Company A has a P/E of 10x and Company B has a P/E of 12x. Company A’s cost of debt is 10%, its cost of cash interest is 1% and its tax rate is 40%. If Company A purchases Company B using 25% stock, 50% debt and 25% cash, is the deal accretive or dilutive?

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.