Excel Formula For Determining Wins And Losses Based On Score Financial Analysis on an Oil Corporation Takeover

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Financial Analysis on an Oil Corporation Takeover

Gulf Oil Corporation – Acquisition

Summary of the facts

o George Keller of Standard Oil Company of California (SoCal) is trying to determine how much he wants to bid for Gulf Oil Corporation. Golf will not consider bids below $70 per share, although their last closing price per share was valued at $43.

o Between 1978 and 1982, the Gulf doubled its exploration and development spending to increase its oil reserves. In 1983, Gulf began to significantly reduce exploration expenditures as oil prices plummeted, with Gulf management repurchasing 30 million of its 195 million shares.

o The Gulf Oil takeover was due to a recent takeover attempt by Boone Pickens Jr. of Mesa Petroleum Company. He and a group of investors spent $638 million and acquired about 9% of all Gulf shares. Pickens was involved in a proxy fight for control of the company but Gulf officials fought Boone’s takeover because he followed up with a partial tender offer at $65 per share. Golf then decided to liquidate on its own terms and approached several firms to participate in the sale.

o The improvement opportunity was Keller’s main attraction to Gulf and now he must decide whether Gulf, if liquidated, is worth $70 per share and how much he should bid for the company.

problems

o What is Gulf Oil’s price per share if the company is liquidated?

o Who are social competitors and how are they a threat?

o What should be the social bid in Gulf Oil?

o What can be done to prevent Socal from operating as a Gulf Oil going concern?

Competition

Major competitors for acquiring Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO, and of course, SoCal.

Mesa Oil:

o Currently holds 13.2% of Golf’s stock at an average purchase price of $43.

o Borrowed $300 million against Mesa securities, and offered $65/share for 13.5 million shares, which would increase Mesa’s holdings to 21.3%.

o Under the reincorporation, they would have to borrow several times the value of Mesa’s net worth to get the majority needed to get a seat on the board.

o Mesa is unlikely to raise that much capital. After all, Bon Pickens and his investor group will make a substantial profit if they sell their current shares to the winner of the bidding.

ARCO:

o The offer price could be lower than $75/share because a bid of $75 would increase its debt ratio, thus making it harder to borrow more.

o SoCal’s debt is only 14% of total capital (Exhibit 3), and banks are willing to lend enough to make potential bids of $90.

Kohlberg Kravis:

o Expertise in leveraged buyouts. Keller thinks the heart of their proposal is protecting the Bay’s name, property and jobs, so they’re a bid to lose. The gulf will inevitably remain a concern until a long-term solution is found.

Socal’s proposal will be based on the value of the Gulf’s reserves without further exploration. Gulf’s other assets and liabilities will be included on SoCal’s balance sheet.

Gulf Oil’s weighted-average cost of capital

o Gulf’s WACC was determined to be 13.75% using the following assumptions:

o CAPM is used to calculate the cost of equity using a beta of 1.5, risk free rate of 10% (1 year T-bond), market risk premium of 7% (Ibbotson Associates data of arithmetic mean from 1926 – 1995). Cost of Equity: 18.05%.

o The market value of equity was determined by multiplying the number of shares outstanding by the 1982 share price of $30. This price was used because it is the un-swept price before being driven by takeover attempts. Market value of equity: $4,959 million, weight: 68%.

o The debt was valued using the book value of the long-term debt, $2,291. Weight: 32%.

o Cost of Loan: 13.5% (Given)

o Tax rate: 67% calculated by net income before tax divided by income tax expense.

Assessment of Gulf Oil

The value of the Gulf is made up of two components: the value of the Gulf’s oil reserves and the value of the firm as a going concern.

o A projection was made of oil production from 1983 until all reserves were exhausted (Exhibit 2). Production in 1983 was 290 million composite barrels, and it was projected to remain constant until 1991 when the remaining 283 million barrels were produced.

o Production costs were kept constant relative to production volume, including depreciation due to the unit-of-production method currently used by Gulf (production would be the same, so the depreciation amount would be the same)

o Because Gulf uses the LIFO method of inventory accounting, it is assumed that new reserves are expensed in the year they are discovered and all other exploration costs, including geological and geophysical costs, are charged against earnings.

