Cost Of Capital In Mergers And Acquisitions

Cost Of Capital In Mergers And Acquisitions

In mergers and acquisitions transactions, one overlooked aspect in valuations is arriving at the target company’s capital cost. I have observed buyers taking an arbitrary discount rate of 12% as a hurdle rate without considering the underlying risks in the target business. In other scenarios, the buyer uses their cost of equity to value the target business. This approach violates the principle of #Capitalbudgeting, which states that the discount rate used for investment should match the investment risk and not the investor risk.

For instance, a large public listed technology firm whose cost of equity is 10% acquires a growing profitable private business with:

Revenues – $100 million
EBIT – $20 million

At 20% tax, NOPAT is 20*(1-20%) = $16 million.

At no growth scenario (reinvestment rate of 0%), the FCFF for the target company is $16 *(1-0%) = $16 million.

At 20% cost of equity for the target, the value of the target is $16/0.2 = $80 million.

However, when the buyer acquires a target, it values the target at 10% cost of equity (the buyer’s cost of equity), valuing the acquisition at $16/0.1 = $160 million. In effect, the buyer ends up overpaying the target by two times.

In effect, valuation is a function of #cashflows, growth in cash flows, and risks inherent in the underlying cash flows. Thus, if the buyer incorrectly values even one of these parameters, it pays more than the target value.