Case 2 – The Chrysler Takeover Attempt 1. Evaluate Chrysler’s financial and operating performance between 1980 and 1992. What financial and investment policies did they pursue and why? How successful were they? During the early 1980s Chrysler recovered from a severe enterprise crisis in 1978. Vehicle sales grew stable from 1980 to 1986 (with a small stagnation in 1982). In 1983 they grew much stronger than the U. S. -vehicle market and their competitors.
This reflected in a steady earnings growth and Chrysler was able to repay a granted government loan 7 years earlier than initially scheduled. In 1987 their vehicle sales declined, due to a lack of investments in new product lines, Chrysler had no major new car developments in the pipeline in the late 80’s, which led to a consistent decrease in sales until 1991. In the meantime, Chrysler followed a diversification strategy (starting around 1983) and acquired different companies from other industries and established some joint ventures. 990 to 1991 was also the time of an economic recession. In order to face the company’s sales decline and the economic downturn they undertook several measures. They ended their diversification strategy and generated cash by selling off non-automotive business units. Cash came also from stock offerings and a debt offering. However, the company was in a miserable position, junk rated and facing an underfunded pension plan. In 1994 the company had reached a solid foundation, outperforming their competitors with an operating profit per vehicle of $1990.
All in all, the time frame can be described as a rollercoaster ride with a solid ending position. 2. What should Chrysler’s capital structure look like? What payout policies should they pursue? How does that compare with the policies pursued by current management? It is hard to tell how the ideal capital structure of a company should look like. Looking at the main US-competitors of Chrysler however reveals that they hold less cash reserves than Chrysler and are more leveraged than Chrysler.
Chrysler was at the verge of bankruptcy and thus manages very conservative in order to avoid a similar situation in the future. However, (already anticipating findings of the following questions), a higher leverage would increase the value of the company severely. * 3. What is the intrinsic value of a share of Chrysler stock? How does that value compare to the market’s valuation? * The intrinsic value of a share, based on the Net Present Value of a 10 year Cash Flow projection plus Terminal Value calculation would be $86. 23.
This is an excess of $31. 23/share compared to the Kerkorian offer of $55. * The intrinsic value calculation is based on the following main assumptions: * Moderate sales growth rate of ~3. 5% per annum * EXCEPTION: Assumed crisis in 2002 which leads to a sales decline of 20% for Chrysler. Historical data suggests some evidence that there is a decline in automotive sales every 4-6 years. Otherwise the Intrinsic value per share would be even higher * Please refer to the Excel sheet for detailed calculations/assumptions. 4. Why is Chrysler a takeover target? Would there be any value created by a takeover? Chrysler has a significant amount of $7. 5 billion cash reserve. Holding excessive cash reserves make companies an attractive takeover target, because parts of the deal can be financed through the cash reserves. Chrysler argued that the cash was necessary for overcoming the next downturn period. Kerkorian on the other hand says that this amount of cash is far too much and that they can lend money during the next economic downturn.
The transaction does not create value in itself but could be the cornerstone for potential future value creation for the following reasons: * Chryslers management may only be interested in protecting their jobs during the next downturn, rather than finding more efficient ways to run the company in such an economic cycle * Chrysler misses the opportunity to deduct interest payments on debt from taxes * Management has to struggle/work hard in order to pay off debt (Performance incentive), while large cash reserves would tempt them to invest in bad projects All of the above do not influence the line of workers, so one could argue that Chrysler would be better off after the leveraged buyout. 5. Evaluate the structure of Kerkorian’s proposed deal in detail. Does it make sense? What risks are involved? What would you do differently? From our point of view, the most salient risk of the offer is that it was made without having the funds raised beforehand! In this respect we would definitely differ from Kerkorian’s approach and clarify the funding at first.
It is also unclear, whether the reduced cash amounts are enough to serve the needs of a possible future downturn. On the other hand, an increased leverage of the firm (as a consequence of the takeover) yielded in a higher intrinsic value per share for Chrysler. Target Debt/Debt+Equity| Resulting intrinsic value/share| 10% (current management case)| $86. 23| 18%| $89. 33| 25%| $92. 24| 6. If you were Eaton, how would you respond to the takeover deal? If you were a shareholder, how would you like Eaton to respond? As the management of Chrysler, represented by Eaton, considered the offer as a hostile takeover attempt, we would respond with actions of defense.
The Poison Pill was already diluted by the share buyback, so some other possibilities as the search for a white knight or a golden parachute for the management could be executed. Another possibility for the management would be that the management undertakes a similar analysis as in Question 3 which lead to the conclusion that the share is undervalued by the market and thus the Kerkorian offer is too low either. If I was a shareholder that follows the beliefs stated in Question 4, I would be quite happy by the Kerkorian offer. On the other hand, I could also follow the management’s line of reasoning or, be even more skeptical, and see the takeover attempt as an excess similar to the corporate raider era in the 1980s.