MANAGEMENT'S REACTION This recommendation was not easy for Adamson to accept. He is a competitive type who doesn't like to get beat at anything, and it was he who led United into food and beverages. He recognizes, however, that the recommendation is sound, and there is even one argument for divestiture that the committee didn't consider. Marketing estimates that the future of the Toiletries division is "extremely bright," and the division is ripe for expansion. However, there is an industry labor shortage and skilled technicians and managers are tough to find. This means that the expansion must be internally staffed, which would be difficult to do if United keeps McGuire. According to Adamson, "The Food and Beverage division has been chewing up executive time and will continue to do so if we keep it." All things considered, Adamson realizes that United isn't much of a food company and should concentrate on areas that it knows best. Not all of United's managers favor the divestiture, however. Some argue that the divestiture will reduce the firm's product diversification and thus raise the risk of the firm to investors. Others believe that United is not likely to receive a decent price for McGuire, given its sorry financial history. They are especially concerned that McGuire might be sold for less than its book value. They find this possibility "alarming" and predict that "investors would react unfavorably." Adamson isn't taking these objections too seriously mainly because he thinks that McGuire has considerable value. He argues that the reasons we bought McGuire are still sound. It has an established customer base and many well-known products. Numerous marketing surveys have shown that its products rate very high in customer loyalty and name recognition. The value of McGuire isn't determined by its performance under our management-which quite frankly wasn't and isn't very good. No, its value is determined by what it can and will be if it is managed effectively. HOLLY GRETHER Though United will hire outside consultants to estimate the value of McGuire, Adamson thinks that it is a good idea to develop an in-house estimate, and Holly Grether an executive in the finance department-volunteers to make it. Grether thinks that the starting point for the analysis should be McGuire's liquidation value. The inventory can be sold to net 70 percent after taxes, and this same percentage can be applied to the firm's receivables. McGuire's plant and equipment is adequate to support inflationary increases in sales. Most of it is state-of-the-art, and a reasonable estimate of its after-tax market value is $14 million. Liquidation will, of course, involve legal and administrative fees and Grether estimates that these will run $750,000. Grether-like Adamson is confident that McGuire is "worth more alive than dead" and one way she will estimate this value is by using a "compara- bles" approach. The idea is to develop price-earnings (P-E) and market-to-book (MV/BV) multiples using information on firms comparable to McGuire. However, she realizes that finding such firms is hard to do since companies dif- fer so much in terms of size, product lines, markets, and so on. After much thought and discussions with other managers, Grether compiled the information shown in Exhibit 3. These are firms that have two important characteristics: They manufacture products similar to those of McGuire and they are companies that may well be interested in an acquisition. Still, she is not comfortable with the list because these companies are at best only "sort of like" McGuire. It isn't clear, though, if a more appropriate set of firms exist. Grether will also use a discounted cash flow (DCF) framework to estimate McGuire's value. Her approach will be to estimate the expected cash flows assuming no interest expense, discount these cash flows at the appropriate cost of capital, and then adjust for financial leverage. But developing an estimate using a DCF model is not especially easy either. Grether knows that DCF esti- mates are frequently sensitive to assumptions made about growth, profit mar- gins, the cost of capital, and the terminal value. Grether strongly feels that using McGuire's past profit margins is inappro- priate. It is a virtual certainty that the firm's operating margin, that is (EBIT + Depreciation)/sales, would increase substantially if it were run by people who know the food and beverage business. After all, the problem is not that McGuire lacks allractive and brand-name products. The problem has been improper pricing, production inefficiencies, and poor marketing decisions which, quite frankly, could have been avoided. She also decides to make the conservative assumption that sales and operal- ing costs will grow with inflation at about 3 percent a year given the Federal Reserve's apparent commitment to anti-inflationary policies. Thus she will ignore the possibility of any "real growth" in sales. At first she was going to use a five-year time horizon. That is, she was going to estimate the cash flows for five years and then develop an estimate of McGuire's terminal value at the end of year 5. At the suggestion of Theodore Seitz, the firm's comptroller, however, she decides to assume that the firm will last "indefinitely," but assume a no-growth scenario after year 5. Thus her DCF model will be a perpetuity with 3 percent growth in years 1 through 5 (1996-2000) and zero thereafter. The advantage of this approach according to Seitz is that "you avoid the difficulty of estimating a terminal value." The firm's current (1995) working capital situation is considered "efficient and appropriate." Depreciation should be 2.2 percent of sales and, in order to maintain plant and equipment, capital expenditures will run 3 percent of sales each year. The relevant tax rate is 30 percent. Perhaps the trickiest part of the analysis is to estimate the appropriate cost of capital. The long-term government bond rate is 8 percent and Grether thinks that it is reasonable to assume that debt used to finance McGuire would run 100 basis points more than this. The risk-premium on an investment of average market risk is about 7 percentage points above the risk-free rate, and Grether estimates that a beta of .9 is appropriate for McGuire's unlevered cash flows. Finally, she will assume a capital structure (using market values) of 20 percent long-term debt and 80 percent equity. (Source: Joseph S., John D., 2017) CASE STUDY: UNITED Sales of United Housewares have increased nearly 8 percent per year over the last four years, yet the firm's operating profit has failed to keep pace. "The problem," Alvin Adamson-the firm's president and chief executive officer- emphatically stated at a recent board meeting, "is the anemic performance of the Food and Beverage (F&B) division." United has four divisions, organized by product lines. The Soap and Detergent and Toiletries divisions are the two largest, with annual sales of nearly $400 million each. F&B accounts for about $300 million of annual sales, and the Housewares division for around $100 million. AN ACQUISITION The F&B division was created six years ago when United acquired McGuire, a firm with a number of brand-name coffees and juices. United decided to expand into the food and beverage market in part because these products are not especially sensitive to the economy. Management also felt that food and beverage products were consistent with the company's stated policy of deliver- ing quality household items. And finally, McGuire a firm with many products that are household names in many parts of the country-was for sale at a price United's management labeled a "bargain." Unfortunately, the acquisition has been nothing but a headache for United with one mistake following another. There have been, for example, a number of run-ins with the Food and Drug Administration (FDA). The FDA actually seized a shipment of orange juice because of misleading claims about freshness. And management initiated a price war with Folger's in order to increase the market share of one of its coffees. The strategy failed. Perhaps the biggest problem has been management structure. United's struc- ture gives heavy responsibility to division managers, unlike McGuire's hierarchy where decisions are passed down from the top. In effect, McGuire's manage ment had to learn a new corporate culture. They were given more freedom but were asked to make more decisions and accept more responsibilities. The result, apparently, is that some decisions were not made and others were made too late. Adamson even tried changing the division manager three times, but to no avail. A few months ago Adamson formed a committee to recommend whether McGuire should be sold or whether it should continue to be operated by United. The committee, after extensive analysis, concluded that it is in the best interest of United's stockholders to sell McGuire and, thus, dismantle the F&B division. A number of companies have shown interest in McGuire, and the commillee concluded that it is clear that United is not able to manage the firm efficiently.