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A COMPARATIVE ANALYSIS OF ITT CORP. VS FLOWSERVE CORP.

Prepared for Professor Manuchehr Shahrokhi

By Rick Emmett and Rajeev Sharma September 11, 2010 NOTE: This Report is prepared in the format and context of the NOKIA Sample Case Analysis. Do not copy this. Just learn from it. Also, at the end of each questions a few important statements and analysis are missing. They are highlighted.

1. Who Are Our Shareholders? ITT Corporations ownership summary and major shareholders:

Source: http://moneycentral.msn.com/ Flowserve Corp.s ownership summary and major shareholders:

Source: http://moneycentral.msn.com/ Missing: Your comment about ownership of each? Which company you choose and why?

2. Why Do Investors Care About Our Capital Structure? Current debt ratio for ITT Corp. is 22.11% with the value of firm (perpetual growth) at $10.684 billion. Current cost of capital for ITT Corp. is 7.84%. The optimal debt ratio with a minimal cost of capital for ITT Corp. is 50%. The cost of capital is reduced to 7.43% and the value of the firm (perpetual growth) has gone up to the highest level at $11.367 billion. Similarly the debt ratio for Flowserve Corp. is 12.59% with the value of firm (perpetual growth) at $6.205 billion. The cost of capital for Flowserve Corp. is 9.68%. The optimal debt ratio with a minimal cost of capital for Flowserve Corp. is 60%. The cost of capital is reduced to 8.46% and the value of the firm (perpetual growth) has gone up to the highest level at $7.607 billion. Advantages of debt: Tax savings. Interest expenses are tax deductible while cash flows to equity (dividends) are not. This benefit increases with the tax rate. Added discipline by increasing the cost of failure. Disadvantages of debt: Higher expected bankruptcy cost (probability of bankruptcy times the cost). The probability of default is greater for firms that have volatile cash flows. Agency costs. Debt exposes the firm to the possibility of conflicts between stock- and bondholders over investment, financing, and dividend decisions. The covenants that bondholders write into bond agreements to protect themselves against expropriation cost the firm in both monitoring costs and lost flexibility. Loss of flexibility. This is more likely to be a problem for firms that have substantial and unpredictable investment opportunities. The following factors have an influence on the optimal debt ratio, i.e. they determine whether the advantages outweigh the disadvantages of taking on debt. Tax rate: Higher tax rate results in higher tax savings and higher optimal debt ratio. Tax rate for the recent year 2009 for ITT Corp. was 28.12% and the optimal debt ratio of ITT Corp. is 50%. Tax rate for year 2009 for Flowserve Corp. was 32.88% with an optimal debt ratio of 60%. Therefore higher the tax rate higher is the optimal debt ratio because the tax savings increase with the increase in debt. This is true only up to a certain point. Too much debt will rapidly increase the probability of default or bankruptcy. Also, higher debt will lower the value of the firm.

The ability to pay interest The interest coverage ratio determines a companys ability to easily pay interest on outstanding debt. The interest coverage ratio of a company is calculated by dividing a company's EBIT by the company's interest expenses for the same period of time. The lower the interest coverage ratio the tougher is for the company to pay interest and hence is difficult to take on more debt. The interest coverage ratio below 1.5 indicates that the companys revenue is not sufficient to support the interest expense. The interest coverage ratio for ITT is 9.29 whereas the interest coverage ratio for Flowserve Corp. is 15.61. This shows that Flowserve is generating enough revenue and can easily pay off its interest faster than ITT Corp. Also Flowserve is in a better position than ITT to take on more debt. Variance in operating income Beta is known as the measure of volatility of a portfolio as compared to the market as a whole. We have experienced in the company analysis of both ITT Corp. and Flowserve Corp. that the beta increases with the higher debt ratios. Also the cost of equity increases with higher debt ratios and rates. Some other factors that are influenced by the beta are bond rating, interest rates, probability and cost of bankruptcy and the cost of equity. Below are variance analysis of ITT Corp. and Flowserve Corp.:
ITT Corp.

