Shaky Assets Corp.

LBO Mini-case

Shaky Asset Corp. (SAC) currently has an invested capital equal to 25MEUR. SAC is
ineffeciently managed with an after-tax ROI of only 7% p.a. and an annual EBIT
growth rate equal to 4%. Management has indicated that the after-tax ROI can be
sustained 5 years, after which it will drop to the level of WACC. Current target
debt/assets ratio for SAC is 20% and the levered equity beta is 0.8. Current cost of
debt is 4% p.a.

An investment bank sees SAC as a tempting LBO case: operative improvements and
financial benefits could be enormous. The LBO plan would involve levering up SAC
to a target 75% debt/assets ratio and using the debt to repurchase shares.
Simultaneously the management team would be replaced and a new motivated
management team is expected to improve after-tax ROI to 10% p.a. and EBIT growth
of 4% p.a., both of which can be realized immediately and maintained at a constant
level for the next 10 years. Beyond that, competition is expected to push after-tax ROI
down to WACC levels.

The added debt would cause SAC bond rating to drop such that the expected cost of
all SAC debt would increase to 4.6% p.a. [Assume all debt levels are at target (market
valued) debt/assets ratio both before and after LBO].

Corporate tax rate is 29%. The market risk premium is assumed to be 5% p.a and the
risk free rate 2.5% p.a. Assume CAPM prices both equity and debt claims (=implied
debt beta obtainable from CAPM).

Question: How much value will the proposed LBO deal create for SCA owners?
SAC LBO Mini-Case Answer:

Step #1. Figure out old WACC

Before LBO Debt beta 0.3 [from CAPM (4%-2.5%)/5%]
Before-LBO Cost of levered equity 6.5% [CAPM 2.5%+0.8*5%]
Before-LBO WACC: 0.80*6.5% + 0.20*4%*0.71 = 5.768%

Step #2. Unlever the beta to get unlevered beta estimate using Hamada equation:
0.8 = βU + (βU-0.3)*0.71*20/80 <=> βU=0.72463.
Cost of unlevered equity 2.5%+0.72463*5% = 6.12314%.

Step #3. Valuation before LBO

KVDs:
Next year's EBIT(1-TaxRate) = 7%*25 =1.75 MEUR.
Plowback ratio 4%/7% = 0.57143
T=5, after that no growth.

Enterprise value (appr. formula "3.", supergrowth+nogrowth) =

1.75/0.05768 + 1.75*0.57143*5*(0.07-0.05768)/(0.05768*1.05768) = 31.35 MEUR of which
20% debt, 6.27 MEUR, and rest equity 25.08 MEUR.

Step #4. Post-LBO WACC:

Debt beta at 75% D/V ratio 0.42 [from CAPM (4.6%-2.5%)/5%]
Levered equity beta at target D/V ratio 75%: 0.72463+(0.72463-0.42)*0.71*75/25=1.3735
Cost of equity = 2.5%+1.3735*5% = 9.3675%
WACC = 0.25*9.3675%+0.75*4.6%*0.71 = 4.7914%.
(lower WACC despite higher financial risk, as "cheaper" debt instrument costing "only" 4.6%
is emphasized yielding tax savings)

Step #5. Valuation after LBO

KVDs:
Next year's EBIT(1-TaxRate) = 10%*25 =2.5 MEUR.
Plowback ratio 4%/10% = 0.4
T=10, after that no growth.

Enterprise value (appr.) =

2.5/0.047914 + 2.5*0.4*10*(0.10-0.047914)/(0.047914*1.047914) = 62.55 MEUR
of which 75% debt, 46.91 MEUR, and rest equity 15.64 MEUR.
Step #6. Deal for shareholders?
They get (46.91-6.27)=40.64 in cash from repurchase of shares with new debt
PLUS holdings equal to 15.64 MEUR, TOTAL= 56.28 MEUR compared to old holding of
25.08 MEUR. Increase is 31.2 MEUR, or 124%!

The final shareholder value consists of :

OLD equity 25.08

+ 7.37 value added from financial effects
+ 23.83 value added from operative improvements
= 56.28.

*) 7.37 = 32.45-25.08 where 32.45 from valuation without oper.improvements:

EV=1.75/0.047914+ 1.75*0.57143*5*(0.07-0.047914)/( 0.047914*1.047914) = 38.72 MEUR
of which 75% debt, 29.04 MEUR, and rest equity 9.68 MEUR.
Equity holders get 22.62 in cash and 9.68 holdings = 32.45.

As total value added was 31.2 MEUR of which 7.37 from financial effects, rest 23.83 must be
due to operative improvements.
SAC LBO MiniCase
Rf 2,50 %
MRP 5%
Taxrate 29 %

Before LBO After LBO

Inv.Cap. 25 25 MEUR
After-tax ROI 7% 10 %
Super-growth 4% 4%
T 5 10 years
Constant growth 0% 0%
Target D/V ratio 20 % 75 %
Cost of debt 4% 4,60 %
Levered equity beta 0,8 1,37349

Cost of equity 6,50 % 9,3674 %

WACC 5,7680 % 4,791359 %
Cost of unlevered equity 6,12314 %
Unlevered equity beta 0,72463
Debt beta 0,3 0,42

EBIT1(1-Tax) 1,75 2,5

Plowback ratio 57,143 % 40,000 %
Enterprise value 31,3495 62,5511
Debt 6,270 46,913
Equity 25,0796 15,6378

Equity holders receive 40,643 in cash

15,6378 holdings
56,2812 total
124,4 % 31,2016 increase

Before LBO FCFF:s & valuation 31,31633

After Tax EBIT Investments FCFF HV PV
1 1,75 -1 0,75 0,709099
2 1,82 -1,04 0,78 0,697246
3 1,8928 -1,0816 0,8112 0,685591
4 1,968512 -1,124864 0,843648 0,674131
5 2,04725248 -1,16985856 0,877394 36,913013 28,55026
6 2,129142579 0 2,129143
7 2,129142579 0 2,129143
8 2,129142579 0 2,129143
9 2,129142579 0 2,129143
10 2,129142579 0 2,129143
11 2,129142579 0 2,129143

After LBO FCFF:s & valuation 62,2056

After Tax EInvestment FCFF HV PV
1 2,5 -1 1,5 1,431416
2 2,6 -1,04 1,56 1,420606
3 2,704 -1,0816 1,6224 1,409878
4 2,81216 -1,12486 1,687296 1,399231
5 2,924646 -1,16986 1,754788 1,388664
6 3,041632 -1,21665 1,824979 1,378177
7 3,163298 -1,26532 1,897979 1,36777
8 3,289829 -1,31593 1,973898 1,357441
9 3,421423 -1,36857 2,052854 1,34719
10 3,55828 -1,42331 2,134968 77,2351 49,70522
11 3,700611 0 3,700611