Case analysis on Revco LBO

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  • 1. 2012Leveraged Buy Out of Revco D S Inc. Group - 4 Department of Finance, University of Dhaka 9/9/2012
  • 2. Leverage Buyout of Revco D S Inc Submitted To: Dr. Md. Sadiqul Islam Professor Department of Finance University of Dhaka Submitted By: Group no. 4 13th batch Department of Finance University of Dhaka Date of Submission: 09 September, 2012
  • 3. Group Members Name RollMohammed Robiul Alam 13-643ASM Zakariya 13-578Rokeya Mahzavin 13-588Md. Shah Naoaj 13-686Taslima Akter 13-666
  • 4. Letter of TransmittalDr. Md. Sadiqul IslamProfessorDepartment of FinanceUniversity Of DhakaSubject: Submission of Case Report.Dear Sir:With great pleasure and honor we are submitting our case report on ―Leverage Buy Out ofRevco D S Inc‖. The case study includes analysis of LBO of Revco. We analyzed the LBOfrom different viewpoints by using various financial tools and software.We have tried our best to accommodate as much information and relevant issues as possibleand follow the instructions that you have given.We would like to thank you for providing us with the opportunity to prepare this case report.Sincerely YoursGroup -0413th batchDepartment of FinanceUniversity of Dhaka
  • 5. Table of Contents1. Introduction .................................................................................................................................................... 1 1.1. The Company ........................................................................................................................................ 1 1.2. Competition ........................................................................................................................................... 1 1.3. Origin and Terms of the Buyout ........................................................................................................... 1 1.4. Management of New Revco .................................................................................................................. 2 1.5. Strategy and Restructuring Plans .......................................................................................................... 2 1.6. Outlook ................................................................................................................................................. 3 1.7. Comparative Analysis ........................................................................................................................... 4 1.8. Capital Adequacy .................................................................................................................................. 52. Business Analysis .......................................................................................................................................... 6 2.1. PESTEL ................................................................................................................................................ 6 2.2. HEPTALYSIS ....................................................................................................................................... 8 2.3. SWOT ................................................................................................................................................. 10 2.4. Porter’s Five Forces Model ................................................................................................................. 12 2.5. SCRS ................................................................................................................................................... 143. Time Series Ratio Analysis of Revco D.S. Inc. ........................................................................................... 16 3.1. Profitability Ratio: ............................................................................................................................... 16 3.2. Liquidity Ratio: ................................................................................................................................... 17 3.3. Efficiency Ratio .................................................................................................................................. 194. Cross Sectional Ratio Analysis of Revco D.S. Inco. ................................................................................... 205. Bankruptcy Risk .......................................................................................................................................... 21 5.1. Altman Z-score ................................................................................................................................... 21 5.2. Estimation of the formula .................................................................................................................... 22 5.3. Accuracy and effectiveness ................................................................................................................. 22 5.4. Z-score estimated for private firms ..................................................................................................... 226. DuPont Analysis .......................................................................................................................................... 23 ROA and ROE ratio ....................................................................................................................................... 247. Case Analysis ............................................................................................................................................... 268. Valuation...................................................................................................................................................... 26 8.1. Assumptions: ....................................................................................................................................... 27 8.2. Calculation WACC: ............................................................................................................................ 28 8.3. Comparative Analysis with Peer Company: ....................................................................................... 31 8.4. Possible Reasons for Going LBO: ...................................................................................................... 339. Capital Adequacy:........................................................................................................................................ 34 9.1. The Variables ...................................................................................................................................... 35 9.2. Results ................................................................................................................................................. 37 9.3. Conclusions and Implications ............................................................................................................. 39
  • 6. 1. IntroductionIn December 1986 the management of Revco D.S. and a group of investors took the company privatein a leveraged buyout (LB0). Revco was the operator of the largest chain of discount drug stores in theUnited States. The buyers paid a 48 percent premium for the shares compared to the price in January1986, before the announcement of plans for the buyout. In addition to the large acquisition premium,this buyout arrested tj1e attention of investors and analysts because of its unusual financing terms.Goldman Sachs advising the board of directors, had declared that the purchase · price was "fair."Salomon Brothers, advising the buyout group, had designed the transaction and employed itsconsiderable bond-trading muscle to promote it-indeed, this was Salomons first major "done deal"acting simultaneously as buyout advisor, underwriter, and merchant banker. On the other hand,Moodys and Standard & Poors, the bond rating agencies, declared Revcos LBO to have a "negativeoutlook" and downgraded their ratings of Revcos public bonds to "speculative" categories. Analystsnoted that debt repayment in the first few years depended significantly on asset sales, an especiallyuncertain source of cash. More importantly, the operating performance of the firm had been decliningover recent quarters. 1.1. The CompanyIn 1986 Revco was the nations largest discount drugstore chain, operating 2,049 stores in 30 states.Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Stripcenters in small cities were the primary location of Revco stores, with approximately 70 percent of thecompanys stores located in cities with a population of less than 25,000. Over the previous 5 years, thenumber of stores had grown at an annual compound rate of 6.24 percent, from 1,514 stores in 1981.The average cost of opening a new store was approximately $300,000, with inventory comprisingapproximately $200,000 of this tota1. 1.2. CompetitionRevco competed with health maintenance organizations, hospital pharmacies, mail-orderorganizations, discount drugstores, combination food-and-drug stores, mass .merchandisers, and therapidly emerging "deep discount" drugstores. Deep discounters were large "super" drug stores relyingon volume to compensate for the unusually low prices they charged. Consequently, deep discountdrugstores were located primarily in cities with populations over 250,000 and were not seen as amajor threat to Revco. The drugstore industry exhibited little cyclicality since most sales werenecessity items and few substitute products existed. 1.3. Origin and Terms of the BuyoutSince April 1984 chief executive officer and chairman of the board Sidney Dworkin had beenconcerned with possible takeover threats following a series of highly publicized mishaps at Revco.Revcos common stock price had not recovered from the negative impact of these adversities.Rumours of an impending hostile takeover attempt on Revco had ebbed through the financial Page 1 of 44
