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Chapter 17 App - Chapter 17 Valuation and Capital Budgeting...

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Chapter 17 Valuation and Capital Budgeting for the Levered Firm 17A-1 The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition by a small group of equity investors of a public or private company financed primarily with debt. The equityholders service the heavy inter- est and principal payments with cash from operations and/or asset sales. The shareholders generally hope to reverse the LBO within three to seven years by way of a public offering or sale of the company to another firm. A buyout is therefore likely to be successful only if the firm generates enough cash to serve the debt in the early years, and if the company is attractive to other buyers as the buyout matures. In a leveraged buyout, the equity investors are expected to pay off outstanding principal according to a specific timetable. The owners know that the firm’s debt–equity ratio will fall and can forecast the dollar amount of debt needed to finance future operations. Under these circumstances, the adjusted present value (APV) approach is more practical than the weighted average cost of capital (WACC) approach because the capital structure is chang- ing. In this appendix, we illustrate the use of this procedure in valuing the RJR Nabisco transaction, the largest LBO in history. The RJR Nabisco Buyout In the summer of 1988, the price of RJR stock was hovering around $55 a share. The firm had $5 billion of debt. The firm’s CEO, acting in concert with some other senior managers of the firm, announced a bid of $75 per share to take the firm private in a management buyout. Within days of management’s offer, Kohlberg, Kravis, and Roberts (KKR) entered the fray with a $90 bid of their own. By the end of November, KKR emerged from the ensuing bidding process with an offer of $109 a share, or $25 billion total. We now use the APV technique to analyze KKR’s winning strategy. The APV method as described in this chapter can be used to value companies as well as projects. Applied in this way, the maximum value of a levered firm ( V L ) is its value as an all-equity entity ( V U ) plus the discounted value of the interest tax shields from the debt its assets will support (PVTS). 2 This relation can be stated as: V L V U PVTS t = 1 UCF t ________ (1 R 0 ) t t = 1 t C R B B t 1 _________ (1 R B ) t In the second part of this equation, UCF t is the unlevered cash flow from operations for year t. Discounting these cash flows by the required return on assets, R 0 , yields the all- equity value of the company. B t 1 represents the debt balance remaining at the end of year ( t 1). Because interest in a given year is based on the debt balance remaining at the end of the previous year, the interest paid in year t is R B B t 1 . The numerator of the second term, Appendix 17A www.mhhe.com/rwj 1 This appendix has been adapted by Isik Inselbag and Howard Kaufold, The Wharton School, University of Pennsylvania, from their unpublished manuscript titled “Analyzing the RJR Nabisco Buyout: An Adjusted Pres- ent Value Approach.” 2 We should also deduct from this value any costs of financial distress. However, we would expect these costs
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