D/(D+E) Ratio = Beta for the Stock = Cost of Equity = Bond Rating = = AT Interest Rate on Debt = WACC Firm Value (Perpetual Growth) = Probability of Default = Expected Bankruptcy Cost =

Current 22.11% 1.11 8.87% AA 4.20%

Optimal 50.00% 1.58 11.01% A3.85%

7.84% 7.43% $10,684,518,418 $11,367,012,001 0.55% 2.5% $13,562,554 $72,116,518

Excel template capstru.xls from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm

Flowserve Corp. Current 12.59% 1.44 10.36% AAA 4.93% 9.68% $6,205,269,724 0.07% $1,076,881 Optimal 60.00% 2.64 15.76% A3.59% 8.46% $7,607,283,398 2.5% $44,835,944

D/(D+E) Ratio = Beta for the Stock = Cost of Equity = Bond Rating = = AT Interest Rate on Debt = WACC Firm Value (Perpetual Growth) = Probability of Default = Expected Bankruptcy Cost =

Excel template capstru.xls from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm Default spreads It is observed that the bond ratings of the companies decrease as the companies try to increase their optimal debt ratio by borrowing more money. Flowserve Corp. is currently rated at AAA with 12.59% debt ratio. At optimal debt ratio of 60% Flowserves bond rating drops to A-. Similarly ITT Corp. currently has 22.11% debt ratio and with an optimal debt ratio of 50% their bond rating also drops to A-. Firm projects Both ITT Corp. and Flowserve Corp. operate in an industry with higher rates of return as compared to other industries. Both the companies operate and invest in projects that earn higher rate of returns as compared to the hurdle rate. We believe that both the companies need flexibility in the future and so the optimal debt ratio should be lower to allow for future borrowings. This explains why both Flowserve Corp. and ITT Corp. have low debt ratios of 12.59% and 22.11% respectively as compared to their optimal debt ratios. Most Favorable Company based on Capital Structure: Flowserve Corp. is considered more favorable than ITT Corp. based on numerous factors. The interest coverage ratio for ITT is 9.29 whereas the interest coverage ratio for Flowserve Corp. is 15.61. Also, current debt ratio of Flowserve Corp. is 12.59% as compared to 22.11% of debt ratio of ITT Corp.; this means that Flowserve is more flexible in terms of its ability to acquire more debt in the future to invest in projects that earn higher rate of returns as compared to ITT. The cost of capital of Flowserve is better than ITT Corp. Also, the bond rating of Flowserve is better than ITT (AAA as compared to AA).

3. What Is Our Cost of Debt Financing? Cost of Debt (Pre-Tax) The pre-tax cost of debt financing for ITT Corporation and Flowserve Corp. in this analysis is estimated by adding a the default spread that is relative to each companies respective credit rating to the risk-free rate. The value of the risk-free rate is estimated by the recent United States 10-Year Treasury bond constant maturity rate of 3.85% as of January 4, 2010; source http://www.federalreserve.gov. The Default Spread for ITT Corporation and Flowserve Corp. is derived by applying each companys recent STANDARD & POORS (S&P) credit rating to the default spread table for large manufacturing firms and retrieving the corresponding default spread value. The default spread table is provided by Professor A. swath Damodaran of the Leonard Stern School of Business at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm. ITT Corporations S&P rating of BBB+ resulting default spread value is 2.0% and Flowserve Corps S&P rating of BB+ resulting default spread value is 3.5%. The pre-taxed cost of financing for ITT Corporation is estimated to be 5.85% and for Flowserve Corp. 7.35%. Cost of Debt (After Tax) The after tax cost of debt is estimated by reducing the pre-tax cost of debt by the tax rate of each respective company. Five year average effective tax rates are used for each company in this analysis as marginal tax rates were unavailable. ITT Corporations average effective tax rate of 28.12% yields a 4.20% after tax cost of debt. Flowserve Corp.s average effective tax rate of 32.88% yields a 4.93% after tax cost of debt.
ITT Corporation
S&P Credit Rating BBB+ 2.00% For large m anufacturing firm s If interest coverage ratio is > to Rating is Spread is -100000 0.199999 D 15.00% 0.2 0.649999 C 12.00% 0.65 0.799999 CC 10.00% 0.8 1.249999 CCC 8.50% 1.25 1.499999 B5.50% 1.5 1.749999 B 5.25% 1.75 1.999999 B+ 4.25% 2 2.25 BB 4.00% 2.25 BB+ 3.50% 2.5 3 4.25 5.5 6.5 8.50 2.49999 2.999999 4.249999 5.499999 6.499999 8.499999 100000 BB+ BBB AA A+ AA AAA 3.50% 2.00% 1.50% 1.25% 1.00% 0.75% 0.50%

