HIGHLY LEVERAGED
TRANSACTIONS:
LBO Valuation and Modeling Basics
A billion here and a billion there soon
adds up to real money.
—Everett Dirksen
Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities
Part I: M&A
Environment
Part II: M&A Process
Part III: M&A
Valuation and
Modeling
Part IV: Deal
Structuring and
Financing
Part V: Alternative
Business and
Restructuring
Strategies
Ch. 1: Motivations for
M&A
Ch. 4: Business and
Acquisition Plans
Ch. 7: Discounted
Cash Flow Valuation
Ch. 11: Payment and
Legal Considerations
Ch. 15: Business
Alliances
Ch. 2: Regulatory
Considerations
Ch. 5: Search through
Closing Activities
Ch. 8: Relative
Valuation
Methodologies
Ch. 12: Accounting &
Tax Considerations
Ch. 16: Divestitures,
Spin-Offs, Split-Offs,
and Equity Carve-Outs
Ch. 3: Takeover
Tactics, Defenses, and
Corporate Governance
Ch. 6: M&A
Postclosing Integration
Ch. 9: Financial
Modeling Techniques
Ch. 13: Financing the
Deal
Ch. 17: Bankruptcy
and Liquidation
Ch. 10: Private
Company Valuation
Ch. 14: Valuing
Highly Leveraged
Transactions
Ch. 18: Cross-Border
Transactions
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
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.
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 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: Cost of Capital Method1
Adjusts 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
1Also
known as the variable risk method.
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)
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)
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.
Cost of Capital 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))
= 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
where ßFL1
ßIUL1
•
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.
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?
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
Cost of Capital Method: An Illustration
Assumptions
Present Value of Equity Cash Flow Using the Cost of Capital Method (CC)
2012
2013
2014
2015
2016
2017
2018
2019
Market Value of 12% PIK Preferred Equity
($ Million)
Market Value of Common
Equity ($ Million)
Equity ($ Million)
Debt ($ Million)
Comparable Firm
Price/Earnings Ratio
Levered Beta (ß)
Debt/Equity Ratio
Unlevered Beta
Marginal Tax Rate
10-Year Treasury Bond Rate
Risk Premium on Stocks (%)
Terminal Period Growth Rate (%)
22
24.6
27.6
30.9
34.6
38.8
43.4
48.6
3
2.3
3.3
4.0
5.0
5.4
5.7
6.0
25
47
27.0
39.5
30.9
31.5
34.9
23.8
39.6
19.2
44.2
14.3
49.1
8.8
54.6
2.7
Terminal Period Cost of Equity (%)
0.10
Year
Debt/ Equity
Leveraged
Beta
Cost of
Equity
Cumulative Discount Factor
Adjusted Equity
Cash Flow
2013
2014
2015
2016
1.5
1.0
0.7
0.5
3.8
3.3
2.9
2.6
0.260
0.230
0.208
0.194
1/(1.26) = 0.7937
1/[(1.26)(1.23)] = 0.6452
1/[(1.26)(1.23)(1.208)] = 0.5341
1/[(1.26)(1.23)(1.208)(1.194)] = 0.4474
.3
.2
1.8
7.4
2017
0.3
2.4
0.184
1/[(1.26)(1.23)(1.208)(1.194)(1.184)] = 0.3778 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
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
8.5
2.4
PV(2013–2019)
Terminal Value
Total PV
6
2.4
0.3
2.0
0.4
0.05
0.055
0.045
PV of Adjusted
Equity Cash
Flow
.3
.1
1.0
3.3
12.5
44.7
57.2
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 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.
Adjusted Present Value Method: An Illustration
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
Firm’s 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
2004–2010 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
Equals: Total Cash Flow
123.8
2.2
1.8
3.2
8.4
8.5
8.7
132.7
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
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.
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.
Key LBO Model Relationships
•
Linking purchase price (enterprise value) to industry multiples
PPTF = (EV/EBITDA) × EBITDATF
•
Linking purchase price (enterprise value) to target firm’s borrowing capacity and
financial sponsor’s 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 sponsor’s equity contribution to the target firm’s 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
Building an LBO Model
• Step 1: Project a firm’s 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 firm’s shareholders.
• Step 4: Estimate the initial equity contribution to be
made by the financial sponsor.1
• Step 5: Calculate the IRR on the financial sponsor’s
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 firm’s maximum borrowing capacity (Step 2).
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.