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Valuing Acquisitions

In Practice 26.7: Valuing A Leveraged Buyout: Congoleum Inc.

The managers of Congoleum Inc targeted the firm for a leveraged buyout in 1979. They planned to buy back the stock at $38 per share (it was trading at $24 prior to the takeover) and to finance the acquisition primarily with debt. The breakdown of the cost and financing of the deal is provided below:

Cost of Takeover:

Buy back stock: $38 * 12.2 million shares : $463.60 million

Expenses of takeover: : $ 7.00 million

Total Cost : $ 470.60 million

Financing Mix for takeover:

Equity: : $ 117.30 million

Debt: : $ 327.10 million

Preferred Stock (@13.5%): : $ 26.20 million

Total Proceeds : $ 470.60 million

There were three sources of debt: 1. Bank debt of $125 million, at a 14% interest rate, to be repaid in annual installments of $16.666 million, starting in 1980. 2. Senior notes of $115 million, at 11.25% interest rate, to be repaid in equal annual installments of $7.636 million each year from 1981. 3. Subordinated notes of $92 million, at 12.25% interest, to be repaid in equal annual installments of $7.636 million each year from 1989. The firm also assumed $12.2 million of existing debt, at the advantageous rate of 7.50%; this debt would be repaid in 1982.

The firm projected operating income (EBIT), capital spending, depreciation and change in working capital from 1980 to 1984 as shown in Table 26.9 (in millions of dollars):

The earnings before interest and taxes were expected to grow 8% after 1984, and the capital spending is expected to be offset by depreciation[25]. Congoleum had a beta of 1.25 in 1979, prior to the leveraged buyout. The treasury bond rate at the time of the leveraged buyout was 9.5%. We begin the analysis by estimating the expected cash flows to the firm from 1980 to 1985. To obtain these estimates, we subtract the net capital expenditures and changes in working capital from the after-tax operating income.

We follow up by estimating the cost of capital for the firm each year, based upon our estimates of debt and equity each year. The value of debt for future years is estimated based upon the repayment schedule, and it decreases over time. The value of equity in each of the future years is estimated by discounting the expected cash flows in equity beyond that year at the cost of equity.

An alternative approach to estimating equity, which does not require iterations or circular reasoning, is to use the book value of equity rather than the estimated market value in calculating debt-equity ratios.[26] The cash flows to the firm and the cost of capital in the terminal year (1985), in conjunction with the expected growth rate of 8%[27], are used to estimate the terminal value of equity (at the end of 1984):

Terminal value of firm (end of 1984)

= FCFE1985/(ke,1985-08)

= $ 72.09/(.1421-.08) = $ 1161 million

The expected cash flows to the firm and the terminal value were discounted back to the present at the cost of capital to yield a present value of $ 820.21 million[28]. Since the acquisition of Congoleum cost only $ 470.6 million, this acquisition creates value for the acquiring investors.

--> merglbo.xls: This spreadsheet allows you to evaluate the cash flows and the value of a leveraged buyout.

--> CT 26.5: If the Congoleum acquisition creates value for the acquiring investors, what are the sources of the increase in value?


24 The numbers in this illustration were taken from the Harvard Business School case titled “Congoleum”. The case is reprinted in Fruhan, Kester, Mason, Piper and Ruback (1992).

25 We have used the assumptions provided by the investment banker, in this case. It is troubling, however, that the firm has an expected growth rate of 8% a year forever without reinvesting any money back.

26 The book value of equity can be obtained as follows: BV of Equityt = BV of Equityt-1 + Net Incomet It is assumed that there will be no dividends paid to equity investors in the initial years of a leveraged buyout.

27 While this may seem to be a high growth rate to sustain forever, it would have been appropriate in 1979. Inflation and interest rates were much higher then than in the 1990s.

28 When the cost of capital changes on a year-to-year basis, the discounting has to be based upon a cumulative cost. For instance, the cash flow in year 3 will be discounted back as follows: PV of cash flow in year 3 = 56.45/(1.13) (1.1329) (1.1366)

Prof. Aswath Damodaran

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