Case summary: MRC, Inc. is a Cleveland based manufacturing company specialized in power brake systems for trucks, buses, and automobiles; industrial furnaces and heat treating equipment; and automobile, truck and bus frames. As till 1957 most of MRC’s sales were made to less than a dozen large companies in the automotive industry, it was exposed to the risk inherent in selling to a few customers in a very cyclical and competitive market. To minimize the risk and to explore new business opportunity MRC’s management decided to diversify their business operation.
After their fifth successful acquisition, the CEO of MRC Archibald Brinton faced with a dilemma of whether to buy American Rayon, Inc. Topics which are covered in this case are: Capital budgeting: in short capital budgeting is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. In our case Acquisition of ARI was a major capital budgeting decision for the MRC management.
Many formal methods are used in capital budgeting, including the techniques such as • Accounting rate of return • Net present value • Profitability index • Internal rate of return • Modified internal rate of return • Equivalent annuity Here in our case, we have used Net Present Value or NPV, which is estimating the size and timing of all the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV.
The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV. Diversification: Diversification is a form of corporate strategy for a company. It seeks to increase profitability through greater sales volume obtained from new products and new markets. Diversification can occur either at the business unit level or at the corporate level. At the business unit level, it is most likely to expand into a new segment of an industry that the business is already in.
At the corporate level, it is generally entering a promising business outside of the scope of the existing business unit. In our case, the managements was actively pursuing a diversification strategy to minimize the risk of selling goods to few customers. Product planning: Product planning plays a major role in the later part of our case. Product planning is a process used to identify and develop new products. The purpose of planning is to make choices about which product ideas a company should invest in. Companies can approach product planning from a number of different perspectives.
Having a system in place before planning begins is important as it helps to avoid wasted time and creates a framework for decision making. Consultants who specialize in marketing and corporate decision making can be involved in the development of a product planning system for a company, which will accommodate the company’s approach to business while helping it avoid expensive dead ends. So, once MRC acquired ARI it will require a great deal of assets invested in product planning for a successful reemerge from the drowning rayon business. Q1. What are the key elements of MRC, Inc. s corporate strategy? Ans: Corporate Strategy is about enabling an organization to achieve and sustain superior overall performance and returns. It is a core responsibility of senior executives and encompasses a range of critical activities, from defining and refining corporate vision to strategic performance measurement and management. Upon becoming the CEO in 1957, Mr. Brinton had begun an active program of diversification by acquisition. So therefore “diversification” was the way forward for MRC. The acquisition strategy was intended to: • Achieve related diversification. Stabilize earnings and cash flow. • Lessen the vulnerability of doing business in a single industry. • To release growth prospects from the cyclical and unexciting automotive industry. • Reduce the threat of backward integration by one or more major customers. After several failed attempt of internal diversification, they realized the lack of knowledge of their management about businesses outside the automotive area. so acquisition brought them quick fix where it brought already knowledgeable people in respective areas in their payroll.
By the end of 1960 the diversification campaign had resulted in five acquisitions, two of which were major transactions. |Year |Company | |December 1957 |J. O. Ross Engineering Corp. | |March 1958 |Hartig Engine and Machine Co. | |October 1958 |Transportation Division of Consolidated Metal Products Corp. | |April 1959 |Nelson Metal Products Co. | |November 1959 |Surface Combustion Corp. | Q2.
Would MRC’s strategic interest be advanced by the acquisition of American Rayon, Inc. (ARI)? If so, How? Ans: ARI Background American Rayon, Inc. , was the third largest producer of rayon in the United States. By early 1961 the company’s stock was trading at less than half of its book value. ARI became attractive to raiders with its new found profitability, along with its great liquidity and a disenchanted shareholder group. So the management was seeking to arrange a marriage with a congenial partner. So ARI was brought into attention of Archibald Brinton, who had expressed tentative interest in a deal.
Acquisition Investigation MRC’s investigation results were mixed. We have highlighted some of the major positives and setbacks found in the investigation. Advantages: • ARI had over $20 million in liquid assets that were not needed for operations. • They had a modern manufacturing facility. • No short or long term debt. • The president of ARI was willing to stay for two years after the acquisition, to give MRC personnel the chance to learn the business. Disadvantages: • From the early 1950s rayon began to falter as competing synthetics became popular. ARI faced earning difficulties with a shrinking industry. • The medium to long term future held continuing decline and eventual liquidation for ARI. • Acquiring ARI might entangle MRC in a dying business. • MRCs management lacked the technical know-how to contribute to the profitability of ARI. So, in a way, acquiring ARI might seem it will help MRC to diversify its operation, but as the sector ARI specialize on, is already dying so, the only benefit MRC might get is from the excess funds ARI is holding in forms of govt. securities. ith this excess funds ARI can fuel their diversification drive in more prosperous sectors which will have lower business risk and stable cash flows.. Q3. Should MRC acquire ARI at the price now available? In answering this question, consider (at least) the following two alternatives frameworks: • Valuation based on projected cash flows, using a discount rate of 15%; • A situation where MRC must liquidate ARI immediately. Ans. We know, business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business.
