Professional Documents
Culture Documents
Structures and
Valuation
Part I: M&A
Environment
Part V:
Alternative
Strategies
Motivations for
M&A
Business &
Acquisition
Plans
Public Company
Valuation
Payment &
Legal
Considerations
Business
Alliances
Regulatory
Considerations
Search through
Closing
Activities
Private
Company
Valuation
Accounting &
Tax
Considerations
Divestitures,
Spin-Offs &
Carve-Outs
Takeover Tactics
and Defenses
M&A Integration
Financial
Modeling
Techniques
Financing
Strategies
Bankruptcy &
Liquidation
Cross-Border
Transactions
Learning Objectives
Impact of Leverage on
Financial Returns
Impact of Leverage on Return to Shareholders
All-Cash
Purchase
($Millions)
50% Cash/50%
Debt
($Millions)
20% Cash/80%
Debt
($Millions)
Purchase Price
$100
$100
$100
$100
$50
$20
Borrowings
$50
$80
$20
$20
$20
Interest @ 10%1
$5
$8
$20
$15
$12
$8
$6
$4.8
Net Income
$12
$9
$7.2
Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.
If EBIT = 0, ($5), and ($8), ROE in 0%, 50% and 20% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%,
respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.
1
2
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Debt Reduction & Reinvestment Increases Free Cash Flow and in turn Builds Firm Value
Debt
Reduction
Adds to Free
Cash Flow by
Reducing
Interest &
Principal
Repayments
Debt Reduction
Reinvest in Firm
Reinvestment
Adds to Free
Cash Flow by
Improving
Operating
Margins
Tax
Shield
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Case 2:
Debt Reduction + Margin
Improvement
Case 3:
Debt Reduction + Margin
Improvement + Properly
Timing Exit
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
$150,000,000
$250,000,000
$100,000,000
7.0 x
$700,000,000
$450,000,000
$185,000,000
$215,000,000
$130,000,00
7.0 x
$910,000,000
$695,000,000
$185,000,000
$215,000,000
$130,000,000
8.0 x
$1,040,000,000
$825,000,000
24%
31.2%
35.2%
4.5 x
6.95 x
8.25 x
Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and principal
repayments reflecting the reduction in net debt.
2
Net Debt = Total Debt Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million
3
Transaction Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year
4
Equity Value = Transaction Value in 7th Year Net Debt
5
The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it
accounts for the time value of money.
1
Discussion Questions
1. Define the financial concept of leverage.
Describe how leverage may work to the
advantage of the LBO equity investor? How
might it work against them?
2. What is the difference between a management
buyout and a leveraged buyout?
3. What potential conflicts might arise between
management and shareholders in a
management buyout?
Valuing LBOs
investors
= The value of common equity
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 firms ability to
Repay such debt as the firm assumes
substantial amounts of new debt and to
Pay interest and dividends on a timely basis.
Recalculate each successive periods with the D/E ratio for that period,
and using that periods , recalculate the firms cost of equity for that period.
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.
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.