A California based security guard firm (CPP) considers the purchase of a similar company (Pinkerton). Key issues are the value of the target firm as well as the financing of the potential acquisition.
Scott P. Mason; Adam S. Berger
Harvard Business Review (291051-PDF-ENG)
May 08, 1991
Case questions answered:
Case study questions answered in the first solution:
- How can Wathen justify a $100 million bid for Pinkerton’s? Did the $85 million bid two weeks earlier make sense? What issues are involved in the bidding strategy for buying Pinkerton’s from American Brands?
- If Wathen proceeds with a $100 million bid for Pinkerton’s, which financing alternative should he choose? Why?
- How should Wathen respond to Morgan Stanley?
Case study questions answered in the second solution:
- What is Pinkerton worth to CPP (Wathen’s sole proprietorship)? What should Tom’s bid be?
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Case answers for Pinkerton (A)
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To: Mr. Tom Wathen, CEO of California Plant Protection (CPP) Re: Acquisition Bid of Pinkerton and Financing Options
Our team has re-evaluated the $100 million bid for Pinkerton proposed by Morgan Stanley (on behalf of American Brands). Although the price tag is near the high end of valuation based on optimistic assumptions of synergy outcomes, the financing terms are attractive and in the best interest of yourself to maximize CPP’s current value and compete as the industry leader after acquisition.
Our recommendation is to respond to Morgan Stanley with a $100 million offer sheet for Pinkerton and receive $75M debt funding and a $25M equity injection (for 45% stake of combined company) from the investment firm.
We first conducted a discounted cash flow valuation of Pinkerton as a standalone entity based on two scenarios: expected management improvements (Exhibit 1) and pessimistic operation assumptions (Exhibit 2), where the key differences are gross profit margin improvement (up to 10.25% in expected scenario and 9.50% in pessimistic scenario) and networking capital reduction (decrease to 6.20% vs. maintain status quo of 9.50%).
Then we added the present value of potential synergies with CPP, which is to be generated by CPP’s gross margin improvement, to the expected scenario. Other assumptions include a cost of unlevered equity of 15%1 and perpetual cash flow growth of 5% for Pinkerton. The valuations can be summarized in the following table:
CPP’s last bid of $85 million is well in the reasonable range for Pinkerton. Although a $100 million bid is slightly above the high end of the valuation, $97.6M, in the eyes of CPP, we still recommend proceeding because the financing terms are enticing in terms of tax shield.
A $75M debt would generate approximately $25.5M present value to the combined firm assuming a tax rate of 34%, increasing Pinkerton’s valuation range to $88.6M to $115.5M.
The second option of $100M debt would generate $34M PV in tax shield. However, taking such a high level doesn’t come without risk, specifically negative cash flow issues. We have to ensure the combined entity has enough cash flow to pay back debt services for the next seven years until a potential exit sale or debt reclassification.
Exhibit 3 shows the pro forma cash flows post-merger with two debt financing options. Clearly, CPP-Pinkerton will run into trouble with a…