Pinkerton: Case Questions

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Lucas Richard
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1 Strategic Financial Management Professor Mitchell Petersen Pinkerton: Case Questions The two fundamental questions in corporate finance are: the valuation or the investment decision (in which projects should a firm invest) and the financing decision (how should the firm raise the capital to fund its projects). We examined both issues in class. I now want you to examine both issues in the Pinkerton case. Do not just mechanically answer the questions. Instead, let these questions guide your recommendation as to what Mr. Wathen should do both in terms of whether he should acquire Pinkerton and how he should finance it. Unlike the prior cases, this case is to be done individually. I understand you have limited time. I have limited what I will ask you. The discussion in class may cover issues which I have not explicitly asked you to prepare and turn in, but which I think are important. This doesn t mean you missed something when completing your answers. When I say you will prepare the case individually, I mean you can ask general questions of your group mates (e.g. what is the formula for cash flow, or which accounts do we include in the definition of net working capital, or how does the NPV formula in Excel work). You may not ask your group mates (or anyone else) questions specific to the case. If you have such questions, you can ask me. To keep the playing field level, I will ask that these questions be asked on the newsgroup. I will not promise to answer all such questions. I may tell you I don t want to answer a question, as it is what I want you to figure out. My experience is that you will learn more from asking me a question, even if I do not answer your question, than from not asking your question. 1) Valuation of the Acquisition. Mr. Wathen s initial bid of $85M has been rejected. If he is to purchase Pinkerton, he will have to pay $100M. Can Mr. Wathen justify a $100M purchase price for Pinkerton? To answer this question, I want you to value the acquisition. What is the value of Pinkerton acquisition worth to Mr. Wathen and CPP? As with Energy Gel, you should include all relevant cash flow, but include only incremental cash flows. 1 The valuation of the acquisition should be the net present value of the relevant cash flows from assets. To simplify the process, you may assume the cost of capital for Wackenhut (the only public traded security firm) is also the correct discount rate for Pinkerton and CPP (See Exhibit 1). 2) Financing of the Acquisition. The bankers have offered Mr. Wathen and CPP two alternative financing arrangements to fund the $100M purchase price. The first 1 To review, what are the asset cash flows to CPP if they do not purchase Pinkerton and what are the asset cash flows to CPP if they do purchase Pinkerton? The difference between these two sets of cash flows is the incremental cash flows from the purchase of Pinkerton. These cash flows should be the basis of your valuation of the acquisition. Remember, you are valuing the asset, not the equity of CPP. If Mr. Wathen buys Pinkerton, he will do it at the end of 1987 and thus the first cash flow which he will receive is the 1988 cash flow. Mr. Wathen is buying the operating assets for $100M and so the cash which appears on the balance sheet of Pinkerton will be retained by American Brands. Use the cash flows from the exhibits and the text as your base case for the valuation. After you have a value, if you think the assumptions are incorrect, you can then explain that and show me how it changes your valuation. Net income is calculated the same way in Exhibit 2 and 3. 1

2 alternative is to have CPP borrow $75M at an interest rate of 11.5%. The loan would be a non-amortizing, seven year loan (meaning no principal will be due until maturity). In this financing alternative, the remaining $25M will be financed by equity. Mr. Wathen would give up 45% of the equity in exchange for $25M. The second alternative is 100% debt financing. CPP would take out a $100M loan at an interest rate of 13.5%. The loan would require $5M in annual principal payments at the end of the first six years and a final principal payment of $70M in year seven. You should analyze the two financing options and then explain to me which is the superior financing arrangement for Mr. Wathen. You can assume there are no transactions costs (remember the M&M assumptions) and that the interest rate on the loans is set so that the loans are correctly priced. This isn t necessarily correct, but it will simplify your analysis and adds little intuition. 3) Acquisition Decision. Should Mr. Wathen acquire Pinkerton and if so which financing method should he use? 2 Pinkerton Case Questions

