Professional Documents
Culture Documents
No one spends other peoples money as carefully as they spend their own. Milton Friedman
Business Alliances
Cross-Border Transactions
Learning Objectives
Primary Learning Objective: To provide students with a knowledge of how to analyze, structure, and value highly leveraged transactions. Secondary Learning Objectives: To provide students with a knowledge of The motivations of and methodologies employed by financial buyers; Advantages and disadvantages of LBOs as a deal structure; Alternative LBO models; The role of junk bonds in financing LBOs; Pre-LBO returns to target company shareholders; Post-buyout returns to LBO shareholders, and Alternative LBO valuation methods Basic decision rules for determining the attractiveness of LBO candidates
50% Cash/50% Debt ($Millions) $100 $50 $50 $20 $5 $15 $6 $9 18%
20% Cash/80% Debt ($Millions) $100 $20 $80 $20 $8 $12 $4.8 $7.2 36%
shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively. EBIT = 0, ($5), and ($8), ROE in 0%, 50% and 20% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%, respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.
LBOs Create Value by Reducing Debt and Increasing Margins Thereby Increasing Potential Exit Multiples
Firm Value
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Debt Reduction & Reinvestment Increases Free Cash Flow and in turn Builds Firm Value
Debt Reduction Adds to Free Cash Flow by Reducing Interest & Principal Repayments
Debt Reduction
Reinvest in Firm
Tax Shield
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
LBO Value is Maximized by Reducing Debt, Improving Margins, and Properly Timing Exit
Case 1: Debt Reduction Case 2: Debt Reduction + Margin Improvement Case 3: Debt Reduction + Margin Improvement + Properly Timing Exit $400,000,000 100,000,000 $500,000,000
LBO Formation Year: Total Debt Equity Transaction Value Exit Year (Year 7) Assumptions: Cumulative Cash Available for Debt Repayment1 Net Debt2 EBITDA EBITDA Multiple Transaction Value3 Equity Value4 Internal Rate of Return Cash on Cash Return5
1Cumulative
cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and principal repayments reflecting the reduction in net debt. 2Net Debt = Total Debt Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million 3Transaction Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year 4Equity Value = Transaction Value in 7th Year Net Debt 5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it accounts for the time value of money.
Discussion Questions
1. Define the financial concept of leverage. Describe how leverage may work to the advantage of the LBO equity investor? How might it work against them? 2. What is the difference between a management buyout and a leveraged buyout? 3. What potential conflicts might arise between management and shareholders in a management buyout?
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 firms ability to Repay such debt as the firm assumes substantial amounts of new debt and to Pay interest and dividends on a timely basis.
Recalculate each successive periods with the D/E ratio for that period, and using that periods , recalculate the firms cost of equity for that period.
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.
Things to Remember
LBOs make the most sense for firms having stable cash flows, significant amounts of unencumbered tangible assets, and strong management teams. Successful LBOs rely heavily on management incentives to improve operating performance and a streamlined decision-making process resulting from taking the firm private. Tax savings from interest expense and depreciation from writing up assets enable LBO investors to offer targets substantial premiums over current market value. Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions. 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.