It was late sunday night and jassir amor was getting weary

Question

Assignment

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 remembering 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 ourselves 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 competition 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 accumulated 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 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 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 earnings 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 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 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 foreseeable future. Moreover, since New Horizon Products was involved in a totally different industrial sector there were some significant diversification 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 acquisition 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	$3,000
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
Marketable Securities	200
Accounts Receivable	400
Inventory	1000
Total Current Assets	2000
Gross Fixed Assets	6000
Accumulated Depreciation	-2000
Net Fixed Assets	4000
Total Assets	6000
Accounts Payables	300
Accruals	200
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)

Revenues	$1,500
Cost of Goods Sold	1,320
Gross Profit	180
Selling & Administration Expenses	50
Depreciation	15
Interest	15
Earnings Before Taxes	100
Taxes (40%)	40
Net Income	60
Dividends Paid ($0.8 per share on 50 million shares)	40
Addition to Retained Earnings

Table 4

New Horizon Products Balance Sheet ($ millions)

Cash	300
Marketable Securities	200
Accounts Receivable	200
Inventory	300
Total Current Assets	1000
Gross Fixed Assets	1400
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

QUESTION

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?

2. Comment on the director's suggestion of playing the "relative P/E game." For your calculations, assume that New Horizons' shareholders have agreed to an exchange ratio of one share of Metallic Creations Inc. for every two shares held in New Horizon. Also, assume that the combined net income of the two firms is the sum of their net incomes prior to the completion of the deal.

3. Using the free cash flow method of valuation, calculate the maximum offer price that Metallic Creations Inc. would be justified in making for New Horizon Products.

4. Let's say that Metallic Creations Inc. is able to close the deal at a price of $1000 million by paying cash or by exchanging one of its shares for two shares of Metallic Creation. Should it use cash or stock as the payment mechanism? Why? What are the pros and cons of each payment mechanism for the acquiring and the target firm respectively?