All-Cash Deals and Dilution, Explained

An all-cash deal can be dilutive even when the target's earnings yield exceeds the after-tax foregone interest rate if there are incremental non-cash charges from the acquisition that reduce pro forma net income by more than the net earnings added. The most common source is incremental depreciation and amortization from writing up the target's tangible and identifiable intangible assets to fair value in purchase price accounting.

For example: acquirer has $500 million of net income and 125 million shares, EPS = $4.00. Target has $60 million of net income, purchased for $1 billion in cash that was earning 2%. Foregone after-tax interest = $1B x 2% x (1 - 0.25) = $15 million. Combined pre-D&A net income = $500M + $60M - $15M = $545M. Shares unchanged at 125M, so pre-write-up EPS = $4.36, accretive.

But purchase price allocation identifies $150 million of intangible assets amortized over 15 years, adding $10 million of annual pre-tax D&A. After-tax D&A hit = $10M x 0.75 = $7.5 million. Pro forma net income falls to $537.5M, EPS = $4.30, still accretive.

To make it dilutive, increase the purchase price or the asset write-up: if the purchase price is $1.5 billion, foregone interest after-tax = $1.5B x 2% x 0.75 = $22.5M, combined NI before D&A = $500M + $60M - $22.5M = $537.5M. And if the write-up is larger, say, $400 million of intangibles amortized over 15 years = $26.7M annual D&A, after-tax $20M, then pro forma NI = $537.5M - $20M = $517.5M, EPS = $4.14, still above $4.00.

Push further: $2 billion purchase price, foregone interest after-tax = $2B x 2% x 0.75 = $30M, NI before D&A = $500M + $60M - $30M = $530M. Write-up of $600M intangibles over 15 years = $40M D&A, after-tax $30M, NI = $500M, EPS = $4.00, breakeven. Beyond that, dilutive. So the mechanism is: large asset write-ups create D&A charges that erode the net earnings pickup even when the cash financing cost is low.

This is why the simplistic 'earnings yield vs. cash yield' comparison is insufficient.

Follow-up pressure:

• If the write-up intangibles have indefinite useful lives and are tested for impairment rather than amortized, how does that change the accretion analysis?
• The target's net income includes $5 million of non-recurring gains. Do you remove them before calculating the earnings yield for your accretion test? Why or why not?
• How do you decide what portion of the purchase price to allocate to intangibles subject to amortization versus goodwill?