Financial Management II

Landmark
Solutions

Facility

Case Analysis
The case presents us with the basic problem that many
firms are faced with - Do we acquire another company
and if so what should we pay for it and how should we
structure the new firm?
SUBRATA BASAK (MP15043)

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Executive Summary
Landmark Facility Solutions presents a situation in which a medium-sized facility
management company assesses whether to acquire a larger facility management
company that is known for its high-quality services and technical expertise. The
acquirer believes the acquisition will help it to become an integrated facility manager
and enter new industries in its home market. The case focuses on valuing the
acquisition opportunity and choosing the right financing for the transaction. It explores
the interaction between corporate investment and financing, and sets the stage for
discussions about capital structure decisions.

Introduction
Broadway, located in USA, was formed by Mr. Harris in 1992. Broadway is providing
facility services like janitorial services, floor and carpet maintenance services and
building maintenance services. In last few years, Broadway has been seeking
significant growth and has spread its operations to other countries like New England
and Florida by providing additional services like educational and industrial services.
The CEO and president of the Broadway aim to spread its operations in addition to
facility support services to building engineering and energy solution. For this purpose,
CEO and President of the Broadway industries are considering acquiring the Landmark
facility solutions.
Landmark facility is specialized in providing commercial building, engineering and
energy solution services. It was found in 1954 and it has significant brand recognition
throughout USA and due to its strong brand recognition, Landmark is capable to
charge premium prices. Instead of charging premium prices, Landmark is currently
facing the problem of reduction in operating profit.
The current financial position of Landmark encourages Mr. Harris to acquire Landmark
because it is expected that the acquisition of Landmark will satisfy the strategic needs
of the Broadway in order to expand its services. However, the management of
Broadway suggested that the current demand from the Landmark is high and the
expected benefits from the acquisition will not justify the purchasing cost. In addition
to this, Mr. Harris is considering the financing of the acquisition because currently
Broadway has two available options and it is identifying which one is suitable if the
acquisition process may proceed.

Problem Statement
1. Does Broadway benefit from acquiring Landmark? If so how and based upon
what? Can the $120 million bid be justified and if so what justifies or does
not justify the bid?
2. If Broadway proceeds with the acquisition which financing alternatives
should be chosen, and why? How Broadway would be servicing its debt after
the acquisition.
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Financial Management II
How do the two financing methods affect the value of the acquisition to
existing shareholders of Broadway?
Does Broadway reduce shareholder value if it selects the mix of debt and
equity financing alternative? What is the cost of equity dilution?
What will be the cost of capital and how the cost of capital will be impacted
by the various financing options?
What is the value of the acquisition to Broadway under both expected and
pessimistic scenarios?

Analysis & Solution

Broadways business strategy involves competing in a highly fragmented and
competitive service-oriented business environment. Such competition is based on
pricing, level of services, and quality of service. This business combination provides an
opportunity to create new economic value for stockholders. New value is expected to
be created in the following ways:
1. Taking advantage of economies of scale. Broadways acquisition could
improve Landmarks operating efficiency and achieve cost reductions. There are
redundancies in management positions and non-essential expenses.
2. Improving target management. Landmarks high operating costs, had
placed it in the bottom quartile of facility management companies, in terms of
operating margin, had resulted from managerial complacency and cost
management, rather than from some underlying flaw in the companys business
model. Harris is confident that by replacing Landmarks management team,
cutting executive pay and lavish perquisites, and reducing non-essential
marketing expenses, Broadway could increase Landmarks operating margin to
3%.
3. Combining complementary resources. The most obvious benefit of
consolidating the two companies is the elimination of common overhead
expenses, such as corporate headquarters, executives, support staff, and
redundant office space. Another source of value would involve the management
of Landmarks net working capital; it is believed that the companys net working
capital to sales ratio could be reduced to that of Broadway following
improvements in some of Landmarks processes.
4. Diversification of services. Typical facility managers in the U.S. provides
comprehensive facility services, including janitorial solutions, HVAC, commercial
cleaning, facility engineering, energy solutions, landscaping, parking, and
security. With global economic power likely to continuing its shift eastwards
towards emerging markets. Increasing competition from new players in
emerging markets will force companies to search for greater differentiation, and
to be innovation in how they adjust their business models and deliver extra
value to clients. The consolidation of the two companies will provide a more
diversified service platform for existing and new clients.
5. Capturing tax benefits. The tax shield that comes from increasing leverage
for Landmark due to operating losses that can be offset against its taxable
income.
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6. Penetrating new geographies. Moving into new geographies can curtail
strong competitive pressures that could inhibit the companys success in
bidding for profitable business and its ability to increase prices as costs rise,
thereby reducing margins.
7. Market power. Landmark is a respected for its high-quality services and
expertise, the acquisition could enable Broadway to market some of its services
under Landmarks brand at a premium price.