  • 7. community in 1984, 1985, and 1986. On March 11, 1986, Dworkin struck first by submitting a buyoutproposal to Revcos board of directors, He later raised the offer price to a cash payment of $38.50 pershare. The board accepted tho offer on August 15. The buyout closed on December 29, 1986.The buyout would require nearly $1.5 billion, to be placed through the issuance of nine differentclasses of securities, the bulk of them being debt and preferred stock. Salomon Brothers, the buyoutgroups investment banker and a part-equity owner, had lined up the required financing from a varietyof sources. 1.4. Management of New RevcoOnce the LBO was completed·, Sidney Dworkin became chairman of the board and Chief executiveofficer of the "new" Revco, the same positions he had held at Reyco D. S. As in the old entity,Dworkin did not control a majority ofthe outstanding shares ofsto.ck; he owned about 15.4 percent.However, these shares were subject to a voting trust of which he was a member. Apparently, Mr.Dworkin would have more control in the "new" Rcvco than he had had at Rcvco D. S., where hisownership percentage was only 2.32 percent. Dworkin received $29.6 million for the stock and stockoptions that he held in the old. Revco. He invested about $8 million in the "new" Revco. 1.5. Strategy and Restructuring PlansIf the merger had occurred on June 2, 1985, earnings before depreciation, amortization, interest, andincome taxes would have been $161 .8 million for the year ended May 31, 1986, just sufficient tocover pro-forma interest expense-of $155 million. Revco managers believed that the companysresults since the beginning of fiscal 1985 were not indicative of future prospects and that Revcosperformance in 1987 and beyond would be more in line with pre-1985 results.Nevertheless, because the interest-coverage ·ratio would be very low, management adopted a programto increase the margin of safety. Elements of the program included the following:Focus on drugstore business. Management planned to divest virtually Revco’s entire nondrugstorebusinesses plus 100 drugstores, thus permitting management to concentrate on expanding its drugstoreoperations and improving drugstore gross margins and profitability. Management had earmarked $230million in assets for sale by the end of June 1987 and had, in principle, reached agreements to sell $89million of those assets by the time the company went private. At least four months would be needed toconsummate these agreements. First, management devised a divestiture program to dispose of all ofthe non-drugstore subsidiaries. The credit agreement with the major banks called for Revco to makeprincipal payments in 1987, 1988, and 1989, that would reduce the term loan to $150 million from$455 million. Of the $305 million In payments, $255 million were expected to occur through thedivestiture program. Duff & Phelps had been engaged to value Revcos seven subsidiaries, and ananalysis dated October 17, 1986 estimated the aggregate market value of these subsidiaries at $224.5million. Book value of these subsidiaries was $178 million. ·Expand. Future expansion plans included opening or acquiring approximately 100 stores per yearover the subsequent five years. This expansion would be financed by working capital from operations.Most of this expansion was to be in small communities. Management believed that Revcos presence Page 2 of 44
  • 8. in prime locations in these small markets discouraged entry by other large drugstore chains. Inaddition; the small size of the market tended to bar entry for deep discount stores, which generallyrequired a larger population base to support profitable operations.Reduce capital expenditures. Because approximately 75 percent of all Revco drugstores either werenew or had been remodeled since the beginning of fiscal I 981, management believed that Revcosprogram of remodeling its existing stores could be implemented each year within a modest budget.Reduce inventory and selling expense. As part of its efforts to increase Revcos profitability,management implemented an inventory-reduction program, which was to be substantially completedby the end offiscal1987. Assuming a ratio of inventory-to-sales consistent with past · experience,management anticipated that inventory levels would be reduced by approximately $129 million fromthe levels that would otherwise exist. In addition, management initiated a program designed to reduceselling, general, and administrative expenses by approximately $24 million during 1987 from thelevels that would otherwise have existed.Maintain current marketing strategy. Management would continue to build on two of Revcosfundamental strengths: its many convenient locations and its "everyday low prices" pricing strategy.Dworkin believed that these two strengths would continue to frame consumers perceptions of Revcoas a convenience drugstore, selling quality products at low prices at all times.Increase sales of non-prescription items. Revcos merchandising and marketing strategy was tomaintain its strong prescription sales as the company" increased sales of and improved margins onnon-prescription items. This would entail rearranging store layouts to draw the customer throughaisles of non-prescription items as the customer proceeded to the drug counter. Non-prescriptionmerchandise would include; lawn furniture, kitchen appliances, small consumer electronic items, etc. 1.6. OutlookSales for the stub period (from the closing on December 26, 1986 to the next fiscal year end, May 31,1987) were expected to be about $990 million, resulting in an operating profit of about $47 million.This would leave an operating profit of$147 million for the 1987 fiscal year ending May 31, modestlyhigher than for 1986s operating profit of $125 million.In making their assessments of the transaction, outside analysts considered historical financialperformance (Exhibits 1 and 2), projected financial performance (Exhibits 3 and 4), information oncomparable companies (Exhibit 5), and current capital market rates and indices (Exhibit 6). Analystsidentified a number of key assumptions:Growth rate of sales per store: The forecast assumed 6 percent annual growth in sales per store,reflecting an anticipated 5 percent inflation rate and a 1 percent real growth rate. Analysts wonderedabout the appropriateness of the real-growth-rate assumption, especially given the very low (or evennegative) population growth rates in small communities.Cost of goods sold (COGS)/sales: The forecast assumed Revcos 5-year historical average, 73percent. Analysts compared Revco with other drug retailers, whose COGS/sales ratio averaged 71percent (see Exhibit 5). Acknowledging the difficulty of achieving a 1 percentage point improvementin this ratio (especially with a policy of discount pricing, analysts wondered whether Dworkin could Page 3 of 44
  • 9. realize some economics following the buyout.Selling, general, and administrative expenses/sales: The forecast assumed Revcos 5 year historicalaverage of 20.8 percent, as opposed to an industry average of23.6 percent. Analysts also wonderedwhether economies were possible in this area.Timing of asset sales: Consistent with Dworkins plan (and bankers expectations), the forecastassumed the sale of $230 million in assets in 1988. However any softening in the acquisitions marketmight delay the sale until 1989 or even 1990.Timing and volume of new store openings: The forecast assumed that Revco would open 100 newstores each year for the next five years and would then stop expanding as the target market becamesaturated. Some analysts questioned Dworkins ambitious store-opening plans, especially in light ofRevcos high leverage. Dworkin countered that the next few years offered a temporary window to gaindominance in certain markets, and that the cash-flow growth afforded by this expansion would assistin the amortization of debt and boost returns to the equity investors. 1.7. Comparative AnalysisAnalysts considered the experience of another major drug store retailer, Jack –Eckerd Corporation,which had been taken private in an LBO in April 1986. In most respects the two companies were quitesimilar: Eckerd had been taken private, however, at a multiple of only 21.3 times, compared withRevcos 24.8 times earnings. Eckerd was also financed at a debt-equity ratio of 11.5 times, comparedwith Revcos 37.6 times.Exhibit 7 presents a forecast of how well Revco and Eckcrd could cover their financial obligations inthe next three years, the period over which analysts perceived the greatest possible risk of default. Foreach company, the financial obligations included interest expense, principal payments, and preferredstock dividend payments. The "coverage of these obligations was estimated as a multiple comparedwith earnings before interest and taxes (EBIT); and "cash flow," which consisted of earnings beforeinterest, taxes, depreciation, and amortization (EBlTDA) plus the receipts from any asset sales lesscapita expenditures. (Additions to net working capital are ignored in this calculation. Ordinarily theydeserve to be included in an analysis like this. Exclusion of this item biases the estimated coveragerates upward.Analysts acknowledged; however that the comparative figure such as those in Exhibit 7 were pointestimates and thus ignored the uncertainty surrounding key assumptions. Revcos financial obligationswere well known at the .time of the buyout. Thus, the uncertainty about Revcos comparative standingversus Jack Eckerd and other firms devolved from forecast uncertainty about the following points:Interest rates: Revcos senior debt bore interest that floated at 1.75 percent above prime rate,currently at 7.50 percentAsset sales: Revco had to sell assets to .meet its principal payments. One could give Revco the benefitof the doubt and assume that all $230 million would actually be realized. But analysts were uncertainabout the timing18 of that realization. By comparison, Jack Eckerd would try to sell $72 million inassets.Capital expenditures: Capital expenditures could be assumed to be driven by Revcos goal of Page 4 of 44
