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HIGHLY LEVERAGED TRANSACTIONS: LBO Valuation and Modeling Basics

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

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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

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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

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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 = PV FCFE – I EQ 0 Where NPV = Net present value PV FCFE = Present value of free cash flows to common equity investors I EQ = The value of common equity From investors and lenders perspective, NPV = PV FCFF – I TC 0 Where PV FCFF = Present value of free cash flows to the firm I TC = Total investment or the value of total capital including common and preferred stock and all debt.

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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.

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Valuing LBOs: Cost of Capital Method 1 Adjusts for the varying level of risk as the firms 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 1 Also known as the variable risk method.

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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)

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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)

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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.

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Cost of Capital Method: Step 4 Adjust the discount rate to reflect changing risk. The firms cost of equity will decline over time as debt is repaid and equity grows, thereby reducing the leveraged ß. Estimate the firms ß as follows: ß FL1 = ß IUL1 (1 + (D/E) F1 (1-t F )) where ß FL1 = Firms levered beta in period 1 ß IUL1 = Industrys unlevered beta in period 1 = ß IL1 /(1+(D/E) I1 (1- t I )) ß IL1 = Industrys levered beta in period 1 (D/E) I1 = Industrys debt-to-equity ratio in period 1 t I = Industrys marginal tax rate in period 1 (D/E) F1 = Firms debt-to-equity ratio in period 1 t F = Firms marginal tax rate in period 1 Recalculate each successive periods ß with the D/E ratio for that period; and, using that periods ß, recalculate the firms cost of equity for that period.

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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?

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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

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Cost of Capital Method: An Illustration Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Assumptions Market Value of 12% PIK Preferred Equity ($ Million) Market Value of Common Equity ($ Million) Equity ($ Million) Debt ($ Million) Comparable Firm Price/Earnings Ratio6 Levered Beta (ß)2.4 Debt/Equity Ratio0.3 Unlevered Beta2.0 Marginal Tax Rate Year Treasury Bond Rate0.05 Risk Premium on Stocks (%)0.055 Terminal Period Growth Rate (%)0.045 Terminal Period Cost of Equity (%)0.10 YearDebt/ EquityLeveraged Beta Cost of Equity Cumulative Discount FactorAdjusted Equity Cash Flow PV of Adjusted Equity Cash Flow /(1.26) = /[(1.26)(1.23)] = /[(1.26)(1.23)(1.208)] = /[(1.26)(1.23)(1.208)(1.194)] = /[(1.26)(1.23)(1.208)(1.194)(1.184)] = /[(1.26)(1.23)(1.208)(1.194)(1.184) (1.174)] = /[(1.26)(1.23)(1.208)(1.194)(1.184) (1.174)(1.165)] = PV(2013–2019) 12.5 Terminal Value 44.7 Total PV 57.2

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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 firms estimated unlevered cost of equity. Step 3: Estimate the present value of the firms tax savings discounted at the firms 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.

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APV Method: Step 1 Project annual free cash flows to equity investors and interest tax savings for the period during which the firms capital structure is changing. –Interest tax savings = INT x t, where INT and t are the firms 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

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APV Method: Step 2 Value target without the effects of debt financing and discount projected cash flows at the firms 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 firms capital structure in the final year of the period during which the structure is changing.

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APV Method: Step 3 Estimate the present value of the firms annual interest tax savings. –Discount the tax savings at the firms 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.

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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

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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?

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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.

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Adjusted Present Value Method: An Illustration Present Value of Equity Cash Flows Using the Adjusted Present Value Method Assumptions Marginal Tax Rate (t)0.4 Comparable Company Unlevered Beta2 10-Year Treasury Bond Rate0.05 Firms Credit RatingB Expected Cost of Bankruptcy as % of Firm Market Value (per Andrade and Kaplan, 1998, and Korteweg, 2010) Cumulative Probability of Default for a B-Rated Firm over 10 Years Risk Premium on Stocks Terminal Period Growth Rate –2010 Unlevered Cost of Equity Terminal Period WACC Adjusted Equity Cash Flow Plus: Tax Shield Plus: Terminal Value Equals: Total Cash Flow 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

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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.

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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.

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Key LBO Model Relationships Linking purchase price (enterprise value) to industry multiples PP TF = (EV/EBITDA) × EBITDA TF Linking purchase price (enterprise value) to target firms borrowing capacity and financial sponsors equity contribution PP TF = (D TF + E TF ) where D TF = net debt (i.e., total debt less cash and marketable securities held by the target firm) E TF = financial sponsors equity contribution to the target firms purchase price PP TF = estimated purchase price of the target firm or enterprise value EBITDA TF = target firm earnings before interest, taxes, depreciation, and amortization EV/EBITDA = recent comparable LBO transaction enterprise value to EBITDA multiple

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Building an LBO Model Step 1: Project a firms 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 firms shareholders. Step 4: Estimate the initial equity contribution to be made by the financial sponsor. 1 Step 5: Calculate the IRR on the financial sponsors initial and subsequent equity investments. 1 The 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 firms maximum borrowing capacity (Step 2).

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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.

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