This BW/IP International, Inc. case study focuses on the company's proposed acquisition of United Centrifugal Pumps (UCP). Where lenders are hesitant to provide funding for the acquisition, BW/IP International must convince those lenders that such an acquisition is advantageous.
Timothy A. Luehrman; Andrew D. Regan
Harvard Business Review (293058-PDF-ENG)
November 19, 1992
Case questions answered:
We have uploaded two case solutions, which both answer the following questions:
- Examine the leveraged buyout that created BW/IP International, Inc. Was this business a good candidate for an LBO? Why (not)?
- Evaluate the equity in the original BW/IP LBO using the Equity Cash Flow methodology. Assume an asset beta of 1.0 and debt betas of 0.0. What is the NPV of this investment?
- How does the analysis change if we consider non-zero debt betas? How does the concluded value change?
- How would you evaluate the buyout using enterprise cash flows and WACC or APV, instead of ECF? In what important ways does such an approach differ from ECF?
- Evaluate the proposed acquisition of United Centrifugal Pumps (UCP). Is the acquisition strategically sensible? Are the projections reasonable? Is the price appropriate (again, assume an asset beta of 1.0)?
- Consider the proposed financing. Why are lenders hesitant to fund the acquisition? Why isn’t the acquisition being funded primarily by equity?
- Would you recommend that BW/IP acquire UCP? Why (not)? Would your recommendation change if BW/IP itself was not highly levered? Why (not)?
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BW/IP International, Inc. Case Answers
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Executive Summary – BW/IP International, Inc.
Until 1987, Industrial Products (IP) was the smallest of Brog-Warner’s (BW) major business groups and manufactured advanced technology fluid transfer and control equipment. The IP Group had a stellar performance in the 1970s due to the booming energy sector. However, due to the oil crisis in the early 1980s, sales growth started declining. Even though the group had never recorded a loss, the lack of growth led to IP losing its strategic value in the eyes of its parent company.
This led to the group’s President, Mr. Valli, submitting an LBO proposal to the parent company worth $239.5 million which was accepted. The new company, now named BW/IP, was established in 1987.
We have evaluated the LBO using the equity cash flow (FCFE) method. As per FCFE, the LBO results in an enterprise value of $67.98 million. This was calculated assuming that the debt is risk-free. However, since it is a highly levered transaction, presuming debt to be risk-free is an over-simplifying assumption.
As the value of debt increases, the value of equity increases further as the risk of cash flows earned is then divided amongst both equity and debt holders. Hence, our calculation for NPV is downward biased.
Within a year of LBO, BW/IP had an attractive offer to acquire United Centrifugal Pumps (UCP) for $19 million. However, for the acquisition to go through, more debt would have to be acquired and the already encumbered management’s time would have to be diverted to the newly acquired company at a time when it was trying to resolve administrative issues at BW/IP. Nonetheless, the acquisition provided strategic benefits.
The acquisition would double the current number of installed pumps for BW/IP and BW/IP’s position in the aftermarket would also be further strengthened due to the acquisition.
In order to go ahead with UCP’s acquisition, more debt would have to be raised. $13 million of the new debt would have to be taken from the bankers who might be hesitant to provide the loan due to BW/IP’s high leverage ratio. On top of this, another recession is imminent, and this acquisition would further concentrate on BW/IP’s portfolio in the oil industry.
However, BW/IP managers have already surpassed the targets they had set for themselves and are confident in their abilities to manage the acquired entity. Despite all the strategic benefits referred to earlier, our calculations show that the NPV of acquiring UCP is negative and hence, BW/IP should not proceed with the acquisition.
Case Introduction – BW/IP International
This case is about the LBO of the Industrial Products Group from its parent company, Bog-Warner Industrial Products Inc. This LBO had to be conducted because the IP group had lost its strategic value for BW. The LBO was conducted at a price of $251.5 million. The LBO has been quite successful, and BW/IP’s managers were able to meet the targets they had set for themselves for the 1st year.
The newly formed corporation, BW/IP Inc. had performed well and within 1st year of its operations stumbled upon the opportunity to acquire United Centrifugal Pumps (UCP) at a price of $19 million. The merger offers synergies but also has certain drawbacks, such as it would divert the management time away from administrative efforts at BW/IP and further concentrating BW/IP’s portfolio in energy markets.
For this acquisition to go through, $13 million will have to be .raised in bank loans, and it is probable that the bank might be hesitant due to the highly levered nature of this transaction.
