Case: Cooper Industries. Inc
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Mergers and Acquisitions
Cooper Industries. Inc
Company Background
Organized in 1919 as a manufacturer of heavy machinery and equipment
A leading producer of engines and massive compressors in mid-1950s
Heavy dependence on sales to the gas and oil industries
Financial strength is attractive
Acquisition made by Cooper Ind. Inc
Between 1959 and 1966 it acquired
(1)A supplier of portable industrial power tools
(2)A manufacturer of small industrial air and process compressors
(3)A maker of small pumps and compressors for oil field operations and
(4)A producer of tire-changing tools for the automotive market
In 1969
The Crescent Niagara Corporation( It has high quality wrenches, pliers, and screwdrivers
Acquisition Acquisition Strategy in 1966
Cooper played a major role in any acquisition
The industry should be fairly stable, with a broad market for the products and a product line of largely small-ticket items 1
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Case: Cooper Industries. Inc
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Acquire only leading companies in their respective market segment
Nicholson File Company
Strengths
One of the largest domestic manufacturers of hand tool and was a leader in its two main product areas
It had 50 % share of 50 million market for files & rasps
Also 9% share of 200 million markets for hand saws and saw blades compare to Sears, Roebuck and co, Inc.
Its highest assets was distribution systems These strengths forecasts 6% to 7% future annual growth
Drawbacks
Annual sales growth 2% (Industry growth 6%)
Profit margin 1/3rd those of other hand tool business
Book value $ 51.25(Market value $44 on May,1972)
P/E ratio 10-14
The company could contribute less than one-sixth of the combined sales
Nicholson’s Atkins saw division seemed vulnerable in view of its low profitability
H.K.Porter Company
A conglomerate with wide ranging interests in electrical equipment, tools, nonferrous metals, and rubber products
It had acquired 44000 shares of Nicholson in 1967
Porter offer $ 42 per share in cash for 437000(out of 584000) to Nicholson
Porter offer $ 50 per share in cash for 177000(out of 584000) to Cooper 2
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Case: Cooper Industries. Inc
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VLN
VLN was broadly diversified company with major- interests in original placement automotive equipment and in publishing
Under the VLN merger term one share of VLN new cumulative convertible preferred stock would be exchanged for each share of Nicholson
Preferred dividend $1.60
Critical issues for making merger between VLN & Nicholson
1. The exchange would be a tax free transaction 2. $1.60 preferred dividend equaled the rate then on the Nicolson Common Stock 3. A preferred share was worth a minimum $53.10
1. If you were Mr. Cizik of Cooper Industries, Inc., would you try to gain control of Nicholson File Company in May 1972?
Mr.Cizik could try to gain control of Nicholson in May 1972 due to their opportunities
Potential profits from every market segments
Cost of goods sold could be reduced from 69% to 65%
Selling, general and administrative expenses from 22% to 19% due to the elimination of sales and advertising duplications
Currently, Sales were made to industrial market and consumer market same proportionately (50:50) which can be offset through Nicholson’s sales ratios (75:25) in this market 3
Case: Cooper Industries. Inc
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Use European distribution systems
Battle between VLN & porter
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2. What is the maximum price that Cooper can afford to pay for Nicholson and still keep the acquisition attractive from the standpoint of Cooper?
The maximum price that Cooper would be able to pay Nicholson, in the form of cash or common stock, would depend on the intrinsic value of Nicholson, based on which, Cooper can make the decision to acquire Nicholson. If the synergistic value of acquisition for Cooper exceeds the premium that Cooper has to pay to Nicholson, only then they can go for the merger. Otherwise, Cooper needs to forecast the long term future of Nicholson’s performance to predict the prospect of their merger.
Synergy is the value that the two firms gain after the merger i.e. the difference between the summation of value of the two firms before the merger and the combined value of the two firm in the form of surviving firm after the merger.
