An LBO firm has tentatively agreed to pay Rs 1.1 billion to acquire a certain business. The managers of the business anticipate EBIT of Rs 100 million for the first year. EBIT is expected to grow at 5 percent per annum for the next five years. The LBO sponsors are confident that they can raise Rs 900 million in debt financing provided they contribute Rs 200 million of equity and that all excess cash generated by the business is used to pay down debt. The sponsors expect to divest their holdings after 5 years. Should they invest the Rs 200 million, and acquire the business? Assume the following:

Tax rate =36 percent Interest rate on debt = 7 percent Capital expenditure equals depreciation and both grow at 5 percent per annum Additions to net working capital start at Rs 10 million in year-1 and grow at 5 percent.

Risk-free rate = 5 percent Asset beta = 0.7 Risk premium = 8 percent Perpetuity growth rate after year 5 = 8 percent The company is likely to achieve a stable capital structure after year 5 at the time of which the discount rate is expected to be 12 percent.

(Hint: Value equity cash flows. The cost of equity is to be estimated for each year. To arrive at the value of equity in year 0 start with the value of equity in year 5, discount it back to year 4, 3, etc., to year 0 using different costs of equity for each year. The value of equity in year 5 is Value of firm – Value of debt outstanding at the end of year 5)