Risk-Free Rate of U.S. 10 year T_Bond as of January 4, 2010 Pre-Tax Borrow ing Cost Effective Tax Rate (5yr avg) After Tax Cost of Debt 28.12%

3.85% 5.85%

4.20%

Flowserve Corp.
S&P Credit Rating

Risk-Free Rate of U.S. 10 year T_Bond as of January 4, 2010 Pre-Tax Borrow ing Cost Effective Tax Rate (5yr avg) 32.88% After Tax Cost of Debt (r d x (1-T)) =

3.85% 7.35%

4.93%

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

Missing: Your overall evaluation of each and which firm do you recommend and why?

4. What Is Our Cost Of Equity Financing? The cost of equity financing for ITT Corporation and Flowserve Corp. is estimated using the Capital Asset Pricing Model (CAPM). The cost of equity (rs) for each company is calculated as rs=rrf+(rm- rrf) where the risk free rate (rrf) is estimated by the long-term U.S. Treasury Bond, market risk (rm) is the geometric mean of the difference of historical stock market returns minus long-term government treasuries, and is derived by regressing the respective companies stock returns against the market returns. The risk free rate in this analysis is 3.85%, the recent United States 10-Year Treasury bond constant maturity rate use earlier when calculating cost of debt. Risk Premium (RP) is equal to rm- rrf so we can rewrite the CAPM equation to be rs=rrf+(RPm*). The value for RP can be estimated from the following table:

Source: Dimson, Marsh and Staunton (2002, 2006) For the United States stock market, Stocks minus Long-term Governments, the historical risk premium geometric mean for 1900 through 2005 is 4.52%. In this analysis RP will equal 4.52%. Beta () for each company is calculated for both 5-Year Monthly returns and 2-Year Weekly returns so we can compare the longer term result with the more recent results.

5-Year Monthly Return Beta and several other statistical measures were calculated for ITT Corporation and Flowserve Corp. using Microsoft Excels built in functions as well as the Data Analysis Tools plug-in for the five year period beginning January 2005 through December 2009. ITT Corporations 5-Year Monthly stock returns verses market returns regression slope, Beta in this application, resulted in = 1.11. If we used a different time period or different return intervals, weekly or daily, for the same time period a different slope, or Beta in this application, can result. ITT Corporations returns are plotted in the following chart on the Y axis against the S&P 500 returns on the X axis:
ITT Corporation vs. S&P500 (5 Year - Monthly) Beta = 1.11
Y = 1.1068x + 0.0061 R2 = 0.5301

0.40 0.30

ITT Corporation (ITT)

0.20 0.10 0.00 (0.15) (0.10) (0.05) 0.00 (0.10) (0.20) (0.30) (0.40) S&P500 (SPC) Series1 Linear (Series1) 0.05 0.10 0.15

(0.20)

Data Source: http://finance.yahoo.com We can measure a given stocks performance relative to CAPM by employing the formula Intercept (a)-rrf(1-) where Alpha (a) = the intercept coefficient, monthly risk free rate (rrf) = the U.S. 10-Year Treasury rate of 3.85 divided by 12 months, and Beta () = the regression result of the stocks return to the markets return. ITT Corporation preformed, 0.6% - ((0.0385/12) x (1-1.11)) = 0.0064, 0.64% better on a monthly basis then the monthly expectations generated using CAPM between January 2005 and December 2009. The annualized excess return can be estimated to be, (1+0.0064)12-1=0.0796, 7.96%. ITT Corporation measure of risk that can be attributed to market risk is estimated by the value of R2, in this analysis 53.01% of the risk comes from market sources including inflation, war, natural disasters, interest rates, etc The remaining 46.99% of the risk variance can be attributed to company specific source which can be reduced by diversification.

