Chapter 12

VALUING AND
ACQUIRING A
BUSINESS

Hawawini & Viallet Chapter 12 1

Background
 Objective of chapter
 How to value a business
• Either that of its assets or of its equity
 The focus is on the methods most commonly
used in valuing firms:
 Valuation by comparables
 Valuation by discounting the cash flows from the
firm’s assets
 Valuation using the adjusted present value approach
 OS Distributors is used to illustrate the methods
 Firm was also analyzed in Chapters 3-5
Hawawini & Viallet Chapter 12 2
Background
 After reading this chapter, students should
understand:
 The alternative methods used to value businesses
and how to apply them in practice to estimate the
value of a company
 Why some companies acquire other firms
 How to value a potential acquisition
 Why a high proportion of acquisitions usually fail to
deliver value to the shareholders of the acquiring firm
 Leveraged buyout (LBO) deals and how they
are put together
Hawawini & Viallet Chapter 12 3
Alternative Valuation Methods
 Most common approaches to valuing a
business:
 Valuation by comparables
• Comparing a business to similar firms in its sector,
 Discounted cash flow or DCF valuation
• Based on discounting a business’ future cash-flow stream at
a required rate of return
 Other measures of a business’ value:
 Liquidation value
 Replacement value

Hawawini & Viallet Chapter 12 4

Valuing A Firm’s Equity Using
Comparables
 The valuation by comparables method is applied to the
estimation of OS Distributors’ equity
 OS Distributors is an unlisted, privately owned firm,
 Financial statements are presented in Exhibits 12.1 and 12.2.
 The equity value that matters to investors is the market
value, not the book value
 Book value is only relevant to the extent that it provides some
useful information about the firm’s future performance.

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EXHIBIT 12.1a:
OS Distributors’ Balance Sheets.
Figures in millions of dollars

DEC. 31, 1998 DEC. 31, 1999 DEC. 31, 2000

ASSETS
CURRENT ASSETS $104.0 $119.0 $137.0
Cash1 $6.0 $12.0 $8.0
Accounts receivable 44.0 48.0 56.0
Inventories 52.0 57.0 72.0
Prepaid expenses2 2.0 2.0 1.0

NONCURRENT ASSETS 56.0 51.0 53.0

Financial assets & intangibles 0.0 0.0 0.0
Property, plant, & equip. (net)
Gross value3 $90.0 $90.0 $93.0
Accumulated depreciation (34.0) 56.0 (39.0) 51.0 (40.0) 53.0

TOTAL ASSETS $160.0 $170.0 $190.0

Hawawini & Viallet Chapter 12 6

EXHIBIT 12.1b:
OS Distributors’ Balance Sheets.
Figures in millions of dollars

DEC. 31, 1998 DEC. 31, 1999 DEC. 31, 2000

LIABILITIES AND
OWNER’S EQUITY
CURRENT LIABILITIES $54.0 $66.0 $75.0
Short-term debt $15.0 $22.0 $23.0
Owed to banks $7.0 $14.0 $15.0
Current portion of 8.0 8.0 8.0
long-term debt
Accounts payable 37.0 40.0 48.0
Accrued expenses4 2.0 4.0 4.0
NONCURRENT LIABILITIES 42.0 34.0 38.0
Long-term
- debt5 42.0 34.0 38.0
Owners’ equity6 64.0 70.0 77.0

TOTAL LIABILITIES AND

$160.0 $170.0 $190.0
OWNERS’ EQUITY
Hawawini & Viallet Chapter 12 7
 EXHIBIT 12.2a:
OS Distributors’ Income Statements.
Figures in millions of dollars

1998 1999 2000

% of % of % of
Net sales $390.0 Sales $420.0 Sales $480.0 Sales

Cost of goods sold ($328.0) ($353.0) ($400.0)

Gross profit 62.0 15.9% 67.0 15.9% 80.0 16.7%

Selling, general, &

administrative expenses (39.8) (43.7) (48.0)
Depreciation expenses (5.0) (5.0) (8.0)

