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 question answered in the second solution:
- What is Pinkerton worth to CPP (Wathen’s sole proprietorship)? What should Tom’s bid be?
Case study questions answered in the third solution:
- Estimate the value of Pinkerton’s to Wathen. Use a discounted cash flow approach (not multiples). The case presents forecasts for the “expected” scenario as well as for a “pessimistic” scenario. Use the “expected” scenario to forecast expected cash flows. Assume that the cost of unlevered equity is 15%.
- Suppose Wathen proceeds with the acquisition of Pinkerton’s. Which financing alternative do you recommend? Explain why and provide the necessary calculations to back up your recommendation.
Note: if your valuation for Pinkerton’s is below $100 million, assume American Brands will lower the price. In other words, irrespective of your answer to question #1, address this question too.
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Pinkerton (A) Case Answers
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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 your 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 a 45% stake of the 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 the expected scenario and 9.50% in the 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 the 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 from $88.6M to $115.5M.
The second option of $100M debt would generate a $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…
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