Epgp sm2 assignment_#6_03 april 10_ rajendra inani #27

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Epgp sm2 assignment_#6_03 april 10_ rajendra inani #27

  1. 1. Strategic Management – 2 3rd March 2010 Assignment #6 Submitted by – Rajendra Inani #27 The RJR Nabisco Buyout RJR Nabisco in 1988 - Manufactures food products (Oreo cookies), cigarettes, etc. It had poor share price performance (stagnant at $55) and outstanding debt valued at $5 billion. RJR was boosting sales by loading cigarette inventories on its distributors. Dealers were encouraged to purchased billions in surplus cigarettes just before semi-annual price increases were put in effect. Some analysts estimated that there were 18 billion excess cigarettes on dealers' shelves as of January 1, 1989. As a result, RJR was able to report higher sales and earnings. In doing so, the management: forfeited future sales at higher prices, accelerated the payment of excise taxes, turned off smokers. The company was trying to produce a smokeless cigarette to boost the market value of RJR shares. At least, it was believed so but the smokeless cigarette, however, had a very unpleasant taste. Kohlberg, Kravis and Roberts (KKR) - Planned to issue almost $24 billion in new debt, buy RJR, and sell several RJR food divisions. Calculation of the present value of the buyout - • The forecasting horizon was divided in two sub-periods: pre and post 1993 • Unlevered cash flow and tax shields were elaborately forecasted up to 1993 • Unlevered cash flow was projected to grow at a constant rate after 1993 • The tax shield after 1993 was estimated using M&M 1963 Cash flows projections(millions) 1989 1990 1991 1992 1993 Operating income 2,620 3,410 3,645 3,950 4,310 Tax on operating income 891 1,142 1,222 1,326 1,448 After tax operating income 1,729 2,268 2,423 2,624 2,862 Add back depreciation 449 475 475 475 475 Less capital expenditures 522 512 525 538 551 Less change in WC -203 -275 200 225 250 Assets sales 3,545 1,805 - - - Unlevered cash flow 5,404 4,311 2,173 2,336 2,536 Projected interest expense (millions) Interest expense 3,384 3,004 3,111 3,294 3,483 Tax shield (T =34%) 1,151 1,021 1,058 1,120 1,184 The present value of unlevered cash flow PVUCF (‘89-’93) at 14% = $12,224 m PVUCF (>‘93) = 2,536(1.03)/[(0.14 - 0.03)(1.14)5] = $ 12,330m (g = 3%) The present value of the tax shield up to 1993 Cost of debt = 13.5% PVTS (‘89 - ‘93) = $3,877 m
  2. 2. Strategic Management – 2 3rd March 2010 Assignment #6 Submitted by – Rajendra Inani #27 The present value of the tax shield beyond 1993 Tax shield (1993) = VL(1993) - VU(1993) D/E = 1/3 WACC (1993)= 12.8% r(cost of equity) = 14% g = 3% VL(1993) = UCF(1994)/(wacc -g)= $2,536(1.03)/(0.128-0.03) = $26,653.9 m VU(1993) = UCF(1994)/(r -g) = $2,536(1.03)/[(0.14 - 0.03) = $23,746 m Tax shield (1993) = $26,653.9 - $ 23,746 m = $2,908 m PVTS (>1993) = $1,544 m The total value of RJR: PVUCF(‘89-’93) +PVUCF(>‘93) + PVTS(‘89 -‘93) + PVTS (>’93) $12,224 m + $12,333 m+ $3,877 m + $1,544 m = $29,978 m The market value of equity VL - D = E $29,978 m - $5,000 m = $24,978 m P = $109.07 per share Discounted Cash Flow Valuation The discounted cash flow methodology determines values by taking a projected stream of cash flows and discounting them at an appropriate discount rate. The steps involved are: - Estimate discount rate D E WACC = E (rd )(1 − t ) + E (re ) D+E D+E - The discount rate is the Weighted Average Cost of Capital (WACC) Where, t = tax rate, E(rd) = expected cost of debt D = amount of debt in capitalization E(re) = expected cost of equity E = amount of equity capitalization - Project Cash flows - Compute Net Present Value (NPV)
