Merger Modelling: The Accretion/Dilution Analysis

Merger modeling requires creating many sub-models which enable decision making. The accretion/dilution analysis is one such sub-model. It is one of the most sought after skills in junior investment bankers who have commonly entrusted the task of creating financial models in major investment banking firms.

In this article, we will have a closer look at what an accretion/dilution model is and how it is used to enable decision making.

What is an Accretion/Dilution Model?

In simple words, an accretion/dilution model measures the effect of the acquisition on the earnings per share of the acquiring company. This means that if the acquiring company had an EPS of $1 prior to the merger and has a proposed EPS of $1.25 after the merger, the merger is said to be accretive. On the other hand, if the EPS of the acquired entity reduces to $0.75, then the merger is said to be dilutive.

The strange thing about the accretive/dilutive model is that it focuses on the short term earnings. Firstly, it is a known fact that investment bankers do not place much trust in the earnings of any company. Instead, they focus on cash flow. Hence, many investors have started focusing their attention towards the cash EPS number instead of book EPS while taking into account the accretive or dilutive effect of the merger.

Also, the EPS is a short term measure, whereas investment bankers are generally focused on the long term value creation potential of any company.

However, it seems like the earnings of a company are under a lot of immediate scrutiny after a merger. Hence, an increasing EPS number makes for good PR and increases investor confidence. This is why a lot of emphases is laid down on the accretion/dilution model during the decision making phase.

Many companies are known only to pursue mergers which are found to be accretive. However, it is important to know that accretion or dilution do not have much impact on the long term value creation. Therefore, using the accretion/dilution analysis as a proxy for shareholder wealth creation may not be an accurate thing to do.

How Sources of Funding Affect Accretion and Dilution?

Acquisition transactions can be financed in many ways. For instance, there could be an all-stock deal. Alternatively, there could also be an all-cash deal. However, in most cases, part of the consideration is paid in cash, whereas the other part is paid in stock.

An accretion/dilution analysis taken into account the funding pattern as well while calculating the effect of the merger.

• In case of an all-stock merger, the financial modeler has a tough task trying to figure out the number of shares of the new entity which will be left outstanding once the merger has taken place. The total earnings of the firm are projected in the combined financial statements. However, these earnings get divided into the number of shares outstanding. This denominator has to be derived based on a number of factors. Typically a number of scenarios are considered.

  For instance, what would be the effect of the merger, if two shares of the existing entity are swapped for one of the new ones? Similarly, the effect of a one-to-one merger will also be one scenario. Based on this analysis, the firm determines the highest compensation that it can provide to the other party without diluting its own earnings or cash flow per share.

• Similarly, in case of an all-cash merger, the company has to take into account increased interest expenses.

  Even if the company has cash lying on its balance sheet, it will have to forego the interest being earned on that cash. That loss also needs to be accounted for. In this case, the denominator i.e., the number of shares outstanding, will not change. However, the numerator i.e., the earnings to be apportioned amongst the shares will change because the effects of interest expenses also have to be taken into account.

• Financial modeler has to consider the various purchase prices which are possible during the merger process.

  For each purchase price, the amount of debt after the transaction has to be derived. Then the expense related to this debt needs to be worked out, and the income statement needs to be adjusted accordingly.

  Just like in the above case, the financial modeler can use the accretion/dilution analysis to predict the maximum amount that can be offered to the counterparty without diluting its own EPS.

• Lastly, transactions are commonly funded using a mixture of debt as well as equity. From a financial modeling point of view, these transactions are exceptionally difficult to model. This is because, in such cases, both the numerator and the denominator of the transaction change. This adds a lot of complexity to the situation.

  The financial modeler needs to create a model which helps decision-makers figure out the best debt to equity mix. These transactions are difficult to model since the cost of debt is not linear, it keeps on increasing as the firm adds more and more debt, and the transactions become risky.

The bottom line is that the accretion/dilution analysis has limited use when a longer time period is considered. However, it is widely used in analyzing the short term impact of the merger.