Case Notes/Answers
Pinkerton (A), by Scott Mason, Adam Berger
Discussion Questions:
1. To gain practice in the standard tools of financial analysis, including pro forma
projections, sensitivity analysis, funds requirements, etc.
2. To review the valuation of a company using the weighted average cost of capital
and estimated free cash flow.
3. To review both short-term and long-term financial policy, including the issues of
target capital structure, flexibility, economic dilution, costs of financial distress,
and the restrictions imposed by debt service.
4. To interpret a quantitative valuation analysis in light of a full range of both
quantitative and qualitative factors; review the interaction between investment
and financing decisions.
, Pinkerton (A)
Teaching Note
Substantive Issues
Pinkerton [A] is a comprehensive review case. The case analysis involves the evaluation of
an acquisition opportunity, to include the weighted average cost of capital, valuation of the
acquisition and related synergies, and bidding strategies. The case also explores the interaction
between corporate investment and financing decisions. The analysis of highly-levered financing
alternatives sets the stage for an interesting discussion of capital structure issues.
This case can be used effectively in combination with the Pinkerton [B] case, No. 292-136.
Pedagogical Objectives
1. To gain practice in the standard tools of financial analysis, including pro forma
projections, sensitivity analysis, funds requirements, etc.
2. To review the valuation of a company using the weighted average cost of capital
and estimated free cash flow.
3. To review both short-term and long-term financial policy, including the issues of
target capital structure, flexibility, economic dilution, costs of financial distress,
and the restrictions imposed by debt service.
4. To interpret a quantitative valuation analysis in light of a full range of both
quantitative and qualitative factors; review the interaction between investment
and financing decisions.
Opportunities for Student Analysis
Tom Wathen is considering a $100 million bid to purchase Pinkerton’s from American
Brands, having just had an $85 million bid turned down. He is eager to purchase the firm, sure that
his own firm, CPP, could add considerable value (to both firms) through efficiencies and a premium-
1
, 292-141 Pinkerton (A)
2
pricing strategy. Pinkerton’s is about 1 times as large as Wathen’s existing firm, so he must turn to
outside financing to fund the purchase. His two financing alternatives are an all-debt bank financing,
and a 75% debt, 25% equity financing that gives up 45% of the new combined firm to outside
investors. Wathen’s board of directors is not nearly as eager about the acquisition, so Wathen must
thoroughly address not only the issue of maximizing expected shareholder value, but also integration
of a difficult but potentially lucrative operating strategy and a highly-levered financial strategy.
2
This teaching plan envisions spending 1 class sessions on this review case, as the first case
of a two-case Pinkerton sequence spread out over three class sessions. The first session is concerned
with a discussion and valuation of the acquisition. Another half-session will be required to evaluate
and discuss the financing options and reach a decision. The [B] case then follows up on the situation
two years later, giving students the full flavor of the importance of a genuine focus on value, the
interaction of operating and financial decisions, and a sense of the real costs of financial distress.
Alternatively, this [A] case can also be covered by itself in one rather full session, if the focus is
narrowed (e.g., give students the WACC ahead of time; or, eliminate qualitative discussions of
bidding strategy; etc.).
The case discussion might start out with a qualitative discussion of the reasons for the
acquisition, or the question, “How do we plan to create value here?”. In addition to listing all the
improvements and changes that are planned, this exercise can get the students thinking about why
the value of Pinkerton’s might be different to different players (American Brands, Wathen, other
bidders). This set up can later be extended to a discussion of bidding strategy, based upon various
valuations (see Exhibit TN-1E).
Valuation
The first issue is to value the acquisition of Pinkerton’s. We will need to estimate the
weighted average cost of capital to use as a discount rate, and the free cash flows associated with the
net assets of Pinkerton’s. A starting point for the determination of the WACC is the target capital
structure. Several incorrect choices may be discussed, such as the structure of the specific deal
financing, or some book value target, or the capital structure of the combined entity immediately after
the acquisition financing. Correct approaches to the target capital structure should consider the risk
of the acquisition target. An argument could be made for using CPP’s capital structure, only because
it is very similar to the acquisition in its business and business risk. A more standard approach might
take the target capital structure of a comparable company, such as the 13% market value D/TC of
Wackenhut (Exhibit 4). Wathen’s premium-pricing strategy seems to be high in both total and
systematic risk, so perhaps the “right” target capital structure would have less debt than less risky
“comparable” companies. The cost of debt to use in the WACC calculation is not 11.5% or 13.5%
(from the deal financing), but is instead the debt rate that is consistent with the target capital
structure. There is very little information on this, but a 13% D/TC capital structure might leave
Pinkerton’s with about an “A” debt rating, or a 10% cost of debt (Exhibit 5).
See Exhibit TN-1A for a derivation of the WACC. By using data from the comparable
company (Wackenhut), we get an estimate of the unlevered beta of Pinkerton’s net assets, of 0.77. As
a sidebar, you can check that the all-equity WACC would be about 14.4%—thus, we’d expect the
WACC at the optimal capital structure to be lower. Relevering the βusing the chosen capital structure
gives us an estimate for the β of the equity of .89. Of course, if we use the Wackenhut capital
structure as our target, then there is no need to unlever and relever—we would simply use their
2
equity β at their capital structure. Using a 7 % market risk premium and a risk-free rate of 8.58%
(from Exhibit 5), the cost of levered equity is 15.3%. With a 10% cost of debt and a 34% corporate tax
rate, the WACC is computed at 14.1%. As this is an estimate, we will use 14% as the discount rate for
the valuation of the free cash flows.
