A merger between Kennecott and Carborundum Essay

Custom Student Mr. Teacher ENG 1001-04 20 June 2016

A merger between Kennecott and Carborundum

In 1968, Kennecott Copper Corporation made a hasty decision when it purchased Peabody Coal Company. In the years preceding the acquisition, Kennecott had experienced wide swings in its profitability, which it was looking to offset by diversification. Investing in another company in a different industry was an intelligent decision; however, Peabody was the wrong company to do this with.

Although Peabody had been profitable and stable over the past few years leading up to the acquisition, the internal rate of return related to the investment was not high enough to justify a purchase of the company. Peabody’s cost of debt was .038. This was calculated by assuming a 40% tax rate and .095 rate on debt (Exhibit 3). There was a .095 interest rate on notes payable due June 30, 1998; therefore, we assumed the rate of debt at the time of purchase would have been similar. Also, Peabody’s cost of equity was .1397. This was calculated by using a risk-free rate of .055, which was the rate of the 90-day T-bill in 1968. A beta of 1 was assumed and a .082 market risk premium was used. The latter figure was determined by taking the average returns on the short-term T-Bill rate from 1951-1975.

This rate was used because we know Peabody was a short-term investment and the years 1951-1975 give a more accurate reflection of the market return than using the figure from 1926-1987. Furthermore, the weight of debt and equity were .35 and .65 respectively. These figures were used because we are told that approximately 65% of Kennecott’s net worth was tied up in Peabody. These figures gave a weighted average cost of capital of 9.70%. The IRR for this purchased was calculated by using $621.5 million as the initial investment. This figure was determined as a result of Kennecott giving Peabody $285 million in cash, assuming $36.5 million in liabilities, and taking on a reserved payment of $300 million.

Also, the figures used to determine IRR came from the figures given under cash flow from operation for the 8 years preceding the Peabody acquisition. This gave us an IRR of 6.8% (Exhibit 3), which is less than the WACC. When the IRR of a project is less than the WACC, the project should not be accepted. Likewise, after Peabody was acquired, it under-performed for several years until Kennecott sold it. Because of its underperformance, Kennecott had to sell Peabody for less than it paid for it.

After being forced to sell Peabody, Kennecott had a large amount of cash on hand, which it did not know what to do with. Instead of giving the money back to its investors in the form of dividends or repurchasing shares of Kennecott stock that was trading below book value of the firm, Kennecott once again chose to diversify by investing in another company. This time Kennecott tendered an offer to Carborundum, a company that produced abrasives and ceramics used in the high-technology industry.

Kennecott is correct in its decision that it must do something with its excess cash. By doing nothing, it will be vulnerable to a takeover; however, we do not believe diversification is the most prudent form of action. Kennecott is simply reacting to low and unstable copper prices, which have drastically hurt its bottom line. Furthermore, there are no obvious synergies connected with this deal. During an acquisition, the company being acquired should provide a greater value to the acquiring firm, than to any other firm. Because there are no synergies and the fact that the $66 tender is over $31 greater than Carborundum’s book value, the acquisition should not be made.

Similarly, when discovering the terminal value, we took the total capital for 1976 and divided it by the net profit (Exhibit 1). We then took this figure, which was 10.68, and used it as our multiplier. We multiplied the projected net incomes for the next 10-years by 10.68 (Exhibit 2) to discover the firms terminal value. Finally we added the firm’s projected terminal value in 1977 to its net present value, which we calculated to be ($1.05 Million). This was achieved by discounting the cash flow each year by the IRR. So for year 1 the formula was (410)/1.054 giving (389). We discounted through 1987 (Exhibit 4). The large initial investment is what hurt Kennecott. They paid too much for a company they knew little about. This gave us a firm value of $ 409.06 million in 1977. At the time of the tender there were 8 million outstanding shares. At $66 per share, Kennecott was paying $528 million for a firm with a value of only $409.6 million. Obviously, it does not make sense to acquire this firm.

Like wise, Kennecott was ignoring its responsibility to its shareholders. Making this acquisition would dilute shareholder value. This was most evident in the actions of one investor who took the time to file a suit against Kennecott. This investor also believed the tender offer was too high. We feel Kennecott would best benefit from a stock repurchase. At the time of the Carborundum tender offer, Kennecott’s stock was trading at $28 per share, which was $14.50 less than its book value. By not partaking in a stock repurchase, it appears as if Kennecott does not believe it can turn its own operations around. If it cannot fix its own business, it should not be expanding. Kennecott must take an inward look at itself and discover where its problems lie. Until this is done, it should put ambitions of expanding on hold.

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