $0.100 in earnings. So, if you raise a dollar of debt that costs you 6.5 cents and use the debt proceeds to buy a dollar of equity that will earn you 10 cents, your net result is positive 3.5 cents. Every dollar of the target's equity that the acquirer buys using debt will increase the acquirer's earnings by 3.5 cents. The acquirer's equity share count is not changing because this is an all debt transaction, so earnings per share is increasing, i.e., the transaction is accretive to EPS.

2/24/11
bankbank:
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

invert the ratios again and think of it as an "equity earnings yield" vs a "cost of debt." you are going to raise $1 of debt that costs you x and you will use that $1 of debt to acquire $1 of the target's equity which will earn you y. if y>x, i.e., the acquired equity earns you more than the cost of the debt, then the deal is Accretive.

10% interest rate after tax is 6.5%. for every $1 of debt you raise, you will pay $0.065 in interest. now compare that cost to the earnings generated by the target's equity. invert the target PE of 10x and you get 1/10=10%. So every $1 of target equity acquired at 10x PE will generate $0.100 in earnings. So, if you raise a dollar of debt that costs you 6.5 cents and use the debt proceeds to buy a dollar of equity that will earn you 10 cents, your net result is positive 3.5 cents. Every dollar of the target's equity that the acquirer buys using debt will increase the acquirer's earnings by 3.5 cents. The acquirer's equity share count is not changing because this is an all debt transaction, so earnings per share is increasing, i.e., the transaction is Accretive to EPS.

Wouldn't you have to take into account a purchase premium? i.e. Target's trading at $10 with EPS of $1, but you have to pay $15 per share, effectively making the transaction neutral? Or should you assume that you're paying 10x EPS?

2/24/11
IUHoosier08:
bankbank:
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

invert the ratios again and think of it as an "equity earnings yield" vs a "cost of debt." you are going to raise $1 of debt that costs you x and you will use that $1 of debt to acquire $1 of the target's equity which will earn you y. if y>x, i.e., the acquired equity earns you more than the cost of the debt, then the deal is Accretive.

10% interest rate after tax is 6.5%. for every $1 of debt you raise, you will pay $0.065 in interest. now compare that cost to the earnings generated by the target's equity. invert the target PE of 10x and you get 1/10=10%. So every $1 of target equity acquired at 10x PE will generate $0.100 in earnings. So, if you raise a dollar of debt that costs you 6.5 cents and use the debt proceeds to buy a dollar of equity that will earn you 10 cents, your net result is positive 3.5 cents. Every dollar of the target's equity that the acquirer buys using debt will increase the acquirer's earnings by 3.5 cents. The acquirer's equity share count is not changing because this is an all debt transaction, so earnings per share is increasing, i.e., the transaction is Accretive to EPS.

Wouldn't you have to take into account a purchase premium? i.e. Target's trading at $10 with EPS of $1, but you have to pay $15 per share, effectively making the transaction neutral? Or should you assume that you're paying 10x EPS?

use whatever target PE they tell you to use for the acquisition. i was assuming 10x represented the PE for the acquisition price. if you need to pay $15/share and it's a 15x PE, then you do the math based on the 15x PE.

the information given was that the target price was 10x PE. you are correct that in most acquisitions the acquirer will have to pay a premium to the undisturbed price, but i wouldn't necessarily assume a premium (50% prem. is probably too high in most cases, by the way). for the interview response, i would just say that i'm assuming the 10x PE already incorporates an acquisition premium. the math at 10x is easier to do in your head.

2/25/11
bankbank:
IUHoosier08:
bankbank:
Newbie_banker:
metalasian:

Here's one I got asked. Threw me off guard but i was able to work it out.

(after answering the all stock accretive/dilutive question)

Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

Assume tax rate of 35%. 1 / after tax cost of debt = 1/ (0.65 * 10%) = 15x. Compare that to target PE of 10x. The deal is accretive.

Anyway, my answer in my previous post is more rigorous than the one I just gave, in relation to debt-financed acquisitions, since it took into account M&A accounting and synergies; but the theory is the same.

invert the ratios again and think of it as an "equity earnings yield" vs a "cost of debt." you are going to raise $1 of debt that costs you x and you will use that $1 of debt to acquire $1 of the target's equity which will earn you y. if y>x, i.e., the acquired equity earns you more than the cost of the debt, then the deal is Accretive.

10% interest rate after tax is 6.5%. for every $1 of debt you raise, you will pay $0.065 in interest. now compare that cost to the earnings generated by the target's equity. invert the target PE of 10x and you get 1/10=10%. So every $1 of target equity acquired at 10x PE will generate $0.100 in earnings. So, if you raise a dollar of debt that costs you 6.5 cents and use the debt proceeds to buy a dollar of equity that will earn you 10 cents, your net result is positive 3.5 cents. Every dollar of the target's equity that the acquirer buys using debt will increase the acquirer's earnings by 3.5 cents. The acquirer's equity share count is not changing because this is an all debt transaction, so earnings per share is increasing, i.e., the transaction is Accretive to EPS.

Wouldn't you have to take into account a purchase premium? i.e. Target's trading at $10 with EPS of $1, but you have to pay $15 per share, effectively making the transaction neutral? Or should you assume that you're paying 10x EPS?

use whatever target PE they tell you to use for the acquisition. i was assuming 10x represented the PE for the acquisition price. if you need to pay $15/share and it's a 15x PE, then you do the math based on the 15x PE.

the information given was that the target price was 10x PE. you are correct that in most acquisitions the acquirer will have to pay a premium to the undisturbed price, but i wouldn't necessarily assume a premium (50% prem. is probably too high in most cases, by the way). for the interview response, i would just say that i'm assuming the 10x PE already incorporates an acquisition premium. the math at 10x is easier to do in your head.

Please clarify 2 points:

1/ in your initial answer to my question you say that 10x is the PE of the acquirer. In your latest answer you say that you assumed that 10x was the PE of the target. Please clarify and assume that 10x is the PE of the buyer and amend if necessary.

2/ when you say "yields/costs" I would like to know to whom?

1/8/13

metalasian:
Say you were to acquire to a company with a 10x PE ratio. Instead of using issuing stock, however, you decide to finance the acquisition using all debt with an interest rate of 10%. Is the deal accretive, dilutive or neutral?

That is a great question, thanks for posting. I guess it is okay to ignore the purchase premium in the answer?

2/8/10

Newbie, that's right. When I answered I forgot the tax shield, but the point of the question was whether or not you'd recognize that the debt was essentially a multiple of its interest rate.

So, when I answered I said that the deal would be neutral, given that you're issuing a 10x interest rate debt for 10x PE firm - again, not completely correct, but showed that I understood the underlying concept and wasn't reciting an answer from the vault guide

9/13/10
metalasian:

Newbie, that's right. When I answered I forgot the tax shield, but the point of the question was whether or not you'd recognize that the debt was essentially a multiple of its interest rate.

