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? 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 cently dropped to $45 per share ensus in the boardroom was that the fir candidates so as to better utilize its rese that the firm should ser utilize its resources 116 growth. The company's stock price had recently The overwhelming consensus in the boare look for suitable acquisition candidates so and diversify its risk. About three months ago, Jones had set up the MA search possible acquisition candidates and present its terly board meeting. He asked the committee members in related as well as unrelated industries and explain the recommendations he M&A committee to re- nt its findings at the quar- nembers to consider firms explain the rationale for their d analysis, the commit- ossible candidates. After the board of directors and asked the committee to con- andidate-New Horizon ularly curious about the low P/E board member had heard ing whether by acquiring New After considerable research, data gathering, and analysis tee had narrowed their choices down to three possible the presentation at the quarterly meeting in March, the board had ruled out two of the three candidates and asked the duct further valuation and analysis on the third candidate_N Products. The board members were particularly curious about the ratio at which the firm was trading. In fact, one board member about "relative P/E magic" and was wondering whether by acau Horizon Products the firm could boost its P/E ratio and possibly its ings per share. New Horizon Products, headquartered in Denver, Colorado wa iver, Colorado, was a mid- sized company with assets of $2 billion. The firm's earnings ner oh 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 $45 million per year for the fore- seeable future. Moreover, since New Horizon Products was involved in a totally different industrial sector there were some significant diversifica tion benefits to be had. Tables 1-4 present the financial statements of Metallic Creations Inc. New Horizon Products respectively. The finance department of Metal Creations Inc. had recently estimated the firm's weighted average capital to be 16% and the required rate of return on equity the firm's weighted average cost of Since Jassir had first suggested New Horizon Products as a possible ac- visition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were "made for each other." Now if only he could convince the board! Table 1 Metallic Creations Inc. Income Statement ($ millions) $3,000 2,550 450 100 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 250 100 150 Dividends Paid ($1 per share on 100 million shares) Addition to Retained Earnings 100 50 Table 3 New Horizon Products Income Statement ($ millions) $1,500 1,320 180 50 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) beto Net Income 15 100 40 60 Dividends Paid ($0.8 per share on 50 million shares) Addition to Retained Earnings 20 Table 2 Metallic Creations Inc. Balance Sheet ($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 400 200 400 1000 2000 Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets 6000 -2000 4000 6000 Accounts Payables Accruals Notes Payable Total Current Liabilities 300 200 500 1000 Long-Term Debt 2000 500 Common Stock (par value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 1000 1500 3000 6000 Table 4 New Horizon Products Balance Sheet($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 300 200 200 300 1000 Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets 1400 -400 1000 2000 150 Accounts Payables Accruals Notes Payable Total Current Liabilities 130 500 780 Long-Term Debt 600 Common Stock (par value = $2 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 100 340 180 2000 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? 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 cently dropped to $45 per share ensus in the boardroom was that the fir candidates so as to better utilize its rese that the firm should ser utilize its resources 116 growth. The company's stock price had recently The overwhelming consensus in the boare look for suitable acquisition candidates so and diversify its risk. About three months ago, Jones had set up the MA search possible acquisition candidates and present its terly board meeting. He asked the committee members in related as well as unrelated industries and explain the recommendations he M&A committee to re- nt its findings at the quar- nembers to consider firms explain the rationale for their d analysis, the commit- ossible candidates. After the board of directors and asked the committee to con- andidate-New Horizon ularly curious about the low P/E board member had heard ing whether by acquiring New After considerable research, data gathering, and analysis tee had narrowed their choices down to three possible the presentation at the quarterly meeting in March, the board had ruled out two of the three candidates and asked the duct further valuation and analysis on the third candidate_N Products. The board members were particularly curious about the ratio at which the firm was trading. In fact, one board member about "relative P/E magic" and was wondering whether by acau Horizon Products the firm could boost its P/E ratio and possibly its ings per share. New Horizon Products, headquartered in Denver, Colorado wa iver, Colorado, was a mid- sized company with assets of $2 billion. The firm's earnings ner oh 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 $45 million per year for the fore- seeable future. Moreover, since New Horizon Products was involved in a totally different industrial sector there were some significant diversifica tion benefits to be had. Tables 1-4 present the financial statements of Metallic Creations Inc. New Horizon Products respectively. The finance department of Metal Creations Inc. had recently estimated the firm's weighted average capital to be 16% and the required rate of return on equity the firm's weighted average cost of Since Jassir had first suggested New Horizon Products as a possible ac- visition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were "made for each other." Now if only he could convince the board! Table 1 Metallic Creations Inc. Income Statement ($ millions) $3,000 2,550 450 100 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income 250 100 150 Dividends Paid ($1 per share on 100 million shares) Addition to Retained Earnings 100 50 Table 3 New Horizon Products Income Statement ($ millions) $1,500 1,320 180 50 Revenues Cost of Goods Sold Gross Profit Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) beto Net Income 15 100 40 60 Dividends Paid ($0.8 per share on 50 million shares) Addition to Retained Earnings 20 Table 2 Metallic Creations Inc. Balance Sheet ($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 400 200 400 1000 2000 Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets 6000 -2000 4000 6000 Accounts Payables Accruals Notes Payable Total Current Liabilities 300 200 500 1000 Long-Term Debt 2000 500 Common Stock (par value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 1000 1500 3000 6000 Table 4 New Horizon Products Balance Sheet($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets 300 200 200 300 1000 Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets 1400 -400 1000 2000 150 Accounts Payables Accruals Notes Payable Total Current Liabilities 130 500 780 Long-Term Debt 600 Common Stock (par value = $2 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 100 340 180 2000