PHILIP MORRIS COMPANIES AND KRAFT,INC

Nicolas Bar-Armstrong
Marc Fritze
Steven Kent Gryskiewicz
Ike Nnoaham
Prabhav Dhoj Shah

Executive Summary
When an acquiring company submits a tender offer, the company being acquired either out rightly
rejects it (via poison-pill) or seeks favorable valuation for its common stock. Such was the case with Kraft
Company; while Philip Morris (PM) offered the price of Krafts stock at 50% premium, Kraft rejected it
considering the valuation to be too low. To counter the offer, and to persuade its equity holders not to
surrender their shares, Kraft came up with a restructuring offer that would value its stock price
significantly higher than PMs offer. Much of this paper looks at the valuation of Krafts restructuring
offer and concludes that it was in the best interest of the board and shareholders to accept Krafts
restructuring offer and reject PMs offer of $90 per share, primarily due to the dividend offered (which is
taxed at a lower rate than capital gain) as well as the tax shield created by the interest expense for new
debt to be assumed under the new plan. The calculation also provides the basis for Krafts management
to negotiate the bid price to be ideally higher than $110 (per valuation of Kraft) and not lower than $102
(per our calculation in Q5).

Nicolas Bar-Armstrong, Marc Fritze, Steven Kent Gryskiewicz,Ike Nnoaham, Prabhav Dhoj Shah

PHILIP MORRIS COMPANIES AND KRAFT,INC

1a)
Debt to Value ratio for Kraft at the end of 1987 can be calculated from the information provided on
Exhibit 2:
Total Liabilities = $3,588.3M
Total Value = $5,486.7M
Debt/Value = 65.4%
Further, if we focus strictly on financial (as oppose to operational) values only,
Financial Debt = Long Term Debt + Current Debt = $895.3M + $37.2M = $932.5M
Total Value = $5,486.7M.
Financial Debt/Value = 17.0%

1b)
We can use CAPM model to calculate the required rate of return on the assets of Kraft.
We note that various Betas are provided in Exhibit 1, however Kraft company sold many business units
until 1987 and thus, we assume that the most representative Beta would be that last beta (i.e. 1987)
rather than the arithmetic mean of all the betas given. The calculation thus follows:
ROR (re) = rf + (premium)
rf
premium

re

8.50%
8.40%
0.74
14.72%

1c)
Pre-bid WACC calculation:
Debt = $932.5M (Current + Long Term Debt)
Equity = $6.32B <= Market value of Equity = Number of shares * Closing stock price = 131M * $48.25
D+E = $7.253B
= 0.74
re = 14.72%
rd = 11%
WACC =13.60% <= re(E/D+E)+rd(1-t)(D/D+E)
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Nicolas Bar-Armstrong, Marc Fritze, Steven Kent Gryskiewicz,Ike Nnoaham, Prabhav Dhoj Shah

PHILIP MORRIS COMPANIES AND KRAFT,INC

Post-restructure WACC calculation
With the new target debt structure, we have to unlever our beta first:
u = 0.68

< = /(1+(1-T)(D/E)) with old D/E

new = 0.87

<= u*(1+(1-T)(D/E) with new D/E (D/E=1/2)

rd = 10%
re = 11%

< = CAPM

new WACC = 12.40%

Q2)
The unlevered cash flows for Kraft for the given period is presented below:

Sales
EBIT

Tax 40%
NOPAT
Cash Proceed
Dep-CapX
CapX
deltaWC
UFCF

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

6,515
1,280
512
768
2,146
0
0
0
2,914

6,804
1,487
595
892
0
0
0
12
880

7,125
1,671
668
1,003
0
0
0
13
990

7,481
1,755
702
1,053
0
0
0
14
1,039

7,855
1,842
737
1,105
0
0
0
15
1,090

8,248
1,935
774
1,161
0
0
0
16
1,145

8,660
2,031
812
1,219
0
0
0
16
1,203

9,093
2,133
853
1,280
0
0
0
17
1,263

9,548
2,239
896
1,343
0
0
0
18
1,325

10,025
2,351
940
1,411
0
0
0
19
1,392

Q3)
The market responded favorably for Kraft's stock as it increased the share price by almost 47% the first
day and rose up to the level of the price offered by PM the next day. This could be because of various
reasons, the most probable reasons being:
i.

Market agreed with PM's valuation of Kraft's stock as the purchaser would have performed
higher level of due diligence compared to an average investor

ii.

ii. The lowest price that the purchaser of the stock would get is the one offered by PM, i.e.
$90/share. This limits the downside while there still is a chance of stock further going up.

