Valuing Acquisition Target Case Study - DCF and IRR?

Question

Wondering how best to answer a case study I need to do. Case study info as follows:

Given Selling company's P&L (3 years actual, 4 years forecast) - closing date on end of year 3 - and a PPT of investment opportunities/risks; value this company and make an investment recommendation.

What's the right way to go about this? My first thought is to do a DCF using provided EBITDA to get enterprise value of seller. But three questions:

1. What discount rate do I use? This is supposed to be a 100% cash purchase but I'm not given any balance sheet info for purchaser or seller to use WACC. It was suggested to me by a friend that it might be okay to use and assume a "required return rate" that the purchaser might use for all projects/acquisitions. Does this make sense?

2. Once I complete DCF and get enterprise value for all 3 cases (mgmt, base, downside) - this would give me the range of acceptable purchase price right?

3. Lastly - is there value in calculating the IRR of purchase price (as a negative) and future cash flows? At first I thought the IRR would equal the discount rate used in DCF but it doesn't seem so in my model - what's the relationship and can I use IRR to compare two mutually exclusive investments? I want to suggest that "we should acquire this company unless there are other options with better IRR, etc"

I'm just talking from a strictly financial perspective here - I know there are other factors I should consider like synergies, market ,etc etc but just wanted to get thoughts on the $$ part. Thanks!

Answer 1

please see my answers below.

1) I would recommend to use one of the following discount rates depending on funding source of the purchase:

• Weighted average cost of capital (WACC)
• Cost of equity
• Cost of debt
• Pre-defined hurdle rate in case of internal corporate project
• Risk-free rate

Value of the acquisition to company is sum of standalone value of the business you are acquiring plus the benefits you anticipate from the acquisition, minus the costs of carrying out the transaction. Standalone value may be based on book value of the business, stock market valuation or value of assets if sold separately. Benefits are synergies from merging operations along with economies of scale of combined operations. Costs are fees, financing and cost of management time.

Does this approach work in real-life? Please note that in real-life acquisitions premium may be paid to ensure the deal to go through. In some cases, acquisition is made even with a discount.

Why this is the case? Presence of other bidders and motivations of buyer and seller may affect the sales price. Uniqueness of acquisition opportunity might push price upwards more than expected. Price paid in previous deals might affect acquisition price too.

In sum, I would say that defining simple correct price is impossible. Instead, you may want to define the range for reasonable acquisition price.

3) As described above, value of the acquisition to company is sum of standalone value of the business you are acquiring plus the benefits you anticipate from the acquisition, minus the costs of carrying out the transaction. I would recommend to take all these factors in the account in your DCF.

Internal rate of return (IRR) calculation assumes that NPV equals to zero. Unlike in the NPV calculation, discounting rate is not known in the IRR calculation. You are correct about using IRR to compare two mutually exclusive investments. Please keep in mind that in real-life investment decisions are not based solely on IRR.

Answer 2

The DCF analysis and the discount rate don't depend on how an acquisition is funded. It merely computes the present value of future cash flows at discount rates that reflect the probability of those cash flows not materializing in part or in full.

One cannot perform a meaningful DCF analysis without cash flow statements and balance sheets. If this level of detail is not available, opt for comparable companies analysis and consider 'downside' (i.e. worst case) as the only scenario given how many known unknowns there are.