Interco Case Study

Topics: Free cash flow, Discounted cash flow, Weighted average cost of capital Pages: 8 (2431 words) Published: December 4, 2010
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Formerly a footwear manufacturing company, Interco developed into a diversified company that comprised subsidiary corporations in four major business areas: apparel manufacturing, general retail merchandising, footwear manufacturing and retailing, and furniture and home furnishings. Due to the fact that Interco's subsidiaries operated as autonomous units and lacked integration between its operating divisions, the company is particularly vulnerable to a highly leveraged takeover, as far as the management concerned. The strategic repositioning program starting in 1984 resulted in a reversal of the sales mix of Interco, with sum of footwear and furniture groups’ sales surpassing that of apparel and general retailing divisions in 1988. The financial performance of Interco in FY 1988 was solid as a whole. Both the outstanding performance of furniture & home furnishings and footwear groups as well as a reduction of the company’s effective tax rate made great contributions to it. Besides, Interco’s relatively high current ratio and low debt level show that the company is flexible, which also indicates healthy financial performance. However, ongoing problems remained in the apparel manufacturing and general retailing divisions as a result of the change in their business nature. As a matter of fact, it was believed that the apparel group’s performance would lead to continuous weakening of Interco’s overall operations and an undervaluation of the company’s common stock by the market. Given Interco’s organizing structure and financial performance at that time, it was unsurprising that the company was offered a merger proposition in July, 1988 by City Capital, a company that acquired undervalued targets with strong market niches. When evaluating the takeover bid offered by City Capital Associates, the board of Interco was advised by Wasserstein Perella and Co. (WPC). Based on Wasserstein Perella’s comparable transaction analysis (Exhibit 11 in the Case), we can get following chart showing share price. Comparables| Minimum | Medium| Maximum|

Sales| $52.65 | $97.64 | $139.81 |
Operating Income| $95.46| $126.97| $171.22|
Operating Cash Flow| $83.69| $91.46| $164.89|

This comparable analysis shows that share price of Interco should be much higher than $70 although the minimum price suggested by sales comparable is low. Therefore, in general the bid price offered by City Capital can be considered too low to be reasonable according to Wasserstein’s analysis. Board members may be persuaded by this result and then reject the bid offer. However, some may argue that the result is doubtful because the comparable transactions selected by Wasserstein may not closely resemble the situation of Interco. In addition to the comparable transaction analysis, premium paid analysis was also offered by Wasserstein Perella. This analysis also showed that City Capital’s offer was not acceptable because the premium offered was much lower than the one day, four week high, and 52-week low averages. Similar to comparable analysis, it was still questionable that the selected deals may not match Interco’s deal in terms of approach (hostile/friendly), size, industry, and transaction type and status. Hence, board should be prudent when make decisions according to this analysis. Another valuation method used by WPC is discounted cash flow (DCF) method. Given assumptions in Case’s exhibit 12, we conducted a DCF analysis to verify the suggested share price reported by Interco’s consulting company WPC. First of all, a few process methodologies used in the DCF model should be addressed. 1. The calculation of cost of capital. With limited information, a 6% market risk premium was assumed by convention. Choosing 30-year treasury yield as the risk free rate, Interco’s cost of equity (15.1%) can be calculated under CAPM with a given equity beta of 1. Considering Interco’s cost of debt, the...
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