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

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. : -Having pledged not to engage in aggressive cost cutting,how do you think HCA and its financial sponsor group planned on paying off the loans?

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 did the buyout firms want a 50-year contract to be the exclusive provider of publishing services to Qwest Communications?

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 would the buyout firms want Qwest to continue to provide such services as billing and information technology support? How might such services be priced?

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. : -What do you believe were the major factors persuading the MGM board to accept the Revised Sony bid? In your judgment,do these factors make sense? Explain your answer.

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. : -Does a hospital or hospital system represent a good or bad LBO candidate? Explain your answer.

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 QwestDex considered an attractive LBO candidate? Do you think it has significant growth potential? Explain the following statement: "A business with high growth potential may not be a good candidate for an LBO.

Financial distress does not have a material indirect cost to firms able to avoid bankruptcy or liquidation.

Case Study Short Essay Examination Questions Cox Enterprises Offers to Take Cox Communications Private In an effort to take the firm private, Cox Enterprises announced on August 3, 2004 a proposal to buy the remaining 38% of Cox Communications' shares that they did not currently own for $32 per share. The deal is valued at $7.9 billion and represented a 16% premium to Cox Communication's share price at that time. Cox Communications would become a subsidiary of Cox Enterprises and would continue to operate as an autonomous business. In response to the proposal, the Cox Communications Board of Directors formed a special committee of independent directors to consider the proposal. Citigroup Global Markets and Lehman Brothers Inc. have committed $10 billion to the deal. Cox Enterprises would use $7.9 billion for the tender offer, with the remaining $2.1 billion used for refinancing existing debt and to satisfy working capital requirements. Cable service firms have faced intensified competitive pressures from satellite service providers DirecTV Group and EchoStar communications. Moreover, telephone companies continue to attack cable's high-speed Internet service by cutting prices on high-speed Internet service over phone lines. Cable firms have responded by offering a broader range of advanced services like video-on-demand and phone service. Since 2000, the cable industry has invested more than $80 billion to upgrade their systems to provide such services, causing profitability to deteriorate and frustrating investors. In response, cable company stock prices have fallen. Cox Enterprises stated that the increasingly competitive cable industry environment makes investment in the cable industry best done through a private company structure. :: -Why does Cox Enterprises believe that the investment needed for growing its cable business is best done through a private company structure?

The total value of the firm according to the adjusted present value method is the present value of the firm's free cash flows to equity investors plus the present value of future tax savings discounted at the firm's unlevered cost of equity.

The adjusted present value method values firm without debt and then subtracts the value of future tax savings resulting from the tax-deductibility of interest.

LBO analyses are similar to DCF valuations in that they require projected cash flows,present values,and discount rates; however,LBO models do not require the estimation of terminal values.

Since an LBO's debt is to be paid off over time,the cost of equity decreases over time,assuming other factors remain unchanged.Therefore,in valuing a leveraged buyout,the analyst must project free cash flows,adjusting the discount rate to reflect changes in the capital structure.

The justification for the adjusted present value method reflects the theoretical notion that firm value should is affected by the way in which it is financed.

In using the adjusted present value method to value highly leveraged transactions,the analyst need not be concerned about the costs of financial distress.

The direct cost of financial distress includes the costs associated with reorganization in bankruptcy and ultimately liquidation.

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. -Compare and contrast the Cost of Capital Method and the Adjusted Present Value Method of valuation.

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. : -Do you believe that MGM is an attractive LBO candidate? Why? Why not?

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. : -In what way do you believe that Sony's objectives might differ from those of the private equity investors making up the remainder of the consortium? How might such differences affect the management of MGM? Identify possible short-term and long-term effects.