Valuation is usually used by financial market participants to determine the price they are willing to pay or receive to acquire a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes. One of the most common used methods of valuation of a business is “Discounted Cash Flow method”.
This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i. e. , the present value). This concept of discounting future money is commonly known as the time value of money. For instance, an asset that matures and pays $1 in one year is worth less than $1 today. The size of the discount is based on an opportunity cost of capital and it is expressed as a percentage. Some people call this percentage a discount rate. In finance theory, the amount of the opportunity cost is based on a relation between the risk and return of some sort of investment.
Classic economic theory maintains that people are rational and averse to risk. They, therefore, need an incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets.
Next, one makes a calculation to compute the present value of the future cash flows. To find out how much MRC should pay for American Rayon, we need to find the present value of its future cash flows as of 1960. For that we need the forecasted free operating cash flows during forecast horizon. Estimate the cost of capital, which will be equal to discount rate or weighted average cost of capital. Estimate continuing value which is the value after the forecast period. Discount all values at present at 1960. [pic]
We can get the projected sales for ARI for 1961-1967 from Exhibit 6, which remain at $55million for the first three year and then gradually started to decline. For this reason the profit margin in 1960 was 8. 8%, 1961-963 it became 9. 8% and then it steadily declines. Earning before Interest and taxes values are also given in exhibit 6. |Year |1961 |1962 |1963 |1964 |1965 |1966 |1967 | |Sales | 55,000,000 | 55,000,000 | 55,000,000 | 52,000,000 | 48,000,000 | 42,600,000 | 40,070,000 |
Another interesting aspect of this case was ARI’s EBIT was the same as Earnings before taxes, it was mainly because the absence of debt financing in ARI’s capital structure. The Tax rate is given at 48%. As depreciation does not create any real outflow of cash, we have to add it to find the operating cash flow for ARI. |Year |1961 |1962 |1963 |1964 |1965 |1966 |1967 | |Operating Cash Flow | 5,517,000 | 5,803,000 | 5,803,000 | 4,893,000 | 4,416,000 | 3,997,000 | 3,437,000 |
As we can only find the working capital requirements for the year 1960 from the given data, we assume the ratio of WCR/Sales will remain the same between years 1961-1967. [pic]From Exhibit for we find that the current assets of ARI is around $45million and the Current liability is around $4million. that leaves us with around $40 million. but in it’s balance sheet ARI stated that it has $20million of U. S. government securities. As this amount is not directly involved in generating cash flow for the business, we deduct this amount from the remaining $40million. o for 1960 we get the following numbers: [pic] By dividing 1960’s WCR by Sales figure we get 0. 39 or 39%. We will assume that this number will remain the same throughout the period of 1961-967 for ARI. To compute the WCR for these periods we will be multiplying the forecasted sales number with the WCR/Sales ratio. After calculating the working capital requirements, we need to find the changes in WRC. This can be achieved by subtracting current year’s WCR from Previous Year’s. it was also given in the case that the capital expenditure will be remain at $300 thousand for every year.
This gives us the below figure: |Year |1961 | |PV of Terminal Value | 7,732,267 | |value of excess cash | 20,024,000 | |Total value for the company | 50,066,965 | We have to add back the Govt. securities of $20 million we have deducted from WCR, as they are equivalent to cash. That gives us ARI’s present value at $50. 1million. In another scenario, we are assuming that the MRC’s management decided to buy ARI and will not continue its operation.
They will liquidate the company’s assets at zero net scrap value and get a tax benefit over the loss amounted from the book value of ARI’s fixed assets. As we have previously calculated the working capital requirements for ARI’s in 1960 was around $21million. For writing off their fixed asset at zero value they received a 48% tax benefit which equals to $11. 4million. they also have cash equivalent U. S. govt. securities valuing at $20million. MRC will receive all these amounts if they liquidate the ARI immediately without continuing its operation.
Total value sums up at around $52. 7million *Details calculations has been shown in Appendix 1 Q4. What is the impact of ARI acquisition on MRC’s E. P. S.? Ans: Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio. E. P. S. calculates the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability.
