Journal of Applied Corporate Finance

S U M M E R 1 9 8 9 V O L U M E 2. 2

How to Value Recapitalizations and Leveraged Buyouts

by Isik Inselbag and Howard Kaufold,
University of Pennsylvania
HOW TO VALUE by Isik Inselbag and Howard Kaufold,
University of Pennsylvania*
RECAPITALIZATIONS AND
LEVERAGED BUYOUTS

F inance theorists and practitioners tend to use one

of three discounted cash flow valuation techniques
when valuing a levered corporation:
1. Weighted average cost of capital (WACC)
2. Adjusted present value (APV)
3. Flows to equity
Practitioners are most likely to use the WACC method,
which estimates a company’s value by discounting its
unlevered cash flows using a constant weighted
average cost of capital. The APV approach, which
calculates the worth of a firm as an all-equity entity plus
any incremental value from leverage, has gained ac-
ceptance especially among theorists. The flows-to-
equity technique involves appraising the value of a
firm’s equity using the shareholders’ required return.
This approach is most popular with leveraged leasing,
leveraged buyout, and project finance specialists.
For decades now, finance theorists and practi-
tioners have argued about the validity of these ap-
proaches. Authors of corporate finance papers and
textbooks seem to feel obligated to choose sides in
this debate. Proponents of the WACC and flows-to-
equity methods argue that these methods are more
appropriate and practicable because required equity
returns can be observed. Those who favor APV coun-
ter that the above methods are correct only under
unrealistic assumptions about the firm’s cash flows
and financing mix.
* The authors would like to thank Donald Chew for suggestions that greatly
improved the paper.

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JOURNAL OF APPLIED CORPORATE FINANCE
 IN ORDER TO EVALUATE THESE COMPETING BIDS RESPONSIBLY, B&G’S BOARD
OF DIRECTORS NEEDS A FINANCIAL MODEL WHICH OFFERS RELIABLE ESTIMATES
FOR THE VALUE OF LEVERED CASH FLOWS.
In an earlier paper, we demonstrated that the
three valuation methods give identical results as long
as each is properly formulated taking into account
changes in the firm’s cash flows and capital structure
over time.1 While our reasoning suggests that the
methods are equivalent under any financial policy,
we also concluded that it is more practical to apply
the WACC approach when the debt-to-capital ratio
is fixed, and the APV technique when the debt ratio
is expected to change but the amount of debt out-
standing falls into a predictable pattern.
In this article, we demonstrate (and advocate) the
use of different valuation methods to appraise a
hypothetical corporation in two different financial
transactions: recapitalizations and leveraged
buyouts. Recapitalizations are cases in which the
debt/equity ratio is changed and then maintained at
a new level into the future. In LBOs, by contrast, the
firm’s debt/equity ratio falls over time, and the dollar
amount of debt outstanding as a result of repayment
of principal can be projected for each future time
period. In the following pages, we will argue that the
WACC approach is most practical for valuing
recapitalizations, whereas APV is ideally suited for
LBO applications.
SELL TO KIN, SELL TO STRANGERS, OR ROLL
YOUR OWN?
Consider the following fictional scenario: B&G,
Inc. is a company with a solid performance in the
lackluster textile industry. While demand for its
products has stagnated over the past decade, the
firm’s respected management team has maintained
earnings on a slow upward trend. Thus far, B&G’s
officers have followed a conservative financial
course, keeping the balance sheet clear of any long-
term indebtedness. But stockholders, disappointed
in the performance of B&G’s shares, have placed
increasing pressure on management to reconsider
the all-equity financial structure.
Two recent offers to purchase the company have
intensified these pressures. Conglomerate, Inc. has
recently offered to purchase all 10 million outstand-
ing shares of B&G at $78 per share, a 20% premium
over the pre-offer market price of $65. This offer is
based on Conglomerate’s assessment that B&G’s
stable earnings could support a debt-to-capital ratio
1. I Inselbag and H. Kaufold, “On the Equivalence of the APV and Weighted
Average Cost of Capital Approaches to Firm Valuation,” unpublished manuscript,
Wharton School, December 1988.
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JOURNAL OF APPLIED CORPORATE FINANCE
of 40% (or debt/equity ratio of 2/3). B&G’s manage-
ment has responded to this recapitalization bid with
a proposal to take the company private in a
leveraged buyout. The management, backed by
credible bank financing, has offered $80 a share.
While this situation is hypothetical, the story line
has been recounted in the financial press with strik-
ing frequency. Nearly 15,000 merger and acquisition
deals, worth more than $640 billion, were consum-
mated in the years 1984 through 1987. Almost 1,100
of these transactions were LBOs, valued at more than
$120 billion. 2 The year 1988 saw record dollar
volume and megadeals, capped by the biggest ever,
the $24.8 billion LBO of RJR-Nabisco Inc. In certain
industries, it is difficult to find firms which have not
recently undergone a financial transformation of
some kind. In the past four years, for example, more
than twenty publicly held food retailers were ac-
quired, taken private or restructured.3
In order to evaluate these competing bids
responsibly, B&G’s board of directors needs a finan-
cial model which offers reliable estimates for the
value of levered cash flows. Armed with this
framework, the board could, for example, determine
what the corporation’s shares would be worth if the
firm undertook the recapitalization itself. It could
also evaluate the Conglomerate and management
offers, allowing the board to better estimate the price
the board should—and can—demand. We now
show how the WACC and APV methods can be used
to analyze the recapitalization and LBO activity
which has come to play such a prominent role in
business restructuring.
HOW TO SIZE UP THE BIDS
Valuing the Unlevered Company
It makes sense to begin by valuing B&G as it
stands—an all-equity firm. The reasonableness of
the firm’s current stock price can be checked by way
of a standard discounted cash flow analysis.
The projected income and cash flow statements
for B&G are given in Exhibit 1. Outside analysts
expect B&G sales to remain at the current $500
million level, but the managers are convinced that
improved marketing could raise revenues at a 10%
annual rate over the next two years. Continued
2. Mergers Acquisitions, Profile tables, various issues.
3. Wall Street Journal, September 26, 1988, “Kroger Rejects Offers, Intends to
Restructure,” p. 4.
EXHIBIT 1 Year 1 Year 2 Year 3
PROJECTED INCOME AND
CASH FLOW STATEMENT Sales 500 550 605
B&G, INC. Cost of Goods Sold 250 275 303
(IN MILLIONS OF DOLLARS) Depreciation 40 45 50
SG&A 50 55 61

