Background!: In October of 1988, the price of RJR Nabisco's stock was hovering around $55 per share. At that time, the firm had $5 billion of debt. On 10/28/1988, the firm's CEO (Ross Johnson) and a group of senior managers announced a bid of $75 per share to take the firm private in a management buyout (MBO). Four days later, Kohlberg, Kravis and Roberts (KKR) entered the fray with a competing bid of $90 per share. After a bidding war, KKR won on 11/30/1988 with a final offer of S109 per share, or about $25 billion based on 229 million shares outstanding. KKR'S acquisition of RJR Nabisco is the largest leveraged buyout (LBO) of all time. Task: use the following information to replicate KKR's biding price decision. The following table presents KKR's projected free cash flows for RJR under the buyout, adjusting for planned asset sales and operating efficiencies. Assume tax rate is 34%. RJR's Projected FCFF (S millions) 1989 1990 1991 1992 1993 Note the information provided in the "Background" paragraph is only for the background story and not the mini case itself. The information you need for the mini case starts on the next paragraph -- "Task: use the following information to replicate KKR's biding price decision." 551 EBIT $2,620 $3,410 $3,645 $3,950 $4,310 Depreciation 449 475 475 475 475 Capital expenditures 522 512 525 538 Change in working capital -203 -275 200 225 250 After-tax Proceeds from asset sales 3,545 1,805 The free cash flow (FCFF) is projected to grow at the modest annual rate of 3% after 1993. With respect to financial strategy, KKR planned a significant increase in leverage of RJR with accompanying tax benefits. The following table presents the projected interest expense from the transaction for years 1989-1993. Projected Interest Expense and Tax Shields (S millions) 1989 1990 1991 1992 1993 Interest expense 3.384 3.004 3.111 3.294 3.483 From 1993, debt will be reduced and maintain a permanent level of $9 billion, 2 The required rate of return on assets, rais 14% at the time of the buyout. The average cost of debt, rd, is approximately 13.5%. Note that at the time of the bidding, RJR had $5 billion of debt (i.e., current debt) and 229 million shares outstanding. Your task: Use the Adjusted Present Value (APV) method to estimate the price per share of RJR. Hint: 1. To set up the case, you need to estimate: - Unlevered value Vu and Present value of tax shied benefit PV(TS); - Then total firm value V = Vu+ PS(TS), equity value E =V-current debt, and price = E / Number of shares outstanding. 2. We are replicating the valuation of KKR's biding estimation, so your answer should be close to its bidding of $109 per share 3