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Nicolas Bar-Armstrong, Marc Fritze, Steven Kent Gryskiewicz,Ike Nnoaham, Prabhav Dhoj Shah

PHILIP MORRIS COMPANIES AND KRAFT,INC

The market wasn't so favorable with PM's share as it's price went down 5% after the offer. This could be
due to various reasons:
I.
II.
III.

Market wasn't as enthusiastic with PM's plan and thought the company is over paying for a
stock whose last trading value was only $60
The change in price is not significant. In the days leading to the offer, PM's stock price had 1-4%
swing. This could be considered normal market behavior.
It is common to see the price of the stock going slightly low for the acquiring company.

We further analyze the market response after the immediate reaction of the market following the bid,
Stock
3
4
5
6
7
10
11
12
13
14
17
Bid 18
19
RJR bids 20
21
Kraft 22
25
26
27
28

PM
97.00
98.00
97.38
96.88
100.88
101.13
100.75
98.875
99.25
98.625
100
95.5
94
99
97.375
97.5
95.875
95.5
95
94.75

S&P
638.71
637.01
640.02
641.36
654.83
655.32
654.68
645.47
648.48
649.23
651.46
658.56
652.97
666.99
668.92
665.76
666.09
663.82
654.24
657.28

PM/S&P
0.15
0.15
0.15
0.15
0.15
0.15
0.15389
0.15318
0.15305
0.15191
0.1535
0.14501
0.14396
0.14843
0.14557
0.14645
0.14394
0.14386
0.14521
0.14415

momentum*
0.197%
-0.170%
-0.109%
0.300%
0.026%
-0.042%
-0.071%
-0.013%
-0.114%
0.159%
-0.849%
-0.105%
0.447%
-0.286%
0.088%
-0.251%
-0.008%
0.135%
-0.106%

Kraft
60.00
58.50
59.38
59.38
60.63
60.75
60.375
59.5
59.25
59.5
60.125
88.25
90.375
90.25
92
102
99
97.5
94.5
96.5

Kraft/S&P
0.09
0.09
0.09
0.09
0.09
0.09
0.09222
0.09218
0.09137
0.09165
0.09229
0.134
0.13841
0.13531
0.13754
0.15321
0.14863
0.14688
0.14444
0.14682

momentum*
-0.210%
0.093%
-0.019%
0.000%
0.012%
-0.048%
-0.004%
-0.081%
0.028%
0.064%
4.171%
0.441%
-0.310%
0.223%
1.567%
-0.458%
-0.175%
-0.244%
0.238%

With The RJR bid price of PM stock goes up again nearly to its former value but goes down again after
the announcement of Kraft and stays there. The market seems to assess the purchase of Kraft at 100 as
slightly too costly and therefore lower the expectations for PM. However, the high bid for RJR seems to
tell the market that bids that high represent correct valuation and therefore the value of PM accelerates
a little bit.
Krafts restructuring proposal pulls PM stock slightly lower, this could either be normal stock market
swing or could be an indication that markets expect a higher bid by PM lowering its value further. On
the other hand, Krafts stock went slightly higher as expected as the valuation (on book) for the stock
went up; however, it didnt go all the way to $110 price point indicating that while the market valued
the price of Krafts stock higher than PMs offering price, it didnt value it all the way to the restructured
valuation point.
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Nicolas Bar-Armstrong, Marc Fritze, Steven Kent Gryskiewicz,Ike Nnoaham, Prabhav Dhoj Shah

PHILIP MORRIS COMPANIES AND KRAFT,INC

Q4)
Assuming 131M shares issued at the time of restructuring, the value to the share holder is
Value per share:
Number of share:
Total value:

$110
131M
$1.4B

Notice however that this valuation is per Krafts management, which estimates the share value to be
around $12/share. We will calculate the value of each share to the shareholders after the restructure in
Q5. As we explore further in Q5 and Q6, the actual value lies in the debt structure and interest tax
shield of the new company.
Q5)
With Krafts restructuring proposal, the company will be taking significant amount of Debt (around
11.8B new debt on top of $904M existing debt) and getting read of some asset ($2.1B asset sale), this
will make Kraft a highly levered company. This looks very similar to LBO arrangement, where the
acquiring party is Krafts shareholders.
As such, we will use APV method of valuation where,
Value of the company = Vu + PVTS
We first calculate the Vu by calculating PV of unlevered cash flow. To get the PV, we have to calculate
unlevered rate of equity (ru).
ru = rf + u(premium) = 8.5% + 0.68(8.4%) = 14.2%
We now calculate the PV of unlevered cash flow that we obtained in Q2:
UFCF
2,914
880
990 1,039 1,090 1,145 1,203 1,263 1,325
PV of CF
2551.7 674.9 664.4 610.9 561.3 516.2 474.7 436.5 401.2
Total PV of CF $7,260.7
Also, Terminal value calculated at 5% growth rate (based upon sales forecast in Exhibit 12):

