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Group 3:

Antonio Carlos Teles Caleia #1028

Federica Carcani #2258
Edoardo Covicchio #2259
Leandro Jos Pereira Domingues #1023
Francesca Romana Gambini #2260

Case 1

Mergers, Acquisition and Restructuring (TB

Prof. Jos Neves de Almeida

Active Gear, Inc. is a privately held footwear company that is thinking of acquiring a
subsidiary of West Coast Fashion, Inc. called Mercury Athletic. The rationality behind
this acquisition is that it will allow the acquiring firm to double its revenue, increase its
leverage with contract manufacturers, and expand its presence with key retailers and
distributors. Our goal is to analyze if Mercury is an appropriate target for AGI, to review
the projections formulated by Liedtke the head of business development for Active
Gear, to use a cash flow based valuation to come up with a possible bid for Mercury
and comment on the result mentioning if it is conservative or an aggressive valuation
and, finally, to comment on possible synergies.
First, given the close relation of the core businesses of the firms and considering the
expected benefits and opportunities that AGI could exploit through the acquisition,
Mercury Athletic Footwear appears to be an appropriate target.
In what concerns the base case projections analysis, it emerges that Liedtke did a
cautious forecast for Mercurys operating accounts, especially in evaluating Mens
Athletic business, while balance sheet accounts seem in line with the target
companys historical trend. These projections are reasonable as long as considering
Mercury as a stand-alone business, and when taking into account possible acquisition
effects some adjustments shall be made.
Regarding the cash flow based valuation, using a WACC of 10.71% and a sustainable
growth rate for the terminal value equal to 1.15%, we arrived to an enterprise value of
$273.83 million as of the end of fiscal 2011. This will correspond to the equity value
since the firm does not have any debt and assuming further that all cash at the end of
fiscal 2011 is operational.

1. Is Mercury an appropriate target for AGI? Why or why not?

Active Gear Inc., a firm operating in the footwear industry, is considering the
possibility of increasing its size. Although being one of the most profitable firms, its
smaller size might translate into a competitive disadvantage. Given the highly
competitive and fragmented sector and the low growth of the footwear industry, the
expansion through the acquisition of Mercury Athletic Footwear represents an
opportunity to be valued, as the firm seems to be an appropriate target.
Due to the close relation between the core businesses of the two firms, showing very
similar production style and distribution channels, AGI could take advantage of several
opportunities if acquiring Mercury. Indeed, the operation could result in increased
competitiveness and revenues, higher bargaining power with contract manufacturer
and a stronger position with respect to main distributors and retailers.
Even so, Mercury displays two main problems. On the one hand, the company has
underperformed since it was acquired by West Coast Fashion Inc, and the reason is
attributed to the companys choice of selling through discount retailers, which in turn
means marketing products at lower prices. On the other hand, its womens casual
footwear line proved to be completely unsuccessful.
Nevertheless, AGI could be able to address these problems and increase the firms
operational inefficiencies. For instance, it could apply its inventory management
system and its same policy of not selling through discount retailers. Moreover, it could
consider combining Mercurys poor performing womens casual footwear line to its
similar existing line. Still, a possible cannibalization effect arising from the acquisition
should also be considered.
Overall, there are a number of benefits that might affect Active Gear Inc. through the
acquisition of Mercury. First, the operation would not change the complexity of AGIs
portfolio: it would maintain simple production and supply chain, still avoiding the
cyclicality of the industrys inventory. Second, AGI could exploit both Mercurys
consolidated brand image, further increasing its competitive position, and Mercurys
knowhow in research and development. Third, apart from the womens casual
footwear line, the other three Mercurys segments report good performance. In
particular, both mens athletic and casual footwear line exhibit higher operating
margins than rival firms. Fourth, Mercurys products would increase the range of AGIs
target customers. Lastly, the overall operation might result relatively simple due to the
independence of Mercury from West Coast Fashion Inc.
2. Review the projections formulated by Liedtke. Are they appropriate? How
would you recommend modifying them?
To value Mercurys Athletic, and calculate how much it would be reasonable to spend
for its acquisition, Liedtke performs some projections for both operating and balance
sheets accounts of the targets four businesses.
Starting from the operating accounts, the reasonableness of the projections have been
checked with respect to both historical and industry trends. For what concerns Mens
Athletic, which constitutes the core and best performing business, Liedtke assumed
increasing revenues but at a slower pace year after year. They grow at a CAGR of

