mrcincppt

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MGMT 310

MRC Inc

Raghu Rau

Today’s class: CompanyValuation: A Case

n Questions to Answer:

n What is the problem that ArchibaldBrinton, president of MRC, Inc., faces?

n Should MRC acquire American Rayon?

n If yes, how much should MCR pay?

General Characteristics of MRC:

n A diversified company, producing powerbreak systems, industrial furnaces, andheat treating equipment

n Has recently acquired several companiesn High leverage

Why diversify?

n Shareholders can diversify on their ownby buying shares of companies indifferent industries. Why should acompany pursue a diversificationstrategy? What are the advantages anddisadvantages to diversification?

Diversification

n Role of internal capital markets

n Bankruptcy costsn Agency costs

n Management over-optimism

General Characteristics ofAmerican Rayon:

n A specialized company;

n A lot of excess cash ($20 Million ingovernment securities);

n No debt in capital structure;

n Poor growth prospects

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How much should MRC pay forAmerican Rayon?

n To find how much MRC should pay forAmerican Rayon, we need to find thepresent value of its future cash flows asof 1960

DISCOUNTED CASH FLOW

STEPS IN VALUATION

1. Forecast free operating cash flows during forecast horizon.

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:

n Find the net present value of the cashflows 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%)

Step 1:

n Find the net present value of the cashflows that the company will generate:• Add depreciation back

• Subtract any increases in Working CapitalRequirements

• Subtract new capital expenditures

• Use a discount rate of 20% to find the NPVof the cash flows that the company willgenerate.

WORKING CAPITAL REQUIREMENTS

· Investments necessary to operate the fixed assets.They consist of:

Operating cash

+ Accounts Receivables

+ Inventories

- Accounts payable

- Net accruals (*)

* Net accurals = accrued liabilities - accrued assets

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Step 2 and 3:

n Add to the NPV of the cash flows $20Million in government securities

n Add the present value of any residualcash flows that can be obtained byselling fixed assets or recovering networking capital at the end of 1967.

Basic Assumptions

n Discount rate = 20%

n Capital expenditure is as givenn 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

ExampleBalance sheet of American Rayon, Inc. at December 31, 1960 (thousands of dollars)

Cash 2,564U.S. government securitiesa 20,024Accounts receivable, net 11,863

34,351Inventories Finished goods 4,376 In process 2,161 Raw materials and supplies 3,919

10,456Prepaid expenses 283 Current assets 45,190Property, plant and equipment, net 23,912Other 125 Total assets $69,227

Liabilities

Accounts payable 2,863Accrued items 1,145 Current liabilities 4,008Common stock 26,959Retained earnings 38,260 Shareholders’ equity 65,219Total liabilities and shareholders’ equity $69,227

How do we find the increases inWCR?

n We will find the ratio of WCR / Sales in1960, and given the sales for each yearafter 1960, we will use this ratio tocalculate the WCR for each year. Thenwe will simply find the differences fromyear to year.


n WCR = Current Assets - CurrentLiabilitiesCurrent assets (1960) = $45.19 MCurrent liabilities(1960) = $4.0M• Note that part of the current assets is an

excess liquidity position of $20.02 Million ingovernment securities. Since these do notcontribute to the generation of future cashflows in any way, we need to exclude themas part of the WCR.

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n 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.

Assumption I for Terminal Value

n Assume that the company:• recovers its net working capital ($15,627)

(collects receivables, pays payables, liquidatesinventory)

• sells its fixed assets at book value

n We need to find the book value of the netfixed assets at the end of 1967.

Assumption I for Terminal Value

n The net fixed assets at the end of each yearare equal to the new capital expendituresduring the year minus the depreciation. Netfixed assets at the end of 1960 are $23,912 .In each subsequent year depreciation is$3,000 Million and new capital expendituresare $300.

Value of the Company -Assumption In The net fixed assets at the end of 1967 are

$5,012 (See spreadsheet)n The total cash flows that the company will

recover at the end of 1967 are: $15,627 +$5,012 = $20,637

n PV(residual cash flows) = $20,637 / (1.2)7 = $5,760

n PV(CF 1961-67) = 19,265n Excess Cash = 20,024n PV (ARI) = $45,049

Assumption II

n Is the assumption of selling the assets atbook value realistic ?

n No : invested capital only earns a returnof 2%. Hence, keeping the fixed assetsoperating does not make any sense.Actually, the total value of the investedcapital plus excess cash today is 45,070+ 20,024 = 65,094.

