Allthat Inc. is a privately owned business (i.e. it has no publicly traded stock). The owner/manager wishes to cash out and retire. He has decided that the firm is too small to justify going public and is instead seeking a private buyer. The owner was never comfortable with the use of significant amounts of debt. The firm has $4.2M in debt costing 8.58% and $1.8M in excess cash. The firm's free cash flow next year is projected to be $1.86M and is expected to grow at 4% forever. EBITDA for the last twelve months was $2.88M. You work for the legendary buyout firm Kohlberg Kravis Roberts (KKR), which is interested in acquiring Allthat. Based on similar firms (same size, industry, and modest debt relative to cash flows) that are publicly traded, you estimate that Allthat has a weighted average cost of capital of 11.5%. The tax rate is 40%. Your boss has asked you for the following analysis to acquire the firm in its current form. (a) Estimate the current enterprise value and EV/EBITDA multiple of Allthat. (b) What is the implied equity value of the current owner of the firm? (c) Firms in the same industry as Allthat and with similar debt have recently sold for an average enterprise multiple of 6.8 times EBITDA. What enterprise value does that imply for Allthat in a possible acquisition? (d) Keeping in mind that KKR will only pay to acquire the equity stake (while inheriting the firm's debt obligations), how much would it actually cost KKR to buy Allthat based on the above estimate? (e) If the current owner agreed to this price in exchange for his equity claim, what is the estimated profit from the transaction for KKR? (f) What is the firm's ratio of debt to market value (D/(D+E))? (g) What is the implied cost of equity capital R_E? (b) What is the unlevered cost of capital R_A? Now your boss tells you he believes the firm could support a debt ratio of 70% which would provide substantial additional tax savings from the deductibility of interest payments. Due to the high leverage, he estimates that the average cost of debt R_D will increase to 10.3%, and the increased financial risk will, of course, raise the cost of equity. (i) Find the cost of equity under the new proposed capital structure. (j) Find the new WACC. What is the overall impact of the increase in leverage on the cost of capital? (k) Use the new WACC to find the enterprise value of the highly levered firm. After removing the debt inherited from the previous owner and adding on the excess cash, how valuable would the firm be to KKR under this capital structure? (l) If KKR paid the same price suggested above (in d) to acquire the equity of Allthat, what would be the profit to KKR under the new highly leveraged capital structure? By how much has expected profit increased by aggressively increasing the use of leverage? (m) If KKR gains this profit, who has "lost" this money from the increased use of leverage? (n) If KKR can create so much value by recapitalizing the firm, why didn't the firm's current owner already do this? (o) If Allthat were a publicly traded firm, would such low leverage make sense? Why