So, when I answered I said that the deal would be neutral, given that you're issuing a 10x interest rate debt for 10x PE firm - again, not completely correct, but showed that I understood the underlying concept and wasn't reciting an answer from the vault guide

how does "1 / after-tax cost of debt" give you a relevant PE multiple? can anyone explain that? thanks!

2/8/10

wow thank you so much, this is really informative, please keep it coming

2/9/10

is that all the questions they wiill ask you about accretion dilution?

2/10/10

please keep it coming guys

2/10/10
maddb218:

please keep it coming guys

That's what she said.

2/11/10

^^ good one - havent heard that in a while :D

9/10/10

Folks,

Can someone post the top 10 questions that could be asked on Accretion/Dilution analysis?

(Or am'I asking too much of spoonfeeding from you guys ?)

V

9/16/10
2/25/11

Also, please confirm/correct my understanding of your answers:

A/ An acquisition is accretive...
If debt financing: Target's earnings yield (E/P) > post-tax cost of debt
If shares financing: Buyer's P/E > Target's P/E

B/ If both financing options are Accretive:
you get the highest accretion with the lowest of the two following costs: Buyer's earnings yield and post-tax cost of debt.

Am I right?

Thanks you so much for your help!

2/9/12

bump, can we have more clarification on this stuff?

10/9/12

SIMPLE:

Think of it as purchase of an asset, be it stock or debt financed. Then just compare the cost of financing and return on purchased asset.

Incase of stock, cost of financing = [earnings/mkt price] = E/P....of acquirer, obviously

Incase of debt, cost of financing = Post tax cost of debt = (1-t)*int. rate on debt

Compare with target's earning yield = E/P...of target, obv.

If target earnings yield > cost of financing, Accretive.

10/10/12

There's two ways of looking at this:

First, by P/E. For an all stock deal, if a big P/E acquires little P/E, then it's accretive. As the acquirer, you're paying less per dollar of earnings than the market values your own earnings. Read that a couple times to really let it sink in. For all cash (debt) deal, the effective "P/E" of the debt is 1/(after-tax cost of debt), which represents how much debt the market is willing to give the acquirer for each dollar of interest it pays. If this is greater than the P/E of the target, then it's accretive.

Second, by the "cost" of your financing vs the "yield" you get, which is what yoursrohan just said before me.

P/E and earnings yield are inverses of each other.

4/17/13

Hi guys,

Most of the time this is a good discussion. However, 2 things:
1) I think what's most important about EPS accretion/dilution is to know that it should absolutely not matter. It is commonly assumed that the market gets easily fooled by holding the P/E ratio of the acquirer constant. But think about it: If in a share swap the P/E ratios of the acquirer and the target differ substantially, should the legal structure alone (A takes over B or the other way around) decide whether there is a large value creation or destruction: No!
Damodaran also explains it in his blog:
http://aswathdamodaran.blogspot.mx/2012/12/acquisi...

There are a few empirical studies out there testing whether the market gets fooled. Only one study (Andrade, 1999) finds a statistically significant outperformance (CAR) of accretive vs. dilutive deals, but the effect is quite low! Damodaran suggests the right thing: the accretion/dilution analysis belongs to the dustbin.

2) If you get still interviewed about it, I think it is quite helpful to understand the matter mathematically. Pls find it below - unfortunately, I cannot post it as a pic and I created it with the Word formula tool, so it may look a little confusing at first sight. A is the acquirer, B is the target, E = earnings, P = Market cap, S = shares, i = interest rate, t = tax rate, _A refers the variable to the acquirer, _B to the target.

Share deal:
The EPS after the merger equals:
(1) (E_A+E_B)/(S_A+P_B/P_A*S_A )=(E_A+E_B)/(S_A (1+P_B/P_A ))
To be accretive, the EPS after the merger needs to be bigger than the aquirer's pre-deal EPS:
(2) (E_A+E_B)/(S_A (1+P_B/P_A ))-E_A/S_A >0
(3) (E_A+E_B)/(S_A (1+P_B/P_A ))-(E_A (1+P_B/P_A ))/(S_A (1+P_B/P_A ))>0
(4) (E_B-E_A*P_B/P_A )/(S_A (1+P_B/P_A ))>0
(5) (E_B*P_B/P_B -E_A*P_B/P_A )/(S_A (1+P_B/P_A ))>0
The key equation follows: The earnings yield of the target needs to be bigger than that of the aquirer:
(6) (P_B (E_B/P_B -E_A/P_A ))/(S_A (1+P_B/P_A ))>0
In terms of P/E ratio:
(7) (P_B (1/(P_B/E_B )-1/(P_A/E_A )))/(S_A (1+P_B/P_A ))>0

Debt-financed deal:
Post-merger EPS - Pre-merger EPS >0:
(8) (E_A+E_B-P_B*i*(1-t_A))/S_A -E_A/S_A >0
(9) (E_B-P_B*i*(1-t_A))/S_A >0
(10) (E_B*P_B/P_B -P_B*i*(1-t_A))/S_A >0
Key equation: The earnings yield of the target needs to be higher than the after-tax cost of debt:
(11) (P_B (E_B/P_B -i*(1-t_A )))/S_A >0
(12) (P_B (1+P_B/P_A )(E_B/P_B -i*(1-t_A )))/(S_A (1+P_B/P_A ))>0

When comparing the accretion gain of the stock deal with that of the debt-financed deal, it is important to notice that a stock deal is punished for the issue of new shares:
(13) ((E_B/P_B -E_A/P_A )-(1+P_B/P_A )(E_B/P_B -i*(1-t_A )))/(S_A (1+P_B/P_A ))>0

I hope this solves all the questions posted here.

4/17/13

they will basically just ask you if company A is trading at 9x and company B is trading at 6x should company A buy company B. Then they will ask if it's Accretive or dilutive.

This is the most common question I came across concerning this.

4/17/13

A - 100M mkt cap, P/E of 10 is merging with B - 60M mkt cap, P/E of 20.

To whom is the deal Accretive/dilutive? What is the new P/E of the combined entity? What do the synergies have to be worth for it to be dilutive to neither party?

4/17/13

^^^Answers:

New entity has earnings of $13M and a mkt. cap of $160M, for a P/E of ~12. It is dilutive to A because their EPS goes down. If however, $3M of synergies per year are to be had, then now the company will have a market cap of $160M, and earnings will be $16M, so EPS is constant and it's dilutive to neither party.

  • Anonymous Monkey
  •  4/17/13

Can you please explain how you reach to each number? How did you get $13M, $160M and P/E of 12?

8/7/16

isn't this wrong? because the market cap of B should be wiped out.

9/26/16
4/17/13

The key is to remember that it's based off of earnings per share, not P/E. So, if a higher P/E acquires a lower P/E, it is Accretive, not dilutive.

