Carborundum acquisition - Sample Essay
I prepared my answers by myself before discussing the case with anyone else. I only consulted other members of this class and this work is my own. Why did Kennecott buy Peabody? Was the acquisition successful in achieving its goals? Does the experience with Peabody have any bearing on the Carborundum acquisition? Kennecott purchased Peabody for two primary reasons, 1) to moderate the wide swings in Kennecott’s profitability created by sharp changes in copper prices and sales, and 2) to provide Kennecott with significant future investment opportunities outside the copper industry.
The acquisition was not successful in achieving these goals. Kennecott’s profits in the years following the acquisition were more erratic than they had been prior to the acquisition, partially due to Peabody’s unexpectedly poor earnings.  In particular, rather than using Peabody to smooth out profits, Kennecott contributed $532M to Peapody’s capital and allowed it to keep all of its net income. Moreover, the Peapody acquisition did not help Kennecott achieve its second goal of providing future investment opportunities outside the copper industry.
Kennecott was forced to divest the acquisition just 6 years after the acquisition took place, removing any long-term investment prospects owning Peapody might provide. Therefore, the Peapody acquisition was not successful in achieving either of its primary goals. Additionally, the acquisition and sale was not very profitable. Kennecott invested $285M in cash, assumed liabilities of $36. 5M, and put in $582M in additional capital (~$900M) and received cash and notes worth only $960M at divestiture. This experience does have a bearing on the Carborundum acquisition.
First, Kennecott learned about the threat posed by the FTC in challenging acquisitions on antitrust grounds. Despite Kennecott’s hiring of good lawyers who believed the deal was legitimate, the Peabody acquisition failed to survive the FTC’s antitrust action because it was believed that the merger would loosen competition in the coal industry. Therefore, Kennecott learned that there was legal risk and cost to going down an acquisition strategy and it could apply this knowledge to the Carborundum acquisition. Second, they learned that Pea
What options did Kennecott have for the use of the Peabody sale proceeds? What do you think of management’s choice of the Carborundum acquisition? What choice should it have made? Kennecott had a number of options for using the Peapody sale proceeds including 1) making additional capital investments in the copper business, 2) diversity the firm’s assets through an acquisition (small $0-100M, medium $100-400M, or large $400-600M), 3) provide a special dividend to shareholders, 4) repurchase existing shares, or 5) pay off some of its long-term debt.
I believe management’s choice of the Carborundum acquisition was poor. As I will show below, Carborundum was not a good deal at $66/share. The deal was dilutive at any price above $53/share as an APV analysis suggests that Carborundum was only worth $428M, not $66*8 = $528M. Therefore, I believe Kennecott management made a mistake. They could have continued to look for other acquisition targets in which there wasn’t a bidding war. Alternatively, they could have used the proceeds of the Peapody sale to pay off some of its long-term debt to reduce the risk of financial distress.
This would be incredibly important in this business given their volatile earnings numbers. They have a higher risk of defaulting with that amount of long-term debt and it would have been prudent to use this money to pay that debt off rather than enter into a dilutive deal to purchase Carborundum. What is the top price (per share) that Kennecott should pay for Carborundum? (Show calculations) The top price per share that Kennecott should pay is $53/share at a valuation of $428M.
Details on this calculation are found below. What Cashflows are being discounted in Exhibit 7? What cashflows should be discounted? First Boston is Discounting the Wrong Cashflows It appears as though First Boston is discounting the wrong set of cash flows in their analysis. The cash flows to Kennecott listed in Exhibit 7 do not reflect that free cash flow. Rather, it subtracts out the profit retentions that Corborundum will keep to support its growth even though Kennecott will own 100% of the equity in Carborundum.
Additionally, to get to the FCF that should be used in an APV analysis, one must take Net Income and add back tax-adjusted interest expense minus interest income, add back depreciation and add back goodwill. Additionally, change in networking capital should be removed and capital expenditures should be subtracted. Therefore, the cashflows being discounted are inappropriate. For example, if you take the share price that First Boston thought they could justify of $85 and multiply by the 8M outstanding shares, you get a market capitalization of $680M.
If you discount the cashflows from Exhibit 7 using a discount rate of 10% (another First Boston assumption), then you get $679M. Therefore, it appears that their entire analysis is based on a false set of cashflows and a flawed DCF analysis. How to get from the cashflows in Exhibit 7 to the cashflows you actually want to discount To value Carborundum using the APV method requires calculating free cash flow to an all equity firm. Since Exhibit 7 does not have EBIT, we must use the formula for calculating FCF that uses Net Income.
FCF = Net Income + (Interest Expense – Interest Income)*(1-Tc) + Depreciation + Goodwill – Capital Expendiures – Increase in Working Capital + Tax-loss Carryforwards Goodwill and Depreciation – goodwill is added back because it is amortized over 40 years and acts similar to depreciation in that it is a non-cash expense that reduces net income but does not reduce free cash. Increase in Net working Capital: increase in networking capital means that the ratio of current assets/current liabilities is getting larger.
This suggests that more cash is being wrapped up in receivables and inventory rather than cold, hard cash. Therefore, these increases must be removed from net income in this calculation. Tax-loss carryforwards: the tax loss carryforwards are also added back to cash flow because they are a form of cash flow that is relevant for an all equity firm and are not included in the other cash flows. Which unlevering formula?
To calculate the appropriate discount rate, we can use rUe = rf + ? U(rm – rf) where rUe is the appropriate discount rate for an all equity firm, U is the unlevered (or asset) beta for the firm, and rm – rf is the market premium over the riskfree rate. To use this equation requires calculating ? U. However, there are two common unlevering formulas, one in which debt is set proportionally to equity so that the company continuously rebalances, and the other which assumes perpetual constant debt. In this case, Carborundum projects a relatively constant debt from 1977 to 1982 between $83. 4M and $91. 7M. Using Carborundum’s estimates in Exhibit 5, therefore, we would use the following unlevering formula.