Case Studies on Cooper Industries Inc

Case: Cooper Industries. Inc.

Mergers and Acquisitions

Cooper Industries. Inc

Company Background

Organized in 1919 as a manufacturer of heavy machinery and equipment

A leading producer of engines and massive compressors in mid-1950s

Heavy dependence on sales to the gas and oil industries

Financial strength is attractive

Acquisition made by Cooper Ind. Inc

Between 1959 and 1966 it acquired

(1)A supplier of portable industrial power tools

(2)A manufacturer of small industrial air and process compressors

(3)A maker of small pumps and compressors for oil field operations and

(4)A producer of tire-changing tools for the automotive market

In 1969

The Crescent Niagara Corporation( It has high quality wrenches, pliers, and screwdrivers

Acquisition Strategy in 1966

Cooper played a major role in any acquisition

The industry should be fairly stable, with a broad market for the products and a product

line of largely small-ticket items

Acquire only leading companies in their respective market segment

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Nicholson File Company

Strengths

One of the largest domestic manufacturers of hand tool and was a leader in its two main

product areas

It had 50 % share of 50 million market for files & rasps

Also 9% share of 200 million markets for hand saws and saw blades compare to Sears,

Roebuck and co, Inc.

Its highest assets was distribution systems

These strengths forecasts 6% to 7% future annual growth

Drawbacks

Annual sales growth 2% (Industry growth 6%)

Profit margin 1/3rd those of other hand tool business

Book value $ 51.25(Market value $44 on May,1972)

P/E ratio 10-14

The company could contribute less than one-sixth of the combined sales

Nicholson’s Atkins saw division seemed vulnerable in view of its low profitability

H.K.Porter Company

A conglomerate with wide ranging interests in electrical equipment, tools, nonferrous

metals, and rubber products

It had acquired 44000 shares of Nicholson in 1967

Porter offer $ 42 per share in cash for 437000(out of 584000) to Nicholson

Porter offer $ 50 per share in cash for 177000(out of 584000) to Cooper

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VLN

VLN was broadly diversified company with major- interests in original placement

automotive equipment and in publishing

Under the VLN merger term one share of VLN new cumulative convertible preferred

stock would be exchanged for each share of Nicholson

Preferred dividend $1.60

Critical issues for making merger between VLN & Nicholson

1. The exchange would be a tax free transaction

2. $1.60 preferred dividend equaled the rate then on the Nicolson Common Stock

3. A preferred share was worth a minimum $53.10

1. If you were Mr. Cizik of Cooper Industries, Inc., would you try to gain control of

Nicholson File Company in May 1972?

Mr.Cizik could try to gain control of Nicholson in May 1972 due to their opportunities

Potential profits from every market segments

Cost of goods sold could be reduced from 69% to 65%

Selling, general and administrative expenses from 22% to 19% due to the elimination of

sales and advertising duplications

Currently, Sales were made to industrial market and consumer market same

proportionately (50:50) which can be offset through Nicholson’s sales ratios (75:25) in

this market

Use European distribution systems

Battle between VLN & porter

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2. What is the maximum price that Cooper can afford to pay for Nicholson and still

keep the acquisition attractive from the standpoint of Cooper?

The maximum price that Cooper would be able to pay Nicholson, in the form of cash or

common stock, would depend on the intrinsic value of Nicholson, based on which, Cooper

can make the decision to acquire Nicholson. If the synergistic value of acquisition for Cooper

exceeds the premium that Cooper has to pay to Nicholson, only then they can go for the

merger. Otherwise, Cooper needs to forecast the long term future of Nicholson’s

performance to predict the prospect of their merger.

Synergy is the value that the two firms gain after the merger i.e. the difference between the

summation of value of the two firms before the merger and the combined value of the two

firm in the form of surviving firm after the merger.

