Introduction Cooper industry, H. K. Porter Company and VLN Corporation are entangled in a battle over the takeover of Nicholson File Company. Both H. K. Porter Company and VLN Corporation have already made their offers to the Nicholson File Company shareholders and now the management of Cooper Industry have to decide whether to jump into the foray for the control of Nicholson File Company or not. The major issues faced by the management of Cooper Industry are as following: 1. Is Nicholson File Company an attractive acquisition target for Cooper Industries? Specifically, what synergies can be created by merging these firms, and in what other aspects is Nicholson an attractive target? In what respect, if any, is Nicholson not an attractive target? Overall, is there sufficient strategic fit to justify pursuing this acquisition? 2. What sort of integration issues is Cooper Industry likely to face if it is successful in acquiring Nicholson? What should Cooper's management do to facilitate successful integration? 3. What should be the range of prices Cooper Industries should be willing to pay for each share of Nicholson's stock, in case it wants to acquire the firm? Strategic Analysis - how does Nicholson fit into Cooper's acquisition strategy Cooper could become a major factor in the hand tools business given its expertise in manufacture of machine tools. Moreover, one of the main problems that Cooper faces currently is a large cyclicality in its business, characteristic of the heavy machine tool industry, but more pronounced because of its dependence on Oil and Gas industries. These industries are heavily correlated with the state of the economy. So when there is a slowdown, Cooper would be one of the first companies to go down - something that they would want to avoid through diversification by way of acquisitions. The hand tools business is a lot less cyclical and cash flows are likely to be less lumpy. This fits in with Cooper's requirement of smoothing its income flows. The hand tools industry has a broad focus ranging from files to saws and hammers - mostly small ticket items. This ensures that Nicholson does not depend on any particular customer/industry for its revenues, as is the case with Cooper. Nicholson is the market leader in files and rasps and ranks 4th in handsaws and saw blades. Thus it very much fits into Cooper's strategy of acquiring only leading companies. The Nicholson acquisition would come on the heels of 3 previous acquisitions, all in the hand tools business, showing definite intent on the part of Cooper to move into this line. Nicholson would provide a wider range to Cooper's current hand tools portfolio. The idea was to build a comprehensive hand tools company that could share the common distribution channels as the parent company, thus improving returns. As per its outlined strategic policy Cooper should look at Nicholson as a favorable acquisition target. Improvements in Nicholson's operations as a result of the acquisition Cooper believes that some of Nicholson's product lines are not profitable, a case which is very common in family run businesses. Cooper's view is that if Nicholson focuses on its profitable product lines then it can reduce its inventory costs and manufacturing efficiency causing the COGS to reduce by 4% of sales. The distribution network required for selling Nicholson's products are the same as those maintained by Cooper for its acquired hand tools businesses. So in case Cooper acquires Nicholson, the Selling, General and Administrative expenses will reduce by 3% of sales. On the basis of these two reductions itself, the PBT of Nicholson would rise by about 7% of its sales value. In 1971, the net sales figure was $55. 3 mn. Therefore the PBT would increase by $ 3. 87 mn. PBT = $ 5. 89 mn PAT = $ 3. 54 mn (tax @ 40%) Equity = $ 31 mn ROE = 11. 4% This is much higher than the current ROE levels. Thus Nicholson has a lot to gain from increases in ROE. As per our projections of ROE, (assuming that the synergies take around 4 years to settle in) the ROE rises from 6. 3% in 1972 to 12. 25% in 1977, meaning an increase of almost 100% in 5 years. There are more synergies to be gained from the acquisition, though these are more difficult to quantify. As mentioned in the case, the sales pattern of Nicholson and Cooper's hand tools business are complementary. Nicholson has strengths in the industrial sector, whereas Cooper is more into the consumer market. Thus an acquisition would lead to a possibility of Nicholson pulling Cooper's hand tools line into the industrial sector (as a result of its strong brand equity in this sector) and vice versa. This would help both to increase their share of the pie in either sector. Bargaining power of Cooper vis--vis Porter Shareholding pattern of Nicholson industries: Shareholder# of sharesRemarks Porter177,000Does not want VLN preferred shares. Will