January of 2013 brought a new year and an important new opportunity to the management team of Sterling Household Products Company. Sterling manufactured and marketed a wide line of consumer goods, including laundry products, soaps, cosmetics, toilet preparations, and cleaning, disinfecting and sanitizing products, which were sold domestically and internationally, and were used every day in millions of households around the world. Sterling's family of quality products included many highly regarded brand names, and the company had consistently delivered impressive sales and profits to the investment community. Sterling's financial measures for all recent years showed that the company was successful, b time series analysis of these same financial measures quickly isolated Sterling's current challenge: growth rates for unit volume, sales, and profits were very low, and company management was looking to expand into businesses and products with more potential for growth. Sterling had identified health care as an industry with more growth potential, and a detailed search for health care products which could fit well into the company's existing operations led to discussions between Sterling and Montagne Medical Instruments Company. Sterling was interested in acquiring Montagne Medical's germicidal, sanitation, and antiseptic products unit, and Montagne Medical was willing to sell the unit for the right price. Negotiations had revealed that Montagne Medical believed the right price was $265 million, so Sterling had to determine if acquiring the unit at this price would generate value for the company and its investors Sterling Household Products: History, Finances, and a Strategic Opportunity Sterling was a leading manufacturer and marketer of consumer products, selling trusted and recognized brand names through mass merchandisers, grocery stores, and other retail outlets. When Sterling was founded in the early 1920s it produced and sold only laundry products, but success in this narrow business line allowed the company to grow and expand the scale and scope of its operations. Sterling invested internally as attractive opportunities were identified, but with brand development in consumer products being both a lengthy and expensive process, much of its growth came from acquisitions of existing and successful brands. By the beginning of 2013 the company manufactured a wide variety of consumer products in more than 20 countries and marketed these products in more than 100 countries. As presented in Exhibit 1, Sterling's well-regarded laundry products, soaps, cosmetics, toilet preparations, and cleaning, disinfecting and sanitizing products combined to generate nearly $3.3 billion of sales and $323 million of net income in 2012, producing a net profit margin of 9.8% of sales. This high profit margin reflected the income statement success of Sterling and its products, and with year-end 2012 total assets equal to nearly $2.7 billion (Exhibit 2), the company produced a rate of return on assets of 12% in the most recent year. Sterling's financial results in the preceding years were just as robust; by any financial measure the company was successful year after year Analysis of Sterling's income statements through time, however, revealed the company's biggest challenge. Between 2010 and 2012 sales grew from S3.14 billion to S3.281 billion, a total increase of 45%, representing a compounded annual growth rate of only 2.2%. Although the company had excellent products and was well-positioned in the industry, growth opportunities were limited and its business was under constant pressure. Th by just less than 1% per year, constrained by weak growth in overall demand and strong competition with other products, giving end consumers a variety of manufacturers and products to choose from. In addition, Sterling's largest retail customer represented 26% of its net sales, and its 10 largest retail customers accounted for 55% of company sales. These powerful retailers regularly squeezed Sterling and other consumer goods manufacturers, with respect to wholesale prices and volumes, as well encouraging end consumers to trade down to private label products which generated more profit for the retailer. The company's operating expenses and commodities costs were also rising faster than the inflation rate, placing even more pressure on Sterling's profits, as shown in Exhibit 1. None o these situations were expected to improve in the near future, so the company was attempting to shift its product offerings into industries with more opportunities for growth and sustained profitability e company's annual sales volume in units had increased Sterling's management team had identified one segment of the health care industry as an attractive investment opportunity. The company had highly regarded and successful household cleaning, disinfecting, and sanitizing products, and justified public health concerns about acquired infections was driving demand for more effective products in health care settings. Acquired infections in hospitals and acute care nursing facilities were a significant and growing concern in the health care industry, with the U.S. Department of Health and Human Services estimating that at any time one in 20 hospital patients had a health-care-associated infection. The entire health care infection-control market was estimated to currently represent $2.5 billion of yearly sales; it was growing rapidly and was also quite fragmented, with no competitor holding more than a 7% market share. Sterling's management recognized