Eaton Corporation: Portfolio Transformation and the Cost of Capital
Posted: 9 Nov 2020
Date Written: September 11, 2020
Eaton Corporation, a diversified industrial conglomerate, had been changing its strategic focus and re-configuring its portfolio of businesses for the past 15 years. Through more than 70 acquisitions and 50 divestitures, Eaton had narrowed its strategic focus considerably and was now pursuing a strategy based on “intelligent power” (i.e., using digitally enabled products, data, and software to increase efficiency and reliability of its products and services). In January 2020, Eaton got an offer from Danfoss, a diversified Danish multinational, to buy its hydraulics business for $3.3 billion. Eaton CEO Craig Arnold must decide if it makes sense strategically to sell this business and if $3.3 billion is a fair price for the business.
This short case shows how firms use discounted cash flow (DCF) analysis to make important strategic decisions. Rather than analyzing the free cash flows in detail, this case focuses on the cost of capital. Designed in this way, it helps students understand the intuition behind and the mechanics for calculating a firm’s weighted average cost of capital (WACC) using the capital asset pricing model (CAPM). An Appendix explains the intuition and derives the WACC formula; case data allows students to calculate the WACC and provides an opportunity to discuss the various assumptions. The case also explains the theoretical differences between a corporate and a divisional cost of capital, and vividly illustrates the potential for serious valuation errors if the incorrect WACC is used. Finally, and equally importantly, this case highlights one of the most successful black executives in corporate America (Craig Arnold) who would be the fifth black CEO to head a Fortune 500 company in 2019 if Eaton were domiciled in the U.S. (Eaton relocated to Ireland in 2012).
Although this case was designed to emphasize the discount rate specifically, it can be used across two classes to teach DCF valuation more generally. On the first day, the instructor can teach the definition and calculation of FCFs (and terminal values); on the second day, the instructor can discuss the WACC and the resulting NPV.
Keywords: Cost of capital, discounted cash flow, WACC, CAPM, discount rate, conglomerate divestiture, acquisition, market risk premium, value creation
JEL Classification: G31, G34, L25
Suggested Citation: Suggested Citation