  • 10. opening 100 stores per year at an investment of$1 00,000 per store. Depreciation could beapproximated as $20 million for 1987, and thereafter scaled according to the percentage net change ofthe difference between asset sales and capital expenditures. By contrast, Jack Eckerd envisionedopening no new stores in the foreseeable future. Eckerds depreciation was forecasted to be $123million, a much higher figure than Revcos because Eckerd tended to own, rather than lease, its stores.Growth: Salomon Brothers contemplated a sales-growth rate no lower than 8 percent; it presentedforecasts to commercial bankers that assumed growth at 12 percent. Goldman Sachs, the advisor toRevcos outside directors, determined that a 12 percent growth rate assumption was "too aggressive."Analysts assumed sales growth of mature stores to be equal to the rate of inflation. In addition, "thenet growth from opening new stores would yield an annual corporate growth rate of 9 percent. ·EBIT margin: From 1974to 1986, Revcos mean EBIT margin was 6.62 percent (standard deviationwas 1.32 percent). The mean and standard deviation for Jack Eckerd Corporation were 8.11 and 1.42percent, respectively; a sample of peer companies over the same period indicated that the mean andstandard deviation were 5.15 and 1.25 percent, respectively. Salomon Brothers assumed an EBITmargin of 8.0 percent. Goldman Sachs opined that this assumption was "a bit aggressive." Only onceover the past 13 years did Revco reach that level, in 1984; thereafter Revcos EBIT margin fell to 3.50and 4.84 percent. Sales growth and EBIT margin depended in part on the rate at which Revco plannedto open new stores analysts challenged the wisdom of this strategy, noting that 70 percent of Revcosstores that had been open for less than one year lost money; the figure dropped to 48 percent for storesAnalysts were unable to decide whether to assume any covariance between growth and margins andgenerally assumed that each year was an independent draw: i.e., that there was no serial covariance inthe forecast assumptions that had been open from one to two years. 1.8. Capital AdequacyLeveraged buyouts were very difficult to, evaluate. Typically the prospective return to creditors andinvestors were quite high, but were they high enough to compensate for the risk involved? Ultimatelythe decision of whether to invest or lend in these deals hinged on some Judgment about the likelihoodthat the buyout firm would survive a arduous financial demand. This judgment necessarily entailedsome analysis of the adequacy of the firms capitalization.The adequacy of Revcos capitalization after the LBO could be judged in several ways. First, onecould test whether, at the time that Revco went private, the market value of Revcos assets was greaterthan the value of Revcos liabilities. This was the classic test of bankrupt firms. If assets were worthless than the face value of liabilities, the creditors would be handed ownership of the firm; but thosewho used this approach confronted a number of challenging valuations questions. Most importantly,this valuation approach said nothing about the adequacy of capitalization where assets were worth alittle more than the face value of liabilities. The key question how much debt could or should the firmcarry was poorly answered by the bankruptcy test.A second approach would be to compare Revcos capitalization ratios (e.g. debt/equity) with those ofother firms that had gone private in leveraged buyouts and with peer firms. In response to thissuggestion, one scholar wrote: ... widely used rules of thumb which evaluate debt capacity in terms of some percentage of balance Page 5 of 44
  • 11. sheet values or in terms of income statement ratios can be seriously misleading and even dangerousto corporate solvency .. debt policy in gene.ral and debt capacity in particular cannot be prescribed for individual company by outsiders or by generalized standards; rather, they can and should bedetermined by management in terms of individual corporate circumstances and objectives and on the basis of observed behavior of cash flows.To focus on "the observed behavior of cash fows" meant asking this question: under the existingcapital structure, how likely was Revco to default on servicing its liabilities? If the probability ofdefault were high, one might judge that Revco was too dependent on debt financing and should alterthe mix away from debt and toward equity. If the probability of default were extremely low, thisanalysis would suggest that Revco could bear additional debt.2. Business AnalysisThere are a number of generic business techniques that a Business Analyst will use when facilitatingbusiness change. 2.1. PESTELThis is used to perform an external environmental analysis by examining the many different externalfactors affecting an organization.It never ceases to amaze me why so many businesses fail to take the time to look at the macro and themicro environments when completing their business plans and strategies. These external forces willplay a big part in shaping the final outcome of the ultimate corporate achievement. Yet, mostmanagers’ focus only on internal factors and it is fair to say that sales growth and profits remain highon their agenda.The macro environment tends to have a long term impact and requires extensive research. Couple thiswith the fact that many managers are over worked and under resourced and we begin to see why theprocess is often not completed. There is no published evidence to confirm this hypothesis, justanecdotal hearsay.The remainder of this article will illustrate an example of a Macro or PESTLE analysis for thepharmaceutical industry. It is set at a very general level but it can be used as a template or adapted tobe more specific if required:The six attributes of PESTLE: Political (Current and potential influences from political pressures) Economic (The local, national and world economy impact) Sociological (The ways in which a society can affect an organization) Technological (The effect of new and emerging technology) Legal (The effect of national and world legislation) Environmental (The local, national and world environmental issues) Page 6 of 44
  • 12. PoliticalThere is now growing political focus and pressure on healthcare authorities across the world. Thismeans that governments will be looking for savings across the board. Some of the questions theindustry should ask are: What pressures will be put on pricing? What services will be cut? Will the same selection of drugs be available to everyone? In addition to this, could there be more harmonization of healthcare systems across Europe or the USA? What impact will reforms have on insurance models?EconomicThe global economic crisis still exists yet government reports still show that the spend on healthcareper capital continues to grow. Will the current healthcare models exist tomorrow? The growth inhomecare (as seen in the Nutrition sector) demonstrates how nursing services have moved to theprivate sector and have become a key business offering.The reduction in consumer disposable income will have an impact on those countries using healthinsurance models particularly where part payment is required.These economic pressures are seeing an increased growth in strategic buying groups who are forcingdown prices.Increased pressure from shareholders has caused a consolidation of the industry: more mergers andacquisitions will take place over the coming years.Social / CultureThe increasing aging population offers a range of opportunities and threats to the pharmaceuticalindustry. The trick will be to capitalize on the opportunities.There is also the problem of the increasing obesity amongst the population and its associated healthrisks.Patients and home carers are becoming more informed. Their expectations have changed and theyhave become more demanding. Public activism has also increased through the harnessing of newsocial networking technologies. How can pharmaceutical companies get closer to consumers withoutover stepping the regulatory boundaries?TechnologicalTechnological advancements will create new business prospects both in terms of new therapy systemsand service provisions. The online opportunities will see the growth in: New info and Communications technologies. Social Media for Healthcare. Customized Treatments. Page 7 of 44
  • 13. Direct to Patient Advertising. Direct to patient communications.LegislationThe pharmaceutical industry has many regulatory and legislative restrictions. There is also a growingculture of litigation in many countries. The evolution of the internet is also stretching the legislativeboundaries with patient’s demanding more rights in their healthcare programmes.EnvironmentalThere is a growing environmental agenda and the key stake holders are now becoming more aware ofthe need for businesses to be more proactive in this field. Pharma companies need to see how theirbusiness and marketing plans link in with the environmental issues. There is also an opportunity toincorporate it within their Corporate Social Responsibility programmes. Marketing and new productdevelopment should identify eco opportunities to promote as well.Summary ECONOMIC-good sales growth, moderate operational profit, strong market demand POLITICAL SOCIAL- -Market Increased quota, govt. aging, inform intervention, ed customers PESTEL ENVIRONM ENTAL- Disposal of TECHNOLOGICAL- the Higher expenditure in debris, eco R&D, State of the art friendly facilities production LEGAL- system Strong restrictions from law, growing culture of litigation 2.2. HEPTALYSIS Page 8 of 44
  • 14. This is used to perform an in-depth analysis of early stage businesses/ventures on seven importantcategories:Market opportunityIn 1986 Revco was the nations largest discount drugstore chain, operating 2,049 stores in 30 states.Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Stripcenters in small cities were the primary location of Revco stores, with approximately 70 percent of thecompanys stores located in cities with a population of less than 25,000. The company is still holding6.25% growth rate per annum, which suggests that it has a good opportunity in the market to expand.Product/solutionRevco competed with health maintenance organizations, hospital pharmacies, mail-orderorganizations, discount drugstores, combination food-and-drug stores, mass merchandisers, and therapidly emerging "deep discount" drugstores.Execution planManagement would continue to build on two of Revcos fundamental strengths: its many convenientlocations and its "everyday low prices" pricing strategy. It is believed by the authority of the companythat these two strengths would continue to frame consumers perceptions of Revco as a conveniencedrugstore, selling quality products at low prices at all times.Financial engineFuture expansion plans included opening or acquiring approximately 100 stores per year over thesubsequent five years. This expansion would be financed by working capital from operations. Most ofthis expansion was to be in small communities. Management believed that Revcos presence in primelocations in these small markets discouraged entry by other large drugstore chains. In addition; thesmall size of the market tended to bar entry for deep discount stores, which generally required a largerpopulation base to support profitable operations.Human capitalThe forecast assumed Revcos 5 year historical average of 20.8 percent, as opposed to an industryaverage of23.6 percent. Analysts also wondered whether economies were possible in this area.Potential returnSales for the stub period (from the closing on December 26, 1986 to the next fiscal year end, May 31,1987) were expected to be about $990 million, resulting in an operating profit of about $47 million.This would leave an operating profit of$147 million for the 1987 fiscal year ending May 31, modestlyhigher than for 1986s operating profit of $125 million. Page 9 of 44