Operating profit 17.2 4.4% 18.3 4.4% 24.0 5.0%

Extraordinary items 0 0 0

Earnings before interest & tax

(EBIT) 17.2 4.4% 18.3 4.4% 24.0 5.0%

Net interest expenses1 (5.5) (5.0) (7.0)

1 There is no interest income, so net interest expenses are equal to interest expenses.

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 EXHIBIT 12.2b:
OS Distributors’ Income Statements.
Figures in millions of dollars

1998 1999 2000

Earnings before tax (EBT) 11.7 3.0% 13.3 3.2% 17.0 3.5%

Income tax expense (4.7) (5.3) (6.8)

Earnings after tax (EAT) $7.0 1.8% $8.0 1.9% $10.2 2.1%

Dividends $2.0 $2.0 $3.2

Retained Earnings $5.0 $6.0 $7.0

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Estimating The Comparable
Value Of OS Distributors’ Equity
 Comparable company for OS Distributors
 General Equipment and Supplies (GES)
• Exhibit 12.3 shows accounting and financial market data for
the two companies
 Value of OS Distributors is estimated from
comparable market multiples on the premise
that
 Comparable firms should trade at the same market
multiples (historical or expected)
• The value varies between $146 million to $160 million
depending upon the multiple used

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EXHIBIT 12.3a:
Accounting and Financial Market Data for OS
Distributors and GES, a Comparable Firm.
GES OS DISTRIBUTORS

Accounting data (2000)

1. Earnings after tax (EAT) $63.5 million $10.2 million
2. “Cash earnings” = EAT $63.5 + $57.5 = $10.2 + $8 =
+ depreciation expenses $121 million $18.2 million
3. Book value of equity $526 million $77 million
4. Number of shares outstanding 50 million shares 10 million shares
5. Earnings per share or EPS [(1)/(4)] $1.27 $1.02
6. “Cash earnings” per share [(2)/(4)] $2.42 $1.82
7. Book value per share [(3)/(4)] $10.52 $7.70

Hawawini & Viallet Chapter 12 11

EXHIBIT 12.3b:
Accounting and Financial Market Data for OS
Distributors and GES, a Comparable Firm.
GES OS DISTRIBUTORS

Financial Market data (January 2001)

8. Share price $20 Not available

Multiples
9. Price-to-earnings ratio [(8)/(5)] 15.7 times Not available
10. Price-to-cash earnings ratio [(8)/(6)] 8.3 times Not available
11. Price-to-book value ratio [(8)/(7)] 1.9 times Not available

Hawawini & Viallet Chapter 12 12

Factors That Determine Earnings
And Cash-flow Multiples
 Earnings and cash earnings multiples are
affected by
 General market environment
• Such as the prevailing level of interest rates
 Factors unique to companies
• Such as their expected growth and perceived risk
 DCF formula is used to explain why
• Companies with high expected rates of growth and low
perceived risk usually have high multiples
• Multiples increase in an environment of declining interest
rates

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Factors That Determine Earnings
And Cash-flow Multiples
 When comparing values of firms in
different countries (and even in different
industries within the same country)
 Cash earnings multiples should be used
rather than accounting earnings multiples
• Neutralizes some of the distortions introduced by
differences in accounting rules across countries
(and across industries within a country)

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EXHIBIT 12.4:
Multiples for Three Markets.
UNITED STATES UNITED KINGDOM JAPAN
(New York (London (Toyko
MULTIPLE1 Stock Exchange) Stock Exchange) Stock Exchange)

Price-to-earnings 29.1 21.5 57.1

1 Datastream, 4th quarter 2000.

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Valuing A Firm’s Assets And Equity
Using The Discounted Cash Flow
Approach
 Estimating the DCF value of a firm’s assets
 According to the DCF method, the value of an asset
is determined by
• Capacity of that asset to generate future cash flows
 Starting with the case of a company with no
expected growth, we
• Examine the impact of factors such as expected growth and
risk
• Provide general formulas to value assets, cash flows and
cost of capital

