What to do when the WACC and IRR don’t match in a PPA

BVWireIssue #116-2
May 9, 2012

There might be many reasons why, when valuing a purchase price acquisition (PPA), the weighted average cost of capital (WACC) doesn’t match the internal rate of return (IRR) generated by the forecast and the price—for example, overpaying, tax planning, overestimation of synergies, or management’s desire to show revenue as early as possible. One thing appraisers should not do: abandon sound finance theory by making inappropriate nonsystematic risk (alpha) adjustments, says Alicia Grosman, a valuation director in PricewaterhouseCoopers’ transaction services, who spoke at the ASA's 20th annual conference on Current Topics in Business Valuations this past Monday in Manhattan.

“WACC is based on systematic risk, so adjusting it for unsystematic risk takes it out of the financial theory based in the CAPM approach and your cost of equity analyses,” Grosman told attendees. “It may also be inconsistent with the concept of fair value accounting.” Before adding premiums or using the IRR—practices that can cause problems in the PPA and all future impairment tests—Grosman suggests that appraisers:

  • Use the actual purchase price—one that doesn’t include compensation, settlements of other relationships, nonoperating assets, or liabilities, etc.
  • Pay particular attention to discount rates when analyzing the intangibles (in the most obvious situation, overpayment will result in higher goodwill, which presents more impairment risks).
  • Double-check the comparables and other inputs.

Finally, “remember that there may be good reasons for a gap between WACC and IRR,” Grosman said, “but you need to recognize and justify them.”

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