Type I acquisitions
These are acquisitions that do not disturb the acquirer’s exposure to either business risk or financial risk.
In theory, the value of the acquired company, and hence the maximum amount that should be paid for it, is the Present Value of the future cash flows of the target business discounted at the WACC of the acquirer.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do impact upon the acquirer’s exposure to financial risk, eg through changing the gearing levels of the acquirer.
Such acquisitions may be valued using the Adjusted Present Value (APV) technique by discounting the Free Cash Flows of the acquiree using an ungeared cost of equity and then adjusting for the tax shield.
Type III acquisitions
These are acquisitions that impact upon the acquirer’s exposure to both business risk and financial risk.
In order to estimate WACC there is a need to establish the cost of capital of the combined businesses.