Estimate esterlines cost of capital

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Reference no: EM131266991

Part -1:

Esterline Technologies Cost of Capital (A)

The calendar on her desk showed January 25, 2005 as Jena Taylor carefully read several stock analysts' reports on Esterline Technologies. Jena had recently been hired to manage an equity portfolio at a mutual fund management firm, and she knew that her first stock picks would be closely scrutinized by senior management. Adding to the pressure was the fact that any year-end bonus Jena might anticipate would be tied to the portfolio's performance.

Jena's portfolio focused primarily on medium to large firms that had made successful acquisitions. Hence, the ideal firm for this portfolio had demonstrated its ability to acquire other (typically smaller) firms and enhance their performance through managerial improvements, organizational efficiency gains, or simple cost cutting. The underlying idea was that firms that had demonstrated the skill and knowledge to successfully acquire and improve other firms could replicate such success with new acquisitions. Thus far the approach seemed to be working.

Jena was considering Esterline Technologies as a potential addition to her portfolio. Centered in Bellevue Washington, Esterline employed more than 6000 people, had manufacturing facilities in 11 states, the U.K., and continental Europe, and had successfully integrated more than 30 acquisitions since 1996.

The firm was listed on the

NYSE as ESL and, in preparation for future acquisitions, had completed an equity offering in November 2004 by issuing 4.36 million new shares of common stock at roughly $25 per share. The company described itself in its website as follows:

"Esterline Technologies is a specialized manufacturing company serving principally aerospace and defense markets. Approximately 80% of total revenues are generated from aerospace/defense markets. The remaining 20% is from the application of these technologies into industrial markets. Esterline management views the company's businesses in three segments related to its set of core competencies: Avionics & Controls, Sensors & Systems, and Advanced Materials."

Each of the three business segments was responsible for approximately one-third of the firm's total 2004 revenues. The company faced stiff competition in each segment. Its principal competitors in the Avionics and Controls segment included Eaton Corporation (ETN), ECE, and Eastprint. Ametek (AME), Deutsch, Tyco, MPC Products and Goodrich were chief competitors for the Sensors and Systems segment; and TransDigm and Meggitt (including Dunlop Standard Aerospace Group) were the primary competitors for the Advanced Materials segment.

In late 2004 and early 2005 Esterline's stock price had taken a beating (see Exhibit 1). It closed at $29.10 on January 25, 2005, down from more than $36 a share on Decemeber 2, 2004 - a loss of more than 15%. Nonetheless, most analysts were lukewarm about the stock, suggesting a lack of consensus over whether the recent drop created a buying opportunity or was a harbinger of worse to come (see Exhibit 2). Based on most analysts' ambivalence, Jena thought that Esterline's stock price would likely fluctuate around $29 over the next couple of months. But she wondered if this price reflected Esterline's long-term value.

Not wanting to stake her bonus on analysts' opinions, Jena decided to do her own valuation of the company using a discounted-cash-flow approach (see Exhibits 3 and 4). Given her cash flow forecasts, the implied value of Esterline's stock depended on the discount rate she applied. Using a 10.2% discount rate, for example, implied a value of around $25.5 per share. At 9.2%, however, the implied value was around $40.1 per share.

Based on her calculations, if Esterline's cost of capital exceeded 9.8% the discounted cash flow analysis suggested that the stock was not a bargain at current prices. If the cost of capital were less than 9.8%, then Jena would be interested in adding the stock to her portfolio. If the cost of capital were close to 9.8%, then Jena wondered if anything could be concluded given the sensitivity of the results to the assumptions.

Case preparation questions

1. Review Jena's cash flow forecast assumptions at the bottom of Exhibit 3, and her long-term growth assumption in Exhibit 4. Is there anything you would change? Explain your reasoning.

2. When estimating the WACC, is it more appropriate to use market or book values for equity? For debt? Explain your reasoning.

3. Using Jena's analysis as a starting point, estimate Esterline's cost of capital (WACC). For simplicity, use 7% as the average market risk premium in the CAPM when estimating the cost of equity.

4. Using Jena's cash flow projections and your estimate of the cost of capital, is Esterline overvalued or undervalued at its current price of $29.10?

Additional class discussion questions

5. What is Esterline's equity beta (also called its "levered beta")? Estimate Esterline's asset beta (also called its "unlevered beta"). Use information in the exhibits to answer this question.

6. Are the betas quoted on financial websites levered or unlevered? What types of risk are associated with asset (unlevered) and equity (levered) betas? Briefly explain.

Part -2:

Esterline Technologies Cost of Capital (B)

Jena Taylor had recently examined the future cash flows, the cost of capital, and the overall value of Esterline Technologies (see "Esterline Technologies Cost of Capital (A)"). Soon after making her decision about whether to add Esterline to her equity portfolio, Jena learned that Esterline was considering expanding its operations in its Avionics and Controls business segment. Apparently, the firm was enjoying increased demand for several of its products including the KDM series AMLCD displays, specialized Mason Control grips, and its specialized 38 mm vandal-proof fascia mounted track balls, and hence was considering whether to expand its capacity through internal
expansion or by making another acquisition.

Because any expansion or acquisition would affect Esterline's stock value, Jena was very interested in the firm's deliberations. She knew that Esterline's managers would evaluate any capital expenditure by calculating its net present value. What, however, would be the appropriate discount rate? Would, and should, the firm use its overall cost of capital for its investments in the Avionics and Controls segment?

As indicated in the A version of this case, one of Esterline's competitors in its Avionics and Controls segment is the Eaton Corporation (ticker: ETN). Exhibit 1 for case B provides some information on the Eaton Corporation.

Case Preparation Questions

1. Suppose that all three of Esterline's business segments have the same risk. What would be the appropriate discount rate to evaluate a potential project in the Avionics and Controls segment? Explain.

2. Now assume the three segments have different levels of risk. What would be the appropriate discount rate to evaluate a potential project in the Avionics and Controls segment? Show how to estimate this rate. (Hint: Assume Eaton's asset beta is the same as the asset beta for Esterline's Avionics and Controls segment).

3. How close is the discount rate for the Avionics and Controls segment to Esterline's overall cost of capital?

Additional class discussion questions

4. What problems might arise if Esterline uses its overall cost of capital to evaluate projects in its Avionics and Controls segment?

5. What problems might arise if Esterline tries to implement a system in which it uses different discount rates for its three main business segments?

6. Suppose all of Esterline's other non-Avionics and Control activities (the activities in the other two divisions) have the same risk, which differs from that of the Avionics and Control segment. What hurdle rate should be used to evaluate capital expenditures in these other divisions?

Attachment:- Assignment.rar

Attachment:- Esterline - case.rar

Reference no: EM131266991

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