If we can derive the market value of Nicholson, then this would be the maximum value that

Cooper could afford to pay, because if Cooper pays more than that value, then Cooper’s

shareholders would not be better off from the merger.

Therefore, in order to estimate the value of Nicholson, we used the free cash flow method to

valuating the firm and also consequently to determine their value of each share of stock.

The data given for Nicholson in the case is for the year of 1967 to 1971 in Income Statement

and the Balance Sheet is given only for the year 1971. We estimated the free cash flow of

Nicholson based on forecasting from 1972 till 1976, including considering their survival of

business forever.

During estimating the free cash flow from Nicholson after the merger, the necessary changes

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due to the synergistic effect has been incorporated in the assumptions.

We are providing here the breakdown of our assumptions along with calculation to determine

the cash flow to Cooper and thereafter the value of Nicholson.

Particulars AssumptionsNet Sales Forecasted based on Avg.

growth rate of 3.39% during 1972-73 and of 6% aligning with industry growth rate based on their future prospect during 1974-76.

1972 1973 1974 1975 1976

57.2 59.1 62.7 66.4 70.4

Particulars Assumptions 1972 1973 1974 1975 19762 Cost of Goods Sold Goes down to 65% from

69% 37.2 38.4 40.7 43.2 45.83 Gross Profit 20.0 20.7 21.9 23.2 24.6

4 Selling &

Administrative Expenses

Goes down to 22% from 19% 10.9 11.2 11.9 12.6 13.4

5 Depreciation Same as of 1971 2.1 2.1 2.1 2.1 2.16 Interest Expense Assumed no new loan

has been availed 0.8 0.8 0.8 0.8 0.8

7 Other deductions Considering the past trend 0.2 0.2 0.2 0.2 0.2

8 Income before Taxes 6.8 7.2 7.7 8.3 9.0

9 Taxes at 40% 2.7 2.9 3.1 3.3 3.6

10 Net Taxes After adjusting for i) investment tax credit and ii) income of equity in net income of partially owned foreign companies. 2.5 2.7 2.9 3.1 3.3

11 Net Income 4.1 4.3 4.6 5.0 5.4 12 Add back:

Depreciation 2.1 2.1 2.1 2.1 2.1 13 Cash Flow 6.2 6.4 6.7 7.1 7.5 14 Less: Retention

needed for growth To finance asset replacement and growth; assumed 20% retention of 1.2 1.3 1.3 1.4 1.5

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cash inflow

Notes:

i) Interest Expense:

Since we are calculating the free cash flow from Nicholson, we ignored the interest expense

in calculating Income before tax (EBT) (which would be actually the Earnings before Interest

& Tax, EBIT) and we considered the cost of debt during discounting the cash flow to get the

present value of the cash flow.

ii) Retention needed for growth:

Some of the cash flow generated from Nicholson is need to be retained back in the company

if in case they need fund to finance replacements of assets. The fund could be used for cooper

to pay dividend on their stock and for redeployment within the firm. The particular fund is

basically require to retain considering the growth of the company. We assumed 20% of cash

flow to be retained for the above purpose.

Particulars Assumptions 1972 1973 1974 1975 197615 Add: Terminal Value

(as on year end 1976)Using the Constant Growth Model: g=2.00% conservatively, Discount rate=9.16%; Nicholson's Cash Flow is expected to grow @ 2.00% after 1976 85.3

16 Working Capital: Accounts Receivables Accounts

Receivables to sales ratio in 1971 8.3 8.6 9.1 9.6 10.2

Inventories Inventories to sales ratio in 1971 18.6 19.2 20.4 21.6 22.9

Accounts Payable Accounts Payable to sales ratio in 1971 2.1 2.1 2.3 2.4 2.5

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17 Change in Net Working Capital:

Change in Accounts Receivables 0.3 0.3 0.5 0.5 0.6

Change in Inventories 0.6 0.6 1.2 1.2 1.3 Change in Accounts

Payable 0.1 0.1 0.1 0.1 0.1 Change in Net Working

Capital 0.9 1.0 1.8 1.9 2.0 18 Capital Expenditure:

Net Plant & Equipment Net Plant & equipment to Sales ratio of 1971 16.5 17.1 18.1 19.2 20.4

Change in Capital Expenditure 0.5 0.6 1.0 1.1 1.2

19 Net Cash Flow to

Cooper 3.5 3.6 2.6 2.7 88.1

This is the cash flow to Cooper from Nicholson after the merger.

