CASE ANALYSIS – MBO

Wavell Corporation, a successful, publicly-traded manufacturer of glass ware, was

purchased by Eastern Pacific, a large conglomerate, which during this period seemed bent
on buying everything in sight. Eventually, however, EP began to focus its interests
predominantly in the transportation, communications and real estate. Wavell did not fit
into the EP mold and languished for a number of years. A small group of disgruntled
Wavell executives began to consider the possibility of a leveraged buy-out, EP was more
than willing to consider divestiture. Wavell’s growth rates did not meet EP’s objectives
and EP had never been comfortable with Wavell’s product line. Although the glassware
industry was not growing rapidly, there was a constant steady demand for Wavell’s
product. The company had very stable production costs and good contribution margins,
which consistently resulted in a strong steady cash flow. The production equipment was
old, but in good condition and its replacement cost far exceeded its book value. Up until
the EP acquisition, Wavell had always been managed well, if conservatively and had
little debt.

Wavell’s current sales were $7,000,000 with EBIT of $650,000 and net income of
$400,000. Negotiations between Wavell management and EP settled on a purchase price
of $2000000 (representing a P/E ratio of 5). Because of the high replacement cost of
Wavell’s assets, its strong cash flow and its relatively unencumbered balance sheet,
Wavell was able to take on a large amount of debt. Banks supplied $1,200,000 of senior
debt at an interest rate of 13%; this debt was secured by the finished goods inventory and
by net property, plant and equipment and was to be amortised over a five year period. An
insurance company loan of $600000 was also arranged in the form of subordinated debt,
at an interest rate of 16% likewise to be amortised over a five-year period. The insurance
company also took an equity position worth $100000; Wavell was expected to repurchase
this equity interest after five years for an amount which would provide the insurance
company with a 40% annual yield. Finally, the Wavell management team put up
$100000 as their own equity position.

Prepare a proforma cash flow calculations for a 5 year period on the basis of following
assumptions. (Some of the assumptions are highly conservative)

a. An average growth of 12% for the next five years is assumed

b. Assume tax rate as 40%
c. Depreciation of the assets (2000000) has to be calculated on a straight-line basis
over a period of 16.67 years.