HIGHLY LEVERAGED TRANSACTIONS:

LBO Valuation and Modeling Basics

A billion here and a billion there soon adds up to real money.

—Everett Dirksen

Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities

Part IV: Deal Structuring and

Financing

Part II: M&A ProcessPart I: M&A Environment

Ch. 11: Payment and Legal Considerations

Ch. 7: Discounted Cash Flow Valuation

Ch. 9: Financial Modeling Techniques

Ch. 6: M&A Postclosing Integration

Ch. 4: Business and Acquisition Plans

Ch. 5: Search through Closing Activities

Part V: Alternative Business and Restructuring

Strategies

Ch. 12: Accounting & Tax Considerations

Ch. 15: Business Alliances

Ch. 16: Divestitures, Spin-Offs, Split-Offs,

and Equity Carve-Outs

Ch. 17: Bankruptcy and Liquidation

Ch. 2: Regulatory Considerations

Ch. 1: Motivations for M&A

Part III: M&A Valuation and

Modeling

Ch. 3: Takeover Tactics, Defenses, and Corporate Governance

Ch. 13: Financing the Deal

Ch. 8: Relative Valuation

Methodologies

Ch. 18: Cross-Border Transactions

Ch. 14: Valuing Highly Leveraged

Transactions

Ch. 10: Private Company Valuation

Learning Objectives

• Primary Learning Objective: To provide students with a knowledge of alternative approaches to valuing leveraged buyouts and the basics of LBO modeling techniques

• Secondary Learning Objectives: To provide students with a knowledge of – Cost of capital approach to valuation;– Adjusted present value approach to valuation;– The advantages and disadvantages of each valuation

approach; and – The underpinnings of LBO structuring and valuation

models

Valuing LBOs

• A leveraged buyout can be evaluated from the perspective of common equity investors or of all investors and lenders

• From common equity investors’ perspective,

NPV = PVFCFE – IEQ ≥ 0

Where NPV = Net present value

PVFCFE = Present value of free cash flows to common equity

investors

IEQ = The value of common equity

• From investors’ and lenders’ perspective,

NPV = PVFCFF – ITC ≥ 0

Where PVFCFF = Present value of free cash flows to the firm

ITC = Total investment or the value of total capital including

common and preferred stock and all debt.

Decision Rules

• LBOs make sense from viewpoint of investors and lenders if PV of free cash flows to the firm is ≥ to the total investment consisting of debt and common and preferred equity

• However, a LBO can make sense to common equity investors but not to other investors and lenders. The market value of debt and preferred stock held before the transaction may decline due to a perceived reduction in the firm’s ability to– Repay such debt as the firm assumes substantial

amounts of new debt and to– Pay interest and dividends on a timely basis.

Valuing LBOs: Cost of Capital Method1

Adjusts for the varying level of risk as the firm’s total debt is repaid.

• Step 1: Project annual cash flows until

target D/E achieved• Step 2: Project debt-to-equity ratios• Step 3: Calculate terminal value• Step 4: Adjust discount rate to reflect

changing risk• Step 5: Determine if deal makes sense1Also known as the variable risk method.

Cost of Capital Method: Step 1

• Project annual cash flows until target D/E ratio achieved

• Target D/E is the level of debt relative to equity at which– The firm will have to resume payment of taxes

and– The amount of leverage is likely to be

acceptable to IPO investors or strategic buyers (often the prevailing industry average)

Cost of Capital Method: Step 2

• Project annual debt-to-equity ratios

• The decline in D/E reflects

– The known debt repayment schedule and

– The projected growth in the market value of shareholders’ equity (assumed to grow at the same rate as net income)

Cost of Capital Method: Step 3

• Calculate terminal value of projected cash flow to equity investors (TVE) at time t, (i.e., the year in which the initial investors choose to exit the business).

• TVE represents PV of the dollar proceeds available to the firm through an IPO or sale to a strategic buyer at time t.

Cost of Capital Method: Step 4

• Adjust the discount rate to reflect changing risk.• The firm’s cost of equity will decline over time as debt is repaid and equity

grows, thereby reducing the leveraged ß. Estimate the firm’s ß as follows:

ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))

where ßFL1 = Firm’s levered beta in period 1 ßIUL1 = Industry’s unlevered beta in period 1 = ßIL1/(1+(D/E)I1(1- tI)) ßIL1 = Industry’s levered beta in period 1 (D/E)I1 = Industry’s debt-to-equity ratio in period 1 tI = Industry’s marginal tax rate in period 1 (D/E)F1 = Firm’s debt-to-equity ratio in period 1 tF = Firm’s marginal tax rate in period 1

• Recalculate each successive period’s ß with the D/E ratio for that period; and, using that period’s ß, recalculate the firm’s cost of equity for that period.