  • 15. Margin of safetySummary Market products- opportunity- Diversified high growth product rate in the range market Human capital-huge Financial expenditure in engines- WC the operations administrative costs Execution Return- plan-every Moderately day low price high Margin of safety- 2.3. SWOTThis is used to help focus activities into areas of strength and where the greatest opportunities lie. Thisis used to identify the dangers that take the form of weaknesses and both internal and external threats.The four attributes of SWOT analysis: Strengths - What are the advantages? What is currently done well? (e.g. key area of best- performing activities of your company) Weaknesses - What could be improved? What is done badly? (e.g. key area where you are performing poorly) Opportunities - What good opportunities face the organization? (e.g. key area where your competitors are performing poorly) Threats - What obstacles does the organization face? (e.g. key area where your competitor will perform well) Page 10 of 44
  • 16. StrengthsThe strengths of the pharmaceutical industry’s SWOT analysis document the internal industrycomponents that are providing value, quality goods and services and overall excellence. The internalindustry components can include physical resources, human capital or features the industry cancontrol. For example, the pharmaceutical industry’s strengths could include low operating overhead,firm fiscal management, low staff turnover, high return on investment (ROI), state-of-the-artlaboratory equipment and an experienced research staff.WeaknessesThe weaknesses of the pharmaceutical industry’s SWOT analysis document the internal industrycomponents that are not providing significant added value or are in need of improvement. The internalindustry components can include physical resources, human capital or features the industry cancontrol. For example, the pharmaceutical industry’s weaknesses could include high-risk businessmodeling, disengaged Board of Directors, dated medical equipment, poor branding, low staff moraleor diseconomies of scale.OpportunitiesThe opportunities of the pharmaceutical industry’s SWOT analysis document the external industrycomponents that provide a chance for the industry (or factions of the industry) to grow in somecapacity or gain a competitive edge. The external industry components should be environmentalfactors or aspects outside the industry’s control, yet reflective of the business marketplace. Forexample, the pharmaceutical industry’s opportunities could include recently published research, anincrease in health-conscious consumers, increased demand for pharmaceutical products, changes inFood and Drug Administration standards or decreases in employee health care costs.ThreatsThe threats of the pharmaceutical industry’s SWOT analysis document the external industrycomponents that could create an opportunity for the industry (or factions of the industry) to decline,atrophy or lose some competitive edge. The external industry components should be environmentalfactors or aspects outside the industry’s control, yet reflective of the business marketplace. Forexample, the pharmaceutical industry’s threats could include increased government regulation, adeclining economy, increasing research and development (R&D) costs or a decrease in the globalpopulation. Page 11 of 44
  • 17. Company SWOT • Strong growth, go • increased od government positioning regulation, a in the declining market, lo economy, increasing w priced research and products development (R&D) Streangth Weakness costs Opportuniti Threat es • severe rivalry from the • segmented competitors, govt. drugstores, c intervention, environ ountry mental issues coverage 2.4. Porter’s Five Forces ModelThreats of entry posed by new or potential competitors – LOWHigh barriers to entry; the company needs to put a lot of capital into research and development,lengthy approval process, marketing before it is able to receive any returns. The ―big Pharma‖companies that were able to build global operations are benefiting from economies of scale in terms ofmanufacturing. They are able to access low-cost supplies, as a result.Challenging regulatory conditions (hurdles to get FDA drug approvals for new products); industry ishighly regulated which to some extend protects from new competition. The FDA approvals appear tohave slowed during 2007. This could be one measure indicating that the FDA is taking a morecautious position on new drug approvals. In addition, legislative changes in the upcoming years mayhave a negative impact for the industry.Pharmaceutical companies benefit from continuation of U.S. employer-based health coverage.Customers buy medication that was prescribed by the doctors. Patent expirations may lead to an entryof new competitors (generic competitions), resulting in decreased revenues. High rates of patentexpirations are approaching in 2010 through 2012. The ability of a pharmaceutical company to offsetloss of revenue from patent expirations depends on growth in existing products as well as successfulexecution from the new product pipeline.Degree of rivalry among existing firms - HIGHMature, consolidating, highly competitive industry (many large pharmaceutical acquisitions closed in Page 12 of 44
  • 18. 2007 including AstraZeneca’s $15.6Bn purchase of Medlmmune Inc. and Schering-Plough’s $15Bnacquisition of Organon BioSciences). Strong credit profiles: companies operate off of high margins(high 70%), healthy balance sheets, and good liquidityIndustry benefits from strong demand from consumers. Weak, small companies usually go out ofbusiness (bankruptcy) if they have no potential ―blockbuster‖ in future pipeline. Others that havesome significant research or valuable assets will be bought by big and strong pharmaceuticalcompanies.Bargaining power of suppliers - LOWSuppliers generally have little room for negotiation. Large pharmaceutical companies generally enjoysignificant buying power. They can dictate the price they want to buy or take their business elsewhere.Bargaining power of buyers - LOWGenerally consumers have very little bargaining power. Most of the medication is prescribed by thedoctors. Consumers will have to buy the drug at any given price if they need it. More educatedconsumers may buy a generic alternative (which have the same impact but less expensive) if availableon the market.Pricing pressure – The U.S. remains one of the few developed markets where drug manufacturershave significant pricing flexibility, and this is in jeopardy due to increasing pressures from consumersand legislators to control health care costs. Governments in other markets are generally the primarycustomers, and therefore, enjoy substantial pricing leverage.Shareholders continue to pressure the companies for increases in the share repurchase programs. Thecompanies looking for ways to increase shareholders returns partly because the industry isapproaching maturity and is not growing as rapidly, and because many companies have a lot of cashon their balance sheet.Closeness of substitute products – MEDIUMCustomers can find substitute medicine if the original product has an expired patent. However, if it isa new product the consumer generally will have no choice for an alternative.Over the few years generic drug manufacturers face excellent opportunities for utilization and volumetrends. Generic companies are increasing focused on establishing global operations in order to achievea lower-cost of supplies, thus posing even more threat to non-generic drug manufacturers.SummeryBased on Porter’s model LOW to MEDIUM forces are present among the strong players in thepharmaceutical industry. Thus, the industry is attractive to investors largely due to the high-barriers toentry, purchasing and pricing power, and strong credit profiles of existing firms. Page 13 of 44
  • 19. Threats of entry posed by new or potential competitors – LOW Degree Closeness Bargainin of rivalry of g power among substitute of buyers existing products – - LOW firms - MEDIUM HIGH Bargaining power of suppliers - LOW 2.5. SCRSThe SCRS approach in Business Analysis claims that the analysis should flow from the high levelbusiness strategy to the solution, through the current state and the requirements. The SCRS is standingfor:StrategyIf the merger had occurred on June 2, 1985, earnings before depreciation, amortization, interest, andincome taxes would have been $161 .8 million for the year ended May 31, 1986, just sufficient tocover pro-forma interest expense-of $155 million. Revco managers believed that the companysresults since the beginning of fiscal 1985 were not indicative of future prospects and that Revcosperformance in 1987 and beyond would be more in line with pre-1985 results. Nevertheless, becausethe interest-coverage ratio would be very low, management adopted a program to increase the marginof safety.Current StateIn 1986 Revco was the nations largest discount drugstore chain, operating 2,049 stores in 30 states.Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Stripcenters in small cities were the primary location of Revco stores, with approximately 70 percent of thecompanys stores located in cities with a population of less than 25,000. Over the previous 5 years, thenumber of stores had grown at an annual compound rate of 6.24 percent, from 1,514 stores in 1981.The average cost of opening a new store was approximately $300,000, with inventory comprisingapproximately $200,000 of this total. Page 14 of 44
  • 20. RequirementsThe company has to mandate the following requirements: Focus on drugstore business Expand Reduce capital expenditures Reduce inventory and selling expense Maintain current marketing strategy Increase sales of non-prescription itemsSolutionSummary Strategy- increase the margin of safety Current State- High growth rate, expanded Solution SCR market, openin g new drugstores Requirements- Focus on drugstoer, expand, redu ce capital expenditure, maintain current market strategy etc. Page 15 of 44
