Gulf Oil Corp. – Takeover

Topics: Inflation, Peak oil, Net present value Pages: 7 (1959 words) Published: August 23, 2009
Executive Summary
Given the facts in the information provided, we do not feel that an offer of more than $64.17 per share is justified. We recommend that management still submit this bid even though it will probably be rejected. Gulf Oil may be forced to accept a bid lower than $70 per share in the event financing falls through for competitors or other unforeseeable circumstances evolve, such as regulation by FTC. The numbers presented below are reliant upon estimates, which makes the findings highly sensitive to changes in the economic environment. For example, if average inflation over the life of the project is 5.8%, then the resulting savings would justify a bid of $70.10 per share. In addition, using 1983 performance would justify a bid of $70.64 per share. The following table shows how inflation rate changes affect analysis. |Savings per Share |$27.10 |$21.17 |$13.36 | |Inflation Rate |5.80% |8.37% |10.00% |

In light of this, we recommend that management review the facts and assumptions and ask the following questions. Are there benefits to the merger not captured in our figures? How does the merger affect the competitive advantage of Socal’s competitors?

Return on Equity
We initially determined that the required rate of return on equity (rE) for Gulf was 6.48%, using the CAPM formula. We assume that the company’s Beta (β) remains 1.15, which we feel is fair given no information that suggests it will change. In addition, we used the current long-term Treasury yield of 12% as the risk free rate (rf) and estimated the market return using average S&P 500 returns from 1976 to 1983. The following table shows how we arrived at rM of 7.20%.

|Year |Standard & |Return | | |Poor's 500 | | | | |(current yr - prev yr) prev | | | |yr | |1976 |$107.46 | | |1977 |95.10 |-11.50% | |1978 |96.73 |1.71% | |1979 |105.76 |9.34% | |1980 |136.34 |28.91% | |1981 |122.74 |-9.98% | |1982 |138.34 |12.71% | |1983 |164.90 |19.20% | | |Average: |7.20% |

Given classroom discussion and chapter 9 of the book, we know this does not make sense. Why would investors ask for less return from a riskier investment? We know that historically the market risk premium has been 6-8%. Thus, we assumed that the market risk premium is 7% and recalculated rE to be 20.05%. Weighted Average Cost of Capital

To determine the weighted average cost of capital, including the value of interest tax shields, we first determined the appropriate ratios. Given the clarification that only $304 million of the $4.8 billion current liabilities was debt, we used Exhibit 1 to determine that total debt for the company is $2.595 billion. This is $304 million of current debt and $2.291 billion of long-term debt, as we assumed this figure included no long-term capital leases. This means that total debt and equity equals $12.723 billion. In addition, we used an expected tax rate of 50% and assumed that Gulf’s debt rating would remain AA (maintaining the current return on debt of 13%). WACC for Gulf is 17.29%, given a constant debt to equity ratio and riskiness of future projects.

r* = ($2.595 billion/$12.723 billion) x 0.13 x (1-0.5) + ($10.128 billion/$12.723 billion) x...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Gulf Oil Corp Essay
  • Gulf Oil Analysis Essay
  • Gulf Oil Case Essay
  • Takeover Essay
  • Gulf Oil Spill Essay
  • Gulf Oil Spill Essay
  • Gulf Oil Case Essay
  • The Gulf of Mexico Oil Spill Essay

Become a StudyMode Member

Sign Up - It's Free