| Cooper Industries [Cooper], founded in 1919, by | | | | were greatly impacted by 1972. This merger also |
| the mid 1950’s was known as the leading | | | | impacts long-term debts. In order to acquire |
| producer of natural gas well extraction engines | | | | Nicholson File Company, Cooper Industries would |
| and compressors. Cooper executed several | | | | have to look for a way of long-term financing, |
| acquisitions to expand its business and broaden its | | | | thereby increasing its debt and debt/equity ratio. |
| diversification to gain market share. | | | | The Cooper/Nicholson acquisition has a positive |
| Cooper’s management was highly | | | | impact on both companies and it is believed that |
| concerned about their need to diversify since | | | | the two companies have great synergistic value. |
| they relied heavily on the sale of oil and gas tools | | | | The acquisition will not only reduce operating costs |
| to industrial customers. | | | | but it will also reduce additional selling and |
| Likewise, earnings volatility was caused by the | | | | administrative expenses, as well. The SG&A |
| cyclical nature of heavy machinery and equipment | | | | expenses should decrease by 10% the first year |
| sales. Regrettably, the effort to reduce the | | | | and should experience no increase in them in |
| earnings volatility for Cooper Industries was not | | | | years after. Revenue too had a 5% increase and |
| successful since sales were entirely concentrated | | | | it too stabilized into having a consistent increase |
| the same industry. By 1959, Cooper ceased | | | | of 8% every year. The 5-year projection after |
| operations in four of the acquired companies that | | | | the acquisition provides a positive glimpse for the |
| broadened their market, yet they did not satisfy | | | | future. |
| the need to diversify the company. In order to | | | | Pursuant to due diligence, we have compiled the |
| avoid any more ineffective acquisitions, Cooper | | | | following report evaluating these financing options: |
| developed three criteria that must to be met for | | | | · Exhibit A Income Statement Balance |
| all future acquisitions, Cooper Industries, Inc.- Case | | | | Sheet without Synergies |
| (1974). Industry choice should permit Cooper | | | | · Exhibit B Income Statement Balance |
| major player status · Industry should be | | | | Sheet with Synergies Financing With Bonds |
| stable and enable sales of “small | | | | · Exhibit C Income Statement Balance |
| ticket” items. | | | | Sheet with Synergies Financing with Cooper |
| Industry leading firms would be acquired Only | | | | Common Stock |
| acquire industry leader Cooper implemented these | | | | · Exhibit D Income Statement Balance |
| criteria by acquiring Lufkin Rule Company in 1967. | | | | Sheet with Synergies Financing with Cooper |
| The new strategy would ensure that | | | | Preferred Stock |
| Cooper’s acquisitions benefited them and | | | | · Exhibit E Summary Combined with |
| their shareholders. Cooper’s next step was | | | | Synergies Financing With Bonds |
| to acquire Nicholson File Company [Nicholson]. This | | | | · Exhibit F Summary Combined with |
| paper is going to further expand and analyze this | | | | Synergies Financing With Cooper Common Stock |
| acquisition. Meeting the Criteria Nicholson as one of | | | | · Exhibit G Summary Combined with |
| the largest domestic manufacturers of hand tools, | | | | Synergies Financing With Cooper Preferred Stock |
| led in its two main products areas: files and rasps. | | | | · Exhibit H 5-Year Projection Income |
| It had 50% share of the $50 million market for | | | | Statement and Balance Sheet |
| files and rasps where they had established | | | | · Exhibit I Net Present Value Calculations |
| excellent reputation for quality and brand name. | | | | This team of authors recommends a bond issue |
| Its hand saw and saw blades also had excellent | | | | as the preferred capital financing structure for a |
| reputation for quality and held a respectable 9% | | | | variety of reasons. Debt capital used more than |
| share of a $200 million market. Nicholson’s | | | | equity capital causes a higher debt to equity ratio, |
| best asset, their distribution system, gave them a | | | | (2004). As this ratio increases then the financial |
| competitive advantage that was attractive to | | | | leverage of the business increases to a point. The |
| Cooper. | | | | maximum ratio of debt to equity is achieved |
| Aside from these attributes Nicholson was in | | | | when a firm can no longer service its debt. The |
| financial trouble. Their common stock was trading | | | | inability of a firm to service or pay its debts is |
| at $23 to $32 per share well below its book value | | | | termed as insolvent. Debt capital, the assumed |
| of $51.25 per share. The company reflected a low | | | | interest rate of 8% is used, with a twenty-year |
| price-earnings ratio of 10-14 compared to 14-17 | | | | term and a sinking fund for future debt |
| times earning for other leading hand tool | | | | retirement over the term of the debt |
| companies. Every aspects of Nicholson’s | | | | commencing in year one or 1972. |
| business met the acquisition criterion that was | | | | This usage of debt rather than equity to finance |
| previously established by Cooper. | | | | the acquisition of Nicholson causes a greater |
| Benefits of Acquisition | | | | return on shareholder equity since the use of |