  • 21. 3. Time Series Ratio Analysis of Revco D.S. Inc.The value of a firm is determined by its profitability and growth. Ratio analysis is used to evaluaterelationships among financial statement items. The ratios are used to identify trends over time for onecompany or to compare two or more companies at one point in time. Financial statement ratio analysisfocuses on three key aspects of a business: liquidity, profitability, and solvency. The objective of ratioanalysis is to evaluate the effectiveness of the firms policies in each of these areas.Time series analysis accounts for the fact that data points taken over time may have an internalstructure (such as autocorrelation, trend or seasonal variation) that should be accounted for.In the time series ratio analysis of Revco, we have calculated the following ratios  Profitability ratio,  Liquidity ratio,  Debt Management ratio,  Efficiency ratio and some other ratios. 3.1. Profitability Ratio:Profitability ratios measure a companys operating efficiency, including its ability to generate incomeand therefore, cash flow. Cash flow affects the companys ability to obtain debt and equity financing.Ratios we have considered here are-  Profit margin. The profit margin ratio, also known as the operating performance ratio, measures the companys ability to turn its sales into net income. To evaluate the profit margin, it must be compared to competitors and industry statistics. It is calculated by dividing net income by net sales.  The return on assets ratio (ROA) is considered an overall measure of profitability. It measures how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio.  The return on common stockholders equity (ROE) measures how much net income was earned relative to each dollar of common stockholders equity. It is calculated by dividing net income by average common stockholders equity. In a simple capital structure (only common stock outstanding), average common stockholders equity is the average of the beginning and ending stockholders equity. Profitability ratio of Revco: a) Net profit margin Page 16 of 44
  • 22. b) Return on asset ratio c) Return on equityWe see- Revcos profit margin in the year 1986 has decreased and according to their projection thedecreasing trend of profitability will continue upto 1991. 3.2. Liquidity Ratio:Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpectedcash needs. Ratios we have considered here are- The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay Page 17 of 44
  • 23. its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities. This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory. Cash ratio which indicates cash adequacy in hand in terms of current liabilities.Liquidity ratio of Revco:The liquidity ratio of Revco also indicating the liquidity shortfall in the projected years though thecompany showed an increment of liquidity in the year1986. 1. Debt Management Ratio:Debt Management Ratios attempt to measure the firms use of Financial Leverage and ability to avoidfinancial distress in the long run. These ratios are also known as Long-Term Solvency Ratios. Debt iscalled Financial Leverage because the use of debt can improve returns to stockholders in good yearsand increase their losses in bad years. Debt generally represents a fixed cost of financing to a firm.Thus, if the firm can earn more on assets which are financed with debt than the cost of servicing thedebt then these additional earnings will flow through to the stockholders. Moreover, our tax lawfavors debt as a source of financing since interest expense is tax deductible.With the use of debt also comes the possibility of financial distress and bankruptcy. The amount ofdebt that a firm can utilize is dictated to a great extent by the characteristics of the firms industry.Firms which are in industries with volatile sales and cash flows cannot utilize debt to the same extentas firms in industries with stable sales and cash flows. Thus, the optimal mix of debt for a firminvolves a tradeoff between the benefits of leverage and possibility of financial distress. Ratios wehave considered here are- Page 18 of 44
  • 24. Debt Management ratio of Revco:Here we find that the D/E ratio of Revco is indicating Negative D/E ratios in the projected yearsbecause we have seen the companys projection says that it will face Net loss from the year 1987 to1989. 3.3. Efficiency Ratio We have calculated to estimate the companys efficiency by using the total asset turnover ratio.The efficiency ratios indicate that over the historical years, the companys efficiency has decreased,but according to their projection it is indicating that the companys efficiency will increase which maybe because of their very high growth rateof projection.Other ratio: Page 19 of 44
  • 25. Sales growth rate shows the scenario of the Revco in this way that the average historical growth rateof Revco is .45% while the projected average growth rate is 10.99% which is very high than theexpected growth rate.4. Cross Sectional Ratio Analysis of Revco D.S. Inco.It is the analysis of a financial ratio of a company with the same ratio of different companies in thesame industry. For example, one may conduct a cross-sectional ratio analysis of the debt ratios ofmultiple companies in the telecommunications industry. Quite simply, one does this by taking the debtratios of each company and comparing them to one another. An analyst does this in order to find thecompany with healthiest financial status.Here we see the cross sectional ratio analysis of Revco- I. 1986 AverageSales Growth Rate Big B 17.5 Eckerd Fays Drug 9.5 Longs Drug 12 Perry Drug 10 Rite Aid 18 Thrifty Walgreen 15.5 13.75 Revco (Historical) -0.449287 Revco (Projected) 10.98726 Revco (Assumed) 73Here we see that the sales growth rate of Revco is very low than the average industry growth rate inthe historical years. Projected years growth rate seems very much inconsistent with its past history. II. 1986 AverageD/E Big B 0.22 Eckerd 0.18 Fays Drug 0.96 Page 20 of 44
  • 26. Longs Drug Perry Drug 1.27 Rite Aid 0.35 Thrifty 1.13 Walgreen 0.12 0.604286 Revco (Historical) 0.853459 Revco (Projected) -27.02621Here we find that though the past history says D/E ratio of Revco was more than the industry average,but it is expected that the D/E ratio will decrease largely by 270%.III. 1986 AverageBeta Big B 1 Eckerd 1 Fays Drug 1 Longs Drug 0.85 Perry Drug 1.1 Rite Aid 1.15 Thrifty 1.1 Walgreen 1.1 1.0375 Revco 6.68The cross sectional beta also indicating that the companys Beta is high enough.5. Bankruptcy RiskThe risk that. an individual or especially a company may be unable to service its debts. Bankruptcyrisk is greater when the individual or firm has little or no cash flow, or when it manages its assetspoorly. Banks assess bankruptcy risk when considering whether to make a loan. It is also calledinsolvency risk. 5.1. Altman Z-score Page 21 of 44
  • 27. The Z-score formula may be used to predict the probability that a firm will go into bankruptcy withintwo years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure forthe financial distress status of companies in academic studies. The Z-score uses multiple corporateincome and balance sheet values to measure the financial health of a company. 5.2. Estimation of the formulaThe Z-score is a linear combination of four or five common business ratios, weighted by coefficients.The coefficients were estimated by identifying a set of firms which had declared bankruptcy and thencollecting a matched sample of firms which had survived, with matching by industry and approximatesize (assets).Altman applied the statistical method of discriminant analysis to a dataset of publicly heldmanufacturers. The estimation was originally based on data from publicly held manufacturers, but hassince been re-estimated based on other datasets for private manufacturing, non-manufacturing andservice companies. The original data sample consisted of 66 firms, half of which had filed forbankruptcy under Chapter 7. All businesses in the database were manufacturers, and small firms withassets of < $1 million were eliminated. 5.3. Accuracy and effectivenessIn its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy twoyears prior to the event, with a Type II error (false positives) of 6%. In a series of subsequent testscovering three different time periods over the next 31 years (up until 1999), the model was found to beapproximately 80–90% accurate in predicting bankruptcy one year prior to the event, with a Type IIerror (classifying the firm as bankrupt when it does not go bankrupt) of approximately 15–20%(Altman, 2000).In this case, Revco D.S. is a private firm. To assess the bankruptcy risk of this firm we used Altman’sZ- score estimation for private firms. 5.4. Z-score estimated for private firmsT1 = (Current Assets − Current Liabilities) / Total AssetsT2 = Retained Earnings / Total AssetsT3 = Earnings Before Interest and Taxes / Total AssetsT4 = Book Value of Equity / Total LiabilitiesT5 = Sales/ Total Assets Page 22 of 44
  • 28. Z Score Bankruptcy Model: Z = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5 Zones of Discrimination: Z > 2.9 -―Safe‖ Zone 1.23 < Z < 2. 9 -―Grey‖ Zone Z < 1.23 -―Distress‖ ZoneItems 1986 1987 1988 1989 weightsT1 = NWC / Total Assets 0.391 0.226 0.154 0.126 0.717T2 = Retained Earnings / Total Assets 3.285 -0.265 -0.798 -1.186 0.847T3 = Earnings Before Interest and 0.127 0.045 0.076 0.084 3.107Taxes / Total AssetsT4 = Book Value of Equity / Total 0.659 -0.006 -0.061 -0.104 0.42LiabilitiesT5= Sales / Total Assets 2.779 1.228 1.452 1.580 0.998ZScore 6.508016103 1.299204 1.093753 0.879761 A low Z-score indicates a company that is likely to go bankrupt. Specifically, a Z-Score of lower than 1.8, indicates a high likelihood of bankruptcy. From our calculation, we can see that in 1986 Revco was in safe position as its z score was 6.508, which is much higher than 2.9. After that, gradually it was entering distress zone with the passes of years. 6. DuPont Analysis The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). The Du Pont identity, however, is less useful for some industries, such as investment banking, that do not use certain concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they also respect the underlying structure of the Du Pont identity. Page 23 of 44
  • 29. High Turnover IndustriesCertain types of retail operations, particularly stores, may have very low profit margins on sales, andrelatively moderate leverage. In contrast, though, groceries may have very high turnover, selling asignificant multiple of their assets per year. The ROE of such firms may be particularly dependent onperformance of this metric, and hence asset turnover may be studied extremely carefully for signs ofunder-, or, over-performance.High margin industriesOther industries, such as fashion, may derive a substantial portion of their competitive advantage fromselling at a higher margin, rather than higher sales. For high-end fashion brands, increasing saleswithout sacrificing margin may be critical. The Du Pont identity allows analysts to determine whichof the elements is dominant in any change of ROE.High leverage industriesSome sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. Incontrast, however, many other industries would see high levels of leverage as unacceptably risky. DuPont analysis enables the third party (relying primarily on the financial statements) to compareleverage with other financial elements that determine ROE among similar companies.ROA and ROE ratio Page 24 of 44
