Exam 14: Highly Leveraged Transactions: Lbo Valuation and Modeling Basics

Case Study Short Essay Examination Questions Cerberus Capital Management Acquires Chrysler Corporation According to the terms of the transaction, Cerberus would own 80.1 percent of Chrysler's auto manufacturing and financial services businesses in exchange for $7.4 billion in cash. Daimler would continue to own 19.9 percent of the new business, Chrysler Holdings LLC. Of the $7.4 billion, Daimler would receive $1.35 billion while the remaining $6.05 billion would be invested in Chrysler (i.e., $5.0 billion is to be invested in the auto manufacturing operation and $1.05 billion in the finance unit). Daimler also agreed to pay to Cerberus $1.6 billion to cover Chrysler's long-term debt and cumulative operating losses during the four months between the signing of the merger agreement and the actual closing. In acquiring Chrysler, Cerberus assumed responsibility for an estimated $18 billion in unfunded retiree pension and medical benefits. Daimler also agreed to loan Chrysler Holdings LLC $405 million. The transaction is atypical of those involving private equity investors, which usually take public firms private, expecting to later sell them for a profit. The private equity firm pays for the acquisition by borrowing against the firm's assets or cash flow. However, the estimated size of Chrysler's retiree health-care liabilities and the uncertainty of future cash flows make borrowing impractical. Therefore, Cerberus agreed to invest its own funds in the business to keep it running while it restructured the business. By going private, Cerberus would be able to focus on the long-term without the disruption of meeting quarterly earnings reports. Cerberus was counting on paring retiree health-care liabilities through aggressive negotiations with the United Auto Workers (UAW). Cerberus sought a deal similar to what the UAW accepted from Goodyear Tire and Rubber Company in late 2006. Under this agreement, the management of $1.2 billion in health-care liabilities was transferred to a fund managed by the UAW, with Goodyear contributing $1 billion in cash and Goodyear stock. By transferring responsibility for these liabilities to the UAW, Chrysler believed that it would be able to cut in half the $30 dollar per hour labor cost advantage enjoyed by Toyota. Cerberus also expected to benefit from melding Chrysler's financial unit with Cerberus's 51 percent ownership stake in GMAC, GM's former auto financing business. By consolidating the two businesses, Cerberus hoped to slash cost by eliminating duplicate jobs, combining overlapping operations such as data centers and field offices, and increasing the number of loans generated by combining back-office operations. However, the 2008 credit market meltdown, severe recession, and subsequent free fall in auto sales threatened the financial viability of Chrysler, despite an infusion of U.S. government capital, and its leasing operations as well as GMAC. GMAC applied for commercial banking status to be able to borrow directly from the U.S. Federal Reserve. In late 2008, the U.S. Treasury purchased $6 billion in GMAC preferred stock to provide additional capital to the financially ailing firm. To avoid being classified as a bank holding company under direct government supervision, Cerberus reduced its ownership in 2009 to 14.9 percent of voting stock and 33 percent of total equity by distributing equity stakes to its coinvestors in GMAC. By surrendering its controlling interest in GMAC, it is less likely that Cerberus would be able to realize anticipated cost savings by combining the GMAC and Chrysler Financial operations. In early 2009, Chrysler entered into negotiations with Italian auto maker Fiat to gain access to the firm's technology in exchange for a 20 percent stake in Chrysler. and Answers: -What were the motivations for this deal from Cerberus' perspective? From Daimler's perspective?

Which of the following is not true about the cost of capital method of valuation?

Case Study Short Essay Examination Questions Financing Challenges in the Home Depot Supply Transaction Buyout firms Bain Capital, Carlyle Group, and Clayton, Dubilier & Rice (CD&R) bid $10.3 billion in June 2007 to buy Home Depot Inc.'s HD Supply business. HD Supply represented a collection of small suppliers of construction products. Home Depot had announced earlier in the year that it planned to use the proceeds of the sale to pay for a portion of a $22.5 billion stock buyback. Three banks, Lehman Brothers, JPMorgan Chase, and Merrill Lynch agreed to provide the firms with a $4 billion loan. The repayment of the loans was predicated on the ability of the buyout firms to improve significantly HD Supply's current cash flow. Such loans are normally made with the presumption that the they can be sold to investors, with the banks collecting fees from both the borrower and investor groups. However, by July, concern about the credit quality of subprime mortgages spread to the broader debt market and raised questions about the potential for default of loans made to finance highly leveraged transactions. The concern was particularly great for so-called "covenant-lite" loans for which the repayment terms were very lenient. Fearing they would not be able to resell such loans to investors, the three banks involved in financing the HD Supply transaction wanted more financial protection. Additional protection, they reasoned, would make such loans more marketable to investors. They used the upheaval in the credit markets as a pretext for reopening negotiations on their previous financing commitments. Home Depot was willing to lower the selling price thereby reducing the amount of financing required by the buyout firms and was willing to guarantee payment in the event of default by the buyout firms. While Bain, Carlyle, and CD&R were willing to increase their cash investment and pay higher fees to the banks, they were unwilling to alter the original terms of the loans. Eventually the banks agreed to provide financing consisting of a $1 billion "covenant-lite" loan and a $1.3 billion "payment-in-kind" loan. Home Depot agreed to assume the loan payments on the $1 billion loan if the investor firms were to default and to lower the selling price to $8.5 billion for 87.5 percent of HD Supply, with Home Depot retaining the remaining 12.5 percent. By the end of August, Home Depot had succeeded in raising the cash needed to help pay for its share repurchase, and the banks had reduced their original commitment of $4 billion in loans to $2.3 billion. While they had agreed to put more money into the transaction, the buyout firms had been successful in limiting the number of new restrictive covenants. Case Study : -Based on the information given it the case,determine the amount of the price reduction Home Depot accepted for HD Supply and the amount of cash the three buyout firms put into the transaction?