4/17/13

thanks! any more?

4/17/13
4/17/13

eps=net income/fully diluted shares

4/17/13

correct me if i'm wrong, but i recall reading somewhere that only in an all-stock deal can you guarantee that if the buyer has a higher p/e, the deal will be Accretive--if the buyer's paying in all cash or all debt, p/e multiples don't matter.

4/17/13

yes, the example given assumes that this is an all stock deal. the stock of the acquirer at 10x PE is "cheap" relative to the stock of the target which is "expensive" at 20x PE. so think of this as buying something expensive (the 20x company). since your stock is relatively cheap at 10x, you will have to fork over more shares to cover the expensive 20x purchase price and that makes the deal dilutive.

  • VanillaThunder12
  •  4/17/13

Those questions are too easy. Here are some tougher ones:
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?

  1. 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?
4/17/13

Sorry for bumping. But can anyone give me some intuition behind the rule (stock deal is accretive when P/E buyer > P/E buyer)

4/17/13

Look at it from this point of view.. Assume both have the same net income and no. of shares o/s, the firm with a higher PE has to issue lesser number of shares v/s. the firm with a lower PE... hence the proforma Net income will be double but the denominator (# of shares) will not.. hence Accretive for the acquiror..

4/17/13

Was wondering if anyone knew how to set up the two problems VanillaThunder12 posted

4/17/13

Maverickz, I think the correct way to set these up is as follows:

  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

Please correct me if I am wrong.

4/17/13

Can you elaborate on #1?

4/17/13

Sure. So currently company A has a PE of 10 meaning you will get $0.01 for each dollar you pay for it whereas Company B has PE of 12 meaning that you will get $0.083 for each dollar you pay for it. So we can say that our cost of stock for Company A is 10% and the cost of stock for Company B is 8.3%. In an all stock deal, you would not invest in Company B as you will be earning less on each dollar you pay than you are earning on each dollar your company A generates. However, if 50% debt is used and if the interest is small enough this deal would be Accretive after interest is equal or less than a certain number (11% in this case). You set up the above equation to enable you to solve for the interest rate. Let me know if you need further clarification.

4/17/13

should you include B's earnings when calculate post merger earnings?

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4/17/13

Hi,

Firstly, you should stop stressing out about your past interview questions. Just brush up on what you need to know for next time.

Generally, Accretion/Dilution modelling is a fundamental analysis performed at the outset of all proposed M&A transactions, irrespective of whether the companies are listed or unlisted - So, well done, your answer "Yes", is correct.

As to the reasoning, in order to ascertain whether a proposed M&A deal will enhance shareholder value, a relatively simple analysis focuses on whether the EPS of the Acquiring Entity is greater post merger than it was prior to the merger. If so, this is an Accretive deal, and generally, it should be encouraged/pursued. If EPS post merger is lower than EPS pre merger, the deal is dilutive, and generally, discouraged.

Accretion/Dilution modelling is also useful in analysing and determining the best way to structure the consideration (purchase price), ie, via cash, scrip or debt (in the case of a LBO). This decision will impact upon the EPS post merger. Eg, if the Acquiring Entity has a lower P/E ratio than the Target and payment is made via scrip with no premium paid for the target, this merger will be dilutive as the Acquiring Entity will have to issue more stock to acquire the Target relative the increase in earnings contributed by the Target. Further consideration regarding cash payment is that the Acquiring Entity will forgo interest earnings on that cash amount, and in the case of debt, the Acquiring Entity will incur more interest expenses.

In addition, you should also consider other factors that result from a merger that may impinge of Accretion/Dilution analysis, such as the syngergies created by the mergers, economies of scale and scope, growth projections, increased capacity, reduction in competition.

A word of warning - the Accretion/Dilution analysis is only a theoretical model used for analysing the impact of an M&A deal on the EPS of the Acquiring Entity post merger. It only takes into account the pro-forma combined earnings for 1 or 2 years. This is unrealistic, as we know that companies are going concerns, and longer term projections may be necessary, esp where there may be integration delays and lagged impacts on the pro-forma earnings.

Hope this helps. Sorry about the rant, but Accretion/Dilution analysis is very important in all M&A deal analyses, irrespective of whether the companies are listed or unlisted.

4/17/13

Thank you very much - mbas3497

1/3/17

We can only conduct Accretive/Dilutive analysis for public acquirers. the absence of share count for private acquirers prevents us from computing EPS, which is integral to Accretive/dilutive analysis.
Public or private status of target does not matter. For private targets, it is impossible to determine purchase price per share as share count is not available. Instead, we utilize lump sum purchase EV for private targets. Besides, we don't have access to F/S of private companies unless our team has been engaged by them. Hope this helps.

4/17/13

Was hoping someone would know how to answer these

4/17/13

1. You are going to want the PE of the debt to equal 14 so the PE that you basically outlay to buy the company is 12 (50%*10 + 50%*14). So just work backwards to find the cost of debt that makes the PE = 14.

2. This is just manipulating numbers and understanding ratios. You should at least post your thought process then someone on here can say if you are in the right or wrong direction.

4/17/13

VandelayIndustries,

1) I'm not very clear on why there would be a separate PE for debt and equity. Can this problem be solved with the available info?

2) I think this one would be old EPS $4, new EPS ($5mm+250k-6%(1-40%)4.5mm)/(1mm+120K), meaning (old earnings + synergies - after tax interest expense)/(old share count + new shares issued). Is that right?

4/17/13

1) is actually not that bad. You just intuitively try to compare Buyer's cost of funding with Target's cost of equity.

Inverse PE to get earnings yield. Buyer COE is 10% and target COE is 8.33%. Cost of Debt is unknown.

So set up an equation like (10% * 50%) + (X% * (1 - 40%)) * 50% = 8.33%.

X represents the cost of debt, which is adjusted by tax shield.

4/17/13

100% cash deals are the most Accretive because the foregone interest rate on cash is less than the interest rate on debt, and also less than the "cost" of issuing stock. Pure debt deals tend to be the next most Accretive after that because the interest rate on debt is also "less expensive" than the cost of issuing stock...but I am not sure if there is a rule of thumb for a deal that involves a mix of cash and debt (I'll defer that question to somebody who has more experience in merger models tho).

In all-stock deals, if the buyer has a higher P/E multiple than the seller, it will be Accretive (assuming no acquisition effects) because the buyer is paying less for each $ of earnings than what its own earnings "cost".

Capitalist

4/17/13
4/17/13

Those pro forma EPS numbers ARE what guide shareholder value. If you owned one share in a company that provided $1 of earnings and suddenly that company decided on an acquisition and your one share now provided $0.50 of earnings, you as a shareholder would be pissed.

