Hi Guys,
Is there a discount rate applied with an acquisition being financed with a 100% cash and using the Discounted Cash Flow model?
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Yes. You're not discounting the cash you're paying with, you're discounting the expected future cash flows of the business you're buying.
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
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?
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.
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.
100% cash wasn't broken into source - ie we don't know if debt is being used.
In a very simplistic sense, assuming cash is from the balance sheet and the capital structure of the target remains unchanged - in this scenario (which is what I assumed given relative lack of info) how does the method of financing affect the relevant discount rate? Wouldn't it be independent i.e. the current WACC of the company - which is unaffected by your cash?
Staying high-level here. The discount rate should reflect the riskiness of the underlying asset.
If the deal is all cash, the only risk is whether the assets of the company can generate cash flows - Use Ra
If the deal involves debt and taxes are a thing, you've got to use WACC or APV. The formula for WACC: Re * E / (E+D) + Rd * (1-tax) * D / (E+D) has the capital structure built in and so will obviously change with the financing.
Alternatively, you can breakout the impact of the debt tax shield using APV: APC = (NPV of all equity deal) + (PV of debt tax shield) Where NPVequity is calculated using Ra and the discount rate for PV(DTS) depends on a few other factors.
Then again, since this was posted in the consulting forum, it may have been from a case interview. In that case, you'd probably just say "Meh. 15% sounds good," crunch the perpetuity formula.and be done with it.
Yes. My point was that assuming the deal is 100% cash and no debt, the discount rate would be the target's WACC and would not be changed - is that wrong or are we saying the same thing in different ways?
Are you talking about the valuation of a target company? If yes, discount rate to be applied is not dependent on the terms of payment of the transaction. Discount rate is based on the factors such as industry of the company, uncertainty of the forecast, and other risks.
Yes it was for a valuation model for a target company
Damnit, I came on here for a 5 minute break from studying for my finance final tomorrow and this is what I see. Guess I'll get back to it...
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