  3. 3. Strategic Management – 2 3rd March 2010 Assignment #6 Submitted by – Rajendra Inani #27 Discount Rate • To calculate the WACC using 1989 figures under the three strategies: 5,204 12,790 Prebid : (.09)(1 − .34) + (.168) = .137 5,204 + 12,790 5,204 + 12,790 11,186 4,202 Mgmt : (.098)(1 − .34) + (.250) = .115 11,186 + 4,202 11,186 + 4,202 18,932 4115 KKR : (.102)(1 − .34) + (.330) = .114 18,932 + 4115 18,932 + 4115 • NOTE: since the capital structure changes over time, we need to recompute the WACC each year to reflect the change in capital structure. Projected Cash Flows • Projected cash flows for 1989 are calculated as follows: Prebid Mgmt KKR Rev. 18,088 7,650 16,190 - Exp. 14,429 5,544 12,596 - Depr. 807 777 1,159 TI 2,852 1,329 2,435 - Tax 970 452 828 Net Inc. 1,882 877 1,607 + Depr. 807 777 1,159 - Cap.Exp. 1,708 432 774 - Chg WC 80 41 79 + Asset Sale 0 12,680 3,500 Net CF 901 13,861 5,413 • The following cash flow represent the cash flow computed from the tables: Year Prebid Management KKR 1989 901 13,861 5413 1990 1385 1486 4909 1991 1856 1768 2526 1992 2528 2062 2745 1993 2985 2278 2855 1994 3261 2507 3101 1995 3555 2755 3364 1996 3887 3029 3651 1997 4246 3332 3970 1998 4575 3666 4319 Terminal Value
  4. 4. Strategic Management – 2 3rd March 2010 Assignment #6 Submitted by – Rajendra Inani #27 • To estimate a terminal value, we need to make an assumption about future growth after 1998. • If cash flows grow by 2.5% per year (and the WACC remains constant), then for the pre-bid strategy: 4575(1 + .025) PV (1998) = = 38,755 .146 − .025 • For the Management Group scenario: 3666(1 + .025) PV (1998) = = 31,055 .146 − .025 • For the KKR scenario: 4319(1 + .025) PV (1998) = = 36,587 .146 − .025 • Results will depend on the growth rate assumption. • Values in 1998 of cash flows for 1999 and beyond for different assumptions are (“Sensitivity Analysis”): Growth Rate Strategy 0% 2.5% 5% Pre-Bid 31,336 38,755 50,039 Management 25,110 31,055 40,097 KKR 29,582 36,587 47,239 Present Value • The present value of the cash flows for the prebid strategy is (using the 2.5% growth rate assumption after 1998): ($ millions) 901 1385 1856 PV = + + + 1.137 (1 + .139) (1 + .14) 3 2 4575 + 38,755 ... + = 22,607 (1 + .146)10 • This represents the total value of RJR Nabisco (ASSETS). • To figure out the value per share of RJR Nabisco to the CURRENT shareholders, consider the pre- bid valuation: Total Assets = 22,607 Current Debt = 5,204 Equity = 17,403 17,403 PerShare = = 70.34 247.4 Valuation
  5. 5. Strategic Management – 2 3rd March 2010 Assignment #6 Submitted by – Rajendra Inani #27 • Estimates of the value per share under the alternatives (again, using the 2.5% growth rate assumption): Strategy Total Debt Equity Share Price Prebid 22,607 5204 17,403 $70.34 Management 30,593 5204 25,389 $102.62 • KKR 29,278 5204 24,074 $97.31 Sources of Value • The company is worth substantially more under either the KKR or the Management Group plan. • There are smaller differences between the KKR value and the management value. • The buyout plans propose to – increase debt – trim excesses – decrease capital expenditures – sell food assets – decrease operating profits • All gains are based on projections. What Happened? Case (11/18) 11/29/88 MGMT $100 $101 KKR 94 106 FB 98-110 103-115 Activities of Special Committee • Concluded that First Boston bid was impractical. • Began to negotiate terms with KKR. • Letter from Management Group protesting negotiations with KKR, offering to negotiate all aspects of its proposal. • Special Committee decided to consider new bids. • Summary of final bids (substantially equivalent): Bid Valuation MGMT $112 $108 KKR 109 108 • Chose KKR: – more equity (25% vs 15% for mgmt) – retain more businesses – fewer PIK securities – more benefits to terminated employees

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