If you buy a company trading at 20x P/E and the deal is financed 100% with debt at 5% interest, is the deal accretive or dilutive?

If you buy a company trading at 20x P/E and the deal is financed 100% with debt at 5% interest, is the deal accretive or dilutive?

• A. Accretive
• B. Neutral
• C. Dilutive
• D. Cannot determine

Answer: (A)

The concept being tested is accretion versus dilution in an acquisition when financing is debt-based. Here, paying 20x earnings means the target’s earnings yield is 5% (earnings = price/20). Financing the purchase entirely with debt at 5% interest sets a pre-tax cost of debt of 5%. If you ignore taxes, the target’s earnings would just cover the interest, giving roughly neutral post-deal earnings per share. However, interest is generally tax-deductible, so the after-tax cost of debt is lower than 5%. That tax shield makes room for additional after-tax income to flow to the existing shareholders, boosting the post-deal EPS above the pre-deal level. That increased EPS is what makes the deal accretive. If there were no tax benefits, the result would be neutral; if the debt cost were higher than the target’s earnings yield, it would be dilutive. But with typical tax treatment, the after-tax debt cost is effectively lower, leading to accretion.

The concept being tested is accretion versus dilution in an acquisition when financing is debt-based. Here, paying 20x earnings means the target’s earnings yield is 5% (earnings = price/20). Financing the purchase entirely with debt at 5% interest sets a pre-tax cost of debt of 5%. If you ignore taxes, the target’s earnings would just cover the interest, giving roughly neutral post-deal earnings per share. However, interest is generally tax-deductible, so the after-tax cost of debt is lower than 5%. That tax shield makes room for additional after-tax income to flow to the existing shareholders, boosting the post-deal EPS above the pre-deal level. That increased EPS is what makes the deal accretive.

If there were no tax benefits, the result would be neutral; if the debt cost were higher than the target’s earnings yield, it would be dilutive. But with typical tax treatment, the after-tax debt cost is effectively lower, leading to accretion.