It was late Sunday night, and Jassir Amor was getting weary. The big presentation was set for 8 am the next day, and Jassir kept remember- ing what Greg LeBlanc, 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 our- selves thoroughly. Make sure that we can substantiate all our numbers and justify all our assumptions." Jassir and Greg were serving on the M&A committee, which had been formed by their chairman and CEO, Nelson Jones, to "look into possible candidates for acquisition. The three of them were employed by Metallic Creations Inc., a fairly large-sized manufacturing firm headquartered in Pittsburgh, Pennsylvania, 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 competi- tion was almost nonexistent. As a result, the company enjoyed significant growth over the years and was able to recruit excellent personnel, many of whom stayed with the company right from the start. The firm had accumu- lated a significant amount of cash and built a good credit history. 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 up, and the managers were hard pressed to search for alternative avenues for 116 uy dropped to S45 per share was that the firm should ter utilize its resources the M&A committee to re- sent its findings at the quar- ee members to consider firms growth. The company's stock price had recently The overwhelming consensus in the boardroom look for suitable acquisition candidates ahle acquisition candidates so as to better and diversify its risk. About three months ago, Jones had set up the M search possible acquisition candidates and presenti terly board meeting. He asked the committee mer in related as well as unrelated industries and recommendations. After considerable research, data gathering, and tee had narrowed their choices down to three dustries and explain the rationale for the the presentation at the quarterly meeting in March, the had ruled out two of the three candidates and asked the further valuation and analysis on the third candidate_N. The board members were particularly curious about the ratio at which the firm was trading. In fact, one board member shout "relative P/E magic" and was wondering whether by a Horizon Products the firm could boost its P/E ratio and pos ings per share. New Horizon Products, headquartered in Denver, Colorado e. and analysis, the commit- ssible candidates. After March, the board of directors asked the committee to con- didate-New Horizon cularly curious about the low P/E board member had heard ering whether by acquiring New its P/E ratio and possibly its earn- martered in Denver, Colorado, was a mid- ay with assets of $2 billion. The firm's earnings per share had been steadily increasing each year and were currently $1.2 per share Surprisingly, however, the committee found that although the firm had a fairly well-diversified customer base, its P/E ratio was rather low at 12.5X-much below the average P/E ratio for the industry. The committee felt that one reason for the low P/E ratio might have been the recent retire- ment of their CEO, who had managed the company in a very centralized manner. All managers reported directly to him, and he made most of the strategic decisions. His experience and vision had been well rewarded in the market. The members of the M&A committee felt that if New Horizon Products were to be acquired by Metallic Creations Inc., production and marketing costs could be significantly reduced due to Metallic Creations technical and marketing expertise. The incremental net cash flows of the combined company were estimated to be at least 545 million per year for the force seeable future. Moreover, since New Horizon Products was involved totally different industrial sector there were some significant on were some significant diversifica- tion benefits to be had. Tables 1-4 present the financial statements of New Horizon Products respectively. The finance deparu Creations Inc. had recently estimated the firm's weighted a capital to be 16% and the required rate of retum inancial statements of Metallic Creations Inc. and finance department of Metallic m's weighted average cost of ad the required rate of return on equity to be Dun Umer 117 Since Jassir had first suggested New Horizon Products as a possible ac- quisition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were "made for each other." Now if only he could convince the board! Table 1 450 Metallic Creations Inc. Income Statement ($ millions) Revenues $3,000 Cost of Goods Sold 2,550 Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 100 50 250 Dividends Paid ($1 per share on 100 million shares) Addition to Retained Earnings 100 550 Your report should consist of the following: A. Briefly, summarize the key facts of the case, identify the problem/decision, and explain why it is important. B. Based on the data and information provided in the case, please respond to the following questions: 1. Using the formula for free cash flow, explain the various reasons why firms undertake mergers and acquisitions. Which of these reasons are most likely to apply to the acquisition that Metallic Creations Inc. is considering? 2. Using the free cash flow method of valuation, calculate the maximum offer price that Metallic Creations Inc. would be justified in making for New Horizon Products. 3. Let's say that Metallic Creations Inc. is able to close the deal at a price of $1000 million by paying cash OR by exchanging one of its shares for two shares of New Horizon. Should Metallic Creations use cash or stock as the payment mechanism? Why? What are the pros and cons of each payment mechanism for the acquiring and the target firm respectively? 4. If New Horizon Products wants to block the takeover attempt what can it do? Explain the rationale and possible outcome of each suggestion. 