The true for ITT Corporation, under the assumption of a normal distribution, will range with 68.26% confidence between the estimated of 1.11-0.1368= 0.9732 to 1.11+0.1368=1.2468 and with 95.46 confidence between the estimated of 1.11-(0.1368 x 2)= 0.8364 to 1.11+(0.1368 x 2)=1.3836. ITT Corporations summary regression results except:

Flowserve Corp.s 5-Year Monthly stock returns verses market returns regression slope, Beta in this application, resulted in = 1.44. Flowserve Corp.s returns are plotted in the following chart on the Y axis against the S&P 500 returns on the X axis:
Flowserve Corp. vs. S&P500 (5 Year - Monthly) Beta = 1.44
Y = 1.4419x + 0.0293 R2 = 0.3695

0.40 0.30

Flowserve Corp. (FLS)

0.20 0.10 0.00 (0.15) (0.10) (0.05) 0.00 (0.10) (0.20) (0.30) (0.40) S&P500 (SPC) Series1 Linear (Series1) 0.05 0.10 0.15

(0.20)

Data Source: http://finance.yahoo.com Flowserve Corp. preformed, 2.93% - ((0.0385/12) x (1-1.44)) = 0.0307, 3.07% better on a monthly basis then the monthly expectations generated using CAPM between January 2005 and December 2009. The annualized excess return can be estimated to be, (1+0.0307)12-1=0.4374, 43.74%. Flowserve Corp. measure of risk that can be attributed to market risk is estimated by the value of R2, in this analysis 36.94% of the risk comes from market sources including inflation, war, natural disasters, interest rates, etc The remaining 63.06% of the risk variance can be attributed to company specific source which can be reduced by diversification. The true for Flowserve Corp., under the assumption of a normal distribution, will range with 68.26% confidence between the estimated of 1.44-0.2473= 1.1927 to 1.44+0.2473=1.6873 and with 95.46 confidence between the estimated of 1.44-(0.2473 x 2)= 0.9554 to 1.44+(0.2473 x 2)=1.9346.

Flowserve Corp.s summary regression results except:

2-Year Weekly Return Beta and several other statistical measures were calculated for ITT Corporation and Flowserve Corp. using Microsoft Excels built in functions as well as the Data Analysis Tools plug-in for the five year period beginning January 2008 through December 2009. ITT Corporations 2-Year Weekly beta is calculated as = 0.94 and its returns are plotted in the following chart on the Y axis against the S&P 500 returns on the X axis. Organic growth is a likely factor in ITT Corporation Beta decreasing from 1.11 for the 5-Year period to 0.94 for the recent 2-Year period. ITT Corporations large overall scale and recent declining investment in net assets produced from acquisitions suggest less risk exposure supporting the reduction of Beta.

ITT Corporation vs. S&P500 (2 Year - Weekly) Beta = 0.94


Y = 0.9440x + 0.0031 R2 = 0.6190

0.40 0.30

ITT Corporation (ITT)

0.20 0.10 0.00 (0.15) (0.10) (0.05) 0.00 (0.10) (0.20) (0.30) (0.40) S&P500 (SPC) Series1 Linear (Series1) 0.05 0.10 0.15

(0.20)

Data Source: http://finance.yahoo.com Flowserve Corp.s 2-Year Weekly beta is calculated as = 1.70 and its returns are plotted in the following chart on the Y axis against the S&P 500 returns on the X axis. Inorganic growth is a likely factor in Flowserve Corp.s Beta increasing from 1.44 for the 5-Year period to 1.70 for the recent 2-Year period. Flowserve Corp.s smaller scale, relative to ITT Corporation in this analysis, and recent increasing investment in net assets produced from acquisitions suggest more risk exposure supporting the increasing Beta.

y = 1.6977x + 0.0071 R2 = 0.5782

Flowserve Corp. vs. S&P500 (2 Year - Weekly) Beta = 1.70 0.40 0.30

Flowserve Corp. (FLS)

