Comment on the director's suggestion of playing the "relative P/E game. For your calculations assume that QuickResolve's shareholders have agreed to an exchange ratio of 1 share of Innovative Concepts for every 2 shares held in QuickResolve. Also, assume that the combined net income of the two firms is the sum of their net incomes prior to the completion of the deal. It was late Sunday night and Dan Peterman was getting weary. The big presentation was set for 8 am the next day and Dan kept remembering what Ray Machado, the chairman of the Mergers and Acquisitions (M&A) committee had said to him. "The board members are going to ask several tough questions at the meeting so we better prepare ourselves thoroughly. Make sure that we can substantiate all our numbers and justify all our assumptions." Dan and Ray were serving on the M&A committee, which had been formed by their CEO, Keith Overby, to "look into possible candidates for acquisition. The three of them were employed by Innovative Concepts, a fairly large-sized manufacturing firm, headquartered in Minneapolis, Minnesota, which produced unique metal products for household and commercial use. Formed in 1980, the company had seen better days. At the time of its inception, its industry sector was still in its infancy stage and was almost non-existent. As a result the company enjoyed over the years and was able to recruit excellent competition significant growth good credit history. up, personnel, many of who stayed with the company right from the start. The firm had accumulated a significant amount of cash and built up a Over the past couple of years, however, due to fierce competition and a lackluster economy, the firm's scope of expansion had all but dried and the managers were hard pressed to search for alternative avenues for growth. The company's stock price had recently dropped to $45 per share. The overwhelming consensus in the boardroom was that the firm should look for suitable acquisition candidates so as to better utilize its resources and diversify its risk. About three months ago, the Chairman and CEO., Keith Overby set up the M&A committee to research possible acquisition candidates and present its findings at the quarterly board meeting. He asked the committee members to consider firms in related as well as unrelated industries and explain the rationale for their recommendations. After considerable research, data gathering, and analysis, the committee had narrowed their choices down to three possible candidates. After the presentation at the quarterly meeting in March, the Board of Directors had ruled out two of the three candidates and asked the committee to conduct further valuation and analysis on the third candidate QuickResolve Products. The board members particularly curious about the low P/E ratio that the firm was trading at. In fact, one board member had heard about "relative P/E magic" and was wondering whether by acquiring QuickResolve the firm could boost it's P/E ratio and possibly its earnings per share. QuickResolve Products, headquartered in Rockford, Illinois, was a mid-sized company with assets of $2 billion. The firm's earnings per share had been steadily increasing each year and were currently $1.20 per share. Surprisingly, however, the committee found that although the low at 12.5X -- much below the average P/E ratio for the industry. The fim had a fairly well diversified customer base, its P/E ratio was rather committee felt that one reason for the low P/E ratio might have been the recent retirement of their CEO who had managed the company in a very centralized manner. All managers reported directly to him and he were were made most of the strategic decisions. His experience and vision had been well rewarded in the market. The members of the M&A committee felt that if QuickResolve were to be acquired by Innovative Concepts, production and marketing costs could be significantly reduced due to Innovative Concepts technical and marketing expertise. The incremental net cash flows of the combined company were estimated to be at least $45 million per year for the foreseeable future. Moreover, since QuickResolve was involved in a totally different industrial sector there some significant diversification benefits to be had. Tables 1-4 present the financial statements of Innovative Concepts and QuickResolve Products respectively. The finance department of Innovative Concepts' had recently estimated the firm's weighted average cost of capital to be 16% and the required rate of return on equity to be 20%. Since Dan had first suggested QuickResolve as a possible acquisition candidate, it was his job to provide the Board with the necessary information, clarification, and estimates. Dan firmly believed that QuickResolve and Innovative Concepts were made for each other!' Now if only he could convince the board! Table 1 Innovative Concepts Income Statement ($ millions) $3,000 2,550 450 100 50 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 50 250 100 150 100 50 Dividends Paid ($1 per share on 100 million shares Addition to Retained Earnings Innovative Concepts Balance Sheet ($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 400 200 400 1,000 2000 Gross Fixed Assets 6000 -2000 Accumulated Depreciation Net Fixed Assets 4000 Total Assets 6000 300 200 Accounts Payables Accruals Notes Payable Total Current Liabilities 500 1000 Long-term debt 2000 500 1000 Common Stock (Par Value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 1500 3000 6000 Quick Resolve Products Income Statement (millions) $1.500 1,320 180 50 15 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 100 40 80 40 Dividends Paid ($0.8per share on 50 million shares) Addition to Retained Earnings 20 QuickResolve Products Balance Sheet ($ millions) 300 200 Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 200 300 1000 Gross Fixed Assets 1400 -400 Accumulated Depreciation Net Fixed Assets 1000 Total Assets 2000 150 130 Accounts Payables Accruals Notes Payable Total Current Liabilities 500 780 Long-term debt 600 100 340 Common Stock (Par Value = $2 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 180 620 2000 