Hawawini & Viallet Chapter 12 16

Valuing A Firm’s Assets And Equity
Using The Discounted Cash Flow
Approach

 The impact of the growth of cash flows

on their DCF value
 The faster the growth rate in cash flows, the
higher is their discounted value
 The impact of the risk associated with
cash flows on their DCF value
 The higher the risk of a cash-flow stream, the
lower is its discounted value

Hawawini & Viallet Chapter 12 17

Valuing A Firm’s Assets And Equity
Using The Discounted Cash Flow
Approach
 A general formula to calculate the DCF value of a
firm’s assets
 Equation 12.3 is the formula to use in calculating the DCF value
of a firm’s assets
CFA1 CFA 2 CFA t
DCFvalue = + +…+ +…
1+k  1+k  1+k 
1 2 t

 To estimate the DCF value of a company’s assets

• Expected cash flows from these assets should be estimated first
and
• Then discounted at a required rate of return that reflects their risk
• With riskier expected cash flows discounted at a higher rate

Hawawini & Viallet Chapter 12 18

Valuing A Firm’s Assets And Equity
Using The Discounted Cash Flow
Approach
 Estimating the cash flows generated by assets
 The net cash flow from assets, called cash flow from assets
or CFA (often referred to as free cash flow) is the cash flow
generated by the firm’s operating and investing activities
• Any items related to the firm’s financing activities are excluded
 Expected CFA and operating margin from the firm’s assets
(earnings before interest and tax, or EBIT) are related
CFA = EBIT(1 - TC )  Depreciation expenses - WCR
- Net capital expenditures

Hawawini & Viallet Chapter 12 19

Valuing A Firm’s Assets And Equity
Using The Discounted Cash Flow
Approach
 Estimating the rate of return required to
discount the cash flows
 The minimum required rate of return used to
discount the cash flows generated by assets must be
at least equal to the cost of financing the assets
• Weighted average cost of capital (WACC) is the relevant
discount rate
equity debt
WACC =  kE +  kD 1-tax rate 
equity + debt equity + debt

• Capital asset pricing model (CAPM) is an approach to

estimating the cost of equity financing
kE = RF  market risk premium  β
Hawawini & Viallet Chapter 12 20
Estimating The DCF Value Of A
Firm’s Equity
 Buying the firm’s assets is not the same
as buying that firm’s equity
 If we buy a firm’s equity from its existing
owners, we will own the firm’s assets and we
will also assume the firm’s existing debt
 The estimated DCF value of a firm’s
equity is the difference between the DCF
value of its assets and the value of its
outstanding debt

Hawawini & Viallet Chapter 12 21

Estimating The DCF Value Of OS
Distributors’ Assets And Equity
 Example: Conducting a DCF valuation
using the valuation of OS Distributors’
assets and equity
 Assumed that the firm will stay as is, i.e. its
operating efficiency remains the same as in
2000
 Stand-alone value is estimated in a four-
step procedure

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Estimating The DCF Value Of OS
Distributors’ Assets And Equity
 Step 1: Estimation of OS Distributors’ cash flow
from assets
 When estimating the DCF value of a firm’s assets,
the usual forecasting period is five years,
• In the case of OS Distributors from 2001 to 2006
 When a firm is valued as a going concern, we also
need to estimate the terminal (or residual) DCF
value of its assets, at the end of the forecasting
period
• Value is based on the cash flows the firm’s assets are
expected to generate beyond the forecasting period

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Estimating The DCF Value Of OS
Distributors’ Assets And Equity
 Estimating the cash flows from assets up to year
2006
 The forecast of OS Distributors’ cash flows and their DCF value
are shown in Exhibit 12.5
• Assumed that the growth rate will drop from 10 percent to a
residual level of 3 percent at the end of the forecast period
• After the growth rates are estimated, expenses are calculated as a
percentage of sales
• Since OS Distributors is valued as is, no major investments are
expected beyond the maintenance of existing assets
• Maintenance costs are assumed to be exactly the same as the
annual depreciation expenses
• Issue of consistency in making forecasts
• For example, if the firm’s activities are assumed to slow down, so
should its capital expenditure and depreciation expenses