If we can derive the market value of Nicholson, then this would be the maximum value that Cooper could afford to pay, because if Cooper pays more than that value, then Cooper’s shareholders would not be better off from the merger.
Therefore, in order to estimate the value of Nicholson, we used the free cash flow method to valuating the firm and also consequently to determine their value of each share of stock.
The data given for Nicholson in the case is for the year of 1967 to 1971 in Income Statement and the Balance Sheet is given only for the year 1971. We estimated the free cash flow of Nicholson based on forecasting from 1972 till 1976, including considering their survival of 4
Case: Cooper Industries. Inc
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business forever.
During estimating the free cash flow from Nicholson after the merger, the necessary changes due to the synergistic effect has been incorporated in the assumptions.
We are providing here the breakdown of our assumptions along with calculation to determine the cash flow to Cooper and thereafter the value of Nicholson. Particulars
Assumptions
Net Sales
1972 57.2
1973
1974
59.1
62.7
2
Particulars Cost of Goods Sold
3
Gross Profit
4
Selling & Administrative Expenses Depreciation Interest Expense
5 6
7
Other deductions
8
Income before Taxes
1975 66.4
1976 70.4
Forecasted based on Avg. growth rate of 3.39% during 1972-73 and of 6% aligning with industry growth rate based on their future prospect during 1974-76.
Assumptions Goes down to 65% from 69%
Goes down to 22% from 19% Same as of 1971 Assumed no new loan has been availed Considering the past trend
1972
1973
1974
1975
1976
37.2 20.0
38.4 20.7
40.7 21.9
43.2 23.2
45.8 24.6
10.9 2.1
11.2 2.1
11.9 2.1
12.6 2.1
13.4 2.1
0.8
0.8
0.8
0.8
0.8
0.2
0.2
0.2
0.2
0.2
6.8
7.2
7.7
8.3
9.0
2.7
2.9
3.1
3.3
3.6
9 10
Taxes Net Taxes
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Net Income
2.5 4.1
2.7 4.3
2.9 4.6
3.1 5.0
3.3 5.4
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Add back: Depreciation
2.1
2.1
2.1
2.1
2.1
at 40% After adjusting for i) investment tax credit and ii) income of equity in net income of partially owned foreign companies.
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Case: Cooper Industries. Inc
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13
Cash Flow
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Less: Retention needed for growth
To finance asset replacement and growth; assumed 20% retention of cash inflow
6.2
6.4
6.7
7.1
7.5
1.2
1.3
1.3
1.4
1.5
Notes: i) Interest Expense:
Since we are calculating the free cash flow from Nicholson, we ignored the interest expense in calculating Income before tax (EBT) (which would be actually the Earnings before Interest & Tax, EBIT) and we considered the cost of debt during discounting the cash flow to get the present value of the cash flow.
ii) Retention needed for growth:
Some of the cash flow generated from Nicholson is need to be retained back in the company if in case they need fund to finance replacements of assets. The fund could be used for cooper to pay dividend on their stock and for redeployment within the firm. The particular fund is basically require to retain considering the growth of the company. We assumed 20% of cash flow to be retained for the above purpose.
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Particulars Add: Terminal Value (as on year end 1976)
Working Capital: Accounts Receivables Inventories
Assumptions Using the Constant Growth Model: g=2.00% conservatively, Discount rate=9.16%; Nicholson's Cash Flow is expected to grow @ 2.00% after 1976
Accounts Receivables to sales ratio in 1971 Inventories to sales ratio in 1971
6
1972
1973
1974
1975
1976
85.3
8.3
8.6
9.1
9.6
10.2
18.6
19.2
20.4
21.6
22.9
Case: Cooper Industries. Inc
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Accounts Payable
17
18
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Accounts Payable to sales ratio in 1971
Change in Net Working Capital: Change in Accounts Receivables Change in Inventories Change in Accounts Payable Change in Net Working Capital Capital Expenditure: Net Plant & Equipment
Net Plant & equipment to Sales ratio of 1971
2.1
2.1
2.3
2.4
2.5
0.3 0.6
0.3 0.6
0.5 1.2
0.5 1.2
0.6 1.3
0.1
0.1
0.1
0.1
0.1
0.9
1.0
1.8
1.9
2.0
16.5
17.1
18.1
19.2
20.4
Change in Capital Expenditure
0.5
0.6
1.0
1.1
1.2
Net Cash Flow to Cooper
3.5
3.6
2.6
2.7
This is the cash flow to Cooper from Nicholson after the merger.
