MGMT 310

Today’s class: Company Valuation: A Case
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MRC Inc Raghu Rau

Questions to Answer: What is the problem that Archibald Brinton, president of MRC, Inc., faces? n Should MRC acquire American Rayon? n If yes, how much should MCR pay?

General Characteristics of MRC:
A diversified company, producing power break systems, industrial furnaces, and heat treating equipment n Has recently acquired several companies n High leverage
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Why diversify?
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Shareholders can diversify on their own by buying shares of companies in different industries. Why should a company pursue a diversification strategy? What are the advantages and disadvantages to diversification?

Diversification
Role of internal capital markets n Bankruptcy costs n Agency costs n Management over-optimism
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General Characteristics of American Rayon:
A specialized company; n A lot of excess cash ($20 Million in government securities); n No debt in capital structure; n Poor growth prospects
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Accounts payable . In 1961-63 it is 9. To find how much MRC should pay for American Rayon.TC) + Depreciation .How much should MRC pay for American Rayon? n DISCOUNTED CASH FLOW STEPS IN VALUATION 1. Estimate continuing value = value after forecast horizon. Estimate the cost of capital = discount rate = weighted average cost of capital.Net capital expenditures . 3. Forecast free operating cash flows during forecast horizon.8%.Net accruals (*) Find the net present value of the cash flows that the company will generate: • Add depreciation back • Subtract any increases in Working Capital Requirements • Subtract new capital expenditures • Use a discount rate of 20% to find the NPV of the cash flows that the company will generate. Discount to the present. – Note also that EBIT are the same as Earnings Before Taxes. * Net accurals = accrued liabilities . They consist of: Operating cash + Accounts Receivables + Inventories . 1.Increase in working capital requirements --------------------------------------------------Free cash flow Step 1: n Find the net present value of the cash flows that the company will generate: • Projected Sales for 1961-67 (Exhibit 6) • Projected EBIT for 1961-67 – Note that the profit margin in 1960 is 8. FREE CASH FLOW EBIT (1 . Why? • Subtract Taxes (at 48%) WORKING CAPITAL REQUIREMENTS Step 1: n · Investments necessary to operate the fixed assets.accrued assets 2 . 4.8%. after which it steadily declines. we need to find the present value of its future cash flows as of 1960 2.

456 + 283 . net Inventories Finished goods In process Raw materials and supplies Prepaid expenses Current assets Property.863 34.19 M Current liabilities(1960) = $4.227 Liabilities Accounts payable 2.260 Shareholders’ equity 65.351 4.456 283 45. 1960 (thousands of dollars) Cash U.863 .Current Liabilities Current assets (1960) = $45.145)/54.158/54. we need to exclude them as part of the WCR.024 n n Add to the NPV of the cash flows $20 Million in government securities Add the present value of any residual cash flows that can be obtained by selling fixed assets or recovering net working capital at the end of 1967.912 125 $69. Then we will simply find the differences from year to year.564 + 11.227 How do we find the increases in WCR? n How do we find the increases in WCR? n We will find the ratio of WCR / Sales in 1960.863 Accrued items 1. 3 .1. and given the sales for each year after 1960.02 Million in government securities.863 + 10.219 Total liabilities and shareholders’ equity $69.39 n Company has excess cash of 20. n Example Balance sheet of American Rayon. plant and equipment. we will use this ratio to calculate the WCR for each year.0M • Note that part of the current assets is an excess liquidity position of $20.Step 2 and 3: n Basic Assumptions Discount rate = 20% Capital expenditure is as given n WCR/sales = (2.145 Current liabilities 4.564 20. WCR = Current Assets .959 Retained earnings 38.008 Common stock 26.376 2.2.919 10. government securitiesa Accounts receivable.S.500 = 21. at December 31. net Other Total assets 2.500 = 0.024 11.161 3. Inc. Since these do not contribute to the generation of future cash flows in any way.190 23.

024 PV (ARI) = $45.070 + 20.032 4 . liquidates inventory) • sells its fixed assets at book value n We need to find the book value of the net fixed assets at the end of 1967. keeping the fixed assets operating does not make any sense.760 PV(CF 1961-67) = 19. would be to assume that the company • 1.094. equal to 5012 x 0.2)7 = $ 5.637 / (1. n Assumption I for Terminal Value n Assume that the company: • recovers its net working capital ($15. n Assumption II n A more realistic assumption (although possibly still optimistic.17 / 54.627 • 2.912 .5 = 39% n Then the WCR for each year during 1961-67 is 39% of the projected sales.405 • Residual value = 15.637 PV(residual cash flows) = $20. Hence.627) (collects receivables. pays payables.012 (See spreadsheet) The total cash flows that the company will recover at the end of 1967 are: $15.024 = 65. Assumption I for Terminal Value n Value of the Company Assumption I n n The net fixed assets at the end of each year are equal to the new capital expenditures during the year minus the depreciation.17M n WCR / Sales = 21.19M . the total value of the invested capital plus excess cash today is 45. n n n n The net fixed assets at the end of 1967 are $5. Sells its fixed assets for zero scrap value • 3.48 = 2.000 Million and new capital expenditures are $300.0M = $21.627 + $5. Net fixed assets at the end of 1960 are $23. Recovers its working capital : 15.012 = $20.265 Excess Cash = 20.02M $4. because it assumes no inventory write-off).627 + 2.$20.How do we find the increases in WCR? Then WCR(1960) = $45. Actually.405 = 18. Gets a tax shield from the write-off. In each subsequent year depreciation is $3.049 Assumption II Is the assumption of selling the assets at book value realistic ? n No : invested capital only earns a return of 2%.