Management may attempt to make the argument that a combination that is dilutive will eventually pay off over time (e.g. deal will be significantly more Accretive in years 2+) and that works sometimes, but generally DCFs and projected synergies numbers are complete bullshit - it comes down to the cold, hard earnings you are going to be providing to shareholders in the near-term.

4/17/13

You are right that acc-dil analysis doesn't necessarily tell you anything about value creation (i.e., will the combined company be greater than the sum of its parts?). What it tells you is "Are the acquirer getting a good deal. An acquisiton doesn't need to achieve synergies or cost savings to be a good idea if you can get a lot of earnings on the cheap. This is what shareholders care about - how much are they paying for a dollar of earnings. If management can make that move in the right direction they've done their job.

4/17/13

But EPS contains non-cash accounting charges. My understanding is that EPS doesn't reflect an accurate picture of cash flow generation. Why do we pay attention to EPS instead of seeing if the acquisition is a positive NPV project?

If stock price (and i'm greatly simplifying this) = enterprise value / diluted shares outstanding, to me this means shareholder value is derived by the future FCF of the company. To me, net income (and therefore EPS) is not an appropriate substitute for FCF.

This is where i'm stuck. If we care about FCF as a driver for shareholder value, why is EPS (and therefore acc-dil analysis) so important?

I'm probably missing something really simple here. I apologize for my thickheaded-ness.

4/17/13
later monkey:

But EPS contains non-cash accounting charges. My understanding is that EPS doesn't reflect an accurate picture of cash flow generation. Why do we pay attention to EPS instead of seeing if the acquisition is a positive NPV project?

If stock price (and i'm greatly simplifying this) = enterprise value / diluted shares outstanding, to me this means shareholder value is derived by the future FCF of the company. To me, net income (and therefore EPS) is not an appropriate substitute for FCF.

This is where i'm stuck. If we care about FCF as a driver for shareholder value, why is EPS (and therefore acc-dil analysis) so important?

I'm probably missing something really simple here. I apologize for my thickheaded-ness.

Stock price doesn't equal Enterprise Value / Diluted Shares Out...

4/17/13
rufiolove:

Stock price doesn't equal Enterprise Value / Diluted Shares Out...

sorry, meant equity value

4/17/13
later monkey:
rufiolove:

Stock price doesn't equal Enterprise Value / Diluted Shares Out...

sorry, meant equity value

Yeah no worries, just wanted to make sure you weren't basing it on that. Other than that I think you make some interesting points but I think the genesis as others mentioned is that shareholders want to view it in terms of their ownership not necessarily on whether or not the earnings is the best cash flow proxy. How is this going to impact what I hold? Is my dollar going to be worth $0.89 after they do this deal or will it be worth $1.05...

4/17/13

I wouldn't use NPV since it's littered with too many assumptions that can steer the project to yield a positive NPV, in that same sense it's quite similar to a DCF. DCF is overly emphasized and in theory it is a correct valuation methodology but in practice it is much more difficult to execute given the littany of assumptions driving the model. Far too often, and depending on the discount rate used, the terminal value drives 90%+ of the enterprise value. This is the least predictable value in the DCF in it of itself.

I personally like using IRR, since it provides a required rate of return that can be measured against the cost of capital used to fund a project, and therefore directly tell me if this is Accretive or dilutive to my cash flow.

FCF is not a direct reflection of cash either, since it based on accruals and not actual. Nothing on the P&:L is a totally accurate reflection of cash, that is only on the BS

4/17/13
socola2003:

. I personally like using IRR, since it provides a required rate of return that can be measured against the cost of capital used to fund a project, and therefore directly tell me if this is Accretive or dilutive to my cash flow.

But aren't you still forecasting FCF to determine your IRR? Isn't an IRR analysis just a different slant NPV/DCF? Determining if your IRR outruns your cost of capital to me is similar to seeing if the project is NPV positive or negative.

Either way, I still haven't nailed down why monkeys/bankers think accretion/dilution is important. Will keep searching.

4/17/13
later monkey:
socola2003:

. I personally like using IRR, since it provides a required rate of return that can be measured against the cost of capital used to fund a project, and therefore directly tell me if this is Accretive or dilutive to my cash flow.

But aren't you still forecasting FCF to determine your IRR? Isn't an IRR analysis just a different slant NPV/DCF? Determining if your IRR outruns your cost of capital to me is similar to seeing if the project is NPV positive or negative.

Either way, I still haven't nailed down why monkeys/bankers think accretion/dilution is important. Will keep searching.

Any projection model will be based off assumptions. What you say above re IRR and NPV is accurate if you use the cost of capital as the discount rate for the NPV, but in practice I have not seen this to be the case.

4/17/13

Will your next question be "Why do we use EV/EBITDA and P/E instead of EV/FCFF and P/FCFE or P/Div."?

I'm grateful that I have two middle fingers, I only wish I had more.

4/17/13

If you buying a business with stock how would do NPV? There is no cash outlay to begin with. You need to see how how the acquisition affects your shareholders on a per-share basis.

I suppose you could do a FCFE/share analysis - though not sure this is right.

I think one reason people to accretion/dillution is because the market cares about earnings in addition to cash flow. EPS is an important metric and people want to know how its going to move.

4/17/13

NPV is ultimately all the matters. The reason you do acc/dil analysis is because you want to guess whether the market will give you credit for the positive NPV. For example, lets say a company is trading at a PE of 10 with $1 in EPS. Pro forma the company is down to $0.90 EPS, due to $0.10 dilution.

So lets say the project is +NPV, but that the synergies come in the out years -- another way of saying this is that growth will be increased. Can management expect multiple expansion to >11 PE (what would be necessary to have the same equity value) or better? Will the market give you credit for that implied future growth as expressed through a better multiple or not?

Basically you'd have to assess what kind of multiple expansion would be necessary, whether that would be reasonable based on comps and other factors. Acc/Dil analysis is a tool that helps you to understand what's at play. That said, if its Accretive in the first and every year, its basically a slam dunk.

4/17/13

Today's case study on how the market may not give you any value on a +NPV project even if it is immediately Accretive: SD's acquisition of Dynamic Offshore. The transaction potenially adds several dollars of NAV and is immediately Accretive to EPS. It also cash flows right off the bat as well. However the stock will open down 15% tomorow because the company significantly outspends cash flow and has a debt/cap ratio of greater than 60%. Sometimes the best acquisitions in the world won't be rewarded by the market. Another great example: CHK.

4/17/13

You should read "Value: The Four Cornerstones of corporate finance" by McKinsey. It says exactly what you are saying, that accretion/dilution is meaningless for long-term investors.

4/17/13

.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

4/17/13

Accretion dilution as a proxy for value - in other words, the idea that an acquirer's share price should drop if it does a dilutive deal - is really problematic. There's no question about that.

