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RJR Nabisco

Some genius invented the Oreo. Were just living off of the inheritance.
F. Ross Johnson

Fair Market Value


Fair Market Value: the price at which the asset would trade between two rational individuals, each in command of all of the information necessary to value the asset, and neither under any pressure to trade. Rocky Higgins Analysis for Financial Management (p. 318)

Capital Budgeting 101


Step 1: Estimate Discount Rate Step 2: Project Cash Flows
Cash flows for 1989-98 in tables Terminal value

Step 3: Compute Net Present Value (NPV)


Accept positive NPV projects

Discount Rate
As we discussed, the discount rate is the weighted average cost of capital (WACC).
D E WACC E (rd )(1 t ) E (re ) DE DE

where t = tax rate, E(rd) = expected cost of debt D = amount of debt in capitalization E(re) = expected cost of equity E = amount of equity capitalization

Discount Rate
To calculate the WACC using 1989 figures under the three strategies:
5,204 12,790 Prebid : (.09)(1 .34) (.168) .137 5,204 12,790 5,204 12,790
11,186 4,202 Mgmt : (. 098 )(1 .34 ) (.250 ) .115 11,186 4,202 11,186 4,202 18,932 4115 KKR : (. 102 )(1 .34 ) (. 330 ) .114 18,932 4115 18,932 4115
NOTE: since the capital structure changes over time, we need to recompute the WACC each year to reflect the change in capital structure.

Projected Cash Flows


Projected cash flows for 1989 are calculated as follows:
Rev. - Exp. - Depr. TI - Tax Net Inc.
+ Depr.

Prebid Mgmt 18,088 7,650 14,429 5,544 807 777 2,852 1,329 970 1,882 807 1,708 80 0 901 452 877 777 432 41 12,680 13,861

KKR 16,190 12,596 1,159 2,435 828 1,607 1,159 774 79 3,500 5,413

- Cap.Exp. - Chg WC
+ Asset

Sale Net CF

Projected Cash Flow


The following cash flow represent the cash flow computed from the tables:
Year 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Prebid Management KKR 901 13,861 5413 1385 1486 4909 1856 1768 2526 2528 2062 2745 2985 3261 3555 3887 4246 4575 2278 2507 2755 3029 3332 3666 2855 3101 3364 3651 3970 4319

Terminal Value
To estimate a terminal value, we need to make an assumption about future growth after 1998. If cash flows grow by 2.5% per year (and the WACC remains constant), then for the pre-bid strategy: 4575(1 .025) PV (1998) 38,755 .146 .025 For the Management Group scenario:
3666 (1 .025 ) PV (1998 ) 31,055 .146 .025

For the KKR scenario:


4319 (1 .025 ) PV (1998 ) 36,587 .146 .025

Terminal Value
Results will depend on the growth rate assumption. Values in 1998 of cash flows for 1999 and beyond for different assumptions are (Sensitivity Analysis): Growth Rate
Strategy Pre-Bid Management KKR 0% 31,336 25,110 29,582 2.5% 38,755 31,055 36,587 5% 50,039 40,097 47,239

Present Value
The present value of the cash flows for the prebid strategy is (using the 2.5% growth rate assumption after 1998): ($ millions)
901 1385 1856 PV 2 3 1.137 (1 .139) (1 .14)

...

4575 38,755 22,607 10 (1 .146)

This represents the total value of RJR Nabisco (ASSETS).

Present Value
To figure out the value per share of RJR Nabisco to the CURRENT shareholders, consider the pre-bid valuation: Total Assets = 22,607 Current Debt = 5,204 Equity = 17,403

17,403 PerShare 70.34 247 .4

Valuation
Estimates of the value per share under the alternatives (again, using the 2.5% growth rate assumption):
Strategy Prebid Management KKR Total 22,607 30,593 29,278 Debt 5204 5204 5204 Equity 17,403 25,389 24,074 Share Price $70.34 $102.62 $97.31

Sources of Value
The company is worth substantially more under either the KKR or the Management Group plan. There are smaller differences between the KKR value and the management value. The buyout plans propose to
increase debt trim excesses decrease capital expenditures sell food assets decrease operating profits

All gains are based on projections.

What Happened?
Per share bids:
Case (11/18) $100 94 98-110 11/29/88 $101 106 103-115

MGMT KKR FB

Activities of Special Committee


Concluded that First Boston bid was impractical. Began to negotiate terms with KKR. Letter from Management Group protesting negotiations with KKR, offering to negotiate all aspects of its proposal. Special Committee decided to consider new bids.

Activities of Special Committee


Summary of final bids (substantially equivalent): Bid Valuation MGMT $112 $108 KKR 109 108 Chose KKR:
more equity (25% vs 15% for mgmt) retain more businesses fewer PIK securities more benefits to terminated employees.

Summary: RJR Nabisco


Fundamentals of firm valuation: discounted cash flow techniques. Relation between managerial decisions and firm cash flows.
Operating decisions can create or destroy value.

Role of a corporate governance system that encourages value-enhancing decisions.