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Pinkerton (B) Case Solution

Solution Id Length Case Author Case Publisher
1084 1600 Words (5 Pages) Elizabeth R. Lawrence, Adam S. Berger Harvard Business School : 292136
This solution includes: A Word File A Word File

If I was Mr. Wathen, I wouldn’t have acquired Pinkerton. Although there were some opportunities for value creation by charging somewhat premium prices and cost efficiencies. But Pinkerton was much bigger than the acquiring company. Sales of Pinkerton were around 60% higher than the California Plant Protection Company. It would be hard for acquiring the company to merge Pinkerton in its operations which would be necessary for reaping benefits of cost efficiencies. Also, it would be difficult for an acquirer to finance a company that was larger than itself. Since the security guard industry was highly-priced competitive and Pinkerton had established its position as a low-cost player in the market, this merger could have severe results for the acquirer if this premium price strategy would not work.

Following questions are answered in this case study solution

  1. In retrospect, if you were Mr. Wathen, would you have acquired Pinkerton? Why? Why not?

  2. Assume you answered 1 above affirmatively, i.e. assume you decided to buy it, which financing plan would you have used? Why?

  3. What is the common denominator of the problems that Wathen faced after he acquired Pinkerton?

  4. Do you think Wathen was justified in paying less than $100 million for Pinkerton? Please provide your reasons.

  5. Did the forecasted benefits in Pinkerton A materialize? Please provide evidence to support your reasons.

  6. What do you think about the Berkeley Capital loan? Are the conditions for the loan good for Wathen?

  7. Discuss the pluses and minuses of the two capitalization plans that Mr. Berger is considering.

  8. Which capitalization plan would you recommend? Why?

  9. What is the total amount of funds that will be raised by the IPO and the new debt?

  10. Is the IPO a good idea for Pinkerton? Discuss the issue qualitatively; you don’t need to answer the question using any numbers.

  11. Wackenhut’s Beta was 0.89 in Pinkerton A. In Pinkerton B, it is 1.3. What factors do you think explain the increase?

  12. Calculate the unlevered cost of equity with the following assumptions. Cost of debt is 13.7%, the tax rate for Wackenhut’s is 37%, the risk free rate is 8%, and the market risk premium, i.e., (Rm - Rf) is 7.5%

Case Analysis for Pinkerton (B)

Assume you answered 1 above affirmatively, i.e. assume you decided to buy it, which financing plan would you have used? Why?

If I had decided to buy Pinkerton, then I would have financed it through a combination of debt and equity. Since the size of Pinkerton Company was higher than the acquirer, it would never be a wise decision to finance acquisition wholly through debt when no significant cash inflows were expected to result from this acquisition. I would have financed this acquisition by at least 50% equity. This equity could be raised from existing shareholders which didn’t seem to be feasible in this case because of Wathen’s illiquid position. It may have to finance by issued equity to new shareholders or by giving some consideration for Pinkerton to American Brands in the form of shares in the consolidated company.

What is the common denominator of the problems that Wathen faced after he acquired Pinkerton?

The common denominator of problems faced by Wathen was the current capital structure of the company and covenants imposed by the debt. The company was suffering because it has to pay a high cost of debt. These covenants required that Pinkerton would maintain a high amount of working capital and imposed limitations on taking further debt. Also, the debt to equity ratio of the company had reached too high to take further debt to finance acquisition to grow. Also, MHTC required that no dividend would be paid. Thus, Wathen being a major shareholder was lacking free cash flow to pay back its personal loan. So this high amount of debt was a major issue that needs to be resolved.

Do you think Wathen was justified in paying less than $100 million for Pinkerton? Please provide your reasons.

Pinkerton had incurred losses in recent years and much of the value would be coming from the consolidated company, not just from Pinkerton. It may be fair to pay less than $100 million for Pinkerton. Another approach for Pinkerton's valuation was to compare it to Wackenhut whose sales in 1989 were $462 million which was comparable to $412 million of Pinkerton before the acquisition. Wackenhut had a market value of $93.6 million ($24/share*3.9 million shares) with sales of $462 million. Other things assumed to be constant, it could be concluded that it was fair for Wathen to pay $95 million for acquiring Pinkerton.

Did the forecasted benefits in Pinkerton A materialize? Please provide evidence to support your reasons.

Expected goals to achieve from the consolidated company is to become one of the largest players in the industry, to improve margins by charging premium prices and achieving cost efficiencies by reducing fixed costs. There is sufficient evidence that almost all of these goals were achieved. Pinkerton's individual was amongst the big players in the industry. So after consolidation, its market share would be increased further. Gross margin had been improved from 7.4% in 1987 to 8.6% in 1988. Unprofitable contracts had been canceled or transferred. These cost reduction steps would lead to an increase in net income to $6.3 million in 1989.

What do you think about the Berkeley Capital loan? Are the conditions for the loan good for Wathen?

The interest rate charged on MHTC is 12% (prime rate of 10.5%+1.5%) but the interest rate charged by Berkeley is starting from 13% and then reach 13.5% till maturity.

 

1989

Number of Shares Outstanding

4,719,569

Value of Equity ($)

23,709,000

Value /Share($)

5.02

Book value per share of Pinkerton in 1989 is $5.02 but Berkeley could get these shares by exercising warrants at a rate of 0.0007 for each share. Thus Berkeley could get these shares at a sufficient discount than book value. Thus, the cost of debt would be much higher than 13%.  Positive aspects about this loan are that its repayment is starting from 1993 thus would give Pinkerton a breathing space to improve its capital structure. Debt covenants were also lenient for Berkeley loan than MHTC loan. Overall this loan had a much higher cost and would be bad for the company.

Discuss the pluses and minuses of the two capitalization plans that Mr. Berger is considering.

Leveraged Capitalization would reduce the cost of debt for the company as well as reduce restrictive debt covenants on the company. This would also help in the resolving issue faced by Wathen by enabling him to pay off his personal debt and it didn’t dilute the ownership of Wathen. Also, there was less risk associated amount of money raised. But the major setback of using leveraged capitalization was that it would not reduce debt/equity ratio to the required level and if the company would not be able to perform well in the future, this high level of debt would be problematic.

Using IPO to improve capital structure would reduce debt/equity ratio to the appropriate level and the cost of debts for notes of 10.35% issued would be even lower than that of the above loan of 13.66% (assuming rating of B being comparable to Wackenhut).

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