Lagoon Inc. is a multinational firm whose stable cash flows have attracted the attention of Bayou Capital, a private equity firm specialized in leveraged buyouts. An analyst at Bayou Capital has made the following projections for the next five years (all numbers in millions):

Year 1 Year 2 Year 3 Year 4 Year 5

Sales 2100 2200 2310 2410 2505

- COGS 700 730 765 800 835

- SG&A 800 840 880 920 960

- Depreciation 200 210 220 230 240

= EBIT 400 420 445 460 470

- Tax 140 147 155.75 161 164.5

= NOPAT 260 273 289.25 299 305.5

+ Depreciation 200 210 220 230 240

- Capex 215 220 225 230 235

- Change in NWC 5 5 5 5 5

= FCF 240 258 279.25 294 305.5 I

f the firm was unlevered, its cost of equity would be 12%. The risk-free rate is 4% and the cost of debt is 8%. The firms marginal tax rate is 35%.

After year five, the firms free cash flow is projected to grow at a rate of 3% per year. The firm will also stop paying down its debt and its debt will grow at the same rate as its free cash flow. The firms schedule of borrowings and principal repayments is as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Debt outstanding at year-end 2750 2590 2395 2155 1875 1560

Principal repayment at year-end 160 195 240 280 315

Interest is paid at year-end based on the amount of principal outstanding at the end of the previous year. Today is the end of year zero. The year zero amount of debt is raised today and is subject to a 1% flotation fee on the gross proceeds raised. The flotation fee can be amortized on a straight line basis over the next five years.

a) What logical mistake did the analyst make in the projection of capital expenditures?

b) Ignoring the above mentioned mistake, perform an APV valuation of the Lagoon Inc LBO. Start by calculating the unlevered firm value, then add interest tax shields and subtract net flotation costs.

c) What is the capital structure of this LBO?