Operating Income 160 175 192

Tax on Operating Income 54 60 65

AT Operating Income 106 116 127

Plus Depreciation 40 45 50

Gross Cash Flow 146 161 177

Less Investment 40 45 50

Unlevered Free Cash Flow 106 116 127

growth beyond that point would require new
product development. The best estimate is that cost
of goods sold would continue to take up 50%, and
administrative expenses 10%, of revenue. Total an-
nual investment in plant and equipment and net
working capital will be $40 and $45 million in the
next two years, and will level off at $50 million per
year thereafter. Depreciation charges are expected to
match investment outlays in each of the future years.
With B&G in the 34% tax bracket, the assumed
equality of depreciation and investment implies that
both after-tax operating income and free cash flow
would reach approximately $127 million in three
years, remaining at that level thereafter.4
All we need to value the company is the ap-
propriate rate to be used to discount these free cash
flows. Since B&G is unlevered, the required return
on assets will equal the required return on equity.
While estimating the expected return on a firm’s
shares is a difficult task, there are well-established
methods for meeting this challenge. If B&G’s stock
is publicly traded, an analysis of the covariance of
share returns with market-wide returns (producing
a measure known as “beta”) will provide an estimate
of the required return on equity. Share price and
fundamental data for comparable, publicly traded
firms can also be used to deduce an appropriate
discount rate.
In this example, we’ll simply assume that the asset
risk in the textile industry justifies a required return of
16%. Using this discount rate, and the free cash flows
4. We have chosen a three-year horizon to keep our illustration as simple as
possible. It is common for LBO practitioners to project cash flows over a five to ten
year period.
from Exhibit 1, the value of B&G (all-equity) can be
calculated as shown in Exhibit 2. Since we expect
B&G’s cash flow to level out at $127 million after year
3, the value of the firm at the end of that year will
equal $792 million ($127 million/.16). Discounting
this terminal value back three years implies a present
value of approximately $507 million. Adding to this
amount the present value of the cash flows from years
l-3 gives a total present value for the all-equity firm
of $765 million (or $76.50 per share).
This valuation suggests that, with B&G’s current
share price set at $65, the market is significantly
undervaluing B&G stock relative to its theoretical
value based on growth prospects. This pricing is
consistent, however, with outside analysts’ expecta-
tion that B&G’s sales are static. With no growth in
revenue, the market value of B&G would equal
$662.5 million ($106 million/.16) (or $66.25 per
share).
Conglomerate Recapitalization Offer
Conglomerate, Inc. views B&G as an attractive
acquisition candidate for three reasons. First, it has
spotted the sales growth possibility that B&G’s
managers have also identified. The market is under-
valuing the target’s shares because analysts have not
yet uncovered the true value of B&G even as an
independent, all-equity company. Conglomerate
may also see the potential for financial (as opposed
to “real” or operating) synergies.

