buy out valuations : Hilton case and the private equity buyout,

1. Leveraged Buyout
Structures and
Valuation

2. No one spends other people’s money
as carefully as they spend their own.
—Milton Friedman

3. Course Layout: M&A & Other
Restructuring Activities
Part IV: Deal
Structuring &
Financing
Part II: M&A
Process
Part I: M&A
Environment
Payment &
Legal
Considerations
Public Company
Valuation
Financial
Modeling
Techniques
M&A Integration
Business &
Acquisition
Plans
Search through
Closing
Activities
Part V:
Alternative
Strategies
Accounting &
Tax
Considerations
Business
Alliances
Divestitures,
Spin-Offs &
Carve-Outs
Bankruptcy &
Liquidation
Regulatory
Considerations
Motivations for
M&A
Part III: M&A
Valuation &
Modeling
Takeover Tactics
and Defenses
Financing
Strategies
Private
Company
Valuation
Cross-Border
Transactions

4. Learning Objectives
• Primary Learning Objective: To provide students with a knowledge of
how to analyze, structure, and value highly leveraged transactions.
• Secondary Learning Objectives: To provide students with a
knowledge of
– The motivations of and methodologies employed by financial
buyers;
– Advantages and disadvantages of LBOs as a deal structure;
– Alternative LBO models;
– The role of junk bonds in financing LBOs;
– Pre-LBO returns to target company shareholders;
– Post-buyout returns to LBO shareholders, and
– Alternative LBO valuation methods
– Basic decision rules for determining the attractiveness of LBO
candidates

5. Financial Buyers or Sponsors
In a leveraged buyout, all of the stock, or assets, of a public
or private corporation are bought by a small group of
investors (“financial buyers aka financial sponsors”),
usually including members of existing management and
a “sponsor.” Financial buyers or sponsors:
• Focus on ROE rather than ROA.
• Use other people’s money.
• Succeed through improved operational performance, tax
shelter, debt repayment, and properly timing exit.
• Focus on targets having stable cash flow to meet debt
service requirements.
– Typical targets are in mature industries (e.g., retailing,
textiles, food processing, apparel, and soft drinks)

6. Impact of Leverage on Return to Shareholders
All-Cash
Purchase
($Millions)
50% Cash/50%
Debt
($Millions)
20% Cash/80%
Debt
($Millions)
Purchase Price $100 $100 $100
Equity (Cash Investment by Financial
Sponsor)
$100 $50 $20
Borrowings 0 $50 $80
Earnings Before Interest and Taxes
(EBIT)
$20 $20 $20
Interest @ 10%1 0 $5 $8
Income Before Taxes $20 $15 $12
Less Income Taxes @ 40% $8 $6 $4.8
Net Income $12 $9 $7.2
After-Tax Return on Equity (ROE)2 12% 18% 36%
Impact of Leverage on
Financial Returns
1Tax shelter in 50% and 20% debt scenarios is $2 million (I.e., $5 x .4) and $3.2 million (i.e., $8 x .4), respectively.
2If EBIT = 0, ($5), and ($8), ROE in 0%, 50% and 20% debt scenarios = $0 / $100, [($5) x (1 - .4)] / $50 and [($8) x (1 - .4)] / $20 = 0%, (6)% and (24)%,
respectively. Note the value of the operating loss, which is equal to the interest expense, is reduced by the value of the loss carry forward or carry back.

7. LBOs Create Value by Reducing Debt and Increasing Margins
Thereby Increasing Potential Exit Multiples
Firm
Value
Debt Reduction Reinvest in Firm
Free Cash Flow
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Debt Reduction & Reinvestment Increases Free Cash Flow and in turn Builds Firm Value
Tax Shield Adds to Free Cash Flow
Debt
Reduction
Adds to Free
Cash Flow by
Reducing
Interest &
Principal
Repayments
Reinvestment
Adds to Free
Cash Flow by
Improving
Operating
Margins
Tax
Shield