0.20 0.10 0.00 (0.15) (0.10) (0.05) 0.00 (0.10) (0.20) (0.30) (0.40) S&P500 (SPC) Series1 Linear (Series1) 0.05 0.10 0.15

(0.20)

Data Source: http://finance.yahoo.com Analyst Research A comparison of the Beta results derived by regression was made to published Beta estimates detailed with their source in the table below:
Published Beta Values
Source ITT Corporation Flowserve Corp

Regression 5-Year Monthly Standard & Poor's Stock Report Value Line www.finance.yahoo.com www.mergentonline.com www.moneycentral.msn.com www.quote.com www.smartmoney.com www.tobsefin1.swlearning.com

1.11 1.10 1.00 1.07 1.09 1.12 1.13 1.13 1.11

1.44 1.53 1.50 1.60 1.42 1.57 1.57 1.57 1.67

Bottom-Up Beta Approach Using the bottom-up approach our Beta result for the ITT Corporation of 1.18 was slightly higher than both the regression result and comparisons with other analyst and the bottom-up approach Beta result of 1.32 for the Flowserve Corp. fell well below the regression result and comparisons with other analyst as shown in the following table.
ITT Corporation % of Revenues 57% 31% 12% Weight Average Beta 1.19 0.68 1.07 0.33 1.42 0.17 1.18

Business Segment Defense Electronic & Service Fluid Technology Motion & Flow Control

Industry Category Aerospace/Defense Industrial Services Heavy Construction

Beta

Flowserve Corp. % of Revenues 61% 27% 12% Weight Average Beta 1.32 0.81 1.42 0.38 1.07 0.13 1.32

Business Segment Flowserve Pump Flow Control Flow Solutions

Industry Category Machinery Heavy Construction Industrial Services

Beta

Source: Thomson Reuters Extel 2009 and http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html Missing: Your overall evaluation of each and which firm do you recommend and why?

5. What Is Our Overall Cost Of Capital?


Market Capitalization Company Financial Statement, Dec 31, 2009 Total Number of Shares Shares Outstanding Average for 2009 Market Capitalization Equity and Debt Ratios Market Value of Debt (D) Market Value of Equity (E) Preferred Stock (PS) Total Debt Ratio D/(D+E+PS) Equity Ratio E/(D+E+PS) Preferred Stock Ratio PS/(D+E+PS) Cost of Capital Cost of Debt Cost of Equity Cost of Preferred Stock WACC 4.20% 8.85% 4.93% 10.37% 1,430,800,000 8,322,692,000 9,753,492,000 14.67% 85.33% 539,373,000 5,424,307,860 5,963,680,860 9.04% 90.96% ITT Corporation 500,000,000 182,900,000 181,750,000 8,322,692,000 Flowserve Corp. 120,000,000 54,956,000 55,085,500 5,424,307,860

8.17%

9.88%

Source: Thomson One Banker The cost of capital is the weighted average cost of equity, debt and preferred stock: For ITT Corporation the WACC = 4.20(0.1467) + 8.85(0.8533) + 0(0) = 8.17% For Flowserve Corp. the WACC = 4.93(0.0904) + 10.37(0.9096) + 0(0) = 9.88% Interest bearing long-term debt was a criteria for determining the market value of debt values above. Missing: Your overall evaluation of each and which firm do you recommend and why?

6. Could We Lower The Cost of Capital By Changing Our Capital Structure? ITT Corporation inputs for analysis: Number scale: Million
Capital Structure Current MV of Equity MV of interest-bearing debt # of Shares Outstanding Debt Value of Operating leases Risk Premium $8,322.69 $1,430.80 182.90 $931.03 4.52% Financial Market Current Beta for Stock 1.11 Current Bond Rating BBB+ Summary of Inputs LT Gov. Bond Rate 3.85% Pre-tax cost of debt 5.85% Income Statement Current EBITDA $1,271.77 Current Depreciation $292.60 Current Tax Rate 28.12% Current Capital Spending $271.60 Current Interest Expense $153.97

