Assignment -
Evaluate the opinions expressed in the following discussion. Point out the ones that you think are incorrect, explain why, and indicate briefly how you would correct them. It is important that you point out the errors. Merely writing down a correct way of addressing the issue is not sufficient.
Recently, Pat Ewing, vice-president of finance of ITT (International This and That), a publicly traded conglomerate, has returned from a management seminar at Hardvare University in Boston. Ewing is trying to implement the techniques of modern financial analysis that were taught in the seminar.
Ewing and Chris Evert, the executive vice-president of ITT, joined Drew Barrymore, the president, for a meeting of the Finance Committee.
1. Ewing: I have rank-ordered all the projects under consideration in Exhibit 1.
2. Evert: What is this IRR?
3. Ewing: That is the required rate of return for each project. Many companies call it the "hurdle rate". It has to be positive for us to accept a project.
4. Barrymore: Our average project returns are not beating the market: the return on S&P 500 is around 14%. This might make our board unhappy.
5. Evert: Pat, I see you have finally figured out a way to estimate our WACC.
6. Ewing: This is one of the important things I learned in the seminar. I calculated our cost of equity based on a model called CAPM that they taught in the seminar. Then I used our borrowing rate and debt ratio to calculate the WACC in Exhibit 2.
7. Evert: Why are we interested in buying Icarus Shoe Company?
8. Barrymore: We are leveraging our core competence of cost efficiency. Icarus has a bloated cost structure and we can reduce costs by our management techniques. Keep in mind our negotiations with them are confidential.
9. Evert: How much cost reduction can we achieve?
10. Ewing: We can cut down COGS by 15% and SG&A by 10%, saving 25%. It will result in annual pre-tax cost savings of $480,000.
11. Barrymore: How much do you propose we pay for Icarus?
12. Ewing: In our negotiations both parties agreed to a premium of 20% over their current stock price. Since their stock is selling for $6, I arrived at the offering price of about $13 million for all their shares as follows:
Current market value of equity of Icarus = 6 * 1.8 = $10.8 million.
Including 20% premium = 10.8 * 1.20 = $12.96 million.
Adding bankers' and lawyers' fees makes our total investment $14 million.
13. Evert: Is it worth spending $14 million on this acquisition?
14. Ewing: We are getting a great deal - paying $14 million for a company with shareholder equity of $17.5 million (Exhibit 4).
15. Barrymore: Is the 20% premium over the stock price justified?
16. Ewing: Since we can expect the cost savings for a long time, the PV of cost savings is about $6 million (480,000/0.08). Since they don't have any financial assets worth mentioning, knocking off their debt of $0.8 million gives us an equity value of $5.2 million. This beats the premium of (12.96 - 10.80) = $2.16 million plus legal costs by a cool $2 million.
17. Barrymore: How much capital do we need for all these projects?
18. Ewing: About $25 million - $14 million for Icarus and 11 million for the other projects.
19. Barrymore: Where are we going to find all that capital? We can generate only about $13 million internally. And we don't have any surplus cash or financial assets to sell.
20. Evert: We can manage if we can buy Icarus through a stock offer.
21. Ewing: That's a good idea. Since our shares are selling at $55, we need to offer their shareholders about 236,400 shares ($13 million ÷ 55).
22. Evert: Fine. What is the project proposal from the Lighting Unit?
23. Ewing: It is to supply all the lighting fixtures for a mall and maintain them. Our investment to light up the mall is about $3 million. The annual installment payments the customer is offering will result in free cash flows of $400,000. Great project, with an IRR of 16%.
24. Barrymore: Pat, do you have anything to report on our goal of reducing working capital?
25. Ewing: I did not forget that. I recently used our surplus cash to pay down some long-term debt. The decrease in current assets has reduced our working capital.
26. Evert: Ingenious!
27. Barrymore: We need to figure out what to do with our entertainment unit. I don't recall the last time I saw a positive bottom line in their income statement. I don't see any prospects for improvement either.
28. Ewing: We should be careful here - another thing I learnt in the seminar is that we should use economic profit to assess performance. I will get the data before our next meeting: the unit's economic profit may turn out to be positive.
29. Barrymore: OK. The board is getting concerned the stock price is not reflecting our potential.
30. Ewing: Don't worry, Drew. In the next investor presentation we will outline our plan for the projects in Exhibit 1. When investors realize that these projects are profitable, it will have a positive effect on the stock price.
Content that they have maximized shareholder value, Patricia Ewing, Christopher Evert, and Andrew Barrymore adjourn for a three-martini lunch and a round of golf.
Attachment:- Assignment File.rar