6.6 Restructuring Financial Effects: EPS, Net Debt to EBITDA, WACC & Divestitures

6.6 Restructuring Financial Effects: EPS, Net Debt to EBITDA, WACC & Divestitures

How this fits: section 6.5 covered the types of corporate restructuring, the motivations, the initial evaluation, and the valuation methods. This section covers the remaining learning outcomes: demonstrating how restructurings affect an issuer's earnings per share, net-debt-to-EBITDA ratio, and weighted average cost of capital, and evaluating divestment, cost, and balance sheet restructurings.

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1. Effect on Earnings Per Share

The P/E rule

For a stock-funded acquisition, the arithmetic reduces to a single comparison:

The deal is accretive to the acquirer's EPS when the acquirer's P/E is higher than the effective P/E paid for the target, and dilutive when it is lower.

The intuition is that the acquirer is issuing a currency worth $1/(E/P)$ of earnings per unit of price. Paying a lower multiple than the currency is worth buys more earnings than it costs in dilution.

Worked example. Acquirer trades at 30.00 with EPS of 2.00 (P/E 15.0) and 100m shares, so net income is 200m. Target has net income of 40m, and the acquirer offers 600m in stock.

• Effective P/E paid: $600/40 = 15.0$ — identical to the acquirer's own multiple
• Shares issued: $600\text{m} / 30.00 = 20\text{m}$; total shares $= 120\text{m}$
• Combined net income (no synergies): $200 + 40 = 240\text{m}$
• New EPS $= 240/120 = 2.00$ — exactly neutral, as the rule predicts

Now suppose the offer is 480m instead (effective P/E of 12.0):

• Shares issued: $480/30.00 = 16\text{m}$; total shares $= 116\text{m}$
• New EPS $= 240/116 = 2.069$, accretive by 3.4%

Cash-funded acquisitions

For a cash deal the comparison is between the target's earnings yield and the after-tax cost of the cash — the same logic as the share repurchase test in section 6.2:

$\text{New } EPS = \frac{NI_{\text{acquirer}} + NI_{\text{target}} + \text{After-tax synergies} - \text{After-tax financing cost}}{\text{Shares outstanding (unchanged)}}$

Because the share count does not change, a cash deal is accretive whenever the target's after-tax earnings exceed the after-tax cost of the funds used.

The caution that carries the marks

EPS accretion is not value creation. A deal can be accretive and destroy value if the acquirer overpays relative to the target's intrinsic value, or if the target's business raises the combined entity's risk so that the higher EPS is discounted at a higher rate. Conversely, a dilutive deal can create substantial value if the target's growth or synergies justify the multiple. Vignettes routinely give you an accretive deal with a negative net present value and ask which conclusion is supported.

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2. Effect on Net Debt to EBITDA

$\text{Net debt / EBITDA} = \frac{\text{Total debt} - \text{Cash}}{\text{EBITDA}}$

Cash- or debt-funded acquisition

The rule follows from comparing the multiple paid on an enterprise basis against the acquirer's existing leverage:

Funding an acquisition entirely with cash or new debt raises net debt to EBITDA when the EV/EBITDA multiple paid exceeds the acquirer's existing net-debt-to-EBITDA ratio, and lowers it when the multiple paid is below that ratio.

Worked example. Acquirer: net debt 900, EBITDA 300, so net debt/EBITDA = 3.0x. It acquires a target with EBITDA of 100 for 800 in cash funded entirely with new debt, an EV/EBITDA multiple of 8.0x.

• Combined net debt: $900 + 800 = 1{,}700$
• Combined EBITDA: $300 + 100 = 400$
• New ratio: $1{,}700/400 = 4.25\times$, up from 3.0x

Because 8.0x paid is far above the existing 3.0x leverage, the ratio rises sharply. This is why leverage-constrained acquirers use stock for high-multiple targets.

Stock-funded acquisition

No new debt is raised, so the combined ratio changes only through the target's own balance sheet:

• Same acquirer, same target, but funded entirely with stock and the target carries net debt of 150.
• Combined net debt: $900 + 150 = 1{,}050$; combined EBITDA 400
• New ratio: $1{,}050/400 = 2.63\times$, down from 3.0x, because the target is less levered than the acquirer.

