FREE online courses on Mergers & Acquisitions - Chapter 4 - Discount Rate

 

Now that we have some idea of our income stream for valuing the Target Company, we need to determine the discount rate for calculating present values. The discount rate used should match the risk associated with the free cash flows. If the expected free cash flows are highly uncertain, this increases risk and increases the discount rate. The riskier the investment, the higher the discount rate and vice versa. Another way of looking at this is to ask yourself - What rate of return do investors require for a similar type of investment?

 

Since valuation of the target's equity is often the objective within the valuation process, it is useful to focus our attention on the "targeted" capital structure of the Target Company. A review of comparable firms in the marketplace can help ascertain targeted capital structures. Based on this capital structure, we can calculate an overall weighted average cost of capital (WACC). The WACC will serve as our base for discounting the free cash flows of the Target Company.