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acqanon - Acquisition Valuation: Seven Steps back to Sanity...

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Aswath Damodaran 1 Acquisition Valuation: Seven Steps back to Sanity… Aswath Damodaran Stern School of Business, New York University www.damodaran.com The original title I had was “Acquirer’s Anonymous: Seven Steps to Sobriety” but I decided that it showed my biases a little too strongly.
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Aswath Damodaran 2 Lets start with a target firm The target firm has the following income statement: Revenues 100 - Operating Expenses 80 = Operating Income 20 - Taxes 8 = After-tax OI 12 Assume that this firm will generate this operating income forever (with no growth) and that the cost of equity for this firm is 20%. The firm has no debt outstanding. What is the value of this firm? Could not be simpler: Value of the firm = 12/.20 = 60 million
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Aswath Damodaran 3 Test 1: Risk Transference… Assume that as an acquiring firm, you are in a much safer business and have a cost of equity of 10%. What is the value of the target firm to you? Does not change. You cannot make the argument (though many do) that since it is your equity that is being used to fund the acquisition, you can use your cost of equity (which would lead you to double the value of the target firm).
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Aswath Damodaran 4 Step 7: Don’t transfer your risk characteristics to the target firm The cost of equity used for an investment should reflect the risk of the investment and not the risk characteristics of the investor who raised the funds. Risky businesses cannot become safe just because the buyer of these businesses is in a safe business. The reason lies in a basic principle in capital budgeting - that a project’s discount rate should reflect the risk of the project and not of the entity taking the project. (Of course, this would also imply that you would use project specific costs of equity and capital….) If you fail on this principle, safe companies will end up overvaluing and overpaying for risky companies (as many did in the late 1990s)
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Aswath Damodaran 5 Test 2: Cheap debt? Assume as an acquirer that you have access to cheap debt (at 4%) and that you plan to fund half the acquisition with debt. How much would you be willing to pay for the target firm? This is a tougher one and you may be tempted to argue that the new cost of capital for the target firm will be: Cost of capital = 20% (.5) + 4% (.5) = 12% This would lead you to value the target firm at 100. What is the problem with doing this? Remember that the reason you are able to borrow money is because you as the acquiring firm have excess debt capacity and you are able to borrow at low rates because you have no default risk. If you use this lower cost of capital, you are in effect subsidizing the target firm stockholders with your excess debt capacity. How about if the target firm could have afforded to have a 50% debt ratio and
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This note was uploaded on 02/29/2012 for the course FINA 274 taught by Professor Williamhandorf during the Fall '11 term at GWU.

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acqanon - Acquisition Valuation: Seven Steps back to Sanity...

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