Financial Management II



Case Analysis
The case presents us with the basic problem that many
firms are faced with - “Do we acquire another company
and if so what should we pay for it and how should we
structure the new firm?”


the management of Broadway suggested that the current demand from the Landmark is high and the expected benefits from the acquisition will not justify the purchasing cost. Introduction Broadway. and sets the stage for discussions about capital structure decisions. Landmark is currently facing the problem of reduction in operating profit. The acquirer believes the acquisition will help it to become an integrated facility manager and enter new industries in its home market. Instead of charging premium prices. Harris is considering the financing of the acquisition because currently Broadway has two available options and it is identifying which one is suitable if the acquisition process may proceed. engineering and energy solution services. Landmark is capable to charge premium prices. Page 2 . It was found in 1954 and it has significant brand recognition throughout USA and due to its strong brand recognition. For this purpose. and why? How Broadway would be servicing its debt after the acquisition. Does Broadway benefit from acquiring Landmark? If so how and based upon what? Can the $120 million bid be justified and if so what justifies or does not justify the bid? 2. The case focuses on valuing the acquisition opportunity and choosing the right financing for the transaction. However. In last few years. Harris to acquire Landmark because it is expected that the acquisition of Landmark will satisfy the strategic needs of the Broadway in order to expand its services. Harris in 1992. Problem Statement 1. CEO and President of the Broadway industries are considering acquiring the Landmark facility solutions. Mr. was formed by Mr. Broadway is providing facility services like janitorial services. If Broadway proceeds with the acquisition which financing alternatives should be chosen. floor and carpet maintenance services and building maintenance services. In addition to this. The CEO and president of the Broadway aim to spread its operations in addition to facility support services to building engineering and energy solution. located in USA. Landmark facility is specialized in providing commercial building. The current financial position of Landmark encourages Mr. It explores the interaction between corporate investment and financing. Broadway has been seeking significant growth and has spread its operations to other countries like New England and Florida by providing additional services like educational and industrial services.Financial Management II Executive Summary Landmark Facility Solutions presents a situation in which a medium-sized facility management company assesses whether to acquire a larger facility management company that is known for its high-quality services and technical expertise.

and security. landscaping. 5.3. Diversification of services. New value is expected to be created in the following ways: 1. The most obvious benefit of consolidating the two companies is the elimination of common overhead expenses. Combining complementary resources. had placed it in the bottom quartile of facility management companies. 4. Financial Management II How do the two financing methods affect the value of the acquisition to existing shareholders of Broadway? Does Broadway reduce shareholder value if it selects the mix of debt and equity financing alternative? What is the cost of equity dilution? What will be the cost of capital and how the cost of capital will be impacted by the various financing options? What is the value of the acquisition to Broadway under both expected and pessimistic scenarios? Analysis & Solution Broadway’s business strategy involves competing in a highly fragmented and competitive service-oriented business environment. executives. such as corporate headquarters. 6. commercial cleaning. With global economic power likely to continuing its shift eastwards towards emerging markets. and redundant office space. 5. Taking advantage of economies of scale. Broadway could increase Landmark’s operating margin to 3%. This business combination provides an opportunity to create new economic value for stockholders. and to be innovation in how they adjust their business models and deliver extra value to clients. including janitorial solutions. Increasing competition from new players in emerging markets will force companies to search for greater differentiation. HVAC. in terms of operating margin. and reducing non-essential marketing expenses. and quality of service.S. energy solutions. rather than from some underlying flaw in the company’s business model. it is believed that the company’s net working capital to sales ratio could be reduced to that of Broadway following improvements in some of Landmark’s processes. level of services. cutting executive pay and lavish perquisites. The tax shield that comes from increasing leverage for Landmark due to operating losses that can be offset against its taxable income. Capturing tax benefits. Such competition is based on pricing. had resulted from managerial complacency and cost management. There are redundancies in management positions and non-essential expenses. provides comprehensive facility services. Landmark’s high operating costs. The consolidation of the two companies will provide a more diversified service platform for existing and new clients. 4. parking. support staff. Another source of value would involve the management of Landmark’s net working capital. 2. facility engineering. Typical facility managers in the U. Broadway’s acquisition could improve Landmark’s operating efficiency and achieve cost reductions. Improving target management. 3. Harris is confident that by replacing Landmark’s management team. Page 3 .

