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Accretion/Dilution Analysis – Part IV: Synergies and Source of Funds for M&A

Accretion/Dilution for M&A with Mixed Funding Sources

Larger, transformative acquisitions tend to require a mix of debt and equity financing unless the acquirer had an underleveraged balance sheet beforehand and substantial cash reserves. As such, finding the breakeven for accretion requires additional calculation.

The appropriate cost of acquisition is accordingly the blended incremental after-tax cost of debt, earnings yield on the acquirer’s stock and foregone after-tax interest on cash spent. This is compared to the earnings yield of the target. As such, there can still be an accretive transaction if the target’s Price-to-Earnings (“P/E”) is higher than the acquirer’s P/E.

Accretion/Dilution Example Question 4: Acquisition Using Cash, Debt & Stock

Company A purchases Company B for \$100 million. Company A has a P/E of 8.0x and Company B has a P/E of 10x. Company A uses 50% stock, 30% debt and 20% cash-on-hand to fund the acquisition. The marginal cost of debt is 6% and interest on cash is 1%. Company A’s marginal corporate tax rate is 40%. Is the acquisition accretive or dilutive?

Target Earnings Yield = 1/(10.0x Price Earnings) = 10%

The earnings yield on Company B is 10%.

The earnings yield on Company A is 12.5%. The after-tax cost of debt is 3.6% (6% x (1-40%)) and the after-tax foregone interest on cash is 0.6% (1% x (1-40%)).

12.5% x 0.5 + 3.6% x 0.3 + 0.6% x 0.2 = 7.45%

The cost of acquisition is lower than the earnings yield on Company B, so this transaction is accretive to earnings.

Synergies and Accretion/Dilution

In M&A analysis, investment bankers will present to the acquirer and the acquirer will put together an informational PowerPoint for their investors which shows the pro-forma EPS with and without synergies.

Remember, the broad CFA M&A formula is:
Value of Combined Firm = Firm A (Acquirer) + Firm B (Target) + Synergies – Payment to Firm B Shareholders – Transaction Costs

Accretion/Dilution Example Question 5: Acquisition with Synergies

Sell Side Handbank, a \$100 billion large global bank with an established capital markets practice, trades at 10.0x P/E. There are 1 billion shares of SSHB. Inefficient Regional Bank trades at a 5.0x P/E for a market capitalization of \$10 billion.

Sell Side Handbank’s corporate development/Financial Institutions Group team is assuming that there will be \$2 billion in annual synergies from streamlining back office processes, cutting corporate headquarters, tax inversions, reduced financial reporting requirements, lower interest on debt, and the implementation of best practices. SSHB decides to offer \$20 billion in stock entirely in shares. Is the transaction accretive or dilutive?

Pro-Forma EPS Without Synergies

The earnings yield for the SSHB shares issued is 10%. After the acquisition premium, the shares of Inefficient Regional Bank have an earnings yield of 10%. The transaction is neither accretive nor dilutive to earnings.

With a 100% acquisition premium, you can look at the price for the target to be 2*Price/Earnings = 2*5x = 10x. The inverse of the P/E is the earnings yield.

Pro-Forma EPS with Synergies

The current earnings per share for SSHB is \$10.

(\$100 billion market cap)/(10.0x P/E) = \$10 billion in earnings

(\$10 billion in earnings)/(1 billion shares) = EPS of \$10

To purchase the target, SSHB will need to issue \$20 billion of shares at \$100 a share.

(\$20 billion)/(\$100 per share) = 200 million shares

Now, we must solve for the new net earnings for the combined company.

Net Income (Acquirer) = \$10 billion

Net Income (Target) = \$2 billion

Synergies = \$2 billion

Pro-Forma Net Income with Synergies = \$14 billion

Afterwards, we solve for the number of shares outstanding in the combined company.

1 billion existing SSHB shares + 200 million new shares = 1.2 billion shares.

New EPS = \$14 billion/1.2 billion shares = \$11.67 per share. The acquisition is accretive because of the synergies.

Accretion & Dilution in a Recapitalization or Share Repurchase

Outside of M&A, this accretion/dilution logic works when issuing shares to repurchase debt. For instance, if the P/E of the company is 10x and debt is 3%, it is certainly accretive to repurchase shares. Instead of a target company, the comparison is between the cost of debt and the cost of equity.

With such cheap debt in today’s low interest rate environment, this has been a widespread practice across Fortune 500 companies who do not know what to reinvest in other than these return of capital initiatives. In a way, it can be argued that the capital structure of the company was not efficient prior to share buybacks as the weighted-average cost of capital (WACC) can be lowered with more debt. If the company rationally believes that the intrinsic value of the firm is lower than the current share price, this debt-fuelled share repurchase is logical.

In a robust and liquid bond market, such as that of the debt market in the US, fixed income investors are generally comfortable with the marketing of a bond with the purpose of share repurchases. However, this does not necessarily mean that it is prudent in the long run.

For the cost of debt in calculating a company’s WACC, analysts can choose between the current indicative cost of debt (heavily reliant on today’s underlying risk-free interest rates across various tenors) or the historical cost (which can be a blend of the various yields on outstanding debt). If WACC is based on the current cost of debt, this means that the capital structure is optimal based on right now instead of across the business cycle – and this also means that the company may feel the pinch of too much debt should this change.