1,392
368.9

TV (FCF) = $4,985.14
PV (TV) = $1,321.34
Vu = $7,260.7+$1,321.34= $8,582.04

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Nicolas Bar-Armstrong, Marc Fritze, Steven Kent Gryskiewicz,Ike Nnoaham, Prabhav Dhoj Shah

PHILIP MORRIS COMPANIES AND KRAFT,INC

Similarly, to calculate PVTS, we have to calculate Interest payment and tax shield created for the
interest:
1989

1994

1995

1996

1997

1998

1. Existing Debt: $904 million @ 8.65%

793
760
703
416
316
69
66
61
36
27
27.44
26.30
24.32
14.39 10.93
23.24
20.50
17.45
9.51
6.65

216
19
7.47
4.18

116
10
4.01
2.07

16
1
0.55
0.26

2. Bank Debt of $6.8 billion at 12%

4,430
3,967
3,389
3,046
2,404
504
441
386
327
274
201.53
176.54 154.44
130.8 109.78
160.66
125.66
98.15
74.22
55.62

2,170
242
96.7
43.74

1,859
199
79.63
32.16

1,459
140
56.09
20.23

3. Junk Bonds of $3.0 Billion at 12.5% to 14.75% (Assume average rate of 13.625%)
Beginning Balance
3,000
3,000
3,000
3,000
3,000
3,000
3,000
3,000
Interest
409
409
409
409
409
409
409
409
Int. Tax Shield
163.5
163.5
163.5
163.5
163.5
163.5
163.5
163.5
PVTS
143.89
126.64
111.45
98.09
86.33
75.98
66.87
58.85
Total PVTS
$865.47

3,000
409
163.5
51.79

3,000
409
163.5
45.58

Beginning Balance
Interest
Int. Tax Shield
PVTS
Total PVTS

904
78
31.28
28.79
$112.65

Beginning Balance
Interest
Int. Tax Shield
PVTS
Total PVTS

6,800
674
269.52
240.64
$851.08

1990

1991

1992

1993

878
62

4. Cram-down Debt issued to stockholders ($14/share*121.7M shares; at 15.25% compounded semiannually. 15.83%
apr
Beginning Balance
1,704
1,974
2,286
2,648
3,067
3,553
3,553
3,553 3,553 3,553
Accrued interest
270
312
362
419
486
0
0
0
0
0
Cash interest
0
0
0
0
0
562
562
562
562
562
Total interest
270
312
362
419
486
562
562
562
562
562
Int. Tax Shield
107.89
124.98
144.76 167.68 194.22 224.97 224.97
224.97
225
225
PVTS
93.62
94.09
94.56
95.04
95.52
96
83.3
72.28 62.71 54.42
Total PVTS
$841.54
Total of all PVTS

$2,670.74

Thus Vl = $8,582.04 + $2,670.74 = $11,252.08

This is the total value of the firm.
Value of Equity = Total value Debt
Where total Debt from restructuring = $6,800M + $3,000M + $904M = $10,704M
Thus Value of Equity = $548M
Value per share = $548M/131M = $4.18 per share
Page 6 of 7

Nicolas Bar-Armstrong, Marc Fritze, Steven Kent Gryskiewicz,Ike Nnoaham, Prabhav Dhoj Shah

PHILIP MORRIS COMPANIES AND KRAFT,INC

Q6
The value of the share was calculated to be about $4.18 per share. This value is certainly less than the
$12 value calculated by Kraft; however, when combined with the dividend and $14 high yield debt, we
get the total value of the restructuring to the share holder = $84+$14+$4.18 = $102.18
This price is significantly higher than Philip Morris cash offer of $90/share and hence Id prefer the
restructuring plan. One more reason the restructuring plan should be preferred is due to further tax
implications. Gains from $90/share offer is taxable, however a significant portion of income for a
shareholder in the restructuring plan comes from dividend which (unless it falls under ordinary dividend
or short-term capital gains) enjoys a significantly lower rate of taxation. This is a huge benefit to the
shareholder.
It should be noted that the valuation of the stock comes with risk since the firm is highly levered,
however since our valuation of the stock was fairly conservative ($4.18), this didnt weigh too heavily in
our decision.

Page 7 of 7