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Case Study LBO

Case Study LBO

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Published by adarshraj

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Published by: adarshraj on Jul 30, 2009
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12/16/2012

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Shaky Assets Corp. LBO Mini-case
Shaky Asset Corp. (SAC) currently has an invested capital equal to 25MEUR. SAC isineffeciently managed with an after-tax ROI of only 7% p.a. and an annual EBITgrowth rate equal to 4%. Management has indicated that the after-tax ROI can besustained 5 years, after which it will drop to the level of WACC. Current targetdebt/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 andfinancial benefits could be enormous. The LBO plan would involve levering up SACto a target 75% debt/assets ratio and using the debt to repurchase shares.Simultaneously the management team would be replaced and a new motivatedmanagement team is expected to improve after-tax ROI to 10% p.a. and EBIT growthof 4% p.a., both of which can be realized immediately and maintained at a constantlevel for the next 10 years. Beyond that, competition is expected to push after-tax ROIdown 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 (marketvalued) 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 therisk free rate 2.5% p.a. Assume CAPM prices both equity and debt claims (=implieddebt 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 [from CAPM (4%-2.5%)/5%]Before-LBO Cost of levered equity 6.5% [CAPM 2.5%+0.8*5%]Before-LBO WACC: 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 =
β
U
+ (
β
U
-0.3)*0.71*20/80 <=>
β
U
=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) = 7%*25 =1.75 MEUR.Plowback ratio 4%/7% = 0.57143T=5, after that no growth.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 which20% 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) = 10%*25 =2.5 MEUR.Plowback ratio 4%/10% = 0.4T=10, after that no growth.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 debtPLUS 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 bedue to operative improvements.

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