Comment on the director's suggestion of playing the "relative P/E game. For your calculations assume that QuickResolve's shareholders have agreed to an exchange ratio of 1 share of Innovative Concepts for every 2 shares held in QuickResolve. Also, assume that the combined net income of the two firms is the sum of their net incomes prior to the completion of the deal. It was late Sunday night and Dan Peterman was getting weary. The big presentation was set for 8 am the next day and Dan kept remembering what Ray Machado, the chairman of the Mergers and Acquisitions (M&A) committee had said to him. "The board members are going to ask several tough questions at the meeting so we better prepare ourselves thoroughly. Make sure that we can substantiate all our numbers and justify all our assumptions." Dan and Ray were serving on the M&A committee, which had been formed by their CEO, Keith Overby, to "look into possible candidates for acquisition. The three of them were employed by Innovative Concepts, a fairly large-sized manufacturing firm, headquartered in Minneapolis, Minnesota, which produced unique metal products for household and commercial use. Formed in 1980, the company had seen better days. At the time of its inception, its industry sector was still in its infancy stage and was almost non-existent. As a result the company enjoyed over the years and was able to recruit excellent competition significant growth good credit history. up, personnel, many of who stayed with the company right from the start. The firm had accumulated a significant amount of cash and built up a Over the past couple of years, however, due to fierce competition and a lackluster economy, the firm's scope of expansion had all but dried and the managers were hard pressed to search for alternative avenues for growth. The company's stock price had recently dropped to $45 per share. The overwhelming consensus in the boardroom was that the firm should look for suitable acquisition candidates so as to better utilize its resources and diversify its risk. About three months ago, the Chairman and CEO., Keith Overby set up the M&A committee to research possible acquisition candidates and present its findings at the quarterly board meeting. He asked the committee members to consider firms in related as well as unrelated industries and explain the rationale for their recommendations. After considerable research, data gathering, and analysis, the committee had narrowed their choices down to three possible candidates. After the presentation at the quarterly meeting in March, the Board of Directors had ruled out two of the three candidates and asked the committee to conduct further valuation and analysis on the third candidate QuickResolve Products. The board members particularly curious about the low P/E ratio that the firm was trading at. In fact, one board member had heard about "relative P/E magic" and was wondering whether by acquiring QuickResolve the firm could boost it's P/E ratio and possibly its earnings per share. QuickResolve Products, headquartered in Rockford, Illinois, was a mid-sized company with assets of $2 billion. The firm's earnings per share had been steadily increasing each year and were currently $1.20 per share. Surprisingly, however, the committee found that although the low at 12.5X -- much below the average P/E ratio for the industry. The fim had a fairly well diversified customer base, its P/E ratio was rather committee felt that one reason for the low P/E ratio might have been the recent retirement of their CEO who had managed the company in a very centralized manner. All managers reported directly to him and he were were made most of the strategic decisions. His experience and vision had been well rewarded in the market. The members of the M&A committee felt that if QuickResolve were to be acquired by Innovative Concepts, production and marketing costs could be significantly reduced due to Innovative Concepts technical and marketing expertise. The incremental net cash flows of the combined company were estimated to be at least $45 million per year for the foreseeable future. Moreover, since QuickResolve was involved in a totally different industrial sector there some significant diversification benefits to be had. Tables 1-4 present the financial statements of Innovative Concepts and QuickResolve Products respectively. The finance department of Innovative Concepts' had recently estimated the firm's weighted average cost of capital to be 16% and the required rate of return on equity to be 20%. Since Dan had first suggested QuickResolve as a possible acquisition candidate, it was his job to provide the Board with the necessary information, clarification, and estimates. Dan firmly believed that QuickResolve and Innovative Concepts were made for each other!' Now if only he could convince the board! Table 1 Innovative Concepts Income Statement ($ millions) $3,000 2,550 450 100 50 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 50 250 100 150 100 50 Dividends Paid ($1 per share on 100 million shares Addition to Retained Earnings Innovative Concepts Balance Sheet ($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 400 200 400 1,000 2000 Gross Fixed Assets 6000 -2000 Accumulated Depreciation Net Fixed Assets 4000 Total Assets 6000 300 200 Accounts Payables Accruals Notes Payable Total Current Liabilities 500 1000 Long-term debt 2000 500 1000 Common Stock (Par Value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 1500 3000 6000 Quick Resolve Products Income Statement (millions) $1.500 1,320 180 50 15 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 100 40 80 40 Dividends Paid ($0.8per share on 50 million shares) Addition to Retained Earnings 20 QuickResolve Products Balance Sheet ($ millions) 300 200 Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 200 300 1000 Gross Fixed Assets 1400 -400 Accumulated Depreciation Net Fixed Assets 1000 Total Assets 2000 150 130 Accounts Payables Accruals Notes Payable Total Current Liabilities 500 780 Long-term debt 600 100 340 Common Stock (Par Value = $2 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 180 620 2000