Question

Company A is considering acquiring company B. The two companies are in different, but not totally unrelated, industries. You are hired by company A to make a positive or negative recommendation about the acquisition. In preparing your recommendation you consider using the Discounted Cash Flow (DCF) model as well as the Real Options model to assess the value of the potential acquisition. You also plan to use the CAPM to assess and value the risk of the acquisition. Explain how the DCF model and the Real Option model can each be used to value the acquisition. Under what circumstances would the Real Option model provide a better approach to value the acquisition than the DCF? Explain.

Finally, discuss how the risk of the acquisition can be assessed via the CAPM model? Comment on the advantages and disadvantages of using the CAPM to the value the acquisition.

Answer 1

Discounted cash flow method will be used to value the cash flows associated with the target company in order to discount the the cash flows of the target company in the future to arrive at a fair value.

Real option value method will be considering all the potential gains which can arise due to acquisition of these companies and this is a wider perspective than the overall discounting cash flows method because real option value method will be considering all the the big potential gain and the Synergy benefits which are gained by acquisition of target company.

circumstances under which real option model will provide a better approach to the valuation than discounted cash flows will be when there would be higher consequences of microenvironment and opportunity cost and possibilities of higher gains and losses than real options valuation should be applied rather than discounted cash flow.

Risk of acquisition can be assessed through the Capital Asset pricing model because Capital Asset pricing model will be including the systematic risk in overall valuation and it will be represented through beta so Capital Asset pricing model will be assessing the risk related to the acquisition.

Limitations associated with Capital Asset pricing model is that Capital Asset pricing model is a one factor model and it is just using the expected rate of return in order to find out whether to acquire the company or not and comparing it with the cost of capital so it is a highly concentrated method.

Benefits associated with capital asset pricing model is that it is a very simple approach and it is highly focused in order to find out the expected rate of return and it is used in practical application.