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Estimating The DCF Value Of OS
Distributors’ Assets And Equity
 Estimating the residual value of assets
at the end of year 2005
 Use the constant growth formula to estimate
the residual value of OS Distributors’ assets
at the end of year 2005
• The firm’s rate of growth in perpetuity after the
year 2006 is the residual level of 3 percent, the
estimated secular growth rate of the entire
economy
• WACC is the one estimated in step 2

Hawawini & Viallet Chapter 12 25

Estimating The DCF Value Of OS
Distributors’ Assets And Equity
 Step 2: Estimation of OS Distributors’ weighted average cost of
capital
 The relevant rate at which to discount the cash flows from the
business’ assets is the business’ WACC
• The appropriate proportions of equity and debt financing must be based on
market values of equity and debt, not their accounting values
• Because OS Distributors is not a listed company, the comparable firm’s (GES)
debt ratio is used (70 percent of equity and 30 percent of debt)
• The cost of debt is the after-tax cost of new borrowing, or 4.5 percent
• The cost of equity is estimated using the CAPM
• The GES beta of 1.14 is used as a proxy of OS Distributors’ beta. The market
risk premium over the government bond rate is 6.2 percent and the risk free rate
is 6 percent
• The estimated value of OS Distributors’ WACC is 10.5 percent, with a cost
of equity of 13.07 percent

Hawawini & Viallet Chapter 12 26

Estimating The DCF Value Of OS
Distributors’ Assets And Equity
 Step 3: Estimation of the DCR value of OS Distributors’ assets
 The general valuation formula is used to estimate the value of OS
Distributors’ assets
• Calculated value: $217 million
• High proportion of the residual value in comparison to the yearly OS Distributors’
cash-flow estimates is not that unusual
• Particularly in cases where the growth rates during the forecasting period
are not exceptionally high and are assumed to decline steadily toward their
perpetual level
 Step 4: Estimation of the DCF value of OS Distributors’ equity
 The estimated value of OS Distributors’ equity ($156 million) is found
as
• Estimated value of its assets ($217 million) less the book value of its
outstanding debt at the end of 2000 ($61 million)

Hawawini & Viallet Chapter 12 27

EXHIBIT 12.5a:
Discounted Cash Flow (DCF) Valuation of OS
Distributors’ Equity at the Beginning of Jan. 2001.
Figures in millions of dollars; historical data from Exhibits 12.1 and 12.2

HISTORICAL DATA
1998 1999 2000

1. Sales growth rate 7.7% 14.3%

2. COGS1 in percent of sales 84.10% 84.05% 83.33%
3. 1
SG&A in percent of sales 10.21% 10.40% 10.00%
4. WCR1 in percent of sales 15.13% 15.00% 16.04%
5. Sales $390.0 $420.0 $480.0
6. less COGS (328.0) (353.0) (400.0)
7. less SG&A (39.8) (43.7) (48.0)
8. less depreciation expenses (5.0) (5.0) (8.0)
9. equals EBIT 1 17.2 18.3 24.0
10. EBIT × (1 – Tax rate of 40%) $10.3 $11.0 $14.4
11. plus depreciation expenses 5.0 5.0 8.0
12. WCR at year-end 59.0 63.0 77.0
13. less  WCR (change in (12)) (4.0) (14.0)
14. less net capital expenditures (0.0) (10.0)
15. equals cash flow from assets –$1.6
16. Residual value of assets at the end of year 2005

Hawawini & Viallet Chapter 12 28

EXHIBIT 12.5b:
Discounted Cash Flow (DCF) Valuation of OS
Distributors’ Equity at the Beginning of Jan. 2001.
Figures in millions of dollars; historical data from Exhibits 12.1 and 12.2