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JOURNAL OF APPLIED CORPORATE FINANCE
 THE WACC METHOD IS A STRAIGHTFORWARD WAY TO EVALUATE THE UNTAPPED
DEBT CAPACITY OF THE TARGET IF THIS FIRM IS TO BE REFINANCED WITH A
STABLE FUTURE CAPITAL STRUCTURE.

EXHIBIT 2 Year 0 Year 1 Year 2 Year 3

ESTIMATED ALL-EQUITY
VALUE OF B&G Unlevered Free Cash Flows 106 116 127
(IN MILLIONS OF DOLLARS) Terminal Value 792
Present Value of Unlevered Free Cash Flows (Years 1-3) 258
Present Value of Terminal Value 507

Unlevered Value 765

EXHIBIT 3 Year 0 Year 1 Year 2 Year 3

ESTIMATED VALUE OF B&G
UNDER RECAPITALIZATION Unlevered Free Cash Flows 106 116 127
DEBT/VALUE RATIO OF 40% Terminal Value 870
(IN MILLIONS OF DOLLARS)
Present Value of Unlevered Free Cash Flows (Years 1-3) 264
Present Value of Terminal Value 579

Value under Recapitalization 843

By “real” synergies, we mean that combining the
two firms would enable Conglomerate to raise the
incremental cash flows from the B&G assets above
those in Exhibit 1 because of some economies in
production, marketing, distribution, or otherwise.
Because this motive for mergers and acquisitions is
well understood, and not our main concern here, we
will instead focus principally on financial synergies.
To clarify the impact of financial synergies alone, we
will assume that Conglomerate is involved in totally
different businesses, and is therefore not expected
to improve on the operating results projected by
management. 5
Conglomerate sees potential financial synergies
in its ability to finance B&G’s operations more ag-
gressively. For example, suppose it can finance up
to 40% of B&G’s value with BBB-rated debt issued at
an interest rate of 10%. The stability of B&G’s cash
flows creates a debt capacity which its current
management has failed to tap. The interest on this
debt would shield some of B&G’s income from tax,
and thereby leave more after-tax payout for the firm’s
investors.
Suppose Conglomerate has correctly estimated
B&G’s optimal market debt-to-capital ratio at 40%.
The WACC method is ideally suited for valuing B&G
under the new, stable debt/equity blend. If a firm
intends to maintain a stable capital structure in
market value terms, the weighted average cost of
capital appropriate for discounting a firm’s free cash
flows is constant and can be calculated as follows:6
In this relation, rA and rD represent the required
returns on B&G’s assets and debt, respectively, t is
the corporate tax rate, and L is the target debt-to-capi-
tal ratio for the firm. The weighted average cost of
capital is below the return on assets because of the
tax subsidy to debt financing.
To calculate the value of B&G under the
recapitalization plan, we discount the free cash flows
by the weighted average cost of capital. As shown in
Exhibit 3, the cash flows from year 4 and beyond
justify a value for the firm of $870 million ($127
million/.146) as of the end of year 3. Discounting it
back to the present using WACC, this amount is worth
$579 million today. The present value of the cash
flows from years 1 through 3 are worth $264 million:

5. If Conglomerate could realize such synergies from the acquisition of B&G, 6. This point has been made by J. Miles and R. Ezzell, “The Weighted Average
we could easily include them in our valuation analysis by appropriately revising Cost of Capital, Perfect Capital Markets and Project Life: A Clarification,” Journal
the cash flows given in Exhibit 1. We assume these gains are insignificant to focus of Financial and Quantitative Analysis (September 1980), pp. 719-730.
on the potential financial synergies alone.