  • 30. The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firmsto evaluate how effectively assets are used. It measures the combined effects of profit margins andasset turnover.The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2] Decomposingthe ROE into various factors influencing company performance is often called the Du Pont system. ROE = Tax burden x Interest burden x Margin x Turnover x LeverageThe DuPont Analysis is important determines what is driving a companys ROE; Profit margin showsthe operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows howmuch leverage is being used.The method goes beyond profit margin to understand how efficiently a companys assets generatesales or cash and how well a company uses debt to produce incremental returns.Items 1986 1987 1988 1989net profit/pretax profit 0.534394 1.084722 1.919534 -3.12441pretax profit/EBIT 0.76593 -0.82198 -0.11997 0.023756EBIT/sales 0.045693 0.03651 0.052304 0.053076sales/assets 2.779439 1.227565 1.451956 1.580434assets/equity 2.51434 -193.164 -18.8428 -10.8559ROE 0.130701 7.718919 0.329522 0.067589 Page 25 of 44
  • 31. 50 0 ROE 1986 1987 1988 1989 net profit/pretax profit -50 pretax profit/EBIT -100 EBIT/sales -150 sales/assets -200 assets/equity -2507. Case AnalysisWe consider three potential sources of problems for buyout investors. The first is the overall pricepaid to take the company private. Regardless of the details of the capital structure, or the extent towhich there are costs of financial distress, it is clear that investors will earn lower returns as the pricespaid increase relative to the fundamental value of company assets.A second potential source of problems is a capital structure that is poorly designed in terms ofcontaining costs of financial distress. Even if the price paid to take a company private is a "reasonablemultiple of cash flow, a high probability of costly distress will obviously lower the prospective returnsto some classes of investors. In evaluating this possibility, it is important to analysis measure ofleverage as total debt to capital and interest coverage or cash flow coverage. These measures canprovide useful information about the likelihood that a company will be unable to meet its contractualobligations. Among them cash flow coverage ratio is the most appropriate to analyze the capitaladequacy of the LBO firm so that it can payout its required cash obligations in the near years.The third and final source of potential problems concerns the incentives of buyout investors. One ofthe supposed spurs to improved performance in buyouts is the increased equity stake of management.Managers who invest a large portion of their wealth in and own a large percentage of post-buyoutequity might be expected to manage better. Conversely, managers who "cash out" a large fraction oftheir pre-buyout equity investment at the time of the buyout may have more of an incentive to takepart in overpriced or poorly structured deals. We examine whether these and other incentives changedover time.From the above analysis we can say that from the case and LBO transaction we can develop threeproblem statements, these are: 1. Was the price paid for the LBO correct? 2. What are the incentives of the buyout investors to enter into such a unusually high levered buyout? 3. Is the firm adequately capitalized after the buyout?8. ValuationIn this part we would like answer some questions. These are- Page 26 of 44
  • 32.  What the firm value of the company is.  Whether the buyout price 1.5 billion dollar is appropriate for this LBO.  Whether the cash offer to stockholder at price 38.5 is appropriate.  What is the probability o survival of the firm and what would be the firm value of Revco after considering distress cost.  Whether the company can generate enough FCFF to pay off its cash obligations.  What will be the return to the equity holder?  Whether the LBO will be successfulTo answer these questions at first we do valuation using Discounted Cash Flow Method. Followingprocedures have done to get the firm value. 8.1. Assumptions:For Base Case:cost of goods sold/sales 73%selling,general and administrative expenses/sales 20.80%inventories/sales 20%minimum cash balance $50,000goodwill amortization $14,056growth rate of store salesmature stores 6%new stores 6%interest, working capital debt 9.25%interest,cash balance 6%days trade payables 30other payables (days) 5depreciation/ gross FA 5%tax rate 36%cost of openingeach new store $100,000new store opening/year 100year assets divested 1988 Page 27 of 44
  • 33. 8.2. Calculation WACC:To value Revco at first we need to calculate WACC. To do this we have taken cost of equity which is40.72%, tax rate is 36% Cost of debt is 11.64%. And preferred stock rate is 14.41% and finally we getWACC is 11.40%.Firm Value:Based on the assumptions and WACC we calculate the firm value of the old Revco. Here we havetaken two scenarios. The first is base case. Here he have taken the assumptions of the manager of thenew revco. And we get the value is 3581079000 dollar. project ed pro forma FY 1987 1988 1989 1990 1993 1994 243614 27029 29929 38846 41176sales 2317381 3 30 62 12 89 177838 19731 21848 28357 30059cost of sales 1720525 5 39 62 67 13 72979 80810 10488 11117gross profit 596856 657759 1 0 45 76selling, general and administrative 56221 62253 80799 85647expense 449931 506718 0 6 9 9depreciation 62318 10530 11030 11530 12970 13352amortization of leaseholds 8043 8043 8043 8043 8043amortization of other assets 5048 5048 5048 5048 5048 14346 16094 21478 22885EBIT 84607 127420 0 2 4 4 10300 13746 14646EBIT*(1-T) 54148 81549 91814 3 2 7 11593 12762 16352 17291Add Noncash Charges 116466 105170 5 4 3 0Less: Net Inv in Fxd Cap 10125 10000 10000 10000 10000 7624 - - 19218Less: Inv in Work Capital 102291 167961 -42671 -38047 -8382 5 14200 14641 14454 13390Interest 152064 146000 0 0 4 2 24042 25867 29936 50393FCFF 58199 344680 1 4 7 7Discount rate 0.114042454Terminal Value( Firm Value) 5465785.301Discounting FactorDiscounted FCFFFirm Value 3581079Cash Out Flow 1500000NPV 2081079 Page 28 of 44
  • 34. In this scenario we have seen that the LBO is quite good decision because the firm Value of old Revcois 3581079 thousands where the cost of LBO is 1.5 billion. Nad most importantly the NPV is positive.But NPV is not the final story of the game. We would like to relax some assumptions that are quiterational in the context of economy and industryThe new Assumptions are-Terminal growth rate is 2% The growth rate is 5% and WCC is 15%. By this assumption we get thefirm value is 1694159 thousands.($ thousands) Projecte d pro forma FY 1987 1988 1989 1990 1992 1993 1994 243325 25549 26826 29576 31055 32607sales 2317381 0.05 12.55 58.18 30.64 12.18 87.78 182493 19161 20119 22182 23291 24455cost of sales 1738035.75 7.538 84.41 93.64 22.98 34.13 90.84 608312. 63872 67066 73940 77637 81519gross profit 579345.25 5125 8.138 4.545 7.661 8.044 6.946selling, general and 535315. 56208 59018 65067 68321 71737administrative expense 509823.82 011 0.762 4.8 8.742 2.679 3.313depreciation 62318 10530 11030 11530 12530 12970 13352amortization of leaseholds 8043 8043 8043 8043 8043 8043amortization of otherassets 5048 5048 5048 5048 5048 5048 62467.5 65617. 68949. 76198. 80195. 84471.EBIT 7203.43 015 3766 7454 9193 3653 6335EBIT*(1-T) 4610 39979 41995 44128 48767 51325 54062Add Noncash Charges 66928 63600 66116 68749 74388 77386 80505Less: Net Inv in Fxd Cap 10125 10000 10000 10000 10000 10000 7624 - - 19218Less: Inv in Work Capital 102291 167961 -42671 -38047 60217 -8382 5 14200 14641 14391 14454 13390Interest 152064 146000 0 0 0 4 2 14078 14092 12709 31912FCFF -40878 261540 2 4 52939 3 8.Discount rate 0.15Terminal Value( Firm Value) 3461311.686Discounting FactorDiscounted FCFFFirm Value 1694159Cash Out Flow 1500000NPV 194159 Page 29 of 44
  • 35. Calculate the Distressed Value of the Firm:As we have seen in the calculation of Z score the firm in distress zone so we have assumed the defaultprobability is 55%. And we consider the distress cost is 30% of NPV. By considering these two issueswe finally get the distressed value of the firm.AssumptionDistress Cost is 30% of Firm ValueProbability of Default 55%FCFF 1694159Distress Cost 508248FCFF less Distress Cost 1185911Firm Value 1414623Cash Out Flow -1500000NPV aftr adj of Dist Cost -85377Here distress cost is 508248 thousands. After deduction and multiplication with the probability wefinally get the Farm Value which is 1.41 billion but certainly this figure is lower than the cashoutflow. So after considering the distress cost it would not be wise decision to go for LBO.Simulation Analysis: Forecast values Trials 1,000 Mean -1562593 Median -1568104 Mode --- Standard Deviation 100817 Page 30 of 44
  • 36. Variance 10164100967 Skewness 0.6557 Kurtosis 3.94 Coeff. of Variability -0.0645 Minimum -1816442 Maximum -1054144 Range Width 762297 Mean Std. Error 3188Here we have take input variables are WACC and Growth rate. Here we have seen that the NPV isnegative. So by considering simulation we should not make decision to LBO the firm. 8.3. Comparative Analysis with Peer Company: Revco DS 87 88 89 90EBIT 149212 161199 175521 191656Total CF Availabale -40878 261540 140782 140924Total Obligation to be covered 297590 305334 208727 192252Coverage Ratio: EBIT 50% 53% 84% 100%coverage Ratio: total cf -14% 86% 67% 73% 400000 EBIT 300000 200000 Total CF Availabale 100000 0 Total Obligation to be covered -100000 87 88 89 90 Jac Eckered 87 88 89 90EBIT 223844 235036 246788 259127Total CF Availabale 291864 303056 278808 291147Total Obligation to be covered 224594 224856 199356 169319 Page 31 of 44