ESTIMATED CASH FLOWS TO YEAR 2006

2001 2002 2003

1. Sales growth rate 10% 8% 7%

2. COGS1 in percent of sales 83.33% 83.33% 83.33%
3. 1
SG&A in percent of sales 10.00% 10.00% 10.00%
4. WCR1 in percent of sales 16.04% 16.04% 16.04%
5. Sales $528.0 $570.2 $610.1
6. less COGS (440.0) (475.2) (508.4)
7. less SG&A (52.8) (57.0) (61.0)
8. less depreciation expenses (8.0) (8.0) (7.0)
9. equals EBIT 1 27.2 30.0 33.7
10. EBIT × (1 – Tax rate of 40%) $16.3 $18.0 $20.2
11. plus depreciation expenses 8.0 8.0 7.0
12. WCR at year-end 84.7 91.5 97.9
13. less  WCR (change in (12)) (7.7) (6.8) (6.4)
14. less net capital expenditures (8.0) (8.0) (7.0)
15. equals cash flow from assets $8.6 $11.2 $13.8
16. Residual value of assets at the end of year 2005

Hawawini & Viallet Chapter 12 29

EXHIBIT 12.5c:
Discounted Cash Flow (DCF) Valuation of OS
Distributors’ Equity at the Beginning of Jan. 1998.
Figures in millions of dollars; historical data from Exhibits 12.1 and 12.2

ESTIMATED CASH FLOWS TO YEAR 2006

2004 2005 2006

1. Sales growth rate 5% 4% 3%

2. COGS1 in percent of sales 83.33% 83.33% 83.33%
3. 1
SG&A in percent of sales 10.00% 10.00% 10.00%
4. WCR1 in percent of sales 16.04% 16.04% 16.04%
5. Sales $640.7 $666.3 $686.3
6. less COGS (553.9) (555.2) (571.9)
7. less SG&A (64.1) (66.6) (68.6)
8. less depreciation expenses (6.0) (6.0) (6.0)
9. equals EBIT 1 36.7 38.5 39.8
10. EBIT × (1 – Tax rate of 40%) $22.0 $23.1 $23.9
11. plus depreciation expenses 6.0 6.0 6.0
12. WCR at year-end 102.8 106.9 110.1
13. less  WCR (change in (12)) (4.9) (4.1) (3.2)
14. less net capital expenditures (6.0) (6.0) (6.0)
15. equals cash flow from assets $17.1 $19.0 $20.7
16. Residual value of assets at the end of year 2005 $276.0

Hawawini & Viallet Chapter 12 30

EXHIBIT 12.5d:
Discounted Cash Flow (DCF) Valuation of OS
Distributors’ Equity at the Beginning of Jan. 1998.
Figures in millions of dollars; historical data from Exhibits 12.1 and 12.2

HISTORICAL DATA
BEGINNING 2001

17. WACC1 10.5%

18. DCF1 value of assets at 11.25% $217
19. less book value of debt (short-term and long-term $61
20. equals DCF value of equity $156
1 COGS = Cost of goods sold, SG&A = Selling, general, and administrative expenses, EBIT =
Earning before interest & tax, WCR = Working capital requirement, WACC = Weighted average cost
of capital, DCF = Discounted cash flow.

Hawawini & Viallet Chapter 12 31

Comparison Of DCF Valuation
And Valuation By Comparables
 The DCF value of OS Distributors’ equity
is lower than any of the values estimated
from comparable multiples
 The fair value of OS Distributors is probably
closer to the DCF value than to any of its
comparable values
• Because DCF valuation is based on the projected
cash flows from OS Distributors’ own assets
• Rather than on a mix of financial market and accounting
data from another company (GES)

Hawawini & Viallet Chapter 12 32

Estimating The Acquisition
Value Of OS Distributors
 The DCF equity value determined as is does not take into account
any potential improvement in managing the firm
 Such improvements—usually expected when the firm is acquired by
another one—result in potential value creation
 When a firm acquires another one, the potential value creation is
shared between the acquirer and the target
 If we call takeover premium the portion going to the target
• Then the net present value of the investment made by the acquirer is the
difference between the potential value creation and the takeover premium
 To estimate the acquisition value of a firm, must first identify the
potential sources of value creation in an acquisition
 If those sources are not present, such as in a conglomerate merger,
an acquisition is not likely to create value

