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ACCA Strategic Professional · Advanced Financial Management · Valuation for acquisitions and mergers

A bidder will fund an acquisition with a large amount of new debt, so the target's gearing will change substantially and then be reduced over several years. Which valuation approach is most appropriate for the target's FCFF?

Adjusted present value is most appropriate. Because gearing changes substantially, a constant WACC would be misleading. APV values operating cash flows at the ungeared cost of equity, then adds the present value of financing side effects such as the interest tax shield separately.

  1. ADiscount at the target's existing WACC, assuming it stays constant
  2. BUse adjusted present value, valuing the base-case cash flows at the ungeared cost of equity and adding financing side effects separatelyCorrect
  3. CDiscount FCFF at the target's current cost of equity
  4. DDiscount FCFE at the target's existing WACC

Explanation

A constant WACC assumes a stable capital structure, which is not true here. APV values the project at the ungeared cost of equity and adds the PV of the tax shield and other financing effects separately. Discounting FCFE at WACC mismatches the cash flow and the discount rate.

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