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TRANSACTIONS:
LBO Valuation and Modeling Basics
A billion here and a billion there soon
adds up to real money.
—Everett Dirksen
Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities
Part I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies
Ch. 1: Motivations for Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances
Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting & Ch. 16: Divestitures,
Considerations Closing Activities Valuation Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-Outs
Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, and Postclosing Integration Modeling Techniques Deal and Liquidation
Corporate Governance
• Recalculate each successive period’s ß with the D/E ratio for that period;
and, using that period’s ß, recalculate the firm’s cost of equity for that period.
Cost of Capital Method: Step 5
• Advantages:
– Adjusts the discount rate to reflect diminishing
risk as the debt-to-total capital ratio declines
– Takes into account that the deal may make
sense for common equity investors but not for
lenders or preferred shareholders
• Disadvantage: Calculations more burdensome
than Adjusted Present Value Method
Cost of Capital Method: An Illustration
Present Value of Equity Cash Flow Using the Cost of Capital Method (CC)
Assumptions 2012 2013 2014 2015 2016 2017 2018 2019
Market Value of 12% PIK Preferred Equity 22 24.6 27.6 30.9 34.6 38.8 43.4 48.6
($ Million)
Market Value of Common 3 2.3 3.3 4.0 5.0 5.4 5.7 6.0
Equity ($ Million)
Equity ($ Million) 25 27.0 30.9 34.9 39.6 44.2 49.1 54.6
Debt ($ Million) 47 39.5 31.5 23.8 19.2 14.3 8.8 2.7
Comparable Firm
Price/Earnings Ratio 6
Levered Beta (ß) 2.4
Debt/Equity Ratio 0.3
Unlevered Beta 2.0
Marginal Tax Rate 0.4
10-Year Treasury Bond Rate 0.05
Risk Premium on Stocks (%) 0.055
Terminal Period Growth Rate (%) 0.045
Terminal Period Cost of Equity (%) 0.10
Year Debt/ Equity Leveraged Cost of Cumulative Discount Factor Adjusted Equity PV of Adjusted
Beta Equity Cash Flow Equity Cash
Flow
2013 1.5 3.8 0.260 1/(1.26) = 0.7937 .3 .3
2014 1.0 3.3 0.230 1/[(1.26)(1.23)] = 0.6452 .2 .1
2015 0.7 2.9 0.208 1/[(1.26)(1.23)(1.208)] = 0.5341 1.8 1.0
2016 0.5 2.6 0.194 1/[(1.26)(1.23)(1.208)(1.194)] = 0.4474 7.4 3.3
2017 0.3 2.4 0.184 1/[(1.26)(1.23)(1.208)(1.194)(1.184)] = 0.3778 7.7 2.9
2018 0.2 2.3 0.174 1/[(1.26)(1.23)(1.208)(1.194)(1.184) 8.1 2.6
(1.174)] = 0.3218
2019 0.0 2.1 0.165 1/[(1.26)(1.23)(1.208)(1.194)(1.184) 8.5 2.4
(1.174)(1.165)] = 0.2762
PV(2013–2019) 12.5
Terminal Value 44.7
Total PV 57.2
Valuing LBOs: Adjusted Present Value
Method (APV)
Separates the value of the firm into (a) its value as if it were debt
free and (b) the value of tax savings due to interest expense.
• Step 1: Project annual free cash flows to equity investors and
interest tax savings.
• Step 2: Value the target without the effects of debt financing and
discount projected free cash flows at the firm’s estimated
unlevered cost of equity.
• Step 3: Estimate the present value of the firm’s tax savings
discounted at the firm’s estimated unlevered cost of equity.
• Step 4: Add the present value of the firm without debt and the
present value of tax savings to calculate the present value of the
firm including tax benefits.
• Step 5: Determine if the deal makes sense.
APV Method: Step 1
• Advantage: Simplicity.
• Disadvantages:
– Ignores the effect of changes in leverage on
the discount rate as debt is repaid,
– Implicitly ignores the potential for bankruptcy
of excessively leveraged firms, and
– Unclear whether true discount rate should be
the cost of debt, unlevered cost of equity, or
somewhere between the two.
Adjusted Present Value Method: An Illustration
Present Value of Equity Cash Flows Using the Adjusted Present Value Method
Assumptions
Adjusted Equity Cash Flow 0.3 0.2 1.8 7.4 7.7 8.1 8.5
Plus: Tax Shield 1.8 1.6 1.3 1.0 0.8 0.6 0.4
Equals: Total Cash Flow 2.2 1.8 3.2 8.4 8.5 8.7 132.7
• Linking purchase price (enterprise value) to target firm’s borrowing capacity and
financial sponsor’s equity contribution
1The required equity contribution equals the difference between the estimated purchase price (Step 3) and the amount of
debt used in financing the transaction, which is less than or equal to the firm’s maximum borrowing capacity (Step 2).
Things to Remember…