Cost of Equity for Company A
1
÷ 10 P/E of Company A
10%
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 B
1
÷ 12 P/E of Company B
8.33%
Since WACC of 5.65% < Earnings Yield for Company B of 8.33%, we are buying a higher return with a lower cost of capital; therefore the deal is accretive.
