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Cooper case Solution Essay

Introduction

Cooper Industries, Inc. is a manufacturer of heavy machinery and equipment. It has acquired some companies in the past as part of their expansion plans. Cooper acquires companies that are leading in their area of business, have a large market share and is the leading company in their area of operation. Currently, Cooper is focusing on building a hand tool business with a full product line that would use a common sales and distribution system and joint advertising. In this effort, Cooper has already acquired Lufkin Rule Company, Crescent Niagara Corporation and Weller Electric Corporation.

Currently the company is making acquisition strategy for Nicholson File Company. An earlier attempt had failed in 1969. Again, in March of 1972, Cooper had to back away due to the bid by H. K. Porter Company because they were afraid that Porter may raid them if they learnt of Cooper’s attempts. Porter made an open offer of $42 per Nicholson share but were able to get only 133,000 shares instead of the required 249,000 shares for a majority stake.

The current situation in May 1972 is that the Nicholson management has recommended a friendly merger bid from VLN Corporation. Porter fears that they will loose value in their investment if this VLN deal goes through. They have approached Cooper to make a bid for Nicholson and have promised support in exchange of a Cooper share deal.

Decisions to be taken

The following decisions confront Cooper management:

Should Nicholson be acquired?

If yes, then how the controlling stake should be acquired.

Should it be a cash or equity offer, and at what terms?

What should be the deal offered to Porter and Nicholson management?

Methodology

The flowing steps were followed in our analysis:

Determining the value of Nicholson File ltd on an “as in” basis. We have used the free cash flow to firm (FCFF) method.

Determining the value of Nicholson on a “synergy” basis i.e. after it has been acquired by Coopers.

Determining the value of Cooper Industries on an “as in” basis. We have used the free cash flow to firm (FCFF) method.

Evaluation of acquisition strategies on the basis of the above calculations and financial situation of Cooper.

Calculation of WACC

The cost of equity was determined by using the following formula:

P/E Ratio = Payout Ratio * (1+g) / (r-g)

Therefore r = g + Payout Ratio * (1+g)

The following table lists the cost of equity for both Nicholson and Cooper under various growth scenarios. Note that we have assumed a stable firm model.

Company P/E ratio Payout Growth Cost of Equity

Cooper Industries 8 62.53% 1% 8.89%

Cooper Industries 8 62.53% 4% 12.13%

Nicholson File 8 66.45% 2% 10.47%

Nicholson File 8 66.45% 4% 12.64%

Nicholson File 8 66.45% 6% 14.80%

The payout for the various scenarios has been taken as the average payout in the previous years. The P/E ratio is taken to be as recommended, i.e. 8.

Valuation of Nicholson (“as in” basis)

We have forecasted the value of Nicholson assuming a stable growth form model under three growth scenarios, 2%, 4% and 6%.

The capital expenditure has been assumed equal to the depreciation charged. This has been done to keep a constant productive capacity for the firm.

The net change in working capital has been calculated under the assumption that the working capital requirements change in the same proportion as sales.

Free Cashflow to Firm (FCFF) = EBIT*(1-Tax rate) – (Capital Spending – Depreciation) – Change in Working Capital

FCFF = $2.82m*(1-0.4) – ($2.1m – $2.1m) – $216,998 = $1,475,002

WACC = Cost of Debt * (1 – tax rate) * Debt / (Debt + Equity) + (Cost of Equity * Equity ) / (Debt + Equity)

We have assumed the Cost of debt = 0.8/12 = 6.67%

Value of Firm = FCFF * (1 + Growth) / (WACC – Growth)

Growth Rate WACC Value of Firm (in $) Value per Share

2.00% 8.82% 22,058,013 $37.77

4.00% 10.44% 23,829,862 $40.80

6.00% 12.05% 25,857,927 $44.27

Valuation of Nicholson (“synergies” basis)

We have assumed that COGS will reduce from 69% to 65%, and the SGA expenses will reduce from 22% to 19%.

We have not assumed any other synergies even though they exist and will only increase the value of Nicholson for Cooper.

The projected income statement for Nicholson after taking into account the synergies are as shown below:

Year 72 73 74 75 76

Sales 58.618 62.13508 65.86318 69.81498 74.00387

COGS 38.1017 40.3878 42.81107 45.37973 48.10252

SGA 11.13742 11.80567 12.51401 13.26485 14.06074

Depreciation 2.1945 2.293253 2.396449 2.504289 2.616982

others 0.2 0.2 0.2 0.2 0.2

EBIT 6.98438 7.44836 7.941661 8.466107 9.023638

Interest 0.832 0.86528 0.899891 0.935887 0.973322

EBT 6.15238 6.58308 7.04177 7.53022 8.050316

Taxes 2.460952 2.633232 2.816708 3.012088 3.220126

PAT 3.691428 3.949848 4.225062 4.518132 4.830189

The valuation has been done exactly in the same manner as done above for the “as is” basis. We assume that after a merger with Cooper, the growth rate for Nicholson products will be equal to the industry average of 6%.

