- 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?
Valuing Corporate Acquisitions Made for Each Other 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 largesized manufacturing rm 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 signicant 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 rm's scope of expansion had all but dried up, and the managers were hard pressed to search for alternative avenues for growth. The company's stock price had recently dropped to $45 per share. The overwhelming consensus in the boardroom was that the rm should look for suitable acquisition candidates so as to better utilize its resources and diversify its risk. About three months ago, Jones had set up the M&A committee to re search possible acquisition candidates and present its ndings at the quar terly board meeting. He asked the committee members to consider rms in related as well as unrelated industries and explain the rationale for their recommendations. After considerable research, data gathering, and analysis, the commit- tee 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 con- duct further valuation and analysis on the third candidateNew Horizon Products. The board members were particularly curious about the low PIE ratio at which the rm was trading. In fact, one board member had heard about \"relative PIE magic\" and was wondering whether by acquiring New Horizon Products the rm could boost its PIE ratio and possibly its earn ings per share. New Horizon Products, headquartered in Denver, Colorado, was a mid sized company with assets of $2 billion. The rm'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 rm had a fairly well-diversied customer base, its PIE ratio was rather low at 12.5Xmuch below the average PIE ratio for the industry. The committee felt that one reason for the low PIE 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 signicantly reduced due to Metallic Creations' technical and marketing expertise. The incremental net cash ows of the combined company were estimated to be at least $45 million per year for the fore- seeable future. Moreover, since New Horizon Products was involved in a totally different industrial sector there were some signicant diversifica- tion benets to be had. Tables 14 present the nancial statements of Metallic Creations Inc. and New Horizon Products respectively. The nance department of Metallic Creations Inc. had recently estimated the firm's weighted average cost of capital to be 16% and the required rate of return on equity to be 20%. Since Jassir had rst suggested New Horizon Products as a possible ac- quisition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were \"made for each other.\" Now if only he could convince the board! Table 1 Metallic Creations Inc. Income Statement ($ millions) Revenues Cost of Goods Sold Gross Prot Selling & Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income Dividends Paid ($1 per share on 100 million shares} Addition to Retained Earnings Table 2 Metallic Creations Inc. Balance Sheet ($ millions) Cash Marketable Securities Accounts Receivable Inventory Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Accounts Payables Accruals Notes Payable Total Current Liabilities Long-Term Debt Common Stock (par value = $5 per share) Capital Surplus Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity Table 3 New Horizon Products Income Statement ($ millions) Revenues Cost of Goods Sold Gross Prot Selling 8: Administration Expenses Depreciation Interest Earnings Before Taxes Taxes (40%) Net Income Dividends Paid ($0.8 per share on 50 million shares) Addition to Retained Earnings
