Technical question - Calculative max cost of debt for an accretive deal

Hi all,

I had a phone interview with Morgan Stanley and was stuck with this question.
Assuming you have 2 firms,

Company A - P/E = 20x
Company B - P/E = 10x

Assuming a 50% tax, what is the maximum cost of debt Company A would pay to acquire Company B?
I understand that when you inverse the P/E multiple, you get the cost of equity. This means that the cost of equity for Company A is [1/20] 5%, cost of equity for C1ompany B is [1/10] 10%. However, I do not know how to reconcile the numbers from here. All help is appreciated

Comments (11)

Most Helpful
Jul 17, 2018

20%.

The yield on company B is 10% (1/PE). That means the cost of capital used to obtain those earnings must not exceed 10% in order to be accretive. Because the tax shield is 50%, the max cost of debt can be 20% (well, technically 19.9999%).

    • 4
Jul 17, 2018

This is correct assuming s 100% debt deal. If I received this question in an interview process I would ask "what is the cash/stock/debt mix in this deal?" This is just to be extra certain you are satisfying the interviewer's question.

Then from there you can use the weighted cost average method and simple algebra to determine the breakeven cost of debt using the same method as above.

    • 1
Jul 17, 2018

But isn't cost of debt always cheaper than equity? So assuming 100% debt deal is a good assumption to make here.

Edit: Sorry I just understood your comment

Jul 18, 2018

Could i confirm if you are referring to 'yield' and 'cost of equity' interchangeably here? From your response, I understood it that Company A would not pay more than company B's existing cost of equity to acquire it. Therefore, it considers Company B's current cost of equity (1/10x) = 10%, and the equivalent cost of debt, less the tax shield would be 10%/(1-0.5)= 20%.

Could i confirm if this theoretical approach is correct? Cheers! Appreciate your insight on this topic.

Jul 17, 2018

No, cost of equity does not play a factor in accretion/dilution analysis. When stock (equity) is used for acquisitions, the cost of capital is considered to be zero.

You can finance an acquistion in 3 ways - stock (free), cash (cost of capital is the foregone future interest you could have earned by keeping that cash in short-term investments, etc), or debt (cost of capital is the interest rate you pay).

Now that we've covered costs of an acquisition, you need to look at what you're getting in return for those costs. If I buy a company with a 10x PE ratio, I am paying $10 for $1 of annual earnings, which means my return on investment is 10% ($1/$10). Hope that clarifies.

    • 1
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Jul 18, 2018

Hi all. Thanks you all so much for your prompt replies. The responses greatly informed my perspective of cost of equity, multiple expansion, and deal financing. Cheers!

Jul 18, 2018

Is this for SA position?

Jul 18, 2018

is this question covered in any of the guides?

Jul 24, 2018
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