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Case Study - Why did Kennecott buy Peabody? Was the acquisition successful in achieving its goals? Does the experience with Peabody have any bearing on the Carborundum acquisition?

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Introduction

´╗┐Kennecott Copper Corporation ? Philip Larson Authors: Philip Larson Kennecott Copper Corporation I prepared my answers by myself before discussing the case with anyone else. I only consulted other members of this class and this work is my own. Why did Kennecott buy Peabody? Was the acquisition successful in achieving its goals? Does the experience with Peabody have any bearing on the Carborundum acquisition? Kennecott purchased Peabody for two primary reasons, 1) to moderate the wide swings in Kennecott?s profitability created by sharp changes in copper prices and sales, and 2) to provide Kennecott with significant future investment opportunities outside the copper industry. The acquisition was not successful in achieving these goals. Kennecott?s profits in the years following the acquisition were more erratic than they had been prior to the acquisition, partially due to Peabody?s unexpectedly poor earnings.[1] In particular, rather than using Peabody to smooth out profits, Kennecott contributed $532M to Peapody?s capital and allowed it to keep all of its net income. Moreover, the Peapody acquisition did not help Kennecott achieve its second goal of providing future investment opportunities outside the copper industry. Kennecott was forced to divest the acquisition just 6 years after the acquisition took place, removing any long-term investment prospects owning Peapody might provide. Therefore, the Peapody acquisition was not successful in achieving either of its primary goals. Additionally, the acquisition and sale was not very profitable. Kennecott invested $285M in cash, assumed liabilities of $36.5M, and put in $582M in additional capital (~$900M) ...read more.

Middle

In this case, Carborundum projects a relatively constant debt from 1977 to 1982 between $83.4M and $91.7M. Using Carborundum?s estimates in Exhibit 5, therefore, we would use the following unlevering formula. Unlevering Formula #1: ?A = [D*(1-Tc)*?D + E*?E]/[E+D*(1-Tc)] where: Tc = 50% (given) ?D= 0.31[2] ?E = 1.16[3] D= 186.2M[4] E= 410[5] ?A = [D*(1-Tc)*?D + E*?E]/[E+D*(1-Tc)] = [75.8*(1-.5)*.31 + 424.5*1.16]/[424.4+75.8*(1-.5)] = 1.00. ?A = 1.00 However, Kennecott?s projected estimates in Exhibit 7 suggest a relatively constant balance of debt/assets of 26.5% or a debt/equity ratio of 53.8%. First Boston presumably created these estimates believing that after the acquisition they would continually rebalance to attempt to maintain a relatively stable debt/equity ratio of 54%. This would suggest that we should use the following unlevering formula: Unlevering Formula #2: ?A = [D/(D+E)]*?D + [E/(D+E)]*?E] where: Tc = 50% (given), ?D = 0.31, ?E = 1.16 D= 186.2M[6] E= 410[7] ?A = .89 I have used the Asset Beta from the first unlevering formula because I assume that the 35% assumed by First Boston were based on assumptions and discussions with Kennecott managers and that this represents their intention to have a constant debt/equity ratio moving forward. At what rate should the cash flow be discounted? rUe = rf + ?U*(rm - rf) where ?U = ?A = .89 rf = 6.3%[8] rm - rf = 8%[9] rUe = 6.3% + .89*8% = 13.5% This is substantially higher than the 10.5% discount rate that Kennecott?s internal group used to justify a price up to $85/share. ...read more.

Conclusion

Here, it is unclear whether Carborundum?s debt is investment grade. I have assumed a corporate lower grade debt beta of .31. [3] See Exhibit 5. [4] This is the Carborundum?s long-term debt as of 1977, adjusted to reflect the acquisition by Kennecott per Exhibit 7. [5] There is a choice between using the shareholder?s equity at historical cost or shareholder?s equity based on replacement cost. Given that replacement cost is a better indication of the actual market value, it might make sense to have used the replacement costs. However, as they were not readily available for 1977 I used the adjusted shareholder equity based on historical costs. [6] Used same debt value to be consistent with prior unlevering formula. [7] Id. [8] The long-term T bonds is 7.8%. However, ordinarily if I used the long-term T-bond rate for the riskfree rate, I would use a risk premium of about 6.5% because that is the return by which the market exceeded T-bonds over the last 50 years according to Kaplan?s article. However, in this case we are told to use a market premium of 8% which is generally used when a with a short rate on a T-bill. Therefore, I am using the market premium of 8% but I have chosen to drop the long-rate by 1.5% to use a final rf of 6.3%. [9] Since the return on the market exceeded T Bonds by about 6.6% per year, a risk premium of about 6.5% is reasonable. ...read more.

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