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JOURNAL OF APPLIED CORPORATE FINANCE
 IN A LEVERAGED BUYOUT, A FIRM’S OWNERS BEGIN WITH A HEAVY DEBT LOAD,
BUT ARE EXPECTED TO PAY OFF OUTSTANDING PRINCIPAL ACCORDING TO A
SPECIFIC TIMETABLE (AND OFTEN VERY RAPIDLY) . . . UNDER THESE
CIRCUMSTANCES, THE APV APPROACH IS A MORE PRACTICAL VALUATION
METHOD.
EXHIBIT 4 Value as of Time
SECURITY ISSUANCE Leveraged Value
IMPLIED BY ADHERENCE Debt (40% of Value)
TO CONSTANT 40/60 Equity (60% of Value)
DEBT/EQUITY STRUCTURE
(IN MILLIONS OF DOLLARS)
106 116 127 g $264 million.
1.146 + (1.146)2 + (1.146)3
Summing the terminal value and the values of
years 1-3 gives an implied value for B&G of $843
million, which is nearly 30% above its current market
value. Conglomerate’s offer of $78 per share, or $780
million, would therefore give more than two thirds
of the gains created by leverage to B&G’s
shareholders, while promising the other third, or
nearly $63 million, for Conglomerate’s owners.
As we’ve cast the situation, there is no reason
B&G couldn’t reap the full gains of the proposed
recapitalization by implementing its own debt-for-
equity swap, assuming it can also convince the
market of the firm’s true sales potential. In that case,
an internal recapitalization could potentially lead to
a share value of $84, higher than both bids presented
to the board. But, in certain circumstances, the ac-
quirer might have greater access to the bond
markets, putting it in a better position to take ad-
vantage of the target’s debt capacity. Furthermore,
acquisitions are rarely based on financial factors
alone. Instead, there is likely to be a combination of
real and financial synergies underlying the transac-
tion. Still, the WACC method is a straightforward way
to evaluate the untapped debt capacity of the target
if this firm is to be refinanced with a stable future
capital structure.
This technique of using a constant weighted
average cost of capital for valuation and capital
budgeting purposes is widely applied by finance
practitioners. For example, the capital budgeting
approach of requiring that prospective projects offer
a return in excess of some firm- or division-wide
“hurdle rate” is in this spirit. It is important to recog-
nize, however, that a firm’s true weighted average
cost of capital, or hurdle rate, will be constant only
7. This statement holds, of course, only if the asset risk of the projects the firm
chooses also remains constant.
8. With a steady state free cash flow of $150 million, B&G would be worth
$1,030 million ($150 million/ .146). This value is correct, though, only if B&G keeps
a 2/3 debt /equity blend, i. e., issues new debt until total outstanding borrowings
reach .4 ($1,030) = $412 million.
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JOURNAL OF APPLIED CORPORATE FINANCE
0 1 2
843 860 870
337 344 348
506 516 522
if the firm maintains a constant debt-to-capital (or,
equivalently, debt/equity) ratio in market value
terms.7
To take B&G as an example, suppose the es-
timates in Exhibit 1 of B&G’s future cash flows are
realized as the years pass. Exhibit 4 illustrates how
the firm’s value will evolve if the 2/3 debt-equity ratio
proposed by Conglomerate is maintained. The ex-
ample shows that B&G’s use of the constant
weighted average cost of capital is predicated on the
assumption that it will undertake debt issues regular-
ly, ultimately raising the total value of debt outstand-
ing to $348 million.
To make the point more strongly, suppose after
a few years that prospects for the textile industry
improve, leading analysts to forecast a new steady
state annual cash flow for B&G of $150 million (up
from $127 million). For the discount rate of 14.6% to
remain valid for valuation purposes, B&G would
have to raise debt outstanding to almost $412 million
and thereby adhere to its target 40/60 blend of debt
and equity.8 If this commitment to constant adjust-
ment of the capital structure is a realistic charac-
terization of the firm’s financial policy, the WACC
approach is the most practical valuation method.
There are a number of situations, however, in
which a firm does not intend to maintain a fixed
debt-to-value capital structure. In these cases, the
weighted average cost of capital changes over time
and therefore loses much of its significance. In a
leveraged buyout, for example, a firm’s owners
begin with a heavy debt load, but are expected to
pay off outstanding principal according to a specific
timetable (and often very rapidly). The owners know
that the firm’s debt/equity combination will fall, and
can accurately forecast the dollar amount of debt
needed to finance future operations. Under these
circumstances, the APV approach is a more practical
valuation method.9 We now illustrate this technique
by valuing management’s LBO bid for B&G.
9. The Adjusted Present Value rule was originally presented in S. C. Myers,
“Interactions of Corporate Financing and Investment Decisions–Implications for
Capital Budgeting,” Journal of Finance (March 1974, pp. 1-25. Another situation
in which the APV technique is particularly useful is in evaluating project financings,
