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Cost of Capital

Recall the determined the cost of capital for Rondo. Rondo's cost of capital is the appropriate discount rate for evaluating company investment projects and we applied it to evaluating Option 1. Now I introduce a twist. When evaluating an acquisition, the appropriate discount rate is not the acquirer's cost of capital but rather the target company's cost of equity. Why? The acquirer's cost of capital is most likely less than the target company's cost of equity. Why accept a lower return than the street would require? In the acquisition, aren't you, in essence, buying the equity of the target firm (plus assumption of their debt)?

The acquisition price should then be negotiated around the stock price of the target firm based on the target firm's cost of equity (retained earnings, not their new common). The actual financing may be at the acquirer's cost of capital or simply debt and/or equity.

The direction I want you to take in analyzing the Poly Pipe acquisition is the projected price of Poly's stock. It has a presumed market price of $36 and Poly management wants a 50% premium. Back into your proposed price using the constant growth model. That would be the price Rondo should consider in negotiating the acquisition. I am looking at price not as a lump sum but either as the required return to Rondo and/or the offer price per share to Poly management. This can also be stated as the number of shares of Rondo stock to be exchanged for Poly stock. Here are some additional hints:

1. Poly does not pay any dividends. How can you use the constant growth model? You could use Rondo's payout since Rondo management would most likely want to receive a dividend. You need to find Rondo's dividend payout ratio.

2. The growth rate for Poly is not given but you can get the ROE from Poly's financial statements and apply Rondo's dividend payout to obtain the retention rate. You then can calculate the sustainable growth.

3. What do you feel is Poly's required return? Applying the constant growth formula with Poly's market price, applying Rondo's dividend payout, and Poly's sustainable growth, you can back into the required return. How does it compare to Rondo's?

The formula for the constant growth model is:

. Re-arranging the terms:

Please process your valuation analysis with supportive dialogue on how to proceed negotiations.

Solution Summary

The solution explains how to calculate the cost of capital for the Rondo Company

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