13.49%1 between 2006 and 2008, which compared to the realized 29.01% in the
previous 2004-2006 seems to be a prudent approach. This assumption is in line with
the matureness and low growth characteristics of the industry, but may underestimate
the good performance of the business. The strong brand image, in combination with
distribution through discount retailers may lead to higher revenue growth projections.
Operating income is assumed to increase steadily at a 13.30% per year starting from
2007 after an higher growth of 14.34% reported in 2006. This seems a reasonable
assumption, since the industry is characterized by stable profit margins. The same
upward adjustment may be applied also to operating margins, in order to reflect the
revenues projections.
Mens Casual forecasts are reasonable, since they report increasing both revenues and
operating margins. This reflects the investments that has been undertaken by Mercury
in order to boost the business. The company, indeed, expected revenues to recover
from 2007 and this is mirrored in Liedtke assumptions. High profit margins also
correctly embed the recent improvement of the line, boosted by an effective
marketing strategy focused on sales through specialty stores.
Womens athletic segment reported below-average margins but should be expected to
grow in the next years, because of targeted promotional programs that have been
started recently. This could yield to a better performance of the segment, which is
partially reflected in the projections. Both revenues and operating margins are
increasing, the latter remaining stable after 2007 at a below-average level. It could be
more realistic to consider a better scenario for operating margins, given the recent
trend of increased participation of women in sports and the marketing effort made by
Mercury to increase sales.
The last and worst business, Womens casual, is assumed to be divested after 2007.
This is a reasonable assumption, since Mercurys management is not willing to invest
into the business anymore, considering the bad results obtained from previous efforts
in improving the line.
Considering consolidated figures, forecasted corporate overhead expenses are in line
with the historical average. This also seems reasonable, as long as the base case
valuation regards Mercurys as a stand-alone entity and does not consider postacquisition effects. Furthermore, operating margins increasing from 9.81% to 10.70%
may be in line with the 11.9% industry average.
Lastly, estimation of capital expenditures are coherent with Mercurys low capital
spending. They are forecasted as growing, but still are little compared to operating
Turning to balance sheet accounts, a number of other considerations occur. In
particular, accounts receivables trend reflects the forecasted increase in revenues.
Inventory is always increasing, leading to a worsening of the days of sales in inventory
ratio. Mercury was already among the worst performer, with a DSI of 61.1 relative to
the lower industry average of 50.9. This negative outlook may be due to the expected
divestiture in Womens Casual business, which could lead to an accumulation of
inventory. Under these circumstances, the forecast may seem reasonable.
A modification of Trademarks & Other Intangibles could better reflect the focus of
Mercurys resources on market research and design, and a constant investment, as the
ones projected by Liedtke, may not be an appropriate assumption.
These considerations lead to the conclusion of an overall correct picture of Mercurys
athletic, but under a cautious approach. Indeed, projections are not overly optimistic,
in particular those regarding sales revenue.

