HIGHLY LEVERAGED TRANSACTIONS: LBO Valuation and Modeling Basics

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HIGHLY LEVERAGED TRANSACTIONSLBO 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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(No Transcript)
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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 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.

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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 Method1

• 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
• 1Also 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
• ßFL1 ßIUL1(1 (D/E)F1(1-tF))
• where ßFL1 Firms levered beta in
  period 1
• ßIUL1 Industrys unlevered
  beta in period 1
• ßIL1/(1(D/E)I1(1-
  tI))
• ßIL1 Industrys levered
  beta in period 1
• (D/E)I1 Industrys
  debt-to-equity ratio in period 1
• tI Industrys
  marginal tax rate in period 1
• (D/E)F1 Firms debt-to-equity
  ratio in period 1
• tF 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) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC) Present Value of Equity Cash Flow Using the Cost of Capital Method (CC)
Assumptions Assumptions 2012 2013 2014 2015 2016 2017 2017 2018 2019
Market Value of 12 PIK Preferred Equity ( Million) Market Value of 12 PIK Preferred Equity ( Million) 22 24.6 27.6 30.9 34.6 38.8 38.8 43.4 48.6
Market Value of Common Equity ( Million) Market Value of Common Equity ( Million) 3 2.3 3.3 4.0 5.0 5.4 5.4 5.7 6.0
Equity ( Million) Equity ( Million) 25 27.0 30.9 34.9 39.6 44.2 44.2 49.1 54.6
Debt ( Million) Debt ( Million) 47 39.5 31.5 23.8 19.2 14.3 14.3 8.8 2.7
Comparable Firm Comparable Firm                  
Price/Earnings Ratio Price/Earnings Ratio 6                
Levered Beta (ß) Levered Beta (ß) 2.4                
Debt/Equity Ratio Debt/Equity Ratio 0.3                
Unlevered Beta Unlevered Beta 2.0                
Marginal Tax Rate Marginal Tax Rate 0.4                
10-Year Treasury Bond Rate 10-Year Treasury Bond Rate 0.05                
Risk Premium on Stocks () Risk Premium on Stocks () 0.055                
Terminal Period Growth Rate () Terminal Period Growth Rate () 0.045                
Terminal Period Cost of Equity () Terminal Period Cost of Equity () 0.10                
Year Debt/ Equity Leveraged Beta Cost of Equity Cumulative Discount Factor Cumulative Discount Factor Cumulative Discount Factor Cumulative Discount Factor Adjusted Equity Cash Flow Adjusted Equity Cash Flow PV of Adjusted Equity Cash Flow
2013 1.5 3.8 0.260 1/(1.26) 0.7937 1/(1.26) 0.7937 1/(1.26) 0.7937 1/(1.26) 0.7937 .3 .3 .3
2014 1.0 3.3 0.230 1/(1.26)(1.23) 0.6452 1/(1.26)(1.23) 0.6452 1/(1.26)(1.23) 0.6452 1/(1.26)(1.23) 0.6452 .2 .2 .1
2015 0.7 2.9 0.208 1/(1.26)(1.23)(1.208) 0.5341 1/(1.26)(1.23)(1.208) 0.5341 1/(1.26)(1.23)(1.208) 0.5341 1/(1.26)(1.23)(1.208) 0.5341 1.8 1.8 1.0
2016 0.5 2.6 0.194 1/(1.26)(1.23)(1.208)(1.194) 0.4474 1/(1.26)(1.23)(1.208)(1.194) 0.4474 1/(1.26)(1.23)(1.208)(1.194) 0.4474 1/(1.26)(1.23)(1.208)(1.194) 0.4474 7.4 7.4 3.3
2017 0.3 2.4 0.184 1/(1.26)(1.23)(1.208)(1.194)(1.184) 0.3778 1/(1.26)(1.23)(1.208)(1.194)(1.184) 0.3778 1/(1.26)(1.23)(1.208)(1.194)(1.184) 0.3778 1/(1.26)(1.23)(1.208)(1.194)(1.184) 0.3778 7.7 7.7 2.9
2018 0.2 2.3 0.174 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174) 0.3218 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174) 0.3218 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174) 0.3218 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174) 0.3218 8.1 8.1 2.6
2019 0.0 2.1 0.165 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174)(1.165) 0.2762 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174)(1.165) 0.2762 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174)(1.165) 0.2762 1/(1.26)(1.23)(1.208)(1.194)(1.184) (1.174)(1.165) 0.2762 8.5 8.5 2.4
PV(20132019)                   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 Present Value of Equity Cash Flows Using the Adjusted Present Value Method Present Value of Equity Cash Flows Using the Adjusted Present Value Method Present Value of Equity Cash Flows Using the Adjusted Present Value Method Present Value of Equity Cash Flows Using the Adjusted Present Value Method Present Value of Equity Cash Flows Using the Adjusted Present Value Method Present Value of Equity Cash Flows Using the Adjusted Present Value Method 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            
Firms 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            
20042010 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 1.8 1.6 1.3 1.0 0.8 0.6 0.4
Plus Terminal Value             123.8
Equals Total Cash Flow 2.2 1.8 3.2 8.4 8.5 8.7 132.7
PV of 20132019 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
• PPTF (EV/EBITDA) EBITDATF
• Linking purchase price (enterprise value) to
  target firms borrowing capacity and financial
  sponsors 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 sponsors equity
  contribution to the target firms 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

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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.

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 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.