that the market for effective germicidal, sanitation, and antiseptic products for use on environmental surfaces, medical equipment, and for skin infection control was large and growing, and management believed that this market was also a natural extension of Sterling's expertise in the household market. Sterling had identified a possible investment opportunity in Montagne Medical Instruments Company, a large health care company which specialized in surgical and medical instruments, but also owned a unit manufacturing and marketing germicidal, sanitation, and antiseptic products which were U.S. Environmental Protection Agency (EPA) registered to ki numerous microorganisms. Sterling approached Montagne Medical about acquiring the unit, and the two firms initiated formal discussions. Montagne Medical Instruments Company Montagne Medical operated in Standard Industrial Classification (SIC) code 3841, Surgical and Medical Instruments and Apparatus, and generated $.756 billion of sales in 2012. The products and services contained within SIC 3841 were quite varied, ranging alphabetically from anesthesia apparatus to veterinarian's instruments and apparatus, with germicidal, sanitation, and antiseptic products included in this classification group. The company's primary focus, however, was medical examination and surgical instruments, which accounted for approximately 90% of its sales and net income. As shown in Exhibits 3 and 4, Montagne Medical was a strong financial performer producing a profit margin and rate of return on assets of 14.6% and 17.8%, respectively in 2012, with increasing at a 12.2% compounded annual growth rate since 2010. y also owned a unit which produced germicidal, sanitation, and antiseptic products for health care settings, which sold wel and generated positive operating income. The unit and its products, however, consumed scarce resources and management time, which the company believed could be better used in its core lines of business. Manaement had been considering exit from this market for some time, so they were happy to discuss sale of the products unit when they were approached by Sterling. Preliminary discussions quickly evolved into detailed negotiations about the sale, resulting in a tentative agreement for Sterling to acquire the unit from Montagne Medical for a The co mpan cash payment of $265 million. The Proposed Sale The tentative sale of the unit by Montagne Medical to Sterling appeared to be a good strategic fit for both companies; Montagne Medical would be able to focus all of its resources on its core medical instruments business while also receiving a large cash payment, and Sterling would acquire a growing and profitable business with products which were closely related to one of Sterling isting and successful product lines. Whether or not this acquisition was a good investmer opportunity for Sterling, however, could not be determined until the expected financial benefits from the acquisition were compared to the $265 million purchase pric Financial information for Montagne Medical's germicidal, sanitation, and antiseptic products unit for the last three years is presented in Exhibit 5. These results show annual sales growth greater than and operating income approaching 19% of sales. Both of these percentages were better than the recent financial results for Sterling, reinforcing Sterling's interest in the acquisition, but they were also lower than recent financial results for Montagne Medical, revealing why the company was illing to negotiate the sale. Using this historical financial information as a base, pro forma financial information for the products unit for the five years from 2013 through 2017 was prepared by Sterling's financial group, and these forecasts are presented in Exhibit 6. The numbers reflect management's expectations for sales, operating expenses, capital expenditures, straight-line depreciation of new capital assets based on a 20-year physical and economic life to zero salvage value, and operating assets and liabilities through Sterling's first five years of ownership. Company management wanted to see five more years of detailed financial forecasts, so these pro forma financial results would have to be extended through the year 2022. Sterling's management team also believed the products unit would stabilize by 2017; sales growth, capital expenditures, depreciation, and all relationships to sales that existed in 2017 would continue for the following five years. The pro forma financial results for 2013 through 2022, however, represent only one-half of the 20- year life of the products unit. Ten more years of sales, profits, and ultimately free cash flow would create additional value for Sterling, which must be included in the investment analysis. Sterling chose to do this by estimating the value of all cash flow from 2023 through 2032 as a terminal value multiple, as of 2022. The finance group's analysis of these 10 years determined that this terminal value could be accurately estimated as a multiple of nine times the free cash flow generated by the products unit in 2022, with free cash flow calculated as operating cash flow, minus capital expenditures, minus increases in net working capital investment. This multiple of nine times free cash flow captured the value of all operating, investment, and liquidation cash flows in the final 10 years of the products unit, as of 2022. For several years Sterling had consciously worked to maintain a capital structure mix of 20% long- term debt finance and 80% equity finance. Current historically