Valuing LBOs
. A LBO can be evaluated from the perspective of common equity investors or of all investors and
lenders
. LBOs make sense from viewpoint of investors and lenders if present value of free cash flows to the
firm is greater than or equal 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 firm’s ability to
- Repay such debt as the firm assumes substantial amounts of new debt and to
- Pay interest and dividends on a timely basis.
Valuing LBOs: Variable Risk Method
Adjust for the varying level of risk as the firm’s 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
Variable Risk 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)
Variable Risk 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 the shareholders’ equity (assumed to grow at
the same rate as net income)
Variable Risk 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 the PV of the dollar proceeds available to the firm through an IPO or sale to a
strategic buyer at time t.
Variable Risk 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 ßFL1
ßIUL1
= Firm’s levered beta in period 1
= Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL1
= Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI
= Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF
= Firm’s marginal tax rate in period 1
. Recalculate 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.
Variable Risk 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?
Evaluating the Variable Risk 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
Valuing LBOs: Adjusted Present Value Method (APV)
Separates 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 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.
APV Method: Step 1
. Project 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, 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
APV Method: Step 2
. Value 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.
APV Method: Step 3
. Estimate the present value of the firm’s annual interest tax savings.
- Discount the tax savings at the firm’s 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.
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
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?
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.
Things to Remember…
. LBOs make the most sense for firms having stable cash flows, significant amounts of
unencumbered tangible assets, and strong management teams.
. Successful LBOs rely heavily on management incentives to improve operating performance and a
streamlined decision-making process resulting from taking the firm private.
.Tax savings from interest expense and depreciation from writing up assets enable LBO investors to
offer targets substantial premiums over current market value.
. Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to
business cycle fluctuations and aggressive competitor actions.
. 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.
Reverse Leveraged Buyouts
. Reverse LBO occurs when an LBO goes public
. Constituted roughly 10% of IPO market in 1980s
. Leverage and ownership changes at time of reverse LBO that moves them back toward pre-LBO
structure
. Leverage falls from 83% to 56% (debt/capital)
. Inside ownership falls from 75% to 49% (management and board – includes sponsor).
. Board size increases from 5 to 7, roughly 1/3 each of operating management, non management
capital providers and external board members.