An acquisition creates shareholder value (increases the value of shareholder stock) by acquiring a business whose fundamental value is higher than the purchase price. If the acquisition is strategic and synergies can be captured, the acquisition creates shareholder value as long as the fundamental value of the target plus the present value of the synergies is greater than the purchase price.

For a long term investor, that's it. EPS accretion or dilution shouldn't play a factor.

However, Wall Street generally frowns upon deals that are EPS dilutive. Analysts and investors may tolerate dilution in the first year, as long as they can be reasonably assured that the deal will turn Accretive in year 2 post-acquisition.

Why do they care? Because EPS accretion/dilution is essentially regarded as a proxy for value creation/destruction. The basic reasoning is that given a fixed PE ratio, if EPS is expected to decline as a result of the deal, price (value) should decline as well.

The problem with this, is that using EPS as a proxy for value carries some substantial limitations - namely EPS is an imperfect accrual (non-cash) accounting based, highly manipulable (i.e. one time restructuring charges) and short term measure of profit , especially when observed over only a short period such as 2 years, as is typically done in accretion/dilution analysis. Fundamental value is driven from expected operating cash flows, returns on capital and the cost of capital - not EPS or accounting profits.

One explanation for acc/dil's continued importance is that the managers pulling the trigger on deals and many investors are more concerned with short term profitability than long term profitability. Another explanation is that the alternative - a DCF or some intrinsic valuation - is so dependent on assumptions that it is not as useful as the McKinsey book or academic professors would have us believe.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

4/17/13
matanf:

...good stuff...

This is an excellent post. Thank you mantanf.

4/17/13

This topic has been answered here before, but the general idea is that a P/E multiple is the inverse of an earnings yield. So, by taking the inverse of after-tax cost of debt, you imply a P/E multiple. If this multiple is higher than the target's P/E, then it's accretive to the buyer.

Better explanation in comments: http://www.wallstreetoasis.com/forums/accretion-di...

4/17/13

Sorry to hear you didn't get it. Technicals have definitely adapted to throw off people who just learn the P/E rule by heart without understanding merger models conceptually. With that said, this is still technically a rule that you can just learn. The main idea is that you should back out the total implied cost of the acquisition for the buyer (acquirer) and compare it to the sellers implied cost of equity (target).

weight of cash * forgone interest on cash + weight of debt * cost of debt + weight of equity * implied buyers cost of equity <? sellers cost of equity

If the buyer/acquirers implied cost of acquisition is higher (more expensive) than the cost of equity of the target company(the return on equity the target's current shareholders are receiving), the transaction is dilutive. Think of it this way, if you're the acquirer and the acquisition costs you 15% after accounting for the interest rate you lose on cash + interest payments you payout + dilutive effects of issuing equity, and the target company returns 10% to its shareholders (equity), you're effectively losing money/lowering your EPS by going through with the transaction since that's the return you'll receive once you acquire the company.

Makes sense?

  1. Forgone interest on cash is just the interest rate you'd normally get on cash or the risk free rate
  2. Interest on debt is the interest you pay after you account for the fact that interest expense saves you taxes at the margin.
  3. Implied cost/return of equity is exactly what it sounds like: given the fact that shareholders are willing to pay 100$ per share to receive 10$ per share of earnings, implying a P/E ratio of 10, what is the implied return on equity?

I've purposely not posted the answer because you should attempt it and either myself or someone else will tell you if you're right. I already laid everything out for you so this should be fairly straightforward.

You speak in in varying levels of verbosity.You often adopt the typing quirks of others as you find it boring to settle on styles.

4/17/13

The answer is its dilutive. Yield of the target (seller) is 1/15 or the inverse of the PE ratio. The yield of the seller should always be less than the avg of the cost of debt/forgone interest and the yield of the buyer combined for it to be Accretive.

4/17/13

This is actually kind of tricky because the buyer's P/E has absolutely no relevance in this question. Reason: no stock is being issued to acquire the seller, so the buyer's cost of equity (the earnings yield) is not used.

The only two things that matter are the cost of cash (essentially Rf rate, holding cost etc) and cost of debt. First of all, you could've showed higher value right away (HUGE opportunity to make an impact here) by saying "Wait, the cost of cash = the cost of debt? That's really rare." And when they prod why, you can respond by saying "Well, because that's an unrealistic scenario. That's basically stating that I'm not being charged a premium over the risk free rate for borrowing money. It is traditional to assume that the federal reserve has 0 chance of default; even if my company has triple A status, my risk is definitely higher than 0. So, whatever bank/financial institution I'm borrowing from is making an irrational decision to invest in me." Lol if you can say that they might not even ask you to answer the question.

But anyways, going back: this question requires no paper because apparently cost of cash = cost of debt. You have a tax shield for both (this can be tricky too, you always think of tax and debt being tied together because of how the two interact on the IS, but cash has an after-tax rate too), and the weightings are equal, so your weighted cost is 7%. The yield of the seller is 1/15 = 6.7%. It is dilutive, ever so slightly as it costs you MORE relative to how much you get back.

"If you have a difficult task, give it to a lazy person; they will find an easier way to do it." - Hlade's Law

4/17/13

SB right back at you haha

You speak in in varying levels of verbosity.You often adopt the typing quirks of others as you find it boring to settle on styles.

4/17/13

If the transaction is 100% stock, you can determine how Accretive (dilutive) the transaction is by comparing the P/E multiples. When you have a mix of stock / cash, as you would expect, the transaction is incrementally more Accretive (or less dilutive) as you increase the proportion of cash in the consideration.

4/17/13

Omganonymous gave you the right concept. If you need more of an accounting answer:

1. Transaction debt generates interest expense and deferred financing fees that negatively impact GAAP earnings. Deferred financing fees are the debt's financing fee amortized over the life of the debt. In actuality, the fee is fully paid out at the time of the transaction. However, due to GAAP rules, the expense must be amortized. This also creates a deferred financing fee asset on the balance sheet. Keep in mind, if asked about non-GAAP cash earnings, deferred financing fees will not come into play.

2. Lost interest income from cash spent in the transaction will also negatively impact GAAP earnings.

4/17/13

Thank you both so much for your responses. I just have a few additional questions.

1) Just to clarify, is Omganonymous wrong in the idea that increasing the amount of cash makes the transaction incrementally Accretive? Because cash has an opportunity cost so it would actually make it less Accretive.

2) So if you have debt in the transaction and wanted to work out whether a deal was Accretive or dilutive, you would have to build a pro forma income statement for the current year which would include the expensed portion of the deferred financing fees and the interest expense.

Those would be the ONLY two new factors in the income statement?

3) Is it correct to say that even if the P/E of company A is higher than the P/E of company B, the deal may still be dilutive depending on the premium paid?

Thank you in advance!