Effect on interest coverage

The parallel measure, EBIT divided by interest expense, falls with any debt-funded deal. Covenant headroom on both ratios is the practical constraint that determines the funding mix, and the debt footnote in a vignette exhibit is where the binding limit is disclosed.

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3. Effect on the Weighted Average Cost of Capital

Two forces operate simultaneously and can move in opposite directions:

1. Business risk of the target. Acquiring a business with lower cyclicality and lower operating leverage lowers the combined asset beta, and therefore lowers the unlevered cost of capital. Acquiring a riskier business raises it. This is the effect that persists.
2. Change in the capital structure weights. Funding with debt raises the weight on the cheaper, tax-shielded component, which mechanically lowers WACC until credit deterioration raises the cost of both components — the pattern developed in section 6.3.

A vignette that reports a rating agency placing the acquirer on negative watch is telling you which line of the table applies.

4. Evaluating Divestment Actions

The analytical questions to ask of a proposed divestiture:

1. Is the segment worth more outside than inside? Compare the price obtainable against the present value of the segment's cash flows retained, including any dis-synergies — shared overhead, procurement scale, and customer relationships that do not transfer.
2. What happens to stranded costs? Corporate overhead allocated to the divested segment does not leave with it. If 40 of overhead was charged to a segment generating 100 of EBITDA, the remaining business absorbs that 40 unless it is actually removed.
3. What is the use of proceeds? Debt reduction, reinvestment, and shareholder distribution have very different value implications, and the announcement almost always specifies one.
4. Tax. A properly structured spin-off is generally tax-free to shareholders and the parent, while a sale triggers tax on the gain — a meaningful difference in net proceeds that vignettes use to distinguish the two.

Effect on the parent's reported figures. A divestiture typically raises the parent's reported margin if the divested business was below the corporate average, raises return on invested capital by removing capital, and reduces absolute revenue and EBITDA. None of that is value creation on its own; the test remains whether the price received exceeded the value of the retained cash flows.

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5. Cost and Balance Sheet Restructuring

Cost restructuring

Actions that reduce the cost base without changing the portfolio of businesses: headcount reduction, facility consolidation, outsourcing, shared-service centres, and procurement renegotiation. Analytical treatment:

• Restructuring charges are non-recurring in name but often recurring in fact. A company taking a "one-off" charge in five consecutive years does not have non-recurring charges; normalized earnings should include an average annual charge.
• Separate cash from non-cash. Severance is cash; asset write-downs are not. Only the cash component affects free cash flow, and only the non-cash component flatters future returns by reducing the depreciation base.
• Test durability. A margin improvement that comes from cutting research and development or maintenance capital expenditure below depreciation is borrowed from future periods, not earned.

Balance sheet restructuring

Actions that change the composition of assets and liabilities without changing operations: sale and leaseback, debt refinancing or exchange, share repurchase, a large special dividend, asset securitization, or a recapitalization.

Worked illustration — sale and leaseback. A retailer sells its distribution centres for 500 and leases them back.

• Immediate: cash rises 500, property is derecognized, a gain or loss is recognized against the carrying amount, and a lease liability with a right-of-use asset is recorded.
• Return on assets rises if the asset base falls more than earnings do.
• Leverage may not improve at all once the lease liability is recognized, which is the point of the accounting standard — the obligation has been converted, not removed.
• Free cash flow falls in every future period by the lease payment, offsetting the one-off inflow.

The analytical conclusion the exam wants: a balance sheet restructuring changes the financing of the business, not its economics, unless it genuinely lowers the cost of capital or releases capital that earns a higher return elsewhere. Reported ratio improvement without a change in the underlying cash flows is a signal to look harder, not a reason to raise a valuation.

Level II traps in this module

1. Equating EPS accretion with value creation.
2. Forgetting that a stock-funded deal changes net debt to EBITDA only through the target's own balance sheet.
3. Assuming a spin-off raises cash for the parent. It does not; a carve-out or a sale does.
4. Ignoring stranded overhead when modelling the parent after a divestiture.
5. Treating repeated "non-recurring" restructuring charges as genuinely non-recurring when normalizing earnings.