Presentation on theme: "HIGHLY LEVERAGED TRANSACTIONS: LBO Valuation and Modeling Basics"— Presentation transcript:
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 OtherRestructuring ActivitiesPart IV: Deal Structuring and FinancingPart II: M&A ProcessPart I: M&A EnvironmentCh. 11: Payment and Legal ConsiderationsCh. 7: Discounted Cash Flow ValuationCh. 9: Financial Modeling TechniquesCh. 6: M&A Postclosing IntegrationCh. 4: Business and Acquisition PlansCh. 5: Search through Closing ActivitiesPart V: Alternative Business and Restructuring StrategiesCh. 12: Accounting & Tax ConsiderationsCh. 15: Business AlliancesCh. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-OutsCh. 17: Bankruptcy and LiquidationCh. 2: Regulatory ConsiderationsCh. 1: Motivations for M&APart III: M&A Valuation and ModelingCh. 3: Takeover Tactics, Defenses, and Corporate GovernanceCh. 13: Financing the DealCh. 8: Relative Valuation MethodologiesCh. 18: Cross-Border TransactionsCh. 14: Valuing Highly Leveraged TransactionsCh. 10: Private Company Valuation
4 Learning ObjectivesPrimary Learning Objective: To provide students with a knowledge of alternative approaches to valuing leveraged buyouts and the basics of LBO modeling techniquesSecondary Learning Objectives: To provide students with a knowledge ofCost of capital approach to valuation;Adjusted present value approach to valuation;The advantages and disadvantages of each valuation approach; andThe underpinnings of LBO structuring and valuation models
5 Valuing LBOsA leveraged buyout can be evaluated from the perspective of common equity investors or of all investors and lendersFrom common equity investors’ perspective,NPV = PVFCFE – IEQ ≥ 0Where NPV = Net present valuePVFCFE = Present value of free cash flows to common equityinvestorsIEQ = The value of common equityFrom investors’ and lenders’ perspective,NPV = PVFCFF – ITC ≥ 0Where PVFCFF = Present value of free cash flows to the firmITC = Total investment or the value of total capital includingcommon and preferred stock and all debt.
6 Decision RulesLBOs 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 equityHowever, 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 toRepay such debt as the firm assumes substantial amounts of new debt and toPay 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 untiltarget D/E achievedStep 2: Project debt-to-equity ratiosStep 3: Calculate terminal valueStep 4: Adjust discount rate to reflect changing riskStep 5: Determine if deal makes sense1Also known as the variable risk method.
8 Cost of Capital Method: Step 1 Project annual cash flows until target D/E ratio achievedTarget D/E is the level of debt relative to equity at whichThe firm will have to resume payment of taxes andThe 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 ratiosThe decline in D/E reflectsThe known debt repayment schedule andThe 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 1ßIUL1 = 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 1tI = Industry’s marginal tax rate in period 1(D/E)F1 = Firm’s debt-to-equity ratio in period 1tF = Firm’s marginal tax rate in period 1Recalculate 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 senseDoes 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 declinesTakes into account that the deal may make sense for common equity investors but not for lenders or preferred shareholdersDisadvantage: 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)Assumptions20122013201420152016201720182019Market Value of 12% PIK Preferred Equity($ Million)2224.627.630.934.638.843.448.6Market Value of CommonEquity ($ Million)32.33.34.05.05.45.76.02527.034.939.6184.108.40.206Debt ($ Million)4739.531.523.8220.127.116.11.7Comparable FirmPrice/Earnings Ratio6Levered Beta (ß)2.4Debt/Equity Ratio0.3Unlevered Beta2.0Marginal Tax Rate0.410-Year Treasury Bond Rate0.05Risk Premium on Stocks (%)0.055Terminal Period Growth Rate (%)0.045Terminal Period Cost of Equity (%)0.10YearDebt/ EquityLeveraged BetaCost of EquityCumulative Discount FactorAdjusted Equity Cash FlowPV of Adjusted Equity Cash Flow18.104.22.16801/(1.26) =.31.00.2301/[(1.26)(1.23)] =.22.214.171.124.2081/[(1.26)(1.23)(1.208)] =126.96.36.199.1941/[(1.26)(1.23)(1.208)(1.194)] =7.40.1841/[(1.26)(1.23)(1.208)(1.194)(1.184)] =188.8.131.521/[(1.26)(1.23)(1.208)(1.194)(1.184)(1.174)] =8.10.02.10.165(1.174)(1.165)] =8.5PV(2013–2019)12.5Terminal Value44.7Total PV57.2
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 1Project 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, respectivelyDuring 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 2Value 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 3Estimate the present value of the firm’s annual interest tax savings.Discount the tax savings at the firm’s unlevered cost of equityCalculate 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 4Calculate the present value of the firm including tax benefitsAdd 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, andUnclear 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 Method2013201420152016201720182019AssumptionsMarginal Tax Rate (t)0.4Comparable Company Unlevered Beta210-Year Treasury Bond Rate0.05Firm’s Credit RatingBExpected Cost of Bankruptcy as % of Firm Market Value (per Andrade and Kaplan, 1998, and Korteweg, 2010)0.2500Cumulative Probability of Default for a B-Rated Firm over 10 Years0.3680Risk Premium on Stocks0.0550Terminal Period Growth Rate0.04502004–2010 Unlevered Cost of Equity0.1700Terminal Period WACC0.1200Adjusted Equity Cash Flow0.30.21.87.184.108.40.206Plus: Tax Shield1.61.31.00.80.6Plus: Terminal Value123.8Equals: Total Cash Flow220.127.116.11.7132.7PV of 2013–2019 Cash Flows$61.07Less: PV Expected Cost of Bankruptcy5.62PV of Cash Flows Adjusted for Expected Cost of Bankruptcy$55.45
23 Discussion QuestionsCompare 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 multiplesPPTF = (EV/EBITDA) × EBITDATFLinking purchase price (enterprise value) to target firm’s borrowing capacity and financial sponsor’s equity contributionPPTF = (DTF + ETF )whereDTF = net debt (i.e., total debt less cash and marketable securities held by thetarget firm)ETF = financial sponsor’s equity contribution to the target firm’s purchase pricePPTF = estimated purchase price of the target firm or enterprise valueEBITDATF = target firm earnings before interest, taxes, depreciation, andamortizationEV/EBITDA = recent comparable LBO transaction enterprise value to EBITDAmultiple
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.1Step 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.