Case Study Short Essay Examination Questions Pacific Investors Acquires California Kool in a Leveraged Buyout Pacific Investors (PI) is a small private equity limited partnership with $3 billion under management. The objective of the fund is to give investors at least a 30-percent annual average return on their investment by judiciously investing these funds in highly leveraged transactions. PI has been able to realize such returns over the last decade because of its focus on investing in industries that have slow but predictable growth in cash flow, modest capital investment requirements, and relatively low levels of research and development spending. In the past, PI made several lucrative investments in the contract packaging industry, which provides packaging for beverage companies that produce various types of noncarbonated and carbonated beverages. Because of its commitments to its investors, PI likes to liquidate its investments within four to six years of the initial investment through a secondary public offering or sale to a strategic investor. Following its past success in the industry, PI currently is negotiating with California Kool (CK), a privately owned contract beverage packaging company with the technology required to package many types of noncarbonated drinks. CK's 2003 revenue and net income are $190.4 million and $5.9 million, respectively. With a reputation for effective management, CK is a medium-sized contract packaging company that owns its own plant and equipment and has a history of continually increasing cash flow. The company also has significant unused excess capacity, suggesting that production levels can be increased without substantial new capital spending. The owners of CK are demanding a purchase price of $70 million. This is denoted on the balance sheet (see Table 13-15 at the end of the case) as a negative entry in additional paid-in capital. This price represents a multiple of 11.8 times 2003's net income, almost twice the multiple for comparable publicly traded companies. Despite the "rich" multiple, PI believes that it can finance the transaction through an equity investment of $25 million and $47 million in debt. The equity investment consists of $3 million in common stock, with PI's investors and CK's management each contributing $1.5 million. Debt consists of a $12 million revolving loan to meet immediate working capital requirements, $20 million in senior bank debt secured by CK's fixed assets, and $15 million in a subordinated loan from a pension fund. The total cost of acquiring CK is $72 million, $70 million paid to the owners of CK and $2 million in legal and accounting fees. As indicated on Table 13-15, the change in total liabilities plus shareholders' equity (i.e., total sources of funds or cash inflows) must equal the change in total assets (i.e., total uses of funds or cash outflows). Therefore, as shown in the adjustments column, total liabilities increase by $47 million in total borrowings and shareholders' equity declines by $45 million (i.e., $25 million in preferred and common equity provided by investors less $70 million paid to CK owners). The excess of sources over uses of $2 million is used to finance legal and accounting fees incurred in closing the transaction. Consequently, total assets increase by $2 million and total liabilities plus shareholders' equity increase by $2 million between the pre- and postclosing balance sheets as shown in the adjustments column.hasi¹ ΔTotal assets = ΔTotal liabilities + ΔShareholders' equity: $2 million = $47 million -$45 million = $2 million. Revenue for CK is projected to grow at 4.5 percent annually through the foreseeable future. Operating expenses and sales, general, and administrative expenses as a percent of sales are expected to decline during the first three years of operation due to aggressive cost cutting and the introduction of new management and engineering processes. Similarly, improved working capital management results in significant declines in working capital as a percent of sales during the first year of operation. Gross fixed assets as percent of sales is held constant at its 2003 level during the forecast period, reflecting reinvestment requirements to support the projected increase in net revenue. Equity cash flow adjusted to include cash generated in excess of normal operating requirements (i.e., denoted by the change in investments available for sale) is expected to reach $8.5 million annually by 2010. Using the cost of capital method, the cost of equity declines in line with the reduction in the firm's beta as the debt is repaid from 26 percent in 2004 to 16.5 percent in 2010. In contrast, the adjusted present value method employs a constant unlevered COE of 17 percent. The deal would appear to make sense from the standpoint of PI, since the projected average annual internal rates of return (IRRs) for investors exceed PI's minimum desired 30 percent rate of return in all scenarios considered between 2007 and 2009 (see Table 13-13). This is the period during which investors would like to "cash out." The rates of return scenarios are calculated assuming the business can be sold at different multiples of adjusted equity cash flow in the year in which the business is assumed to be sold. Consequently, IRRs are calculated using the cash outflow (initial equity investment in the business) in the first year offset by any positive equity cash flow from operations generated in the first year, equity cash flows for each subsequent year, and the sum of equity cash flow in the year in which the business is sold or taken public plus the estimated sale value (e.g., eight times equity cash flow) in that year. Adjusted equity cash flow includes free cash flow generated from operations and the increase in "investments available for sale." Such investments represent cash generated in excess of normal operating requirements; and as such, this cash is available to LBO investors. The actual point at which CK would either be taken public, sold to a strategic investor, or sold to another LBO fund depends on stock market conditions, CK's leverage relative to similar firms in the industry, and cash flow performance as compared to the plan. Discounted cash flow analysis also suggests that PI should do the deal, since the total present value of adjusted equity cash flow of $57.2 million using the CC method is more than twice the magnitude of the initial equity investment. At $56 million, the APV method results in a slightly lower estimate of total present value. See Tables 13-14,13-15, and 13-16 for the income, balance-sheet, and cash-flow statements, respectively, associated with this transaction. Exhibits 13-1 and 13-2 illustrate the calculation of present value of the transaction based on the cost of capital and the adjusted present value methods, respectively. Note the actual Excel spreadsheets and formulas used to create these financial tables are available on the CD-ROM accompanying this book in a worksheet, Excel-Based Leveraged Buyout Valuation and Structuring Model. -What are the advantages and disadvantages of using enterprise cash flow in valuing CK? In what might EBITDA been a superior (inferior)measure of cash flow for valuing CK?

The deal makes sense to lenders and noncommon equity investors if the present value of free cash flow to equity investors exceeds the total cost of the deal.

