Why is Arnold considering the sale of Eaton's hydraulics business?

Does it make sense

strategically and financially to sell the business?
Review Eaton's forecast for the hydraulics business provided in Exhibit 5. Are the assumptions
used reasonable? What sensitivities would you suggest?
What factors affect Eaton's WACC? Using the case data, calculate Eaton's WACC. Using this
WACC, what is the estimated value of the hydraulics business?
Review the data and descriptions of hydraulic equipment manufacturers shown in Exhibits 8.
Based on your analysis, what do you think is an appropriate WACC for Eaton's hydraulics
business as a stand alone entity? Using this divisional WACC, what is the estimated value of
the hydraulics business?
Should Arnold agree to sell the hydraulics business to Danfoss for $3.3 billion? Why or why
not?

Report Order
Re: Sale of Eaton Corporation Hydraulics Division
Background (hydraulics forecast, sensitivities, why sell)
- Eaton corporation valued at market value of equity + book value of debt (LTD + current
portion of LTD)
- As of Fiscal Year Ending Dec. 31, 2019, Eaton Corporation is valued at
approximately USD$47.7 billion.
- Company shift to intelligent power management & focus on profitability and smooth
earnings
- As the company strategically shifts to intelligent power management, there is the
option of divesting in the Hydraulics Division. Due to cyclicality (volatility) of the
division’s earnings and low operating margin of 9.5%, it does not fit with the
company’s current focus on profitability and stable earnings.
- Forecasts for the hydraulics division assume: 1) Annual revenue growth rate of
2%. A conservative when compared to expected annual market sales growth of
4%. 2) Operating margin of 9.5%, the average operating margin across the
business cycle in 2019. 3) Depreciation/Amortization as a portion of sales of
3.5%. 4) Net Working Capital as a portion of sales of 20%. 5) Capital
expenditures as a portion of sales of 3.5%. Sensitivity analyses should be done
on growth rate, as the projected sales growth of the market is 4% rather than 2%,
and operating margin, as the hydraulics market is highly cyclical.
- Earnings cyclicality (short-cycle volatile business)
- Operating margins (9.5%) remain well below other businesses over a cycle
- 15% of Eaton’s revenue (~67% revenue from electrical products, power distribution
systems, and related)
- Annual growth rate of 4%
The offer
- $3.3 billion, excludes filtration and golf grips businesses
- Danfoss Corporation made an offer to purchase the Hydraulics Division for
USD$3.3 billion in January 2020. Offer excludes the filtration and golf grips
businesses included in reporting of the segment.

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 - From Danfoss, Power Solutions division is major firm in global market for hydraulic
motors and pumps
- With complimentary product portfolios and aligned innovation and quality,
Danfoss Corporation would double its own Hydraulics Division with the
acquisition.
Valuation based on Eaton’s WACC
- WACC = E/(E+D) * Re + D/(E+D) * (1-T) * Rd
- WACC = 0.8 * (1.92% + 1.09 * 5.1%) + 0.2 * (1 - 12.5%) * (1.92% + 0.76%) = 6.45%
- D/(E+D) = 0.2 (target market value but 0.35 at end of 2019) therefore E/(E+D) =
0.8
- Re = 1.92% + 1.09 * 5.1%
- Rd = 1.92% + 0.76%
- T = 12.5%
- Based on the Eaton Corporation’s firm WACC of 6.45%, the Hydraulics Division
would be valued at almost USD$4.1 billion. Assumptions for the WACC
calculation include: 1) Target leverage ratio of 20%, measured using market
value. 2) Risk-free rate of return of 1.92%, based on 10-year yield on US
Treasury Securities. 3) 2-year equity beta of 1.09. 4) Market risk premium of
5.1%, an average of three forward-looking estimates. 5) Credit spread of 0.76%
based on S&P credit rating A. 6) Irish corporate tax rate of 12.5%.
Why WACCHydDiv is different
- Divisional risk because risk associated with different divisions, (hydraulics division has
more risk than electrical products division due to cyclicality, cash flows are not
consistent)
- Beta will be different
- However, this valuation is invalid. Using the firm WACC is unacceptable when
there is a difference in the risk associated with a specific division. Difference in
risk (beta) will amount to a difference in cost of equity. As the Hydraulic Division
experiences higher risk due to volatility in earnings (cyclicality), the cost of equity
is different. Therefore, a divisional WACC should be used for valuation of the
Hydraulic Division.
Valuation based on HydDiv’s WACC
- Comparables (looking for pure play): NOT Parker Hannifin bc hydraulics only 24% of
sales, Helios Technologies hydraulics 80% of revenue, Enerpac Tool Group hydraulics
93% of revenue, NOT Caterpillar Inc. bc not hydraulics manufacturer, however cyclical
sales pattern is similar
- Use divisional beta of 1.72 or 1.51
- The divisional beta used for the Hydraulics Division’s WACC will be taken from
“pure play” companies, Helios Technologies and Enerpac Tool Group. While
Helios Technologies and Enerpac Tool Group are both far smaller corporations
compared to Eaton Corporation, their revenues are mainly generated from their
hydraulics manufacturing segments at 80% and 93% respectively. As the
business operations are highly similar to the Hydraulics Division, their equity

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 betas,1.72 and 1.51 respectively, will be suitable estimates for the Hydraulics
Division’s divisional beta.
- The Hydraulics Division’s WACC was calculated to be 8.59%. The subsequent
valuation of the Hydraulics Division comes to USD$2.75 billion. Assumptions for
the WACC calculation include: 1) Target leverage ratio of 20%, measured using
market value. 2) Risk-free rate of return of 1.92%, based on 10-year yield on US
Treasury Securities. 3) Equity beta of 1.615, found by averaging HLIO’s 2 year
equity beta of 1.72 and EPAC’s 2 year equity beta of 1.51. 4) Market risk
premium of 5.1%, an average of three forward-looking estimates. 5) Credit
spread of 0.76% based on S&P credit rating A. 6) Irish corporate tax rate of
12.5%.
Recommendation
- If divisional WACC > 7.5% (IRR of offer), then sell, if divisional WACC < 7.5%, negotiate
- Since the WACCHydDiv is more than the IRR of Danfoss Corporation’s offer,
Danfoss valued the division at higher than the internally calculated value.
Therefore, Eaton Corporation would profit from the sale of the Hydraulics Division
at the offered price. Due to strategic streamlining and profit on the sale, Eaton
Corporation should sell the Hydraulics Division to Danfoss Corporation for
USD$3.3 billion.

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