2
Pinkerton (A), by Scott Mason, Adam Berger
Discussion Questions:
1. To gain practice in the standard tools of financial analysis, including pro forma
projections, sensitivity analysis, funds requirements, etc.
2. To review the valuation of a company using the weighted average cost of capital
and estimated free cash flow.
3. To review both short-term and long-term financial policy, including the issues of
target capital structure, flexibility, economic dilution, costs of financial distress,
and the restrictions imposed by debt service.
4. To interpret a quantitative valuation analysis in light of a full range of both
quantitative and qualitative factors; review the interaction between investment
and financing decisions.
, Pinkerton (A)
Teaching Note
Substantive Issues
Pinkerton [A] is a comprehensive review case. The case analysis involves the evaluation of
an acquisition opportunity, to include the weighted average cost of capital, valuation of the
acquisition and related synergies, and bidding strategies. The case also explores the interaction
between corporate investment and financing decisions. The analysis of highly-levered financing
alternatives sets the stage for an interesting discussion of capital structure issues.
This case can be used effectively in combination with the Pinkerton [B] case, No. 292-136.
Pedagogical Objectives
1. To gain practice in the standard tools of financial analysis, including pro forma
projections, sensitivity analysis, funds requirements, etc.
2. To review the valuation of a company using the weighted average cost of capital
and estimated free cash flow.
3. To review both short-term and long-term financial policy, including the issues of
target capital structure, flexibility, economic dilution, costs of financial distress,
and the restrictions imposed by debt service.
4. To interpret a quantitative valuation analysis in light of a full range of both
quantitative and qualitative factors; review the interaction between investment
and financing decisions.
Opportunities for Student Analysis
Tom Wathen is considering a $100 million bid to purchase Pinkerton’s from American
Brands, having just had an $85 million bid turned down. He is eager to purchase the firm, sure that
his own firm, CPP, could add considerable value (to both firms) through efficiencies and a premium-
1
, 292-141 Pinkerton (A)
2
pricing strategy. Pinkerton’s is about 1 times as large as Wathen’s existing firm, so he must turn to
outside financing to fund the purchase. His two financing alternatives are an all-debt bank financing,
and a 75% debt, 25% equity financing that gives up 45% of the new combined firm to outside
investors. Wathen’s board of directors is not nearly as eager about the acquisition, so Wathen must
thoroughly address not only the issue of maximizing expected shareholder value, but also integration
of a difficult but potentially lucrative operating strategy and a highly-levered financial strategy.
2
This teaching plan envisions spending 1 class sessions on this review case, as the first case
of a two-case Pinkerton sequence spread out over three class sessions. The first session is concerned
with a discussion and valuation of the acquisition. Another half-session will be required to evaluate
and discuss the financing options and reach a decision. The [B] case then follows up on the situation
two years later, giving students the full flavor of the importance of a genuine focus on value, the
interaction of operating and financial decisions, and a sense of the real costs of financial distress.
Alternatively, this [A] case can also be covered by itself in one rather full session, if the focus is
narrowed (e.g., give students the WACC ahead of time; or, eliminate qualitative discussions of
bidding strategy; etc.).
The case discussion might start out with a qualitative discussion of the reasons for the
acquisition, or the question, “How do we plan to create value here?”. In addition to listing all the
improvements and changes that are planned, this exercise can get the students thinking about why
the value of Pinkerton’s might be different to different players (American Brands, Wathen, other
bidders). This set up can later be extended to a discussion of bidding strategy, based upon various
valuations (see Exhibit TN-1E).
Valuation
The first issue is to value the acquisition of Pinkerton’s. We will need to estimate the
weighted average cost of capital to use as a discount rate, and the free cash flows associated with the
net assets of Pinkerton’s. A starting point for the determination of the WACC is the target capital
structure. Several incorrect choices may be discussed, such as the structure of the specific deal
financing, or some book value target, or the capital structure of the combined entity immediately after
the acquisition financing. Correct approaches to the target capital structure should consider the risk
of the acquisition target. An argument could be made for using CPP’s capital structure, only because
it is very similar to the acquisition in its business and business risk. A more standard approach might
take the target capital structure of a comparable company, such as the 13% market value D/TC of
Wackenhut (Exhibit 4). Wathen’s premium-pricing strategy seems to be high in both total and
systematic risk, so perhaps the “right” target capital structure would have less debt than less risky
“comparable” companies. The cost of debt to use in the WACC calculation is not 11.5% or 13.5%
(from the deal financing), but is instead the debt rate that is consistent with the target capital
structure. There is very little information on this, but a 13% D/TC capital structure might leave
Pinkerton’s with about an “A” debt rating, or a 10% cost of debt (Exhibit 5).
See Exhibit TN-1A for a derivation of the WACC. By using data from the comparable
company (Wackenhut), we get an estimate of the unlevered beta of Pinkerton’s net assets, of 0.77. As
a sidebar, you can check that the all-equity WACC would be about 14.4%—thus, we’d expect the
WACC at the optimal capital structure to be lower. Relevering the βusing the chosen capital structure
gives us an estimate for the β of the equity of .89. Of course, if we use the Wackenhut capital
structure as our target, then there is no need to unlever and relever—we would simply use their
2
equity β at their capital structure. Using a 7 % market risk premium and a risk-free rate of 8.58%
(from Exhibit 5), the cost of levered equity is 15.3%. With a 10% cost of debt and a 34% corporate tax
rate, the WACC is computed at 14.1%. As this is an estimate, we will use 14% as the discount rate for
the valuation of the free cash flows.
2
