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Flinder Valves And Controls Case Study Solution Report

Unformatted text preview: Contents: 1. Description and goals of the case 2. Questions you must answer in your report 3. Appendix 1: Confidential Supplementary Information for Management of Flinder Valves and Controls 4. Appendix 2: Confidential Supplementary Information for Management of RSE International 5. Supplemental Technical Note: Valuation and Merger Negotiation Case 43: FLINDER Valves and Controls Inc. Description and goals Set in May 2008, this case reflects the separate perspectives of chief executive officers Tom Eliot and Bill Flinder as they approach the negotiations of RSE International Corporation to acquire Flinder Valves and Controls Inc. Your task is to complete a valuation analysis of the target and buyer and to negotiate a price and exchange ratio with the counterparty. The case has the following goals: Exercise valuation skills: The case affords opportunities for valuation based on discounted cash flow, comparable transaction multiples, and current market prices. Also included are such valuation details as options and contingent interests, operating synergies, gains from horizontal expansion, and the need to satisfy various stakeholders. ● Illustrate practical concerns about mergers and acquisitions: Additional questions the buyers and sellers face include setting the exchange ratio of shares, tax exposure, dilution, and voting power. Questions for your report: 1. Using the case and the supplementary data in Appendices 1 and 2, how do you see FVC’s situation? What are the strengths and weaknesses of FVC and RSE? Why should the two companies want to negotiate? 2. What is FVC worth? What are the key value drivers? 3. What opening price do you think Flinder should offer to sell the company to RSE? At what price should he walk away from the negotiation? How did you estimate those values? 4. Do you recommend that RSE pays in cash or stock? If stock, what exchange ratio do you recommend? In a merger there are two parties with asymmetric information, that is, when they come to the negotiation table one party has information the other party does not and vice versa. For example, top management has better information about the strengths and weaknesses of the firm, knows about major structural changes in the firm, or is knowledgeable about a major expansion of the firm into new foreign markets. The information in appendices 1 and 2 reflects the type of information only the top management of firm posses. Use it for your analysis. Appendix 1 FLINDER VALVES AND CONTROLS INC. Confidential Supplementary Information for Management of Flinder Valves and Controls As Bill Flinder neared retirement, the idea of selling FVC to a bigger firm seemed almost necessary. He had a good top-management team, but he didn’t think any one of them could step in and run the show alone. He found stability in the RSE International combination that was worth something to him. In the increasingly global market place with more costly development, FVC needed a deep-pocketed partner to expand and to bankroll more research. Flinder believed that the company would also benefit from gaining access to a large marketing and distribution network. As the company continued to grow, it would need to gain production know-how for high-volume manufacturing. Flinder Valves did not have this kind of expertise. Finally, there had been an increasing trend of consolidation in Flinder Valves’ industry over the last year. Flinder feared that without a well-financed partner, the company would be swamped by competition. He was intrigued with the possibility that Flinder Valves might be more fully valued if it were part of a larger, more diversified enterprise. Thus, when the merger opportunity with RSE International Corporation came along in 2007, Flinder determined to make it work as best as he could. Flinder believed that FVC had alternatives to this deal. Rockheed-Marlin Corporation, a large defense contractor (or any of a number of others), might be induced to make an offer for Flinder Valves, though Flinder preferred RSE International Corporation as a merger partner. FVC and RSE might establish a joint venture of some sort, though Flinder suspected that joint ventures faced the same kinds of integration problems as did acquisitions; as a result, he thought joint ventures were an inferior alternative. FVC could move forward alone, but that would require raising large sums of new debt and equity to finance the rapid expansion of the firm’s “widening gyre” program. Flinder was concerned that he might lose voting control of the firm regardless. It seemed to him that doing a deal with a known and friendly partner today would prepare the way for an orderly transition for himself and the firm. Flinder expected the merger to generate significant cost gains. RSE’s greater purchasing power would lower the cost of materials and components for FVC. RSE’s new resource-management system could be expected to reduce FVC’s in-process costs. Estimates from FVC’s accounting group had identified pretax constant-dollar cost savings of $2 million in the first year of operation and $4 million thereafter. He also recognized other synergy gains that arose from RSE’s stronger marketing clout, crossselling with other RSE products, and its deep financial pockets. He believed that the widening-gyre project could have a broad application in nautical, aerospace, and automotive products. Based on the investment required to bring such technology to market, he estimated the economic value at between $10 and $18 million Bill Flinder had known Tom Eliot for several years, having been introduced at an industry conference where they were both speakers. As founders and significant stockholders in their respective firms, they liked and respected each other. Flinder hoped that RSE would recognize the fair value of his company. Appendix 2 FLINDER VALVES AND CONTROLS INC. Confidential Supplementary Information for Management of RSE International Flinder Valves was the first among several potential targets identified by Catherine MacAvity, RSE’s vice president of Business Development, and the architect of the acquisition program. Eliot approved the choice and believed a smooth and successful acquisition of FVC was critical to RSE’s expansion plans. Recent news in the U.S. credit markets had been grim. MacAvity worried that the news in the financial markets might chill the ongoing talks. If the merger fell through after going this far, Eliot feared his board might become discouraged. On the other hand, if FVC was acquired at too high a price or failed to produce adequate returns, the RSE board would be unlikely to give its full support to future mergers. In planning RSE’s expansion, Eliot had considered several companies as possible acquisition candidates. Eliot was seeking a small, well-managed manufacturer that could offer RSE strong growth opportunities and bring it more specialized, higher-technology products that would be less susceptible to succumbing to the competition. Although RSE had done well, Eliot felt the company lacked the ability to be innovative. No new products had been developed over the past two years, and Eliot personally felt that the research and development (R&D) group at RSE International had fallen behind its