Question

ATT (the phone company) had a beta of .57 before it bought Warner Brothers Studios (a content maker and television show producer) with a beta of 1.11 . When doing the analysis for the acquisition of Warner should ATT use it own beta of .57 in calculating the cost of capital for the acquisition or should it have used the 1.11 beta for Warner Brothers Studios? Why?

As a follow on to the prior questions what should happen to the beta of the combined company after the acquisition. In otherwords should the combined beta be higher or lower than the .57 beta for ATT before the merger? Why?

Answer 1

It should use its own beta of 0.57. This is because the cost of capital is the opportunity cost of the funds. The acquiring company needs to assess its own opportunity cost and hence discount future cash flows from teh acquisition using its cost of capital. Hence it should use 0.57 as the beta.

Once the company has been acquired, it becomes a single entity. Warner Brothers has a very high beta of 1.1. This will impact the risk of the entire company after acquisition. Hence a higher beta should be used as the combined beta after merger.