Although the proposition that the value of the firm should be independent of the way in which it is financed may make sense for a firm whose debt-to-capital ratio is relatively stable and similar to the industry's,it is highly problematic when it is applied to highly leveraged transactions.

Case Study Short Essay Examination Questions Private Equity Firms Acquire Yellow Pages Business Qwest Communications agreed to sell its yellow pages business, QwestDex, to a consortium led by the Carlyle Group and Welsh, Carson, Anderson and Stowe for $7.1 billion. In a two stage transaction, Qwest sold the eastern half of the yellow pages business for $2.75 billion in late 2002. This portion of the business included directories in Colorado, Iowa, Minnesota, Nebraska, New Mexico, South Dakota, and North Dakota. The remainder of the business, Arizona, Idaho, Montana, Oregon, Utah, Washington, and Wyoming, was sold for $4.35 billion in late 2003. Caryle and Welsh Carson each put in $775 million in equity (about 21 percent of the total purchase price). Qwest was in a precarious financial position at the time of the negotiation. The telecom was trying to avoid bankruptcy and needed the first stage financing to meet impending debt repayments due in late 2002. Qwest is a local phone company in 14 western states and one of the nation's largest long-distance carriers. It had amassed $26.5 billion in debt following a series of acquisitions during the 1990s. The Carlyle Group has invested globally, mainly in defense and aerospace businesses, but it has also invested in companies in real estate, health care, bottling, and information technology. Welsh Carson focuses primarily on the communications and health care industries. While the yellow pages business is quite different from their normal areas of investment, both firms were attracted by its steady cash flow. Such cash flow could be used to trim debt over time and generate a solid return. The business' existing management team will continue to run the operation under the new ownership. Financing for the deal will come from J.P. Morgan Chase, Bank of America, Lehman Brothers, Wachovia Securities, and Deutsche Bank. The investment groups agreed to a two stage transaction to facilitate borrowing the large amounts required and to reduce the amount of equity each buyout firm had to invest. By staging the purchase, the lenders could see how well the operations acquired during the first stage could manage their debt load. The new company will be the exclusive directory publisher for Qwest yellow page needs at the local level and will provide all of Qwest's publishing requirements under a fifty year contract. Under the arrangement, Qwest will continue to provide certain services to its former yellow pages unit, such as billing and information technology, under a variety of commercial services and transitional services agreements (Qwest: 2002). : -Why was the equity contribution of the buyout firms as a percentage of the total capital requirements so much higher than amounts contributed during the 1980s?

Case Study Short Essay Examination Questions Pacific Investors Acquires California Kool in a Leveraged Buyout Pacific Investors (PI) is a small private equity limited partnership with $3 billion under management. The objective of the fund is to give investors at least a 30-percent annual average return on their investment by judiciously investing these funds in highly leveraged transactions. PI has been able to realize such returns over the last decade because of its focus on investing in industries that have slow but predictable growth in cash flow, modest capital investment requirements, and relatively low levels of research and development spending. In the past, PI made several lucrative investments in the contract packaging industry, which provides packaging for beverage companies that produce various types of noncarbonated and carbonated beverages. Because of its commitments to its investors, PI likes to liquidate its investments within four to six years of the initial investment through a secondary public offering or sale to a strategic investor. Following its past success in the industry, PI currently is negotiating with California Kool (CK), a privately owned contract beverage packaging company with the technology required to package many types of noncarbonated drinks. CK's 2003 revenue and net income are $190.4 million and $5.9 million, respectively. With a reputation for effective management, CK is a medium-sized contract packaging company that owns its own plant and equipment and has a history of continually increasing cash flow. The company also has significant unused excess capacity, suggesting that production levels can be increased without substantial new capital spending. The owners of CK are demanding a purchase price of $70 million. This is denoted on the balance sheet (see Table 13-15 at the end of the case) as a negative entry in additional paid-in capital. This price represents a multiple of 11.8 times 2003's net income, almost twice the multiple for comparable publicly traded companies. Despite the "rich" multiple, PI believes that it can finance the transaction through an equity investment of $25 million and $47 million in debt. The equity investment consists of $3 million in common stock, with PI's investors and CK's management each contributing $1.5 million. Debt consists of a $12 million revolving loan to meet immediate working capital requirements, $20 million in senior bank debt secured by CK's fixed assets, and $15 million in a subordinated loan from a pension fund. The total cost of acquiring CK is $72 million, $70 million paid to the owners of CK and $2 million in legal and accounting fees. As indicated on Table 13-15, the change in total liabilities plus shareholders' equity (i.e., total sources of funds or cash inflows) must equal the change in total assets (i.e., total uses of funds or cash outflows). Therefore, as shown in the adjustments column, total liabilities increase by $47 million in total borrowings and shareholders' equity declines by $45 million (i.e., $25 million in preferred and common equity provided by investors less $70 million paid to CK owners). The excess of sources over uses of $2 million is used to finance legal and accounting fees incurred in closing the transaction. Consequently, total assets increase by $2 million and total liabilities plus shareholders' equity increase by $2 million between the pre- and postclosing balance sheets as shown in the adjustments column.hasi¹ ΔTotal assets = ΔTotal liabilities + ΔShareholders' equity: $2 million = $47 million -$45 million = $2 million. Revenue for CK is projected to grow at 4.5 percent annually through the foreseeable future. Operating expenses and sales, general, and administrative expenses as a percent of sales are expected to decline during the first three years of operation due to aggressive cost cutting and the introduction of new management and engineering processes. Similarly, improved working capital management results in significant declines in working capital as a percent of sales during the first year of operation. Gross fixed assets as percent of sales is held constant at its 2003 level during the forecast period, reflecting reinvestment requirements to support the projected increase in net revenue. Equity cash flow adjusted to include cash generated in excess of normal operating requirements (i.e., denoted by the change in investments available for sale) is expected to reach $8.5 million annually by 2010. Using the cost of capital method, the cost of equity declines in line with the reduction in the firm's beta as the debt is repaid from 26 percent in 2004 to 16.5 percent in 2010. In contrast, the adjusted present value method employs a constant unlevered COE of 17 percent. The deal would appear to make sense from the standpoint of PI, since the projected average annual internal rates of return (IRRs) for investors exceed PI's minimum desired 30 percent rate of return in all scenarios considered between 2007 and 2009 (see Table 13-13). This is the period during which investors would like to "cash out." The rates of return scenarios are calculated assuming the business can be sold at different multiples of adjusted equity cash flow in the year in which the business is assumed to be sold. Consequently, IRRs are calculated using the cash outflow (initial equity investment in the business) in the first year offset by any positive equity cash flow from operations generated in the first year, equity cash flows for each subsequent year, and the sum of equity cash flow in the year in which the business is sold or taken public plus the estimated sale value (e.g., eight times equity cash flow) in that year. Adjusted equity cash flow includes free cash flow generated from operations and the increase in "investments available for sale." Such investments represent cash generated in excess of normal operating requirements; and as such, this cash is available to LBO investors. The actual point at which CK would either be taken public, sold to a strategic investor, or sold to another LBO fund depends on stock market conditions, CK's leverage relative to similar firms in the industry, and cash flow performance as compared to the plan. Discounted cash flow analysis also suggests that PI should do the deal, since the total present value of adjusted equity cash flow of $57.2 million using the CC method is more than twice the magnitude of the initial equity investment. At $56 million, the APV method results in a slightly lower estimate of total present value. See Tables 13-14,13-15, and 13-16 for the income, balance-sheet, and cash-flow statements, respectively, associated with this transaction. Exhibits 13-1 and 13-2 illustrate the calculation of present value of the transaction based on the cost of capital and the adjusted present value methods, respectively. Note the actual Excel spreadsheets and formulas used to create these financial tables are available on the CD-ROM accompanying this book in a worksheet, Excel-Based Leveraged Buyout Valuation and Structuring Model. -Describe how PI financed the purchase price.Speculate as why each source of financing was selected? How did CK pay for feels incurred in closing the transaction?

