What is the best approach to calculate the Weighted Average Cost of Capital (WACC) for an acquisition target?

The Weighted Average Cost of Capital (WACC) is a crucial metric that reflects the average rate of return a company is expected to pay its security holders to finance its assets. In the context of an acquisition target, it is essential to derive a WACC that accurately reflects the specific characteristics and risk profile of that target.

Basing the WACC on the target's risk and adjusting for its new capital structure is the most appropriate approach because it takes into account the unique financial circumstances surrounding the acquisition. This includes considering the target's operations, industry risk, and market conditions, which can significantly differ from those of the acquiring company. Additionally, adjustments for the new capital structure post-acquisition are vital since the proportions of debt and equity financing directly affect the WACC. By accurately incorporating these factors, the calculated WACC can provide a more reliable measure of the expected return on investment for the acquisition.

Reliance on the previous year's WACC can lead to outdated or irrelevant assessments, as it may not reflect the current risk profile and capital structure of the target. Similarly, using market averages may not provide a true representation of the target’s unique situation. Ignoring Beta and focusing solely on company size disregards the critical insights that risk metrics provide regarding the volatility