We wrapped up the previous episodes by

mentioning the sensitivity analysis with respect to some important value drivers.

And we specifically said that we perform sensitivity with respect to drivers that,

get into the formula in a non-linear way.

Of those special attention must be given to cost of capital.

Well, we talked about cost of capital quite a bit on the corporate finance course.

So what I'll be saying right now is to some extent just a repetition,

but it also points out certain things

that previously we could not enjoy if you will.

And the idea here is that in M&As,

we normally value public companies in the vast majority of cases.

So, sometimes the application,

the cost of capital is sort of easier.

Well, let's start with

the famous and well known to us idea of capital as a pricing model.

I think you all remember that it basically says that the cost of

capital of the asset or the right expected rate of return.

What is this?

It's risk free rate plus beta of

this asset times the market risk premium.

This one as you might recall is somewhere between six and eight percent per annum.

And beta is the asset specific or company specific coefficient

that basically describes its contribution to the overall risk of the market portfolio.

Now, when we dealt with that in corporate finance,

we said that this formula although very nice and easy to use,

and in general it's sort of correct because it does

depict the most important things with respect to risk and return here.

But we said that it's difficult for

us to deal with this betas because we're private companies.

These betas have to be taken from somewhere else.

For public companies what we can do,

historical betas are no problem.

The only problem that persists is the forecast of this beta.

But, if for a long period of time we could have seen

that the changes in beta have not been that drastic,

that might be a good starting assumption.

Then we also said that if we know this sort of beta,

then this whole idea becomes easier to implement.

And that again is a huge plus for valuation in M&As.

I'm not saying that it's applicable to

all cases but again for the vast majority of publicly known,

publicly rated companies, that is an option.

Now, so I will put it in blue here,

it's sort of easier to use.

And again I'll put in quotes.

Well, what other methods are people using here?

Well, one thing that I would also like to mention is

the so-called bond yield

plus equity risk premium.

The idea is very simple.

We know that in general equity is riskier than that.

So, the benchmark, the return on debt is changing over time.

But here the assumption is made that over a long period of time,

the risk premium over this debt for this company stays sort of the same.

So what people are doing is they take

historical RE minus RD for this company.

Because looking backwards, we've seen these returns and we can see the trend.

And then we just take

the current yield on let's say equivalent debt.

I'll put debt. And we're all set.

So, again that seems to be a less scientific approach.

But it deals with the actual history of the company that we're valuing.

Well, what else?

Let me also mention another thing that must look familiar to you.

This is the dividend growth model.

Again this model basically says that the return on equity is

dividend one over p sub zero plus g where this is the dividend at point one,

this is the current price of the stock and this is the rate of growth of dividends.

Well, again, if this is constant,

this is more of an assumption.

Then clearly we go back to

the most simplistic approaches that we had in corporate finance,

and we'll be all set here.

But like I said,

some people say well,

putting this g constant is too rough.

Well but remember in what we just discussed when we look backwards,

we also take some historical data.

And we assume or we claim if you will that this trend will

persist in the future which clearly is an assumption and is a strong assumption.

Well, there are some other approaches but I will

mention all of these on the pages of this flip chart,

there are some more in our handouts.

But now I would like to make an emphasis on the idea of capital structure.

Because you remember that

all the previous approaches were devoted to the cost of equity.

And if the company has a significant portion of debt,

you know that the right and

the better estimate of its cost of capital is so-called weighted average cost of capital,

that I will reproduce on this page in just a moment.

But in order to be able to identify that,

we have to realize what the capital structure of the company is,

namely what's the proportion of debt and equity.

Well, there is a lot of discussion in our handouts and in the book that

says that this idea of optimal or better capital structure

and its interaction with the M&A transactions and

with the M&A overall approach to these companies,

this requires some special attention.

But for us the important thing is not to forget about that.

And here we can say well,

if this is the case,

then we know that there is weighted average cost of capital, that is,

let me remind you D over D plus E times RD times one minus T where T

is a tax rate plus E over D plus E times RE.

So basically, all the previous approaches and the ones that we do not discuss here,

they all provide us with this RE.

And this RD we take from equivalent bonds on the market,

and then we feed this formula and get this rated average cost of

capital that is used in all valuation formulas.

Well, here I would not delve deeper in all these effects of the changes.

Get those structure because here this is a snapshot.

Because you can see if the debt to equity ratio changes then so does WACC.

We talked about that in greater detail in corporate finance and it's the same here.

But what I'm trying to say is that

now you can see why we mentioned this sensitivity analysis,

and why we put so much emphasis on that.

Because given the fact that even if we have a lot of information,

our assessment and our estimates of these returns and with the average cost of capital,

they are linked to the assumptions that we're

making or to some historical data and historical trends,

then clearly we can never come up with

the absolutely correct weighed average cost of capital.

So it is really important to run

the sensitivity analysis with respect to that because this is the nonlinear component.

And that might be of quite some importance.

That's it for cost of capital for now.

And in what follows I will show

some examples of how all these approaches and valuations are used

to arrive at the gain or maybe loss that is as a result of an M&A transaction.