Question

I'm confused about how to apply the Discounted Cash Flow (DCF) model to mergers and acquisitions. The PowerPoint for my class gives me this information, but I don't think I understand it. Does this mean that for the transitionary period, the target company uses its own discount rate, and then uses the acquiring company's discount rate during the stable period?

Valuation-DCF Approach

•Valuation with synergies

–Cash flow

•A forecast period: transition state (5-10 years)

•A terminal value: steady-state

–Discount rate

Acquirer: Toy manufacturer

Target: Petrochemical company

–Terminal growth rate

Answer 1

Solution:

I attempt to answer your question from the limited data specified in the question.

The discount rates to be used in M&A is still a very debatable question. However, we attempt to answer this.

WACC or the discount rate must reflect the capital costs that investors would require or demand in owning assets of similar business risk to the assets being valued.

Same Business Risk

If the assets being acquired are in the same industry, they have similar business risk, in that case, assuming the acquirers financial structure is optimal, the acquirers cost of capital can be considered.

Different Businessess

If the assets being acquired are not in the same industry, they have different business risk, in that case, the target firms cost of capital can be considered (assuming the target firm has optimal capital structure).

In case of Valuation with Synergies (which seems to be your topic), the process followed is:

Step 1: Value the Target firm by discounting its free cash flows with its cost of capital

Step 2: Value the Acquiring Firm by discounting its free cash flows with its cost of capital

Step 3: Determine the cost of capital of the combined entity by determining the business betas of the two companies and computing unlevered businees beta of the combined company and then relevering it to levered beta of the combined business. Using this beta to calculate the WACC of combined firm.

This is used to discount the free cash flows of the combined firm (this will have synergy cash flows as well) giving the Value of Combined Firm.

Value of Synergy = Value of Combined Firm - Value of target firm - value of acquiring firm.

Note: For your confusion of 'Does this mean that for the transitionary period, the target company uses its own discount rate, and then uses the acquiring company's discount rate during the stable period?' - Its not done that way due to paucity of any logic.

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