Cost of Capital Method: Step 5

• Determine if deal makes sense

– Does the PV of free cash flows to equity investors (including the terminal value) equal or exceed the equity investment including transaction-related fees?

Evaluating the Cost of Capital Method

• Advantages:– Adjusts the discount rate to reflect diminishing

risk as the debt-to-total capital ratio declines– Takes into account that the deal may make

sense for common equity investors but not for lenders or preferred shareholders

• Disadvantage: Calculations more burdensome than Adjusted Present Value Method

Cost of Capital Method: An Illustration Present Value of Equity Cash Flow Using the Cost of Capital Method (CC)

Assumptions 2012 2013 2014 2015 2016 2017 2018 2019

Market Value of 12% PIK Preferred Equity ($ Million)

22 24.6 27.6 30.9 34.6 38.8 43.4 48.6

Market Value of CommonEquity ($ Million)

3 2.3 3.3 4.0 5.0 5.4 5.7 6.0

Equity ($ Million) 25 27.0 30.9 34.9 39.6 44.2 49.1 54.6Debt ($ Million) 47 39.5 31.5 23.8 19.2 14.3 8.8 2.7Comparable Firm                 Price/Earnings Ratio 6               Levered Beta (ß) 2.4               Debt/Equity Ratio 0.3               Unlevered Beta 2.0              Marginal Tax Rate 0.4              10-Year Treasury Bond Rate 0.05              Risk Premium on Stocks (%) 0.055              

Terminal Period Growth Rate (%) 0.045              

Terminal Period Cost of Equity (%) 0.10              

Year Debt/ Equity Leveraged Beta

Cost of Equity

Cumulative Discount Factor Adjusted Equity Cash Flow

PV of Adjusted Equity Cash Flow

2013 1.5 3.8 0.260 1/(1.26) = 0.7937 .3 .32014 1.0 3.3 0.230 1/[(1.26)(1.23)] = 0.6452 .2 .12015 0.7 2.9 0.208 1/[(1.26)(1.23)(1.208)] = 0.5341 1.8 1.02016 0.5 2.6 0.194 1/[(1.26)(1.23)(1.208)(1.194)] = 0.4474 7.4 3.3

2017 0.3 2.4 0.184 1/[(1.26)(1.23)(1.208)(1.194)(1.184)] = 0.3778 7.7 2.9

2018 0.2 2.3 0.174 1/[(1.26)(1.23)(1.208)(1.194)(1.184)(1.174)] = 0.3218

8.1 2.6

2019 0.0 2.1 0.165 1/[(1.26)(1.23)(1.208)(1.194)(1.184)(1.174)(1.165)] = 0.2762

8.5 2.4

PV(2013–2019)           12.5Terminal Value           44.7Total PV           57.2

Valuing LBOs: Adjusted Present Value Method (APV)

Separates the value of the firm into (a) its value as if it were debt free and (b) the value of tax savings due to interest expense.

• Step 1: Project annual free cash flows to equity investors and interest tax savings.

• Step 2: Value the target without the effects of debt financing and discount projected free cash flows at the firm’s estimated unlevered cost of equity.

• Step 3: Estimate the present value of the firm’s tax savings discounted at the firm’s estimated unlevered cost of equity.

• Step 4: Add the present value of the firm without debt and the present value of tax savings to calculate the present value of the firm including tax benefits.

• Step 5: Determine if the deal makes sense.

APV Method: Step 1

• Project annual free cash flows to equity investors and interest tax savings for the period during which the firm’s capital structure is changing.– Interest tax savings = INT x t, where INT and t are the

firm’s annual interest expense on new debt and the marginal tax rate, respectively

– During the terminal period, the cash flows are expected to grow at a constant rate and the capital structure is expected to remain unchanged

APV Method: Step 2

• Value target without the effects of debt financing and discount projected cash flows at the firm’s unlevered cost of equity.– Apply the unlevered cost of equity for the

period during which the capital structure is changing.

– Apply the weighted average cost of capital for the terminal period using the proportions of debt and equity that make up the firm’s capital structure in the final year of the period during which the structure is changing.

APV Method: Step 3

• Estimate the present value of the firm’s annual interest tax savings.– Discount the tax savings at the firm’s

unlevered cost of equity– Calculate PV for annual forecast period only,

excluding a terminal value, since the firm is sold and any subsequent tax savings accrue to the new owners.

