How do I run an accretion/dilution test for a share buyback, and when does a buyback actually increase EPS?
I'm studying CFA Level I equity and the concept of share buybacks and their EPS impact. I've heard that a buyback is 'accretive' if it increases EPS and 'dilutive' if it decreases EPS. But how do I actually test this? Is there a simple rule to determine whether a company should buy back shares?
The accretion/dilution framework for buybacks is elegant once you see the underlying logic. The key insight is that when a company uses cash to repurchase shares, it gives up the earnings on that cash (opportunity cost) but reduces the share count.
The Rule:
A buyback is accretive to EPS if the earnings yield (E/P) of the stock exceeds the after-tax cost of financing the buyback.
- If funded with cash: Compare E/P to the after-tax return on cash
- If funded with debt: Compare E/P to the after-tax cost of debt
Worked Example:
Harborview Industries has:
- Net income: $240M
- Shares outstanding: 80M
- Current EPS: $3.00
- Share price: $40
- Earnings yield: $3.00 / $40 = 7.5%
- Cash earns 4% pre-tax, tax rate 25%, so after-tax cash yield = 3.0%
Harborview uses $200M in cash to buy back 5M shares at $40.
After Buyback:
- Lost after-tax cash income: $200M x 3.0% = $6M
- New net income: $240M - $6M = $234M
- New shares: 80M - 5M = 75M
- New EPS: $234M / 75M = $3.12
EPS rose from $3.00 to $3.12 — the buyback is accretive because the earnings yield (7.5%) exceeded the after-tax cash yield (3.0%).
Quick Decision Rule:
| Earnings Yield vs. Financing Cost | EPS Impact |
|---|---|
| E/P > after-tax financing cost | Accretive (EPS increases) |
| E/P < after-tax financing cost | Dilutive (EPS decreases) |
| E/P = after-tax financing cost | Neutral |
Exam Tip: The CFA exam may present a scenario where a company funds a buyback with debt. If the after-tax cost of debt is 4% and the earnings yield is 6%, the buyback is still accretive. Always compare E/P to the after-tax cost, not the pre-tax cost.
Practice more buyback scenarios in our CFA Level I question bank.
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