Accretion Or Dilution: What A Raise Does To Earnings

Accretion and dilution compare earnings per share after a transaction with earnings per share before it. The answer is decided by one comparison: what the money buys, measured as earnings on the price paid, against what the money costs after tax. Buy at a higher yield than the funding costs and earnings per share rises; buy at a lower one and it falls.

The fields above arrive filled with the funding actually used by Harivansh Packaging Limited, an invented maker of packaging, and that setting is the worked example the rest of this guide follows. Combined earnings of Rs 218.50 crore over a combined 18.00 crore shares is Rs 12.1389/-, shown as Rs 12.14/-, against Rs 12.50/- before. The move from Rs 12.50/- to Rs 12.14/- is a dilution of 2.89 per cent, reported as 2.9 per cent everywhere the second decimal is not doing any work.

What do accretion and dilution actually measure?

The mechanism is easiest to see in a domestic setting. Suppose a household of four people lives on one salary of Rs 80,000/- a month, so each person has Rs 20,000/- of it. A fifth person moves in and brings a job paying Rs 15,000/-. The household is richer by Rs 15,000/- and the per person figure has fallen to Rs 19,000/-. Nobody is worse off. The total went up and the way it is divided changed, and those are two different facts about the same month.

AccretionA rise in earnings per share after a transaction compared with the figure before it. Nothing more than that one line moving up. and dilutionA fall in earnings per share after a transaction compared with the figure before it. A fall does not mean value was destroyed, only that the per share figure went down. are that same arithmetic, applied to one line of one statement. Earnings per share is profit after tax divided by the share count. A transaction can move the numerator, the denominator, or both. Accretion means the figure afterwards is higher than the figure before. Dilution means it is lower. The comparison of one figure with the other is the whole definition, and neither word carries a verdict inside it.

Harivansh Packaging Limited earns profit after tax of Rs 225 crore on 18.00 crore shares, so its earnings per share is Rs 12.50/-. Devyani Kulkarni, its chief financial officer, is looking at a purchase and at three ways of paying for it. The test tells her whether Rs 12.50/- becomes something larger or something smaller, and nothing else at all.

The figure that comes out of the test is called pro forma earningsEarnings restated as though the transaction had already happened at the start of the period, so the before and after figures sit on the same basis.. Pro forma earnings are a comparison device: not a forecast, not audited, and not a description of any year that has occurred.

How is the test run, step by step?

Harivansh Packaging Limited is buying 100 per cent of Sundarban Polymers Private Limited. The enterprise value agreed is Rs 1,320 crore. Taking off the target's net debt of Rs 180 crore leaves an equity value of Rs 1,140 crore reaching the sellers. The bridge from enterprise value to equity value is covered separately, and its output is used below without rebuilding it: the amount the test charges funding against is the Rs 1,140 crore actually paid, never the Rs 1,320 crore enterprise value.

Sundarban Polymers earns Rs 98 crore of earnings before interest and tax (EBIT). On its own borrowings, at a contracted rateThe rate written into a specific facility agreement for a specific borrower. The rate is that agreement's own number and says nothing about rates generally. of 9.0 per cent on Rs 180 crore, its finance cost is Rs 16.2 crore, so profit before tax is Rs 81.8 crore. At an effective tax rateTax charged divided by profit before tax, taken from the tax note rather than from any statute. of 25.0 per cent that is Rs 61.35 crore of profit after tax. The record for this transaction locks the rounded figure of Rs 61 crore, and that figure is used throughout. On the exact Rs 61.35 crore the chain below lands at Rs 12.16/- and a dilution of 2.7 per cent instead of Rs 12.14/- and 2.9 per cent. The transaction is dilutive on either figure, so the rounding moves the headline and not the lesson.

1. Take the earnings the purchase bringsSundarban Polymers contributes Rs 61 crore of profit after tax, already struck after its own finance cost and its own tax.
2. Take the after-tax cost of the money that paid for itRs 1,000 crore of new borrowing at the contracted 9.0 per cent is Rs 90 crore of interest, which at 25.0 per cent tax costs Rs 67.5 crore after tax.
3. Net the two into profit after taxRs 225 crore plus Rs 61 crore less Rs 67.5 crore is Rs 218.5 crore.
4. Divide by the share count afterwardsRs 218.5 crore over an unchanged 18.00 crore shares is Rs 12.1389/-, shown as Rs 12.14/-.

Step four is where the funding route enters, and it is the reason one purchase can produce several different answers. If the money had come from issuing shares, step two would have been nil and step four would have carried a larger denominator. Nothing about Sundarban Polymers would have changed. The steps look like a description of the target and they are mostly a description of the cheque.

Why does one purchase give three different answers?

Harivansh Packaging Limited had three routes available, all sized at the same Rs 1,140 crore and all buying the same Sundarban Polymers Private Limited. Only the funding mixThe split of a purchase price between borrowed money, cash already held and newly issued shares. differs. The target, the price and the earnings are held identical across all three, so every difference in the three answers below is the funding and nothing else.

