Why use debt in an LBO?
Larger PE funds and / or PE firms executing LBOs in non-cyclical industries with recurring cash flows aim for 20% IRR, which is a 2.5x multiple of capital over 5 years. 25% IRR is the threshold for LBOs in more cyclical industries with higher growth rates, such as growth equity investments. This is a 3x […]
Company A’s P/E is 10x, Company B’s P/E is 8x. If your cost of financing was 12%, would the transaction be accretive or dilutive?
Earnings yield of the target is the reciprocal of the P/E, or 1/8=12.5% 12.5% > 12%, earnings yield of target > cost of financing Therefore the deal is accretive.
If a large company acquires a smaller target company, in what situation would the P/E of the smaller target company be lower than the acquiror?
There are several reasons why the P/E ratio of the target company may be lower than that of the acquirer: Liquidity: The smaller target company may be less liquid than the larger acquiring company and have significantly less trading volume, making it harder to buy and sell the stock. Small Company Risk: As companies get […]
What is industry consolidation and why does it happen?
Industry consolidation is when smaller and more fragmented companies are being acquired by larger companies in the same industry. This often becomes a self reinforcing trend. As more and more small companies are acquired, there will be fewer and fewer left, leading to a scarcity effect where demand continues to rise as the supply of […]
If a company with a P/E of 10 acquires a company with a P/E of 12 with 50% debt and 50% equity, is it accretive or dilutive? The cost of debt is 10% and the tax rate is 40%.
Cost of equity of acquiror:1/10=10% Cost of acquisition capital:(50%)(10%)(1-40%)+(50%)(10%)= (5%)(60%)+(5%)= 3%+5%= 8% Earnings yield of the target:1/12=8.33% 8.33% > 8%, earnings yield of the target > cost of acquisition capitalTherefore the acquisition is accretive.
Why does an LBO produce a tax shield?
This is because interest expense is tax deductible. Any new debt raised to buy the company will result in more interest expense, which will reduce tax expense. Therefore, the true cost of debt is the after-tax of debt, which is equal to the pre-tax cost of debt x (1-tax rate).
Buyer has $100 share price, 3M S/O, $20M net income, 40% tax rate. Target has $18 share price, 500,000 S/O, $5M net income, 40% tax rate. Buyer purchases target with 25% debt and 75% equity at $20/share. Debt has interest rate of 8%. There are $900,000 in pre-tax synergies. What is the $ value and % of accretion/dilution?
Purchase Price of Target$20 share purchase pricex 500k shares outstanding$10,000k purchase price Interest Expense$10,000k purchase pricex 25% financed by debt$2,500k debtx 8% interest rate $400 pre-tax interest expensex 60% 1- tax rate$120 after-tax interest expense # of Shares Issued$10,000k purchase pricex 75% financed by debt$7,500k equity value÷ 100 share price of buyer75k shares issued Total […]
Company A has a P/E of 10x and Company B has a P/E of 12x. Company A’s cost of debt is 10%, its cost of cash interest is 1% and its tax rate is 40%. If Company A purchases Company B using 25% stock, 50% debt and 25% cash, is the deal accretive or dilutive?
Cost of Equity for Company A1÷ 10 P/E of Company A10% Weighted Average Cost of Capital (WACC)(% Equity)(Cost of Equity) + (% Debt)(Cost of Debt)(1-Tax Rate) + (% Cash)(Cost of Cash)(1-Tax Rate)= (25%)(10%) + (50%)(10%)(1-40%)+(25%)(1%)(1-40%)= 2.5%+(5%)(60%)+(0.25%)(60%)= 2.5%+3%+0.15%= 5.5%+0.15%= 5.65% Earnings Yield (Return) for Company B1÷ 12 P/E of Company B8.33% Since WACC of 5.65% < […]
Company A has a net income of $240, share price of $3 and has 160 shares outstanding. Company B has a net income of $300, share price of $4 and has 15 shares outstanding. If Company A purchases Company B in an all stock deal at a 25% premium, what is the % change in accretion or dilution?
Equity Value of Company B $4 share pricex 15 shares outstanding$60 equity valuex 1.25 (25% premium)$75 acquisition price # of Shares Issued to Buy Company B $75 equity value÷ $3 share price25 shares issued Total # of Shares Outstanding 160 common shares outstanding+ 25 shares issued185 total shares outstanding Combined Net Income and EPS $240 […]
Company E has an EBITDA of $300M and Company F has an EBITDA of $150M. Let’s say that Company E acquires Company F and realizes $50M in revenue synergies from additional unit sales and $100M from cost synergies. What is the pro forma EBITDA? Assume that the pro forma company has a gross margin of 60%.
If there are revenue synergies of $50M in additional unit sales, then this also suggests that these extra units sold will incur an additional cost. Since we know that the gross margin is 60%, we can assume that cost of goods sold can be calculated as $50M x 60% = $30M. Therefore, we are earning […]
