YEATS VALVES CONTROLS INC.

I. CASE BACKGROUND

Yeats Valves and Controls Inc. was founded in 1980 by its CEO, Bill Yeats. It was principally
engaged in the manufacture of specialty valves and heat exchangers. The firm had many
standard items, but nearly 40% of its volume and 50% of its profit derived from special
application for the defense and aerospace industries. In 1987, as soon as the product was
brought to the commercial stage, the company was organized to acquire the patents and
properties, both owned and leased, of the engineering corporation. The raw material
used by the company was obtained in ample supply from a number of competitive
suppliers.

However, Bill Yeats is approaching his retirement, hence, he started to make future plans
for the company. Serious negotiations about a merging with TSE International
Corporation, a well-known competitor, started in the late 1999. Part of the negotiation is
that Bill Yeats shall remain as the CEO of the YVC who will receive a monthly salary and
year-end bonuses.

Auden Company, a large concern in a related field, was an important foreign distribution
channel under a nonexclusive distributor arrangement. About 15% of YLC sales came from
Auden. Foreign sales through Auden and direct sales through YLC own staff accounted for
30% of sales. Although the foreign-currency crisis in the mid-1990s had interrupted sales
growth for the company, better economic condition in the markets of developed
countries, together with its recent introduction of new product in aerospace and defense
industries offered the company excellent prospect for improved performance.

YLCs plants were organized for efficient handling of small production orders. From 1997
to 1999, net additions to property totaled $7.6 million. The success of YLC had brought
numerous overtures from companies looking for diversification, plant capacity,
management efficiency, financial resources, or an offset to cyclical business. YLC feared
that without a well-financed partner, the company would be swamped by competition.
Thus, when a merger with TSE International Corporation came along in 1999, YLC
determined to make it work as best as he could.

On the other hand, TSE International Corporation was incorporated in 1970. By 2000, the
company manufactured products ranging from advanced industrial components to chain,
bolts, nuts, cables, and other similar products, and they sold them, for the most part
indirectly, to various industrial users. The company's raw material came from various
producers. TSE plants were modern, ample, well equipped, and adequately served by
railroad sidings.

As the possibility o0f merging with TSE Company came up, Bill Yeats decided to make the
best out of this opportunity. Yeats was also thinking about joint ventures but it did not
 seem to be the best option. He is also thinking about moving on alone but that means
they would have to raise new debt and equity to finance the growth of the company.

The merger proposal was discussed with Auden Company due to their number of shares.
Auden was not convinced about the merger but decided not to refuse the offer. Thus,
they decided to sell their shares. Kate Porter, director of YVC believed that the company
will be more valued if it became a part of large company.

II. CASE ANALYSIS

Part of the negotiations between the YVC and the TSE are the discussions about the
appropriate take over price, thus, it is necessary to come up with some calculations about
the fair value of the YVC. There is also a need to determine whether the merger will
benefit both companies and its stockholders.

Hence, to determine whether merger will benefit for both company or not one must do
this:
1. Estimate the value of the YVC after merger with TSE International.
2. Determine the minimum stock price to stockholder’s profit from merger.
3. Give recommendation to YVC to do merger or not.

To do so, we must analyze evaluate different market valuation as follows:

1. Discounted Cash Flow:

In discounted cash flows valuation, the value of an asset is the present value of the
expected cash flows on the asset, discounted back at a rate that reflects the riskiness of
these cash flows.
Table 1. Value of Yeats before Merger
 Actual Projected
1999 2000 2001 2002 2003 2004
Sales $49,364 $59,600 $66,000 $73,200 $81,200 $90,000
Cost of goods sold 37,044 42,316 47,850 52,704 58,058 63,900
Gross profit 12,320 17,284 18,150 20,496 23,142 26,100
Selling, general, admin. 2,936 3,612 4,024 4,464 4,952 5,492
Depreciation 1,508 1,660 1,828 2,012 2,212 2,432
Other income, net 228 240 264 288 320 352
Income before taxes 8,104 12,252 12,562 14,308 16,298 18,528
Taxes 3,242 4,901 5,025 5,723 6,519 7,411
Net income 4,862 7,351 7,537 8,585 9,779 11,117

Cash Flow:
Net income 4,862 7,351 7,537 8,585 9,779 11,117
Depreciation 1,508 1,660 1,828 2,012 2,212 2,432
Operating Cash Flow 6,370 9,011 9,365 10,597 11,991 13,549

Capital expenditures - 1,826 2,011 2,213 2,433 2,675

Working capital needs - 3,492 3,867 4,289 4,757 5,273
Free Cash Flow 6,370 3,693 3,488 4,095 4,800 5,601
Terminal Cash Flow 102,531
Total 6,370 3,693 3,488 4,095 4,800 108,132
PV of Free Cash Flow $3,215.76 3036.59 $3,565.42 4,179.52 $4,876.44
Total $18,873.74
PV of Terminal Cash Flow $89,273.96
Net Present Value of Free
Cash Flows /Equity Value $114,518
Less : Debt $0.00
Divided by: Outstanding
Shares 1,440
Equity Value Per Share $79.53
 Table 2. TSE International Value before Merger

