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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?”


Landmark facility is specialized in providing commercial building. 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. The case focuses on valuing the acquisition opportunity and choosing the right financing for the transaction. Broadway is providing facility services like janitorial services. Problem Statement 1. The current financial position of Landmark encourages Mr. was formed by Mr. In last few years. and why? How Broadway would be servicing its debt after the acquisition. Instead of charging premium prices. CEO and President of the Broadway industries are considering acquiring the Landmark facility solutions. However. floor and carpet maintenance services and building maintenance services. engineering and energy solution services. 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. Harris in 1992. Mr. Page 2 . and sets the stage for discussions about capital structure decisions. 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. located in USA. 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. For this purpose. Landmark is capable to charge premium prices. Introduction Broadway. It explores the interaction between corporate investment and financing. The acquirer believes the acquisition will help it to become an integrated facility manager and enter new industries in its home market. In addition to this. 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. It was found in 1954 and it has significant brand recognition throughout USA and due to its strong brand recognition. If Broadway proceeds with the acquisition which financing alternatives should be chosen. The CEO and president of the Broadway aim to spread its operations in addition to facility support services to building engineering and energy solution. Landmark is currently facing the problem of reduction in operating profit.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.

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

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

Financial Management II The discount rate was considered to be the weighted average cost of capital of the firm. using the average debt-equity ratio of the firms given. the capital structure of Broadway consists of 75% debt and 25% equity at a WACC of 8. It is not until 2018. Broadway would not be capable of servicing its debt on its 100% loan obligation. While in the mix of debt and equity case. Landmark facility is not listed. respectfully.0 million interest payments on the mix of debt and equity are payable by Broadway over the life of the loan term. the information of equity betas given in the case can provide the unlevered beta. Based on interest payments calculations.9%. where in the cost of equity for Landmark facility was calculated by the Capital asset pricing model using the beta of the industry. While the $3.4 million in expense due in 2015 and 2016.5 million and $1. In the 100% debt case. It is projected that Broadway would experience net income losses of $0. With $6. the capital structure consists of 40% debt and 60% equity at a WACC of 8. the levered beta helps us find the cost of equity using CAPM. Since.3 million.31%. and market risk premium of 5. Net income losses occur from 2015 thru 2017. that the company is able to absorb its loan payments.56%. and info given in the case wherein the risk free rate was chosen to be the ten year treasury bond rate of 2.01%.6 million in loan interest expense and an additional $0. The Page 5 .

the best financing alternative for the company in order to fund this $ 120 million acquisition opportunity is to seek 50% debt and 50% equity. 3. while the 40% debt structure for the mix debt-equity is serviceable over the terms presented for investment. as the company is presently experiencing a strain in growth. 2. profitability. 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. These ratios for both the financing alternatives for optimistic and pessimistic case would be (3. Overall. and eroding operating efficiency to industry peers. the speed at which Broadway is able to consolidate and implement cost-cutting measures are a concern.34) and (2. Page 6 . the 75% capital debt structure for the all-inclusive $120 million loan is not serviceable. therefore. 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. if the level of debt increases beyond a certain optimal level then the firm is at risk. However.03) times. However. 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. Conclusions The valuation of the acquisition opportunity has been performed on the basis of both the scenarios.Financial Management II company generates sufficient cash and yields positive yearly net incomes. Looking at the valuations of the Landmark Company.16. funding the entire acquisition by 100% of debt might prove to be risky for the company in future. 1. Moreover. Landmark’s equity valuation under expected conditions is falls below expectations.85. the interest coverage ratio and the free cash flow over interest expense ratios have been calculated. the company should proceed with the deal given the combined synergies of this deal are a plus for Broadway Industries.4) and (1.31% under this alternative. Again it could be seen that these ratios are much higher for the second financing alternative. Thus. Therefore. 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 2.64. 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. Even though. In order to determine that whether Broadway would be able to service its debt or not. The post-acquisition capital structure of 100% debt financing reduces shareholder value for Broadway by increasing the risk of financial distress.61. 2. the best financing alternative for the management is to basically go ahead with a mix of debt and equity financing. Moreover. Broadway benefits from acquiring Landmark.63) times. The firm value under this financing alternative is highest and significantly high with a cost of capital of 8. Nonetheless.

Financial Management II Exhibit 1: Page 7 .

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