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IAI Actuarial Core Principles · Business Finance · Corporate growth, restructuring and divestment

In valuing a target for acquisition using discounted cash flow, which discount rate is most appropriate for the target's free cash flows?

Use a rate reflecting the target's own business risk and financing mix, typically its weighted average cost of capital. The cash flows being valued carry the target's risk, not the acquirer's, so the acquirer's cost of equity, the risk-free rate or the cost of debt alone would misstate the value.

  1. AThe acquirer's cost of equity, whatever the target's business risk
  2. BThe target's post-tax cost of debt
  3. CThe risk-free rate of return on government securities
  4. DA rate reflecting the target's own business risk and its financing mix, such as its WACCCorrect
  5. The historic dividend yield of the target

Explanation

Free cash flows of the target should be discounted at a rate that reflects the risk of those cash flows and the target's capital structure, i.e. its WACC. Using the acquirer's rate ignores differences in risk; the risk-free rate and cost of debt understate required returns.

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