RJR Nabisco was facing stagnant share prices and high debt in 1988. Kohlberg, Kravis and Roberts (KKR) planned a buyout of RJR Nabisco that would issue $24 billion in new debt. A discounted cash flow valuation was performed to calculate the present value of RJR Nabisco under pre-bid management, management buyout, and KKR buyout scenarios using projected cash flows from 1989-1998 and a terminal value. The analysis found the total present value of RJR Nabisco to be $29.978 billion under the KKR buyout scenario, valuing the company at $109.07 per share.

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. 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. 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. 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. 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