Case Study LBO

Shaky Assets Corp. LBO Mini-case Shaky Asset Corp. (SAC) currently has an invested capital equal to 25MEUR. SAC is ineffeciently managed with an after-tax ROI of only 7% p.a. and an annual EBIT growth rate equal to 4%. Management has indicated that the after-tax ROI can be sustained 5 years, after which it will drop to the level of WACC. Current target debt/assets ratio for SAC is 20% and the levered equity beta is 0.8. Current cost of debt is 4% p.a. An investment bank sees SAC as a tempting LBO case: operative improvements and financial benefits could be enormous. The LBO plan would involve levering up SAC to a target 75% debt/assets ratio and using the debt to repurchase shares. Simultaneously the management team would be replaced and a new motivated management team is expected to improve after-tax ROI to 10% p.a. and EBIT growth of 4% p.a., both of which can be realized immediately and maintained at a constant level for the next 10 years. Beyond that, competition is expected to push after-tax ROI down to WACC levels. The added debt would cause SAC bond rating to drop such that the expected cost of all SAC debt would increase to 4.6% p.a. [Assume all debt levels are at target (market valued) debt/assets ratio both before and after LBO]. Corporate tax rate is 29%. The market risk premium is assumed to be 5% p.a and the risk free rate 2.5% p.a. Assume CAPM prices both equity and debt claims (=implied debt beta obtainable from CAPM). Question: How much value will the proposed LBO deal create for SCA owners?

SAC LBO Mini-Case Answer: Step #1. Figure out old WACC Before LBO Debt beta 0.3 Before-LBO Cost of levered equity 6.5% Before-LBO WACC:

[from CAPM (4%-2.5%)/5%] [CAPM 2.5%+0.8*5%] 0.80*6.5% + 0.20*4%*0.71 = 5.768%

Step #2. Unlever the beta to get unlevered beta estimate using Hamada equation: 0.8 = βU + (βU-0.3)*0.71*20/80 βU=0.72463. Cost of unlevered equity 2.5%+0.72463*5% = 6.12314%. Step #3. Valuation before LBO KVDs: Next year's EBIT(1-TaxRate) = Plowback ratio T=5, after that no growth.

7%*25 =1.75 MEUR. 4%/7% = 0.57143

Enterprise value (appr. formula "3.", supergrowth+nogrowth) = 1.75/0.05768 + 1.75*0.57143*5*(0.07-0.05768)/(0.05768*1.05768) = 31.35 MEUR of which 20% debt, 6.27 MEUR, and rest equity 25.08 MEUR. Step #4. Post-LBO WACC: Debt beta at 75% D/V ratio 0.42 [from CAPM (4.6%-2.5%)/5%] Levered equity beta at target D/V ratio 75%: 0.72463+(0.72463-0.42)*0.71*75/25=1.3735 Cost of equity = 2.5%+1.3735*5% = 9.3675% WACC = 0.25*9.3675%+0.75*4.6%*0.71 = 4.7914%. (lower WACC despite higher financial risk, as "cheaper" debt instrument costing "only" 4.6% is emphasized yielding tax savings) Step #5. Valuation after LBO KVDs: Next year's EBIT(1-TaxRate) = Plowback ratio T=10, after that no growth.

10%*25 =2.5 MEUR. 4%/10% = 0.4

Enterprise value (appr.) = 2.5/0.047914 + 2.5*0.4*10*(0.10-0.047914)/(0.047914*1.047914) = 62.55 MEUR of which 75% debt, 46.91 MEUR, and rest equity 15.64 MEUR.

Step #6. Deal for shareholders? They get (46.91-6.27)=40.64 in cash from repurchase of shares with new debt PLUS holdings equal to 15.64 MEUR, TOTAL= 56.28 MEUR compared to old holding of 25.08 MEUR. Increase is 31.2 MEUR, or 124%! The final shareholder value consists of : OLD equity 25.08 + 7.37 value added from financial effects + 23.83 value added from operative improvements = 56.28. *) 7.37 = 32.45-25.08 where 32.45 from valuation without oper.improvements: EV=1.75/0.047914+ 1.75*0.57143*5*(0.07-0.047914)/( 0.047914*1.047914) = 38.72 MEUR of which 75% debt, 29.04 MEUR, and rest equity 9.68 MEUR. Equity holders get 22.62 in cash and 9.68 holdings = 32.45. As total value added was 31.2 MEUR of which 7.37 from financial effects, rest 23.83 must be due to operative improvements.

SAC LBO MiniCase Rf MRP Taxrate

2,50 % 5% 29 %

Inv.Cap. After-tax ROI Super-growth T Constant growth Target D/V ratio Cost of debt Levered equity beta

Before LBO 25 7% 4% 5 0% 20 % 4% 0,8

After LBO 25 10 % 4% 10 0% 75 % 4,60 % 1,37349

Cost of equity WACC Cost of unlevered equity Unlevered equity beta Debt beta

6,50 % 5,7680 % 6,12314 % 0,72463 0,3

9,3674 % 4,791359 %

EBIT1(1-Tax) Plowback ratio Enterprise value Debt Equity

1,75 57,143 % 31,3495 6,270 25,0796

2,5 40,000 % 62,5511 46,913 15,6378

Equity holders receive

40,643 15,6378 56,2812 124,4 %

MEUR

years

0,42

in cash holdings total 31,2016

increase

Before LBO FCFF:s & valuation After Tax EBIT Investments FCFF HV 1 1,75 -1 0,75 2 1,82 -1,04 0,78 3 1,8928 -1,0816 0,8112 4 1,968512 -1,124864 0,843648 5 2,04725248 -1,16985856 0,877394 36,913013 6 2,129142579 0 2,129143 7 2,129142579 0 2,129143 8 2,129142579 0 2,129143 9 2,129142579 0 2,129143 10 2,129142579 0 2,129143 11 2,129142579 0 2,129143

After LBO FCFF:s & valuation After Tax EInvestment FCFF HV 1 2,5 -1 1,5 2 2,6 -1,04 1,56 3 2,704 -1,0816 1,6224 4 2,81216 -1,12486 1,687296 5 2,924646 -1,16986 1,754788 6 3,041632 -1,21665 1,824979 7 3,163298 -1,26532 1,897979 8 3,289829 -1,31593 1,973898 9 3,421423 -1,36857 2,052854 10 3,55828 -1,42331 2,134968 77,2351 11 3,700611 0 3,700611

62,2056 PV 1,431416 1,420606 1,409878 1,399231 1,388664 1,378177 1,36777 1,357441 1,34719 49,70522

31,31633 PV 0,709099 0,697246 0,685591 0,674131 28,55026