When calculating, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period. [pic] We get the total earnings for MRC and ARI for 1960 which are $3. 9million and $2. 5million respectively from exhibit 1 and 3. From Exhibit 7 we find the total number of outstanding shares. only MRC has to pay preferred dividend of $760thousands.
Following the formula of E. P. S we can calculate the current E. P. S of MRC at $1. 16 and ARI at $1. 35, which can be checked with the value from Exhibit 3 and 7. For the after acquisition scenario, we have to find the new share MRC has to issue to buy ARI at current asking price at $40million. as MRC’s shares are currently trading at $14. 5. the company has to issue over 2. 7million of new shares to pay off the shareholders of ARI. with this new share and existing 2. 7million shares, MRC will have a total number of share of 5. 4million.
As ARI is being acquired by MRC the total earnings of ARI will be added with the total earnings of MRC, which will make the total of $6. 4million. MRC still has to pay that $760,000 preferred dividend. Deducting that amount from the total net earnings and divided that by MRC’s total number of shares of 5. 4million gives us the new earnings per share of $1. 03. Which is lower both form MRC and ARI’s separate EPS. AS EPS is one of the major determinants of a company’s share value and low EPS will surely push down MRC’s share value downward and that in affect will lower the company value. o, the aim for stakeholder is to maximize the value they invested on, acquiring ARI may add some profitability in the financial statements in short term but in a broader scenario it will eventually cause the company’s value to decline. Q5. Is MRC’s management control system well suited handle ARI? Management Structure As the diversification program carried MRC into wider markets and technologies, the existing highly centralized decision making process became inappropriate for MRC management.
So by the end of 1959 MRC diversified to a highly decentralized management structure, which transferred substantial decision-making power to division managers. But Mr. Brinton felt that he could exercise adequate control over the decentralized organization through his power to hire and fire at the division manger level and more importantly through control of the elaborate capital budgeting system. So acquiring a company like ARI initially may cause some mismanagement in the part of MRC, but eventually with MRCs decentralized management structure ARI could be controlled properly.
So for a diversified business like ARI the decentralized management structure of MRC is quite appropriate. Conclusion & Recommendation: With all the information presented above we can clearly say that there are certain opportunities & some drawbacks for MRC in the acquisition of ARI. To succeed in business risks are to be taken. We think at a current asking price of $40 million, it will be profitable of MRC to acquire ARI. But considering both scenarios, if they continue ARI’s business operation, it will push them in the uncertainty of a dying rayon business.
Even though this scenario has a discounted net present value of $50million, we will recommend the immediate liquidation of the company. because, if we follow the immediate liquidation strategy, then MRC will have their much needed cash injection in their capital structure, which have suffered from the quick succession of five acquisition. Liquidation also will minimize the business risk and future uncertainty in rayon business, and the excess cash of gained from this venture can be better and more efficiently utilized in any other promising business sector, where MRC has a better chance of prospering.
The Outcome of the ARI Acquisition Decision MRC acquired ARI in 1961 at the price indicated in the case. The transaction was accounted for as a “pooling of interests,” thereby adding $25. 2 million more to MRC’s net worth than would have been the case under “purchase” accounting. Instead of slowly liquidating ARI through the mid-1960s, by 1966 MRC was drawn into a $30+ million investment at ARI for facilities designed to produce a new-generation fibre (polyester).
One reason for continuing in the fibre business beyond the mid-1960s may have been MRC’s reluctance to take the large write-off that could have been avoided if the acquisition of ARI had originally been treated as a purchase for accounting purposes. While MRC invested a huge amount of capital in ARI’s polyester plant, the plant was still too small to be cost-competitive with plants four times as large, which were built by other fibre competitors such as Du Pont. MRC struggles along in the polyester business for several years.
Finally, in 1969, MRC sold ARI, absorbing a book loss of nearly $12 million before tax offsets. ARI was purchased by American Cyanamid, a firm that basically repeated MRC’s experience, albeit on a smaller scale. ARI was acquired by American Cyanamid for $20 million in cash and notes on December 31, 1969. In 1970, the new owner invested $10 million to increase polyester production at ARI. By mid-1972, ARI discounted rayon polyester as well, taking a large write-off and ending the business of ARI. ———————– EBIT (1-TC) + Depreciation – Net capital expenditures Increase in working capital requirements __________________________________ Free Cash Flow WCR = Current Assets – Current Liabilities |(+) Current Asset | $45,190,000 | |(-) Current Liabilty | $ 4,008,000 | |(-) US Govt Securities [as it doesn’t create any future cash flow] | $20,024,000 | |WCR for 1960 | $21,158,000 | EPS = (Total earnings-Preferred Dividend)/no. share outstanding