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Learn about rules of thumb you can use to determine whether an acquisition will be accretive or dilutive in advance, based on the P/E multiples of the buyer and seller, the % cash, stock, and debt used, and the prevailing interest rates on cash and debt.
By http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"

Here's an outline of what we cover in the lesson, and the step-by-step process you can follow to figure this out for yourself:

Why Do We Care About Rules of Thumb for M&A Deals / Merger Models?

It's a VERY common interview question - "How can you tell whether an M&A deal is accretive or dilutive?"

People often believe, incorrectly, that there's no way to tell without building the entire model.

But shortcuts always exist!

Plus, this shortcut is very useful in real life. You can use it to "sanity check" your model, approximate the impact of a deal in advance, and so on.

So it's a time-saver and a good way to check your work.

Rules of Thumb for Merger Models AKA Accretion / Dilution Models:

CONCEPT: An M&A deal is accretive if the combined company's EPS (Earnings Per Share) is higher than the buyer's standalone EPS prior to the transaction.

It's dilutive if the combined EPS is lower, and it's neutral if the EPS is the same afterward.

The outcome depends on price paid for the seller, the method of payment (cash, stock, or debt), the interest rate on debt and cash, and the buyer's P/E multiple, among other factors.

In real life, it's very difficult to tell with high precision whether the deal will be accretive or dilutive without running the whole model - due to added costs, synergies, write-ups, timing differences, the cumulative impact of additional interest on debt and foregone interest on cash, etc...

BUT you can approximate the impact with a simple rule of thumb:

1. Calculate the Weighted "Cost" of Acquisition for the Buyer...

2. And compare it to the Seller's "Yield" AT its purchase price. (i.e. Seller's Net Income / Equity Purchase Price)

This step is essential - if the seller is currently valued at $900 million and the buyer pays $1 billion for the seller, you NEED to use the $1 billion actually paid for the seller or these yields won't be correct.

3. If the Seller's "Yield" is higher, it's accretive - otherwise, if it's lower, it's dilutive...

Think of it as the buyer getting MORE from the seller than what it's paying for the seller, vs. getting LESS than what it's paying.

4. How do you calculate the Weighted "Cost" of Acquisition?

You need to calculate the after-tax "cost" of each component, since Net Income is also after-tax.

After-Tax Cost of Cash = Foregone Cash Interest Rate * (1 - Buyer's Tax Rate)

After-Tax Cost of Debt = Interest Rate on Debt * (1 - Buyer's Tax Rate)

After-Tax Cost of Issuing Stock = 1 / Buyer's P/E Multiple (i.e. take the reciprocal of the buyer's P/E multiple)

That last one is effectively the buyer's "after-tax yield"...

For example, if you buy 1 share of the buyer's stock, it's the Net Income you'd be entitled to with that 1 share...

So in this example, 1 / Buyer's P/E Multiple = 1 / 11.3 x = 8.9%.

That means that for each $1.00 of United stock you buy, you get $0.089 in Net Income.

Finally, you calculate the Weighted Average Itself with this formula:

Weighted Average Cost of Acquisition = Cost of Cash * % Cash Used + Cost of Stock * % Stock Used + Cost of Debt * % Debt Used

And if this weighted average cost of acquisition is greater than the seller's yield, it's dilutive - otherwise, if the weighted average cost of acquisition is lower than the seller's yield, it's accretive.

LIMITATIONS:

This trick doesn't hold up if the tax rates for the buyer and seller are different, especially if they're VERY different.

This also doesn't work if you also factor in write-ups / write-downs, synergies, the cumulative impact of interest paid on debt and foregone interest on cash, merger closing costs,
integration costs, etc...

And it also doesn't work if the acquisition closes mid-year or in between fiscal years - you need to adjust for that with stub periods and the calendarization of financials...

But this is a common interview question, so who cares! It's still very useful to know, and will save you a lot of time in interviews and on the job.