Route one dilutes by 2.9 per cent. Route two accretes by 4.0 per cent. Route three dilutes by 4.67 per cent. The spread between the best and the worst of them is Rs 1.08/- per share, or 8.67 per cent of the opening figure. Every paisa of the spread was produced inside the treasury department. Ashwin Rege, who leads the transaction team at Harivansh Packaging, can present any of the three as the answer, and each one is arithmetically correct.

What is the yield against cost rule?

The sign of the answer can be had before any of the arithmetic above is done. The purchase buys an earnings yieldEarnings expressed as a percentage of the price paid for them. The inverse of a price to earnings multiple.: Rs 61 crore of earnings for Rs 1,140 crore of price is 5.3509 per cent. The money used to buy it carries an after-tax cost of fundingWhat the money costs the profit statement each year after tax relief on any interest, expressed as a percentage of the amount raised.. If the yield is above the cost, earnings per share rises; if it is below, earnings per share falls, and this holds before a single earnings figure has been computed.

Debt costs interest after tax relief. Rs 1,000 crore at 9.0 per cent is Rs 90 crore, and at a 25.0 per cent effective rate the profit statement feels Rs 67.5 crore. Equity looks free because no interest is paid, but it is not. Issuing 4.00 crore shares at Rs 285/- hands new holders a claim on Rs 12.50/- of earnings each. The claim given away is Rs 50 crore a year. Expressed on the Rs 1,140 crore raised, that is 4.3860 per cent. The rights issue at Rs 190/- gives away Rs 12.50/- on each of 6.00 crore shares. The claim given away is Rs 75 crore, or 6.5789 per cent on the same Rs 1,140 crore.

Put the four numbers on one scale and every sign is settled before a single earnings figure is computed. The placement sits below the yield and accretes. The locked borrowing route and the rights issue both sit above the yield and dilute. The arithmetic afterwards only fixes the size of each move.

The same scale answers the question raised at the start. Sundarban Polymers was bought at 10.0 times its EBITDA while Harivansh Packaging Limited itself trades at 12.58 times, on an illustrative share price of Rs 300/- at the record date for this transaction, so the target looks cheaper by 2.58 turns. The multiple comparison and the funding cost answer two different questions, so a purchase at a lower multiple than the buyer can still dilute. The multiple comparison asks what the two businesses are priced at. The accretion test asks what the earnings bought are worth against what the cheque costs. Nothing forces those to agree, and on the funding actually used they do not.

Why must the yield and the cost sit on the same amount?

Here is the discipline that makes the rule reconcile, and it is the part most treatments never make explicit. The yield and the cost must be struck on the same amount of money, or the spread will give the right sign and the wrong size. The yield is Rs 61 crore over Rs 1,140 crore. So the cost has to be the total annual after-tax charge, whatever its shape, also divided by Rs 1,140 crore.

On route one the after-tax interest is Rs 67.5 crore. Divide that by the full Rs 1,140 crore and the cost is 5.9211 per cent. Rs 140 crore of the price came from cash already held by Harivansh Packaging Limited, and cash carries no charge in the profit statement. The 5.9211 per cent is therefore neither the 9.0 per cent contracted rate nor the 6.75 per cent after-tax rate on the borrowed portion. The Rs 67.5 crore has to spread across the whole price, and spreading a fixed charge over a larger base gives a lower percentage.

Now watch the spread reconcile. 5.3509 per cent less 5.9211 per cent is minus 0.5702 points. On Rs 1,140 crore that is minus Rs 6.50 crore. And 18.00 crore shares multiplied by the Rs 0.3611/- fall in earnings per share is also minus Rs 6.50 crore. Exact, to the paisa. The same check closes on route two, where plus 0.9649 points is plus Rs 11.00 crore against 22.00 crore shares times a Rs 0.50/- gain, and on route three, where minus 1.2281 points is minus Rs 14.00 crore against 24.00 crore shares times a Rs 0.5833/- fall.

Compare that with the version a reader meets more often. Take the 5.3509 per cent yield struck on Rs 1,140 crore and set it against the 6.75 per cent after-tax rate struck on the Rs 1,000 crore borrowed alone. The sign is still right, and it is dilutive. But the spread of minus 1.3991 points applied to Rs 1,140 crore implies a fall of Rs 15.95 crore, against an actual fall of Rs 6.50 crore. The implied fall is out by a factor of nearly two and a half and ties to nothing in the worked example, so a reader who checks finds two figures that do not meet and no way of telling which to trust.

How much borrowing has to become equity to change the sign?

The distance from the accretion figure to the place where the sign flips is far more useful than the figure itself. The distance tells Devyani Kulkarni how much room the structure has before the answer changes character. The funding mix at that place is the crossover pointThe funding mix at which earnings per share after the transaction lands exactly on the figure before it, so the result is neither accretive nor dilutive..

