Question

When calculating the value of a firm for an acquisition of a target firm, how should the discount rate for calculating this value be determined?  If there are gains of synergy associated with this acquisition, how will the acquiring firm account for this in their valuation of the target?

Answer 1

When calculating the acquisition value of a firm, the firm should consider using a rate which should be similar to a risk adjusted rate for a project which would have similar risk. The acquisition of a company should be treated as just another project which the company is undertaking and the discount rate that should be used would be similar to the what we would have used for similar risky project. If the acquisition is going to add significant value for the project and the probability of the cash flow is high then the risk premium that we would use is low but if the value added from the acquisition is not too much and the probability of value addition is low then the risk premium would be high. The acquisition should be treated as just another project and it should be evaluated on the basis of the its value addition.

If there are gains from synergy associated with the acquisition then that would be treated as an inflow of cash and the risk premium would have to be reduced regarding that acquisition or the cash flow in the analysis of the project should be increased. Also, if the synergy associated are high then the acquiring firm might be willing to pay a premium price over its current stock value because for him this investment would be strategic and he will benefit from this acquisition.