i cant get my head around as to why would the cost of capital applicable to the target be used as opposed to the acquirers cost of capital.
The company post acquisition would be able to raise funding at the cost of capital applicable to the acquirer and hence its value is to the acquirer is more than would be estimated had the cost of capital applicable to the target been used.
But the text says that the target’s cost of capital is what should be used.
can anybody explain?
Because the optimal capital structure is unique to each project/firm.
The weighted complex average of all the WACCs for all the projects under a firm, is the firm’s WACC. Which is a hypothetical number that isn’t always the real WACC of anything, just a blended number of different costs of capital.
The risk of the target company is very different from the acquirer. So if the acquirer acquires the target, the company should be valued at target’s hurdle rate ( cost of capital) and not the acquirer. Imagine the target is a very risky company ( ex. Beta =2), and the acquirer very safe, If you value the target using acquirer’s cost of capital, wouldnt you raise the value of the target which its not even worth?
Another way is - Think of a company in three different businesses, would you value these three businesses ( different risks) at company’s cost of capital? The answer is no. You would value each businesses at its own cost of capital.
Hope this helps.