8. LBO Value is Maximized by Reducing Debt, Improving
Margins, and Properly Timing Exit
Case 1:
Debt Reduction
Case 2:
Debt Reduction + Margin
Improvement
Case 3:
Debt Reduction + Margin
Improvement + Properly
Timing Exit
LBO Formation Year:
Total Debt
Equity
Transaction Value
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
$400,000,000
100,000,000
$500,000,000
Exit Year (Year 7) Assumptions:
Cumulative Cash Available for
Debt Repayment1
Net Debt2
EBITDA
EBITDA Multiple
Transaction Value3
Equity Value4
$150,000,000
$250,000,000
$100,000,000
7.0 x
$700,000,000
$450,000,000
$185,000,000
$215,000,000
$130,000,00
7.0 x
$910,000,000
$695,000,000
$185,000,000
$215,000,000
$130,000,000
8.0 x
$1,040,000,000
$825,000,000
Internal Rate of Return 24% 31.2% 35.2%
Cash on Cash Return5 4.5 x 6.95 x 8.25 x
1Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and
principal repayments reflecting the reduction in net debt.
2Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million
3Transaction Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year
4Equity Value = Transaction Value in 7th Year – Net Debt
5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it
accounts for the time value of money.

9. LBO Deal Structure
• Advantages include the following:
– Management incentives,
– Better alignment between owner and manager objectives,
– Tax savings from interest expense and depreciation from asset
write-up,
– More efficient decision processes under private ownership,
– A potential improvement in operating performance, and
– Serving as a takeover defense by eliminating public investors
• Disadvantages include the following:
– High fixed costs of debt raises firm’s break-even point,
– Vulnerability to business cycle fluctuations and competitor
actions,
– Not appropriate for firms with high growth prospects or high
business risk, and
– Potential difficulties in raising capital.

10. Classic LBO Models:
Late 1970s and Early 1980s
• Debt normally 4 to 5 times equity. Debt amortized over
no more than 10 years.
• Existing corporate management encouraged to
participate.
• Complex capital structure: As percent of total funds
raised
– Senior debt (60%)
– Subordinated debt (26%)
– Preferred stock (9%)
– Common equity (5%)
• Firm frequently taken public within seven years as tax
benefits diminish

11. Break-Up LBO Model (Late 1980s)
• Same as classic LBO but debt serviced from
operating cash flow and asset sales
• Changes in tax laws reduced popularity of this
approach
– Asset sales immediately upon closing of the
transaction no longer deemed tax-free
– Previously could buy stock in a company and
sell the assets. Any gain on asset sales was
offset by a mirrored reduction in the value of
the stock.

12. Strategic LBO Model (1990s)
• Exit strategy is via IPO
• D/E ratios lower so as not to depress EPS
• Financial buyers provide the expertise to grow earnings
– Previously, their expertise focused on capital structure
• Deals structured so that debt repayment not required
until 10 years after the transaction to reduce pressure on
immediate performance improvement
• Buyout firms often purchase a firm as a platform for
leveraged buyouts of other firms in the same industry

13. LBOs in the New Millennium
• Explosion in frequency and average size of LBOs in the U.S. during
2005-2007 period ($5-$10 billion range)
• Tendency for buyout firms to bid for targets as a group (“Club
Deals”)
• Increased effort to “cash out” earlier than in past to boost returns
due to increased competition for investors
• LBO “boom” fueled by
– Global savings glut resulting in cheap financing
– Fed “easy” money policies
– Excess capacity in many industries encouraging consolidation
– Attempt to avoid onerous reporting requirements of Sarbanes-
Oxley
• LBOs increasingly common in European Union due to liberalization
and “catch-up” to U.S.

