How does a Projected Increase in Growth and Cash Flows Affect the Cost of Capital in Merger and Acquisition (MA) Transactions?

Introduction

For over three decades, I have been involved in mergers and acquisitions (MA) transactions, and in this time, I have developed a valuation software that defies many conventional norms. Recently, I have been asked a question regarding the impact of a projected increase in growth and cash flows on the cost of capital.

Assumptions and Factors Affecting Cost of Capital

The scenario involves an increase in growth from g1 to g2, with the assumption that this increase in growth does not increase the risk of achieving it.

Impact on Equity Cost

Higher growth often requires a higher equity cost because:

A business's ability to borrow does not increase with higher growth, even if banks are cash flow (CF) lenders. A business's ability to service debt does not proportionally increase with the value increase from g1 to g2.

These factors indicate that higher growth generally means a lower debt-to-equity ratio, which in turn increases the cost of capital.

Implications for Cost of Capital

Even if the cost of capital does not increase due to higher growth, it often does in MA transactions for several reasons:

Projections in MA are highly subjective, and there is a significant information gap between the buyer and seller. Buyers are hesitant to pay additional consideration simply because management has changed their assumptions.

This article explores the intricate relationship between growth, cash flows, and the cost of capital in the context of MA transactions.

Theoretical vs. Practical Implications

Theoretical models often suggest that an increase in future free cash flows (FCF) should not impact the weighted average cost of capital (WACC). This is because companies are valued based on their expected FCF, and an optimistic outlook on future FCF would typically be reflected in a higher valuation or price-to-earnings (P/E) ratio.

However, in practice, MA transactions often show a different trend. An increase in FCF projections may lead to an increase in WACC. This is due to the subjective nature of future projections and the vast information asymmetry that exists between the buyer and seller. Buyers are unlikely to pay a premium based on management's optimistic projections alone, as they often seem overly optimistic in hindsight.

Implications for Valuation and Stock Price

When management adjusts their earnings guidance upwards, it sometimes results in a temporary boost to the company's stock price. This happens because investors often view improved guidance favorably, expecting higher dividends, earnings, or both.

Subjectivity and Information Asymmetry

However, in the context of MA transactions, an increase in future FCF is typically not accompanied by an increase in WACC. This is because:

Buyers prefer to see concrete and reliable evidence rather than optimistic projections. There is a large information gap between the buyer and the seller, making it difficult to fully trust optimistic projections. Even if FCF projections are higher, buyers are unlikely to adjust their valuation based solely on these projections.

As such, while an optimistic outlook on future FCF can provide a short-term boost to a company's stock price, it does not usually result in a proportional increase in WACC or valuation in the MA context.

Conclusion

The relationship between growth, cash flows, and the cost of capital in MA transactions is complex and often counterintuitive. While higher growth and cash flows can lead to higher equity costs and informal adjustments in investors' perceptions, these factors typically do not significantly impact WACC in a structured valuation and acquisition process. This highlights the importance of objective and rigorous valuation methods in MA transactions.

Using advanced valuation software that integrates these complexities can provide a more accurate and reliable assessment, helping both buyers and sellers make informed decisions.

In conclusion, while theoretical models suggest a more stable relationship, practical MA transactions often show a more nuanced and sometimes contradictory relationship between growth, cash flows, and the cost of capital. Understanding and navigating these complexities is crucial for successful MA transactions.