sell at approx $50 / share to Cooper Nicholson family117,000They won't sell stake unless assured of management independence. Are more likely to take the VLN offer than Cooper. Uncommitted shareholders172,000They would most likely go by the management's advice Speculators75,000They will go wherever they find short term gains Cooper29,000They want to take control of Nicholson. Will probably make an open offer and get into an agreement with Porter VLN14,000They want to take control of Nicholson, but are willing to allow management independence. Their offer is dubious in terms of the value of the preferred stock in the future. Cooper needs 265,000 more shares to get a simple majority in order to take control. The Nicholson family would not part with any of its shareholding, since Cooper is not likely to allow independent management. In fact Cooper's entire offer is based on the premise of improving operations at Nicholson. This would require retiring certain lines of business and cutting down on the distribution and sales personnel and using Cooper's distribution network. This is not likely to be acceptable to Nicholson's management. The total shareholding of the speculators and uncommitted shareholders is 247000. So even if this entire lot sells its stock to Cooper (a highly unlikely event) they would still be short of the 50. 1% mark. So they cannot afford to not get into an agreement with Porter. On the other end, Porter is stuck with a huge stockholding of 177,000 shares. In case the VLN offer goes through then as per Rhode Island laws, Porter will have to accept VLN preference shares, which in its view are not valuable. Therefore they would be quite desperate to get out of this shareholding, and Cooper's preference shares seem to be a plausible arrangement. Therefore, both sides Cooper and Porter are somewhat on loose bargaining grounds. In the event of this, it may be possible for Cooper to negotiate and try and bring down its costs from $50/share of Nicholson's as quoted by Porter. Integration issues of Cooper with Nicholson The entire analysis of projected cash flows and ROE assumes that Cooper is successful in brining about the changes in Nicholson's operations and bring about effective synergies. In case the merger does not work out in the sense that Cooper is expecting it to, then the price of approximately $50/share that it will land up paying would probably be too much. In the event of Cooper going in for the acquisition without the buy-in of the Nicholson management and shareholders, there is likely to be friction between the two operations post-merger. It is quite unlikely that Nicholson's top management would remain with the merged firm, as had been the case with the previous 3 mergers. This would mean extra costs for Cooper to put in a new management in place. The distribution network used by Nicholson is likely to be rationalized post-merger. This is because the distribution network already owned by Cooper for its hand tools business more or less covers the requirements of Nicholson as well. This would mean laying off a number of workers. This might not go down very well with the rest of the personnel. This again might not be exactly what Cooper is expecting in terms of the coordination. This could be a very significant roadblock in the path of affecting the synergies between the two companies. The premise that Nicholson would help Cooper gain market share in the industrial sector is an estimate at best. This may not happen, since the Nicholson brand is specific to a particular set of tools, and it may not be directly possible to extend this to Cooper's entire line of products. Keeping in mind the various strategic and integration issues of Nicholson File Company with the Cooper Industries, we believe that in spite of few hiccups, it should be good acquisition target for Cooper. We will now move to the valuation of the Nicholson File Company to find out what should be the price Cooper should be ready to pay for each share of Nicholson File Company for the takeover. Valuation of the Nicholson File Company Estimation of Cost of Debt: Nicholson pays an interest of $0. 8 mn on the long term debt of $ 12 mn. This gives the cost of debt for Nicholson as: Cost of Debt = (0. 8 / 12) * 100 = 6. 66 % Assuming the tax rate to be 40%, then after tax cost of debt is: After tax cost of Debt = 6. 666 * (1-0. 4) = 4% Estimation of cost of Equity: The company's common stock had the market value of $30 on 3rd March, 1972. The industry has been growing at annual rate of 6%, while Nicholson had been growing at 2%. Given Nicholson's sound market presence a distribution network, we assume that the investors expect it to grow at CAGR of 6%. Now, the company has been paying a dividend of $1. 6 per annum. M&M theory states that the dividend policy does not matter. Hence, the capital appreciation expected in the Nicholson, coupled with constant dividend of $1. 