Exhibit 12: Average Credit Quality Ratios^[1]

Based on this information you can compare O&Rs financial ratios to the average debt rating ratios above to assess what O&Rs credit rating would be if it were scored by the credit rating agencies.However, because we are assuming a capital structure that differs from the actual capital structure, it is necessary to create pro-forma financial ratios assuming that O&R had a capital structure in line with the assumed capital structure. This will require that we compute ratios using a proforma value for debt as well as a proforma estimate for interest expense. As a starting point, you can use book values for this calculation as shown in Formula 9 below:^[2]

(Formula 9)

(BV_e + BV_d) x W_d = PFV_d

where

BV_e= Book value of equity;

BV_d= Book value of debt;

W_d= Assumed weight of debt in the capital structure; and

PFV_d= Proforma value of debt.

The calculation is thus: ($1,460.7 million + $80.3 million) x 15.0% = $231.2 million

After completing the valuation exercise, you will likely come to a concluded value for equity that differs from the book value you used as a starting point, so it may be necessary to re-run the formula above with concluded market values replacing the book values. This iterative process should rapidly converge so you will likely only need to run one or two iterations before your proforma debt value is stable. ^[3] Exhibit 13 below reflects the pro-forma debt calculation for the historical period.

Exhibit 13: Odd & Rich Pro-Forma Debt and Equity

Once completing your estimate of the debt value for your proforma calculation, you will need to estimate a proforma interest expense. As a starting point, you can use the 5.44% interest rate calculated based on the historical interest expense/average debt outstanding calculation run previously. Again, this may be necessary to run an additional iteration if the concluded cost of debt no longer reasonably approximates the interest rate used as a starting point. This iterative process should also converge quickly and the likelihood of needing to run more than one extra iteration is low. Exhibit 14 reflects the pro-forma interest expense calculation as well as relevant pro-forma income statement metrics.Exhibit 15 reflects the relevant actual historical metrics for O&R.

Exhibit 14: Odd & Rich Pro-Forma Interest Expense

Exhibit 15: Odd & Rich Historical Ratios

Exhibit 16 below reflects the relevant pro-forma financial ratios for O&R based on the analysis above with bolded figures reflecting values that changed as a result of the pro-forma adjustment.^[4]

Exhibit 16: Odd & Rich Historical and Pro-Forma 2016 Ratios

Debt-to-EBITDA is calculated as follows:

Actual: $80.3 million / $270.0 million = 0.3x

Pro-forma: $231.2 million / $270.0 million = 0.9x

EBITDA-to-interest is calculated as follows:

Actual: $270.0 million / $3.4 million = 79.4x

Pro-forma: $270.0 million / $12.2 million = 22.1x

Based on this information, you estimate the credit rating that would correspond to each financial metric as shown in Exhibit 17 below.

Exhibit 17: Credit Rating Analysis

Based on this analysis you estimate that, the debt of O&R would, under the assumed capital structure, be assigned a rating of "AA" by S&P. Obviously, not all categories fall into the same credit rating.Accordingly, a subjective assessment of the various indications will be necessary in developing your estimate for O&R's hypothetical credit rating.

Information for the range of interest rates can be found at the Intercontinental Exchange Inc. Index Platform.^[5] An example of this data is shown in the Exhibit 18 below.

Exhibit 18: Interest Rates as of December 31, 2016

Based on this information we are able to estimate a cost of debt of 4.51% based on the selected rating for AA rated debt.

Determination of the WACC

Now that we have our input for the weight of debt and equity, the cost of equity, and cost of debt, we can apply that input into the WACC formula (Formula 1),

Cost of equity: 14.14%

Cost of debt: 4.51%

Tax rate: 0.40

Capital structure: 15% debt, 85% equity

WACC = K_e x W_e+ K_d (1-T) x W_d

WACC = 14.14% x (85.00%)+ 4.51% x (1-0.40) x 15.00%

WACC = 12.42%

The Assignment

1. Assume that when your private equity firm acquires O&R, you are planning to use 50% leverage (i.e., debt to capital) at the time of purchase, with the leverage trending back to the industry average over time due to principal repayment. How would your analysis be different?
2. Assume instead of seeking to acquire a controlling position in O&R, your firm instead was going to acquire a minority position in the company with existing management remaining in pace. How might your cost of capital analysis be different?
3. How might your cost of capital analysis been different if you had be computing the WACC near the beginning of the COVID 19 pandemic in March of 2020 rather than December 2016?