The combination of operating and financial synergies could be realized quickly post
acquisition. Since, Broadway has a culture of operational efficiency, the replacement of
non-performing management, cost costing in nonessential expenses, and a new
pricing strategy based on Landmarks model, could be realized in an increase
Landmarks operating margin to 3% and Broadways gross margin to 8.5% as early as
2015. The valuation of combined firm is very high compared to individual values of
separate firms (Refer exhibit 1 to 4).
Additional value generated due to this synergy = Value of combined firm Value of
landmark Value of Broadway. There is additional value for both optimistic and
pessimistic scenario.
There are two alternatives for financing this acquisition100% debt or 50% debt and
50% equity. The understand the effects of each alternative we must look at the
companys capital structure. Because debt financing is an option for acquiring the
target shares (100% debt case), Broadway could significantly increase the net financial
leverage of Landmark (i.e., the 100% debt financing option could increase Landmarks
leverage by adding value by lowering its tax by increasing the interest tax shield).

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Financial Management II

The discount rate was considered to be the weighted average cost of capital of the
firm, where in the cost of equity for Landmark facility was calculated by the Capital
asset pricing model using the beta of the industry. Since, Landmark facility is not
listed, the information of equity betas given in the case can provide the unlevered
beta, using the average debt-equity ratio of the firms given, the levered beta helps us
find the cost of equity using CAPM, and info given in the case wherein the risk free rate
was chosen to be the ten year treasury bond rate of 2.56%, and market risk premium
of 5.9%.
In the 100% debt case, the capital structure of Broadway consists of 75% debt and
25% equity at a WACC of 8.01%. While in the mix of debt and equity case, the capital
structure consists of 40% debt and 60% equity at a WACC of 8.31%.
Based on interest payments calculations, Broadway would not be capable of servicing
its debt on its 100% loan obligation. With $6.6 million in loan interest expense and an
additional $0.4 million in expense due in 2015 and 2016. It is projected that Broadway
would experience net income losses of $0.5 million and $1.3 million, respectfully. Net
income losses occur from 2015 thru 2017. It is not until 2018, that the company is
able to absorb its loan payments. While the $3.0 million interest payments on the mix
of debt and equity are payable by Broadway over the life of the loan term. The
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Financial Management II
company generates sufficient cash and yields positive yearly net incomes. Thus, the
75% capital debt structure for the all-inclusive $120 million loan is not serviceable,
while the 40% debt structure for the mix debt-equity is serviceable over the terms
presented for investment. The post-acquisition capital structure of 100% debt
financing reduces shareholder value for Broadway by increasing the risk of financial
distress.

Conclusions
The valuation of the acquisition opportunity has been performed on the basis of both
the scenarios. Looking at the valuations of the Landmark Company, it could be seen
that the alternative 2 of financing which is going for 50% debt and 50% equity is the
best financing alternative for the company. The firm value under this financing
alternative is highest and significantly high with a cost of capital of 8.31% under this
alternative. Moreover, funding the entire acquisition by 100% of debt might prove to
be risky for the company in future; therefore, the best financing alternative for the
management is to basically go ahead with a mix of debt and equity financing.
In order to determine that whether Broadway would be able to service its debt or not,
first of all the operating income and the free cash flows for the Broadway company
have been calculated on the basis of the optimistic and the pessimistic assumptions
for both the financing alternatives. The relative interest payments under both the
financing alternatives have also been calculated based upon the structures of the $
120 million and $ 60 million loans under alternative 1 and 2. Moreover, the interest
coverage ratio and the free cash flow over interest expense ratios have been
calculated.
The average interest coverage ratio and the FCF/Interest expense ratio for first
financing alternative under the best case and worst case scenario for Broadway would
be (2.16, 1.4) and (1.64, 2.03) times. These ratios for both the financing alternatives
for optimistic and pessimistic case would be (3.61, 2.34) and (2.85, 3.63) times. Again
it could be seen that these ratios are much higher for the second financing alternative.
Nonetheless, debt has advantages as it is much cheaper as compared to equity and
the reason for this is that the interest expenses on the debt are basically tax
deductible and this results in the increase of the firm value also. However, if the level
of debt increases beyond a certain optimal level then the firm is at risk. Therefore, the
best financing alternative for the company in order to fund this $ 120 million
acquisition opportunity is to seek 50% debt and 50% equity.
Overall, Broadway benefits from acquiring Landmark. However, the speed at which
Broadway is able to consolidate and implement cost-cutting measures are a concern,
as the company is presently experiencing a strain in growth, profitability, and eroding
operating efficiency to industry peers. Even though, Landmarks equity valuation
under expected conditions is falls below expectations, the company should proceed
with the deal given the combined synergies of this deal are a plus for Broadway
Industries.
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Financial Management II

Exhibit 1:

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Financial Management II
Exhibit 2:

Exhibit3:

Exhibit 4:

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