5. What are some tax issues that must be considered by Metallic Creations Inc.' management team when making the bid? 6. One M&A committee member told Jassir that the main advantage of this deal to Metallic Creations Inc. is the diversification benefit that exists from the two 0 Table 1 Metallic Creations Inc. Income Statement ($ millions) 0 0 $3,000 2,550 450 100 Revenues Cost of Goods Sold Gross Profit 8 Selling & Administration Expenses 9 Depreciation 10 Interest 11 Earnings Before Taxes 12 Taxes (40%) 13 Net Income 50 50 250 100 150 14 Dividends Paid ($1 per share on 100 million 15 shares 16 Addition to Retained Earnings 100 50 It was late Sunday night, and Jassir Amor was getting weary. The big presentation was set for 8 am the next day, and Jassir kept remember- ing what Greg LeBlanc, 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 our- selves thoroughly. Make sure that we can substantiate all our numbers and justify all our assumptions." Jassir and Greg were serving on the M&A committee, which had been formed by their chairman and CEO, Nelson Jones, to "look into possible candidates for acquisition. The three of them were employed by Metallic Creations Inc., a fairly large-sized manufacturing firm headquartered in Pittsburgh, Pennsylvania, 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 competi- tion was almost nonexistent. As a result, the company enjoyed significant growth over the years and was able to recruit excellent personnel, many of whom stayed with the company right from the start. The firm had accumu- lated a significant amount of cash and built a good credit history. 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 up, and the managers were hard pressed to search for alternative avenues for 116 uy dropped to S45 per share was that the firm should ter utilize its resources the M&A committee to re- sent its findings at the quar- ee members to consider firms growth. The company's stock price had recently The overwhelming consensus in the boardroom look for suitable acquisition candidates ahle acquisition candidates so as to better and diversify its risk. About three months ago, Jones had set up the M search possible acquisition candidates and presenti terly board meeting. He asked the committee mer in related as well as unrelated industries and recommendations. After considerable research, data gathering, and tee had narrowed their choices down to three dustries and explain the rationale for the the presentation at the quarterly meeting in March, the had ruled out two of the three candidates and asked the further valuation and analysis on the third candidate_N. The board members were particularly curious about the ratio at which the firm was trading. In fact, one board member shout "relative P/E magic" and was wondering whether by a Horizon Products the firm could boost its P/E ratio and pos ings per share. New Horizon Products, headquartered in Denver, Colorado e. and analysis, the commit- ssible candidates. After March, the board of directors asked the committee to con- didate-New Horizon cularly curious about the low P/E board member had heard ering whether by acquiring New its P/E ratio and possibly its earn- martered in Denver, Colorado, was a mid- ay with assets of $2 billion. The firm's earnings per share had been steadily increasing each year and were currently $1.2 per share Surprisingly, however, the committee found that although the firm had a fairly well-diversified customer base, its P/E ratio was rather low at 12.5X-much below the average P/E ratio for the industry. The committee felt that one reason for the low P/E ratio might have been the recent retire- ment of their CEO, who had managed the company in a very centralized manner. All managers reported directly to him, and he made most of the strategic decisions. His experience and vision had been well rewarded in the market. The members of the M&A committee felt that if New Horizon Products were to be acquired by Metallic Creations Inc., production and marketing costs could be significantly reduced due to Metallic Creations technical and marketing expertise. The incremental net cash flows of the combined company were estimated to be at least 545 million per year for the force seeable future. Moreover, since New Horizon Products was involved totally different industrial sector there were some significant on were some significant diversifica- tion benefits to be had. Tables 1-4 present the financial statements of New Horizon Products respectively. The finance deparu Creations Inc. had recently estimated the firm's weighted a capital to be 16% and the required rate of retum inancial statements of Metallic Creations Inc. and finance department of Metallic m's weighted average cost of ad the required rate of return on equity to be Dun Umer 117 Since Jassir had first suggested New Horizon Products as a possible ac- quisition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were "made for each other." Now if only he could convince the board! Table 1 450 Metallic Creations Inc. Income Statement ($ millions) Revenues $3,000 Cost of Goods Sold 2,550 Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 100 50 250 Dividends Paid ($1 per share on 100 million shares) Addition to Retained Earnings 100 550 Your report should consist of the following: A. Briefly, summarize the key facts of the case, identify the problem/decision, and explain why it is important. B. Based on the data and information provided in the case, please respond to the following questions: 1. Using the formula for free cash flow, explain the various reasons why firms undertake mergers and acquisitions. Which of these reasons are most likely to apply to the acquisition that Metallic Creations Inc. is considering? 2. Using the free cash flow method of valuation, calculate the maximum offer price that Metallic Creations Inc. would be justified in making for New Horizon Products. 3. Let's say that Metallic Creations Inc. is able to close the deal at a price of $1000 million by paying cash OR by exchanging one of its shares for two shares of New Horizon. Should Metallic Creations use cash or stock as the payment mechanism? Why? What are the pros and cons of each payment mechanism for the acquiring and the target firm respectively? 4. If New Horizon Products wants to block the takeover attempt what can it do? Explain the rationale and possible outcome of each suggestion. 5. What are some tax issues that must be considered by Metallic Creations Inc.' management team when making the bid? 6. One M&A committee member told Jassir that the main advantage of this deal to Metallic Creations Inc. is the diversification benefit that exists from the two 0 Table 1 Metallic Creations Inc. Income Statement ($ millions) 0 0 $3,000 2,550 450 100 Revenues Cost of Goods Sold Gross Profit 8 Selling & Administration Expenses 9 Depreciation 10 Interest 11 Earnings Before Taxes 12 Taxes (40%) 13 Net Income 50 50 250 100 150 14 Dividends Paid ($1 per share on 100 million 15 shares 16 Addition to Retained Earnings 100 50