Canada: Determining Rates Of Return For Corporate Acquisitions

When corporate buyers are looking at acquiring another company, the executive team often wonders what rate of return they should be seeking on their invested capital. Using a low rate of return could cause the buyer to overpay, and not provide adequate compensation for the risk that the acquired company's financial results will fall short of expectations following the transaction. A high rate of return could mean that the buyer's offer isn't competitive, and the seller chooses another suitor.

Rates of return are highly subjective, and there is no "right" answer per se. However, buyers should consider the following factors when developing rates of return for the purpose of corporate acquisitions: (i) prevailing risk free rates; (ii) an equity risk premium; (iii) liquidity risk; (iv) company-specific risk; and (iv) debt capacity.

Prevailing Risk Free Rates

Appropriate rates of return are a function of alternative investments that can be made with available capital. Since corporate acquisitions represent long-term investment decisions, the starting point in the rate of return analysis should be the yield on long-term government bonds, which represents a "risk-free" investment alternative. At present (May 2014) the yield on long term government of Canada bonds is approximately 3%.

Equity Risk Premium

Since corporate acquisitions represent equity investments, the next element to consider is the premium that a buyer could expect to generate by investing in the stock market in general, as opposed to risk-free government bonds. While equity returns fluctuate each year, over the long-term the equity risk premium (which reflects capital appreciation and dividend income for stocks listed on major indices such as the TSX or S&P 500) has been about 5%.

Liquidity Risk

Adding the yield to maturity on long-term government bonds (3%) and the equity risk premium (5%) suggests that an equity investment should generate a return of about 8% per annum, over the long term. But it's important to recognize that this represents the return on a very liquid and highly diversified stock portfolio such as the TSX or S&P 500. Both of these elements are missing when a buyer acquires a private company. Therefore, the rate of return has to be adjusted accordingly.

With respect to liquidity, an investor could sell most publicly traded shares in minutes if they no longer wanted to be invested. However, the divestiture of a private company normally takes between six to twelve months to complete, during which time the owners are exposed to the risk of adverse developments which could erode the company's value. Furthermore, unlike publicly traded stocks where the price is readily known, there's uncertainty regarding the price that might be obtained for a private company when it's sold in the open market.

Liquidity risk is difficult to quantify, but a benchmark that's sometimes used is based on the observed discounts in restricted stock studies. That is, shares of public companies that are not freely tradable for a period of about six months to 24 months are worth less than comparable shares that can be readily liquidated. There have been numerous studies conducted on this topic, and the results differ in each case. However, the median discount for restricted stock has been around 20% (i.e. restricted shares are worth about 20% less than comparable shares without restrictions). Converting this discount into rates of return for private company acquisitions suggests that target rates of return should be increased by about 2% to compensate for liquidity risk.

Company-specific Risk

As previously discussed, the equity risk premium is based on a stock portfolio that enjoys the benefits of liquidity and diversification. Liquidity risk was addressed above. In the absence of diversification, buyers need to consider company-specific risk inherent in the acquisition target. This can be highly subjective. As a very general guideline, company-specific risk can range from about 2% for larger, well-established companies with a strong competitive advantage, to 10% (or more) for smaller companies that are dependent on a handful of customers or certain employees (e.g. the business owner). While not an exhaustive list, some of the factors that buyers should consider when quantifying company-specific risk for an acquisition target include:

  • whether its product and service offerings have a differential advantage, or alternatively whether the company must compete primarily on the basis of price;
  • the degree of customer concentration and repeat business;
  • the breadth, depth and commitment of the management team;
  • whether historical operating results have been relatively stable or volatile; and
  • industry-specific risk factors such as the competitive landscape, regulations, and major trends.

Combining the risk-free rate with the equity risk premium, liquidity risk premium and company-specific risk premium suggests that a return on equity for a corporate acquisition should be in the range of about 12% to 20%, with the major variable being company-specific risk. Note that this assumes the acquisition target is an established company, as opposed to an early-stage business or venture capital type investment, for which rates of return can be significantly higher.

Debt Capacity

A buyer's ability to use debt in lieu of equity in order to finance an acquisition helps to reduce the required rate of return. This is because the interest rate on debt financing is lower than the required return on equity financing, particularly given that interest expense is tax-deductible.

Whether or not a buyer intends to use debt as a source of financing, rates of return for corporate acquisitions should be based on the target company's ability to accommodate senior debt in its capital structure. Debt financing ratios are subjective, but are mainly driven by two factors that lenders look for, being:

  • the level and stability of cash flows, which are required to service interest and principal repayments; and
  • the quantum and nature of assets that can be used as security.

It's important to note that while debt is attractive due to its low cost, the use of debt introduces financial risk, which increases the required return on equity. This is because debt financing ranks ahead of equity financing in its claim against the cash flows and assets of the acquired company. While there are formulas for calculating the impact of debt financing and financial risk, the following table can be used to provide an indication of the resultant "weighted average cost of capital", i.e. the required rate of return for an acquisition target, given the estimated return on equity and debt utilization.

These represent after-tax rates of return on total capital. Therefore, they should be applied to forecast discretionary cash flow for the target company, calculated as cash flow after capital expenditure requirements and corporate income taxes, but before debt servicing costs.


In the end, rates of return are subjective. Therefore, buyers should prepare economic models that allow for sensitivity analysis. Rates or return may also be adjusted where an acquisition target is considered highly strategic. In addition, buyers (and sellers) should remember that the terms of the deal (i.e. how and when the purchase price is paid) are just as important as the purchase price itself. However, by considering the various components that comprise rates of return, being: (i) prevailing risk free rates; (ii) the equity risk premium; (iii) liquidity risk; (iv) company-specific risk; and (iv) debt capacity, buyers can make a more informed decision about the rate of return to apply when assessing corporate acquisition opportunities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions