Case 089Accretion and dilutionCore

A paint company earning Rs 250 crore on 50 crore shares wants to buy a coatings firm earning Rs 40 crore, all in cash borrowed at 8% before tax, with Rs 10 crore of pre-tax synergies. What is the highest price it can pay without diluting EPS?

The situation

Jalvik Paints earns Rs 250 crore after tax and has 50 crore shares, so EPS is Rs 5.00. It wants to buy Ornav Coatings, an industrial coatings maker with no debt that earns Rs 40 crore after tax.

Jalvik will pay entirely in cash, all of it borrowed at 8% before tax. Tax is 25%. The deal team expects Rs 10 crore a year of pre-tax cost synergies from shared purchasing and distribution.

Your task

Find the maximum price that keeps Jalvik's EPS at Rs 5.00, with and without synergies, and say whether paying that price is a good idea.

Quick check

Without synergies, what is the most Jalvik can pay before EPS falls?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Jalvik can pay up to about Rs 792 crore, 19.8x Ornav's earnings, before EPS falls. Debt costs 6.0% after tax, and Ornav brings Rs 40 crore plus Rs 7.5 crore of after-tax synergies. Without synergies the ceiling is about Rs 667 crore. EPS-neutral is not value-neutral: paying the ceiling hands every rupee of synergy to Ornav's owners.

Step 1What is the shortcut for the break-even price?

Ask how much debt the target's earnings can service. EPS is unchanged when the after-tax interest on the purchase price equals the after-tax earnings the target brings, so the break-even price is earnings divided by the after-tax cost of debt. A landlord who borrows at 6% after tax to buy a flat earning Rs 40,000 a year in rent breaks even at a price of Rs 6.7 lakh; pay more, and the rent no longer covers the interest. Here: (40 + 7.5) / 0.06 is about Rs 792 crore.

The relationship
250+40+7.5−0.06P50=5.00⇒P=47.50.06≈792\frac{250 + 40 + 7.5 - 0.06P}{50} = 5.00 \quad\Rightarrow\quad P = \frac{47.5}{0.06} \approx 792
250Jalvik's own earnings
40Ornav's earnings
7.5Rs 10 crore of synergies after 25% tax
0.06Pafter-tax interest on a price of P at 8% x (1 - 25%)
What it says in wordsEPS stays at Rs 5.00 when the earnings bought, synergies included, exactly pay the after-tax interest on the price.
Step 2How quickly does EPS move away from the break-even?

Every extra Rs 100 crore of price adds Rs 6 crore of after-tax interest, 2.4% of Jalvik's earnings. So the line is straight: at Rs 700 crore the deal is 2.2% accretive with synergies, and at Rs 900 crore it is -2.6% dilutive. Without synergies the whole line shifts down by Rs 7.5 crore of earnings, 3.0% of EPS, and crosses zero at Rs 667 crore.

EPS change against the price Jalvik pays, all debt funded-10%-5%+5%+10%0%4005006007008009001000Price paid for Ornav, Rs croreRs 792 crore: break even with synergiesRs 667 crore: withoutwith Rs 7.5 crore after-tax synergiesno synergies
With synergies Jalvik's EPS is unchanged at a price of about Rs 792 crore, 19.8x Ornav's earnings; without them the break-even falls to about Rs 667 crore, 16.7x.
Step 3Should Jalvik pay the break-even price?

No, and saying why is where the marks are. Accretion compares the target's earnings yield with the after-tax cost of debt, 6%, which is far below what equity investors demand, so almost any cash deal looks accretive at a reasonable price. Value is a different test. If Ornav and its synergies are worth, say, 15x their combined Rs 47.5 crore of earnings, Rs 712 crore, then paying Rs 792 crore is EPS-neutral but gives away about Rs 79 crore. The 15x is an illustrative assumption; the point is that the ceiling from accretion and the ceiling from value are set by different costs of capital.

Close with the limits of the model. The new debt also raises Jalvik's leverage and its risk, which should raise its cost of equity; a deal that adds earnings but makes every rupee of them riskier can lower the share price. And synergies are a plan, not a fact, so a negotiator usually bids nearer the no-synergy ceiling and keeps the synergies for Jalvik's own shareholders.

Where candidates lose it

The common slip is using the pre-tax rate: 40 / 0.08 gives Rs 500 crore. Interest is tax deductible, so each rupee of interest costs Jalvik only 75 paise of earnings.

The second is treating the break-even price as a fair price. EPS-neutral means only that this year's accounting earnings per share are unchanged; it says nothing about whether the deal earns its cost of capital.

What the interviewer asks next

  • Jalvik pays half in shares at a P/E of 25. What is the break-even price now?
  • Purchase accounting creates Rs 15 crore a year of new amortisation. How does that change the ceiling?
  • At what pre-tax interest rate would a Rs 700 crore price be exactly EPS-neutral without synergies?

Company names and figures are illustrative.