where the debt-to-capital ratio declines over time, while the dollar amount of
outstanding debt falls in a predictable pattern.
EXHIBIT 5 Payment at end of year
DEBT REPAYMENT PLAN
B&G LBO 1 139
(IN MILLIONS OF DOLLARS)
2 139
3 139
9 139
10
Management’s LBO Proposal
The basis for the Adjusted Present Value method
is that the value of a levered firm (VJ is its value as
an all-equity entity (V,,> plus the present value of the
interest tax shields (PVTS) from the debt its assets
will support.10 This relation can be written as follows:
vL “V” + PVTS.
The principle is straightforward. The firm’s un-
levered value is determined by the operating income
generated by its assets. This is exactly the value we
calculated in Exhibit 2 for B&G in its pre-reorganiza-
tion, all-equity form. The debt supported by these
operating cash flows enhances value because inter-
est payments (but not income paid to stockholders
such as dividends) are deductible from the firm’s
income for corporate tax purposes. As a result, for a
given level of operating income, the after-tax amount
available for bondholders and stockholders taken
together increases as more of the payout is in the
form of interest rather than dividends.
To illustrate the APV method, let’s add some
detail to the hypothetical LBO offer. Management
has offered $80 for each of the 10 million shares of
B&G outstanding. Suppose management has lined
up $725 million of debt financing at an interest rate
of 14%, 4 points above the rate on the BBB debt that
10. To be entirely true to Myers’ concept’ we should also deduct from this
value any costs of having the debt outstanding, such as the costs of liquidating the
firm’s assets if it is unable to service the debt. For simplicity, we assume these are
negligible LBOs have been most common in industries in which cash flows are
relatively stable, where the probability of debt service difficulties is relatively low.
Also, while these so-called “costs of financial distress” (CFD) would reduce the
value of the levered firm, we are more concerned with the relative values of the
LBO and the recap offers. Though one would normally expect CFD to increase
with the amount of debt issued, it does not follow that these costs are higher for
the LBO than for the recap in our example. The firm is likely to have both fewer
shareholders and fewer creditors under the LBO than when it is public. As a result,
it is probably easier for the bondholders as a group to 1) form a coherent view of
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JOURNAL OF APPLIED CORPORATE FINANCE
Amount Interest Principal Balance
102 37 688
96 43 645
90 49 596
32 107 122
139 17 122 0
would be used in the less levered recapitalization.11
This of course means that the managers, possibly
with other investors, will have to invest $75 million
of equity in the reorganized firm. The creditor agree-
ment stipulates that the debt principal be paid down
according to the 10-year amortization schedule
presented in Exhibit 5. We’ll assume that the
managers’ plan is to take the firm public again at the
end of year 3. At that time, the owners would repay
in full the remaining debt balance of approximately
$596 million.
The APV approach is well-suited to valuing this
LBO proposal. The distinguishing feature of an LBO is
that it is the dollar value of debt outstanding, rather than
the debt-to-capital ratio, that is the target under the
firm’s financial plan. The debt-equity blend obviously
falls over the life of the LBO, so that the required return
on equity and the weighted average cost of capital
change as the creditors are paid off. The APV technique
is especially useful in this context because the discount
rate needed to calculate the firm’s all-equity value is
independent of its (changing) debt/equity mix. We will
illustrate these effects below.
To make our calculations comparable to those
under the recapitalization, we make two assump-
tions. First, the sales and cost projections are the
same under the recapitalization as under the LBO.12
Second, when the managers reverse the LBO, the
new owners use the same 2/3 debt/equity mix used
how the firm is to be managed and 2) affect the firm’s direction if, in the creditors’
view, the managers stray from the appropriate course. These factors tend to temper
the fears of creditors even as debt levels climb.
11. For convenience, we assume a single source of debt capital in financing
about 90% of the buyout price, with the remaining 10% in equity. In typical LBO
transactions, a combination of senior and subordinated debt, and preferred and
common stock‚ is used in the capital structure The valuation of deals with such
layers of financing is a straightforward extension of the APV method
12. As pointed out in footnote 5 above. we could account for any impact of
the LBO per se on the operating cash flows by revising the cash flows of Exhibit 1
accordingly. The reasons one might expect improved operating results under the
private ownership structure are discussed below.
 THE DIFFERENCE IN THE VALUES OF THE LBO AND RECAP OFFERS IN OUR
EXAMPLE, $894 VS $843 MILLION, IS DUE SOLELY TO THE VALUE OF THE
INTEREST TAX SHIELDS ON THE ADDITIONAL DEBT ISSUED UNDER THE LBO.

