FINA535 - L1

Strategic Finance and Value Creation

Assignment 5
Acova Radiateurs
December 9, 2006

Written by:

Group No. 2

Frances CHIN 05933771

Andy CHOW 05930913
Aslan LAM 05930169
Joseph LAM 05934062
Pitney SIT 05933654
Philip WAN 05931682
1. Is Acova a good LBO candidate?
Acova should be a suitable candidate for Leverage Buyout (LBO), given its marketing-
leading position in a steadily growing industry.
Based on its stable historical and projected sales performance, we believe its prospective
cash flow would be steady and sufficient to offset the debt and interest expenditure
incurred with the LBO. It also had a strong market position within France and Europe.
Another evidence substantiating its suitability was the current ROIC of around 17.7%
[NOPLAT / Invested Capital = EBIT * (1-tax rate) / (Total Asset – Excess Cash – non-
interest bearing liabilities = 36.5 * (1-0.37) / (233.9 – (12.5 - 2%*337.4) – (88.1 + 5.0 +
5.3))]. With its experienced management, there is still room for further utilization of
existing assets and hence potential of generating higher sales.
Also, many of its production machines were manufactured internally. If Management
changed the policy and would buy its new production machinery more cheaply from other
suppliers the production cost could be reduced. The competent and enthusiastic
management teams were valuable assets to the company.
All in all, Acova basically fulfilled the criteria of a good LBO candidate, (apart from the
fact that the buyout offered limited synergy opportunities) yet whether the buyout was
justifiable depended largely on the offered price which was determined by an accurate
valuation of firm value.

2. What is the value of Acova? Does it merit the proposed acquisition price of FFr 340MM?
The firm value of Acova prior to LBO was determined by using Discounted Cash Flow
method, by using two different data sets: the data set projected by Baring, and the data set
estimated with a more conservative sales growth.
[Please refer to Appendix 1 and Appendix 2 for the computations]
Given the fact that Acova was one of the major players in the radiator industry and had a
leading position in several major European countries, its business performance as well as
risk should be relatively similar to that of the whole market, in other words, its beta should
be close to one. In this regard, beta values ranging from 0.8 to 1.5 were adopted in our
valuation model. Moreover, the cost of debt was assumed to be 12.2%, which is the
arithmetic average of interest rates of three kinds of debt. [Please refer to Appendix 3]
With the conservative sales growth projection (4.5% perpetual growth rate), the firm value
obtained with a beta of 0.8 is 422.9 [Appendix 1] million FFr, while the Baring’s data set
revealed a firm value of 529.1 [Appendix 2] million FFr. In conclusion the firm value
generated with either data set was greater than the proposed acquisition price of 340
million FFr.
Therefore, the acquisition price should be merited by its value, even with a more
conservative growth forecast.

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3. Why does Baring Capital Investors seek such a high rate of return of 30 – 35%?
Baring Capital Investors should demand a rate of return much higher than the market rate
of return under the circumstance of LBO, as they were taking a higher risk in such kind of
investment.
First of all, BCI had to raise quite a large amount of debt in every LBO investment. The
consistently high leverage increased the risk of liquidation for Baring. Its beta must be
very high when compared to general companies in the market.
Secondly, in the next few years after LBO it had to use a substantial proportion of the
future cash flow of the acquired firm to pay the debt interest and the principle. Very lean
or possibly no cash flow would be expected to be pocketed during this period until the
acquired firm could be sold. What’s more, a lot of uncertainties might complicate the
condition of company during this period, for example, some serious investment mistakes
made by particular staffs would adversely affect the cash flow and potentially brought the
company to liquidation.
[Please refer to Appendix 3 for the free cash flow after repayment of debt and interest]
Thirdly, the optimistic free cash flow and exit value were estimated based on the
assumption that operation efficiency could be improved with the experienced and
enthusiastic management team which contributed to steady growth rate of the revenue
going forward. However, such expectation might not be materialized if the competent
staffs left the company after the buyout, and the perpetual growth rate and subsequently
the exit value might not be as high as projected due to lack of synergy between Baring and
the acquired firm.
Finally, apart from the high risk attached to a LBO, some intangible benefits contributed
by Baring to the acquired firm might also justify a high rate of return. Such potential
benefits might include expertise in particular area for management and provision of
special financial arrangements. In other words, the required high rate of return might have
incorporated the cost perceived as “consultant fee” or “service fee”.
Specifically for the Acova case, the risk could be further increased as there was not much
technology barrier for manufacturing of Acova’s products. Moreover, the prospect of
household development in Europe might not be as promising as expected. All of the
above discussed factors might account for the higher hurdle rate required by Baring.

4. How does the levered cost of equity compare to BCI’s 30 – 35% hurdle rate on
investment?
The levered cost of equity is computed using the relevered beta which reflects the change
in debt ratio following a LBO. [Please refer to Appendix 3 for the computation]

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In this case, the relevered beta (2.18 – 3.28) of Acova was much higher than the original
equity beta we assumed (0.8 – 1.2), because of the huge increase in debt incurred in the
LBO. The resulted cost of equity became 21.0% – 26.4%, which was substantially higher
than the original cost of equity (14% - 16%), yet was still lower than the hurdle rate
required by Baring. In fact, the levered cost of equity of 30% – 35% corresponded to an
equity beta of 1.5 – 1.8 for the acquired firm.
Possible explanations for the discrepancy, other than difference in assumptions, would be:
1) For every LBO investment, BCI would have to assume a high risk, arising from huge
debt financing. Before the firm could be sold to a third party, very tiny or even no
cash flow would be generated. During this “cultivating period”, fluctuations in
interest rate and economic conditions might undermine the exit value and hence the
risk would possibly be higher than originally anticipated. In this regard, a required of
return higher than the levered cost of equity should be demanded to factor the risk
pertaining to uncertainty.
2) BCI would have to incur additional overhead or administrative costs (e.g. cost of
employees, consultancy, financial study, etc.) for each LBO. These expenses should
be counted on top of the levered cost of equity, which basically only reflects the return
for shareholders in normal investment.

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