Assumption II

n A more realistic assumption (althoughpossibly still optimistic, because itassumes no inventory write-off), wouldbe 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, equalto 5012 x 0.48 = 2,405

• Residual value = 15,627 + 2,405 = 18,032

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Assumption II:

n Assume that the company• Recovers its working capital ($15,627)

• Sells its fixed assets ($5,012) for zero scrapvalue

• Gets a tax shield from the asset write-off, equalto $5,012 x 0.48 = $2,405;

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

Assumption III:n Assume that you liquidate the fixed assets

($23,912) today for zero net scrap value andrecover 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) $52,660Note that you assumed that your fixed assets areworth nothing in the market! The company isworth more dead than alive!

Assumption IV:n Sales remain at 55,000 without any

additional capital expenditures.

n Value of free cash flows (61-68) 17,371n PV of terminal value* 7,385

n Value of excess cash 20,024 44,809* TV = 21,450 + 5,012 = 26,462Conclusion : sales increase, profitsincrease, but value falls!.

Moral:

n WHY? Working capital requirements!

n VALUE CREATION is not the same asSALES MAXIMIZATION or PROFITMAXIMIZATION

THE COMPANY’SACQUISITION STRATEGY

n "Diversify in order to stabilise earningsand cash flow"• shareholders can diversify on their own

without paying takeover premiums

n "Avoid dilution in earnings per share bybuying low P/E companies"

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THE EPS GAME

n EPS & Price-Earnings Behaviour inEquity Financed Acquisitions

n Target is purchased at market price andbuyer issues shares to compensatetarget’s shareholders.

B u y e r 1 2 3

Tota l Earn ings A $20 ,000 $2 ,000 $2 ,000 $2 ,000

Number o f sha re s 10 ,000 5 0 0 5 0 0 5 0 0

E P S $2 .00 $4 .00 $4 .00 $4 .00

M arket Pr ice per Share $30 .00 $40 .00 $60 .00 $80 .00

Pr ice-earnings ra t io 1 5 1 0 1 5 2 0

Targe t ’s marke t pr ice $20 ,000 $30 ,000 $40 ,000

New Sha re s I s sued byB u y e r

6 6 7 1 ,000 1 ,333

Target Alternatives

Buyer 1 2 3

Buyer After Acquis i t ion

M arket Price per Share B $30.00 $30.00 $30.00

E P S $2.06 $2.00 $1.94

Price-earning Ratio 14.56 15.00 15.46

Notes : A present year’s earnings, assumed unchanged by acquisition B no value added due to acquisition

A buys B

↓ ↓

High P/E Low P/E

Good thing

B buys A

↓ ↓

Low P/E High P/E

Bad thing

But AB ≡≡ BA !

WHY is this a MEANINGLESSSTRATEGY ?

The Outcome of the ARIAcquisition Decision

n MRC acquired ARI in 1961 at the priceindicated in the case. The transactionwas accounted for as a "pooling ofinterests," thereby adding $25.2 millionmore to MRC’s net worth than wouldhave been the case under "purchase"accounting.

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


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n One reason for continuing in the fibrebusiness beyond the mid-1960s may havebeen MRC’s reluctance to take the largewrite-off that could have been avoided if theacquisition of ARI had originally been treatedas a purchase for accounting purposes.


n While MRC invested a huge amount ofcapital in ARI’s polyester plant, the plantwas still too small to be cost-competitivewith plants four times as large, which werebuilt by other fibre competitors such as DuPont. MRC struggles along in the polyesterbusiness for several years.


n Finally, in 1969, MRC sold ARI, absorbing abook loss of nearly $12 million before taxoffsets. ARI was purchased by AmericanCyanamid, a firm that basically repeatedMRC’s experience, albeit on a smallerscale.


n ARI was acquired by American Cyanamidfor $20 million in cash and notes onDecember 31, 1969. In 1970, the newowner invested $10 million to increasepolyester production at ARI. By mid-1972,ARI discounted rayon polyester as well,taking a large write-off and ending thebusiness of ARI.


Conclusion

n The sequence of owners for ARI andthe magnitude of their successivelosses suggest how hard it is to kill adying business. The organizationalforces aimed at preserving a businessare very strong. It takes considerableresolve to finally bring a dying businessto a halt.

Next time

n Read RWJ Chapter 10

n Solve Web Question

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