Weighted Average Cost of Capital and Yeats

Category: Capital, Investment
Last Updated: 26 Mar 2023
Pages: 6 Views: 387

What is the situation that this company faces?

Yeats Valves and Controls, Inc. is currently considering a merger with TSE International Corporation. The founder, who is Chair and CEO, W. B. “Bill” Yeats, is about to reach his 62nd birthday and does not have a succession plan. He is concerned with the future of his company as none of the other executives can take his place because they are all specialists. Bill Yeats believes that TSE can provide stability to Yeats as he is reaching retirement, and TSE is a larger company with better marketing and global distribution channels. However, he is concerned with the fit of the two companies even though he thinks TSE is a better partnership than other alternatives.

What are the strengths and weaknesses of Yeats and its counterparty, TSE?

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Unlike TSE, which is more global-oriented with indirect distribution channels, Yeats has a stronger national and direct distribution channel. TSE has a larger mass-market production system (high volume) while Yeats has a more customized market production (lower volume). In addition, Yeats has a strong R&D, having many patents for multiple applications, particularly with its latest development of the Widening Gyre Program that has a high-profile government contract. This might not be reflected in the stock of the company as a growth opportunity.

Why should Yeats and TSE want to negotiate a merger deal?

Yeats is considering this merger deal because it would offer a succession plan for the company as TSE is a much larger company that can offer Yeats financial stability without having Yeats to identify new capital (debt and equity) on its own to fund the Widening Gyre Program (an advanced hydraulic-controls system). Yeats needs additional funding in order to continue the R&D of the Widening Gyre Program. Also, TSE has the expertise of mass manufacturing that Yeats need for widening its reach in commercialized distribution. In order to maintain a competitive edge, Yeats need both the finance and manufacturing capabilities of TSE as other competitors in the same industry have been consolidating more and more.

However, Bill Yeats is concerned about losing voting control from a merger with TSE. He also wants to ensure that Yeats employees are kept after the merger and its stockholders gain value from the merger. He wants TSE to continue the R&D and commercialization of the Widening Gyre Program; and for him to stay on as head of Yeats until TSE can fully operate Yeats by offering him a reasonable bonus plan. Though Bill Yeats could turn to another company, Lockheed Marlin, a large defense contractor, or other companies, he prefers TSE because he is familiar with TSE and they have complementary needs. Bill Yeats also ruled out a joint venture with TSE because he felt it was an inferior alternative as it will have the same integration issues. To reduce tax obligations, Yeats and TSE want to complete the merger in a stock-swap deal.

Use valuation analysis to determine the valuation of Yeats. What are the key value drivers?

As mentioned above - Note the Harvard web site has a student spreadsheet for Yeats Valves that you should use as the basis for your analysis. Questions are continued below – One way of determining the valuation of Yeats is through WACC, the Weighted Average Cost of Capital. It is the minimum return a company needs to earn in order to satisfy its investor base (as weighted for the amount of debt vs. equity in the target/capital structure), which is what the company must pay investors to raise new financing to support new projects or ventures. WACC is particularly useful here because Yeats has no debt, thus, it is an equity-financed company. In the case of Yeats, the company must have the capital to continue to develop and market its new Widening Gyre Program. The formula for WACC = Re (E/V) + Rd (D/V)(1-t).

However, because Yeats does not have debt, the second half of this formula, Rd(D/V)(1-t) is not necessary. Being that Yeats has zero debt, the value of its equity is in full, which represents its Enterprise Value. Tax (t) is determined in the case as 40% or  40 (p. 5). We must then calculate the CAPM for the cost of equity (see Excel sheet for details): Re = Rf + Beta (Rm-Rf) Re = Required Return on Equity Rf = Risk-Free Rate = 5. 98 (p. 16) Beta = Measure of Risk relative to the general market (volatility) = 1. 5 (p. 5) Rm-Rf = Equity Market Risk Premium (EMRP) = 5. 5 (p. 16) Rm = Market Risk Rf = Risk-Free Assets (U. S. treasury security) With Beta at 1, the stock price changes in precise tandem with the market, but with Yeat’s beta at 1. 5, it is riskier than a group of peer stocks. Thus, Re = Rf + Beta (Rm-Rf) Re = 5. 98 + 1. 5 x 5. 5. Re = 14. 23%, the cost of equity at for Yeats. Then calculate WACC = Re (E/V) + Rd (D/V)(1-t) WACC = 14. 23 (100%) + 0 (0%) (1-40%) WACC = 14. 23% Additional Questions for Yeats / TSE cases

What do you believe Yeats valves is worth?