Notes:

iii) Terminal Value:

Considering that after 1976, Nicholson will operate forever after getting merge with Cooper,

and grow at constant rate. In this case, our conservative assumption is 2.00% of growth rate

keeping in view their present performance.

Now, in order to find the appropriate discount rate, we determine the Weighted Average Cost

of Capital.

2) Calculation of Cost of Capital / discounting rate:a Cost of Debt: Calculation Long Term Debt (as on 31-Dec-1971) i $ 12 Million Interest Expense (as on 31-Dec-1971) ii $ 0.8 Million Cost of Debt kd = ii / i 6.67%

Cost of Debt is calculated assuming no new debt has been availed by the company.

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B Cost of Equity: market price per share (average that of

1971) p $ 27.5 Dividend per share = D1 d $ 1.6 Growth rate (industry rate) g 6.00% Cost of Equity ke = (d/p)+g 11.82%

The cost of equity has been determining based on the Constant Growth Model.

Nicholson has been paying fixed dividend of $1.6 over the years. We assumed that the cash flow

in the form of dividend would be $1.6 which we consider D*(1+g) = D1 = $1.6. The dividend is

expected to grow at 6% in align with the industry =growth rate if Nicholson can achieve this

growth rate after receiving the synergistic effect during the post merger period.

c Weight of Debt wd 0.34 Weight of Equity we 0.66 Tax Rate t 40% WACC wd*kd*(1-t)+we*ke 9.16%

Now, lets focus on the valuation of Nicholson after the merger.

Figures in $ MillionEstimating Market Value of Nicholson after merger: Forecasted Forecasted Years 1971 1972 1973 1974 1975 1976Net Cash Flow to Cooper ($ Million) 3.5 3.6 2.6 2.7 88.1 Valuation of Cash Flows as on year end 1971 ($ Million) 66.9 Loan amount 12.0 Cash flow for Stockholders 54.9 No. of shares outstanding of Nicholson

584,000 Value of each share of Stock of Nicholson ($)

93.99 This implies that, if Cooper has to pay more than $66.90 million to Nicholson, then the

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shareholders of Cooper will loose. On the other hand, if Cooper can pay less than this value,

their shareholders will gain.

Now, if we consider the no. of shares of Nicholson to be 584,000 and the market price of

share of stock to be $44, then the total market value of Nicholson appears to be $25.69

million. Now, if the shareholders of Nicholson receive more than this value from Cooper for

acquisition, then they will be better off.

The gap between the market value of $25.96 million and $66.90 million is the Bargaining

Range which equals to the synergy.

3. What are the concerns and what is the bargaining position of each group of

Nicholson stockholders? What must Cooper offer each group in order to acquire its

shares?

The different stockholders of Nicholson offered different offer in different form. Their

bargaining position is as below:

H. K. Porter Company’s Offer:

On March 03, 1972, Porter tendered 437,000 out of 584,000 shares of Nicholson at $42 per

share in cash, reflecting $12 premium over the most recent price of stock of Nicholson.

Moreover, Porter would support the merger between Cooper and Nicholson if they receive

Cooper’s convertible securities in a tax free exchange worth at least $50 for each share of

Nicholson

Cooper’s offer to Porter:

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Cooper can take the offer of Porter of $50 for each share of stock for the 177,000 shares of

Nicholson since the market value of Nicholson for each share of stock of $114.53, as derived

from our calculation is far more than the offered price.

