M&A DCF Question

If trying to find the NPV of a merger to the acquiring firm using DCF for the incremental cash flows of firm being taken over, on the street do you discount at the WACC of the acquirer or the firm being acquired?

e.g. If Firm A is taking over Firm B and they anticipate the following FCF for the next five years from Firm B:

Year 1: 50 mm

Year 2: 55 mm

Year 3: 60 mm

Year 4: 65 mm

Year 5: 70 mm

Assuming Firm A has a WACC of 10%, and firm B has a WACC of 12%, would Firm A discount these at 10 or 12%, or a combination of the two?

 

To determine the offer price of the target company using DCF, you take FCF and discount using target's WACC. You take that "price" as net cash outflow, then calculate the NPV of target's FCF discounted by your required rate of return (usually acquirer's WACC). If NPV is positive, then deal is worth it. Then you look at what the combined company will be worth post deal by using the combined cash-flow (increased if there's synergy) with new combined WACC using new leverage depending on how you financed it. If the combined company is worth more than the two companies separately, then you merge, if not, but NPV is positive then you invest based on the offer price. Of course this is very simplistic M&A 101 stuffs, in a real deal there's actually an incredible amount of fudging and reverse engineering of target price that goes on. Most MD/client will tell you what numbers they want, then you make it seem like that number is legit by using legitimate valuation techniques and lots of fudging.

 
Best Response

Why would you obtain the NPV by comparing the FCF discounted by target's WACC with the FCF discounted by acquirer's WACC? The price paid is obtained by discounting FCF by target's WACC, as you started off saying, but then that is compared with the synergy value to the target and the synergy value to the acquirer. You never discount target's FCF by acquirer's WACC in order to calculate the NPV of the purchase, nor to compare it with the price paid.

We're Italian, "WACC" means something else to us.
 

Yes of course use the new WACC for the synergy values - but, and I may have misunderstood, Simboy was suggesting to get the purchase NPV by comparing FCF discounted by target WACC with FCF discounted with acquirer WACC. Acquirer WACC and new merged company's WACC (or, technically, the target WACC that's found by least distress risk and highest tax cut and other considerations) are different things.

We're Italian, "WACC" means something else to us.
 

I think you're confusing price/value with NPV. Price is function of your expected cashflow discounted by a risk adjusted rate. Here the "risk" is chance of you not getting the future cashflow. Hence, when you calculate the price, you use the target's WACC.

Now, NPV is a slightly different animal, NPV is used to decide whether the acquisition is worth it based on YOUR risk appetite and expected return. It's not to figure out how much a company is worth. For NPV, you do this - NPV = -Price + FCF of target discounted to present by your required rate of return,which is usually your cost of capital = WACC. If NPV is positive that means that the deal generates cashflow that exceeds YOUR cost of cap.

Take a 10year treasury for example. If DCF values treasury (using market risk free rate) as $100. What would the NPV be if you use the "target"'s WACC - the same risk free rate? It'd be "0". In fact, it'll always be 0, and NPV really is a useless tool. But, if you're a hedgefund, and your required return is 15%, NPV would obviously be negative, and you wouldn't touch treasuries unless you use leverage.

Price - function of target's risk and expected return. NPV - function of price, expected return, and your cost of capital. (remember, NPV is net present value, so it's net of "cost" which reflects the target's risk aleady.)

For merged entity, it's pretty straight forward that you should use the new WACC, so I'll stop it here.

This is really it. Like I said M&A 101. - cheers

 
Gerry:
Can somebody explain me how an acquirer can benefit from (financial) synergy effects when his WACC is lower than the WACC of the target?

Well for one, the new WACC of the combined company may be lower than the original WACC of the acquirer...even if it isn't, the benefits from proposed synergies will (hopefully) more than make up for the increased costs of capital. So either way, the acquirer is going profit--or he wouldn't want to acquire in the first place.

Haters gonna hate
 
sisurain:

how to calculate the new WACC, if the target WACC is higher than the acquirer, the new WACC should be higher than the acquirer's the WACC, why new WACC is lower?

