| What is cost of equity really? |
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nanotech
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| What is cost of equity really? |
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Hi guys,
I am doing a corporate finance case for a class. In the case, one of the underlying questions is whether or not it is worth it for the a BIG COMPANY to acquire LITTLE COMPANY. I am trying to value the LITTLE COMPANY and am having a difficult time trying to figure out what discount rate to use. Since it is a "pooling of assets" deal and its going to be acquired by giving away shares only (non-cash transaction), that means that it is going to be bought out using "equity." So in valuing the LITTLE COMPANY, instead of using the cost of capital of the BIG COMPANY I should use cost of equity. However, it is difficult to figure out what the cost of equity is since the stock of the BIG COMPANY is not widely traded and the company doesn't pay out any dividends. In doing comparables, I came up with an unlevered beta for the industry of 0.75, but when I find cost of equity, I have to lever the beta using the debt-to-equity ratio. However, the debt-to-equity ratio of the BIG COMPANY is so high that the beta comes up to be 2.085 and then the corresponding cost of equity becomes 19.8%. At that discount rate, the LITTLE COMPANY is not worth it at the price it is being offered at. But my question is, should I really use that high of a cost of equity? Does the equity really have a 20% cost if the company is not even paying out any dividends? How do I do this? Help!!!
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Wed Dec 08, 2004 7:08 am |
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BlankenshipFP
Money Talk Advisor
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If those are all of the details that you have, it sounds like you've answered the question - that it isn't worth it for the big co to acquire the little co.
Being a case study, I realize you may have fewer details than real life. In real life you'd likely have revenue numbers for the little co, as well as more detail on the big company's cost of equity.
Hope this helps -
Jim Blankenship, CFP�, EA
Blankenship Financial Planning, Ltd.
www.BlankenshipFinancial.com
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Thu Dec 09, 2004 3:20 am |
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