ITT Corporation results from capital structure analysis: Current 22.11% 1.11 8.87% 4.20% Optimal 50.00% 1.58 11.01% 3.85% Change 27.89% 0.47 2.15% -0.36% -0.41% $586,145,807 $682,493,583 $3.20 $3.73

D/(D+E) Ratio = Beta for the Stock = Cost of Equity = AT Interest Rate on Debt = WACC Implied Growth Rate = Firm Value (no growth) = Firm Value (Perpetual Growth) = Value/share (No Growth) = Value/share (Perpetual Growth) =

7.84% 7.43% 0.99% $10,684,518,418 $11,270,664,225 $10,684,518,418 $11,367,012,001 $45.50 $48.71 $45.50 $49.24

Excel template capstru.xls from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm

ITT Corporation summary of firms values at different debt ratios:


Debt Ratio 0% $ Debt $0 Tax Rate 28.12% 28.12% 28.12% 28.12% 28.12% 28.12% 28.12% 28.12% 28.12% 24.80% Unlevered Firm Value $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 $10,036,399,607 Tax Benefits Bond Probability Rating of Default $0 AAA $300,448,658 AAA $600,897,316 AA $901,345,974 A $1,201,794,632 A$1,502,243,290 A$1,802,691,948 BBB $2,103,140,605 B $2,403,589,263 B$2,384,497,566 CCC 0.07% 0.07% 0.51% 0.66% 2.50% 2.50% 7.54% 36.80% 45.00% 59.01% Expected Bankruptcy Cost $1,756,370 $1,808,948 $13,562,554 $18,047,280 $70,238,714 $72,116,518 $223,166,876 $1,116,837,700 $1,399,498,748 $1,832,392,855 Value of Levered Firm $10,034,643,237 $10,335,039,317 $10,623,734,369 $10,919,698,301 $11,167,955,525 $11,466,526,379 $11,615,924,679 $11,022,702,513 $11,040,490,123 $10,588,504,318

10% $1,068,451,842 20% $2,136,903,684 30% $3,205,355,525 40% $4,273,807,367 50% $5,342,259,209 60% $6,410,711,051 70% $7,479,162,893 80% $8,547,614,735 90% $9,616,066,576

Excel template apv.xls from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm Flowserve Corp. inputs for analysis: Number scale: Million
Capital Structure Current MV of Equity MV of interest-bearing debt # of Shares Outstanding Debt Value of Operating leases Risk Premium $5,424.31 $539.37 54.96 $241.59 4.52% Financial Market Current Beta for Stock 1.44 Current Bond Rating BB+ Summary of Inputs LT Gov. Bond Rate 3.85% Pre-tax cost of debt 7.35% Income Statement Current EBITDA $722.16 Current Depreciation $95.45 Current Tax Rate 32.88% Current Capital Spending $108.45 Current Interest Expense $27.76

Flowserve Corp. results from capital structure analysis:


Current 12.59% 1.44 10.36% 4.93% 9.68% 2.92% $6,205,269,724 $6,205,269,724 $98.70 $98.70 Optimal 60.00% 2.64 15.76% 3.59% 8.46% $7,098,100,203 $7,607,283,398 $114.95 $124.21 Change 47.41% 1.20 5.40% -1.34% -1.22% $892,830,479 $1,402,013,674 $16.25 $25.51

D/(D+E) Ratio = Beta for the Stock = Cost of Equity = AT Interest Rate on Debt = WACC Implied Growth Rate = Firm Value (no growth) = Firm Value (Perpetual Growth) = Value/share (No Growth) = Value/share (Perpetual Growth) =