What key financial assumptions determine the range of high and low values in your valuation analysis? Also, draw on any other valuation approaches and information that you can. With WACC = 14. 23% Assuming Terminal Growth Rate = 4% 1) Terminal Value (or present value at a future point) with $ represented in 1,000 = $7059. 8 (1+4%) (14. 23% - 4%) $71771. 1 = $72 million 2) DCF (Discounted Cash Flow calculated using a financial calculator): CF0 = 0 CO1 = 4689. 3 CO2 = 4584. 3 CO3 = 5302. 1 CO4 = 6127. 4 CO5 = 78830. 9 I = 14. 23 NPV = 55306. 17 NPV = $55. 306 million 3) Equity Value= 55,306,170 Minus Debt= 0 Divided by Outstanding Shares = 1,440,000 or $55,306,170 1,440,000 Equity Value per Share = $38. 407 per share Other valuations can include comparing P/E ratios with other peer companies. Also comparable are Price/Revenues, Price/EBIT and Price/EBITDA. See exhibits 8 and 9 for comparable Ratios of Peer Firms.

What are the advantages and disadvantages of a combination between Yeats and TSE Int?

The advantage of combining Yeats with TSE would be that Yeats can offer R&D expertise that TSE lacks, and TSE can offer manufacturing and marketing expertise that Yeats lacks. With TSE’s commercialized global reach and Yeats’ national government contracts, it would be expected that there would be financial synergies that would benefit both companies in the long-term, including cost savings from greater purchasing power for materials and components, and application of TSE’s Six Sigma for higher quality control savings. This would increase value to stockholders of both organizations and offer diversification. However, the disadvantage would be that the two companies operate differently and will have to find a common ground that would allow them to merge their cultures. One of the concerns mentioned in the case is that Yeats has a more entrepreneurial operation that might not fit TSE. Both companies will have to be open-minded to learn each other’s methods of operations.

What risks do TSE Int? and Yeats Valves face in the proposed merger?

Consider a range of transaction, financial, and operating risks. What effect do these risk factors have on the value of Yeats Valves? In the proposed merger, TSE will not want to overpay for the proposed merger while Yeats will not want to be under-valued in the stock swap. Yeats has a concern that TSE may under-value its Widening Gyre Program, which could be under-estimated by the market price. Bill Yeats wants to stay on to operate Yeats after the merger with a bonus and return to R&D rather than focusing on raising capital. TSE has to know how much value such a transaction will offer TSE being that TSE has very little experience in financing R&D.

Both companies must consider their differences in operating cultures and the risks involved in the long-term viability of the two companies. TSE must consider how long they will have Bill Yeats as he is nearing retirement at a time when TSE might need Bill Yeats to maintain the success of this merger. What long term bonuses may be required to attract Bill Yeats to remain, and what succession plan might TSE have to come up with for Yeats Inc.? These are all risks to both parties.

Develop a negotiating strategy i. e. , an opening asking price to sell your company - Yeats – as well as the price below which you would walk away from the deal. Justify your ‘drop dead’ or walk away price. Being that the Terminal Value is at $72 million, we would ask to sell Yeats to TSE at that opening price.

However, in calculating the Discount Cash Flow Value with Net Present Value at $55 million, this would be the drop-dead price we would walk away from the deal. A value between these ranges would be preferred, as the minimum ($55 million) represents the equity value of Yeats and the maximum ($72 million) represents the future value of Yeats. In addition to the price negotiations, we would also negotiate social terms (as suggested by Bill Yeats). This includes for Yeats’ employees not to be terminated after the merger and Bill Yeat to remain as head of Yeats with bonuses (five-year options to purchase 80,000 shares of TSE stock at 90% of market price at the close of the acquisition, and an incentive bonus of $50,000 to $200,000 per year).

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Weighted Average Cost of Capital and Yeats. (2017, Jan 31). Retrieved from https://phdessay.com/weighted-average-cost-of-capital-and-yeats/

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