o There will be no further exploration going forward, only expenses will be considered which are the costs involved in production to deplete reserves.

o The price of oil was not expected to increase over the next ten years, and since inflation affects both the selling price of oil and the cost of production, it cancels itself and is rejected in the cash flow analysis.

o Revenue minus expenses determined cash flow for the years 1984-1991. The cash flow stopped in 1991 when all oil and gas reserves were exhausted. Cash flow accounts only for the liquidation of oil and gas assets, and does not account for the liquidation of other assets such as current assets or net assets. The cash flows are then discounted by the net present value using the Gulf’s cost of capital as the discount rate. Total cash flows until liquidation is complete, discounted by Gulf’s 13.75% discount rate (WACC), comes to $9,981 million.

The value of the bay as a going concern

o The second component of a bay’s value is its price.

o Relevant to the valuation because Socal does not plan to sell any Gulf assets other than its oil under the liquidation plan. Instead, SoCal will use other assets in the bay.

o Socal may choose to convert the Gulf into a going concern at any time during the liquefaction process, requiring the Gulf to begin the exploration process all over again.

o Value as a going concern was calculated by multiplying the number of shares outstanding by the 1982 share price of $30. Price: $4,959 million.

o The 1982 share price was chosen because this price is the market assigned price before the price was driven by takeover attempts.

Bid strategy

o When two companies merge it is common practice for the acquiring company to pay more for the acquired firm.

o Results in shareholders of the acquired company benefiting from overpayments and shareholders of the acquiring company losing value.

o Socal’s liability is to their shareholders, not Gulf Oil’s shareholders.

o Socal has set the price of Gulf Oil, in liquidation, at $90.39 per share. Paying anything above this amount would be a loss for social shareholders.

o The maximum bid amount per share was determined by finding the price per share with Socal’s WACC, 16.20%. The resulting price was $85.72 per share.

1. This is the price per share at which Socal should still be able to make a profit from the merger, as Socal’s WACC of 16.2% is closer to what Socal expects to pay its shareholders.

o The minimum bid is usually determined by the price the stock is currently selling for, which would be $43 per share.

1. However, Gulf Oil will not accept a bid below $70 per share.

2. Also, adding a competitor’s willingness to bid at least $75 per share increases the winning bid price.

o Socal averaged the maximum and minimum bid prices, resulting in a bid price of $80 per share.

Maintaining social value

o If Socal buys Golf for $80 it is based on the liquidation value of the company and not as a going concern. Therefore, if Socal operates Golf as a going concern their stock will be devalued by about half. Social stockholders fear that management could seize control of the company and take control of the company, which is valued at its current stock price of $30.

o After the acquisition, there will be huge interest payments which may force the management to improve performance and operational efficiency. The use of debt in takeovers not only serves as a financing technique but also as a tool to force changes in managerial behavior.

o There are some strategies that SoCal can use to convince stockholders and other relevant parties that SoCal will take over and use the Gulf at an appropriate price.

o The contract may be executed at or before the time of bidding. It will specify the future liabilities of the social management and include their liquidation strategy and estimated cash flows. Although management may honor the contract, there is no real incentive to prevent them from implementing their own agenda.

o Management can be monitored by an executive; However, this is often an expensive and ineffective process.

o Another way to ensure shareholders, especially when monitoring is too expensive or too difficult, is to align management’s interests with those of stockholders. For example, an increasingly common solution to the difficulties arising from the separation of ownership and management of public companies is to pay managers partially with shares and share options in the company. This gives managers a powerful incentive to act in the interests of owners by maximizing shareholder value. This is not a perfect solution because some managers with many share options engage in accounting fraud in order to increase the value of those options enough that they can cash some of them, but to the detriment of their firm and its other shareholders. .

o It would be most beneficial and least expensive for SoCal to align its managers with stockholders’ concerns by partially paying their managers shares and stock options. There are risks associated with this strategy but it will certainly be a boost for Gulf Oil’s management.

recommendation

o Socal will bid for Gulf Oil because its cash flows show it is worth $90.39 in a liquidated state.

o Socal will bid $80 per share but limits further bidding to a maximum of $85.72 because paying a higher price would hurt Socal’s shareholders.

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