4/17/13

1. No, Omganonymous is not wrong. Keep in mind, you implicitly raised two issues here: (a) stock versus cash consideration, and (2) the composition of any cash used (balance sheet cash versus new debt). Regarding issue (a), as you increase the stock component of consideration, you increase the denominator (outstanding stock) in your EPS calculation. This dilutive effect generally outweighs any negative impact that new interest expense will have on the numerator (earnings). That is what O. was addressing. I was addressing issue (b). Yes, there is lost interest income from cash spent in the transaction. However, this lost interest income is cheaper than the interest expense on any transaction debt. So, assuming that the overall cash component of consideration is the same in both cases, it is less dilutive to use balance sheet cash than to issue more debt.

2. To figure out the precise accretion/dilution, yes, you need to calculate the pro forma impact on the income statement (then calculate any adjustment to shares outstanding as well). However, this does not require building out the whole income statement. You can use the incremental/short-from method and simply add up all the transaction effects to adjust your pro forma earnings.

To be clear, adjusting interest expense/income and adding in deferred financing fees are not the only changes to make in a merger model. But you only asked about the effects relating to debt.

3. Yes. The transaction costs might tip the scale. Still, that is highly technical. Conceptually, comparing P/Es is generally enough.

4/17/13

Thanks for the additional reply (+SB)

Regarding point 1), is it the case then that cash is always less dilutive than using shares? (Assuming the cost of cash is at the current levels).

2) In an all-debt/all-cash transaction, there would be no adjustment to shares outstanding necessary so it would just be the incremental effects of the deferred financing and interest costs, correct?

3) So for two companies who have very similar P/E, the premium paid (ignoring transaction costs) may dilute the NewCo's EPS.

Thanks!

4/17/13

21:

Thanks for the additional reply (+SB)

Regarding point 1), is it the case then that cash is always less dilutive than using shares? (Assuming the cost of cash is at the current levels).

2) In an all-debt/all-cash transaction, there would be no adjustment to shares outstanding necessary so it would just be the incremental effects of the deferred financing and interest costs, correct?

3) So for two companies who have very similar P/E, the premium paid (ignoring transaction costs) may dilute the NewCo's EPS.

Thanks!

1. All else being equal, yes, it is less dilutive to fund a transaction with cash than stock.

2. No. There are purchase accounting changes: additional depreciation and amortization from the PP&E write-up and allocation to intangibles. Also, you have to account for potential revenue and cost synergies.

3. The premium paid for the target company versus market cap is a separate issue from transaction-related costs and adjustments. New interest expense, reduced cash interest income, increased D&A from purchase accounting, and deferred financing fees are all negative adjustments to pro forma earnings that can turn a deal dilutive on a GAAP basis even if the acquiror and target P/Es are on par.

4/17/13

Thank you so much! You have been so much help.

Sorry for all the dumb questions.

4/17/13

do you mean pre-tax synergies to break even? If so, take Accretive/dilutive $ amount and multiply by # of diluted shares and divide by (1-t)

NI is an after-tax #, not sure why you want pre-tax accretion/dilution

4/17/13

Right I have pre-tax synergies to break even. I thought it was an odd request, but I'm thinking he simply wanted me to add taxes back to the acquirer and pro forma net incomes to see what it spits out. Thanks for the quick response!

4/17/13

Firms that have interests less than 100% in other firms will consolidate all of their revenue into their financial statements, "minority interest in earnings" represents the portion of earnings they do not control. The treatment for balance sheet consolidation is different, i do not remember all of the rules off the top of my head, but this should give you the general idea.

The reason you add the "minority interest" balance sheet value to the Enterprise Value is because since you have effectively consolidated all of the revenues of the minority interest, you need to take into account that you will effectively have to "buy out" the portion of the firm not owned, or the minority interest, in order to receive all of this earning power.

A more accurate way to do this would be exclude the minority interest in earnings from EBITDA when calculating the multiple, which is a different way to get to the same endpoint, you can intuitively follow this by thinking that if you have lower EBITDA (by removing the minority interest in earnings), and pay a fixed amount, your EV/EBITDA multiple for the transactoin will be higher, the same way it will be higher if you add a balance sheet value of minority interest to enterprise value, the difference is one factors into the numerator (balance sheet value of minority interest), the other factors into the denominator (removing minority interest from EBITDA).

Often it is difficult to get the exact minority interest in EBITDA because it's provided on an "earnings basis" after giving effect to depreciation, SG&A, and COGS, and additionally other one time charges, so in the event you don't have perfect information, you would use minority interest balance sheet value and add it to enterprise value, to make sure you are "paying" for all the earnings consolidated into revenue.

Hope this helps.

4/17/13

Minority interest is recorded when a company acquires less than 100% of a target, but enough (>50%) where it has to consolidate the income statement. For example, company A acquires 90% of target B. In 2010, target B has $100 million in net income. Company A's income statement will show a fully consolidated A+B (all $100 million of target B's net income included), but because company A only has claims on 90% of the net income ($90 million), A will record a $10 million liability -- this is called minority (now "noncontrolling") interest, and basically offsets the portion of net income that flowed into the retained earnings account that A does not own.

You must add minority interest to get enterprise value because it is very similar to debt -- it is a claim on the company's equity. So, if the company's equity value is $200 million, the total enterprise value needs to account for the minority interest to consider the effect the 100% consolidation has on the income statement (revenue, EBITDA, net income are of company A are all metrics that are 100% consolidated, despite the fact that A cannot claim all 100% of target B's revenue, EBITDA, net income).

A-D for all-cash transaction is basically whether the net income of the target is greater than foregone cash interest on the cash paid. So, say you pay $100 million, in cash, for a company with $10 million in net income. You can generally earn 3% on your cash. So you are foregoing $3 million in interest income by paying $100 million for $10 million of net income -- this is Accretive. If you could earn 11%, the deal would be dilutive. There are, of course, additional intricacies with this calculation (i.e. taxes on the interest income -- you may have foregone $11 million in cash interest, but you'll also have to take into account the company's tax rate).

Hope this helps.

4/17/13

really helpful - appreciate it guys!

4/17/13

(y-x)/x

standard percentage calculation.

4/17/13

Don't you need to know the number of shares outstanding and the number of shares repurchased?

4/17/13

weird technical question, but here's my take. Also, I'm assuming you meant "10x [EV]/EBITDA-Capex", since FV/EBITDA-Capex makes pretty much no sense / is rather ambiguous.

accretion/dilution is done on a per share basis. normally the fact that you're working with EBITDA numbers here would make this question impossible to answer, but they tell you that both companies have the same leverage metrics, so capital structure is irrelevant and you can ignore the fact that this would normally be an apples-to-oranges comparison.

after you know that, the fact that its all cash means that there will be no dilution from either interest payments on debt incurred for the acquisition or lost interest income from cash that was used for the acquisition. Lets also assume no net working capital synergies.

so lets say both companies have Enterprise Values of $100mm. That means both companies have EBITDA's of $20mm. It also means company A's EBITDA - Capex is ~14.28mm; company B's EBITDA - Capex is ~10mm. This means company A's Capex is 6.72, while Company B's Capex is 10.