  • 37. Coverage Ratio: EBIT 100% 105% 124% 153%coverage Ratio: total cf 130% 135% 140% 172% 350000 300000 250000 EBIT 200000 150000 Total CF Availabale 100000 50000 Total Obligation to be 0 covered 87 88 89 90Analysts considered the experience of another major drug store retailer, Jack –Eckerd Corporation,which had been taken private in an LBO in April 1986. In most respects the two companies were quitesimilar: Eckerd had been taken private, however, at a multiple of only 21.3 times, compared withRevcos 24.8 times earnings. Eckerd was also financed at a debt-equity ratio of 11.5 times, comparedwith Revcos 37.6 times.presents a forecast of how well Revco and Eckcrd could cover their financial obligations in the nextthree years, the period over which analysts perceived the greatest possible risk of default. For eachcompany, the financial obligations included interest expense, principal payments, and preferred stockdividend payments. The "coverage of these obligations was estimated as a multiple compared withearnings before interest and taxes (EBIT); and "cash flow," which consisted of earnings beforeinterest, taxes, depreciation, and amortization (EBlTDA) plus the receipts from any asset sales lesscapita expenditures. (Additions to net working capital are ignored in this calculation. Ordinarily theydeserve to be included in an analysis like this. Exclusion of this item biases the estimated coveragerates upward.Analysts acknowledged; however that the comparative figure such as those in Exhibit 7 were pointestimates and thus ignored the uncertainty surrounding key assumptions. Revcos financial obligationswere well known at the .time of the buyout. Thus, the uncertainty about Revcos comparative standingversus Jack Eckerd and other firms devolved from forecast uncertainty about the following points:Interest rates: Revcos senior debt bore interest that floated at 1.75 percent above prime rate,currently at 7.50 percentAsset sales: Revco had to sell assets to .meet its principal payments. One could give Revco the benefitof the doubt and assume that all $230 million would actually be realized. But analysts were uncertainabout the timing18 of that realization. By comparison, Jack Eckerd would try to sell $72 million inassets.Capital expenditures: Capital expenditures could be assumed to be driven by Revcos goal ofopening 100 stores per year at an investment of$1 00,000 per store. Depreciation could beapproximated as $20 million for 1987, and thereafter scaled according to the percentage net change of Page 32 of 44
  • 38. the difference between asset sales and capital expenditures. By contrast, Jack Eckerd envisionedopening no new stores in the foreseeable future. Eckerds depreciation was forecasted to be $123million, a much higher figure than Revcos because Eckerd tended to own, rather than lease, its stores.Growth: Salomon Brothers contemplated a sales-growth rate no lower than 8 percent; it presentedforecasts to commercial bankers that assumed growth at 12 percent. Goldman Sachs, the advisor toRevcos outside directors, determined that a 12 percent growth rate assumption was "too aggressive."Analysts assumed sales growth of mature stores to be equal to the rate of inflation. In addition, "thenet growth from opening new stores would yield an annual corporate growth rate of 9 percent. ·EBIT margin: From 1974to 1986, Revcos mean EBIT margin was 6.62 percent (standard deviationwas 1.32 percent). The mean and standard deviation for Jack Eckerd Corporation were 8.11 and 1.42percent, respectively; a sample of peer companies over the same period indicated that the mean andstandard deviation were 5.15 and 1.25 percent, respectively. Salomon Brothers assumed an EBITmargin of 8.0 percent. Goldman Sachs opined that this assumption was "a bit aggressive." Only onceover the past 13 years did Revco reach that level, in 1984; thereafter Revcos EBIT margin fell to 3.50and 4.84 percent. Sales growth and EBIT margin depended in part on the rate at which Revco plannedto open new stores analysts challenged the wisdom of this strategy, noting that 70 percent of Revcosstores that had been open for less than one year lost money; the figure dropped to 48 percent for storesAnalysts were unable to decide whether to assume any covariance between growth and margins andgenerally assumed that each year was an independent draw: i.e., that there was no serial covariance inthe forecast assumptions that had been open from one to two years. 8.4. Possible Reasons for Going LBO:Management:Much of the controversy regarding LBOs has resulted from the concern that senior executivesnegotiating the sale of the company to themselves are engaged in self-dealing. On one hand, themanagers have a fiduciary duty to their shareholders to sell the company at the highest possible price.On the other hand, they have an incentive to minimize what they pay for the shares. Accordingly, ithas been suggested that management takes advantage of superior information about a firms intrinsicvalue. The evidence, however, indicates that the premiums paid in leveraged buyouts comparefavorably with those in inter-firm mergers that are characterized by arms-length negotiations betweenthe buyer and seller.Once the LBO was completed·, Sidney Dworkin became chairman of the board and Chief executiveofficer of the "new" Revco, the same positions he had held at Reyco D. S. As in the old entity,Dworkin did not control a majority ofthe outstanding shares ofsto.ck; he owned about 15.4 percent.However, these shares were subject to a voting trust of which he was a member. Apparently, Mr.Dworkin would have more control in the "new" Rcvco than he had had at Rcvco D. S., where hisownership percentage was only 2.32 percent. Dworkin received $29.6 million for the stock and stockoptions that he held in the old. Revco. He invested about $8 million in the "new" Revco. Moreovermanger assumes to enjoy tax savings.Existing Share Holder: Page 33 of 44
  • 39. Purchase cost 1253315price 38.5No of Shares 32553.64premium 0.48market price 26.01351Book Value equity 392530Book value per share 12.05795Earnings 51304EPS 1.575984P/E 21.2375P/E based share price 33.46995Existing Share holders get 48% premium over the price on last trade. The stock holder gets price 38,5dollar per share but its market price was 26.012$. Its book value were 12.055$ and P/E based price is33.46$. In every respect shareholder becomes gainer.Debt holder:The debt holders bear the risk of default equated with higher leverage as well, but since they have themost senior claims on the assets of the company, they are likely to realize a partial, if not full, returnon their investments, even in bankruptcy. In the case of Revco the debt holders gets 10-113% interestrate which are attractive, The bear default risk so they commensurate themselves by charging higherinterest rate.Not all LBOs are successful, however, so there are also some potential disadvantages to consider. Ifthe companys cash flow and the sale of assets are insufficient to meet the interest payments arisingfrom its high levels of debt, the LBO is likely to fail and the company may go bankrupt. Anotherdisadvantage is that paying high interest rates on LBO debt can damage a companys credit rating.Finally, it is possible that management may propose an LBO only for short-term personal profit. So inthe case of Revco it has high probability of becoming default and high probability of beingunsuccessful as well.9. Capital Adequacy:We have used Monte Carlo simulation to test the ability of Revoc to meet its financial cash obligation,particularly we have done simulation to get probability of successfully covering the firm’s cashinterest, debt principal and preferred dividend payments over the first three calendar years followingthe buyout. At issue is the sensitivity of the probability of survival based on variations in the operatingassumptions by Revoc versus assumptions consistent with the historical performance or comparablecompanies and Revco. Page 34 of 44
  • 40. 9.1. The VariablesThe simulation model forecasts a cash-flow debt-service coverage ratio ("CF Coverage") for 1987,1988, and 1989, the first three years following the LBO. Revco used a fiscal year end of May 31, but,because the LBO was consummated on December 29, 1986, we adopted the convention of using thecalendar year as the fiscal year to coincide with the LBO date. Thus, each of the projected yearscontains 12 months of sales covering the calendar years 1987,1988, and 1989. The structure of thefinancing makes a longer forecast period unnecessary, because the first three years following thebuyout represent the maximum risk exposure for Revco.Cash-flow coverage ratio was calculated as EBIT (earnings before interest and taxes) plus proceedsfrom asset sales (AS) less capital expenditures on new stores (CAPE° plus depreciation (DEPR),divided by cash interest payments (INT) plus principal payments (PRIN) plus cash dividends (DIV),i.e.,The ratios were modeled in a Excel spreadsheet and simulated 1000 times using "Cryatal Ball"simulation software.For the most part, Revcos financial obligations (INT, PRIN , and DIV) were known at the time of thebuyout and were, therefore, entered in the model as fixed numbers. Exhibit below summarizesRevcos cash payment obligations for the simulation period, 1987-1989. Interest on fixed coupon debt,principal and preferred dividend payments was determined according to the schedules provided in thecase. Only cash payments were included in the simulation; no consideration was given to noncashobligations such as payment-in-kind (PIK) preferred stocks. Of the three preferred issues used in thebuyout, two, the 15.25% cumulative exchangeable and the 17.62% cumulative junior preferred, werePIKs. The 12.0% cumulative convertible preferred stock with a face value of $85 million isresponsible for the $10.2 million of preferred dividends.Reported in the case there are fixed and floating rate interest payments. Of the $1,331 million of debtused in the LBO, $455 million had a floating interest rate, and the remaining $876 million had fixedrates. The fixed- rate debt obligations had an average interest rate of 12.9% with no principalpayments due during the study period. The term loan was structured in such a way that Revco couldchoose interest payments as either 1.75% over the prime rate or 2.75% over LIBOR (LondonInterbank Offer Rate). The floating interest payments reported in case assume that the prime-rateoption is chosen and that prime remains at the December 1986 rate (7.50%) for the entire three years.The only payments of principal during the study period are for the term loan, as specified by itsamortization schedule. Thus, the floating interest payments decline over time as the term loan isretired, whereas the fixed interest payment remains constant at $112 million. To simulate the floatingrate interest payments, we modeled all the prime rate (PRIME) as a normal distribution with meanequal to the December 1986 rate of 7.50% and a standard deviation of 3.60%, as estimated fromhistorical data.EBIT, AS, and DEPR remain as the stochastic variables needed to compute the coverage ratios. To Page 35 of 44