Case Study Short Essay Examination Questions RJR NABISCO GOES PRIVATE- KEY SHAREHOLDER AND PUBLIC POLICY ISSUES Background The largest LBO in history is as well known for its theatrics as it is for its substantial improvement in shareholder value. In October 1988, H. Ross Johnson, then CEO of RJR Nabisco, proposed an MBO of the firm at $75 per share. His failure to inform the RJR board before publicly announcing his plans alienated many of the directors. Analysts outside the company placed the breakup value of RJR Nabisco at more than $100 per share-almost twice its then current share price. Johnson's bid immediately was countered by a bid by the well-known LBO firm, Kohlberg, Kravis, and Roberts (KKR), to buy the firm for $90 per share (Wasserstein, 1998). The firm's board immediately was faced with the dilemma of whether to accept the KKR offer or to consider some other form of restructuring of the company. The board appointed a committee of outside directors to assess the bid to minimize the appearance of a potential conflict of interest in having current board members, who were also part of the buyout proposal from management, vote on which bid to select. The bidding war soon escalated with additional bids coming from Forstmann Little and First Boston, although the latter's bid never really was taken very seriously. Forstmann Little later dropped out of the bidding as the purchase price rose. Although the firm's investment bankers valued both the bids by Johnson and KKR at about the same level, the board ultimately accepted the KKR bid. The winning bid was set at almost $25 billion-the largest transaction on record at that time and the largest LBO in history. Banks provided about three-fourths of the $20 billion that was borrowed to complete the transaction. The remaining debt was supplied by junk bond financing. The RJR shareholders were the real winners, because the final purchase price constituted a more than 100% return from the $56 per share price that existed just before the initial bid by RJR management. Aggressive pricing actions by such competitors as Phillip Morris threatened to erode RJR Nabisco's ability to service its debt. Complex securities such as "increasing rate notes," whose coupon rates had to be periodically reset to ensure that these notes would trade at face value, ultimately forced the credit rating agencies to downgrade the RJR Nabisco debt. As market interest rates climbed, RJR Nabisco did not appear to have sufficient cash to accommodate the additional interest expense on the increasing return notes. To avoid default, KKR recapitalized the company by investing additional equity capital and divesting more than $5 billion worth of businesses in 1990 to help reduce its crushing debt load. In 1991, RJR went public by issuing more than $1 billion in new common stock, which placed about one-fourth of the firm's common stock in public hands. When KKR eventually fully liquidated its position in RJR Nabisco in 1995, it did so for a far smaller profit than expected. KKR earned a profit of about $60 million on an equity investment of $3.1 billion. KKR had not done well for the outside investors who had financed more than 90% of the total equity investment in KKR. However, KKR fared much better than investors had in its LBO funds by earning more than $500 million in transaction fees, advisor fees, management fees, and directors' fees. The publicity surrounding the transaction did not cease with the closing of the transaction. Dissident bondholders filed suits alleging that the payment of such a large premium for the company represented a "confiscation" of bondholder wealth by shareholders. Potential Conflicts of Interest In any MBO, management is confronted by a potential conflict of interest. Their fiduciary responsibility to the shareholders is to take actions to maximize shareholder value; yet in the RJR Nabisco case, the management bid appeared to be well below what was in the best interests of shareholders. Several proposals have been made to minimize the potential for conflict of interest in the case of an MBO, including that directors, who are part of an MBO effort, not be allowed to participate in voting on bids, that fairness opinions be solicited from independent financial advisors, and that a firm receiving an MBO proposal be required to hold an auction for the firm. The most contentious discussion immediately following the closing of the RJR Nabisco buyout centered on the alleged transfer of wealth from bond and preferred stockholders to common stockholders when a premium was paid for the shares held by RJR Nabisco common stockholders. It often is argued that at least some part of the premium is offset by a reduction in the value of the firm's outstanding bonds and preferred stock because of the substantial increase in leverage that takes place in LBOs. Winners and Losers RJR Nabisco shareholders before the buyout clearly benefited greatly from efforts to take the company private. However, in addition to the potential transfer of wealth from bondholders to stockholders, some critics of LBOs argue that a wealth transfer also takes place in LBO transactions when LBO management is able to negotiate wage and benefit concessions from current employee unions. LBOs are under greater pressure to seek such concessions than other types of buyouts because they need to meet huge debt service requirements. : -Describe the potential benefits and costs of LBOs to shareholders,employers,lenders,customers,and communities in which the firm undergoing the buyout may have operations.Do you believe that on average LBOs provide a net benefit or cost to society? Explain your answer.

