What is the net present value of the acquisition

Question

Case Scenario:

Sharon Scotia, CFO of Rome Industries, must decide what to do about Procras Corporation, a major customer that is technically insolvent. Rome Industries is a large plastic-injection-molding firm that produces plastic products to customer order. Procras Corporation is a major customer of Rome Industries that designs and markets a variety of plastic toys. As a result of mismanagement and inventory problems, Procras cannot pay its bills as they come due. Among its unsecured debts are total past due accounts of $1.9 million owed to Rome Industries.

Procras is attempting to restructure under the terms of the Companies Creditors Arrangement Act (CCAA). However, given the company's high debt load and other significant financial problems, a restructuring will likely not be possible. As a result, the company will likely be declared bankrupt.

Recognizing that it probably cannot recover the full $1.9 million that Procras Corporation owes it, the management of Rome Industries has isolated two mutually exclusive alternative actions: (1) acquire Procras through an exchange of common shares or (2) let Procras be liquidated and recover Rome Industries proportionate claim against any funds available for unsecured creditors.

Rome's management feels that acquisition of Procras would have appeal in that it would allow Rome to integrate vertically and expand its business from strictly industrial manufacturing to include product development and marketing. Of course, the firm wants to select the alternative that will create the most value for its shareholders. Charged with making a recommendation as to whether Rome should acquire Procras Corporation or allow it to be liquidated, Ms. Scotia gathered the following data.

Acquire Procras Corporation Negotiations with Procras's management and board have resulted in a planned ratio of exchange of 0.1 share of Rome Industries for each common share of Procras. Rome's common shares are currently trading for $32.00 per share. Rome will also acquire all of Procras's liabilities. Procras has 60,000 common shares outstanding. With proper management in place, Sharon Scotia believes that Procras could generate incremental after-tax operating income of $180,000 per year for an indefinite future for Rome Industries. Rome's cost of capital is 12 percent; this rate will be used to analyze the acquisition of Procras.

Liquidate Procras Corporation Procras's secured and unsecured creditors both voted to reject the company's Plan of Arrangement and the firm was immediately declared bankrupt. The firm's pre-bankrupt balance sheet is provided below. After analyzing the firm's assets, the company's court-appointed receiver expected to be able to liquidate the current assets for $2,200,000 and the fixed assets for $700,000. The court and trustee fees associated with the CCAA process total $250,000. These must be fully paid from the proceeds from the liquidation. The accrued wages, unpaid source deductions, and income taxes payable must also be fully paid from the liquidation proceeds.

The secured creditors have agreed to accept $0.95 per $1.00 owed. The line of credit is secured by the company's inventory and receivables, but given the decline in value of these two assets, the bank that holds the line of credit has CHAPTER CASES 29 agreed to accept $0.65 per $1.00 owed. In both cases, these secured creditors have agreed to have the unpaid amounts written off; they will not become part of the unsecured creditor pool. The unsecured creditors will share equally in the remainder of the proceeds from the liquidation. The common shareholders have been promised nothing from the liquidation process.

Procras Corporation
Pre-bankrupt Balance Sheet

Assets		Liabilities and shareholders' equity
Cash	$             20,000	Accounts payable	$2,800,000
Marketable securities	1,000	Line of credit-bank	1,300,000
Accounts receivable	1,800,000	Accrued wagesa	180,000
Inventories	3,000,000	Income taxes payable	70,000
Prepaid expenses	14,000	Total current liabilities	$4,350,000
Total current assets	$4,835,000	First mortgageb	300,000
Land	415,000	Second mortgageb	200,000
Net plant	200,000	Unsecured bonds	400,000
Net equipment	350,000	Total long-term debt	S      900,000
Total fixed assets	965,000	Common shares (60,000 shares)	$      600,000
Total assets	$5,800,000	Retained earnings	-50.000
		Total shareholders' equity	$      550,000
		Total liabilities and equity	$5,800,000

a Represents wages of $600 per employee for 200 of the firm's employees, plus source deductions that have not been paid for 5 months.
bThe first and second mortgages are fully secured by the firm's total fixed assets.

Required:

Question 1: Determine the value of Procras Corporation to Rome Industries. What is the net present value of the acquisition? Is synergy created? Comment.

Question 2: From the information provided in the case, determine and show how the proceeds from the liquidation will be allocated among the various parties owed money. What is the total amount the unsecured creditors will share from the liquidation? How much will they receive per $1.00 owed?

Question 3: How much, if any, will Rome Industries recover of its $1.9 million balance due from Procras Corporation as a result of the liquidation of Procras?

Question 4: Compare your findings in (2) and (3), and make a recommendation for Rome Industries with regard to its best action acquisition of Procras or its liquidation.

Question 5: Which alternative would the shareholders of Procras Corporation prefer? Why?