Excel template capstru.xls from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm Flowserve Corp. summary of firms values at different debt ratios:
Debt Ratio 0% 10% $ Debt $0 $620,526,972 Tax Rate 32.88% 32.88% 32.88% 32.88% 32.88% 32.88% 32.88% 32.88% 32.88% 32.55% Unlevered Firm Value $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 $5,949,575,385 Tax Benefits Bond Probability Rating of Default $0 AAA $204,029,269 AAA $408,058,537 AAA $612,087,806 AAA $816,117,074 A+ $1,020,146,343 A $1,224,175,611 A$1,428,204,880 B+ $1,632,234,148 CCC $1,817,725,885 CCC 0.07% 0.07% 0.07% 0.07% 0.60% 0.66% 2.50% 25.00% 59.01% 59.01% Expected Bankruptcy Cost $1,041,176 $1,076,881 $1,112,586 $1,148,291 $10,148,539 $11,500,041 $44,835,944 $461,111,267 $1,118,506,451 $1,145,871,120 Value of Levered Firm $5,948,534,209 $6,152,527,773 $6,356,521,336 $6,560,514,900 $6,755,543,921 $6,958,221,687 $7,128,915,053 $6,916,668,998 $6,463,303,082 $6,621,430,151

20% $1,241,053,945 30% $1,861,580,917 40% $2,482,107,890 50% $3,102,634,862 60% $3,723,161,834 70% $4,343,688,807 80% $4,964,215,779 90% $5,584,742,751

Excel template apv.xls from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm Missing: Your overall evaluation of each and which firm do you recommend and why? 7. How Would A Financial Restructuring Affect The Value Of Our Company? The results of the capital structure analysis for IIT Corporation, and with even more clarity the results the adjusted present value analysis, suggest increases in debt financing from the current 22.11% debt to equity ratio up to 50% debt to equity could increase ITT Corporations value from the current $10,684,518,418 to the optimal value $11,367,012,001 on a perpetual growth basis. The net gain in ITTs value in this analysis could achieve $682,493,583.

Flowserve Corporations analysis suggests a similar scenario to ITTs. Flowserves capital structure analysis and its related adjusted present value analysis suggest increases in debt financing from the current 12.59% debt to equity ratio up to 60% debt to equity could increase Flowserve Corp.s value from the current $6,205,269,724 to the optimal value $7,607,283,398 on a perpetual growth basis. The net gain in Flowserve Corp.s value in this analysis could achieve $1,402,013,674. In both the case of ITT Corporation and Flowserve Corp. these analyses conclude an increase the value of the respective firms could be improved by capital restructuring, specifically adding debt financing. Missing: Your overall evaluation of each and which firm do you recommend and why? 8. Would More Debt Create Unnecessary Risk? Both ITT Corp. and Flowserve Corp. have debt ratios well below their optimal debt ratios. Theoretically optimal debt ratio is calculated by analyzing the cost of capital. At optimal debt both the companies seem to have low average cost of capital and other advantages but there are some other risks involved with carrying more debt than it is necessary. Debt carrying capacity for companies depends on the industry and market in which a particular company is operating. Some of the advantages of carrying more debt or operating at optimal debt ratio: Tax savings. Interest expenses are tax deductible while cash flows to equity (dividends) are not. This benefit increases with the tax rate. Added discipline by increasing the cost of failure. Increase in firm value Increase in Beta Disadvantages of carrying more debt: Higher expected bankruptcy cost. The probability of default is greater for firms that have volatile cash flows. Probability of default increases Decrease in bond ratings Agency costs. Debt exposes the firm to the possibility of conflicts between stock- and bondholders over investment, financing, and dividend decisions. Loss of flexibility. This is more likely to be a problem for firms that have substantial and unpredictable investment opportunities. It is clear from the analysis of capital structure of both ITT Corp. and Flowserve Corp. that more debt would create an unnecessary risk for them. They both operate in an industry with higher rates of return as compared to other industries. Both the companies operate and invest in projects that earn higher rate of returns as compared to the hurdle rate. We believe that both the companies need flexibility in the future and so the optimal debt ratio should be lower to allow for future borrowings. This explains why both Flowserve Corp. and ITT Corp. have low debt ratios of 12.59% and 22.11% as compared to their optimal debt ratios or 60% and 50% respectively. Missing: Your overall evaluation of each and which firm do you recommend and why?