Solve it rather than guess it. Let the amount raised as shares out of the Rs 1,000 crore be some figure. Every rupee raised that way removes 6.75 paise of after-tax interest and adds one share for every Rs 285/- raised. Each of those shares carries Rs 12.50/- of the opening earnings, or 4.38596 paise per rupee raised. The gain per rupee is therefore 6.75 less 4.38596, or 2.36404 paise, and the gap to close is the Rs 6.50 crore shortfall computed above. Rs 6.50 crore divided by 2.36404 paise per rupee gives Rs 274.95 crore.

Rounded to Rs 275 crore, borrowing falls to Rs 725 crore, after-tax interest to Rs 48.94 crore, profit after tax to Rs 237.06 crore, and the share count rises to 18.96 crore. Dividing gives Rs 12.50/- to the paisa. So 27.5 per cent of the borrowing is the entire distance between a 2.9 per cent dilution and no change at all. The journey is much shorter than the headline suggests. Knowing that is worth more than knowing the dilution figure, because it says what would have to move, and by how much, before the sentence in the note changes.

Why is accretion not the same thing as a good decision?

The accretion test has no term in it for risk, for leverage, for what the money would otherwise have done, or for whether the acquired earnings persist, so an accretive answer is not evidence that a transaction was worth doing. Consider a household again. Borrowing against the house to buy a shop that earns more than the loan costs raises the monthly income of that household. The borrowing also pledges the house. The income statement improves and the exposure changes, and only one of those two facts appears in the monthly income figure.

Look at what the three routes did to the balance sheet of Harivansh Packaging Limited alongside what they did to earnings. Route one takes borrowings from Rs 740 crore to Rs 1,740 crore and cash to nil, so net debt on the acquirer's own books is Rs 1,740 crore. Net debt of that size is 3.65 times the acquirer's own EBITDA of Rs 477 crore, against 1.26 times before. A consolidated basis also carries the Rs 180 crore of net debt that Sundarban Polymers Private Limited brings across on a 100 per cent purchase. Consolidated net debt is Rs 1,920 crore over combined EBITDA of Rs 609 crore, or 3.15 times. Routes two and three leave the acquirer's own net debt at Rs 600 crore and 1.26 times, unchanged.

Set route one against route three and the point is unavoidable: route one produces the better earnings figure while carrying 2.9 times the net debt. Meanwhile route two produces the best earnings figure of all and leaves leverage exactly where it was, so the two rankings are not merely different, they are unrelated. The test cannot see the difference because leverage is not one of its inputs.

What does the test assume, and therefore hide?

Four assumptions sit under every accretion figure ever printed. Each one is checkable by a reader who thinks to ask, and each one can move the answer further than the funding route does.

The first is that the acquired earnings arrive intact. The Rs 61 crore that Sundarban Polymers earned last year is assumed to keep being earned under new holding, at the same margin, with the same customers. Since Sundarban Polymers sells to some of the same customers as Harivansh Packaging Limited, a buyer concentrating two suppliers into one may find a customer moving volume elsewhere, and the whole test was built on that Rs 61 crore staying put.

The second is that nothing is spent to get them. No integration cost, no retention payment, no systems work, no advisory fee sits anywhere in the four steps. The third is that the funding costs its contracted rate for the whole period. The facility agreement fixes that rate for as long as it fixes it and no longer. The fourth is that the share count is the only thing the raise changed. The assumption ignores any instrument that might convert later and any share issued to sellers as part of the consideration.

How does a transaction team actually use this?

Ashwin Rege does not run this test once. He runs it across every funding route under consideration, prints all of them on a single sheet, and puts the leverage outcome in the column beside the earnings outcome so nobody can read one without the other. The single accretion figure answers a question nobody asked, so the output a transaction team actually uses is the table of routes and the crossover.

A lender reads the same arithmetic backwards. A borrower's earnings per share is not what services a facility. The lender reads the Rs 1,740 crore and the 3.65 times rather than the Rs 12.14/-. An analyst covering Harivansh Packaging Limited reads it a third way, checking whether the earnings figure quoted in a note reconciles to a funding structure that has actually been arranged, or to one that has merely been assumed. And a person holding shares reads it a fourth way. A placement at Rs 285/- issues shares to somebody else, and a rights issue at Rs 190/- offers them first to the people already there. The question there is who ends up holding the business, not the earnings line at all.

The practical discipline is short. Name the base of every yield and every cost in the same sentence as the figure. A spread that does not tie is a signal that one of the two numbers is struck on the wrong amount, so show the spread reconciling to the movement in rupees. Print the crossover. And write the leverage sentence next to the earnings sentence every single time.

The calculator above runs that discipline. Every field carries the document its figure is read off, both reconciliations close on screen, the crossover is solved rather than guessed, and the leverage outcome sits beside the earnings outcome so that neither can be read on its own.

Where does an accretion figure appear in public?

Once Harivansh Packaging Limited says anything about this transaction outside its own rooms, the figure stops being a working number and becomes a statement made to a market. The Securities and Exchange Board of India (SEBI) sets out what may be said, when, to whom, and what has to accompany it, and the allotment and resolution machinery behind any new shares sits with the Ministry of Corporate Affairs.