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M&A Fundamentals – Using the Capital Asset Pricing Model to Calculate Cost of Equity

The cost of equity (“Ke”) is a key component of the working average cost of capital (“WACC”) formula that M&A professionals use to calculate a discount rate when using a DCF present value model to prepare a valuation of an M&A target.

We explain the WACC calculation in another article from this M&A Fundamentals series:  M&A Fundaments  -Working Average Cost of Capital (WACC).

Most M&A professionals use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity capital either for their own company, or in some circumstances for the M&A target.  A separate cost of equity for the M&A target will be used when it operates in a market or region where the risk profile mandates a higher cost of capital.

We dig deeper into the circumstances where a cost of equity specific to the M&A target might be needed in our Advanced Business Valuation training course.

 

 

What is the Capital Asset Pricing Model?

 

The Capital Asset Pricing Model is widely used by financial analysts, investors, and M&A professionals to calculate the cost of equity capital.  The concept was developed in the 1970s by Nobel laureate economist William Sharpe.

The starting point for the model is the insight that any investment in traded equities comes with two inherent types of risk:

 

Systematic Risk

Systematic risk is the risk to the whole market (or system) from external factors such as elections, wars, interest changes or the business cycle.  As the total equity invested in the stock market is already diversified across all the different companies listed on the exchange, risk is already diluted to the maximum extent possible if investing in equities.

Unsystematic Risk

Unsystematic risk is the risk of investing in an individual stock listed on the stock exchange.  The risk that comes from poor management, technological change, a risky financial structure, or a whole host of other factors.  Just the kind of things an M&A professional would look for in due diligence. Changes in the share price of an individual company caused by these factors will not necessarily move in tandem with the overall market system.  This is sometimes called the “specific risk” of the company.

 

If the unsystematic risk of a company is high investors, and after all M&A professionals are investing on behalf of the shareholders, will require a higher return on equity capital to invest in its shares.

 

What is the Formula for the Capital Asset Pricing Model?

 

The formula for calculating the cost of equity using CAPM is set out below.

Diagram 1:  The CAPM Formula

Ke = Cost of equity

rf = Risk free rate

Β = The specific risk of the company.

rm = The overall stock market risk

rm-rf  = The systematic risk of the stock market

 

In plain English the cost of equity (Ke) is the return on a risk-free investment (rf), plus the overall risk of investing in shares on a stock exchange (rm-rf) multiplied by the specific risk factor of the company (B).

 

 

Elements of the CAPM Formula

 

Cost of Equity (Ke)

The cost of equity Is the overall return investors require to invest in the company.

Risk Free Rate (rf)

The risk free Is the return an investor could achieve by investing in a risk-free security.  For the purposes of the CAPM this is the redemption yield on a government bond with a maturity oof at least 15 years.

Overall Market Risk (rm)

The overall market risk is taken to be the annual returns on equity for a stock market over an extended period.  In London, New York, and other long-established exchanges this analysis may be extended over 70 years or more.

Beta (B)

Beta measure the volatility of an individual company’s stock in comparison to the overall volatility of the stock market on which it is traded. In simple It measures how much the price of share moves up and down compared with how much the entire stock market moves up and down.  If the price of a share moves exactly in line with the market, then the beta is 1.  A company with a share less volatile than the market would have a beta less than 1, and a company with a share more volatile than the market greater than 1.

Beta is calculated for every share on a stock exchange by a statistical analysis of individual, daily share price changes in comparison with the market’s daily movement over a defined period – usually a few weeks.  M&A professionals can find the latest beta for an M&A target on the website for the stock exchange on which the company is traded.

 

How Would an M&A Professional Use the CAPM?

 

The chart below shows the steps an M&A professional would follow when calculating the cost of equity to use in the WACC calculation for an M&A target.

 

Diagram 2:  CAPM Process Flowchart

 

 

 

 

 

About The Merger Training Institute

We provide practical, in-career mergers and acquisitions training for boards, executives and professionals in global corporations.

Our short, intense M&A courses are designed for executives needing to understand best M&A practice or adding new M&A responsibilities to their existing roles.

The courses are taught by tutors with hands-on M&A experience gained as part of corporate management teams. As well as being academically rigorous they are rich with case studies and real-world examples based on our tutor’s practical mergers and acquisitions experience.

Our course participants come from a wide range of industries and roles including general management, business development, strategy, marketing, finance, human resources, operations and legal.

 

Our Mergers and Acquisitions Training Courses

Core Mergers and Acquisitions Skills Training Course

The Core Mergers and Acquisitions Skills programme (M&A training course) is a three- day programme that teaches all the commercial and technical skills you will need to confidently lead or support a successful M&A transaction.

Our expert tutors guide you through the M&A process from strategy and deal origination to valuation, due diligence, deal structuring, contract negotiation and post-merger integration.

M&A Due Diligence Training Course

The M&A Due Diligence Training Course is a two-day programme that offering a solid grounding in the techniques used by some of the world’s most successful companies to assess risks, evaluate synergies and confirm the strategic fit of an M&A target. The course is designed specifically for executives involved in corporate M&A.

Successful Post-Merger Integration Training Course

The Successful Post-Merger Integration Training Course is a two-day programme that provides a solid grounding in the post-merger integration techniques used by some of the world’s most successful companies to deliver value from their M&A transactions.

Across the two days of the course you move from the key decisions made in the pre-deal phase, through the critical first 100 days and on to full synergy delivery. The course covers the post-merger integration issues most likely to arise in each business function and the most important business processes.

Advanced Business Valuation Training Course

The Advanced Business Valuation training course is a two-day expert level business valuation training course that teaches participants how to prepare robust business valuations in the context of a corporate M&A transaction.

Our expert tutors move you past the stage of plugging numbers into a standard spreadsheet and help you explore how risk, synergies and the quality of the target company might impact its value.

 


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