Case 072Accretion and dilutionHard
Amravi Foods buys Tanvik Beverages for cash funded by debt, and Rs 300 crore of the price is booked as intangibles amortised over ten years. Is the deal accretive on reported EPS, on cash EPS, and which should the board look at?
1The situation
Amravi Foods earns net income of Rs 400 crore on 100 crore shares, Rs 4.00 a share. It agrees to buy Tanvik Beverages, which earns Rs 60 crore, for Rs 900 crore in cash, 15x earnings. The whole price is funded with new debt at 8% before tax; Amravi's tax rate is 25%.
In the purchase price allocation, Rs 300 crore of the price is assigned to Tanvik's brands and customer relationships, to be amortised straight-line over 10 years. This amortisation is a book charge only: the deal is a share purchase, the tax base of the assets does not change, and a deferred tax liability of Rs 75 crore is set up against the intangibles and unwinds as they are amortised. Ignore synergies and transaction costs.
2Your task
Compute year-one EPS on a reported basis and on a cash basis, before and after the deal, and say which figure the board should weigh.
Quick check
The Rs 30 crore a year of amortisation is a book charge with no cash and no tax deduction. How much does it reduce reported net income?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
On cash earnings the deal is accretive, EPS Rs 4.060 against Rs 4.00, up 1.5%; on reported earnings it is dilutive, Rs 3.835, down 4.1%. Tanvik adds Rs 60 crore, after-tax interest takes Rs 54 crore, and after-tax amortisation of Rs 22.5 crore then pulls reported profit below standalone. The board should weigh cash EPS, because the amortisation is the price being written off, not a cost of running the business, but it must also expect the reported line to be questioned for ten years.
Step 1What does the deal do to earnings before any accounting?
Think of buying a second taxi with a bank loan. The question is whether the fares it earns beat the loan interest; how your accountant depreciates the taxi changes your tax return, not your bank balance. Tanvik earns Rs 60 crore, a yield of 6.67% on the Rs 900 crore price, and the debt costs 6.0% after tax, Rs 54 crore, so cash earnings rise by Rs 6 crore. That is the whole economic test of a debt-funded cash deal: earnings yield against after-tax cost of debt. Amravi would have broken even on cash EPS at a price of Rs 1,000 crore, where Rs 60 crore of earnings equals 6.0% of the price; at Rs 900 crore it is paying 15x, inside that line.
Step 2How does purchase accounting turn that into a dilutive deal?
When Amravi consolidates Tanvik it must allocate the Rs 900 crore price across what it bought. Rs 300 crore lands on brands and customer relationships with a 10-year life, so Rs 30 crore a year is charged against profit. Because the tax authority does not recognise the step-up, the charge gets no cash tax relief; instead the deferred tax liability of Rs 75 crore set up at completion unwinds through the tax line, so the after-tax hit to reported profit is Rs 22.5 crore. Reported net income is Rs 383.5 crore, Rs 3.835 a share, 4.1% below standalone, while cash earnings are Rs 406 crore, Rs 4.060 a share, 1.5% above. Same deal, same cash, two verdicts.
| Rs crore | Standalone | Cash basis | Reported basis |
|---|---|---|---|
| Amravi net income | 400 | 400 | 400 |
| Tanvik net income | 60 | 60 | |
| Interest, 8% on 900, after 25% tax | -54 | -54 | |
| Amortisation, 30 a year, after deferred tax unwind | -22.5 | ||
| Net income | 400 | 406 | 383.5 |
| Shares, crore | 100 | 100 | 100 |
| EPS, Rs | 4.00 | 4.060 (+1.5%) | 3.835 (-4.1%) |
Step 3Which line should the board look at?
Cash EPS, with eyes open about the reported line. The amortisation is the purchase price being written off over ten years: Rs 225 crore after tax in total, which is simply part of the Rs 900 crore Amravi has already paid. Charging it again against earnings double counts the price. The test of the deal is whether Tanvik's cash earnings beat the cost of the money used to buy it, and they do, by Rs 6 crore a year. Most acquisitive companies report an adjusted EPS that adds back acquired-intangible amortisation for exactly this reason, and analysts value them on it.
Two cautions keep the answer honest. First, the size of the charge is a valuation judgement, not a fact: had the valuers put Rs 100 crore on intangibles and the rest in goodwill, which is not amortised, reported EPS would be Rs 3.985; at Rs 500 crore it would be Rs 3.685. A number that swings with an appraiser's allocation is a poor test of a deal. Second, the cash view is only as good as the earnings: Tanvik's Rs 60 crore has to hold up, and a brand that needs reinvestment to stay a brand has a real cost the amortisation is crudely standing in for. The board should ask for cash EPS, the earnings yield against the cost of debt, and the leverage the Rs 900 crore of new debt adds, in that order.
Where candidates lose it
Candidates compute reported EPS, see -4.1%, and call the deal dilutive. The right answer separates the cash economics, which are accretive, from a book charge that writes off a price already paid.
The second slip is taking the full Rs 30 crore off net income. The deferred tax liability set up on the intangibles unwinds alongside the amortisation, so the after-tax charge is Rs 22.5 crore, and the gap between cash and reported EPS is Rs 0.225 a share, not Rs 0.30.
What the interviewer asks next
- If Amravi paid in shares at a P/E of 20x instead of cash, would the deal be accretive on either basis?
- The deal was an asset purchase and the amortisation is tax deductible. How do cash and reported EPS change?
- What leverage does the Rs 900 crore of new debt add if Amravi's EBITDA is Rs 700 crore, and does that change the verdict?
Company names and figures are illustrative.