Using the adjusted present value method to value a LBA assumes the total value of the firm is the present value of the firm's free cash flows to lenders plus the present value of future tax savings discounted at the firm's unlevered cost of equity.

Without adjusting for the cost of financial distress,the adjusted present value method implies that the value of the firm could be increased by continuously taking on more debt.

Case Study Short Essay Examination Questions RJR NABISCO GOES PRIVATE- KEY SHAREHOLDER AND PUBLIC POLICY ISSUES Background The largest LBO in history is as well known for its theatrics as it is for its substantial improvement in shareholder value. In October 1988, H. Ross Johnson, then CEO of RJR Nabisco, proposed an MBO of the firm at $75 per share. His failure to inform the RJR board before publicly announcing his plans alienated many of the directors. Analysts outside the company placed the breakup value of RJR Nabisco at more than $100 per share-almost twice its then current share price. Johnson's bid immediately was countered by a bid by the well-known LBO firm, Kohlberg, Kravis, and Roberts (KKR), to buy the firm for $90 per share (Wasserstein, 1998). The firm's board immediately was faced with the dilemma of whether to accept the KKR offer or to consider some other form of restructuring of the company. The board appointed a committee of outside directors to assess the bid to minimize the appearance of a potential conflict of interest in having current board members, who were also part of the buyout proposal from management, vote on which bid to select. The bidding war soon escalated with additional bids coming from Forstmann Little and First Boston, although the latter's bid never really was taken very seriously. Forstmann Little later dropped out of the bidding as the purchase price rose. Although the firm's investment bankers valued both the bids by Johnson and KKR at about the same level, the board ultimately accepted the KKR bid. The winning bid was set at almost $25 billion-the largest transaction on record at that time and the largest LBO in history. Banks provided about three-fourths of the $20 billion that was borrowed to complete the transaction. The remaining debt was supplied by junk bond financing. The RJR shareholders were the real winners, because the final purchase price constituted a more than 100% return from the $56 per share price that existed just before the initial bid by RJR management. Aggressive pricing actions by such competitors as Phillip Morris threatened to erode RJR Nabisco's ability to service its debt. Complex securities such as "increasing rate notes," whose coupon rates had to be periodically reset to ensure that these notes would trade at face value, ultimately forced the credit rating agencies to downgrade the RJR Nabisco debt. As market interest rates climbed, RJR Nabisco did not appear to have sufficient cash to accommodate the additional interest expense on the increasing return notes. To avoid default, KKR recapitalized the company by investing additional equity capital and divesting more than $5 billion worth of businesses in 1990 to help reduce its crushing debt load. In 1991, RJR went public by issuing more than $1 billion in new common stock, which placed about one-fourth of the firm's common stock in public hands. When KKR eventually fully liquidated its position in RJR Nabisco in 1995, it did so for a far smaller profit than expected. KKR earned a profit of about $60 million on an equity investment of $3.1 billion. KKR had not done well for the outside investors who had financed more than 90% of the total equity investment in KKR. However, KKR fared much better than investors had in its LBO funds by earning more than $500 million in transaction fees, advisor fees, management fees, and directors' fees. The publicity surrounding the transaction did not cease with the closing of the transaction. Dissident bondholders filed suits alleging that the payment of such a large premium for the company represented a "confiscation" of bondholder wealth by shareholders. Potential Conflicts of Interest In any MBO, management is confronted by a potential conflict of interest. Their fiduciary responsibility to the shareholders is to take actions to maximize shareholder value; yet in the RJR Nabisco case, the management bid appeared to be well below what was in the best interests of shareholders. Several proposals have been made to minimize the potential for conflict of interest in the case of an MBO, including that directors, who are part of an MBO effort, not be allowed to participate in voting on bids, that fairness opinions be solicited from independent financial advisors, and that a firm receiving an MBO proposal be required to hold an auction for the firm. The most contentious discussion immediately following the closing of the RJR Nabisco buyout centered on the alleged transfer of wealth from bond and preferred stockholders to common stockholders when a premium was paid for the shares held by RJR Nabisco common stockholders. It often is argued that at least some part of the premium is offset by a reduction in the value of the firm's outstanding bonds and preferred stock because of the substantial increase in leverage that takes place in LBOs. Winners and Losers RJR Nabisco shareholders before the buyout clearly benefited greatly from efforts to take the company private. However, in addition to the potential transfer of wealth from bondholders to stockholders, some critics of LBOs argue that a wealth transfer also takes place in LBO transactions when LBO management is able to negotiate wage and benefit concessions from current employee unions. LBOs are under greater pressure to seek such concessions than other types of buyouts because they need to meet huge debt service requirements. : -What were the RJR Nabisco board's fiduciary responsibilities to the shareholders? How well did they satisfy these responsibilities? What could/should they have done differently?

The adjusted present value method implies that the firm should optimally use 100% debt financing to take maximum advantage of the tax shield created by the tax deductibility of interest.