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Identifying The Potential Sources Of
Value Creation In An Acquisition
 In order to create value an acquisition must achieve one
of the following:
 Increase the cash flows generated by the target firm’s assets
 Raise the growth rate of the target firm’s sales
 Lower the WACC of the target firm
 Inefficient management and synergy provide the
most powerful reasons to justify an acquisition
 Other reasons
• Undervaluation hypothesis
• Market power hypothesis

Hawawini & Viallet Chapter 12 34

Identifying The Potential Sources Of
Value Creation In An Acquisition
 Specific sources of value creation in an
acquisition
 Increasing the cash flows generated by the target
firm’s assets
• A reduction in a firm’s cost of goods sold or in its selling,
general, and administrative expenses will increase its
operating profits, thus increasing the firm’s cash flows
• A reduction in tax expenses will have the same effect
• Another way to increase the target firm’s cash flows is to
use its assets more efficiently
• A more efficient use of assets can be achieved by reducing
any over-investment (e.g. in cash, working capital requirement
or in fixed assets)

Hawawini & Viallet Chapter 12 35

Identifying The Potential Sources Of
Value Creation In An Acquisition
 Raising the sales growth rate
• All other things being equal, faster growth in sales will
create additional value
• Can be achieved by increasing the volume of goods or
services sold and/or by raising their price using superior
marketing skills and strategies
 Lowering the cost of capital
• If the target firm’s capital structure is currently not close to
its optimal level, then changing the firm’s capital structure
when the firm is acquired should lower its WACC and raise
its value

Hawawini & Viallet Chapter 12 36

Identifying The Potential Sources Of
Value Creation In An Acquisition
 A merger is unlikely to lead to a reduction in the
cost of equity
 Often argued that if the merged firms are perceived
by their creditors to be less likely to fail as a
combination than as separate entities
• Then their post-merger cost of debt could be lower
(coinsurance effect)

Hawawini & Viallet Chapter 12 37

Why Conglomerate Mergers Are Unlikely
To Create Lasting Value Through
Acquisition
 Conglomerate merger may increase the
conglomerate’s earnings per share (EPS)
 But the growth in EPS is unlikely to be accompanied
by a permanent rise in shareholder value
• Acquiring unrelated businesses is unlikely to create
lasting value
• May make sense from the perspective of the acquirer’s
managers, but it is unlikely to create value
• Since investors can generate the same value by
combining shares of the two companies in their personal
portfolios (homemade diversification)
• Only types of mergers that are likely to create lasting
value are those that result in managerial improvements or
synergistic gains (i.e. horizontal or vertical mergers)

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Why Conglomerate Mergers Are Unlikely
To Create Lasting Value Through
Acquisition
• Raising earnings per share through
conglomerate mergers is unlikely to create
lasting value
• Some conglomerates grow rapidly by continuously
buying firms that have a lower price-to-earnings (P/E)
ratio than the P/E of the conglomerate firm, on the
premise that
• Market will value the combination for more than the
sum of the pre-merger firms

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EXHIBIT 12.6a:
Data for a Conglomerate Merger
Based on Raising EPS.
THE ACQUIRING THE TARGET
FIRM FIRM

1. Earnings after tax $300 million $200 million

2. Number of shares 150 million 100 million
3. Price-to-earnings ratio (P/E) 20 10
4. Earnings per share (EPS) = (1)/(2) $2.00 $2.00
5. Share price = (3) × (4) $40 $20
6. Total value = (2) × (5) $6,000 million $2,000 million

Exhibit 12.6 demonstrates that if such an acquisition is a simple

combination that does not create any value and the market is not fooled,
the share price will remain unchanged. If, on the other hand, the market
is fooled, the acquirer could then use its higher share price to make
another acquisition and continue to do so, until the bubble bursts.

