MGMT 310

Todays 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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How much should MRC pay for American Rayon?

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DISCOUNTED CASH FLOW STEPS IN VALUATION 1. Forecast free operating cash flows during forecast horizon.

To find how much MRC should pay for American Rayon, we need to find the present value of its future cash flows as of 1960

2. Estimate the cost of capital = discount rate = weighted average cost of capital.

3. Estimate continuing value = value after forecast horizon.

4. Discount to the present.

1. FREE CASH FLOW EBIT (1 - TC) + Depreciation - Net capital expenditures - Increase in working capital requirements --------------------------------------------------Free cash flow

Step 1:
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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 8.8%. In 1961-63 it is 9.8%, after which it steadily declines. Note also that EBIT are the same as Earnings Before Taxes. Why?

Subtract Taxes (at 48%)

WORKING CAPITAL REQUIREMENTS

Step 1:
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Investments necessary to operate the fixed assets. They consist of: Operating cash + Accounts Receivables + Inventories - Accounts payable - 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.

* Net accurals = accrued liabilities - accrued assets

Step 2 and 3:
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Basic Assumptions
Discount rate = 20% Capital expenditure is as given n WCR/sales = (2,564 + 11,863 + 10,456 + 283 - 2,863 - 1,145)/54,500 = 21,158/54,500 = 0.39 n Company has excess cash of 20,024
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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.

Example Balance sheet of American Rayon, Inc. at December 31, 1960 (thousands of dollars) Cash U.S. government securitiesa Accounts receivable, net Inventories Finished goods In process Raw materials and supplies Prepaid expenses Current assets Property, plant and equipment, net Other Total assets 2,564 20,024 11,863 34,351 4,376 2,161 3,919 10,456 283 45,190 23,912 125 $69,227 Liabilities Accounts payable 2,863 Accrued items 1,145 Current liabilities 4,008 Common stock 26,959 Retained earnings 38,260 Shareholders equity 65,219 Total liabilities and shareholders equity $69,227

How do we find the increases in WCR?

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How do we find the increases in WCR?

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We will find the ratio of WCR / Sales in 1960, and given the sales for each year after 1960, we will use this ratio to calculate the WCR for each year. Then we will simply find the differences from year to year.

WCR = Current Assets - Current Liabilities Current assets (1960) = $45.19 M Current liabilities(1960) = $4.0M
Note that part of the current assets is an excess liquidity position of $20.02 Million in government securities. Since these do not contribute to the generation of future cash flows in any way, we need to exclude them as part of the WCR.

How do we find the increases in WCR?

Then WCR(1960) = $45.19M - $20.02M $4.0M = $21.17M n WCR / Sales = 21.17 / 54.5 = 39% n Then the WCR for each year during 1961-67 is 39% of the projected sales.
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Assumption I for Terminal Value

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Assume that the company:

recovers its net working capital ($15,627) (collects receivables, pays payables, liquidates inventory) sells its fixed assets at book value

We need to find the book value of the net fixed assets at the end of 1967.

Assumption I for Terminal Value

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Value of the Company Assumption I

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The net fixed assets at the end of each year are equal to the new capital expenditures during the year minus the depreciation. Net fixed assets at the end of 1960 are $23,912 . In each subsequent year depreciation is $3,000 Million and new capital expenditures are $300.

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The net fixed assets at the end of 1967 are $5,012 (See spreadsheet) The total cash flows that the company will recover at the end of 1967 are: $15,627 + $5,012 = $20,637 PV(residual cash flows) = $20,637 / (1.2)7 = $ 5,760 PV(CF 1961-67) = 19,265 Excess Cash = 20,024 PV (ARI) = $45,049

Assumption II
Is the assumption of selling the assets at book value realistic ? n No : invested capital only earns a return of 2%. Hence, keeping the fixed assets operating does not make any sense. Actually, the total value of the invested capital plus excess cash today is 45,070 + 20,024 = 65,094.
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Assumption II
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A more realistic assumption (although possibly still optimistic, because it assumes no inventory write-off), would be to assume that the company
1. Recovers its working capital : 15,627 2. Sells its fixed assets for zero scrap value 3. Gets a tax shield from the write-off, equal to 5012 x 0.48 = 2,405 Residual value = 15,627 + 2,405 = 18,032