low borrowing rates as well as the company's low level of business risk-and its income tax rate of 35% had caused Sterling to reconsider this capital structure. After a great deal of analysis and discussion involving the finance group, top management, and the board of directors, this capital structure target was changed; future capital investments would be financed with a mix of 30% long-term debt finance and 70% equity finance, which included the proposed acquisition of the unit from Montagne Medical. Current market yields on Sterling's existing long-term debt were approximately 4.5%, but by increasing the weight of debt finance in its capital structure, the company's cost of borrowing for the transaction would increase to 5.1%. This rate was well above the current yield to maturity on long- term U.S. Treasury bonds o finance, and interest paid on borrowed funds was fully tax deductible for the company. Sterling currently used a market risk premium of 5% when estimating its cost of equity using the capital asset pricing model, but the appropriate beta coefficient for the cost of equity calculation, given the risk of the acquisition, was a source of discussion within the company's finance group. Financial information for Montagne Medical's six primary competitors in the market for germicidal, sanitation, and antiseptic products, including equity beta coefficients, is presented in Exhibit 7. Four of these companies sold a wide variety of medical products (Teleological, Labyrinth, Stratus, and Vortex), and two of the firms were more focused, with approximately 80% of their revenue coming from sales of germicidal, sanitation, f 31%, but it was still significantly less expensive than equity ptic products for health care uses (Chiron and Pathoger An Expansion Opportunity The proposed acquisition of the products unit from Montagne Medical had one more potential benefit for Sterling: the option to invest and expand the unit's capacity. As currently configured, the unit was operating very close to full capacity, and by the year 2014 it would be at full capacity; therefore the pro forma increases in sales dollars presented in Exhibit 6 for years 2014 and beyond were entirely due to forecasted price increases. The property that contained the products unit also had sufficient unused space for expansion, which would allow the company to increase its sales into the rapidly growing health care market. If Sterling chose to exercise this option and expand the products unit, the company would invest $60 million to purchase and install new capital equipment during 2013, with the expansion coming online and generating additional sales in 2014. These additional sales would equal 20% of base sales from the unit in 2014, and would grow to 30% of base sales in 2015, and finally to 40% of base sales in 2016. In years 2017 through 2032 additional sales from the expansion would remain at 40% of base sales. To maintain production capacity in this expansion investment, the company anticipated $600,000 of additional capital expenditures each year, and all new capital assets would be depreciated straight-line to zero salvage value using a 20-year physical and economic life, also starting in 2014 when the investment came online. The net working capital investment necessary to support these additional sales would remain at the same percent of sales as the base products unit and would occur and selling & administrative expenses were similarly forecasted to remain at the same percent of sales as the base products unit in in the same year as the additional sales. Manufacturing expenses each year from 2014 through 2032, but research and development expenses were not expected to change if the unit was expanded. Although the expansion would increase capacity and sales, Sterling's management believed that the research and development expenditures in the base forecast for the products unit were sufficient to ensure a steady stream of new and effective products for the health care market; the company would benefit from economies of scale in research and development through expansion. Consistent with the analysis of the base acquisition, Sterling's management wanted to see a detailed forecast for the expansion opportunity for the years 2013 through 2022; the value of all cash flow from 2023 through 2032, as of 2022, would be estimated with a terminal value multiple of nine times the free cash flow generated in 2022. Conclusion The tentative agreement to acquire the germicidal, sanitation, and antiseptic products unit from Montagne Medical appeared to be a good fit with Sterling's goal to expand its operations into new products and industries with better potential for profitable growth. The purchase price for the unit been tentatively agreed upon by both parties, but one question remained to be answered: would the proposed investment be value-additive for Sterling, given the risk of the acquisition, its expected cash flow, and the $265 million purchase price? Exhibit 1 Income Statement for Sterling Household Products Company (S in millions except per share amounts) 2010 2011 2012 Net sales Cost of goods sold Gross profit s3,140 3,138 3,281 $1,860 $1,398 1387$1,421 $1,751 General, selling& administrative expenses Research & development expenses Income before interest and income taxes $726 $67 $740 $72 $769 578 $83 522 $70 $505 576 $498 Interest expenses Income before income taxes Income taxes expenses $178 $171 $175 Net income Weighted number of shares Earnings per share Dividends per share 84,160 850 79,508 S4.06 $2.44 $4.09 $244 $4.10 $2.44 $58.79 14.4 $63.78 15.6 $65.46 16.1 0.40 Stock price at end of year Price/Earnings ratio Equity beta coefficient Exhibit 2 Balance Sheet for Sterling Household Products Company (S in millions except per share amounts) 2010 2011 2012 Current assets Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets 5346 $346 $231 596 $1,019 $324 $199 $315 $229 591 Total current assets $1,043 Property, plant & equipment, net Goodwill &trademarks Other assets $1,019 $86 912 586 591 Total assets Liabilities & Shareholders Equity Current liabilities Accounts payable Short-term bank notes pavable Accrued liabilities $245 $222 $339 $243 $181 $254 Total current liabilities $819 Long-term debt Other long-term liabilities Total liabilities $1,274 06 $1257 $497 $418 498 $455 Shareholders' equity Contributed capital $474 $2,687 $2,954 $207 S478 $2,816 $3,085 Treasury stock Stockholders' equity $2,788 Total liabilities & shareholders' equity s2,728s2,587 2,686 Exhibit 4 Balance Sheet for Montagne Medical Instruments Company (S in millions except per share amounts) 2010 2011 2012 Current assets Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets $109 $126 $510 5306 $247 S180 $86 5819 $541 $184 $1,074 $216 597 Total current assets Property, plant& equipment, net Intangible assets, net Other assets $101 $41 $66 $718 $187 Total assets $1,121 $1,440 Liabilities &Shareholders Equity Current liabilities Accounts payable Accrued liabilities $67 $112 $179 589 S137 113 $148 $261 Total current liabilities Long-term debt Other long-term liabilities Total liabilities $1 $27 $1 5307 Shareholders' Equity Contributed capital Retained earnings Treasury stock Shareholders equity $249 -$85 $51 $424 5515 -$85 $772 585 Total liabilities & shareholders' equity $718 $1,121 $1,440 Exhibit 5 Financial Information for Montagne Medical Instruments Company's germicidal, sanitation, and antiseptic products unit Income Statement ($ in thousands) 2010 2011 2012 Net sales $128,462 $135,496 142,528 $71,399 75,512 $79,231 27285 $28,712 30,301 $3,618 Selling & administrative expenses Research & development expenses Depreciation expenses Total costs $3,314 $3,606 $104,215 $110,170 $115,577 Operating income $24,247 25,326 $26,951 Balance sheet ($ in thousands) 2010 2011 2012 Operating assets: Accounts receivable $16,533 17,217 $17,675 $21,059$22,772 $23,802 $48,454 $18,695 $21,133 $27,321 Inventory $43,840 $46,172 Property, plant & equipment, at cost -Accumulated depreciation Property, plant & equipment, net Total operating assets $27,474 27 477 $68 Operating liabilities: Accounts payable $10,573 SI 1,143 $11,689 Net operating assets $54,493 $56,323 $57,109 Percent of sales ratios: 2010 2011 2012 Manufacturing expenses Selling & administrative expenses Research & development expenses Accounts receivable 555% 21.2% 25% 12.9% 16.4% 21.4% 82% 555% 21.3% 2.5% 12.4% 16.7% 19.2% 8.2% 55.7% 21.2% 2.7% Property, plant & Accounts payable 16.8% 20.3% 82% equipment, net Exhibit 6 Sterling's Projected Pro Forma Financial Information for Montagne Medical Instruments Company's germicidal, sanitation, and antiseptic products unit Income Statement ($ in thousands) 2015 149369 $152,954 $156,625 $160,384 $164,233 $86,927 $3,916 $126,409 $30,216 2013 2014 2016 2017 Net sales $89,013 33,681 $4,010 $2,750 $129,453 $91,149 $34,489 $83,049 Selling & administrative expenses Research & development expenses 32,120 $3,824 $123,434 $29,520 2 525 si 20,975 Total costs $132569 $28,394 $30,931 31,664 Balance sheet ($ in thousands) 2013 2014 2015 2016 2017 Accounts receivable Inventory Property, plant&equipment, at cost $18,966 25,543 $20,365 27,427 $56,192 34,508 $21,684 $69,4 $19,888 $24,945 $50,192 $23,658 $26,534 $26,258 $25,434 $69,944 $26,156 53,192 $28,933 $24,259 $69,8 $31,683 $23,009 $69,681 Property, plant & equipment, net Total operating assets Operating liabilities: $12,542 $57,401 2014 55.5% $12,843 $56,994 2015 $13,467 $56,009 2017 Net operating assets $57,752 2013 55.6% $56,529 Percent of sales ratios: 2016 55.5% 21.0% 2.5% 12.4% 16.7% 15.5% 8.2% 55.5% 21.0% 2.5% 12.4% 16.7% 14.3% 8.2% 55.5% 21.0% 2.5% 12.4% 16.7% 13.2% 8.2% 21.2% 21.0% Research & development expenses 25% 25% 16.7% 16.6% 8.2% Property, plant&equipment, net 17.8% 8.2% Exhibit7 Financial information for selected companies in S.I.C. 3841 (surgical and medical instnuments & apparatus) with significant shares of the germicidal, sanitation, and antiseptic products market Tel eological Labyrinth 2012 2010 2011 Sa les revenue ($ in millions) Net income ($ in millions) Earnings per share Dividends per share $72 $154 $7.98 $1.36 $488 $224 $338 $144 $1.74 $2.17 $1.36 $1.36 ear-end price /earnings ratio Year-end common stock 18.78 24.93 46.52 $44.19 3 8838 33.70 $54.30 $60.36 $100 $1,034.3 1,164.8 $33.55 $655.6 $826 $26.56 31.00 30.16 $1 221.8 $1,4152 $14457 Market value of equity (in mlions) Balance sheet capitalization (at market value) % debt 96 common stock $1320 $1,271 33% $1,3% 32% 68% $683 52% 48% 63% 82% Equity beta coefficient In terest coverage 24.5 Vortex Pathogen 2011 2012 2012 $223 $2.33 $215 Sales revenue ($ in millions) Net income ($ in millions) Earnings per share Dividends per share $144 $2.18 $0.44 $0.20 $0.73 $0.56 $0.66 $007 $0.09 Year-end price /earnings ratio Year-end common stock price Market value of equity (Sinmillions) 3670 $31.56 $276.5 293.6 $30.83 $291.1 12670 $1624 $25.34 $25.17 $487.2 760.2 $827.5 $17.91 249.4 $232.9 360.2 $16.94 $2479 Balance sheet capitali zation (at market value) % debt % common stock $153 $232 78% Equity be ta coefficient Interest coverage 32.6 