Hi one concept I never really understood to the fullest was:
Let’s say you have a Target A. The WACC formula is well known etc.
Now let’s say you have a private equity firm, who has a cost of equity of 20%, so in my mind the WACC of the private equity firm will be higher than that of a potential let’s say strategic. Is this true?
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No, it doesn’t. WACC considers the financing costs of the asset (both debt and the spectrum of equity), and not the financing cost of the acquiring company. If the target and acquirer were identical in terms of theoretical capital structure, idiosyncratic risk, etc., then the respective WACCs of the target and acquirer may coincidentally match.
As an illustrative point, WACC must be relative to the risk of the acquired asset, or else $10 of predicted CF from a high end luxury software company (where demand is highly elastic) would be the same PV as $10 of predicted CF from a manufacturer of critical medical supplies for a widespread disease (where demand is relatively inelastic).
I’m confused on your response. Say you’re a public company or a large private strategic - your cost of equity should be lower than the cost of equity of the smaller target. The same could be true for cost of debt. I would think that part of deciding how much you should pay would be valuing the business based off the target’s cost of financing vs the acquirers and putting an implied valuation that is in the middle….this is just another way of saying Multiple arbitrage.
The PE uses higher gearing, making the WACC competitive to a strategic.
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