Valuation of RJR Nabisco Inc. At the time of this example, RJR Nabisco Inc. was amongst the world's largest consumer products companies with leading positions in both tobacco and food products. The principal operating units were R.J. Reynolds Tobacco Co., Nabisco Brands, Inc., and Del Monte Tropical Fruit Co. The three businesses produced a wide range of products, including cigarettes, cookies, crackers, nuts, snacks, confectionery products, processed fruits and vegetables, cereals, margarines, and fresh fruit. RJR Nabisco also controlled brands such as Winston, Salem, Camel, Life Savers, Ritz, Oreo, Planters, and Del Monte. In addition, it operated 260 production facilities in 40 countries. The consumer goods were marketed in 160 countries and territories around the world. On October 20, 1987, a management group made a buyout offer for the shares of RJR Nabisco. The group consisted of F. Ross Johnson, president and CEO of RJR Nabisco, Ed Horrigan, the vice chairman of RJR Nabisco and CEO of RJ Reynolds Tobacco Company, and the investment banking firm of Shearson Lehman Hutton. The offer was for $75 per share or $18.8 billion in total. Shares of RJR Nabisco traded for $45 at the end of 1987 and were trading for $55.88 in mid-October of 1988. You are an analyst at Kohlberg, Kravis, Roberts & Co. (KKR). KKR outbid Johnson's management group and ultimately bought RJR Nabisco and took it private. Your job is to estimate a fair price for RJR Nabisco shares as of Dec 31, 1987 using the historical statements and the assumptions provided below. Answer the questions that follow to guide you through the forecast and valuation. Assumptions Valuation Model Assumptions Ignore preferred shares in the WACC and in the valuation of the equity. Forecast the financial statements (and free cash flow) for 1988 and then assume that free cash flow grows at a constant rate in perpetuity. Assume that all cash flows occur at year end, so the 1988 cash flows will occur in one year. Assume a long-term growth rate of 4%. Financial Statements Forecast Assumptions Sales in 1988 will be 4% larger than 1987. The ratio of growth CAPEX to the change in sales (gCAPEX/ASales) is 0.23576. This is the average for RJR historically and is similar to the value for a group of competitors. Assume that the investment in net working capital (for the free cash flow calculation) is 21.0088% of the increase in sales. So if sales in 1988 are $1 more than in 1987, then the investment in net working capital is $0.210088. The average depreciation rate, dr, is 7.70%. This is the average for RJR Nabisco historically. Assume that the following accounts remain unchanged in 1988: Intangible Assets, Other Assets, Short-Term Debt, Other Liabilities, Preferred Stock, and Paid-In Capital. Restructuring Costs and Income from Extraordinary Items are $0 in 1988. Long-term debt is the plug account. No dividends are paid in 1988. Use 1987 ratios for all percent-of-sales forecasts. The tax rate is 40.5%. WACC Assumptions Interest cost on debt = 10%. (This was the yield on AAA corporate bonds in 1987.) The inflation rate in 1987 was 3.6%. The risk-free rate, k, is 7%. (T-bill yields were 6% and T-bond yields were higher in 1987.) The market risk premium, E(KM) - Kf = 7%. RJR's beta is 0.78. RJR Nabisco's capital structure weights are wp = 30% and we = 70%. Assume that these weights are optimal and that RJR will maintain them in perpetuity. RJR Nabisco Inc. Income Statement December 31 ($000,000s) Revenue Cost of Goods Sold SG&A Depreciation Expense Restructuring Costs EBIT Interest Expense Earnings Before Taxes Income Taxes Net Income from Continuing Ops Income (loss) Extraordinary Net Income Shares Outstanding December 31 ($000,000s) Cash and Cash Equivalents Accounts Receivable Inventories Other Current Assets Total Current Assets Property, Plant, and Equipment Intangible Assets Other Assets TOTAL ASSETS LIABILITIES Short-Term Debt Accounts Payable Other Current Liabilities Total Current Liabilities Long-Term Debt Other Liabilities Preferred Stock Common Shareholders' Equity Paid in Capital Retained Earnings Total Common Equity Total Liabilities and Owners' Equity 1986 15,102 7,920 4,440 402 0 2,340 558 1,782 757 1,025 39 1,064 251 1986 827 1,675 2,620 273 5,395 5,343 4,603 1,360 16,701 941 2,923 202 4,066 4,833 2199 291 480 4,832 5,312 16,701 1987 Ratios 15,766 8,221 4,541 450 250 2,304 488 1,816 735 1,081 -80 1,001 251 1,088 1,745 2,678 329 1987 Ratios 5,840 5,847 4,525 649 16,861 604 3,187 332 4,123 3,884 2,643 173 490 5,548 6,038 0.04 16,861 0.10 0.405 Forecast 1988 16,397 0 0 Forecast 1988 4,525 649 604 2,643 173 490 Part 1 What is the depreciation expense in 1988? (Hint: First calculate maintenance CAPEX, growth CAPEX, and total CAPEX.) Express your answer in millions of dollars rounded to two decimal places. Depreciation expense = $ Part 2 What is free cash flow in 1988? Express your answer in millions of dollars rounded to two decimal places. Free cash flow = $ Part 3 What is RJR's WACC? Express your answer in percentage form rounded to one decimal place. WACC = M % Fair price = $ Part 4 What is the fair price for a share of RJR? Round your answer to the nearest cent. Check Answer Check Answer Check