Growth Rate WACC Value of Firm (in $) Value per Share

2.00% 8.82% 41,134,444 $70.44

4.00% 10.44% 44,438,642 $76.09

6.00% 12.05% 48,220,638 $82.57

Valuation of Cooper

1771 seems to be a downturn year for Cooper. Taking the numbers just from that year will yield biased results, thus we have calculated the averages over 5 years for Cooper e.g. EBIT, CAGR etc are all over 5 years.

We have forecasted the value of Cooper assuming a stable growth form model under three growth scenarios, 1%, 4%.

The capital expenditure has been assumed equal to the depreciation charged. This has been done to keep a constant productive capacity for the firm.

The net change in working capital has been calculated under the assumption that the working capital requirements change in the same proportion as sales.

Free Cashflow to Firm (FCFF) = EBIT*(1-Tax rate) – (Capital Spending – Depreciation) – Change in Working Capital

FCFF = $25.6m*(1-0.4) – ($4.2m – $4.2m) – $949,519 = $14,410,481

WACC = Cost of Debt * (1 – tax rate) * Debt / (Debt + Equity) + (Cost of Equity * Equity ) / (Debt + Equity)

We have assumed the Cost of debt = 3/39 = 7.69%

Value of Firm = FCFF * (1 + Growth) / (WACC – Growth)

Growth Rate WACC Value of Firm (in $) Value per Share

1.00% 7.65% 218,965,826 $51.90

4.00% 10.44% 252,088,329 $59.76

Acquisition Decisions

Should Nicholson be acquired?

The current fair price of Nicholson assuming the current 2% growth continues is $37.77. In case we take an optimistic view of 6% growth, the Nicholson’s stock price goes up to $44.27. More importantly, if Cooper were to merger Nicholson with itself and realize the synergies, Nicholson is worth $82.57 at a growth rate of 6%. Even if Nicholson’s growth is 2%, it is still worth $70.44 to Cooper. Moreover this gives access to a large distribution channel to Cooper and a diverse mix of customers. This industry also satisfies the criteria that have been set for acquisitions by Cooper. Thus, Cooper should definitely bid for Nicholson and the maximum bid should be $70.44 per share (to be on the safe side).

If yes, then how the controlling stake should be acquired?

Should it be a cash or equity offer, and at what terms?

According to our calculations, the stock price of Cooper is severely depressed at $24 per share. We believe it is fairly priced at $51.9 per share assuming a growth rate of 1% (equal to its CAGR). Thus, any move to use common equity would be detrimental to the shareholders of Cooper. Thus, Cooper should make a cash only bid for Nicholson shares. As they have cash balance of only $9,000,000 and they would require buying at least 263,000 more shares (as they hold 29,00 shares currently), Cooper would have to take debt to cover the shortfall.

Porter’s offer for $42 failed to get the requisite number of shares. VLN’s offer it touted to be worth $53.10 as the best case. This is the number that the speculators and the stockholders would like to believe even though we know that their actual offer will turn out to be much less. Thus, we propose to offer $50 per share for Nicholson stock.

Porter has offered Cooper that it will take Cooper stock for giving Nicholson stock. We believe that this is a bad choice for Cooper. They should offer to buy Porter’s share of Nicholson stock (177,000 shares) at $50 per share cash, valuing the deal as $8.85 million. Porter should accept this offer as they are afraid of getting stuck with VLN stock if Cooper does not come to their rescue. Moreover, a return of 20% in the space of a few months should be very welcome.

This price should also be attractive to the speculators holding anywhere from 50,000 to 100,000 shares. This should give Cooper the further 86,000 shares required for control.

As $50 per share and existing funds of $9 million, Cooper would need to borrow $4.3 million at a rate of ~8% (Cooper’s cost of debt). This should not be a tremendous burden on Cooper as they are a low leveraged firm have capacity for more leverage.

What should be the deal offered to Porter and Nicholson management?

In keeping view the long standing policy of having friendly takeover by Cooper, they should talk with the Nicholson management and assure them that they would be the ones running the Nicholson operations. The additional benefit may be that the management may indicate their acceptance of this offer from Cooper, thus tilting the undecided as well as the management control votes in Cooper’s favour.

Also, the possibility of a full merger with Cooper cannot be rule out in the future. The management should be made aware of this and they should be shown the fair valuation of Cooper stock and also the synergies that the firms will be able to leverage together. Even at current fair value, a Cooper stock should be worth $51.9 assuming 1% growth. Post merger, the value of Cooper stock will rise further.


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