competitors. FVC, with its proven management and engineering skills, seemed to offer the R&D capabilities and growth prospects that Eliot sought. Eliot realized that time was of the essence, especially since other competitors were also interested in Flinder Valves. Nonetheless, he wanted to be certain that acquiring it would truly place RSE in a better competitive position. One concern was how well FVC’s employees would handle the transition from working in a small, entrepreneurial company to a much bigger place like RSE. The two companies possessed quite different cultures. Another concern was about the earnings dilution that RSE might incur from the acquisition. In fact, two directors had cautioned Eliot against impairing the firm’s forecasted growth in earnings per share. Eliot and MacAvity expected the merger to generate significant cost gains. RSE’s greater purchasing power would lower the cost of materials and components for FVC. RSE’s new resource management system could be expected to reduce FVC’s in-process costs. Estimates from RSE’s duediligence process had identified pretax constant-dollar cost savings of $1.5 million in the first year of operation and $3 million thereafter. They also recognized other synergy gains that arose from RSE’s stronger marketing clout, cross-selling with other RSE products, and its deep financial pockets. But for the sake of conservatism, they chose not to include these in the valuation. They believed that the widening-gyre project could have a broad application in nautical, aerospace, and automotive products. Based on the investment required to bring such technology to market, they estimated the economic value at between $5 and $15 million Tom Eliot had known Bill Flinder for several years, having been introduced at an industry conference where they were both speakers. As founders and significant stockholders in their respective firms, they liked and respected each other. Eliot hoped that RSE could put together a deal that not only worked for the two founders but made broad economic sense. The information below is for your own knowledge if you ever have to negotiate a merger or any other form of financial transaction. Supplemental Technical Note: Valuation and Merger Negotiation Experienced financial decision-makers know that valuation is imprecise. Too many parameters are uncertain, which renders any particular point estimate uncertain. This situation leads to two important questions for negotiators of mergers and acquisitions: (1) What role can quantitative analysis play? (2) How can one negotiate rationally and advantageously amidst this uncertainty? The Role of Quantitative Analysis Two classic naive responses are made to the uncertainty of valuation: (1) to assert (with a straight face) that the point estimate is the true value of the company, and (2) to chuck the quantitative analysis out the window and to rely on some other method of guidance.1 The more sophisticated response is to embrace the uncertainty and focus not on point estimates of value but on a range of value. Quantitative analysis is essential for determining this range. The classic ways of setting the range include: Sensitivity analysis: Here, one identifies the key value drivers of a firm and determines the variation in value as the drivers vary. One must take care to do this sensibly because quickly generating a blizzard of numbers is easy. Scenario analysis: This analysis is similar to the sensitivity analysis, but acknowledges that many assumptions will tend to vary together. In this approach, one estimates values of a company associated with different views of the future. These scenarios could simply be based on a general sense of how things will turn out (i.e., optimistic, pessimistic, etc.) or could be tied to specific events that have a competitive foundation (e.g., a major foreign competitor enters your domestic market) or a political/economic foundation (e.g., Britain endures a long recession). Here also one must take care to do the analysis sensibly because as the saying goes, “garbage in, garbage out.” Also, almost any scenario may be framed in such a way as to produce the results that one wants. Break-even analysis: At the least, knowing what assumptions are necessary to produce a target value will be extremely useful. This approach explicitly solves the valuation in reverse and leaves it to the decision maker to judge whether the break-even assumptions are reasonable. 1 Investing folklore is replete with success stories in which the critical insights wereobtained from sources as varied as astrology, gossip, and charting the height of women’s hemlines. Using these methods to produce a negotiating range, bounded on one side by the opening price and on the other by the walk-away price, provides vital discipline for a negotiating team and may help the team in its assessment of new information that could appear in the negotiations. In short, quantitative analysis serves an important role in merger negotiations. The sophisticated user acknowledges the uncertainty of value estimates and can use the insights derived from careful analysis as a foundation for negotiation strategy. Negotiating Well Research on merger negotiations conducted in laboratory experiments suggests that 30% to 50% of merger outcomes represent a significant adverse deviation from what the negotiators actually wanted—walking away from negotiations where a satisfactory outcome was feasible or closing a deal beyond the walk-away price. This finding is attributable to a significant psychological influence on what, in theory, is a simple economic event. The psychological phenomena include the following, adapted from Negotiating Rationally:2 1. Irrationally escalating to an initial course of action, even when it is no longer the most beneficial choice 2. Assuming your gain must come at the expense of the other party and missing opportunities for trade-offs that benefit both sides 3. Anchoring your judgments on such irrelevant information as the initial offer 4. Being overly affected by the way that information is presented to you. 5. Relying too much on readily available information, while ignoring more relevant data 6. Failing to consider what you can learn by focusing on the other side’s perspective 7. Being overconfident about attaining outcomes that favor you 2 Max H. Bazerman and Margaret A. Neale, Negotiating Rationally, (New York: Free Press, 1992). The lessons of most studies of financial negotiation include the following: Know thyself. Know thy counterparty. Risk aversion, optimism (or pessimism) about the future, the desire to settle, and an expectation of settling are influential on bargaining outcomes. Do not abandon sound quantitative analysis. Do your homework before negotiating. Estimate bargaining ranges; set walk-away prices. Be disciplined in negotiating. Stick to predetermined walk-away prices unless you have significant new information or other sound reasons for abandoning them. Mastery of negotiating tactics pays. Anchoring or framing the other party’s expectations, the number of proposals, the pattern of concessions, the use of time, the use of interruptions—all these affect outcomes. Negotiate based on several attributes, such as price and terms, rather than one. Oneattribute negotiation often leads to deadlock. ...
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