PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 295number of publicly traded insurers and they tend to be multilinefirms involved in a wide variety of businesses (many of whichhave substantially different risk profiles). These considerationssupport using a single hurdle rate reflecting average risk activitiesand then adjusting the amount of required capital so that the riskof the acquisition is equivalent to the average risk of the firm.3. Method of financing the acquisitionIf the acquisition is to be financed with a mix of debt andpreferred and common equity, then the appropriate hurdle rateshould reflect the weighted average after-tax costs to the firmof acquiring capital through these vehicles. The capital structureunderlying the acquisition, and not necessarily the existing capitalstructure of the acquiring entity, is the relevant issue. Forexample, if a firm is currently financed with a mix of debt andequity, but intends to pursue an acquisition financed solely byequity, then the relevant hurdle rate is the equity cost of capital.4. Consistency with other assumptionsThe discount rate depends on relative risk, which in turn dependson several factors that may be related to other aspects ofthe valuation. For example, in addition to the intrinsic risk ofits specific business activities, the cost of capital for a firm willdepend, among other things, on the firm’s leverage and mix ofassets. Both of these factors, however, will have an impact on theprojected free cash flow that forms the foundation of the valuation.There must be consistency between the assumptions usedto develop the cash flows and those used to develop the discountrate. 234.8. Capital NeedsThe capital required to support an insurance company is a keyassumption in the valuation process.23 The discount rate is often viewed as the sum of a risk-free rate and a market riskpremium as in the CAPM. The value of the market risk premium is a topic of debateamong financial economists.