The unlevered cost of equity is often viewed as the appropriate discount rate rather than the cost of debt or a risk-free rate because tax savings are subject to risk,since the firm may default on its debt or be unable to utilize the tax savings due to continuing operating losses.

Case Study Short Essay Examination Questions Kinder Morgan Buyout Raises Ethical Questions In the largest management buyout in U.S. history at that time, Kinder Morgan Inc.'s management proposed to take the oil and gas pipeline firm private in 2006 in a transaction that valued the firm's outstanding equity at $13.5 billion. Under the proposal, chief executive Richard Kinder and other senior executives would contribute shares valued at $2.8 billion to the newly private company. An additional $4.5 billion would come from private equity investors, including Goldman Sachs Capital partners, American International Group Inc., and the Carlyle Group. Including assumed debt, the transaction was valued at about $22 billion. The transaction also was notable for the governance and ethical issues it raised. Reflecting the struggles within the corporation, the deal did not close until mid-2007. The top management of Kinder Morgan Inc. waited more than two months before informing the firm's board of its desire to take the company private. It is customary for boards governing firms whose managements are interested in buying out public shareholders to create a committee within the board consisting of independent board members to solicit other bids. While the Kinder Morgan board did eventually create such a committee, the board's lack of awareness of the pending management proposal gave management an important lead over potential bidders in structuring a proposal. By being involved early on in the process, a board has more time to negotiate terms more favorable to shareholders. The transaction also raised questions about the potential conflicts of interest in cases where investment bankers who were hired to advise management and the board on the "fairness" of the offer price also were potential investors in the buyout. Kinder Morgan's management hired Goldman Sachs in February 2006 to explore "strategic" options for the firm to enhance shareholder value. The leveraged buyout option was proposed by Goldman Sachs on March 7, followed by their proposal to become the primary investor in the LBO on April 5. The management buyout group hired a number of law firms and other investment banks as advisors and discussed the proposed buyout with credit-rating firms to assess how much debt the firm could support without experiencing a downgrade in its credit rating. On May 13, 2006, the full board was finally made aware of the proposal. The board immediately demanded that a standstill agreement that had been signed by Richard Kinder, CEO and leader of the buyout group, be terminated. The agreement did not permit the firm to talk to any alternative bidders for a period of 90 days. While investment banks and buyout groups often propose such an agreement to ensure that they can perform adequate due diligence, this extended period is not necessarily in the interests of the firm's shareholders because it puts alternative suitors coming in later at a distinct disadvantage. Later bidders simply lack sufficient time to make an adequate assessment of the true value of the target and structure their own proposals. In this way, the standstill agreement could discourage alternative bids for the business. A special committee of the board was set up to negotiate with the management buyout group, and it was ultimately able to secure a $107.50 per share price for the firm, significantly higher than the initial offer. The discussions were rumored to have been very contentious due to the board's annoyance with the delay in informing them. Reflecting the strong financial performance of the firm and an improving equity market, Kinder Morgan raised $2.4 billion in early 2011 in the largest private equity-backed IPO in history. The majority of the IPO proceeds were paid out to the firm's private equity investors as a dividend. ^{Berman and Sender, 2006} Financing LBOs--The SunGard Transaction With their cash hoards accumulating at an unprecedented rate, there was little that buyout firms could do but to invest in larger firms. Consequently, the average size of LBO transactions grew significantly during 2005. In a move reminiscent of the blockbuster buyouts of the late 1980s, seven private investment firms acquired 100 percent of the outstanding stock of SunGard Data Systems Inc. (SunGard) in late 2005. SunGard is a financial software firm known for providing application and transaction software services and creating backup data systems in the event of disaster. The company's software manages 70 percent of the transactions made on the Nasdaq stock exchange, but its biggest business is creating backup data systems in case a client's main systems are disabled by a natural disaster, blackout, or terrorist attack. Its large client base for disaster recovery and back-up systems provides a substantial and predictable cash flow. SunGard's new owners include Silver lake Partners, Bain Capital LLC, The Blackstone Group L.P., Goldman Sachs Capital Partners, Kohlberg Kravis Roberts & Co., Providence Equity Partners Inc. and Texas Pacific Group. Buyout firms in 2005 tended to band together to spread the risk of a deal this size and to reduce the likelihood of a bidding war. Indeed, with SunGard, there was only one bidder, the investor group consisting of these seven firms. The software side of SunGard is believed to have significant growth potential, while the disaster-recovery side provides a large stable cash flow. Unlike many LBOs, the deal was announced as being all about growth of the financial services software side of the business. The deal is structured as a merger, since SunGard would be merged into a shell corporation created by the investor group for acquiring SunGard. Going private, allows SunGard to invest heavily in software without being punished by investors, since such investments are expensed and reduce reported earnings per share. Going private also allows the firm to eliminate the burdensome reporting requirements of being a public company. The buyout represented potentially a significant source of fee income for the investor group. In addition to the 2 percent management fees buyout firms collect from investors in the funds they manage, they receive substantial fee income from each investment they make on behalf of their funds. For example, the buyout firms receive a 1 percent deal completion fee, which is more than $100 million in the SunGard transaction. Buyout firms also receive fees paid for by the target firm that is "going private" for arranging financing. Moreover, there are also fees for conducting due diligence and for monitoring the ongoing performance of the firm taken private. Finally, when the buyout firms exit their investments in the target firm via a sale to a strategic buyer or a secondary IPO, they receive 20 percent (i.e., so-called carry fee) of any profits. Under the terms of the agreement, SunGard shareholders received $36 per share, a 14 percent premium over the SunGard closing price as of the announcement date of March 28, 2005, and 40 percent more than when the news first leaked about the deal a week earlier. From the SunGard shareholders' perspective, the deal is valued at $11.4 billion dollars consisting of $10.9 billion for outstanding shares and "in-the-money" options (i.e., options whose exercise price is less than the firm's market price per share) plus $500 million in debt on the balance sheet. The seven equity investors provided $3.5 billion in capital with the remainder of the purchase price financed by commitments from a lending consortium consisting of Citigroup, J.P. Morgan Chase & Co., and Deutsche Bank. The purpose of the loans is to finance the merger, repay or refinance SunGard's existing debt, provide ongoing working capital, and pay fees and expenses incurred in connection with the merger. The total funds necessary to complete the merger and related fees and expenses is approximately $11.3 billion, consisting of approximately $10.9 billion to pay SunGard's stockholders and about $400.7 million to pay fees and expenses related to the merger and the financing arrangements. Note that the fees that are to be financed comprise almost 4 percent of the purchase price. Ongoing working capital needs and capital expenditures required obtaining commitments from lenders well in excess of $11.3 billion. The merger financing consists of several tiers of debt and "credit facilities." Credit facilities are arrangements for extending credit. The senior secured debt and senior subordinated debt are intended to provide "permanent" or long-term financing. Senior debt covenants included restrictions on new borrowing, investments, sales of assets, mergers and consolidations, prepayments of subordinated indebtedness, capital expenditures, liens and dividends and other distributions, as well as a minimum interest coverage ratio and a maximum total leverage ratio. If the offering of notes is not completed on or prior to the closing, the banks providing the financing have committed to provide up to $3 billion in loans under a senior subordinated bridge credit facility. The bridge loans are intended as a form of temporary financing to satisfy immediate cash requirements until permanent financing can be arranged. A special purpose SunGard subsidiary will purchase receivables from SunGard, with the purchases financed through the sale of the receivables to the lending consortium. The lenders subsequently finance the purchase of the receivables by issuing commercial paper, which is repaid as the receivables are collected. The special purpose subsidiary is not shown on the SunGard balance sheet. Based on the value of receivables at closing, the subsidiary could provide up to $500 million. The obligation of the lending consortium to buy the receivables will expire on the sixth anniversary of the closing of the merger. The following table provides SunGard's post-merger proforma capital structure. Note that the proforma capital structure is portrayed as if SunGard uses 100 percent of bank lending commitments. Also, note that individual LBO investors may invest monies from more than one fund they manage. This may be due to the perceived attractiveness of the opportunity or the limited availability of money in any single fund. Of the $9 billion in debt financing, bank loans constitute 56 percent and subordinated or mezzanine debt comprises represents 44 percent. SunGard Proforma Capital Structure ¹The roman numeral II refers to the fund providing the equity capital managed by the partnership. Case Study Discussion Questions: -In what ways is this transaction similar to and different from those that were common in the 1980s? Be specific.