7.Financial Management II 6. There are two alternatives for financing this acquisition—100% debt or 50% debt and 50% equity. Penetrating new geographies. Additional value generated due to this synergy = Value of combined firm – Value of landmark – Value of Broadway. The valuation of combined firm is very high compared to individual values of separate firms (Refer exhibit 1 to 4). Broadway could significantly increase the net financial leverage of Landmark (i.e. the acquisition could enable Broadway to market some of its services under Landmark’s brand at a premium price. could be realized in an increase Landmark’s operating margin to 3% and Broadway’s gross margin to 8. thereby reducing margins. Landmark is a respected for its high-quality services and expertise. cost costing in nonessential expenses. There is additional value for both optimistic and pessimistic scenario.5% as early as 2015. the replacement of non-performing management. Page 4 . Broadway has a culture of operational efficiency. The combination of operating and financial synergies could be realized quickly post acquisition. the 100% debt financing option could increase Landmark’s leverage by adding value by lowering its tax by increasing the interest tax shield). The understand the effects of each alternative we must look at the company’s capital structure. and a new pricing strategy based on Landmark’s model.. Since. Because debt financing is an option for acquiring the target shares (100% debt case). Moving into new geographies can curtail strong competitive pressures that could inhibit the company’s success in bidding for profitable business and its ability to increase prices as costs rise. Market power.

0 million interest payments on the mix of debt and equity are payable by Broadway over the life of the loan term. the levered beta helps us find the cost of equity using CAPM. using the average debt-equity ratio of the firms given.9%.6 million in loan interest expense and an additional $0. The Page 5 . and info given in the case wherein the risk free rate was chosen to be the ten year treasury bond rate of 2. the capital structure consists of 40% debt and 60% equity at a WACC of 8. In the 100% debt case.5 million and $1. While the $3. Net income losses occur from 2015 thru 2017. It is projected that Broadway would experience net income losses of $0. With $6. Landmark facility is not listed. and market risk premium of 5.4 million in expense due in 2015 and 2016. the information of equity betas given in the case can provide the unlevered beta. that the company is able to absorb its loan payments. It is not until 2018.Financial Management II The discount rate was considered to be the weighted average cost of capital of the firm.3 million. Since.56%. Based on interest payments calculations.01%. respectfully. While in the mix of debt and equity case. Broadway would not be capable of servicing its debt on its 100% loan obligation. where in the cost of equity for Landmark facility was calculated by the Capital asset pricing model using the beta of the industry.31%. the capital structure of Broadway consists of 75% debt and 25% equity at a WACC of 8.

3. 2. the company should proceed with the deal given the combined synergies of this deal are a plus for Broadway Industries. the best financing alternative for the company in order to fund this $ 120 million acquisition opportunity is to seek 50% debt and 50% equity. the interest coverage ratio and the free cash flow over interest expense ratios have been calculated.16. Landmark’s equity valuation under expected conditions is falls below expectations.4) and (1. The post-acquisition capital structure of 100% debt financing reduces shareholder value for Broadway by increasing the risk of financial distress. In order to determine that whether Broadway would be able to service its debt or not. The firm value under this financing alternative is highest and significantly high with a cost of capital of 8. it could be seen that the alternative 2 of financing which is going for 50% debt and 50% equity is the best financing alternative for the company. Conclusions The valuation of the acquisition opportunity has been performed on the basis of both the scenarios. The average interest coverage ratio and the FCF/Interest expense ratio for first financing alternative under the best case and worst case scenario for Broadway would be (2. as the company is presently experiencing a strain in growth. Page 6 . debt has advantages as it is much cheaper as compared to equity and the reason for this is that the interest expenses on the debt are basically tax deductible and this results in the increase of the firm value also. first of all the operating income and the free cash flows for the Broadway company have been calculated on the basis of the optimistic and the pessimistic assumptions for both the financing alternatives. Again it could be seen that these ratios are much higher for the second financing alternative. 1. therefore.64.31% under this alternative. Moreover. The relative interest payments under both the financing alternatives have also been calculated based upon the structures of the $ 120 million and $ 60 million loans under alternative 1 and 2.34) and (2. Broadway benefits from acquiring Landmark. the best financing alternative for the management is to basically go ahead with a mix of debt and equity financing. Therefore. Nonetheless. 2. However. Moreover. the 75% capital debt structure for the all-inclusive $120 million loan is not serviceable. These ratios for both the financing alternatives for optimistic and pessimistic case would be (3.85. However. and eroding operating efficiency to industry peers. Thus. Looking at the valuations of the Landmark Company. the speed at which Broadway is able to consolidate and implement cost-cutting measures are a concern. Even though. Overall.03) times. if the level of debt increases beyond a certain optimal level then the firm is at risk. while the 40% debt structure for the mix debt-equity is serviceable over the terms presented for investment.61. profitability. funding the entire acquisition by 100% of debt might prove to be risky for the company in future.63) times.Financial Management II company generates sufficient cash and yields positive yearly net incomes.

Financial Management II Exhibit 1: Page 7 .

Financial Management II Exhibit 2: Exhibit3: Exhibit 4: Page 8 .