If D&A is the same for both companies (another assumption that should be made), the acquisition will be dilutive to FCF, since the incremental cash flow is less, due to the higher Capex.

"Success means having the courage, the determination, and the will to become the person you believe you were meant to be"

4/17/13

a) depends on the price of cash
b) depends on the relative PEs. If P/E acquirer > target it is Accretive
c) needs to compare the P/E of cash to the P/E of debt and the financing proportions

4/17/13
youngmonkey:

a) depends on the price of cash
b) depends on the relative PEs. If P/E acquirer > target it is Accretive
c) needs to compare the P/E of cash to the P/E of debt and the financing proportions

a. by price of cash, do you mean the interest rate? How would A/D depend on that?

b. Also, I had heard so far that P/E of two companies should be compared for a quick analysis of A/D. Are you saying that this rule is only valid for a 100% equity deal? Could you please explain why?

c. Could you please give some more info about how such analysis could be carried out?

Thank you!

4/17/13
beatallica:
youngmonkey:

a) depends on the price of cash
b) depends on the relative PEs. If P/E acquirer > target it is Accretive
c) needs to compare the P/E of cash to the P/E of debt and the financing proportions

a. by price of cash, do you mean the interest rate? How would A/D depend on that?

b. Also, I had heard so far that P/E of two companies should be compared for a quick analysis of A/D. Are you saying that this rule is only valid for a 100% equity deal? Could you please explain why?

c. Could you please give some more info about how such analysis could be carried out?

Thank you!

A. The "price" of an all-cash transaction is the foregone interest on cash (interest income you would have received had you not spent it).

B. For a true Merger Consequences model, you can only use the P/E of the target and acquirer as a means of determining dilution or accretion when the transaction is an all-stock deal. This is because the cost of purchasing the added earnings of the target is directly determined by the price of the new earnings relative to the current market price of the acquirers earnings. To simplify, the EPS will be diluted by the overall price of issuing additional shares. If the transaction were a mix of stock/cash/debt then there will be the added costs associated with each type of financing, which will make the P/E ratios an apples to oranges comparison.

C. The merger consequence is essentially combined income statements with a reflection of the added revenue or cost synergies minus the incurred costs of the transaction (foregone interest on cash, newly incurred interest expense, added shares issued). Then once the pro-forma earnings of the merger is completed, the net income is divided by the new number of shares outstanding.

4/17/13
youngblood:

B. For a true Merger Consequences model, you can only use the P/E of the target and acquirer as a means of determining dilution or accretion when the transaction is an all-stock deal. This is because the cost of purchasing the added earnings of the target is directly determined by the price of the new earnings relative to the current market price of the acquirers earnings. To simplify, the EPS will be diluted by the overall price of issuing additional shares. If the transaction were a mix of stock/cash/debt then there will be the added costs associated with each type of financing, which will make the P/E ratios an apples to oranges comparison.

Thanks very much for your reply again. I am still not clear on the above point. My understanding of why a deal involving higher P/E company (H) acquiring a lower P/E company (L) will be Accretive is:

  1. Market value the earnings of the "H" higher than "L" by paying higher price for the same $1 of earnings
  2. This means that, relatively, "H" will have to pay lesser of their own "new" equity to acquire the earnings of "L"
  3. For the pro-forma EPS:
    3.a numerator is (for sake of simplicity), Net Income(H) + Net Income(L)
    3.b denominator is Orginal number of fully diluted shares of H + new shares of "H" issued to buy "L"'s equity
    3.c As the numerator increase is relatively greater than the denominator, the overall EPS will be higher
  4. This will however not be observed in all cash deal as no new equity is created and thus will entirely depend on the impact on the pro-forma Net Income

is that correct? Or am I missing something?

4/17/13
beatallica:
youngblood:

B. For a true Merger Consequences model, you can only use the P/E of the target and acquirer as a means of determining dilution or accretion when the transaction is an all-stock deal. This is because the cost of purchasing the added earnings of the target is directly determined by the price of the new earnings relative to the current market price of the acquirers earnings. To simplify, the EPS will be diluted by the overall price of issuing additional shares. If the transaction were a mix of stock/cash/debt then there will be the added costs associated with each type of financing, which will make the P/E ratios an apples to oranges comparison.

Thanks very much for your reply again. I am still not clear on the above point. My understanding of why a deal involving higher P/E company (H) acquiring a lower P/E company (L) will be Accretive is:

  1. Market value the earnings of the "H" higher than "L" by paying higher price for the same $1 of earnings
  2. This means that, relatively, "H" will have to pay lesser of their own "new" equity to acquire the earnings of "L"
  3. For the pro-forma EPS:
    3.a numerator is (for sake of simplicity), Net Income(H) + Net Income(L)
    3.b denominator is Orginal number of fully diluted shares of H + new shares of "H" issued to buy "L"'s equity
    3.c As the numerator increase is relatively greater than the denominator, the overall EPS will be higher
  4. This will however not be observed in all cash deal as no new equity is created and thus will entirely depend on the impact on the pro-forma Net Income

is that correct? Or am I missing something?

That is correct, you understand the underlying concepts.

4/17/13

Pretty much. Combine revenues and any revenue synergies, take out COGS and operating expenses (less synergies), subtract interest expense (add income) based on post-transaction levels of cash and debt, remove taxes, and bam! Done.

That's a simplistic view. There will likely be additional D&A expenses due to capitalized financing fees, and the write-up in PPE and intangibles.

EDIT: You also calculate taxes based acquiror's tax rate. Don't just add the taxes of target and acquiror to foot to net income.

4/17/13

You just have to rerun the accretion/dilution. If the deal is Accretive to the acquirer, itll be dilutive to the target, and vice versa. Multiplying by the exchange ratio will not help you. The easiest way to make sense of accretion/dilution is to just run simple numbers:
Acquirer Target
Net income 100.0 120.0
Shares 40.0 50.0
EPS 2.50 2.40
Share price $60.0 $70.0
PE 24.0x 29.2x
if "acquirer" buys, the deal is .26 dilutive, if the "target" buys, its .21 Accretive....

4/17/13

In a cash/debt deal, you can look at the combine proforma net income compared to the stand alone acquiror net income. If the proforma net income is lower than the stand alone, the deal would be dilutive to earnings.

Your proforma net income should include after tax adjustments like forgone interest on cash, additional interest expenses, additional D&A, and synergies.