Bog-Warner Industrial Products Inc. was, until 1987, fully owned by the Borg-Warner Corporation and was then known as “Industrial Products”. IP manufactured advanced technology fluid transfer and control equipment and aimed to apply advanced industrial technologies in the energy sector. IP had been a star performer within the BP Group for several years.
However, due to the oil prices crash and recession of the early 1980s, the group was unable to register growth. By the 1980s, the IP group’s strategic value to the parent company had been eroded since now BW focused on diversifying its portfolio and focusing on industries other than energy. Therefore, the IP group was being neglected by BW. Hence, a buyout was requested by the IP group’s management, which was subsequently approved.
Along with its historical good performance, the fact that the IP group had very little debt on its balance sheet made it a good LBO candidate1. Moreover, the group had never recorded a loss, even in adverse external and internal conditions. In 1986, the company recorded $30.5 million in earnings before taxes from $244.8 million in sales.
Furthermore, the $70.4 positive net working capital of the subsidiary showed strong short-term health, with a high potential to invest and grow. Adding to this, the company owned very little debt, with an Equity-to-Sales ratio of 80%. Because of this very low leverage, the company could benefit from acquiring additional debt, through an IPO, to gain potential tax benefits. BW/IP had grown into a mature company over the last decade, and with a talented and motivated management team, it posed as a strong candidate for a leveraged buy-out
Evaluation of the original BW/IP International LBO using FCFE
With the help of C&D, Mr. Valli and his team reached a deal for the buyout proposal in May of 1987. The deal amounted to $251.5 million, from which $20 million was issued in new equity and the rest was a mixture between bank debt, subordinated debentures, and junior subordinated debentures. Hence, this was a highly levered transaction.
To compute the Net Present Value of the investment for the equity holders, using the Free Cash Flow to Equity (FCFE) method allow us to easily value highly levered equity claims. In order to implement the FCFE, we make the following assumptions:
- Growth Rate: We assume that after our forecasted cash flow, BW/IP will, in the long run, grow at the same pace as the global US economy. Therefore, we set the growth rate at 3.6%, which is the historical average between 1961 and 1986.
- Risk-Free Rate: The risk-free rate is taken from exhibit 7 and set at the week-ending 10-year treasury bond at the time of the transaction (20/05/1987).
- Market Risk Premium: The market risk premium is unobservable but varies around 5%. The long-term arithmetic average of the S&P 500 is used as a proxy to reach 5%.
- Interest Payments: The interest payments are assumed to remain at the 1993 level until perpetuity.
- Tax Rate: From the forecasted cash flows in Exhibit 3A, we find that BW/IP is expected to pay a 38% tax rate. The tax rate is derived by dividing income taxes by earnings before tax from the exhibits.
Beta: As given in the case questions, we set the beta at 1 .6
By using the forecasted cash flows until 1993, we were able to compute the amount of the principal BW/IP International is planning to pay back to the lenders. We assumed that all positive cash flows during those first 7 years are only used to reduce the debt amount.
Terminal value requires some additional assumptions. As for standard valuations, we assume the difference between the depreciation and the change in net working capital to be zero. Moreover, the capital expenditures level of the year 1993 is assumed to continue until perpetuity.
To get the FCFE, we assumed the earnings before taxes (EBIT) to grow at 3.6%2 until eternity and added the constant interest payment. By using the Gordon growth formula and subtracting the outstanding debt in the year 1993, we find a terminal value of equity to be $389.04 million.
To estimate the value of equity at the closing of the transactions, we follow a backward approach by discounting the terminal value in 1993 by the appropriate cost of equity. Once we have discounted the TV from 1993 into 1992 standards, we compute the new debt and equity level to adapt the levered beta and cost of equity.
This approach is repeated until 1987 when we found a value of equity at the closing of $87.08 million. By subtracting the initial amount invested of $20 million, we find a positive Net Present Value (NPV) of $67.08 million.
The exact computation and assumptions can be seen in exhibit 1.
Non-Zero Debt Beta and its Impact
The assumption of risk-free debt (debt beta equal to 0) causes us to overestimate the equity beta. The debt payment is not without risks, as the company could default and only pay a fraction of the interest and principal payment promised. This risk would then reduce the expected cash flows compared to the promised cash flows of the previous question.
Due to this underestimation, the equity value will systematically be underestimated, and the expected terminal value overestimated. The various closing value of equity is illustrated in the graph below for different debt beta levels. The reader can identify a positive trend between the debt beta and the equity value, as with a higher debt beta the risk will be spread amongst debt and equity holders.
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