Mergers and Acquisitions

Prof. Pratham J Click to edit

Master subtitle style

Session 3, 4: 7 Dec 2011 Course: SLFI 604; Second Year Sem 2; Class of 2012

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Cost of Equity and Asset Pricing Model

Ke Cost of Equity CAPM Capital Asset Pricing Model states:

Expected return on any asset is equal to a risk free rate of return plus a risk premium

Risk

Free Rate of Return

Use of Short term or long term depends on how long the investor intends to hold the investment

Market

risk of equity premium refers to the additional rate of return in excess of risk free
Ke= Rf + (Rm - Rf ) Rf - Risk Free rate of return Beta Rm - Expected rate of return on equities 3/20/12

Firm Size Premium

Lower the firm size greater the risk of default and greater the risk premium demanded Ke= Rf + (Rm - Rf ) + FSP Firm Size Premium - FSP Ex: Firm Size < USD 50mm =1.75 Rf =5% FSP = 9.2% What is the cost of equity?

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Pre Tax Cost of Debt

Cost

of Debt = Cost of debt of borrowed funds Reflects the default risk of the firm Can be measured by the firms credit rating For non rated firms

Operating margins Interest Coverage Ratio Debt to Equity Ratio

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Cost of Preferred Stock

Kpr

= dpr/PR

Kpr - Cost of Preferred Stock Dpr Dividend per share PR Market Value of Preferred Stock

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Weighted Average Cost of Capital

Weighted

average Cost of Capital = Ke* (E/E+D+PR) + i*(1-t)*D/D+E+PR + Kpr*PR/(D+E+PR)

Market value of equity D- Market value of Debt PR Market Value of Preferred Stock
Non

interest bearing liabilities excluded

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Analyzing Risk
Non diversifiable and Diversifiable Risk Represents non diversifiable portion of the risk < 1 Less risky than the general market >1 More Risky than general market
Investors

compensated for risk that cannot be eliminated through diversification calculate by this regression equation

Can

Rf = + Rm

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Leverage on Beta
Financial

Leverage boosts equity returns in good times and depresses in bad times l = u [ 1 + (1-t)D/E]
Steps

to calculate Levered Beta

Determine firms current equity Beta* and D/E* Estimate unlevered u = l/ [ 1 + (1-t)D/E] Now estimate levered Beta using the latest target D/E structure l = u [ 1 + (1-t)D/E**] Estimate the firms cost of equity for new levered
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Free cash Flow to Firm

FCFF

= EBIT (1- Tax rate) + Depreciation and Amortization Gross Capex Change in Net working capital Represents cash flow to all investors holding claims to firms resources FCFE = [Net Income + Depreciation and Amortization Change in working Capital]1 Gross Capex2 + [New preferred Equity Preferred Dividends + New Debt Issue Principal Payments]3 1- CFO, 2- CFI, 3 CFF
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