9. What Do Other Companies Do?


IDEX CORP (IEX) Mkt Cap Scale: in Millions Assets Cash Other Current Assests Long-term Assets Total Liabilities and Equity Current Liabilites Long-term Liabilities Shareholders' Equity Total 2.281B ROPER INDUSTRIES INC (ROP) 4.684B FLOWSERVE CORP (FLS) 5.036B ITT CORPORATION (ITT) 8.590B

73.53 378.18 1,646.45 2,098.16

3.50% 18.02% 78.47%

167.71 703.04 3,456.99 4,327.74

3.88% 16.24% 79.88%

654.32 1,845.00 1,749.57 4,248.89

15.40% 43.42% 41.18%

1,215.60 3,040.20 6,873.30 11,129.10

10.92% 27.32% 61.76%

189.68 640.38 1,268.10 2,098.16

9.04% 30.52% 60.44%

478.01 1,428.24 2,421.49 4,327.74

11.05% 33.00% 55.95%

1,458.08 989.06 1,801.75 4,248.89

34.32% 23.28% 42.41%

2,615.60 4,635.20 3,878.30 11,129.10

23.50% 41.65% 34.85%

Source: Thomson ONE Banker "SEC Financials" (data from company 10K)
Cash, Other Current Asset, and Long-Term Assets as a % of Total Assets
Other Current Assets as a % of Total Assets

60%
50%

40%
30%

20%
10%

0% 0% 20% 40% 60% 80% 100%

Long-Term Assets as a % of Total Assets

IDEX CORP (IEX)

ROPER INDUSTRIES INC (ROP)

FLOWSERVE CORP (FLS)

ITT CORPORATION (ITT)

Current Liabilities, Long-Term Liabilities, and Shareholders' Equity as a % of Total Liabilities and Equity 80% 70% 60% 50% 40% 30% 20% 10% 0%

Shareholders' Equity

0%

10%

20%

30%

40%

50%

Long-Term Liabilites

IDEX CORP (IEX)

FLOWSERVE CORP (FLS)

ROPER INDUSTRIES INC (ROP)

ITT CORPORATION (ITT)

Within the industry other companies including IDEX Corp. and Roper Industries Inc. appear to be more weighted in Long-Term Assets and generally less liquid than our subject companies, especially Flowserve Corp. in terms of Cash as a percentage of Total Assets. Stockholder Equity of IDEX and Roper Industries is also notably higher than subject companies. IDEX and Roper

Industries split our subject companies in terms of Long-Term Debt as a percentage of Total Liabilities plus Equity and the ratio of Long-Term Debt to Equity where ITT Corporation holds the highest ratios and Flowserve Corp. has the lowest ratios.
IDEX CORP (IEX) 31.00% 40.00% 2,280.940 ROPER INDUSTRIES INC (ROP) 34.00% 44.00% 4,684.530 ITT FLOWSERVE CORPORATION CORP (FLS) (ITT) 30.00% 37.00% 58.00% 65.00% 5,035.900 8,589.640

Long-Term Debt / Equity Total Liabilites / Total Assets Market Capitalization (in Millions)

Market Capitalization - Debt Ratio - LT Debt/Equity


Total Liabilites / Total Assets 100% 80% 60% 40% 20% 25% 27% 29% 31% 33% 35% 37% 39% 41% 43% 45% Long-Term Debt / Equity IDEX CORP (IEX) ROPER INDUSTRIES INC (ROP) FLOWSERVE CORP (FLS) ITT CORPORATION (ITT)

Missing: Your overall evaluation of each and which firm do you recommend and why? 10. Is Our Stock Price Fairly Valued? By definition a fairly valued stock is a stock whose perceived value or intrinsic value is equal to its current market price. It is arguable that there is not one right answer to the question of whether a stock price is fairly valued. Using historical data and our best estimates of future expectations our judgment relative to each respective company is offered in the following: ITT Corporations most recent stock price closing value is $45.60 per share and is only slightly higher than the value derived from this analysis of $45.50 per share. Technically this differential points to overvalued in ITT Corporations case but a reasonable conclusion is that its current price is Fairly Valued. Flowserve Corp.s most recent stock closing value is $102.25 per share, which is moderately higher than the value derived from this analysis of $98.71 per share. Thus, the valuation suggests that Flowserve Corp. is Overvalued. Missing: Different valuation models must be used and then make recommendations based on valuation and then which company and why????