January of 2013 brought a new year and an important new opportunity to the management team of Sterling Household Products Company. Sterling manufactured and marketed a wide line of consumer goods, including laundry products, soaps, cosmetics, toilet preparations, and cleaning, disinfecting and sanitizing products, which were sold domestically and internationally, and were used every day in millions of households around the world. Sterling's family of quality products included many highly regarded brand names, and the company had consistently delivered impressive sales and profits to the investment community. Sterling's financial measures for all recent years showed that the company was successful, b time series analysis of these same financial measures quickly isolated Sterling's current challenge: growth rates for unit volume, sales, and profits were very low, and company management was looking to expand into businesses and products with more potential for growth. Sterling had identified health care as an industry with more growth potential, and a detailed search for health care products which could fit well into the company's existing operations led to discussions between Sterling and Montagne Medical Instruments Company. Sterling was interested in acquiring Montagne Medical's germicidal, sanitation, and antiseptic products unit, and Montagne Medical was willing to sell the unit for the right price. Negotiations had revealed that Montagne Medical believed the right price was $265 million, so Sterling had to determine if acquiring the unit at this price would generate value for the company and its investors Sterling Household Products: History, Finances, and a Strategic Opportunity Sterling was a leading manufacturer and marketer of consumer products, selling trusted and recognized brand names through mass merchandisers, grocery stores, and other retail outlets. When Sterling was founded in the early 1920s it produced and sold only laundry products, but success in this narrow business line allowed the company to grow and expand the scale and scope of its operations. Sterling invested internally as attractive opportunities were identified, but with brand development in consumer products being both a lengthy and expensive process, much of its growth came from acquisitions of existing and successful brands. By the beginning of 2013 the company manufactured a wide variety of consumer products in more than 20 countries and marketed these products in more than 100 countries. As presented in Exhibit 1, Sterling's well-regarded laundry products, soaps, cosmetics, toilet preparations, and cleaning, disinfecting and sanitizing products combined to generate nearly $3.3 billion of sales and $323 million of net income in 2012, producing a net profit margin of 9.8% of sales. This high profit margin reflected the income statement success of Sterling and its products, and with year-end 2012 total assets equal to nearly $2.7 billion (Exhibit 2), the company produced a rate of return on assets of 12% in the most recent year. Sterling's financial results in the preceding years were just as robust; by any financial measure the company was successful year after year Analysis of Sterling's income statements through time, however, revealed the company's biggest challenge. Between 2010 and 2012 sales grew from S3.14 billion to S3.281 billion, a total increase of 45%, representing a compounded annual growth rate of only 2.2%. Although the company had excellent products and was well-positioned in the industry, growth opportunities were limited and its business was under constant pressure. Th by just less than 1% per year, constrained by weak growth in overall demand and strong competition with other products, giving end consumers a variety of manufacturers and products to choose from. In addition, Sterling's largest retail customer represented 26% of its net sales, and its 10 largest retail customers accounted for 55% of company sales. These powerful retailers regularly squeezed Sterling and other consumer goods manufacturers, with respect to wholesale prices and volumes, as well encouraging end consumers to trade down to private label products which generated more profit for the retailer. The company's operating expenses and commodities costs were also rising faster than the inflation rate, placing even more pressure on Sterling's profits, as shown in Exhibit 1. None o these situations were expected to improve in the near future, so the company was attempting to shift its product offerings into industries with more opportunities for growth and sustained profitability e company's annual sales volume in units had increased Sterling's management team had identified one segment of the health care industry as an attractive investment opportunity. The company had highly regarded and successful household cleaning, disinfecting, and sanitizing products, and justified public health concerns about acquired infections was driving demand for more effective products in health care settings. Acquired infections in hospitals and acute care nursing facilities were a significant and growing concern in the health care industry, with the U.S. Department of Health and Human Services estimating that at any time one in 20 hospital patients had a health-care-associated infection. The entire health care infection-control market was estimated to currently represent $2.5 billion of yearly sales; it was growing rapidly and was also quite fragmented, with no competitor holding more than a 7% market share. Sterling's management recognized