Assumption II:
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Assumption II:
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Assume that the company

Recovers its working capital ($15,627) Sells its fixed assets ($5,012) for zero scrap value Gets a tax shield from the asset write-off, equal to $5,012 x 0.48 = $2,405;

Residual value = 15,627 + 2,405 = $18,032 PV(CF 61-67) $19,265 PV(Residual value) 5,033 Value of excess cash 20,024 PV (ARI) $44,321

Assumption III:
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Assumption IV:
Sales remain at 55,000 without any additional capital expenditures. n Value of free cash flows (61-68) 17,371 n PV of terminal value* 7,385 n Value of excess cash 20,024 44,809 * TV = 21,450 + 5,012 = 26,462 Conclusion : sales increase, profits increase, but value falls!.
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Assume that you liquidate the fixed assets ($23,912) today for zero net scrap value and recover the working capital ($21,158):
Working capital $21,158 Excess cash $20,024 Write-off tax benefit $11,478 ( = 0.48 x 23,912) PV (ARI) $52,660 Note that you assumed that your fixed assets are worth nothing in the market! The company is worth more dead than alive!

Moral:
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THE COMPANYS ACQUISITION STRATEGY

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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

"Avoid dilution in earnings per share by buying low P/E companies"

THE EPS GAME

Total EarningsA

Target Alternatives
Buyer $20,000 10,000 $2.00 $30.00 15 1 $2,000 500 $4.00 $40.00 10 $20,000 667 2 $2,000 500 $4.00 $60.00 15 $30,000 1,000 3 $2,000 500 $4.00 $80.00 20 $40,000 1,333

EPS & Price-Earnings Behaviour in Equity Financed Acquisitions n Target is purchased at market price and buyer issues shares to compensate targets shareholders.
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Number of shares EPS M arket Price per Share Price-earnings ratio Targets 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

High P/E
$30.00 $2.06 14.56 $30.00 $2.00 15.00 $30.00

Low P/E

Good thing
B buys A

$1.94

15.46

Low P/E
Notes : A present years earnings, 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

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The Outcome of the ARI Acquisition Decision

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MRC acquired ARI in 1961 at the price indicated in the case. The transaction was accounted for as a "pooling of interests," thereby adding $25.2 million more to MRCs net worth than would have been the case under "purchase" accounting.

Instead of slowly liquidating ARI through the mid-1960s, by 1966 MRC was drawn into a $30+ million investment at ARI for facilities designed to produce a new-generation fibre (polyester).

The Outcome of the ARI Acquisition Decision

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The Outcome of the ARI Acquisition Decision

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One reason for continuing in the fibre business beyond the mid-1960s may have been MRCs 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.

While MRC invested a huge amount of capital in ARIs polyester plant, the plant was still too small to be cost-competitive with plants four times as large, which were built by other fibre competitors such as Du Pont. MRC struggles along in the polyester business for several years.

The Outcome of the ARI Acquisition Decision

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The Outcome of the ARI Acquisition Decision

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Finally, in 1969, MRC sold ARI, absorbing a book loss of nearly $12 million before tax offsets. ARI was purchased by American Cyanamid, a firm that basically repeated MRCs experience, albeit on a smaller scale.

ARI was acquired by American Cyanamid for $20 million in cash and notes on December 31, 1969. In 1970, the new owner invested $10 million to increase polyester production at ARI. By mid-1972, ARI discounted rayon polyester as well, taking a large write-off and ending the business of ARI.

Conclusion
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Next time
Read RWJ Chapter 10 n Solve Web Question
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sequence of owners for ARI and the magnitude of their successive losses suggest how hard it is to kill a dying business. The organizational forces aimed at preserving a business are very strong. It takes considerable resolve to finally bring a dying business to a halt.