Choosing a Discount Rate to Value an Acquired Business

Summary

The document poses a valuation question about an acquired subsidiary funded partly with debt and partly with equity. It gives the acquirer’s financing assumptions, a separate target capital structure and cost of equity for comparable businesses, a tax rate, and an expected free cash flow that repeats each period. The question is whether the comparable companies’ financing mix and equity cost should determine the subsidiary’s weighted average cost of capital, which would then be used to value the cash flows.

No answer or worked valuation is included, and the proposed weighted-average-cost formula is incomplete and appears to mix inputs incorrectly. The material therefore does not establish which discount rate to use or calculate a defensible business value. It does highlight the key analytical issue: separating the acquired business’s operating risk and appropriate financing assumptions from the particular way the buyer finances the purchase. Any valuation would also depend on assumptions about perpetuity, taxes, and whether the stated cash flow is sustainable.

Key ideas

• The question concerns valuing a subsidiary from recurring expected free cash flows.
• It distinguishes the buyer’s financing assumptions from comparable companies’ capital structure and equity cost.
• A weighted average cost of capital depends on correctly matching debt, equity, and tax inputs.
• The document provides no answer or completed valuation, so the appropriate discount rate remains unresolved.

Tags

# Valuation of a company


# Valuation of a company












Alpha Corp purchases Beta Sub. Alpha Corp finances the purchase price of € 100 million by raising € 50 million in debt and € 50 million in equity issued by Alpha. The debt is risk free and the interest rate that the firm pays on its debt is 2%. Alpha Corp has a target capital structure of 0.4 (D/V) and cost of equity of 9%, companies in a comparable industry as Beta Sub have a target capital structure of 0.6 (D/V) and a cost of equity of 10%. Alpha’s marginal tax rate is 20%.

Assume that the project generates an expected free cash flow of € 6 million in every future period.

Q:How large is the value of Beta Sub?

I would have used the target capital structure of the compareable firms and the cost of equity of the compareable firms in order to calculate the $r_{wacc}$ of Beta Sub.

$r_{wacc}=0.4*0.+0.6*(1-0.2)*0.6$

Then

$V_{beta}=\frac{6}{r_{wacc}}$ .

Would this be correct?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.