| Cooper analyzed the benefits of merging with | | | | other peoples money (OPM) causes a |
| Nicholson. Cooper estimated that | | | | magnification on return of the existing capital |
| Nicholson’s cost of good sold could be | | | | structure. If the Firm were to issue more stock in |
| reduced from 69% of sales to 65%. The | | | | lieu of debt then the existing equity structure |
| acquisition would eliminate the sales and | | | | would be diluted and the return on |
| advertising duplication, which would lower the | | | | shareholder’s equity reduced. The |
| general and administrative expenses from 22% of | | | | objective of the Firm would be to maximize |
| sales to 19%. In addition, “75% of | | | | shareholders’ wealth and debt-financing |
| Nicholson’s sales were to the industrial | | | | structure achieves the objective better than the |
| market and only 25% to the consumer | | | | issuance of more shares of stock. Another cause |
| market” (page 5) compared to the inverse | | | | for debt issue for the financing is linked to the |
| for Cooper, since they distributed between the | | | | United States Tax Code allowing companies to |
| consumer market at 25% and industrial market | | | | expense interest expense as a financing expense |
| at 75%. | | | | accounted for in the statement of cash flows |
| Synergies | | | | where it is deducted from net income before |
| Synergy can be defined as the value that is | | | | taxes prior to federal income tax calculation. The |
| created by combining companies, which yields a | | | | boon of tax benefit is not available in many other |
| result greater than the value of these companies | | | | foreign nations where interest expense is not a |
| as separate entities. It is important to recognize | | | | tax preference item. |
| the synergy that existed with the two | | | | Therefore, the 8% interest expense will reduce |
| corporations. The acquisition would provide a | | | | net income before interest and taxes dollar for |
| greater marketability for both of these | | | | dollar and subsequent income taxes at 34¢ |
| companies. Both of these companies will improve | | | | on the dollar of earnings before interest and |
| their profit margin by working together instead of | | | | taxes. Furthermore, as the Firm grows, the debt |
| as competitors. When companies are acquired, | | | | to equity ratio will probably change assuming |
| competition should be reduced giving companies | | | | profitability and the assumptions are mainly |
| better opportunities to advantageously control | | | | correct. As profits are generated over time and |
| price. In addition, the acquisition will provide | | | | they are kept in the Firm in the form of retained |
| growth. With each of these product lines, both of | | | | earnings at that point in time will have dropped |
| these companies together can achieve greater | | | | and the total equity in the company will have |
| sales expansion. Improved distribution methods by | | | | grown. This is exactly what most companies look |
| Nicholson to Cooper would reduce operating costs | | | | for in a merger or acquisition. |
| to the venture as a whole. | | | | Since the acquirer and Nicholson are both |
| Capital Structure | | | | companies heavily laden with inventory and that |
| Cooper Industries should structure the deal to | | | | inventory needs to be financed either by cash or |
| finance the acquisition of Nicholson. Cooper has | | | | accounts payable to the extent that this case |
| capital structure options to finance this acquisition. | | | | was analyzed prior to the new Wal-Mart/Dell |
| They can issue debt, arrange lease financing, bond | | | | Computer method of working capital financing. In |
| swapping, offer preferred stocks, warrants, | | | | this model, the vendor does not bill the purchaser |
| convertible bonds and callers. These selections | | | | (Wal-Mart or Dell or the Firm) prior to purchase |
| offer investment options for Cooper. | | | | but the customer thereby avoiding the need to |
| “Typical financing decisions include how | | | | finance. In the case of the Firm, inventory is a |
| much debt and equity to sell, what types of debt | | | | requirement. Depending on the industry and to the |
| and equity to sell, and when to sell debt and | | | | extent that cash is generated by it leveraging is |
| equity. Just as the net present value criterion was | | | | needed more or less. In other words, the more |
| used to evaluate capital budgeting projects, we | | | | cash generated from operations the less leverage |
| now want to use the same criterion to evaluate | | | | required during the operations of a company |
| financing decisions” A five-year projection | | | | notwithstanding the acquisitions. To the extent |
| (Exhibit H) has been created to demonstrate the | | | | that the bond underwriters will issue bonds and |
| desired progress toward the projected goal of | | | | the bonds will be graded (priced) to the extent of |
| this acquisition in regards to the synergies. | | | | the debt to equity ratio, solvency and future |
| Appendix A illustrates the combined financial | | | | value is key. |
| statements without synergies in detail. In 1972, | | | | That key is the cost of capital. The team of |
| the true effect of the acquisition is felt with the | | | | authors have assumed a rate of 8% annually flat |
| increase in net income and then leveling out as | | | | over the 5 year pro-forma. |
| the year’s progress. Earnings per share | | | | |