4/17/13

generally you do acc/dil for an acquiror. The target is getting a premium, and partially cashing out, so its not quite as relevant.

for acquiror acc/dil you don't need private target's EPS. Only net income.

standalone EPS = acquiror's Net Income / Current Shares
Pro Forma EPS = Combined net income (w/synergies) / pro forma shares

where PF shares = current acq. shares + new shares issued for consideration

for target acc/dil in a 100% stock deal, there is a way to calculate it. I forget if its off of the PF ownership of the exchange ratio... for a 50/50, not positive how the calc works, but search around for that. sorry not of more help.

"Success means having the courage, the determination, and the will to become the person you believe you were meant to be"

4/17/13

The problem is that you're adding the two EVs together to get market cap, which is wrong.

PF structure should be mkt cap = $1,800 and net debt = $200, assuming you're acquiring the target at a zero percent premium.

4/17/13

You might be hard pressed to get a model from anyone. If you're an analyst now, you should have built one during Training the Street. While those are basic versions, they should get you through your interviews.

4/17/13

EPS accretion / dillution can be done regardless of whether the company is public or private. Your best bet for both is to start by forecasting the 2 businesses andlooking at it on a pro-forma business and comparing it to the stand-alones

as for MBO that's a diff question. People don't do MBOs because they want it to be Accretive per se. MBOs are typically if they think the business is undervalued. You're not merging anything

4/17/13

I see.

Yes, that's what I thought about the MBO as well; that an A/D analysis doesn't make sense.

But I was asked about the A/D of an MBO I listed on my CV during an interview... that's when I got puzzled.

Thank you very much!

4/17/13
4/17/13

Cash accretion dilution is funky because it has different definitions depending on who you ask.
1) If you're looking at a cash basis, you add back non cash items like amortization to GAAP NI, which originally had D&A deducted
2) Companies don't always break this out in their 10k, so you may have to make an assumption. Research reports may have it
3) There's not always write ups for PP&E and Intangibles; ultimately there will be accountants / valuation experts on those assets who actually determine the value, so they never really are accurate in the model. DTL gets created because it's a stock sale and not an asset sale or 338(h) so you receive should receive no tax benefits from write-ups - the DTL line is then amortized over time and the tax shield effect is canceled out in your cash flow statement.

in an asset sale or 338(h), you instead get DTAs and those are your tax benefits. If you're just looking at a stock sale, which is most of the time, the write-ups have no effect on cash, they only impact GAAP

4/17/13
JustADude:

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Thanks for the response! I understand that on a cash basis you add back non-cash items, however the acc/dil model I'm looking at still adds back Existing Amortization in the GAAP basis. Not sure why that is?

Acquirer standalone GAAP Net Income
+ Target unlevered GAAP Net Income
+ Target Existing Amortization
- Amortization of acquisition Intangibles
+ Synergies
- Interest forgone

= Proforma GAAP Net Income

Also where in the 10k can I even get an estimate to make the assumption of the existing amortization?

thanks for your help!

4/17/13

Given how common accretion / dilution models are, I'm surprised that there aren't more people who know the answers :)

4/17/13

ok I managed to figure out the section of the 10k with the existing amortization. It's typically housed within Goodwill/intangible assets section and some companies are even nice enough to forecast it out for the next 5 years.

Now my other question still stands: Why do you add back existing and subtract the new intangibles in the GAAP basis?

4/17/13

Okay a lot of confusion here because you shift back and forth between Cash basis and GAAP. Questions related to cash basis has been answered, so moving onto your GAAP question:

Acquirer standalone GAAP Net Income
+ Target unlevered GAAP Net Income
+ Target Existing Amortization
- Amortization of acquisition Intangibles
+ Synergies
- Interest forgone

= Proforma GAAP Net Income

You add back targets existing amortization and then subtract the new amortization because for GAAP purposes, there are usually write ups (in assets, including intangibles). So basically, the new amortization is a function of 1. Targets existing amortization and 2. The additional amortization from write up.

4/17/13

http://www.ibankingfaq.com/
This is a question that walks you through an accretion/dilution analysis. Hope this helps

4/17/13
4/17/13

you apply it to the equity purchase price so in this case if you're funding this using 100% cash (ie debt), you are getting a $1000 loan to pay for it. Then, you apply the interest expense on the $1000.

(Net Income 1 +NI 2 +- adjustments (ie interest expense, depreciation from writeups, synergies)) / (total new shares)

this gives you the pro forma eps.

if you're funding this with actual cash, then you're using $1000 cash to pay for the company. However, remember that you also acquire the other company's cash after the acquisition so essentially you're still really only paying $700.

I'm not really sure what you mean by "funding of cash is 1%," can you explain that a bit?

BossMode

4/17/13

No. Not without any information around profitability of each entity and what the pro forma equity cap table looks like.

4/17/13

why would you use all equity financing? that would just dilute your shareholders... I'd think you'd use all cash and recoup it once the merger has completed... but then again, I specialize in LBOs not M&A...

4/17/13

I don't think you do the accr/dilution part of the analysis any different than normal. The key here should be that you would decrease the enterprise value by the pile of cash the target sits on (effectively lowering the cost of the deal to the acquiror). This, of course, would automatically reduce the amount of financing you need, and by extension a decrease in expenses and the magnitude of the dilutive effects.

4/17/13

Particularly concerning the target with the large cash, the preferred option would rest upon the deal structure whether it is a stock (net debt is assumed) or asset (potential for double tax, but would be likely be cash/debt free transaction) sale.

The above posters are assuming a 100% purchase of targetco. I believe the financing/ accr/dilution part analysis, wouldn't be any different than normal.

4/17/13

you just adjust for the incremental interest expense for the amount of debt raised

4/17/13

Depending on the context of this question, it's either a trick or asking you to consider the cost of cash / debt in your accretion / dilution analysis.

First of all, preexisting debt, both of the target and acquirer, is irrelevant. It's already baked into acq/target's net income, and acc/dil is on a P/E basis. So let's talk about new debt issued in acquisition, if any.

If your acc/dil model is simply stock swap, there is no debt issued. Done.

If you're modeling a cash/stock mix, with the cash coming from a combination of cash on hand and new debt, you need to adjust the combined net income for the foregone interest on cash on hand (cost of cash - around 2-3%) and, more importantly, the interest expense on the new debt (depends on the kind of debt we're talking about...). Once you reduce combined EBT by the appropriate interest, tax-affect at the acquirer's eff. tax rate and get a new net income figure, divide by new FD shares out (assuming cash/stock mix - if all cash then new FDSO = old FDSO).

4/17/13

well existing debt does matter if you pay off the target's debt in the acquisition - this would lead to decreased interest expense (tax-affected) that would flow to the net income of the pro forma entity.

existing debt on the acquirer doesn't matter because yes, it is already reflected in the net income.

4/17/13

i think it's just like what mergerarb15 said, you have the interest rate on debt and you basically have that rate times by the debt to get the interest expense. You then put that number under your combined income statement to get the pro forma number

4/17/13

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4/17/13
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