3 Exhibit 1: Wackenhut s Cost of Capital To calculate Wackenhut s cost of capital (the cost of capital for discounting the cash flow to assets), we will calculate the weighted average of the cost of debt and equity. This cost of capital does not include the value of the interest tax shield and so technically is not WACC. This means the value of the tax shield will need to be included later. If you purchased all of the debt and all of the equity, you would own all of Wackenhut s assets. The expected return on your portfolio of Wackenhut assets would be: Debt Equity r asset = r debt +requity (1) Assets Assets By including the required return on debt and equity from CAPM, we obtain the required return on assets or the cost of capital for Wackenhut. We can obtain the value of equity and debt from Exhibit 4 of the case [see expanded version of the exhibit in the Pinkerton spreadsheet]. The market value of equity is the number of Wackenhut shares times the share price or $70.2M [3.9M shares * 18.00/share]. We do not have the market value of debt, so I used the book value of debt ($10.6M) from the balance sheet as an estimate of the market value of debt. This implies the market value of the firm s assets is $80.8M and the firm is 13% debt. We derive the required return on the debt and equity using CAPM. The equity and debt β are given in Exhibit 4. The debt β is typical of investment grade debt. Notice that the equity β is low, i.e. below one. This implies that the asset β will be below one or that demand for security services and the cash flows of the security services business rise and fall less over the business cycle than the average firm. This sounds like it is more of a necessity then a luxury. We are going to forecast cash flows for five years, thus I used the five year risk-free rate from Exhibit 5 (which I added). I used 7.4% as the market price of risk. This is the excess return on the market over long term treasuries over the last seventy years. Using the debt and equity β, this gives us an expected or required return on both debt and equity. r =r +β E r -r debt risk-free debt market risk-free = E 7.4 =9.1 r =r +β E r -r equity risk-free equity market risk-free Thus the discount rate for Wackenhut s 13.5% and this is what I will use for discounting the asset cash flows to both Pinkerton and CPP. 2 (2) Debt Equity r asset = r debt +requity Assets Assets = =13.5 (3) 2 You could also calculate the asset β, using an expression similar to equation (3). The asset β is 0.8, which leads to a discount rate of 13.5%. The two approaches will always be the same. 3

4 Appendix 1: Hints for Valuing the Pinkerton Acquisition To assist you in putting your valuation and financing package together, I wanted to provide some additional guidance or hints. 1) Strategic questions. Mergers and acquisitions are a major event in a firm s life which reveals how managers both define and execute their strategy. The success or failure of a merger depends heavily upon whether management is clear and realistic in what gains (or synergies) they expect from the merger as well as their ability to implement the merger plans and integrate the two firms. Don t mechanically answer the following questions (A- C). Instead use them to guide your thinking about what cash flows are relevant and thus the value of the acquisition. As I have said many times, the fact that the spreadsheet says an investment is a positive NPV doesn t mean it is. The numbers have to be consistent with the economic reality of the investment. A) What are the sources of value to CPP from the acquisition of Pinkerton? B) How can CPP improve Pinkerton's performance? C) What is the value of synergies associated with the Pinkerton-CPP combination? To answer this question you should consider what the value of CPP without the acquisition? 2) Assumptions from the case. The text of the case gives both an expected scenario and a pessimistic scenario for several variables. Assume the expected scenario reflects the expected value, not an optimistic scenario (e.g. we expect gross profit margins to rise to 10.25% in 1991 not to 9.5% or to some number between 9.5% and 10.25% see page 3 of the case). If it helps, you can fill in the table of assumptions which you find below and in the excel spreadsheet and then use these assumptions as a basis for your valuation of the Pinkerton acquisition. 3 The value of the acquisition is the NPV of the relevant cash flow to assets discounted at the correct discount rate. Cash flow Asset,t = Revenuet -Costst -Depreciation t -Taxest R -C-D (4) - Capital Expenditure -Depreciation - Increase in NWC t t t The first line of the cash flow to assets formula is after tax profits. The second line is net investment which we subtract off from after tax profits. The increase in NWC is the net investment in short term capital. Capital expenditure minus depreciation is the net investment in long term capital. 3 A version of this table is also contained in the Pinkerton spreadsheet which I have posted on Canvas. You will find it in the Valuation of Pinkerton tab. 4 Pinkerton Case Questions

