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Problem Solution: Lester Electronics

Lester Electronics, Inc. (LEI), a company that was founded in 1978 is an industrial electronics parts distributor in the US, traded at the NASDAQ.

Shang-way (SWA) manufactures capacitors and has an exclusivity agreement with LEI for LEI to being the sole distributor in the US for the capacitors manufactured by Shang-wa.

Transnational Electronics Corporation (TEC) is a large manufacturer and distributor of electronics components in the US. TEC is looking for possibilities to expand their business and grow. TEC is interested in acquiring Schang-wa so that they can distribute the capacitors to the US market. This would lead to a decline in turnover for LEI of 45% over the next 5 years.

Avral Electronics, S.A. (Avral) is a French electronic equipment and component parts manufacturer with manufacturing sites in Ireland, France and Asia. Avral has a broad shareholder base and managed to increase revenues from $300 to $900 million. Avral has a good financial status and explores possibilities for growth in the US.

The founder of LEI, Bernhard Lester and the owner of SWA, John Ling have a long relationship and John Ling is member of the board of directors at LEI. Both executives wish to retire from the day-to-day business. Nevertheless, LEI and SWA need to grow and maximize shareholder wealth to prevent hostile takeovers.

LEI has decided to merge with SWA to benefit from vertical market synergies and needs to investigate the financing options for the merger. LEI faces several issues and opportunities which are described next.

Situation Analysis

Issue and Opportunity Identification

Table 1 shows several issues and opportunities that LEI is facing. If LEI and Shang-wa merge, the consolidated income statement will have a decreased cash flow and gross profit because the combined company will lose the sales of products to LEI. This is a major obstacle that makes it impossible for LEI to just buy Shang-wa with cash. But in order to compensate for that loss, LEI will use the synergies that come from the vertical merger such as revenue enhancement, tax gains, diversification and an increased product portfolio. The major task will be to determine the right price. Prices in mergers and acquisitions can be determined in various ways. One way would be to evaluate the assets and use this figure as the basis for the transfer to LEI. LEI could just take over the debt part of the value of the company and let John Lin still have his equity part. LEI could also buy the shares from John Ling at an adequate price.

The balance sheet of Shang-wa states assets with a book value of $142,292.70 but the market value could be much higher or lower. The debt ratio of Shang-wa is almost 75% whereas shareholder equity is only around 25%. As Shang-wa is a production company, a higher debt ratio is quite common, but the products are highly innovative, so the risk is high and costs for financial distress could be also high. As the scenario does not provide information about the stock price of Shang-wa, it is difficult to make a final approach through market value of stock. The only way would be to use the constant growth valuation model and thus define the present value of operations (present value of all future free cash flows from the company at the constant growth rate). Thus, LEI could find out the value of the equity. As Shang-wa has negative cash flow as well as relatively low net income (if one reduces the income by the one that comes directly from LEI), the negotiation position for LEI would be quite good to receive a low price for the shares of John Ling.

Financing the take-over is another issue. LEI does not have enough cash to buy the assets. Thus, there is the possibility to either issue new debt or to issue new equity. Debt would increase the possibility of tax saving, equity would lower the costs for financial distress. LEI needs to calculate the best ratio of debt to equity to achieve lowest possible weighted average cost of capital.

LEI needs to make sure that it can pay its debt in the future, especially the short-term financing is an issue here. LEI needs to evaluate the possibilities of bank borrowing or commercial paper issuing in order to make sure that the net working capital remains positive. A close look at the short-term assets and short-term liabilities will give insight to the possible carrying costs or shortage costs. Calculations need to be based on future sales forecasts as well as possible economic exposure to exchange rates. Becoming