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Context : The change in capital structure of a combined company on its market value.
Question : Pursuit June 2011This will cause the proportion of market value of equity to market value of debt to
change, and thus change the cost of capital. Therefore the changes in the
market value of the company and the cost of capital are interrelated.
To resolve this problem, an iterative procedure needs to be adopted where the
beta and the cost of capital are recalculated to take account of the changes in
the capital structure, and then the company is re?valued. This procedure is
repeated until the assumed capital structure is closely aligned to the capital
structure that has been re?calculated. This process is normally done using a
spreadsheet package such as Excel. This method is used when both the
business risk and the financial risk of the acquiring company change as a result
of an acquisition (referred to as a type III acquisition).Could you please explain what is meant by assumed capital structure is in this case? And why does the process need to be iterated until it reaches the re-calculated capital structure?
You can not be asked to use an iterative approach in the exam (and neither can you be asked to refer to it as a type 3 acquisition, because knowledge of the names of the different types was removed from the syllabus several years ago).
However the cost of equity (and therefore the MV of equity) will change as the gearing changes. So doing the calculation at one level of gearing results in a different MV of equity and therefore a different level of gearing. Repeating the excercise at this new level of gearing results in a different cost of equity, therefore a different MV of equity, and therefore a different level of gearing. So the process would keep needing to be repeated over and over again – this is known as iteration.
I do mention this in my free lectures, but again you cannot be required to do it in the exam.
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