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Comments (12)

Dec 8, 2014 - 7:00pm

so I guess it was a trick question. I was asked what discount rate to use in a dcf model if the company
is financing the purchase will all cash

Dec 8, 2014 - 7:05pm

What was your answer?

As above, discount rate doesn't depend on how you're financing the transaction - two different things. Think of it this way: 1) find value/price of target (using an appropriate discount rate in the DCF) and then 2) how are you going to finance the purchase?

Dec 8, 2014 - 7:11pm

I believe I answered it incorrectly because I didn't understand the question initially, so I stated WACC, but cash is not apart of that equation. So I stated using median comps for WACC as a barometer of the discount rate that should be used. The target company would be a relatively small all cash deal.

Best Response
Dec 8, 2014 - 9:14pm

notthehospitalER:

What was your answer?

As above, discount rate doesn't depend on how you're financing the transaction - two different things. Think of it this way: 1) find value/price of target (using an appropriate discount rate in the DCF) and then 2) how are you going to finance the purchase?

Doesn't it though? Financing with debt adds value because of the debt tax shield.

Valuing a company using DCF, the "appropriate" discount does depend on the financing. For an all equity transaction, you'd use return on assets as the DR. For a debt and equity transaction, you'd use WACC or APV.

In a typical example, the process looks something like this:
1. Find companies similar to the one you're looking to buy
2. Calculate their equity betas
3. Unlever said equity betas using each companies D/E to find asset betas
4. Average asset betas
5. Re-lever the average asset beta using D/E for the acquisition to find it's equity beta (skip this step if all-cash)
6. Calculate required return on equity using Re = Rf + Be (Rm-Rf), where Rf is the risk free rate and Rm is the market risk premium
7. Calculate WACC and use it to discount future cash flows

Without taxes, use the Ba calculated in Step 4 to calculate Ra and then discount.

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Dec 8, 2014 - 10:42pm

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