14. Role of Junk Bonds in Financing LBOs
• Junk bonds are non-rated debt.
– Bond quality varies widely
– Interest rates usually 3-5 percentage points above the prime rate
• Bridge or interim financing was obtained in LBO transactions to
close the transaction quickly because of the extended period of time
required to issue “junk” bonds.
– These high yielding bonds represented permanent financing for
the LBO
• Junk bond financing for LBOs dried up due to the following:
– A series of defaults of over-leveraged firms in the late 1980s
– Insider trading and fraud at such companies a Drexel Burnham
(Michael Milken), the primary market maker for junk bonds
• Junk bond financing is highly cyclical, tapering off as the economy
goes into recession and fears of increasing default rates escalate

15. Discussion Questions
1. Define the financial concept of leverage.
Describe how leverage may work to the
advantage of the LBO equity investor? How
might it work against them?
2. What is the difference between a management
buyout and a leveraged buyout?
3. What potential conflicts might arise between
management and shareholders in a
management buyout?

16. Factors Affecting Pre-Buyout Returns
• Premium paid to target firm shareholders frequently
exceeds 40%
• These returns reflect the following (in descending
order of importance):
– Anticipated improvement in efficiency and tax
benefits
– Wealth transfer effects (e.g., from bondholders to
shareholders)
– Superior Knowledge
– More efficient decision-making

17. Factors Determining Post-Buyout Returns
• Empirical studies show investors earn abnormal post-
buyout returns due to
--Full effect of increased operating efficiency not
reflected in the pre-LBO premium.
--More professional management, tighter
performance monitoring by owners, and reputation of
financial sponsor.
--Studies may be subject to “selection or survival
bias,” i.e., only LBOs that are successful are able to
undertake secondary public offerings.
--Abnormal returns may also reflect the acquisition of
many LBOs 3 years after taken public.
--Properly timing when to exit the business.

18. Valuing LBOs
• A leveraged buyout can be evaluated from the perspective of
common equity investors or of all investors and lenders
• From common equity investors’ perspective,
NPV = PVFCFE – IEQ ≥ 0
Where NPV = Net present value
PVFCFE = Present value of free cash flows to common equity
investors
IEQ = The value of common equity
• From investors’ and lenders’ perspective,
NPV = PVFCFF – ITC ≥ 0
Where PVFCFF = Present value of free cash flows to the firm
ITC = Total investment or the value of total capital including
common and preferred stock and all debt.

19. Decision Rules
• LBOs make sense from viewpoint of investors
and lenders if PV of free cash flows to the firm is
≥ to the total investment consisting of debt and
common and preferred equity
• However, a LBO can make sense to common
equity investors but not to other investors and
lenders. The market value of debt and preferred
stock held before the transaction may decline
due to a perceived reduction in the firm’s ability
to
– Repay such debt as the firm assumes
substantial amounts of new debt and to
– Pay interest and dividends on a timely basis.

20. Valuing LBOs: Cost of Capital Method1
Adjusts for the varying level of risk as the firm’s
total debt is repaid.
• Step 1: Project annual cash flows until
target D/E achieved
• Step 2: Project debt-to-equity ratios
• Step 3: Calculate terminal value
• Step 4: Adjust discount rate to reflect
changing risk
• Step 5: Determine if deal makes sense
1Also known as the variable risk method.

21. Cost of Capital Method: Step 1
• Project annual cash flows until target D/E ratio
achieved
• Target D/E is the level of debt relative to equity
at which
– The firm will have to resume payment of taxes
and
– The amount of leverage is likely to be
acceptable to IPO investors or strategic
buyers (often the prevailing industry average)

22. Cost of Capital Method: Step 2
• Project annual debt-to-equity ratios
• The decline in D/E reflects
–the known debt repayment schedule
and
–The projected growth in the market
value of the shareholders’ equity
(assumed to grow at the same rate as
net income)

23. Cost of Capital Method: Step 3
• Calculate terminal value of projected cash
flow to equity investors (TVE) at time t,
(i.e., the year in which the initial investors
choose to exit the business).
• TVE represents PV of the dollar proceeds
available to the firm through an IPO or
sale to a strategic buyer at time t.

24. Cost of Capital Method: Step 4
• Adjust the discount rate to reflect changing risk.
• The firm’s cost of equity will decline over time as debt is repaid and equity
grows, thereby reducing the leveraged ß. Estimate the firm’s ß as follows:
ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))
where ßFL1 = Firm’s levered beta in period 1
ßIUL1 = Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL1 = Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI = Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF = Firm’s marginal tax rate in period 1
• Recalculate each successive period’s ß with the D/E ratio for that period,
and using that period’s ß, recalculate the firm’s cost of equity for that period.