1 CAGR computed as


Revenues 2008 ( 13 )
) 1
Revenues 2006

Lastly, all the forecasts seems to regard Mercury as a stand-alone business. Synergies
and post-acquisition effects are not considered, thus leading to a worse performance
in some areas.
In particular, considering the acquisition effects, overhead-to-revenue ratio could
decrease and inventory can be optimized. Property, Plant and Equipment investment
could be reduced, due to the concentration of the companies activities. Moreover, if
taking into account the opportunity of maintaining the Womens Casual business the
overall performance may improve.
3. Estimate the value of Mercury using a discounted cash-flow approach and
Liedtke's base case projections.
In a cash flow based valuation the Enterprise value has two components: the value of
the firm unlevered and the PV of the tax shields. To perform this kind of valuation, it is
first necessary to estimate a Free Cash Flow (FCF) map from 2007 until 2011 the
explicit period. This map was based on the base case projections for the balance sheet
and income statement made by Liedtke. The bottom-line of the FCF map is the
unlevered FCF which corresponds to the cash flows available to all investors of
Mercury Athletic Footwear, both debt holders and equity holders. As the firm plans to
keep a constant debt-to-equity ratio in market values, the risk of the tax shields will be
equal to the risk of the firms cash flows. Therefore, both the unlevered FCF and the
tax shields should be discounted at the unlevered cost of capital. To simplify our
calculations, we have used the WACC valuation method which accounts for the tax
shield on the discount rate. Thus, in order to get the Enterprise Value it is just
necessary to discount the unlevered FCF at the WACC during the explicit period (from
2007 to 2011) and then add the continuation value. The Equity Value, which is the
value that Active Gear is willing to pay for Mercury Athletic Footwear, will be equal to
the Enterprise Value if we assume that all cash at the end of fiscal 2011 is operational
since the target company does not have any debt
Starting by the FCF map, the Unlevered FCF can be though as follow:

Unl . FCF =EBIT( 1t )+ DepreciationCAPEXInvestment NWC Other Assets+ Other Liabilities

The operating income is already estimated by Liedtke, hence, we just need to subtract
the taxes hypothetical paid if the firm had no debt. From 2007 onwards we have
assumed that there are no tax credits neither other deductible items, such that the
marginal tax rate is equal to the effective tax rate and, hence, there are no tax
adjustments. In order to get the gross operational cash flow we need just to add to the
NOPLAT the depreciation. The CAPEX is equal to the variation in the item Property
Plant and Equipment (PPE) plus the depreciation. This way, we will have the variation
in money of the PPE. Regarding the investment in Working Capital (WC), we have
considered that the operating cash, the account receivables, the inventories and the
prepaid expenses correspond to the WC assets and that the account payables and
accrued expenses correspond to the WC liabilities. Therefore, the investment in NWC
corresponds to the variation of the WC assets minus the variation of the WC liabilities.
Lastly, to get the Unlevered FCF we have just subtract the variation on other assets
(Trademarks & Other Intangibles, Goodwill and Other Assets) and added the variation
on other liabilities (Deferred Taxes and Pension Funds).
To discount the Unlevered FCF during the explicit period and to project the value of
firm in perpetuity we need an estimate of the WACC, which is defined as follows:


Rd( 1t )+


The cost of debt was already estimated by Liedtke at 6% and the marginal tax rate is
expected to be constant at 40% from 2007 onwards. Therefore, the after-tax cost of

debt is 3.6%. To get the required return by equity holders we have to get first the beta
of equity and then use the CAPM. Based on the assumption that the risk of the tax
shields is equal to the risk of the firms cash flows (txa (tax shield) is equal to u), the
beta of equity can be defined as follows:


( BuBd ) +Valuetxa ( BuBtxa )=u+ ( BuBd )

