DUKE UNIVERSITY

Fuqua School of Business

FINANCE 351 - CORPORATE FINANCE
Hint Sheet: Congoleum Corporation
Prof. Simon Gervais Fall 2011 Term 2
This case illustrates a leveraged buyout and highlights some of its value-creating aspects. You
are invited to combine the valuation principles and methods discussed in the course to evaluate a
complex transaction from the perspectives of the various participants. Here are some guidelines for
your valuation analysis.
Overview of the Valuation Process. Given the nature of the forecast data, it is useful
for valuation purposes to treat the 1980-1984 period dierently from the post-1984 period.
In fact, the case writer hinted at the possibility of another reorganization at the end of 1984
in the note to Exhibit 14. Throughout, assume that time 0 is year 1979.
Make sure that you notice the changing debt ratios in 1980-1984. Which is the best valuation
approach to deal with this?
Free Cash Flow. As usual, the following (unlevered) free-cash-ow formula should prove
useful:
EBIT = Operating Income Corporate Expenses Depreciation,
UFCF = (1 t
c
)EBIT + Depreciation Change in NWC Capital Expenditures.
Note that there is a dierence between UFCF dened above and what are referred to as free
cash ows in Exhibit 13 (on line 14)?
Discount Rates. As we mentioned when discussing the Marriott case, the choice of discount
rates is an important part of any valuation procedure. It is worthwhile to spend some time
thinking carefully about these issues.
Congoleums equity beta is known (see Exhibit 9). Do you need to rely on comparable
companies data to obtain Congoleums asset beta?
For the borrowing cost in the LBO years and the borrowing cost in the post-1984 pe-
riod, you may use an average of the yields on corporate bonds of appropriate ratings
(Exhibit 10). In particular, in this case, it would probably not be legitimate to use the
coupon rates on the new LBO debts as r
D
in the LBO years. Why? Of course, this
means that the loans have a positive net present value (the coupon rate is less than the
discount rate), so dont forget that part of the value. For the post-1984 period, should
we expect the bond rating to improve (and r
D
to decrease)? Why or why not?
For the debt-to-value ratio (i.e., debt capacity) after 1984, feel free to rely on an average
of the debt-to-value ratios of Congoleums competitors (in Exhibit 9). You can use the
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identiable assets of each division as of 1978 (from Exhibit 4) for the relative weights.
You should also explore a few additional debt-to-value ratios around this number in your
sensitivity analysis.
Feel free to use the information in the footnote to Exhibit 9 as your inputs (risk-free
rate and market premium) to the CAPM.
Feel free to do all your levering/unlevering assuming a debt beta of zero. Also, let us
assume that all debt is permanent (i.e., not rebalanced).
Wherever the case mentions Debt % capital, you can treat this as the correct (i.e.,
market) debt-to-value ratio.
Adjusted Present Value (APV). The present value of nancing decisions is obtained
by discounting all relevant debt cash ows at Congoleums debt cost: principal receipts,
principal repayments, interest payments, interest tax shields. Indeed, as mentioned above, it
is not sucient to just include the tax shields in your valuation, as the coupon rate on the
debt is smaller than the proper (i.e., market) discount rate; that is, the loan has a positive
net present value. Also note the following.
Preferred stock can be thought of as a type of debt that does not create any interest tax
shields.
Do not forget that some old long-term debt remains after 1979 and the new owners
need to service it even though no cash is received on this debt in 1979.
It is convenient, for valuation purposes, to assume that all debts (old, new, preferred
stock) are paid o at the end of 1984 when the LBO group takes the company public
again and sells it for its terminal value.
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Terminal Value. Obtaining an accurate measure of the terminal value is critical in this
case. You may start with the following as an approximation:
Terminal Value as of 1984 =
(1 + g) (Avg UFCF)
1980-1984
(Discount Rate)
post 1984
g
,
where g is a growth rate and the discount rate is WACC (or RADR, as in the article by
Inselbag and Kaufold).
Based on your understanding of the case facts, what growth rate would you use? How
sensitive is your result to the choice of growth rate (e.g., try a few rates between g = 0%
and g = 10%)? How does your choice of g compare to the ination rate at that time
(which is not mentioned in the case)?
What discount rate would you use to bring this terminal value back to 1979? How
sensitive is your result to this choice? How would you split the terminal value between
unlevered assets and value of nancing, and how should each part be discounted back
to 1979?
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If these debts are not paid o, then the new buyer of the company will pay a price equal to the terminal value
minus the value of outstanding debts.
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Adjustments. To value the rm as a whole, you need some further adjustments that re-
ect the rms current cash and liability situation (UFCF during 1979 is not part of LBO
valuation):
V
Congoleum
=
1979 adjustments

Excess Cash Expiring LT Debt Unfunded Pension
+ APV

1980-84
+PV of Terminal Value

post-1984 period
.
Feel free to use the same numbers as in Exhibit 7 for the 1979 adjustments.
Objective. A primary objective of this case is for you to evaluate the LBO proposal and render an
opinion as to the appropriateness of the $38 oer price. In addition, however, you need to quantify
(in terms of their impact on the companys after-tax cash ows and their impact on the share
price) the incremental eects of LBO (as compared to no LBO) on Congoleum as a whole, i.e.,
what portions of the sizable purchase premium (or of your calculated share price) are attributable
to:
the cost savings in corporate expenses for 1980-1984? (Use the savings mentioned at the top
of Exhibit 14; note that these are pre-tax savings.)
the step-up of asset values for depreciation for 1980-1984? (Use footnote b in Exhibit 13 to
gure out the increment in depreciation and amortization.)
the interest tax shields? (Use footnote a in Exhibit 13 to gure out the increment in tax
shields.)
The rest of the value probably has to do with the unrecognized value/growth or other improvements
in Congoleums operations after the LBO.
Report. As usual, your write-up should address and defend the assumptions that underlie the
inputs to your analysis (cash ow projections, the dierent discount rates, leverage ratio, growth
rate, etc.) before you proceed to present your results. Sensitivity analysis could be done at the
end.
The nal report should consist of 2-4 pages of text, followed by spreadsheet exhibits that are
referred to in the text. The following questions serve to organize your discussion.
What makes Congoleum an LBO target?
Based on your analysis, what do you think of the $38 per share oer? Your valuation analysis
(as described above on this hint sheet) should make the bulk of your report and serve to
answer this question.
What are the roles of the equity kicker and strip nancing?
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