that the market for effective germicidal, sanitation, and antiseptic products for use on environmental surfaces, medical equipment, and for skin infection control was large and growing, and management believed that this market was also a natural extension of Sterling's expertise in the household market. Sterling had identified a possible investment opportunity in Montagne Medical Instruments Company, a large health care company which specialized in surgical and medical instruments, but also owned a unit manufacturing and marketing germicidal, sanitation, and antiseptic products which were U.S. Environmental Protection Agency (EPA) registered to ki numerous microorganisms. Sterling approached Montagne Medical about acquiring the unit, and the two firms initiated formal discussions. Montagne Medical Instruments Company Montagne Medical operated in Standard Industrial Classification (SIC) code 3841, Surgical and Medical Instruments and Apparatus, and generated $.756 billion of sales in 2012. The products and services contained within SIC 3841 were quite varied, ranging alphabetically from anesthesia apparatus to veterinarian's instruments and apparatus, with germicidal, sanitation, and antiseptic products included in this classification group. The company's primary focus, however, was medical examination and surgical instruments, which accounted for approximately 90% of its sales and net income. As shown in Exhibits 3 and 4, Montagne Medical was a strong financial performer producing a profit margin and rate of return on assets of 14.6% and 17.8%, respectively in 2012, with increasing at a 12.2% compounded annual growth rate since 2010. y also owned a unit which produced germicidal, sanitation, and antiseptic products for health care settings, which sold wel and generated positive operating income. The unit and its products, however, consumed scarce resources and management time, which the company believed could be better used in its core lines of business. Manaement had been considering exit from this market for some time, so they were happy to discuss sale of the products unit when they were approached by Sterling. Preliminary discussions quickly evolved into detailed negotiations about the sale, resulting in a tentative agreement for Sterling to acquire the unit from Montagne Medical for a The co mpan cash payment of $265 million. The Proposed Sale The tentative sale of the unit by Montagne Medical to Sterling appeared to be a good strategic fit for both companies; Montagne Medical would be able to focus all of its resources on its core medical instruments business while also receiving a large cash payment, and Sterling would acquire a growing and profitable business with products which were closely related to one of Sterling isting and successful product lines. Whether or not this acquisition was a good investmer opportunity for Sterling, however, could not be determined until the expected financial benefits from the acquisition were compared to the $265 million purchase pric Financial information for Montagne Medical's germicidal, sanitation, and antiseptic products unit for the last three years is presented in Exhibit 5. These results show annual sales growth greater than and operating income approaching 19% of sales. Both of these percentages were better than the recent financial results for Sterling, reinforcing Sterling's interest in the acquisition, but they were also lower than recent financial results for Montagne Medical, revealing why the company was illing to negotiate the sale. Using this historical financial information as a base, pro forma financial information for the products unit for the five years from 2013 through 2017 was prepared by Sterling's financial group, and these forecasts are presented in Exhibit 6. The numbers reflect management's expectations for sales, operating expenses, capital expenditures, straight-line depreciation of new capital assets based on a 20-year physical and economic life to zero salvage value, and operating assets and liabilities through Sterling's first five years of ownership. Company management wanted to see five more years of detailed financial forecasts, so these pro forma financial results would have to be extended through the year 2022. Sterling's management team also believed the products unit would stabilize by 2017; sales growth, capital expenditures, depreciation, and all relationships to sales that existed in 2017 would continue for the following five years. The pro forma financial results for 2013 through 2022, however, represent only one-half of the 20- year life of the products unit. Ten more years of sales, profits, and ultimately free cash flow would create additional value for Sterling, which must be included in the investment analysis. Sterling chose to do this by estimating the value of all cash flow from 2023 through 2032 as a terminal value multiple, as of 2022. The finance group's analysis of these 10 years determined that this terminal value could be accurately estimated as a multiple of nine times the free cash flow generated by the products unit in 2022, with free cash flow calculated as operating cash flow, minus capital expenditures, minus increases in net working capital investment. This multiple of nine times free cash flow captured the value of all operating, investment, and liquidation cash flows in the final 10 years of the products unit, as of 2022. For several years Sterling had consciously worked to maintain a capital structure mix of 20% long- term debt finance and 80% equity finance. Current historically