1. HIGHLY LEVERAGED TRANSACTIONS: LBO Valuation and Modeling Basics

2. A billion here and a billion there soon adds up to real money.
—Everett Dirksen

3. Part IV: Deal Structuring and Financing
Exhibit 1: Course Layout: Mergers, Acquisitions, and Other
Restructuring Activities
Part IV: Deal Structuring and Financing
Part II: M&A Process
Part 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

4. 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

5. 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.

6. 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.

7. 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 sense
1Also known as the variable risk method.

8. 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)

9. 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)

10. 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.

11. 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 ßFL = Firm’s levered beta in period 1
ßIUL1 = Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL = 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.

12. 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?

13. 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

14. 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 Common
Equity ($ Million) 3
2.3
3.3
4.0
5.0
5.4
5.7
6.0 25
27.0
34.9
39.6
44.2
49.1
54.6
Debt ($ Million) 47
39.5
31.5
23.8
19.2
14.3
8.8
2.7
Comparable 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
1.5
3.8
0.260
1/(1.26) = .3
1.0
0.230
1/[(1.26)(1.23)] = .2 .1
0.7
2.9
0.208
1/[(1.26)(1.23)(1.208)] =
1.8
0.5
2.6
0.194
1/[(1.26)(1.23)(1.208)(1.194)] =
7.4
0.184
1/[(1.26)(1.23)(1.208)(1.194)(1.184)] =
7.7
0.2
0.174
1/[(1.26)(1.23)(1.208)(1.194)(1.184)
(1.174)] =
8.1
0.0
2.1
0.165
(1.174)(1.165)] =
8.5
PV(2013–2019)
12.5
Terminal Value
44.7
Total PV
57.2

15. 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.

16. 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

17. 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.

18. 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.

19. 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

20. 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?

21. 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.

22. 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
1.6
1.3
1.0
0.8
0.6
Plus: Terminal Value
123.8
Equals: Total Cash Flow
2.2
3.2
8.4
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

23. Discussion Questions
Compare and contrast the cost of capital and the adjusted present value valuation methods?
Which do you think is a more appropriate valuation method? Explain your answer.

24. 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.

25. 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

26. 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).

27. 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.