Seminar in Finance (FIN-6320): Discount Rate in M&A Discussion

This discussion post addresses the factors to consider when determining an appropriate discount rate for mergers and acquisitions (M&A). The post emphasizes the importance of the weighted average cost of capital (WACC) as the discount rate, calculated through the Capital Asset Pricing M...Read More

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The discount rate the company should use when considering the mergers and acquisitions is
the cost of equity of the existing company or the target company. The discount rate depends
upon the cash flow stream that the company is measuring. If the existing company is
considering the buying equity or owners of the target company, then the discount rate shall
have to be adjusted for the additional risks incurred from the use of these funds. When the
company choses to use the Capital Asset Pricing model, then the company will have to
determine the beta coefficient (Matt, 2020).
The appropriate weighted average Cost of capital would depend upon some basic factors,
such as the following:
1. The amount of the business risk of the cash flows that the new company would entail
in the years to come?
2. Appropriate financial structure of the company after the merger and acquisition has
taken place.
In the above factors, there are basically two scenarios. The first being the scenario wherein
the target company and the acquirer belongs to the same industry and when they do, they
have the similar business risk. In such a case, the company would have an optimal financial
structure. Since the business risk would be similar, then WACC could also be used for the
purposes of valuing the merger of the cash flows. In case, the target company and the
acquirer belong to the different industries, then the business risks would also be different, an
example of which would be a pharmaceutical company which acquires an airline company.
Then the business risks shall be different, their assets, collateral, debt paying abilities would
also be very different. In such of the cases, the acquiring company would realise the value
from the transaction from the target in a manner that is optimal. Hence, in such case, WACC
shall be calculated using the business risks and the financing through which the company
shall be acquired.
While choosing the appropriate discount rate to determine the present value of the cash flows
of the target company, few of the adjustments will have to be made to the approaches on the
basis of individual judgments. The main concern in finding the WACC is the reflection of the
business as well as the financial risks of the cash flows of the target company. This is mainly
due to the fact that there shall be a different capital cost after the two companies have merged
connected with the operating and the financial synergy. The determination of the appropriate

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WACC is exposed to many challenges such as the company being public or non-public, the
development rate of the capital markets etc (AYDIN, 2017).
The appropriate discount rate is chosen for the merger company instead of the target
company.
The use of an appropriate discount arte is of an utmost importance since is shows an
incremental changes to the cash flows which forms a major part to the process of valuation.
Since the future is uncertain, it would be useful to run the cash flow estimates through
sensitivity analysis using different variables for the assessment of “what if” analysis (Evans,
2020).
The course content clearly states that the weighted average cost of capital should be the
appropriate discount rate to be used in mergers and acquisitions, same as listed above.
The calculation is WACC is done through the use of CAPM model. In this, the risk free rate
of return is used along with the market risk premium which ranges between 5% to 8%. Beta
shows the riskiness of the security in the market. The cost of debt and equity is calculated and
using this model, the future cash flows of the combined company are calculated and then the
appropriate decisions is taken. I was able to ascertain the fact that WACC is too be used as
discount rate but did not consider the way through which WACC would be calculated. It shall
be calculation by the way of using CAPM model which would help in calculation of cost of
equity. And the cost of debt shall be calculated as it is.

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References:
AYDIN, N. (2017). Mergers and Acquisitions: A Review of Valuation Methods. [online]
Ijbssnet.com. Available at: http://ijbssnet.com/journals/Vol_8_No_5_May_2017/18.pdf
[Accessed 22 Feb. 2020].
Evans, M. (2020). Course 7: Mergers & Acquisitions (Part 2). [online] Exinfm.com.
Available at: https://exinfm.com/training/pdfiles/course07-2.pdf [Accessed 22 Feb. 2020].
Evans, M. (2020). Valuations in Mergers and Acquisitions. [online] Exinfm.com. Available
at: https://exinfm.com/board/valuation_mergers_acquisitions.htm [Accessed 22 Feb. 2020].