low borrowing rates as well as the company's low level of business risk-and its income tax rate of 35% had caused Sterling to reconsider this capital structure. After a great deal of analysis and discussion involving the finance group, top management, and the board of directors, this capital structure target was changed; future capital investments would be financed with a mix of 30% long-term debt finance and 70% equity finance, which included the proposed acquisition of the unit from Montagne Medical. Current market yields on Sterling's existing long-term debt were approximately 4.5%, but by increasing the weight of debt finance in its capital structure, the company's cost of borrowing for the transaction would increase to 5.1%. This rate was well above the current yield to maturity on long- term U.S. Treasury bonds o finance, and interest paid on borrowed funds was fully tax deductible for the company. Sterling currently used a market risk premium of 5% when estimating its cost of equity using the capital asset pricing model, but the appropriate beta coefficient for the cost of equity calculation, given the risk of the acquisition, was a source of discussion within the company's finance group. Financial information for Montagne Medical's six primary competitors in the market for germicidal, sanitation, and antiseptic products, including equity beta coefficients, is presented in Exhibit 7. Four of these companies sold a wide variety of medical products (Teleological, Labyrinth, Stratus, and Vortex), and two of the firms were more focused, with approximately 80% of their revenue coming from sales of germicidal, sanitation, f 31%, but it was still significantly less expensive than equity ptic products for health care uses (Chiron and Pathoger An Expansion Opportunity The proposed acquisition of the products unit from Montagne Medical had one more potential benefit for Sterling: the option to invest and expand the unit's capacity. As currently configured, the unit was operating very close to full capacity, and by the year 2014 it would be at full capacity; therefore the pro forma increases in sales dollars presented in Exhibit 6 for years 2014 and beyond were entirely due to forecasted price increases. The property that contained the products unit also had sufficient unused space for expansion, which would allow the company to increase its sales into the rapidly growing health care market. If Sterling chose to exercise this option and expand the products unit, the company would invest $60 million to purchase and install new capital equipment during 2013, with the expansion coming online and generating additional sales in 2014. These additional sales would equal 20% of base sales from the unit in 2014, and would grow to 30% of base sales in 2015, and finally to 40% of base sales in 2016. In years 2017 through 2032 additional sales from the expansion would remain at 40% of base sales. To maintain production capacity in this expansion investment, the company anticipated $600,000 of additional capital expenditures each year, and all new capital assets would be depreciated straight-line to zero salvage value using a 20-year physical and economic life, also starting in 2014 when the investment came online. The net working capital investment necessary to support these additional sales would remain at the same percent of sales as the base products unit and would occur and selling & administrative expenses were similarly forecasted to remain at the same percent of sales as the base products unit in in the same year as the additional sales. Manufacturing expenses each year from 2014 through 2032, but research and development expenses were not expected to change if the unit was expanded. Although the expansion would increase capacity and sales, Sterling's management believed that the research and development expenditures in the base forecast for the products unit were sufficient to ensure a steady stream of new and effective products for the health care market; the company would benefit from economies of scale in research and development through expansion. Consistent with the analysis of the base acquisition, Sterling's management wanted to see a detailed forecast for the expansion opportunity for the years 2013 through 2022; the value of all cash flow from 2023 through 2032, as of 2022, would be estimated with a terminal value multiple of nine times the free cash flow generated in 2022. Conclusion The tentative agreement to acquire the germicidal, sanitation, and antiseptic products unit from Montagne Medical appeared to be a good fit with Sterling's goal to expand its operations into new products and industries with better potential for profitable growth. The purchase price for the unit been tentatively agreed upon by both parties, but one question remained to be answered: would the proposed investment be value-additive for Sterling, given the risk of the acquisition, its expected cash flow, and the $265 million purchase price? Exhibit 1 Income Statement for Sterling Household Products Company (S in millions except per share amounts) 2010 2011 2012 Net sales Cost of goods sold Gross profit s3,140 3,138 3,281 $1,860 $1,398 1387$1,421 $1,751 General, selling& administrative expenses Research & development expenses Income before interest and income taxes $726 $67 $740 $72 $769 578 $83 522 $70 $505 576 $498 Interest expenses Income before income taxes Income taxes expenses $178 $171 $175 Net income Weighted number of shares Earnings per share Dividends per share 84,160 850 79,508 S4.06 $2.44 $4.09 $244 $4.10 $2.44 $58.79 14.4 $63.78 15.6 $65.46 16.1 0.40 Stock price at end of year Price/Earnings ratio Equity beta coefficient Exhibit 2 Balance Sheet for Sterling Household Products Company (S in millions except per share amounts) 2010 2011 2012 Current assets Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets 5346 $346 $231 596 $1,019 $324 $199 $315 $229 591 Total current assets $1,043 Property, plant & equipment, net Goodwill &trademarks Other assets $1,019 $86 912 586 591 Total assets Liabilities & Shareholders Equity Current liabilities Accounts payable Short-term bank notes pavable Accrued liabilities $245 $222 $339 $243 $181 $254 Total current liabilities $819 Long-term debt Other long-term liabilities Total liabilities $1,274 06 $1257 $497 $418 498 $455 Shareholders' equity Contributed capital $474 $2,687 $2,954 $207 S478 $2,816 $3,085 Treasury stock Stockholders' equity $2,788 Total liabilities & shareholders' equity s2,728s2,587 2,686 Exhibit 4 Balance Sheet for Montagne Medical Instruments Company (S in millions except per share amounts) 2010 2011 2012 Current assets Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets $109 $126 $510 5306 $247 S180 $86 5819 $541 $184 $1,074 $216 597 Total current assets Property, plant& equipment, net Intangible assets, net Other assets $101 $41 $66 $718 $187 Total assets $1,121 $1,440 Liabilities &Shareholders Equity Current liabilities Accounts payable Accrued liabilities $67 $112 $179 589 S137 113 $148 $261 Total current liabilities Long-term debt Other long-term liabilities Total liabilities $1 $27 $1 5307 Shareholders' Equity Contributed capital Retained earnings Treasury stock Shareholders equity $249 -$85 $51 $424 5515 -$85 $772 585 Total liabilities & shareholders' equity $718 $1,121 $1,440 Exhibit 5 Financial Information for Montagne Medical Instruments Company's germicidal, sanitation, and antiseptic products unit Income Statement ($ in thousands) 2010 2011 2012 Net sales $128,462 $135,496 142,528 $71,399 75,512 $79,231 27285 $28,712 30,301 $3,618 Selling & administrative expenses Research & development expenses Depreciation expenses Total costs $3,314 $3,606 $104,215 $110,170 $115,577 Operating income $24,247 25,326 $26,951 Balance sheet ($ in thousands) 2010 2011 2012 Operating assets: Accounts receivable $16,533 17,217 $17,675 $21,059$22,772 $23,802 $48,454 $18,695 $21,133 $27,321 Inventory $43,840 $46,172 Property, plant & equipment, at cost -Accumulated depreciation Property, plant & equipment, net Total operating assets $27,474 27 477 $68 Operating liabilities: Accounts payable $10,573 SI 1,143 $11,689 Net operating assets $54,493 $56,323 $57,109 Percent of sales ratios: 2010 2011 2012 Manufacturing expenses Selling & administrative expenses Research & development expenses Accounts receivable 555% 21.2% 25% 12.9% 16.4% 21.4% 82% 555% 21.3% 2.5% 12.4% 16.7% 19.2% 8.2% 55.7% 21.2% 2.7% Property, plant & Accounts payable 16.8% 20.3% 82% equipment, net Exhibit 6 Sterling's Projected Pro Forma Financial Information for Montagne Medical Instruments Company's germicidal, sanitation, and antiseptic products unit Income Statement ($ in thousands) 2015 149369 $152,954 $156,625 $160,384 $164,233 $86,927 $3,916 $126,409 $30,216 2013 2014 2016 2017 Net sales $89,013 33,681 $4,010 $2,750 $129,453 $91,149 $34,489 $83,049 Selling & administrative expenses Research & development expenses 32,120 $3,824 $123,434 $29,520 2 525 si 20,975 Total costs $132569 $28,394 $30,931 31,664 Balance sheet ($ in thousands) 2013 2014 2015 2016 2017 Accounts receivable Inventory Property, plant&equipment, at cost $18,966 25,543 $20,365 27,427 $56,192 34,508 $21,684 $69,4 $19,888 $24,945 $50,192 $23,658 $26,534 $26,258 $25,434 $69,944 $26,156 53,192 $28,933 $24,259 $69,8 $31,683 $23,009 $69,681 Property, plant & equipment, net Total operating assets Operating liabilities: $12,542 $57,401 2014 55.5% $12,843 $56,994 2015 $13,467 $56,009 2017 Net operating assets $57,752 2013 55.6% $56,529 Percent of sales ratios: 2016 55.5% 21.0% 2.5% 12.4% 16.7% 15.5% 8.2% 55.5% 21.0% 2.5% 12.4% 16.7% 14.3% 8.2% 55.5% 21.0% 2.5% 12.4% 16.7% 13.2% 8.2% 21.2% 21.0% Research & development expenses 25% 25% 16.7% 16.6% 8.2% Property, plant&equipment, net 17.8% 8.2% Exhibit7 Financial information for selected companies in S.I.C. 3841 (surgical and medical instnuments & apparatus) with significant shares of the germicidal, sanitation, and antiseptic products market Tel eological Labyrinth 2012 2010 2011 Sa les revenue ($ in millions) Net income ($ in millions) Earnings per share Dividends per share $72 $154 $7.98 $1.36 $488 $224 $338 $144 $1.74 $2.17 $1.36 $1.36 ear-end price /earnings ratio Year-end common stock 18.78 24.93 46.52 $44.19 3 8838 33.70 $54.30 $60.36 $100 $1,034.3 1,164.8 $33.55 $655.6 $826 $26.56 31.00 30.16 $1 221.8 $1,4152 $14457 Market value of equity (in mlions) Balance sheet capitalization (at market value) % debt 96 common stock $1320 $1,271 33% $1,3% 32% 68% $683 52% 48% 63% 82% Equity beta coefficient In terest coverage 24.5 Vortex Pathogen 2011 2012 2012 $223 $2.33 $215 Sales revenue ($ in millions) Net income ($ in millions) Earnings per share Dividends per share $144 $2.18 $0.44 $0.20 $0.73 $0.56 $0.66 $007 $0.09 Year-end price /earnings ratio Year-end common stock price Market value of equity (Sinmillions) 3670 $31.56 $276.5 293.6 $30.83 $291.1 12670 $1624 $25.34 $25.17 $487.2 760.2 $827.5 $17.91 249.4 $232.9 360.2 $16.94 $2479 Balance sheet capitali zation (at market value) % debt % common stock $153 $232 78% Equity be ta coefficient Interest coverage 32.6