Cost of Capital and Valuation of Merging and Acquisition Operations

Abstract

Most often, value analyses of companies involved in Merging and Acquisition operations have shown a strong divergence between the stand-alone theoretical value of the company object of acquisition and the price paid. This divergence (acquisition premium) is difficult to explain by theoretical analysis, even considering revenue and cost synergies. The general practice tends to relate the premium paid to intangible aspects that cannot be explained with a financial formula. In this article, however, I show how most of the effects of an acquisition can be evaluated by financial analysis, even if it implies a deeper analysis than a simple net present value of synergies cash flow. In particular, possible approaches with the use of cost of capital corrections that evaluate the effect on the value of the acquiring company, consequent to its risk profile variation, were considered. Preface Value analyses of companies involved in Merging and Acquisition operations (hereafter also indicated as M&A operations) have shown strong divergences between the stand-alone theoretical values of the company object of acquisition (hereafter also called the target) evaluated on the basis of expected cash flows or stock price multiples, or both, and the paid price. These differences (hereafter, for simplicity defined as acquisition premiums) can be only partially explained with the revenue/cost synergies granted by the M&A operation. They instead could be explained with other effects pursued by the acquirer, such as the attempt to modify the market competitive equilibrium or its risk profile. These kinds of effects can be difficult to numerically quantify but could represent the main drivers of the operation. With this premise, the objective of this article is to formulate possible approaches in the process of evaluating M&A operations, with particular reference to the effects of the operation for the acquirer.