A client is considering an all-cash acquisition funded with debt. The target has a P/E of 18x, the acquirer has a P/E of 15x, and the interest rate on new debt is 5%. The tax rate is 25%. Is the deal accretive or dilutive? Assume no synergies.
A core M&A Advisory interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
First, calculate the earnings yield of the target: 1/18 = 5.56%. The after-tax cost of debt is 5% * (1-0.25) = 3.75%. Since the target's earnings yield (5.56%) exceeds the after-tax cost of debt (3.75%), the deal is accretive. The exact accretion can be calculated by comparing the EPS impact, but the rule of thumb is: if earnings yield > after-tax cost of debt, accretive.
WHAT INTERVIEWERS LISTEN FOR
- ✓Earnings yield of target = 1/PE
- ✓After-tax cost of debt = interest rate*(1-tax)
- ✓Compare earnings yield to after-tax cost of debt
- ✓No synergies assumed
COMMON MISTAKES
- ✗Using pre-tax cost of debt
- ✗Comparing P/E directly without conversion
- ✗Forgetting tax shield on interest
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