Notes: iii) Terminal Value:
Considering that after 1976, Nicholson will operate forever after getting merge with Cooper, and grow at constant rate. In this case, our conservative assumption is 2.00% of growth rate keeping in view their present performance.
Now, in order to find the appropriate discount rate, we determine the Weighted Average Cost of Capital.
2) Calculation of Cost of Capital / discounting rate: a
Cost of Debt: Long Term Debt (as on 31-Dec-1971) i Interest Expense (as on 31-Dec-1971) ii
Calculation $ 12 Million $ 0.8 Million
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88.1
Case: Cooper Industries. Inc
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Cost of Debt
kd = ii / i
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6.67%
Cost of Debt is calculated assuming no new debt has been availed by the company.
B
Cost of Equity: market price per share (average that of 1971) p Dividend per share = D1 d Growth rate (industry rate) g Cost of Equity ke = (d/p)+g
$ 27.5 $ 1.6 6.00% 11.82%
The cost of equity has been determining based on the Constant Growth Model.
Nicholson has been paying fixed dividend of $1.6 over the years. We assumed that the cash flow in the form of dividend would be $1.6 which we consider D*(1+g) = D1 = $1.6. The dividend is expected to grow at 6% in align with the industry =growth rate if Nicholson can achieve this growth rate after receiving the synergistic effect during the post merger period. c
Weight of Debt Weight of Equity Tax Rate WACC
wd we t wd*kd*(1-t)+we*ke
0.34 0.66 40% 9.16%
Now, lets focus on the valuation of Nicholson after the merger. Figures in $ Million Estimating Market Value of Nicholson after merger: Forecasted Years Net Cash Flow to Cooper ($ Million) Valuation of Cash Flows as on year end 1971 ($ Million) Loan amount Cash flow for Stockholders
1971
66.9 12.0 54.9
No. of shares outstanding of Nicholson 584,000
8
1972 3.5
1973 3.6
Forecasted 1974 1975 2.6 2.7
1976 88.1
Case: Cooper Industries. Inc
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Value of each share of Stock of Nicholson ($)
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93.99
This implies that, if Cooper has to pay more than $66.90 million to Nicholson, then the shareholders of Cooper will loose. On the other hand, if Cooper can pay less than this value, their shareholders will gain.
Now, if we consider the no. of shares of Nicholson to be 584,000 and the market price of share of stock to be $44, then the total market value of Nicholson appears to be $25.69 million. Now, if the shareholders of Nicholson receive more than this value from Cooper for acquisition, then they will be better off.
The gap between the market value of $25.96 million and $66.90 million is the Bargaining Range which equals to the synergy.
3. What are the concerns and what is the bargaining position of each group of Nicholson stockholders? What must Cooper offer each group in order to acquire its shares?
The different stockholders of Nicholson offered different offer in different form. Their bargaining position is as below:
H. K. Porter Company’s Offer:
On March 03, 1972, Porter tendered 437,000 out of 584,000 shares of Nicholson at $42 per share in cash, reflecting $12 premium over the most recent price of stock of Nicholson. Moreover, Porter would support the merger between Cooper and Nicholson if they receive Cooper’s convertible securities in a tax free exchange worth at least $50 for each share of Nicholson
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Case: Cooper Industries. Inc
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Cooper’s offer to Porter:
Cooper can take the offer of Porter of $50 for each share of stock for the 177,000 shares of Nicholson since the market value of Nicholson for each share of stock of $114.53, as derived from our calculation is far more than the offered price.