EXHIBIT 6 Year 0 Year 1 Year 2 Year 3

VALUING THE LBO
THE ADJUSTED PRESENT Terminal Value of All-Equity Firm 792
VALUE APPROACH Terminal Value at Target Capital Structure 870
(IN MILLIONS OF DOLLARS)
Debt Tax Shield at Target Capital Structure 78
Interest on LBO Debt (Exhibit 5) 102 96 90
Unlevered Value (Exhibit 2) 765
Present Value of Interest Tax Shield (After Year 3) 53
Present Value of Interest Tax Shield (Years 1-3) 76
Value of Leveraged Buyout 894

in Conglomerate’s recap offer. The steps involved in
evaluating the LBO proposal are shown in Exhibit 6.
The first component of the LBO value is what
B&G is worth in unlevered form. We earlier (in
Exhibit 2) found this value to be $765 million. We
must add to this the present value of the interest tax
shields from the debt used to finance the operations
of B&G. At the end of year 3, the managers will take
the firm public again. If the new owners use the 2/3
debt/equity financing assumed under the
recapitalization plan, the expected sale price at that
time is $870 million, the terminal value calculated for
the recap in Exhibit 3. The difference between this
amount and the terminal value for the firm in all-
equity form is $78 million, which represents the
value (as of the end of year 3) of the tax shield on the
debt used to finance B&G after year 3. Discounting
at the debt rate of 14%, this amount is worth $53
million in present value.
Finally, we must add the tax savings from the debt
outstanding during the LBO years. Every dollar of
interest reduces taxes by 34 cents, so the present
value of the debt tax shield for years 1-3 is as follows:13
.34 x (g4+ --!& + --$$$ G $76 million.
(1.14)2 .
The value of the leveraged buyout (approximate-
ly $894 million) is the sum of the all-equity value of
$765 million plus the present value of all interest tax
shields. The $94 million difference between this value
and the $800 million LBO offer is the excess the
managers win for themselves if their bid is accepted.
As is typical in LBO deals, the bulk of the payoff
to the managers/stockholders in our example comes
in year 3 when the firm is resold. (See Exhibit 7.)
Dividend payments are minimal during the LBO
years since most of the firm’s income is committed
to debt interest and principal payments. If B&G is
resold at fair value at the end of year 3, the LBO
owners net $274 million after retiring the remaining
debt principal.
We should again emphasize that the difference in
the values of the LBO and recap offers in our ex-
ample, $894 vs $843 million, is due to the value of
the interest tax shields on the additional debt issued
under the LBO. It has purposely been assumed that
the underlying cash flows would be unaffected by
the form of reorganization the directors of B&G
accept. There is a strong argument, however, that the
firm’s assets would be managed more efficiently
under the LBO option, since the managers’ own
wealth is more closely tied to the performance of the
company in this case. The recapitalization offer by
the outside corporation may still prove to be more
valuable, though, if the synergies from the combina-
tion of the acquirer and target outweigh the com-
bined effects of enhanced management incentives
and greater interest tax shields under the LBO.
Though the APV method we have outlined above
is simple and theoretically sound, it is rare for prac-
titioners to use this approach to analyze LBOs. Most
LBO analysts determine buyout prices for deals by
applying price earnings multiples for comparable
transactions to historical operating income for the
target. Cash flow projections are widely used, but
less for valuation than for structuring the financial

13. In our example, the debt service is fixed independent of the annual cash
flows generated by B&G. In many LBO transactions, debt covenants require that
the entire free cash flow be dedicated to interest and principal payments. Under
these conditions, the amount of debt outstanding and, therefore, the interest tax
shields at any point in time are a direct function of the unlevered free cash flows
of the firm. Since the debt balance then becomes as risky as the cash flows, the
required return on assets, r& is the appropriate discount rate to be used in
calculating the present value of interest tax shields. See Miles and Ezzell for a more
detailed discussion.

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JOURNAL OF APPLIED CORPORATE FINANCE
 EBIT MULTIPLES, P/E RATIOS, AND OTHER “BACK-OF-THE-ENVELOPE” METHODS
ARE USEFUL BENCHMARKS IN THE VALUATION PROCESS. BUT SUCH METHODS
CAN SERIOUSLY MISREPRESENT A FIRM’S TRUE VALUE IF ITS CASH FLOW
CHARACTERISTICS DO NOT EXACTLY MATCH THOSE OF THE “COMPARABLES.”