Lol pretty amazing that this 2008 thread has been randomly brought back from the dead twice.

Step back for a second and remember what WACC depends on. Two things, business-specific risk and financial risk/capital structure. When you have business A and business B combine, it's not a good idea to think about WACC in terms of the previous WACC for the two companies and try to average the two or something, because you are dealing with two distinct elements. Instead think separately about how business risk (beta) changes and how capital structure changes, recalling that capital structure affects WACC in two opposing ways (higher debt => greater risk, but more tax benefits; so often more debt lowers WACC but at high levels it would raise it).

The resulting WACC could be higher than both the acquirer and target, it could be in between, it could be lower.

 

I would discount the cash flows @ the acquirer's cost of capital. The transaction needs to make sense from the perspective of the investor, which in this case is Company A. To be included in the portfolio, the Investment (Company B) needs to at least earn its cost of capital so that NPV of Company A is at least neutral or positive.

 

Since no one has taken a shot at this, I will try and help you out. First of all, you are going to have to combine the balance sheet and income statement of the target and acquiror to get your pro forma balance sheet and income statement. You will also need to figure out the Total Diluted Shares Outstanding to get a correct Price per share for the new company, which is dependent on the exchange ratio of the # of acquiror shares to the # of target shares.

After that, make some good forecasting assumptions and run a dcf analysis. Thats all I think you need to do, but hopefully someone with alot more experience will come by and set things straight.

 

Hrmm, I don't do DCF's, but if you are acquiring a 30% stake in a company wouldn't you account for the acquisition using the equity method? i.e. you would book your investment on the B/S and increase the investment reported on the B/S for NI and decrease the investment for dividends.

 

That means the acqusition won't be consolidated on the BS, but rather as an equity investment line as Charming Chimp said. However, if the subsidiary is paying dividends, I would assume this has to be reflected in projected future cash flows in the DCF, since these are cash flows that become available to the parent company. The dividends received aren't taxed at the full rate because of the Dividends Received Deduction, so you'd have to adjust for that. Not 100% sure, but that would be my argument.

 

Thanks mshutzy.

Two things: I tried both the multiple and growth rate method to determine the terminal value. the multiple approach gave me an end result of the stock being undervalued, while the perpetuity method left me with a stock that is over valued.

i'm not sure if these end results can be so far apart, and obviously my multiple (or wacc/growth rate) may have flaws.

addressing your point: I thought of this as well, but a bit confused on your point. are you saying that this overvaluation is only the result of the synergies from the merger? if you could elaborate that would be very helpful

thanks for the help

 

Maybe this will help - think about levers you can pull on your DCF that drive value. I assume you're using some five or 10 year forecast from research. If that's the case, what are your major inputs?

  1. Discount Rate
  2. Terminal Value

I work in an M&A group at a bank and the sensitivity we always show clients is a data table with the y axis being a range of discount rates and the x axis being a range of terminal values. I would suggest that rather thinking about the stock as either "overvalued" and "undervalued," take a look at how sensitive the value is and what that suggests for your overall analysis. Remember, intrinsic value is a very real concept theoretically, but in practice it is very much a hypothetical.

Which leads me to your next point - how could an acquiror look at this business? Let's start with discount rates. If there is a big difference in the two, there tends to be a debate over which WACC to use -- the acquirors or the targets. Often times, this is a huge negotiating point and both parties eventually meet in the middle. Make sure you are showing a range of discount rates that make sense.

A second point you probably need to think about is the potential for synergies. Typically, we show clients a "synergy" case and a "stand-alone" case. An acquiror might be willing to pay more because it can reduce operating costs (which boosts near term cash flow as well as your terminal value), or that owning the asset has some strategic value (which from a practical standpoint typically shows up in how you look at terminal value).

On your point about PEs, they don't really matter much from a DCF/intrinsic value perspective. However, you should know that in general, in a transaction in which the consideration is stock, if the acquirors PE is higher than the targets PE, the deal is accretive. That doesn't impact your DCF value, but it typically plays a role in marketing the deal to the street.

Hope that helps and makes some sense.

 

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