APV Method: Step 4

• Calculate the present value of the firm including tax benefits

– Add the present value of the firm without debt and the PV of tax savings

APV Method: Step 5

• Determine if deal makes sense:

– Does the PV of free cash flows to equity investors plus tax benefits equal or exceed the initial equity investment including transaction-related fees?

Evaluating the Adjusted Present Value Method

• Advantage: Simplicity.• Disadvantages:

– Ignores the effect of changes in leverage on the discount rate as debt is repaid,

– Implicitly ignores the potential for bankruptcy of excessively leveraged firms, and

– Unclear whether true discount rate should be the cost of debt, unlevered cost of equity, or somewhere between the two.

Adjusted Present Value Method: An Illustration

Present Value of Equity Cash Flows Using the Adjusted Present Value Method

  2013 2014 2015 2016 2017 2018 2019

Assumptions              

Marginal Tax Rate (t) 0.4            

Comparable Company Unlevered Beta 2            

10-Year Treasury Bond Rate 0.05            

Firm’s Credit Rating B            

Expected Cost of Bankruptcy as % of Firm Market Value (per Andrade and Kaplan, 1998, and Korteweg, 2010)

0.2500            

Cumulative Probability of Default for a B-Rated Firm over 10 Years 0.3680            

Risk Premium on Stocks 0.0550            

Terminal Period Growth Rate 0.0450            

2004–2010 Unlevered Cost of Equity 0.1700            

Terminal Period WACC 0.1200            

Adjusted Equity Cash Flow 0.3 0.2 1.8 7.4 7.7 8.1 8.5

Plus: Tax Shield 1.8 1.6 1.3 1.0 0.8 0.6 0.4

Plus: Terminal Value             123.8

Equals: Total Cash Flow 2.2 1.8 3.2 8.4 8.5 8.7 132.7

PV of 2013–2019 Cash Flows             $61.07

Less: PV Expected Cost of Bankruptcy             5.62

PV of Cash Flows Adjusted for Expected Cost of Bankruptcy             $55.45

Discussion Questions

1. Compare and contrast the cost of capital and the adjusted present value valuation methods?

2. Which do you think is a more appropriate valuation method? Explain your answer.

What is An LBO Model?

• An LBO model is used to determine what a firm is worth in a highly leveraged transaction.

• It is applied when there is the potential for a financial buyer or sponsor to acquire the business.

• The model helps define the amount of debt a firm can support given its assets and cash flows.

• Investment bankers frequently employ such analyses in addition to discounted cash flow and relative valuation methods in valuing businesses they are attempting to sell.

• Financial buyers seek LBO opportunities offering a financial return in excess of their desired rate of return, while allowing the target firm to meet potential future operating challenges.

Key LBO Model Relationships

• Linking purchase price (enterprise value) to industry multiples

PPTF = (EV/EBITDA) × EBITDATF

• Linking purchase price (enterprise value) to target firm’s borrowing capacity and financial sponsor’s equity contribution

PPTF = (DTF + ETF )

where

DTF = net debt (i.e., total debt less cash and marketable securities held by the

target firm)

ETF = financial sponsor’s equity contribution to the target firm’s purchase price

PPTF = estimated purchase price of the target firm or enterprise value

EBITDATF = target firm earnings before interest, taxes, depreciation, and

amortization

EV/EBITDA = recent comparable LBO transaction enterprise value to EBITDA

multiple

Building an LBO Model

• Step 1: Project a firm’s future cash flows.

• Step 2: Estimate the maximum borrowing capacity of the firm.

• Step 3: Determine the purchase price necessary to buy out the target firm’s shareholders.

• Step 4: Estimate the initial equity contribution to be made by the financial sponsor.1

• Step 5: Calculate the IRR on the financial sponsor’s initial and subsequent equity investments.

1The required equity contribution equals the difference between the estimated purchase price (Step 3) and the amount of debt used in financing the transaction, which is less than or equal to the firm’s maximum borrowing capacity (Step 2).

Things to Remember…

• Tax savings from interest expense and depreciation from writing up assets and the potential for margin improvement enable LBO investors to offer targets substantial premiums over their current market value.

• Post-LBO investors create value by providing firms access to capital, increased monitoring, margin improvement, tax savings not fully reflected in pre-LBO purchase price premium, and timing the exit from the target firm.

• For an LBO to make sense, the PV of cash flows to equity holders must equal or exceed the value of the initial equity investment in the transaction, including transaction-related costs.