EXHIBIT 7 Year 0 Year 1 Year 2 Year 3

EQUITY CASH FLOWS
B&G LBO PROPOSAL Operating Income 160 175 192
(IN MILLIONS OF DOLLARS)
Interest 102 96 90
Earnings Before Tax 59 79 102
Taxes on EBT 20 27 35
Earnings After Tax 39 52 67
Plus Depreciation 40 45 50
Less Investment 40 45 50
Less Principal Payment on Debt 37 43 49
Cash Flow to Equity 1 9 18

Proceeds from Sale of Firm 870

Less Debt Principal (Exhibit 5) 596
Residual Value to Equity 274

Total Equity Flows –75 1 9 292

Return to Equity 60.5%

package to meet lender requirements (coverage
ratios) and to maximize equity returns given a
buyout price based on multiples. The financial
analysis for LBO lenders involves preparing pro
forma statements along the lines of Exhibit 7, and
determining whether coverage ratios comply with
standard rules of thumb.
LBO equity investors calculate the internal rate of
return earned on the equity cash flows, and pursue
those deals which offer returns above a pre-deter-
mined hurdle rate. As this article goes to press, most
LBO firms require a minimum return between 30% and
40%. The return to equity in our hypothetical example
is 60.5% (Exhibit 7), so this deal would be considered
acceptable assuming B&G’s board is willing to sell the
firm to management at the $800 million price.14
From a valuation perspective, current practice
suffers from two shortcomings. The first is its reliance
on income multiples in determining the fair value of
the target firm. EBIT multiples, P/E ratios, and other
“back-of-the-envelope” methods are useful
benchmarks in the valuation process. But it is well
known that such methods can seriously mis-
represent a firm’s true value if its cash flow charac-
teristics do not exactly match those of the “com-
parables.”
The second shortcoming is that LBO equity in-
vestors tend to use ad hoc hurdle rates. The cutoff
rate which is appropriate for any particular transac-
tion depends on the riskiness of the target firm’s
underlying asset cash flows, and the level and repay-
ment schedule of the debt financing. In spite of these
complications (or perhaps because of them), prac-
titioners generally apply the same minimum re-
quired return to all deals. Furthermore, the return
that equity investors should require changes
dramatically over the life of an LBO, since firms
reduce debt over time and often shed assets as well.
Exhibit 8 demonstrates how the required return
on equity and the weighted average cost of capital
changes over the three-year period of the B&G trans-
action. (For a derivation of these numbers, see the
Appendix to this article.) Equity investors using a
hurdle rate approach must decide which of the
values in the first row above is the appropriate re-
quired return for the B&G transaction. The answer,
of course, is that each is correct for the equity cash
flow expected in the corresponding year, while the

14. Steven Kaplan has conducted a study of actual returns to equity investors
in management buyout transactions (“Management Buyouts: Efficiency Gains or
Value Transfers,” unpublished manuscript, University of Chicago, October 1988).
Of the 76 buyouts completed between 1980 and 1986 that exceeded $50 million,
Kaplan is able to value 21 of them at some time after the buyout. For these 21 deals,
the median (mean) return to equity investors was 113% (128%) per annum. As
Kaplan points out, these figures probably overstate MBO equity returns because
the firms that could be valued tended to have higher-than-average post-buyout
performance. Specifically, a disproportionate number of the firms that could be
valued were those that had been taken public.

