Debt vs Equity Financing for Acquisitions: An EPS Analysis

Debt vs Equity: Which is better for EPS after an Acquisition?

This example breaks down how debt financing and equity financing affect Earnings Per Share (EPS) when a company is acquiring another. Let's analyze the case of 'Big Fast Company' acquiring 'Tiny Corporation.'

Scenario:

• Big Fast Company is acquiring Tiny Corporation.
• Combined entity's projected EBIT: $66 million
• Corporate tax rate: 35%

Financing Options:

1. Debt Financing:
   • Requires an annual interest payment of $8.125 million.
2. Equity Financing:
   • Requires issuing 7.5 million new shares.
   • Total outstanding shares after issuance: 22.5 million

Let's calculate the EPS for both scenarios:

Debt Financing:

1. EBIT - Interest = Earnings Before Tax (EBT) $66 million - $8.125 million = $57.875 million

2. EBT * (1 - Tax Rate) = Net Income $57.875 million * (1 - 0.35) = $37.61875 million

3. Net Income / Number of Shares Outstanding = EPS $37.61875 million / 15 million shares = $2.51

Equity Financing:

1. EBIT * (1 - Tax Rate) = Net Income $66 million * (1 - 0.35) = $42.9 million

2. Net Income / Number of Shares Outstanding = EPS $42.9 million / 22.5 million shares = $1.91

Conclusion:

Debt financing results in a higher EPS of $2.51 compared to $1.91 for equity financing. In this scenario, debt financing appears more favorable for enhancing EPS.

Important Considerations:

While this example highlights the potential for debt to increase EPS, it's crucial to consider:

• Risk: Debt increases a company's financial leverage and risk. High debt levels can make a company vulnerable, especially during economic downturns.
• Long-term Impact: This analysis focuses on a single period. Long-term projections considering factors like principal repayments and potential changes in interest rates are crucial for a comprehensive evaluation.
• Other Factors: This analysis solely focuses on EPS. Other factors, such as control dilution (in the case of equity financing) and the company's overall capital structure, are vital when making financing decisions.