Financing a merger - Most expensive way?

TeddyTheBearThe most expensive way is by issuing equity. This might throw them off guard, but depending on the person they might love the answer. With cost of capital for corporate debt at record low levels, its the cheapest solution. Shareholders usually have a higher cost of capital because they expect a chunk of the profit. Obviously there are other instruments such as mezz and things like that, but I think equity is a better answer.

Without taking into account the low interest rates present in the current debt capital markets, would it be advisable to mention in an interview the possibility of a firm's cost of debt being higher than its cost of equity if the P/E ratio of the firm is ridiculously high? I would follow that up by saying that an extremely high P/E ratio (let's say 100) means that shareholders aren't demanding as much earnings from they're paying, which results in a lower cost of equity.

ct52Expected returns are a function of risk. Debt is given pre-negotiated payments and is paid out before equity in the case of default, so it is inherently less risky than equity. If the cost of debt was higher than the cost of equity, no one would ever invest in the equity of that company. Thus you can never have a cost of debt higher than cost of equity.

This only takes into account default risk. You still have to consider interest rate risk, fx risk, etc.

ct52Expected returns are a function of risk. Debt is given pre-negotiated payments and is paid out before equity in the case of default, so it is inherently less risky than equity. If the cost of debt was higher than the cost of equity, no one would ever invest in the equity of that company. Thus you can never have a cost of debt higher than cost of equity.

yes. i would go with subdebt.

ct52Expected returns are a function of risk. Debt is given pre-negotiated payments and is paid out before equity in the case of default, so it is inherently less risky than equity. If the cost of debt was higher than the cost of equity, no one would ever invest in the equity of that company. Thus you can never have a cost of debt higher than cost of equity.

Hi ct52,

Can you please explain what you mean by no one would ever invest in the equity of the company, if the cost of debt was to be higher than the cost of equity? Thanks.

A Fellow LinguistTeddyTheBear,

With regards to the different payment methods that can be used in accretion/dilution models, how would you calculate the cost of debt, cost of stock and the yield of the seller?

According to the BIWS guide that I'm using, it says that to calculate the two, you use:

"Cost of Debt = Interest Rate on Debt * (1 – Buyer Tax Rate)

Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e. E / P or Net Income / Equity Value

Yield of Seller = Reciprocal of the Seller’s P / E multiple (ideally, the P /E multiple at the purchase price for the deal)"

This is a little confusing to me. Would you recommend using something like CAPM to calculate the cost of stock, rather than the reciprocal of the buyer's P/E multiple?

CAPM would be the appropriate method to calculate cost of equity. However, if you use the reciprocal of P/E, that is just a good proxy to "estimate" the cost of equity (e.g. if you would wanna quickly look at the cheapest or most expensive form of financing). Correct me if I'm wrong here guys. Thanks.