Project 3: Beckys Leveraged Buyout Decision

Project description

Becky is a financial analyst specializing in identifying potential buyout targets. She has been interested in Bechannel Corporation for a year. She believes that the management at Bechannel has not been doing a good job. Now Bechannel is financed entirely with equity. Because the cash flows of the company are relatively steady, Becky thinks the companys debtequity ratio should be at least 0.25. Also, Becky thinks that Bechannel should focus on its core business by selling some divisions. However, the management does not seem to want any change. Becky thinks that Bechannel is a good target for a leveraged buyout.

A leveraged buyout (LBO) is the acquisition by a small group of equity investors of a public or private company. Generally, an LBO is financed primarily with debt. The new shareholders service the heavy interest and principal payments with cash from operations and/or asset sales. Shareholders generally hope to reverse the LBO within three to seven years by way of a public offering or sale of the company to another firm. A buyout is therefore likely to be successful only if the firm generates enough cash to serve the debt in the early years and if the company is attractive to other buyers a few years down the road.

Potential LBO partners have asked Becky to provide projections of the cash flows for Bechannel. Becky has provided the following estimates (in millions):

Year	2021	2022	2023	2024	2025
Depreciation	534	568	591	620	633
EBT	1,686	1,768	1,953	1,920	1,996
CAEX	307	266	334	339	334
NWC	-134	-205	111	105	119
Asset Sales	1,560	1,131

At the end of 2025, Becky estimates that the growth rate in cash flows will be 3.5% year. The capital expenditures are for new projects and the replacement of equipment that wears out. Additionally, the company would realize cash flow from the sale of several divisions. Even though the company will sell these divisions, overall sales should increase because of a more concentrated effort on the remaining divisions.

Becky and her partners believe that in 2025 they will be able to sell the company to another party or take it public again. They are also aware that they will be able to borrow $10,000 to pay part of the purchase price. Because of the high debt level, the debt will carry a yield to maturity of 12.5% for the next five years. The interest payments on the debt for each of the next five years if the LBO is undertaken will be these (in millions):

Year	2021	2022	2023	2024	2025
Interest Payment	1,250	1,250	1,250	1,250	1,250

The company currently has a required return on assets of 14%. When the debt is refinanced in five years, they believe the new yield to maturity will be 8 percent.

Bechannel currently has 385 million shares of stock outstanding that sell for $29 per share. The corporate tax rate is 21%. If Becky and her partners decide to undertake the LBO, what is the most they should offer per share?

HINTS:

1. You may need the following equations:

FCF=EBIT(1-T)+DP-net CAPX-NWC

WACC=wdrd(1-T)+w_sr_s

R_S = R₀ + (B/S)(R₀ R_B)(1 T_C)

The PV of a growing perpetuity: PV=(CF₁)/(WACC-g)

V_L=V_U+NPV of the loan

NPV of a loan: Proceeds from the loan-PV of after-tax interest payments-PV of the loan repayment

2. The maximum that Becky and her partners should pay is the value of the loan plus the present value of the cash flows generated by Bechannel after LBO for Becky and her partners, including the first five years CFs and the terminal equity value at the end of year 5 when Becky and her partners sell the company. The CFs given for the first 5 years are unlevered cash flows but Bechannel will have heavy debt over these years after LBO. Since the debt ratio is unknown, APV is a good tool for the CFs in the first 5 years. The debt ratio after year 5 will be 25% for ever and so WACC is good for the CFs beyond year 5. Which rate should be used to discount the terminal value at year 5 to year 0 is a question. Also note that, at the end of year 5, Becky and her partners need to pay to retire the loan when selling the company.