6 is equivalent to the annual growth rate of 6% on dividend, starting with dividend at time t=1, D1 = $1. . Hence, the expected return wanted of the equity investment in Nicholson is calculated as shown: MV of share = PV of future dividends $ 30 = $1. 6 / (r - 0. 06) r = 11. 33% Calculation of WACC: At present Nicholson has a Long term Debt of $12 mn and equity of $ 31mn. This gives the values of: D / (D + E) = 12 / 43 = 29% E / (E + D) = 31/43 = 71% We assume that after acquisition, Cooper will maintain the same capital structure in Nicholson. Hence, the weighted average cost of capital (WACC) is as calculated below: Type of securityAfter-tax cost of capitalWeight in capital structureWeighted cost of capital Debt40. 91. 160 Common stock11. 660. 718. 279 WACC9. 439 Predicting the future Free Cash Flows (FCFs): In predicting the future Free Cash Flows (FCF), we make the following assumptions: 1. Tax rate remains constant at 40% 2. Depreciation remains constant at $2. 1 mn per year. 3. Long-term debt remains constant and no further new Equity is issued. Any cash requirement, if any, is funded through Short term debts. 4. Interest is paid on the debt at 6. 66% pa. 5. Number of shareholders remains constant at 5,73,275. 6. Other deductions remain constant at $0. 2 mn per annum 7. The company maintains a constant operating cash of $1 mn. Any excess cash that is generated is considered non operating. 8. Sales grow at the rate of 6% pa from 1972 to 1976. Thereafter, they grow at 4% per annum. 9. Accounts receivables, Accounts payables, inventories and net Plant, property and equipments grow at the same rate as the sales. 10. The Cost of goods sold decreases from 68% of the sales in 1972 to 65% in 1975. Afterwards it remains constant at 65% until 1981. 11. The selling, general and administrative expenses change from 22% of sales to 19% from 1972 to 1975. Thereafter they remain constant at 19% of sales. 12. We assume that the investments in subsidiaries are operating. This assumes that the subsidiaries further the business ambitions of the company. Calculating the Market value of Nicholson after acquisition by Cooper: Using the above assumptions, the market value was arrived at with the help of 2 methods: 1. Discounted FCF 2. Equity value - to - Book value multiple The results are summarized as shown below: Discounted FCFEquity value-to-BV Market Value$ 21. 2 mn$ 26. 2 mn Value of single share$ 36. 6$ 45. 7 Calculations shown in Appendix 1-5 Does the merger make Economic Sense for Cooper? Thus far we have considered the strategic overtures of the merger. Now from the above discussion, we can fairly say that as a strategic initiative this merger makes good sense to Cooper. Now the next factor to consider is whether the price that Cooper will have to pay for the Nicholson shares is worth the value. For this purpose, we first performed a valuation of Nicholson using 2 methods: oDiscounted Free Cash Flows oEquity-value to Book-value multiple The two methods resulted in different values of a Nicholson share viz. $36 and $45 respectively. Now if Cooper was to agree to Porter's demand of $50/share then the amount it would be paying for 177,000 shares would be $50. Moreover, the current market (in May 1972) was quoting $44 per Nicholson share. So if Cooper was to lure the other shareholders (uncommitted and speculators) it would have to make an offer with a premium over $44. We can safely assume that the final cost per share for this merger would be anywhere between $48 and $50. Now as per our valuation, the average value of each share would be approximately $40-42. So Cooper will land up paying a lot more than the actual value it stands to gain from this merger. Therefore just looking at these numbers, our recommendation to Cooper would be to not go into this deal. But then there are some caveats to this recommendation. Firstly, the $50/share value that we are paying to Porter is based on the premise that the share price of Cooper is set to rise in the years to come. This may not materialize in which case the cost of the acquisition may not be as much as it comes out of this analysis. Moreover, considering the bargaining position of Cooper vis--vis Porter, it may be possible to negotiate the price to somewhat below the quote of $50/share. Moreover the synergies that are expected out of the merger might be very significant, and have not been factored into the analysis. These inflows might just make the $3-4 premium that Cooper is paying over the market value at present worthwhile. Therefore, our recommendation would be that the spread between the value received and paid is quite thin, and hence Cooper should take a decision based on its estimate of the synergies that are possible with the present portfolio, and also with possible acquisitions in the near future.
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