Answer Valuation of RJR Nabisco Inc. At the time of this example, RJR Nabisco Inc. was amongst the world's largest consumer products companies with leading positions in both tobacco and food products. The principal operating units were R.J. Reynolds Tobacco Co., Nabisco Brands, Inc., and Del Monte Tropical Fruit Co. The three businesses produced a wide range of products, including cigarettes, cookies, crackers, nuts, snacks, confectionery products, processed fruits and vegetables, cereals, margarines, and fresh fruit. RJR Nabisco also controlled brands such as Winston, Salem, Camel, Life Savers, Ritz, Oreo, Planters, and Del Monte. In addition, it operated 260 production facilities in 40 countries. The consumer goods were marketed in 160 countries and territories around the world. On October 20, 1987, a management group made a buyout offer for the shares of RJR Nabisco. The group consisted of F. Ross Johnson, president and CEO of RJR Nabisco, Ed Horrigan, the vice chairman of RJR Nabisco and CEO of RJ Reynolds Tobacco Company, and the investment banking firm of Shearson Lehman Hutton. The offer was for $75 per share or $18.8 billion in total. Shares of RJR Nabisco traded for $45 at the end of 1987 and were trading for $55.88 in mid-October of 1988. You are an analyst at Kohlberg, Kravis, Roberts & Co. (KKR). KKR outbid Johnson's management group and ultimately bought RJR Nabisco and took it private. Your job is to estimate a fair price for RJR Nabisco shares as of Dec 31, 1987 using the historical statements and the assumptions provided below. Answer the questions that follow to guide you through the forecast and valuation. Assumptions Valuation Model Assumptions Ignore preferred shares in the WACC and in the valuation of the equity. Forecast the financial statements (and free cash flow) for 1988 and then assume that free cash flow grows at a constant rate in perpetuity. Assume that all cash flows occur at year end, so the 1988 cash flows will occur in one year. Assume a long-term growth rate of 4%. Financial Statements Forecast Assumptions Sales in 1988 will be 4% larger than 1987. The ratio of growth CAPEX to the change in sales (gCAPEX/ASales) is 0.23576. This is the average for RJR historically and is similar to the value for a group of competitors. Assume that the investment in net working capital (for the free cash flow calculation) is 21.0088% of the increase in sales. So if sales in 1988 are $1 more than in 1987, then the investment in net working capital is $0.210088. The average depreciation rate, dr, is 7.70%. This is the average for RJR Nabisco historically. Assume that the following accounts remain unchanged in 1988: Intangible Assets, Other Assets, Short-Term Debt, Other Liabilities, Preferred Stock, and Paid-In Capital. Restructuring Costs and Income from Extraordinary Items are $0 in 1988. Long-term debt is the plug account. No dividends are paid in 1988. Use 1987 ratios for all percent-of-sales forecasts. The tax rate is 40.5%. WACC Assumptions Interest cost on debt = 10%. (This was the yield on AAA corporate bonds in 1987.) The inflation rate in 1987 was 3.6%. The risk-free rate, k, is 7%. (T-bill yields were 6% and T-bond yields were higher in 1987.) The market risk premium, E(KM) - Kf = 7%. RJR's beta is 0.78. RJR Nabisco's capital structure weights are wp = 30% and we = 70%. Assume that these weights are optimal and that RJR will maintain them in perpetuity. RJR Nabisco Inc. Income Statement December 31 ($000,000s) Revenue Cost of Goods Sold SG&A Depreciation Expense Restructuring Costs EBIT Interest Expense Earnings Before Taxes Income Taxes Net Income from Continuing Ops Income (loss) Extraordinary Net Income Shares Outstanding December 31 ($000,000s) Cash and Cash Equivalents Accounts Receivable Inventories Other Current Assets Total Current Assets Property, Plant, and Equipment Intangible Assets Other Assets TOTAL ASSETS LIABILITIES Short-Term Debt Accounts Payable Other Current Liabilities Total Current Liabilities Long-Term Debt Other Liabilities Preferred Stock Common Shareholders' Equity Paid in Capital Retained Earnings Total Common Equity Total Liabilities and Owners' Equity 1986 15,102 7,920 4,440 402 0 2,340 558 1,782 757 1,025 39 1,064 251 1986 827 1,675 2,620 273 5,395 5,343 4,603 1,360 16,701 941 2,923 202 4,066 4,833 2199 291 480 4,832 5,312 16,701 1987 Ratios 15,766 8,221 4,541 450 250 2,304 488 1,816 735 1,081 -80 1,001 251 1,088 1,745 2,678 329 1987 Ratios 5,840 5,847 4,525 649 16,861 604 3,187 332 4,123 3,884 2,643 173 490 5,548 6,038 0.04 16,861 0.10 0.405 Forecast 1988 16,397 0 0 Forecast 1988 4,525 649 604 2,643 173 490 Part 1 What is the depreciation expense in 1988? (Hint: First calculate maintenance CAPEX, growth CAPEX, and total CAPEX.) Express your answer in millions of dollars rounded to two decimal places. Depreciation expense = $ Part 2 What is free cash flow in 1988? Express your answer in millions of dollars rounded to two decimal places. Free cash flow = $ Part 3 What is RJR's WACC? Express your answer in percentage form rounded to one decimal place. WACC = M % Fair price = $ Part 4 What is the fair price for a share of RJR? Round your answer to the nearest cent. Check Answer Check Answer Check