94
JOURNAL OF APPLIED CORPORATE FINANCE
EXHIBIT 8 Costs of Financing for the Year
COSTS OF FINANCING
Return on Equity
UNDER THE LBO PLAN
Wtd. Avg. Cost of Capital
appropriate overall hurdle rate is a complicated
average of these returns.15
Assuming investors are somehow able to deter-
mine appropriate cutoff rates, the approach used in the
marketplace still only reveals whether or not a deal
should be pursued. The additional advantage of the
APV method is that it provides a measure of the wealth
created for the equity investors in an LBO. This infor-
mation is extremely valuable in providing a foundation
for rational price negotiation in a bidding contest.
WHAT SHOULD THE BOARD DO?
Having outlined the alternative valuation methods,
we return to the original question: How can the board
react responsibly to a set of offers on the table? In the
particular example we have considered, the LBO reor-
ganization is worth more than the recapitalization be-
cause of the assumed absence of synergies and costs
of financial distress. While the original management
bid of $80 exceeds Conglomerate’s, the recap value is
higher than the LBO bid. If the board resists the initial
management proposal, Conglomerate is likely to
leapfrog the LBO share offer, and force the manage-
ment buyout group to surrender more of the value to
existing shareholders. Many outcomes are possible,
but what is clear is the importance to the board of
having a consistent method of comparing alternative
offers for their firm.
More generally, we have described some of the
most important factors determining the relative value
15. Exhibit 8 also indicates the difficulties of using a WACC approach to value
a firm undergoing a leveraged buyout. The weighted average cost of capital
increases over the life of the LBO since the financing subsidy from the interest tax
shield dwindles as the debt is repaid. The returns given in Exhibit 8 for the end of
n ISIK INSELBAG
is Adjunct Professor of Finance at the University of
Pennsylvania’s Wharton School. He is also Director of its Execu-
tive M.B.A. program.
95
JOURNAL OF APPLIED CORPORATE FINANCE
0 1 2 3
23.0% 21.6% 20.5% 19.9%
11.9% 12.1% 12.3% 14.6%
of three forms of corporate restructuring: internal
recapitalization, recapitalization by an outside firm,
and a leveraged buyout. All of these forms of reor-
ganization should add value because of the income
tax shields the debt provides. The LBO maximizes
these tax advantages, and will therefore be the most
valuable option when the costs of financial distress
are insignificant. The buyout also gives management
the heaviest equity stake. Eliminating the
bureaucratic layers between owners and managers
may improve operating results and firm value. In
spite of these advantages, the external recapitaliza-
tion will prove to be more valuable if there are
significant synergies when the target is combined
with the other assets in the acquirer’s portfolio.
Our analysis also shows that there are generally
several ways to value any restructuring proposal.
The weighted average cost of capital approach will
be best when the capital structure is stable, while the
APV method will be most direct if the capital struc-
ture changes but the debt amortization schedule is
predictable. In fact, this finding is much more general
than the context we have considered. When valuing
a going concern that is expected to maintain a con-
stant debt/equity structure, the weighted average
cost of capital is a legitimate and convenient discount
rate to apply to corporate operating cash flows. In
situations where the financing mix will change over
time, the weighted average cost of capital loses sig-
nificance, and the APV method becomes the better
valuation technique.
year 3 assume the LBO is reversed at that time, with the new owners achieving the
target debt-to-capital mix of 40%. The resulting required return on equity will be
constant at 19.9%, implying the weighted average cost of capital of 14.6% used in
the recap analysis above.
n HOWARD KAUFOLD
is Adjunct Associate Professor of Finance at the Wharton School,
and Associate Director of its M.B.A. program.
APPENDIX n How the Cost of Capital Changes Over Time.

EXHIBIT 9 Value as of Time 0 1 2 3

EVOLUTION OF LBO
EQUITY VALUE Unlevered Value 765 782 792 792
(IN MILLIONS OF DOLLARS) Value of Interest Tax Shields 129 112 95 78

Value of Leveraged Buyout 894 895 887 870

Loan Balance (Exhibit 5) 725 688 -645 596

Equity (LBO Value - Loan Balance) 169 207 243 274

Exhibit 8 in the paper describes the evolution in the
return on equity and the weighted average cost of
capital over the life of the LBO. The return to the
stockholders consists of annual cash flow and ap-
preciation in equity value. Specifically, the rate of
return over any particular year is equal to the following:
(Cash Flow to Equity + Increase in Equity Value)
rE =
Initial Equity Value
The cash flow to the shareholders is presented in
Exhibit 7 in the text. Because the bulk of earnings is
committed to servicing the debt in an LBO, most of
the shareholders’ return is earned in the form of
capital gains. To calculate the appreciation in equity
value, we can use the same APV valuation method
used to construct Exhibit 6 to trace the LBO value
over time. (See Exhibit 9.)
The value of the shareholders’ stake is the total
value of the LBO less the remaining debt balance.
Exhibit 9 indicates that equity value rises by $38
($207 – $169) million over the first year of the LBO.
Adding to this the $1 million cash flow to
shareholders in that year (see Exhibit 7), the return
to equity is 23.0% ($39/$169), as given in Exhibit 8.
The equity returns for the other years are computed
in similar fashion.
The weighted average cost of capital is the weighted
average of the cost of debt and equity financing. We’ve
just shown how the equity cost is measured. The before-
tax cost of debt in our example is 14%. The weighted
average cost of capital as the LBO begins is therefore:
= (debt) rD( 1 - t) + !$C@&&
r
wAcc ( v a l u e )
= (725) (.14) (l-.34) + $@&) (230)
(894)
G .119,
as given in Exhibit 8. Following the same process,
one can calculate the weighted average cost of capi-
tal for each of the LBO years.
Using Exhibit 4 and the equity cash flows under
the recapitalization plan, the return to equity with
this restructuring is constant at 19.9%. Weighting the
costs of debt and equity by their relative use under
the recap, the weighted average cost of capital is the
14.6% figure used in the text.

96
JOURNAL OF APPLIED CORPORATE FINANCE
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