The footwear industry is highly competitive industry with fairly stable profit margins. Active Gear is a profitable firm in the industry; however Active Gear is a smaller firm than many other competitors and its small size is becoming a competitive disadvantage. The rise of large retailers has also endangered Active Gear’s growth. Mercury Athletic Footwear designs and distributes athletic and casual footwear dominantly to the youth market. Mercury competes in four main product lines: men’s and women’s athletic and casual footwear. Men’s athletic footwear is the leading product for Mercury Athletic. Women’s casual footwear is Mercury’s worst performing product and post-acquisition the line may be discontinued by Active Gear. The acquisition of the Mercury Athletic division has sources of potential including an increase in Active Gear’s revenue, an increase in leverage with contract manufacturers, boosting capacity utilization and expanding its presence with retailers and distributors. Upon the review of the opportunity to acquire Mercury Athletic Footwear, the results of the financial analysis below indicate Active Gear should proceed with the acquisition. Based on the Free Cash Flow Method, considering the financial projections and assumptions for Mercury Athletic, indicate the acquisition has a positive net present value of $112,778,000 [Present Value of Future Cash Flows (59,440,000) + Terminal Value ($276,921,000) – Purchase Price ($223,583,000)]. There are also possible synergies that could make the project even more financially favorable, which are discussed below in the analysis.
John Liedtke, the head of business development for Active Gear, Inc. is responsible for developing the financial projection for the acquisition of Mercury Athletic. Below is a summarized comparison of Active Gear and Mercury Athletics’ current operations: | Active Gear, Inc.| Mercury Athletic|
2006 Revenue| $470 million| $431 million|
% of Revenue Product| 42% athletic shoe58% casual footwear| 79% athletic shoe21% casual footwear| 2006 Operating Income| | |
Revenue Growth| 2-6%| 12.5%|
Average Industry Revenue Growth| 10%| 10%|
Mr. Liedtke used historical performance information to project future operating income. To estimate a discount rate, Liedtke assumed the same degree of leverage (20%) for Mercury that is currently used by Athletic Gear. Given current credit market conditions, Liedtke expected the degree of leverage to imply a cost of debt of 6%. According to the case at the time of the analysis, U.S. treasury bills with maturities of 1,5,10 and 20 years were yielding 4.50%, 4.69%, 4.73% and 4.93%, respectively.
Liedtke must capture, analyze, and compare an accurate body of financial data for the acquisition of Mercury. A thorough analysis of this data will further expose the strengths and weaknesses of the acquisition. In order to complete this analysis the following questions must be answered: 1. What are the cash flows?
2. What are the cash flows worth today?
3. What is the NPV of the acquisition?
4. To what degree does the acquisition strengthen the company as a whole? 5. What happens after 2011?
6. How or will synergies improve the value of the acquisition?
Mercury Athletic’s EBIT margin for 2006 was 9.8%. Liendke’s 2007 projected EBIT reflects a conservative increase in EBIT of 9% compared to the average industry growth rate of 10%. Based on the information given in the case, Liendke’s EBIT projections for 2007 through 2011 reflect an accurate growth in earnings for Mercury Athletic. In order to determine the NPV of the acquisition, the first step is to calculate the free cash flows. The Earnings before Interest after Taxes (EBIAT) cash flows of Mercury’s operations was determined using the projected EBIT calculated by Liedtke minus the assumed corporate tax rate (40%). The free...