  • 41. calculate EBIT, we multiplied sales by an EBIT margin defined asMargin =Margin was modeled as normal with mean and variance estimated from historical performance datafor Revco and ECKRD. The sale of existing stores and other assets (AS) was modeled as the appraisalfigure given in the case ($230 million). Consistent with the case, we assumed that the company couldrealize 100% of the divestiture proceeds during the first two years of the LBO. AS for 1987 wasassumed to be uniformly distributed over 25 to 75%; i.e. The model assumed that Revco could sellwith equal probability anywhere from $57.5 million to $172.5 million of the $230 million of assets inthe first year. For 1988, the second year after the buyout, AS equals the $230 million less therealization of 1987 asset sales. Because of holding the total asset sales constant at $230 million, theonly uncertainty introduced into the model is the timing of the asset sales.We modeled AS as described,for several reasons. Unlike most other variables in the analysis, nohistorical data exist to guide us in the modeling of AS. The lack of data makes our modeling choicesfor AS somewhat arbitrary and, hence, easy prey to criticism. Faced with such a challenge, we choseto model AS in a way that the model would be biased in favor of finding a high survival probability.The first step in this direction was to assume, as Revco did at the time, that Salomon Brothers wouldbe able to sell the assets within the first two years following the LBO. In our view, this assumptionrepresents a best-case scenario for Revco.The second step was to recognize that allowing the total amount of asset sales to vary around $230million would, in fact, act to reduce Revcos computed probability of survival. As was true for mostLBOs, the Revco financial structure contained a covenant in the term loan that required any excessproceeds of the divestiture to be used as prepayments of the loan. Thus, if Revco should happen to belucky enough to realize more than the $230 million for the assets at the end of the second year, theextra cash could not be used to service the third years cash flow obligations. Rather. the money wouldhave to be used as a prepayment of the term loan, which would only slightly reduce the interestpayments in the third year. On the other hand, if Revco should realize a shortfall in the sale of theassets, the reduced inflow would significantly reduce the firms ability to service its obligations in thefirst and/or second years. The overall effect of allowing the $230 million figure to vary is that thedownside fluctuations hurt the survival of the LBO more than the upside fluctuations help it. Thus,our assumptions about AS are conservative and bias the model toward the conclusion that the LBOwould succeed.An offset to AS is CAPEX, the outlay required for starting new stores each year. To model thisvariable, we assumed new stores would open at a rate of 100 per year, consistent with the goals statedin the prospectus. We assumed that $100,000 per store would cover the investment in fixtures,systems, and other assets unrelated to inventory and that, consistent with Revcos past practice, newstore buildings and land would be leased. As new stores are added and existing stores sold in themodel, total revenue is adjusted according to the assumed sales per year figure. These sales figures areincreased each year by a growth rate (GROWTH), assumed to be inflation, which was modeled as anormal distribution with a mean of 6.0% and standard deviation of 3.90% as measured from a timeseries of historical inflation rates. Depreciation expense (DEPR) was approximated as $33.7 millionfor 1987 and was scaled according to the percentage net change of (AS - CAPEX). Page 36 of 44
  • 42. Assets Sale Uniform distribution with parameters: Minimum 25.00% Maximum 75.00% Margin Normal distribution with parameters: Mean 6.60% Std. Dev. 1.32% Growth Rate Normal distribution with parameters: Mean 5.00% Std. Dev. 3.90% Prime Rate Normal distribution with parameters: Mean 7.50% Std. Dev. 2.50% 9.2. ResultsTo illustrate the inputs and outputs of the model, Exhibit presents a series of histograms of variabledistributions as modeled for the base case.Exhibit below displays the CF coverage ratio distributions for 1987, 1988, and 1989. For these base-case scenarios, the mean coverage ratios are 0.97 in 1987, 0.98 in 1988, and 0.96 in 1989. The mass ofthe distribution to the right of 1.0 represents the probability of surviving a given year. Thus, thecumulative probability of survival is computed as the product of each of the three annual probabilitiesof realizing a ratio greater than 1.0. For the base case, the three annual probabilities of survival are0.47, 0.45, and 0.45, and the cumulative probability of survival is 0.10 (0.43*0 .45 *0.27). Each Year Annual Cash Flow Coverage Three Year Cash Flow Ratio (%) Coverage Ratio (AM) Particulars Cumulative Probability 1987 1988 1989 Probability 1987-89 of Survival of Survival 97.24 98.55 96.56 Base Case 10% 97.45 45.9 (47.2) (45.2) (45.3) Changed Margin (Base Case 6.6%) Revco’s 84-85 margin 78.78 79.11 65.59 0.017 74.49 6.2 (4.17%) (7.8) (8.0) (2.8) Page 37 of 44
  • 43. Changed Growth (Base Case 5% 96.76 97.55 94.18 1% below base (4%) 6.8 96.16 41.1 (41.5) (44.8) (37.0) 97.72 99.56 98.98 1% over base (6%) 10.88 98.75 47.76 (46.1) (49.1) (48.1) Changed Store (Base Case 100/year) 97.91 97.45 92.63 50/year 4.6 96 36.7 (43.4) (39.1) (27.6) 96.58 99.65 100.44 150/year 8.9 98.89 44.8 (46.3) (43.6) (44.5) 1.32 1.34 1.18 Debt/Equity 3.84 times 65.19 1.28 87.1 (93.6) (93.0) (74.9) 1.215 1.23 1.122 Debt/Equity 6.8 times 52.85 1.189 81.33 (88.0) (86.8) (69.2) 129.95 134.78 139.85 Jack Eckerd Corporation 84.46 134.86 94.5 (93.0) (95.2) (95.4) Value in () are probability of survival of the respective dataExhibit also shows the distribution of the three-year cash-flow-coverage ratio— i.e., the probabilitythat the sum of the cash flows for 1987-1989 is sufficient to cover the surn of the obligations for theperiod. This ratio assumes that past and future cash flows are available to service the financialobligations for any year. Thus, the ratio represents a best-case measure of the models estimate ofRevco s ability to pay. The area to the tight of 1.0 is the probability of survival. Because the ratio hasa mean less than I .0 (0.97) and the variance of the distribution is small, the probability of survival isapproximately 45%, much larger than the product of the three independent-year probabilities.To test the robustness of the model to our assumptions, we performed two comparisons. First, weconducted a sensitivity analysis on the means of the stochastic variables. As revealed in the Exhibit,the coverage ratios for Revco are consistently less than 1.0, and the probability of successful coverageremains low regardless of variations in assumptions for MARGIN, GROWTH, and STORES (thenumber of new-store openings per year).The three-year ratio probabilities in Exhibit are consistently higher than the cumulative independentprobabilities for the three years. For example, the base-case probability is 45% for the three-year ratiocompared to only 10% assuming independent cash flows. The reader should keep in mind that thethree-year ratio is a strong upwardly biased measure of survival and that the base-case probability of45% is, in itself, a very low survival probability. The three-year probability rises to 47.76% ifincreased margin of 8.0% is used, but for every other scenario reported in Exhibit , the three-yearprobability is less than that. Interestingly, when MARGIN is assumed to equal Revcos averageperformance for 1984-1985 of 4.17%, the probability of survival is virtually zero under eitherprobability measure. Thus, the model yields consistently low survival probabilities for Revco.As a second check of the models robustness, we applied the simulation to the Jack EckerdCorporation, one of Revcos competitors in discount-drugstore retailing and itself the subject of aleveraged buyout in 1986. As with Revco, we used historical performance data as the basis for EBITprojections and case data for financial obligation projections. Over the period 1974-1986, EckerdsMARGIN averaged 8.11% with a standard deviation of 1.42% compared to Revcos 6.60% and1.32%. A more important difference from Revco, however, was that Eckcrds interest and principal Page 38 of 44
  • 44. payment schedules were substantially deferred. The simulations for Eckerd produced coverage ratiosof 1.30, 1.34, and 1.39 for the first three years following the buyout. These individual probabilitiesimply a cumulative probability of survival of 84% and a three-year probability of 94.5%. 9.3. Conclusions and ImplicationsThe analysis in this study suggests that Revco had a probability of between 10% and 45% ofsuccessfully servicing its financial obligations in the first three years after going private. Thesesurvival possibilities are so low as to suggest that Revco was undercapitalized in the sense that thenew debt obligations exceeded its expected cash flow and hence, the buyout was doomed to fail fromthe start. It is only when Revcos earning power is assumed at almost double that of its recent past thatthe survival probability (assuming independence of cash flows) approaches 50%. The survivalprobabilities are relatively insensitive to assumptions concerning asset sales and growth of salessuggesting that it was the leveraged buyout and the restructuring strategy rather than flawed executionof the strategy by management. Ironically, the strategy of the newly Ovate Revco was to focus onasset sales and growth, and only secondarily to focus on profitability, The deteriorating environmentfor retailers in late 1987 and 1988 could be chalked up as bad luck, but we believe the hallmark of agood strategy is the ability to withstand unforeseen adversities. We leave it for others to speculate asto why the deal was consummated.A simulation-based research methodology, such as that used here, has its weaknesses. Our strategyhas been to address the weaknesses by stating them plainly and then to construct the model .so that itis biased in favor of survival. The base-case assumptions were reasonable in that they were consistentwith information a financial analyst would have had in December 1986, when Revco went private.Other assumptions for which there was no strong bate of public information Or historical experience(e.g., tax exposure, asset sales, working capital requirements) were tilted in Revcos favor. Despite themodel being biased in favor of survival, however, we consistently found low survival probabilitiesand conclude that they arise because of Revcos onerous payment schedule and anemic earning powerrather than as an artifact of our methodology. Our sensitivity analysis revealed that even granting theoptimistic assumptions used by Revcos financial advisers and bankers produces survival probabilitiesof less than 50%. In addition, testing our methodology on another drug retailer taken private at aboutthe same time, Jack Eckerd Corporation produced high probabilities of survival. In other words, ourex ante approach produced results that are consistent to date with the fates of Revco and Eckcrd. Thus,we conclude that the model discriminates reasonably well and is not prone to predict disaster for everyLBO. Page 39 of 44