What's Wrong With Merger Valuation

As with any capital budgeting analysis, the valuation of a target company for an acquisition is a difficult task. A recent article argues that there are common reasons a company may overpay for an acquisition. We would like to discuss two assumptions in the article. First, using the example in the article, is that the two year loan interest rate is inappropriate since it is not possible to repay the two year loan with the cash flows from the target company. Using the two year loan violates the matching principle of capital structure, namely, that long-term assets should be funded with long-term liabilities and short-term assets funded with short-term liabilities. Although we don't doubt that a mistake has been made, it should not be made if the acquisition is viewed holistically, which is what the author is arguing. Second, we would take offense to the statement "There’s another assumption in finance theory that Adhikari questions that’s worth noting, and it’s also related to debt: that’s the belief that the target’s industry doesn’t matter." Obviously, this statement is incorrect. Suppose Company B, with a WACC of 8 percent, is considering acquiring Company T, with a WACC of 11 percent. What is the correct cost of capital to discount the cash flows from the acquisition? If you have been following this chapter (and the textbook as a whole), you would know that in general, the correct required return is 11 percent. The cost of capital depends on the use of funds, not the source of funds, even in an acquisition. The statement that finance theory ignores the target's industry is incorrect unless you are following incorrect finance theory.