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"Cooper Industries, Inc." case study seeks to answer whether the executive president of a major industrial company should acquire a small company and how much would the value of such acquisition be.
Thomas R. Piper
Harvard Business Review (274116-PDF-ENG)
December 01, 1973
Case questions answered:
- If you were Mr. Cizik of Cooper Industries, would you try to gain control of Nicholson File Company in May 1972? What makes the target an attractive candidate for Cooper?
- What is the maximum price that Cooper can afford to pay for Nicholson and still keep the acquisition attractive from the standpoint of Cooper’s shareholders? Do a DCF valuation of Nicholson, using a WACC of 9 %. How should you think about potential synergies?
- What is the minimum price that Nicholson’s shareholders are willing to accept to sell the company? Assuming that the Cash Flows remain the same, how much does the WACC have to change in order to obtain the maximum price that Cooper is willing to pay? Provide a sensitivity analysis with respect to the WACC.
- How should Cooper pay for Nicholson – stock or cash? What exchange ratio can Cooper offer before the transaction has a dilutive effect on Cooper’s earnings per share (EPS)? Is it important to consider EPS? Why(not)?
- What are the concerns and what is the bargaining position of each group of Nicholson stockholders? What must Cooper offer different shareholders in order to acquire their shares? Discuss briefly how Cooper can control for the free-rider problem. Which methods (e.g. conditional offer on 51% of the voting rights) could Nicholson use to mitigate such a problem?
- Assume that on March 2, the day before Porter’s offer, Cooper stock closed at $22 and Nicholson stock at $30. Moreover, assume that Cooper on the evening of May 3 offers Nicholson shareholders an exchange ratio of 2:1 (i.e.2 Cooper shares per Nicholson share). The next day, Cooper stock closes at $25 and Nicholson stock at $45.What are the minimum synergies required for this offer to make sense for Cooper’s shareholders? What is the market’s consensus opinion on the probability that the deal will close and the size of the synergies that a merger between the two firms could create?
- What should Mr. Cizik recommend that the Cooper management do?
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Case answers for Cooper Industries, Inc.
This case solution includes an Excel file with calculations.
Executive Summary – Cooper Industries, Inc.
Cooper Industries, Inc. started out in 1919 and, by the middle of the twentieth century, had become the market leader in the manufacturing industry of heavy equipment and engines. However, the industry was highly cyclical and therefore the company wanted to diversify its business risks and explored the idea of growing through acquisitions.
Cooper Industries has been trying to acquire the Nicholson File company for the past three years. The expansion policy of Cooper focuses on acquiring the industry leaders in their respective markets who would strategically be in line with the current operations and aspirations of Cooper Industries.
However, there are other companies (H.K. Porter and VLN Corporation) who are interested in the acquisition of Nicholson. The cash offer from H.K. Porter wasn’t in line with Nicholson management’s endeavors and the offer from VLN did please the management and the Nicholson family but couldn’t get enough support from major stockholders.
The difference in the valuation of Nicholson in the situations that the company continues to operate as a stand-alone firm. And that the company is acquired by Cooper revealed that high synergies would be generated from the merger attributing to higher sales and cost-cutting by better management of business activities in the firm.
For the acquisition to seem attractive to the shareholders of both firms, the offered share price should be between the pre-merger and post-merger share price of Nicholson which is $25 and $64 respectively. The sensitivity analysis points out that the synergies generated by the merger ($38 per share) would not be achieved by Nicholson alone at any point in time since the cost of capital to attain is practically impossible. Therefore, a merger makes economic sense and a wise decision to pursue.
This would then raise the basic question of financing and we believe that using just stock or cash as a form of method is a simplistic approach since the transaction with just share issues would not help with the market performance of the stock which has been declining over the past few months. However, most of the major shareholders of Nicholson (the family and management, Porter) want a tax-free swap of shares so as to avoid immediate tax liability they would have in case of cash transactions.
Cooper also cannot finance all of it through by raising cash through new debt issue since it would not be what the management and other key shareholders want; more so that raising such high levels of debt will greatly affect their market leverage ratio and which might also lead to a downgrading of their credit rating. A solution is to use a combination of stocks and any convertible security or other financial instruments.
The announcement of a simple stock swap with an exchange ratio of 2:1 by Cooper and its effect on the stock price reflects the probability of how the market would perceive the transaction going forward. There is a 63% probability of the acquisition being completed and there are expected synergies of $34 million in the case Cooper acquires Nicholson completely or $33 million if they just move for a majority stake in the firm.
