Topics: Weighted average cost of capital, Net present value, Discounted cash flow Pages: 6 (1809 words) Published: March 30, 2015
Statement of the Problem

In January 2013, Sterling Household Products Company (Sterling), a highly successful manufacturer and marketer of household goods, was experiencing low growth rates for unit volume, sales, and profits which led management to seek expansion into higher growth industries. Between 2010 and 2012, sales had a compounded annual growth rate (CAGR) of only 2.2%, sales volumes in units were less than 1% per year, operating expenses rising faster than inflation, and retailers with high buying power (The 10 largest customers accounted for 55% of sales). Sterling identified the health care infection-control market as an attractive sector with high growth opportunities, and the product lines were a natural extension of Sterling’s current production. Sterling found its ideal investment opportunity through Montagne Medical Instruments Company’s (Montagne) germicidal, sanitation, and antiseptic products unit (GS&A Unit). The unit was profitable with an operating margin of 18.9% in 2012 and sales grew over 5% annually the past two years. However it was not a core focus for Montagne and required scarce resources and time, so Montagne was eager to sell the unit.

The acquisition also provided an option to expand capacity (current full capacity will be reached in 2014) for $60 million and generate additional sales of 20% base sales in 2014, 30% in 2015, and 40% thereafter. The two companies tentatively agreed on a cash offer of $265 million. However, a discounted cash flow (DCF) analysis of the base acquisition and option will be performed along with a strategic and sensitivity analysis to help Sterling determine the value of the acquisition, the expansion option, and in combination. Sterling must ultimately decide whether to pursue the acquisition either with or without the option, retract its offer, or renegotiate the terms.

Weighted Average Cost of Capital (WACC) Calculation
Cost of Equity (COE) Cost of Debt (COD)

The two components of the WACC are the COE and COD in their corresponding weights. The COE for the investment in Montagne’s GS&A Unit is calculated using the capital asset pricing model (CAPM) and its underlying beta. Sterling’s beta cannot be used because it characterizes a different business line. Montagne’s equity beta is not an accurate representation since the GS&A Unit is only one aspect of its product lines. Therefore, an industry and peer group average were calculated to determine the riskiness of the unit. The peer group beta of .8750, which includes Chiron and Pathogen, was chosen over the industry average of .8667 for many reasons (Exhibit 7 & A). First, the peer group more closely represents Montagne’s GS&A Unit as 80% of the companies’ sales come from the same products. Second, the other firm betas varied greatly from .53 to 1.04, which was most likely caused by the fact that these firms sell a wide assortment of medical products. Third, using the peer group beta is the more conservative option as it raises the cost of capital and ultimately the WACC. Once the beta was calculated, a market premium of 5% and a risk-free rate of 3.1% were utilized to compute a cost of equity of 7.48%. The targeted capital structure of 30% debt and 70% equity was incorporated over the current capital structure because it represents the financing structure and risk for future capital (including the acquisition). The new capital structure is expected to raise the cost of debt to 5.10%, and the tax rate is expected to remain at about 35%. Using these inputs, the WACC for this investment is 6.20%.

Base Case Acquisition Value
Following the assumptions given in the case, the GS&A Unit had a sales compound annual growth rate (CAGR) of 2.16%, far below the 5% growth that attracted Sterling to the investment. This is due to the GS&A Unit reaching capacity in 2014. One positive aspect is the unit produces an operating income CAGR of 2.30%, which shows an ability to...
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