Case Study Short Essay Examination Questions HCA's LBO Represents a High-Risk Bet on Growth While most LBOs are predicated on improving operating performance through a combination of aggressive cost cutting and revenue growth, HCA laid out an unconventional approach in its effort to take the firm private. On July 24, 2006, management again announced that it would "go private" in a deal valued at $33 billion including the assumption of $11.7 billion in existing debt. The approximate $21.3 billion purchase price for HCA's stock was financed by a combination of $12.8 billion in senior secured term loans of varying maturities and an estimated $8.5 billion in cash provided by Bain Capital, Merrill Lynch Global Private Equity, and Kohlberg Kravis Roberts & Company. HCA also would take out a $4 billion revolving credit line to satisfy immediate working capital requirements. The firm publicly announced a strategy of improving performance through growth rather than through cost cutting. HCA's network of 182 hospitals and 94 surgery centers is expected to benefit from an aging U.S. population and the resulting increase in health-care spending. The deal also seems to be partly contingent on the government assuming a larger share of health-care costs in the future. Finally, with many nonprofit hospitals faltering financially, HCA may be able to acquire them inexpensively. While the longer-term trends in the health-care industry are unmistakable, shorter-term developments appear troublesome, including sluggish hospital admissions, more uninsured patients, and higher bad debt expenses. Moreover, with Medicare and Medicaid financially insolvent, it is unclear if future increases in government health-care spending would be sufficient to enable HCA investors to achieve their expected financial returns. With the highest operating profit margins in the industry, it is uncertain if HCA's cash flows could be significantly improved by cost cutting, if the revenue growth assumptions fail to materialize. HCA's management and equity investors have put themselves in a position in which they seem to have relatively little influence over the factors that directly affect the firm's future cash flows. : -How did Time Warner's entry into the bidding affect pace of the negotiations and the relative bargaining power of MGM,Time Warner,and the Sony consortium?

