($ millions except percentages) Financial Projections - As Per The Case 2003 2004 2005 2006 2007 EBIT $ 90.7 $ 96.6 $ 102.9 $ 109.5 $ 116.7 Capital expenditures 175.0 130.0 140.0 150.0 160.0 Depreciation expense 84.2 90.0 96.0 102.0 108.5 Assumptions Steady-state growth 5.00% Perpetual Growth Rate 5.50% WACC (Calculated below) 7.80% Effective U.S. Tax Rate in 2002* 40.00% WACC Calculation Common stock 169.20 2002 price per share (closing price) $ 21.53 Common Stock - Market Value $ 3,642.88 Target Capital Structure Value Weight Debt at book value $ 2,092.10 36% Wd Common stock at market value $ 3,642.88 64% Ws Total debt and common stock $ 5,734.98 100% WACC =WdKd (1-tax rate) + Wsks 5.38% 37.56% 3.55% 1.12 Market premium assumed at 6 percent 6.00% Cost of Equity (Ks) 10.28% Alone Unit Number of outstanding shares in 2002 (millions) - Per 2003 financial report* kd (Bond rating is assumed at AA) as follows: Total debt/capital (%) for 2002= $2092.10/ ($2092.10+$3478.2) According to Exhibit 6 provided by the case (Financial Ratios by S&P Credit Rating Categories), Ingersoll Rand's credit rating is assumed at AA with a total debt/capital % of 37.56% Ks = Rf + β(RPm) Rf equals the intermediate government bond yield (case) β (Please see below for adjusted beta for Torrington)
This memo will examine Timken Company’s decision to acquire Torrington by examining the stand-alone value of Torrington, the synergies of this acquisition and the effect on Timken’s investment grading. Acquiring Torrington seems to fit well with Timken’s long term growing strategy. Torrington and Timken share 80% of their customers but only overlap 5% in their product offerings. Not only would this allow customers to make Timken a one stop shop for many of their needs but also according to a survey done by the University of Michigan, companies that were integrated were more profitable than those who focused on only one good. Acquiring Torrington would help in their efforts of becoming more global by increasing their presence in the global bearing market from 7% to 11%, making the two companies combined the third largest producer of bearings in the world. Finally, the acquisition of Torrington could give Timken an expected annual cost savings of 80 million dollars by the end of 2007, which are the expected synergies.
Per calculation, Torrington’s stand-alone valuation is 192.789 million dollars (see Exhibit X), with the assumption that NWC equals 13.5% of sales. All of the numbers in this Exhibit are from the attachments of Timken case. EBIT, capital expenditure, net sales, and depreciation expense are from Exhibit 5 of the Timken case. Tax rate is calculated based on Timken Corporate Income Statements from Exhibit 1 of the Timken case. For the WACC calculation, cost of equity is calculated the assumption of a risk premium of 6.5%, since the market premium decreased over time from 7.1% to 4.7% and it is reasonable to assume that the market premium would be close to 6% by 2002. Risk free rate and cost of debt is from Exhibit 9 of the Timken case. With the assumption that Torrington and Timken are similar to each other, beta is drawn from Exhibit 8 of the Timken case. Then, the weights of equity and debt are calculated based on Timken’s balance sheet.
For the years after 2007, a perpetual growth rate of 5% is assumed according to the WACC value of about 7%. All of the cash flows are discounted back to the year of 2002 in the calculation of NPV value. With the annual cost savings of $80 from 2003 to 2007 and the integration cost of total $130, Timken’s new NPV is calculated to be -$970.42. There is the possibility that Timken can lose its BBB investment-grade rating. This is due to Timken taking on the $800 million in debt it needs to purchase Torrington. The change in the company’s debt composition will change ratios such as debt-to-capital which is used to determine the investment-grade rating. Compared to other industrial firms, Timken shows relatively high sales numbers ($279.4 million) as well EBITDA figures ($275.7 million). According to table 3 (p. 4), only three ratios will change as taking on the $800 million in debt.
The first one is EBIT Interest Coverage Ratio, which drops from 2.63 to 0.90 and investment-rating scale falls from BBB to B. The second ratio is EBITDA Interest Coverage Ratio, which drops from 4.3 to 3.14 and investment-rating scale falls from BBB to B. The third one is Total Debt/Capital Ratio, which increases from 43 percent to 67 percent and drives the rating from BB to B. In conclusion, the $800 million debt has a negative impact on Timken, since it lowers company’s investment-rating scale. If Timken decides to go forward with the acquisition, Timken should structure the deal with both cash and stock-for-stock offering. Ingersoll-Rand is likely to want a cash deal from this acquisition not only because of the riskiness and vulnerability of the stock market but also Ingersoll-Rand’s current desire to allocate capital to higher potential growth and higher return service businesses.
However, it would be unprofitable for Timken to raise more than 800 million dollars solely by debt due to the expected dramatic downgrading of Timken’s interest rating, which is inconsistent with Timken’s current business priority. Thus, in order to provide Ingersoll-Rand with funding for new investments and maintain a reasonable debt rating for Timken, it is safer for Timken to structure the deal with both cash and stocks. In conclusion, Torrington fits in Timken’s business structure, and it is profitable for Timken to acquire Torrington as long as it offers a deal with the correct mixture of cash and stocks. Thank you for your time. If you have any questions, please feel free to contact us.