If Pursuit Co aims to acquire Fodder Co using debt finance and cash reserves, then the capital structure of the combined company will change. It will also change if they adopt the Chief Financial Officer’s recommendation and acquire Fodder Co using only debt finance.
Both these options will cause the cost of capital of the combined company to change. This in turn will cause the value of the company to change. This will cause the proportion of market value of equity to market value of debt to change, and thus change the cost of capital. Therefore the changes in the market value of the company and the cost of capital are interrelated.
To resolve this problem, an iterative procedure needs to be adopted where the beta and the cost of capital are recalculated to take account of the changes in the capital structure, and then the company is re-valued. This procedure is repeated until the assumed capital structure is closely aligned to the capital structure that has been re-calculated. This process is normally done using a spreadsheet package such as Excel. This method is used when both the business risk and the financial risk of the acquiring company change as a result of an acquisition (referred to as a type III acquisition).
Alternatively an adjusted present value approach may be undertaken. |