Case Study Short Essay Examination Questions Cerberus Capital Management Acquires Chrysler Corporation According to the terms of the transaction, Cerberus would own 80.1 percent of Chrysler's auto manufacturing and financial services businesses in exchange for $7.4 billion in cash. Daimler would continue to own 19.9 percent of the new business, Chrysler Holdings LLC. Of the $7.4 billion, Daimler would receive $1.35 billion while the remaining $6.05 billion would be invested in Chrysler (i.e., $5.0 billion is to be invested in the auto manufacturing operation and $1.05 billion in the finance unit). Daimler also agreed to pay to Cerberus $1.6 billion to cover Chrysler's long-term debt and cumulative operating losses during the four months between the signing of the merger agreement and the actual closing. In acquiring Chrysler, Cerberus assumed responsibility for an estimated $18 billion in unfunded retiree pension and medical benefits. Daimler also agreed to loan Chrysler Holdings LLC $405 million. The transaction is atypical of those involving private equity investors, which usually take public firms private, expecting to later sell them for a profit. The private equity firm pays for the acquisition by borrowing against the firm's assets or cash flow. However, the estimated size of Chrysler's retiree health-care liabilities and the uncertainty of future cash flows make borrowing impractical. Therefore, Cerberus agreed to invest its own funds in the business to keep it running while it restructured the business. By going private, Cerberus would be able to focus on the long-term without the disruption of meeting quarterly earnings reports. Cerberus was counting on paring retiree health-care liabilities through aggressive negotiations with the United Auto Workers (UAW). Cerberus sought a deal similar to what the UAW accepted from Goodyear Tire and Rubber Company in late 2006. Under this agreement, the management of $1.2 billion in health-care liabilities was transferred to a fund managed by the UAW, with Goodyear contributing $1 billion in cash and Goodyear stock. By transferring responsibility for these liabilities to the UAW, Chrysler believed that it would be able to cut in half the $30 dollar per hour labor cost advantage enjoyed by Toyota. Cerberus also expected to benefit from melding Chrysler's financial unit with Cerberus's 51 percent ownership stake in GMAC, GM's former auto financing business. By consolidating the two businesses, Cerberus hoped to slash cost by eliminating duplicate jobs, combining overlapping operations such as data centers and field offices, and increasing the number of loans generated by combining back-office operations. However, the 2008 credit market meltdown, severe recession, and subsequent free fall in auto sales threatened the financial viability of Chrysler, despite an infusion of U.S. government capital, and its leasing operations as well as GMAC. GMAC applied for commercial banking status to be able to borrow directly from the U.S. Federal Reserve. In late 2008, the U.S. Treasury purchased $6 billion in GMAC preferred stock to provide additional capital to the financially ailing firm. To avoid being classified as a bank holding company under direct government supervision, Cerberus reduced its ownership in 2009 to 14.9 percent of voting stock and 33 percent of total equity by distributing equity stakes to its coinvestors in GMAC. By surrendering its controlling interest in GMAC, it is less likely that Cerberus would be able to realize anticipated cost savings by combining the GMAC and Chrysler Financial operations. In early 2009, Chrysler entered into negotiations with Italian auto maker Fiat to gain access to the firm's technology in exchange for a 20 percent stake in Chrysler. and Answers: -Which of the leading explanations of why deals sometimes fail to meet expectations best explains why the combination of Daimler and Chrysler failed? Explain your answer.

An LBO model helps define the amount of debt a firm can support given its assets and cash flows.

Case Study Short Essay Examination Questions Cerberus Capital Management Acquires Chrysler Corporation According to the terms of the transaction, Cerberus would own 80.1 percent of Chrysler's auto manufacturing and financial services businesses in exchange for $7.4 billion in cash. Daimler would continue to own 19.9 percent of the new business, Chrysler Holdings LLC. Of the $7.4 billion, Daimler would receive $1.35 billion while the remaining $6.05 billion would be invested in Chrysler (i.e., $5.0 billion is to be invested in the auto manufacturing operation and $1.05 billion in the finance unit). Daimler also agreed to pay to Cerberus $1.6 billion to cover Chrysler's long-term debt and cumulative operating losses during the four months between the signing of the merger agreement and the actual closing. In acquiring Chrysler, Cerberus assumed responsibility for an estimated $18 billion in unfunded retiree pension and medical benefits. Daimler also agreed to loan Chrysler Holdings LLC $405 million. The transaction is atypical of those involving private equity investors, which usually take public firms private, expecting to later sell them for a profit. The private equity firm pays for the acquisition by borrowing against the firm's assets or cash flow. However, the estimated size of Chrysler's retiree health-care liabilities and the uncertainty of future cash flows make borrowing impractical. Therefore, Cerberus agreed to invest its own funds in the business to keep it running while it restructured the business. By going private, Cerberus would be able to focus on the long-term without the disruption of meeting quarterly earnings reports. Cerberus was counting on paring retiree health-care liabilities through aggressive negotiations with the United Auto Workers (UAW). Cerberus sought a deal similar to what the UAW accepted from Goodyear Tire and Rubber Company in late 2006. Under this agreement, the management of $1.2 billion in health-care liabilities was transferred to a fund managed by the UAW, with Goodyear contributing $1 billion in cash and Goodyear stock. By transferring responsibility for these liabilities to the UAW, Chrysler believed that it would be able to cut in half the $30 dollar per hour labor cost advantage enjoyed by Toyota. Cerberus also expected to benefit from melding Chrysler's financial unit with Cerberus's 51 percent ownership stake in GMAC, GM's former auto financing business. By consolidating the two businesses, Cerberus hoped to slash cost by eliminating duplicate jobs, combining overlapping operations such as data centers and field offices, and increasing the number of loans generated by combining back-office operations. However, the 2008 credit market meltdown, severe recession, and subsequent free fall in auto sales threatened the financial viability of Chrysler, despite an infusion of U.S. government capital, and its leasing operations as well as GMAC. GMAC applied for commercial banking status to be able to borrow directly from the U.S. Federal Reserve. In late 2008, the U.S. Treasury purchased $6 billion in GMAC preferred stock to provide additional capital to the financially ailing firm. To avoid being classified as a bank holding company under direct government supervision, Cerberus reduced its ownership in 2009 to 14.9 percent of voting stock and 33 percent of total equity by distributing equity stakes to its coinvestors in GMAC. By surrendering its controlling interest in GMAC, it is less likely that Cerberus would be able to realize anticipated cost savings by combining the GMAC and Chrysler Financial operations. In early 2009, Chrysler entered into negotiations with Italian auto maker Fiat to gain access to the firm's technology in exchange for a 20 percent stake in Chrysler. and Answers: -Cerberus and Daimler will own 80.1% and 19.9% of Chrysler Holdings LLC,respectively.Why do you think the two parties agreed to this distribution of ownership?

For simplicity,the market value of common equity can be assumed to grow in line with the projected growth in a firm's account receivables.