These expected synergies will be shared in the ratio of the shareholding in the merged company (NewCo) and Cooper’s share in both scenarios would be $20 million approximately. Moreover, the minimum synergies for the transaction to not destroy value for Cooper’s shareholders would be $8.2 million if they move for complete ownership and $7.8 million in the case if they only seek a simple majority.
The findings lead us to the conclusion that Cooper should move to seek ownership and the majority stake in Nicholson as Nicholson’s stock is undervalued and there is the serious capability to raise their revenues to industry averages and reduce costs at the same time turning this into an extremely profitable business. Cooper will also reach new customers and international markets by using Nicholson’s sales and distribution network. Mr. Cizik and the management of Cooper should move for control of Nicholson.
Cooper Industries has been the leading manufacturer of engines and heavy equipment in the mid-1950s but several unsuccessful acquisitions between 1959 and 1966 left the firm sensitive to developments in financial conditions. A new acquisition strategy was developed in 1966. The strategy was to focus on targets with stable businesses, leaders in respective markets, and restrict the diversification of the firm to a few distinctive sectors. In the quest of acquiring a hand tool business company, Nicholson; an offer was sent out to the target firm in 1969.
Nicholson File company was run by the Nicholson family. Even though the company was the biggest hand tools manufacturer; low annual growth rate, poor sales, depreciating stock investor’s interest and a very conservative style of management was one of the many reasons the company was not performing well over the years. On the other side of the spectrum, Nicholson was one of the known business leaders with less risk. Nicholson’s business was in line with the business aspirations of Cooper industries.
Nicholson would be an attractive candidate as an acquisition now as their stock is performing poorly, their costs have increased a lot when compared with the industry peers. Moreover, the product lines of Cooper Industries would be broadened with the Nicholson’s hand tool products. The Cooper industrial consumer market would serve well with Nicholson’s strong distribution system present in Europe and by efficiently working upon the manufacturing and inventory mismanagement system.
Cooper would have highly benefited from the low-risk diversification to make the business more profitable. They have been successful in the recent past by pursuing their acquisition policy and have been able to integrate them with their firm. So, our recommendation would be that Mr. Cizik should move to gain control of Nicholson as it would be a great strategic fit.
Now that we have decided to move and make an offer, we need to value the company as of now and the projections after the proposed changes have taken place in order to value the synergies and calculate the price that Mr. Cizik and Cooper can offer to Nicholson shareholders. The valuation reflected in appendices reveals that the current value of the company with discounted cash flow projections using a 9% cost of capital (WACC) suggests that the value of Nicholson is less than their book which is also indicated on their current stock market performance. This considers that no changes take place in the operations of the firm (no cost-cutting, same growth rate).
However, if we are to compare this with a valuation with proposed changes from Cooper in a couple of years and grow the firm equal to that of other firms in the industry, we see that the numbers in the valuation of Nicholson show high synergies.
The acquisition would create positive synergies both in the business as well as the financial dimensions of Cooper industries. The maximum price that Cooper may pay and keep the acquisition still attractive is $64 per share along with the inventory reductions (approximately $12 per share) and subsequently deducting the transaction costs that would be incurred. The total synergies created would be $23 million or $38 per share which primarily comes from increased sales growth and reduced costs.
Nicholson should be willing to accept anything above $26 per share which is the mid-year 1972 share price valuation for Nicholson under the given assumptions. However, the main assumption, in this case, is that Nicholson’s cost of capital is 9% and there is no way to check if that is the case. The value for Beta and the cost of debt is missing from the information to come to a substantive conclusion about their cost of capital. These synergy values and the maximum price that can be offered will change depending upon the change in the rate we use as the cost of capital.
The sensitivity analysis on WACC as shown in the graph below tells us that for Nicholson to get its share price to as high as $64 on its own without any merger or acquisition, the cost of capital would have to be 1.5% which is an impossible number to achieve for any firm. So, there is no way that Nicholson can have its share price equal to the maximum price offered by Cooper. Therefore, an acquisition by Cooper seems to be the decision that should be taken by its management in order to safeguard the interests of the shareholders.
We have seen the benefits of the transaction and how this will add value for Cooper in the long run as well as fit their strategy of growing through acquisitions. The major question to answer now is how they would like to carry out this transaction. Do they want to offer stocks or want to pay with cash in full? One of the most used methods of payments in mergers and acquisitions is a combination of both. We have seen that Cooper wanted to have an…
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