First, we computed the d. Using the CAPM we arrived to a d of 0.25, assuming a

market return of 9.78% and a risk free of 4.73% which corresponds to the S&P return
from 1987 until 2006 and the interest rate on the 10 Years U.S. Treasury obligations,
respectively. To get the u we took the average of the unlevered betas of the
comparable firms, which was 1.28. Given the previous u and d, we got a e equal to
1.54. Using the CAPM, the required return for the shareholders is 12.48%. As Active
Gear wants a target debt-to-EV in market value of 20% for Mercury Athletic Footwear,
the WACC is 10.71%.
Lastly, it was necessary to compute the terminal value. For that purpose we used the
perpetuity formula to calculate the EV as of the end of 2011 and then discount it back
to the end of 2006. The perpetuity formula needs three inputs: the unlevered FCF of
2012, the WACC and the sustainable growth rate (g). As in the long-run the firm is
already in the steady-state, where the revenues and the costs grow at the g, the FCF
of 2012 is simply the FCF of 2011 multiplied by 1+g. Therefore, the only missing input
was the g, which was calculated by the multiplication of long-run ROIC and the
Reinvestment Rate. The ROIC is defined as the NOPLAT of the current year divided by
the total invested capital by the equity holders and debt holders in the previous year.
Regarding the Reinvestment Rate, it was defined has the new investments the firm
has made during the year divided by the NOPLAT. In the new investments made during
the year, we have assumed that a part of the CAPEX equal to the depreciation is used
to replace the existing assets, thus, just the remaining amount accounts for new
investments. We took an average of the expected growth rates for the explicit period,
which was 1.15%, and assumed it to be the sustainable growth rate. Given the
expected 2012 unlevered FCF of $29.85 million, the WACC of 10,71% and the growth
rate of 1.15%, the terminal value as of 2011 is $312.82 million.
Discounting the unlevered FCF of the explicit period at the WACC and discounting the
terminal value to the end of 2011, we get an EV of $273.84 million.
5. How would you analyze possible synergies or other sources of value not
reflected in Liedtke's base case assumptions?
When two companies merge they become a unique entity, and this can lead to
advantages, both on the financial or operating side. Those improvements are usually
referred as to synergies.
As highlighted previously Liedtkes base case assumptions in performing the valuation
of Mercury refer to its actual position. This can be considered a correct approach to
evaluate the investment an acquirer should make. Nevertheless, it actually does not
take into account those improvements that the post-merge entity will benefit from.
Firstly best-in-class management techniques from one side can be implemented in the
targets processes, starting from the implementation of inventory management
system in use at AGI into Mercurys processes too. Since the former has proven to be
more effective, this would lead to a lower inventory turnover.

Another important aspect of the synergies that would be generated from the
acquisition stems from the possibility of not shutting down Mercurys women casual
business branch and instead folding it into the respective acquirer division. Forecasts
projections highlight 3% revenues growth and 9% EBIT, and under this scenario the
division will be profitable, with little increase in revenue but a higher one in before tax
profits. Follows that this profitability is driven from cost reduction stemming from lower
production costs. Although production is outsourced, probably this assumption relies
majorly on the fact that in the post-acquisition scenario the two lines will share the
supervising team (although larger than AGIs previous one, would be smaller than both
firms aggregate), which is in turn a cost optimization synergy.
On a broader view there is room for cost reduction as well relative to the base case
scenario, on different aspects. Major cost optimization would stem from the operating
side. A practical example could be the supervision function optimization highlighted
above for the woman casual line of business. In fact this can be broaden to all other
Moreover the merged company will have a broader market share, and so higher
bargaining power over both manufacturers and distributors. This will make AGI better
off in its position towards Chinese manufacturer as well, giving the possibility of
effectively contrasting the suppliers trend to aggregate and requesting larger orders.
Furthermore incorporating Mercurys product line would enlarge AGIs offering, which
for the time being is quite restricted.
Overhead costs would for sure will be higher compared to the relative costs faced from
every single company on a pre-acquisition date, but still lower with respect to their
aggregate. This is due to its larger size and so larger administrative structure, but
some expenses that previously were incurred from both companies will be instead
driven into a single invoice (for example they will have a single headquarter, one BoD,
Finally, research and development will be convoyed into a single pool, so that
technicians will have more technologies, designs and know-how available to create
new products. Surely this is a desirable outcome that could lead to improvements in
technological and creative side of AGIs offering.