VLN’s Bargaining Position:
VLN’s merger terms are that one share of VLN convertible preferred stock would be exchanged for each share of Nicholson common stock. The VLN preferred stock would pay an annual dividend of $1.6 and would be convertible into five shares of VLN common stock during the first year following the merger, scaling down to four shares after the fourth year. The preferred would be callable at $50 a share after the 5th year and would have liquidating rights of $50 per share. In addition to this, they assured Nicholson of colonized operating independence of the Nicholson’s management. However, as pointed out by Porter that VLN common stock has recently sold for $4.625 per share that put the value in first year of $23.12 on the VLN preferred. Since, VLN did not pay any common dividend since 1970, converting into VLN common stock would result in incurring sharp income loss. Porter do not need to offer VLN i.e. acquire the shares of VLN since the no. of VLN shares is as low as 14,000 compare to total no. of shares of 584,000 of Nicholson and due to above mentioned reason, Cooper might have to suffer in future for acquiring their shares.
Uncommitted Shareholder’s position:
The uncommitted shareholder, holding 172,000 shares, and also the shareholders of shares unaccounted for, would go by the advice of Nicholson’s management and the speculators bought the shares hoping of escalation or appreciation of acquisition offer. Therefore, if Cooper can offer a price that satisfy both the Nicholson’s management and also it leads to gain of the speculators and the shareholders of shares unaccounted for, then Cooper would be able to acquire majority of the outstanding shares of Nicholson. Now, since the 10
Case: Cooper Industries. Inc
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market value of Nicholson as derived from the calculation is quite high than any other offer made in the market, Cooper can just offer $50 to these shareholders keeping in mind the offer made by Porter that supports the Cooper-Nicholson merger.
4. On the assumption that the Cooper management wants to acquire at least 80 percent of the outstanding Nicholson stock and to make the same offer to all stockholders, what offer must Cooper management make in terms of dollar value and the form of payment (cash, stock, debt).
To finance an acquisition by cash or by shares of stock depends on several factors that can be considered by Cooper as followsi)
Over valuation: If the acquiring company’s stock is overvalued, then using shares of stock is less costly than using cash.
ii)
Taxes: Acquisition by cash is a taxable transaction whereas that with stock is tax free.
iii)
Sharing Gains: Using stock for acquisition can help the shareholders of the acquiring company to gain as well as to incur loss depending on the company’s performance. On the other hand, acquisition with cash lead the shareholders to get fixed price.
In order to acquire the 80% of shares of Nicholson, Cooper do not need to offer VLN considering the factors pointed out by Porter. Therefore, to attract the speculators and the shareholders of shares unaccounted for, Cooper can offer a price that satisfies these shareholders along with the management of Nicholson. Cooper also need top consider the offer made by the Porter of $50 per hare of stock.
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Case: Cooper Industries. Inc
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Assumption: If Cooper offer price of Particulars
Present Earnings Shares Outstanding Earnings per Share Price per Share Price/Earnings Ratio
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$50 Before Merger as on 1972 Cooper Nicholson $5,600,000 4,218,69 1 $1.12 $28 $25
$1,350,000 584,00 0 $2.32 $44 $12
Exchange ratio
0.88
After Merger Cooper $6,950,000 4,732,61 1 $1.47
5. What should Mr. Cizik recommend that the Cooper management do?
From our calculation based on free cash flow method, the estimated value of each share of Nicholson came to be $114.53. It obviously exceeds any offer made in the market to acquire the Nicholson’s shareholder. Since valuation has been determined considering the synergistic effect along with several conservative assumptions, though which the value came to be quite higher, it implies that if Nicholson’s business survive in the form of merging with Cooper from 1976 afterwards, the market value of Nicholson is undervalued and the acquisition of their shares should benefit the shareholders of Cooper for taking the decision to get merge with Nicholson.
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