Accretion primarily means gradual or incremental growth. However, with respect to finance, it has the following technical meaning
- Bond Markets – Accretion refers to the change in the price of a bond bought at a discount price to the par value of the bond or the capital gains a bondholder receives when buy/sell of bond happens, the gain/loss. In other terms, it can be described as the amortization of the bond. Amortization is the depreciation of any intangible assetIntangible AssetIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. . It means the increase or decrease in the price of bond during a transaction, also referred to as amortization.
- Mergers and acquisitions – In the context of M&A, accretion is referred to as the increase in the company’s earnings posts the transaction. For example, if the company has an EPS of 1$ and after acquiring the EPS rose to 1.30$, then the acquisition would be referred to like 30% accretive. In accounting terms, accretion expense is expense created when the present value (PV) of financial instruments is updated. Accretion in corporate finance is the actual value created in a particular transaction. The deal will always be accretive if the acquirer’s PE ratioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. is greater than the PE ratio of the target, including the acquisition premiumAcquisition PremiumAcquisition premium is the excess amount paid by the acquirer over the actual value of the target firm to close the deal during a corporate takeover. It is the difference between the purchase consideration and the target company's pre-merger value..
Accretion in Bond Market
- In bond markets, as interest rate increases, the value of live bonds declines in value as they would have promised a lesser interest rate than prevailing. It depletes its demand, and value decreases. As all bonds will mature at face amount only, the gain due to discounted purchase of the bond is accretion.
- Compound Accreted Value (CAV) comes into the picture when dealing with zero-coupon bonds as these bonds will not have coupon payments as traditional bonds. CAV is arrived by adding all the interest earned up to a given point in time to the original price of the bond.
Accretion in Bond Market Example
In the bonds market, it is calculated using the following formula –
The negative value is dilution, while the positive value determines the accretion.
When an investor purchases a bond at a discount, the discount must be accreted over the full life of the bond until its maturity. It comprises adjusting the cost basisCost BasisCost basis is the valuation of assets at their original or at-cost price inclusive of incidental expenses determined after making relevant adjustments for dividends, stock splits and distribution of return on capital. It facilitates the taxation of assets. (paid the price) of the bond at par for each year the bond is being held. It, in turn, increased both cost and reported net income of the bond.
Consider an investor who has bought a bond at 80$ whose maturity is 10 years and par is 100$. Investor’s accretion, in this case, would be (20/10=2) 2$. His reported net income would be 5$(interest) +2$ (accretion) = 7$.
Accretion in Mergers and Acquisitions
Accretive deals can occur if the assets are acquired at a discount to their previous market value. In general accretive investments refer to any security that is purchased at a discount.
Accretion and dilution are used to test the impact of an acquisition or mergerMergerA merger is a voluntary fusion of two existing entities equal in size, operations, and customers deciding to amalgamate to form a new entity, expand its reach into new territories, lower operational costs, increase revenues, and earn greater control over market share. on the acquirer firm’s earning per share (EPS). It helps the buyer firm study the effect of the merger on the firm in terms of profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. consequences comprising all factors and complexities. The synergy of the merger can be depicted doing such analysis.
- Post deal EPS > Buyer EPS —>Accretion
- Post deal EPS < Buyer EPS —>Dilution
- Post deal EPS = Buyer EPS —>Breakeven
The Consensus EPS is one that is obtained post the merger, and this is used to determine the accretion or dilution. This analysis is thus helpful in understanding the consequences of the merger. Usually, a merger is preceded by thorough due diligence of the target firm. In some cases, the target firm will also conduct due diligence in the buyer firm. During the same period before finalizing the merger, the accretion dilution analysis is performed to study the consequences.
If the merger is resulting in dilution, the buyer firm will think twice to go ahead with a merger or other means to compensate for the decrease in overall EPS in the future.
Overall it is a crucial factor while a buyer is planning on a merger or accounting terms while factoring for the tax amount. It also helps to determine the rationale behind the combining two companies, if the dilution is too high, then the acquirer will probably not go ahead with the transaction, or if the accretion is too high, the buyer may go one step forward or increase the bid to close the deal and benefit from the synergy of a merger.
This article has been a guide to accretion and its meaning/definition. Here we discuss accretion in Bond Markets and Mergers and Acquisitions along with examples. You can learn more about Investment Banking from the following articles –