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Accretion can be defined as a gradual growth of assets and earnings which can be given by several reasons: mergers or acquisitions, business expansion, company’s internal growth. From the financial point of view, accretion is the collection of the additional income that an investor is planning to receive after they have bought a bond at a discount and are holding it until maturity. Zero-coupon bonds and cumulative preferred stock are the most common examples of financial accretion.
In corporate finance, thanks to the accretion additional value are created through a transaction or organic growth. To illustrate, accretion happens when after the transaction acquiring assets are expected to grow in value. It also occurs when assets are purchased at a discount or when their price does not reach the perceived current market value (CMV).
Buying at a discount means acquiring bonds below their face or par value. Respectively, buying at a premium refers to acquiring bonds above their face value. In finance, the cost base is adjusted from the purchase price (discount) to the expected redemption price at maturity by accretion. When a bond is bought for an amount of 70% of the face amount, the accretion makes 30%.
When it comes to bonds, the following principle applies: the higher the interest rates, the lower the value of existing bonds. This means that as the interest rates increase, bonds on the market are losing value. Since all bonds expire at the face value, an investor who buys a bond at a discount earns more money, which is recognized by accretion.
Divide the discount by the number of years in the definition you would get the rate of accretion. The interest earned on zero-coupon bonds would not accumulate with time. Although the bond’s value rises at the agreed-upon interest rate, it must be kept for the agreed-upon period to be cashed out.
Let’s consider a situation when an investor buys a bond on $1,000 for $800 that matures in 5 years. We see an additional income of $200 that must be recognized by the investor between the date of the bond’s purchase and its maturity date. The $200 is applied as a credit on the bond portfolio when the bond is bought. During the next 5 years, gradually every year a part of $200 is reclassified to the bond income account. By the maturity date, the whole $200 is moved to the income.
Earnings available to common owners measured by average common stock outstanding is the earnings-per-share (EPS) ratio. In this case, the accretion corresponds to a rise in a company’s EPS when an acquisition occurs.
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