405 = $18. but value falls!.912) • PV (ARI) $52.024 PV (ARI) $44.660 Note that you assumed that your fixed assets are worth nothing in the market! The company is worth more dead than alive! Moral: n n THE COMPANY’S ACQUISITION STRATEGY n WHY? Working capital requirements! VALUE CREATION is not the same as SALES MAXIMIZATION or PROFIT MAXIMIZATION "Diversify in order to stabilise earnings and cash flow" • shareholders can diversify on their own without paying takeover premiums n "Avoid dilution in earnings per share by buying low P/E companies" 5 .Assumption II: n Assumption II: n n n n n Assume that the company • Recovers its working capital ($15. n Value of free cash flows (61-68) 17.033 Value of excess cash 20.450 + 5.809 * TV = 21. equal to $5.627 + 2. n Assume that you liquidate the fixed assets ($23.462 Conclusion : sales increase. profits increase.012 = 26.024 44.48 x 23.371 n PV of terminal value* 7.48 = $2.265 PV(Residual value) 5.912) today for zero net scrap value and recover the working capital ($21.321 Assumption III: n Assumption IV: Sales remain at 55.012 x 0.405.478 ( = 0.385 n Value of excess cash 20.032 PV(CF 61-67) $19.024 • Write-off tax benefit $11.000 without any additional capital expenditures.158): • Working capital $21. Residual value = 15.627) • Sells its fixed assets ($5.158 • Excess cash $20.012) for zero scrap value • Gets a tax shield from the asset write-off.

The transaction was accounted for as a "pooling of interests." thereby adding $25.333 EPS & Price-Earnings Behaviour in Equity Financed Acquisitions n Target is purchased at market price and buyer issues shares to compensate target’s shareholders. by 1966 MRC was drawn into a $30+ million investment at ARI for facilities designed to produce a new-generation fibre (polyester).000 500 $4.00 10 $20. n Number of shares EPS M arket Price per Share Price-earnings ratio Target’s market price New Shares Issued by Buyer WHY is this a MEANINGLESS STRATEGY ? A buys B ↓ Buyer Buyer After Acquisition M arket Price per S h a r e EPS Price-earning Ratio B 1 2 3 ↓ High P/E $30.00 $30.00 15 $30.THE EPS GAME Total EarningsA Target Alternatives Buyer $20.00 20 $40.00 $2. 6 .00 $60.06 14.00 Low P/E Good thing B buys A ↓ $1.00 15.000 10.46 Low P/E Notes : A present year’s earnings.00 $40.56 $30.000 $2.94 ↓ 15.000 500 $4.000 500 $4.000 1.00 $2.000 667 2 $2.00 $30.000 1.2 million more to MRC’s net worth than would have been the case under "purchase" accounting.00 $80. Instead of slowly liquidating ARI through the mid-1960s. assumed unchanged by acquisition B no value added due to acquisition High P/E Bad thing But AB ≡ BA ! The Outcome of the ARI Acquisition Decision n The Outcome of the ARI Acquisition Decision n MRC acquired ARI in 1961 at the price indicated in the case.000 3 $2.00 15 1 $2.

In 1970. ARI discounted rayon polyester as well. absorbing a book loss of nearly $12 million before tax offsets. the plant was still too small to be cost-competitive with plants four times as large. MRC struggles along in the polyester business for several years. 7 . The Outcome of the ARI Acquisition Decision n The Outcome of the ARI Acquisition Decision n Finally. ARI was purchased by American Cyanamid. taking a large write-off and ending the business of ARI. MRC sold ARI. albeit on a smaller scale. 1969. By mid-1972. in 1969. The organizational forces aimed at preserving a business are very strong. a firm that basically repeated MRC’s experience. the new owner invested $10 million to increase polyester production at ARI.The Outcome of the ARI Acquisition Decision n The Outcome of the ARI Acquisition Decision n One reason for continuing in the fibre business beyond the mid-1960s may have been MRC’s reluctance to take the large write-off that could have been avoided if the acquisition of ARI had originally been treated as a purchase for accounting purposes. which were built by other fibre competitors such as Du Pont. While MRC invested a huge amount of capital in ARI’s polyester plant. ARI was acquired by American Cyanamid for $20 million in cash and notes on December 31. It takes considerable resolve to finally bring a dying business to a halt. Conclusion n The Next time Read RWJ Chapter 10 n Solve Web Question n sequence of owners for ARI and the magnitude of their successive losses suggest how hard it is to kill a dying business.

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