What are some tax issues that must be considered by Metallic Creations Inc. management team when making the bid?

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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 large-sized manufacturing firm headquartered in Pittsburgh, Pennsylvania, which produced unique metal products for W 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 growth. The company's stock price had recently dropped to $45 per share. The overwhelming consensus in the boardroom was that the firm 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 findings at the quar terly 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 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 candidate-New Horizon Products. The board members were particularly curious about the low P/E ratio at which the firm was trading. In fact, one board member had heard about "relative P/E magic" and was wondering whether by acquiring New Horizon Products the firm could boost its P/E 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 firm'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 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 $45 million per year for the fore- seeable future. Moreover, since New Horizon Products was involved in a totally different industrial sector there were some significant diversifica- tion benefits to be had. Tables 1-4 present the financial statements of Metallic Creations Inc. and New Horizon Products respectively. The finance department of Metallic Creations Inc. had recently estimated the firm's weighted average cost of capital to be 16% and the required rate of return on equity to be 20% Since Jassir had first suggested New Horizon Products as a possible ac quisition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were "made for each other." Now if only he could convince the board! Table 1 Metallic Creations Inc. Income Statement ($ millions) $3,000 Revenues Cost of Goods Sold 2,550 Gross Profit 450 Selling & Administration Expenses 100 Depreciation 50 Interest 50 Earnings Before Taxes 250 Taxes (40%) 100 Net Income 150 Dividends Paid ($1 per share on 100 million shares) 100 Addition to Retained Earnings 50 Table 2 Metallic Creations Inc. Balance Sheet ($ millions) Cash 400 200 Marketable Securities Accounts Receivable 400 Inventory 1000 Total Current Assets 2000 Gross Fixed Assets 6000 Accumulated Depreciation -2000 4000 Net Fixed Assets Total Assets 6000 Accounts Payables 300 200 ccruals Notes Payable 500 Total Current Liabilities 1000 Long-Term Debt 2000 Common Stock (par value = $5 per share) 500 Capital Surplus 1000 Retained Earnings 1500 Total Shareholders' Equity 3000 Total Liabilities and Shareholders' Equity 6000 Table 3 New Horizon Products Income Statement ($ millions) $1,500 Revenues 1,320 Cost of Goods Sold Gross Profit 180 Selling& Administration Expenses 50 Depreciation 15 Interest 15 Earnings Before Taxes 100 Taxes (40%) 40 60 Net Income Dividends Paid ($0.8 per share on 50 million shares) 40 20 Addition to Retained Earnings Table 4 New Horizon Products Balance Sheet ($ millions) 300 Cash Marketable Securities 200 Accounts Receivable 200 300 Inventory Total Current Assets 1000 1400 Gross Fixed Assets Accumulated Depreciation -400 Net Fixed Assets 1000 Total Assets 2000 Accounts Payables 150 Accruals 130 Notes Payable 500 Total Current Liabilities 780 Long-Term Debt 600 Common Stock (par value = $2 per share) 100 Capital Surplus 340 Retained Earnings 180 Total Shareholders' Equity 620 Total Liabilities and Shareholders' Equity 2000 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 large-sized manufacturing firm headquartered in Pittsburgh, Pennsylvania, which produced unique metal products for W 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 growth. The company's stock price had recently dropped to $45 per share. The overwhelming consensus in the boardroom was that the firm 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 findings at the quar terly 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 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 candidate-New Horizon Products. The board members were particularly curious about the low P/E ratio at which the firm was trading. In fact, one board member had heard about "relative P/E magic" and was wondering whether by acquiring New Horizon Products the firm could boost its P/E 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 firm'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 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 $45 million per year for the fore- seeable future. Moreover, since New Horizon Products was involved in a totally different industrial sector there were some significant diversifica- tion benefits to be had. Tables 1-4 present the financial statements of Metallic Creations Inc. and New Horizon Products respectively. The finance department of Metallic Creations Inc. had recently estimated the firm's weighted average cost of capital to be 16% and the required rate of return on equity to be 20% Since Jassir had first suggested New Horizon Products as a possible ac quisition candidate, it was his job to provide the board with the necessary information, clarification, and estimates. Jassir firmly believed that New Horizon Products and Metallic Creations Inc. were "made for each other." Now if only he could convince the board! Table 1 Metallic Creations Inc. Income Statement ($ millions) $3,000 Revenues Cost of Goods Sold 2,550 Gross Profit 450 Selling & Administration Expenses 100 Depreciation 50 Interest 50 Earnings Before Taxes 250 Taxes (40%) 100 Net Income 150 Dividends Paid ($1 per share on 100 million shares) 100 Addition to Retained Earnings 50 Table 2 Metallic Creations Inc. Balance Sheet ($ millions) Cash 400 200 Marketable Securities Accounts Receivable 400 Inventory 1000 Total Current Assets 2000 Gross Fixed Assets 6000 Accumulated Depreciation -2000 4000 Net Fixed Assets Total Assets 6000 Accounts Payables 300 200 ccruals Notes Payable 500 Total Current Liabilities 1000 Long-Term Debt 2000 Common Stock (par value = $5 per share) 500 Capital Surplus 1000 Retained Earnings 1500 Total Shareholders' Equity 3000 Total Liabilities and Shareholders' Equity 6000 Table 3 New Horizon Products Income Statement ($ millions) $1,500 Revenues 1,320 Cost of Goods Sold Gross Profit 180 Selling& Administration Expenses 50 Depreciation 15 Interest 15 Earnings Before Taxes 100 Taxes (40%) 40 60 Net Income Dividends Paid ($0.8 per share on 50 million shares) 40 20 Addition to Retained Earnings Table 4 New Horizon Products Balance Sheet ($ millions) 300 Cash Marketable Securities 200 Accounts Receivable 200 300 Inventory Total Current Assets 1000 1400 Gross Fixed Assets Accumulated Depreciation -400 Net Fixed Assets 1000 Total Assets 2000 Accounts Payables 150 Accruals 130 Notes Payable 500 Total Current Liabilities 780 Long-Term Debt 600 Common Stock (par value = $2 per share) 100 Capital Surplus 340 Retained Earnings 180 Total Shareholders' Equity 620 Total Liabilities and Shareholders' Equity 2000