Introduction to Corporate Finance

21: Mergers, Acquisitions and Corporate Control

Compute post-merger EPS:

(Bidder net income + Target net income + After-tax synergies – Adjustment)/(Bidder shares outstanding

• New shares issued)
  = ($50 million + $15 million + $5 million – $2.83 million)/(10 million + 600,000) = $6.34.
  Given that the original Peanut Butter EPS is $5, management expects this merger to be accretive. Note
  that merger synergies are one important reason that this deal increases earnings. Using debt to finance part of
  the acquisition, instead of all shares, also increases EPS in this example, though as discussed next, this made
  the earnings riskier because they were levered up.

EPS Accretion

From Main Street to Wall Street, a common benchmark to measure the gains from a merger is how it

affects the acquiring company’s earnings per share (EPS). To measure this effect, you sum the earnings

of the two companies and divide by the sum of the two companies’ number of shares outstanding, plus a

few adjustments. If the EPS of the acquiring company goes down, the merger is said to dilute EPS (and,

implicitly, hurt share price), while if EPS increases, the deal is accretive to earnings. Sometimes analysts

implicitly assume that higher EPS necessarily leads to higher share price. But is it true that higher EPS

always leads to higher share price? For example, if EPS increases but earnings also become riskier, does

share price necessarily increase? Regardless of the answer to that question, managers of the bidding

company as well as Wall Street analysts place a great deal of importance on the effects of a merger on the

company’s earnings. The next section illustrates how to measure those effects.

21-2b CALCULATING THE EFFECT OF A MERGER ON

EARNINGS PER SHARE

The following example illustrates how to determine what EPS will be after a merger deal is closed. The

key inputs are earnings of bidder and target before the merger, shares outstanding before and new shares

issued to complete the merger, and some adjustments that capture merger-related incremental changes

to earnings, such as increases due to synergies. Given that earnings are earned over the year, most

analysts use a weighted average of shares outstanding over the year (though others may use year-end

shares outstanding). The basic calculation looks like this:

Post-merger EPS = (Bidder net income + Target net income + After-tax synergies

± Adjustments) ÷ (Bidder shares outstanding + New shares issued)

The adjustments are calculated as follows:

1 Subtract after-tax depreciation and amortisation from write-ups.

2 Subtract incremental after-tax interest expense associated with new debt financing.

3 Subtract lost opportunity cost of cash balances for cash that is used to finance the acquisition.

4 Add interest expense associated with target’s debt that is retired and preferred share dividends

associated with preferred shares that are liquidated or converted as part of the acquisition.

5 Adjustments are sometimes made for one-time acquisition-related charges, but we ignore those here.

In an all-equity deal, excluding

synergies and where the

acquirer’s price-to-equity

multiple exceeds the target’s

price-to-equity multiple, is the

deal accretive or dilutive to

earnings?

example

thinking cap

question