VLN’s Bargaining Position:

VLN’s merger terms are that one share of VLN convertible preferred stock would be

exchanged for each share of Nicholson common stock. The VLN preferred stock would pay

an annual dividend of $1.6 and would be convertible into five shares of VLN common stock

during the first year following the merger, scaling down to four shares after the fourth year.

The preferred would be callable at $50 a share after the 5th year and would have liquidating

rights of $50 per share. In addition to this, they assured Nicholson of colonized operating

independence of the Nicholson’s management.

However, as pointed out by Porter that VLN common stock has recently sold for $4.625 per

share that put the value in first year of $23.12 on the VLN preferred. Since, VLN did not pay

any common dividend since 1970, converting into VLN common stock would result in

incurring sharp income loss.

Porter do not need to offer VLN i.e. acquire the shares of VLN since the no. of VLN shares is

as low as 14,000 compare to total no. of shares of 584,000 of Nicholson and due to above

mentioned reason, Cooper might have to suffer in future for acquiring their shares.

Uncommitted Shareholder’s position:

The uncommitted shareholder, holding 172,000 shares, and also the shareholders of shares

unaccounted for, would go by the advice of Nicholson’s management and the speculators

bought the shares hoping of escalation or appreciation of acquisition offer.

Therefore, if Cooper can offer a price that satisfy both the Nicholson’s management and also

it leads to gain of the speculators and the shareholders of shares unaccounted for, then

Cooper would be able to acquire majority of the outstanding shares of Nicholson. Now, since

the market value of Nicholson as derived from the calculation is quite high than any other

offer made in the market, Cooper can just offer $50 to these shareholders keeping in mind the

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offer made by Porter that supports the Cooper-Nicholson merger.

4. On the assumption that the Cooper management wants to acquire at least 80

percent of the outstanding Nicholson stock and to make the same offer to all

stockholders, what offer must Cooper management make in terms of dollar value

and the form of payment (cash, stock, debt).

To finance an acquisition by cash or by shares of stock depends on several factors that can be

considered by Cooper as follows-

i) Over valuation: If the acquiring company’s stock is overvalued, then using shares of

stock is less costly than using cash.

ii) Taxes: Acquisition by cash is a taxable transaction whereas that with stock is tax free.

iii) Sharing Gains: Using stock for acquisition can help the shareholders of the acquiring

company to gain as well as to incur loss depending on the company’s performance.

On the other hand, acquisition with cash lead the shareholders to get fixed price.

In order to acquire the 80% of shares of Nicholson, Cooper do not need to offer VLN

considering the factors pointed out by Porter. Therefore, to attract the speculators and the

shareholders of shares unaccounted for, Cooper can offer a price that satisfies these shareholders

along with the management of Nicholson. Cooper also need top consider the offer made by the

Porter of $50 per hare of stock.

Assumption:

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If Cooper offer price of $50

Particulars Before Merger as on 1972Exchange

ratio After

Merger Cooper Nicholson Cooper Present Earnings $5,600,000 $1,350,000 $6,950,000

Shares Outstanding 4,218,691

584,000

0.88 4,732,611

Earnings per Share $1.12 $2.32 $1.47 Price per Share $28 $44 Price/Earnings Ratio $25 $12

5. What should Mr. Cizik recommend that the Cooper management do?

From our calculation based on free cash flow method, the estimated value of each share of

Nicholson came to be $114.53. It obviously exceeds any offer made in the market to acquire the

Nicholson’s shareholder. Since valuation has been determined considering the synergistic effect

along with several conservative assumptions, though which the value came to be quite higher, it

implies that if Nicholson’s business survive in the form of merging with Cooper from 1976

afterwards, the market value of Nicholson is undervalued and the acquisition of their shares

should benefit the shareholders of Cooper for taking the decision to get merge with Nicholson.

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Case Studies on Cooper Industries Inc

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