25. Cost of Capital Method: Step 5
• Determine if deal makes sense
–Does the PV of free cash flows to equity
investors (including the terminal value)
equal or exceed the equity investment
including transaction-related fees?

26. Evaluating the Cost of Capital Method
• Advantages:
– Adjusts the discount rate to reflect diminishing
risk as the debt-to-total capital ratio declines
– Takes into account that the deal may make
sense for common equity investors but not for
lenders or preferred shareholders
• Disadvantage: Calculations more burdensome
than Adjusted Present Value Method

27. Valuing LBOs: Adjusted Present
Value Method (APV)
Separates value of the firm into (a) its value as if it were debt free
and (b) the value of tax savings due to interest expense.
• Step 1: Project annual free cash flows to equity investors and
interest tax savings
• Step 2: Value target without the effects of debt financing and
discount projected free cash flows at the firm’s estimated
unlevered cost of equity.
• Step 3: Estimate the present value of the firm’s tax savings
discounted at the firm’s estimated unlevered cost of equity.
• Step 4: Add the present value of the firm without debt and the
present value of tax savings to calculate the present value of the
firm including tax benefits.
• Step 5: Determine if the deal makes sense.

28. APV Method: Step 1
• Project annual free cash flows to equity investors and
interest tax savings for the period during which the firm’s
capital structure is changing.
– Interest tax savings = INT x t, where INT and t are the
firm’s annual interest expense on new debt and the
marginal tax rate, respectively
– During the terminal period, the cash flows are
expected to grow at a constant rate and the capital
structure is expected to remain unchanged

29. APV Method: Step 2
• Value target without the effects of debt financing and
discount projected cash flows at the firm’s unlevered
cost of equity.
– Apply the unlevered cost of equity for the period
during which the capital structure is changing.
– Apply the weighted average cost of capital for the
terminal period using the proportions of debt and
equity that make up the firm’s capital structure in the
final year of the period during which the structure is
changing.

30. APV Method: Step 3
• Estimate the present value of the firm’s annual
interest tax savings.
– Discount the tax savings at the firm’s
unlevered cost of equity
– Calculate PV for annual forecast period only,
excluding a terminal value, since the firm is
sold and any subsequent tax savings accrue
to the new owners.

31. APV Method: Step 4
• Calculate the present value of the firm
including tax benefits
–Add the present value of the firm without
debt and the PV of tax savings

32. APV Method: Step 5
• Determine if deal makes sense:
–Does the PV of free cash flows to equity
investors plus tax benefits equal or
exceed the initial equity investment
including transaction-related fees?

33. Evaluating the Adjusted
Present Value Method
• Advantage: Simplicity.
• Disadvantages:
– Ignores the effect of changes in leverage on
the discount rate as debt is repaid,
– Implicitly ignores the potential for bankruptcy
of excessively leveraged firms, and
– Unclear whether true discount rate should be
the cost of debt, unlevered cost of equity, or
somewhere between the two.

34. Discussion Questions
1. Compare and contrast the cost of capital
and the adjusted present value valuation
methods?
2. Which do you think is a more appropriate
valuation method? Explain your answer.

35. Things to Remember…
• LBOs make the most sense for firms having stable cash flows,
significant amounts of unencumbered tangible assets, and strong
management teams.
• Successful LBOs rely heavily on management incentives to improve
operating performance and a streamlined decision-making process
resulting from taking the firm private.
• Tax savings from interest expense and depreciation from writing up
assets enable LBO investors to offer targets substantial premiums
over current market value.
• Excessive leverage and the resultant higher level of fixed expenses
makes LBOs vulnerable to business cycle fluctuations and
aggressive competitor actions.
• For an LBO to make sense, the PV of cash flows to equity holders
must equal or exceed the value of the initial equity investment in the
transaction, including transaction-related costs.