What is Accretion?
Accretion is a common term in finance that can refer to accounting, bonds, or corporate finance. At its core, the term “accretion” is another way to reference growth. In the financial world, it’s the creation of value, whether through the capital gains you earn cashing in on a bond or through a corporate acquisition.
While accretion represents a positive increase in value from a financial transaction, dilution represents a decrease in value from a financial transaction.
What is accretion used for?
Accretion is used in several financial contexts, but it’s used most often to describe:
- Bonds - Accretion is the gain you earn when you buy a bond at a discount.
- Corporate finance - Accretion is the value you create when you merge or acquire another business. This increases your earnings per share (EPS), increasing the value of your stockholder’s shares.
How accretion works for bonds
Accretion is an important concept for seeing a return on your investment in bonds. When you understand this concept, you can better calculate the exact returns you’ll earn on a particular bond. It’s also important to understand it so you can better plan for taxes.
Businesses or government entities use bonds to raise money. As a bondholder, you earn interest on the bond annually and receive the money back that you originally invested, in addition to the interest.
Accretion occurs when you buy a bond for less than its face value, which puts more money in your pocket.
Here’s how it works for bonds:
- An investor buys a bond for below its face value, called a discounted bond. For example, a bond worth $1,000 that you paid $800 for is a discounted bond.
- You hold onto the bond until its maturity date.
- Once the bond matures, you earn interest on it, as well as the difference between the discount and the face value. That means you would earn $200 on a discounted bond worth $1,000 if you paid only $800. You would also earn interest on the face value of the bond ($1,000).
Bond interest is paid out either annually or as a lump sum once the bond matures. You can calculate the accretion of your bond in one of two ways: the straight-line method or the constant yield method. Let’s take a look at both calculation methods.
The straight-line method spreads out the value of your bond throughout its term.
Here’s how to calculate it:
- Let’s say the term of your bond is 5 years. You received a $500 discount on the face value of the bond.
- The bond issuant reports on its financials every quarter, which means you have 20 financial periods until the bond’s maturity date.
- Divide the discount ($500) by the number of financial periods (20) and you’ll see a $25 accretion per quarter until the bond matures.
In other words, the value of your bond balance will increase by $25 every quarter until its maturity date.
Constant yield method
The constant yield method increases the value of the bond closer to its maturity date. That means some financial periods will show bigger gains, especially those near the end of the bond’s life.
Both bond accretion calculations will put money in your pocket at the end of the bond term. But the constant yield method helps the bond issuer buy more time before they need to increase the value of the bond.
How accretion works with corporate finance
Accretion is also a popular concept in the world of corporate finance, especially with mergers and acquisitions. Accretion is usually a good thing for corporations because it adds more value to the bottom line. Accretive deals increase the value of a company’s stocks and give its shareholders more value.
While accretion is often the goal of M&A, it’s not always guaranteed. That’s why it’s important for corporations to carefully calculate the pros and cons of M&A to ensure it’s beneficial to the company in the long term.
Here’s how accretion works in corporate finance:
- Company A wants to acquire Company B.
- Company A’s earnings per share (EPS) is $100 and Company B’s EPS is $50.
- When you combine the EPS from Company A and Company B, you see a positive increase to $150 EPS.
- That positive increase is considered as accretion, or an accretive deal because it’s adding value to the stock.
Accretion is beneficial in corporate finance because it usually indicates profitability and earning potential.
With implications for both bonds and corporate finance, developing a solid understanding of accretion is a must for savvy investors and corporations alike.