Actual Projected
1999 2000 2001 2002 2003 2004

$2,480,78 $2,642,03 $2,813,76

Sales $2,187,208 $2,329,373 5 7 9 $2,996,658
Cost of goods sold 1,793,511 1,910,086 2,034,244 2,166,470 2,307,291 2,457,260
Gross profit 393,697 419,287 446,541 475,567 506,478 539,398
Selling, general,
admin. 120,296 125,786 131,482 140,028 146,316 155,826
Depreciation 26,800 27,950 29,770 31,700 33,170 133,314
Other income, net - - - - - -
Income before
taxes 246,601 265,551 285,289 303,839 326,992 250,258
Taxes 98,640 106,220 114,116 121,536 130,797 100,103
Net income 147,961 159,331 171,173 182,303 196,195 150,155

Cash Flow:
Net income 147,961 159,331 171,173 182,303 196,195 150,155
Depreciation 26,800 27,950 29,770 31,700 33,170 133,314
Operating Cash
Flow 174,761 187,281 200,943 214,003 229,365 283,469

Free Cash Flow 174,761 187,281 200,943 214,003 229,365 283,469

Terminal Cash Flow 9,411,099

Total 174,761 187,281 200,943 214,003 229,365 9,694,567

PV of Free Cash
Flow $176,004 $188,844 $201,117 $215,554 $266,400
Total $1,047,919
PV of TFCF $8,844,416
Net Present Value
of Free Cash Flows
/Equity Value 10,067,096
$119,100.0
Less : Debt 0
Divided by:
Outstanding
Shares 62,694
Equity Value Per
Share $158.67
 Table 3: Valuation after Merger

Actual Projected
1999 2000 2001 2002 2003 2004
Cash Flow:
Net income 152,823 166,682 178,711 190,888 205,974 161,272
Depreciation 28,308 29,610 31,598 33,712 35,382 135,746
Operating Cash
Flow 181,131 196,292 210,309 224,600 241,356 297,018

Free Cash Flow 181,131 196,292 210,309 224,600 241,356 297,018

Terminal Cash Flow 24,831,790

Total 181,131 196,292 210,309 224,600 241,356 25,128,808

PV of FCF 178,448 191,190 204,182 219,415 270,016

Total 1,063,250
PV of TFCF 22,574,355
Net Present Value
of Free Cash Flows
/Equity Value 23,818,736
Less : Debt $119,100.00
Divided by:
Outstanding Shares 64,134
Equity Value Per
Share $369.53

From Table 1, the value of YVC is $ 114,510. Meanwhile, from Table 2, the value of TSE International is $
10,067,096. And from the Table 3, we can see that the value of company after merger is $ 23,818,736. We
can see that the value of company after merger is higher than the value from each company. It means
that it is beneficial for both companies to do the merger.

2. P/E Ratio

The P/E ratio reflects the amount investors are willing to pay for each dollar of earnings. The average P/E
ratio in a particular industry can be used a guide to a firm’s value – if it is assumed that investors value the
earnings of that firm in the same way they do the “average” firm in the industry. The price/earnings
 multiple approach is a popular technique used to estimate the firm’s share value; it is calculated by
multiplying the firm’s expected EPS by the average P/E ratio for the industry.

Table 4 EPS for Yeats and TSE

EPS for Yeats 3.87 EPS for TSE 2.23

EPS for Industrial Sector Average 11.1 EPS for Industrial Sector Average 11.1
Value per Share of Yeats 42.957 Value per Share of TSE 24.753

From table above, we can see that Yeats’s PER is higher than TSE’s.

3. Book Value

Yeats TSE
Total Assets $ 42,124,000 $ 1,245,825,000
Total Liabilities $ 5,360,000 $ 350,088,000
Total Shares Outstanding $ 1,440,000 $ 62,694,361
Book Value per share $ 25.53 $ 14.29

From table above, we can see that the book value per share from the Yeats is higher than TSE’s.

4. Market Value

Based on exhibit 7, market value for Yeats on May 1, 2000 is $39.75, and market value for TSE
International is $21.98. It shows that market price of Yeats is higher than TSE. Which means, the
demand for Yeats share are higher than the TSE.

From the explanations above, we can conclude that the merger between Yeats and TSE will be benefit
both of them. It can be seen from the value per share was increased after the merger. The DCF calculation
above shows us that the value of the merge company is higher than the sum of value of each company
before merger.

5. Computation of Minimum Stock Price

Particulars Value Weighted Amount

DCF $79.53 60% $47.72
EPS 42.957 20% $8.59
BV 25.53 10% $2.55
Market price $39.75 10% $3.98
Minimum Stock Price $62.84
Yeats Market Capitalization= Minimum Stock Price x Shares Outstanding
$90,482,871.22

III. Recommendation

After careful analysis of the merger plan of YVC to TSE, we would recommend that YVC should
merge to TSE with a minimum stock price that Yeats should ask to TSE of $ 90,482,871.22 or
$ 62.84 per share.