set for 8 am the next day and Peterman kept remembering what Ray Machado, the chairman of the Mergers and Acquisitions (M&A) committee has 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. Peterman and Machado 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 Chicago, Indiana. The core business of the firm was producing 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 infancy stage and competition was non-existent. 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 has accumulated a significant amount of cash and built up a good credit history. Over the past couple of years, due to fierce competition and a lackluster economy, the firms scope of expansion had all but dried up. The managers were hard pressed to search for alternatives avenues for growth. The companys share price had recently dropped to $45 per share. The overwhelming consensus in the boardroom was 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 the 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 3rd candidate QuickResolve Products. The board members were 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 its 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 firms earnings per share had been steadily increasing each year and were currently $1.20 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 retirement 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 QuickResolve were to be acquired by Innovative Concepts, production and marketing costs could be significantly reduced due to Innovative conceptss 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, the existence of some significance diversification is inevitable. Since Peterman had first suggested QuickResolve as a possible acquisition candidate, it was his job to provide the Board with the necessary information, clarification and estimations. Peterman firmly believed that QuickResolve and Innovative Concepts were made for each other. He now had to convince the Board of Directors that it was so. Table Q2(a) Q2(d) present the financial statement of Innovative Concepts and QuickResolve Products respectively. The Finance Department of Innovative Concepts had recently estimated the firms weighted average cost of capital to be 16% and the required rate of return on equity to be 20%.

(a) (i) The current total firm value of Quick Resolve. (ii) The expected return on Quick Resolves equity. (iii) The value of the firm at weighted average cost of capital. (b) Compute and justify the maximum price that Innovative Concepts would offer for Quick Resolve Products using both the cash flow and book value method.

(c) Assume that Innovative Concepts is able to close the deal at a price of $100 million by paying cash or by exchanging 1 of its shares for 2 of Quick Resolve Products. (i) Justify whether Innovative Concepts should use cash or share as payment mechanism in the acquisition exercise. (ii) Explain the advantage(s) or disadvantage(s) of each payment mechanism for the acquiring and the target company respectively. (d) Discuss the methods that Quick Resolve Products can utilize to block the takeover attempts. Please include the rationale and possible outcome in the discussion.

Table Q2(a): Innovative Concepts Income Statement Innovative Concepts Income Statement ($ millions) Revenues Cost of Goods Sold Selling and Administration Expenses Depreciation Interest Earnings before taxes Taxes (40%) Net Income Dividends paid ($1 per share on 100 mil shares) Addition to retained earnings $3.000 2.550 450 100 50 50 250 100 150 100 50 Table Q2(b): Innovative Concepts Balance Sheet 400 200 400 1,200 2,000 6,000 Innovative Concepts Balance Sheet ($ millions) Cash Marketable securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Account Payables Accruals Notes Payable Total Current Liabilities Long-term Debt Common Share (Par Value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 4,000 6,000 300 200 500 1,000 2.000 500 1000 1,500 3,000 6,000 Table Q2(c): QuickResolve Products Income Statement QuickResolve Products Income Statement ($ millions) Revenues Cost of Goods Sold Selling and Administration Expenses Depreciation Interest Earnings before taxes Taxes (40%) Net Income Dividends paid ($0.80 per share on 50 mil shares) Addition to retained earnings $1,500 1,320 180 50 15 15 100 40 60 40 20 Table Q2(d): QuickResolve Products Balance Sheet QuickResolve Products Balance Sheet ($ millions) Cash Marketable securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Account Payables Accruals Notes Payable Total Current Liabilities Long-term Debt Common Share (Par Value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 300 200 200 300 1,000 1,400 (400) 1,000 2,000 150 130 500 780 600 100 340 180 620 2.000 Table Q2(a): Innovative Concepts Income Statement Innovative Concepts Income Statement ($ millions) Revenues Cost of Goods Sold Selling and Administration Expenses Depreciation Interest Earnings before taxes Taxes (40%) Net Income Dividends paid ($1 per share on 100 mil shares) Addition to retained earnings $3.000 2.550 450 100 50 50 250 100 150 100 50 Table Q2(b): Innovative Concepts Balance Sheet 400 200 400 1,200 2,000 6,000 Innovative Concepts Balance Sheet ($ millions) Cash Marketable securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Account Payables Accruals Notes Payable Total Current Liabilities Long-term Debt Common Share (Par Value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 4,000 6,000 300 200 500 1,000 2.000 500 1000 1,500 3,000 6,000 Table Q2(c): QuickResolve Products Income Statement QuickResolve Products Income Statement ($ millions) Revenues Cost of Goods Sold Selling and Administration Expenses Depreciation Interest Earnings before taxes Taxes (40%) Net Income Dividends paid ($0.80 per share on 50 mil shares) Addition to retained earnings $1,500 1,320 180 50 15 15 100 40 60 40 20 Table Q2(d): QuickResolve Products Balance Sheet QuickResolve Products Balance Sheet ($ millions) Cash Marketable securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Account Payables Accruals Notes Payable Total Current Liabilities Long-term Debt Common Share (Par Value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 300 200 200 300 1,000 1,400 (400) 1,000 2,000 150 130 500 780 600 100 340 180 620 2.000