5 Revenue (% of 1987 level) 90% 80% 70% Revenue growth (after 1990) 5% 5% Gross profit margin (% of sales) Operating expenses (% of sales) Net PPE (% of sales) NWC (% of sales) 3) Future value. When you forecast the cash flows to Pinkerton and/or CPP, forecast them through This doesn t mean we will shut the firm down at the end of We expect both Pinkerton and CPP to continue to operate and grow. Thus your valuation will need to include the value of cash flows in 1993 and beyond. Use an exit or terminal valuation as we did in the West Teleservice case. 5

6 Appendix 2: Hints for Financing the Pinkerton Acquisition 1) Adjusted present value. To determine which financing method is superior and whether Mr. Wathen should pursue the acquisition at all, you should use the adjusted present value method. You already have the answer to the first half of this expression; now you need to include the NPV[Financing]. You will need to decide which terms of the NPV[Financing] are relevant to this situation. 4 NPVProject = NPVProject CSI + NPV Financing (5) 2) Tax shield and costs of financial distress. When you first analyze the financing scenarios, I want you to ignore the tax shield and costs of financial distress by assuming they are equal in magnitude and thus their net value is zero, i.e. NPVTaxShield -NPV Costsof FinancialDistress =0 (6) I am assuming you know how to calculate the value of the tax shield, as you have already done it for the UST case. I will have you come back and do this calculation below. 3) Selling equity. In scenario I, Mr. Wathen and CPP are selling equity. They are giving up 45% of the equity in the combined firm in exchange for $25M. You need to figure out how to include this part of the financing scenario in your valuation and decision. Think about what Mr. Wathen is receiving and what Mr. Wathen is giving up when he sells 45% of the combined firm to the outside investors. This gain or loss should be included in your NPV[ Financing ] calculation. Information to generate cash flows for CPP (without Pinkerton) is given in Exhibit 3 of the case. 5 Use the same cost of capital as you used for Pinkerton. 4) Optimal leverage. When we decided how much debt UST should have, we were searching for the optimal leverage ratio the leverage ratio that maximized the value of the firm. In this case, the choice of debt may be driven by other factors. Do you think the level of debt in the two scenarios is optimal (i.e. it maximizes the value of the firm)? If the level of debt is not optimal, is CPP borrowing too much or too little to finance the acquisition? If the level of debt is not optimal, then raising or lowering the level of debt should increase the value of the firm and the value of Mr. Wathen s equity stake. I would expect Mr. Wathen has the incentive to maximize the value of his equity. 6 Now that you have thought about these general questions, go back and think about your APV calculation. How big would the value of the tax shield minus the costs of financial 4 Each term in the NPV[ Financing ] expression comes from one of the assumptions of the M&M theorem. We have discussed several of these in the UST and the WT case. 5 CPP has long term debt which will be paid off over time. This affects its interest expense going forward. I have given you the schedule of debt repayments though These numbers are in the Pinkerton spreadsheet on the web in the tab labeled Valuation of CPP. 6 If the level of debt is not optimal, then changes in the level of debt will raise the NPV[ Financing]. Specifically it could raise the value of the tax shield minus the cost of financial distress (e.g. NPV[ Tax shield ] - NPV[ CFD ]). 6 Pinkerton Case Questions

7 distress have to be to change your answer? Do very few calculations. 7 I want you to argue with logic, not numbers. 7 We spent a lot of time discussing the costs of financial distress when we discussed the UST case. You do not need to go through another extensive discussion in this case. You can and should calculate the value of the tax shield. Do not spend much time calculating costs of financial distress. Go back and look at the questions I asked to guide your thinking. If you want to calculate some of the credit ratios we used in UST, you may do so. But do this only if it helps guide your thinking and thus helps you form your answer. 7

CAPITAL STRUCTURE AND VALUE

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