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EXHIBIT 12.6b:
Data for a Conglomerate Merger
Based on Raising EPS.
VALUE OF THE MERGED FIRM IF
THE MARKET ASSIGNS THE
COMBINATION A P/E THAT
IS VALUE EXCEEDS VALUE
NEUTRAL NEUTRALITY

1. Earnings after tax $500 million $500 million

2. Number of shares 200 million 200 million
3. Price-to-earnings ratio (P/E) 16 18
4. Earnings per share (EPS) = (1)/(2) $2.50 $2.50
5. Share price = (3) × (4) $40 $45
6. Total value = (2) × (5) $8,000 million $9,000 million

Hawawini & Viallet Chapter 12 41

The Acquisition Value Of OS
Distributors’ Equity
 To consider OS Distributors an acquisition target
 Potential acquirer first would have to determine that OS Distributors’
performance could be improved
 Assume that a prospective acquirer of OS Distributors has identified
four separate improvements that would result in a potential value
creation
 Reduction in cost of goods sold
 Reduction in administrative and selling expenses
 More efficient management of the operating cycle
 Faster growth
• The value impact of those improvements is presented in Exhibits 12.7, 12.8,
and 12.9
 Overconfidence about the acquirer’s ability to realize the full potential
of a target often leads to paying too much for the target
 Almost all of the gains from the acquisition end up in the pockets of the
target company’s shareholders
Hawawini & Viallet Chapter 12 42
EXHIBIT 12.9:
Summary of Data in Exhibits 12.7 and 12.8.
SOURCES OF VALUE CREATION POTENTIAL VALUE CREATION

1. Reduction in the cost of goods sold to

82.33% of sales $42 million (39%)
2. Reduction in overheads to 9.50% of sales $21 million (20%)
3. Reduction of working capital requirement
to 13% of sales $22 million (21%)
4. Faster growth in sales (2 percentage
points higher) $14 million (13%)
5. Interaction of growth and improved
operations $8 million ( 7%)

Total potential value creation $107 million (100%)

Hawawini & Viallet Chapter 12 43

Estimating The Leveraged
Buyout Value Of OS Distributors
 In a typical leveraged buyout (LBO)
 Group of investors purchases a presumably underperforming
firm by raising an unusually large amount of debt relative to
equity funding
 Assume that the top managers of OS Distributors buy
the firm from the current owner for $200 million
 Financed by $160 million of debt and $40 million of equity
 Exhibit 12.10 compares OS Distributors’ balance
sheets before and after the LBO
 Key issues regarding the LBO of OS Distributors are:
• Whether the acquisition is a value-creating investment
• Whether the acquired assets will generate sufficient cash to
service the LBO loan

Hawawini & Viallet Chapter 12 44

EXHIBIT 12.10:
Comparison of OS Distributors’ Balance Sheet
Before and After the LBO.
Figures in millions of dollars; before-LBO figures from Exhibit 12.1

BALANCE SHEET BEFORE THE LBO AFTER THE LBO

Cash 8 (6%) 8 (4%)

Working capital requirement 77 (56%) 77 (39%)
Net fixed assets 53 (38%) 115 (57%)
Net assets $138 $200
Total debt 61 (44%) 160 (80%)
Equity 77 (56%) 40 (20%)
Total capital $138 $200

Hawawini & Viallet Chapter 12 45

Estimating The Leveraged Buyout
Value Of OS Distributors Equity
 DCF approach assumes that the WACC will
remain constant
 Not the case in an LBO, where a large portion of the
corresponding loan is repaid over just a few years
• This problem is circumvented using the adjusted present
value (APV) method
• The adjusted present value method
• DCF value of a firm’s assets is first estimated assuming
they are not financed with debt
• Then DCF value of future tax savings due to borrowing,
estimated by discounting the future stream of tax savings
at the cost of debt, is added

Hawawini & Viallet Chapter 12 46

Estimating The Leveraged Buyout
Value Of OS Distributors Equity
 The leveraged buyout value of OS Distributors’ equity
 Note that in a merger, some of the performance improvements are
expected to come from synergistic gains resulting from combining the
two businesses
 In an LBO, all the improved performance must come from better
management of the firm
 OS Distributors’ unlevered cost of equity
 First, OS Distributors’ asset beta is calculated
 Then CAPM is used to estimate the firm’s unlevered cost of equity
(12.2 percent)
 OS Distributors’ equity value
 APV valuation steps are described in Exhibit 12.11
• At a purchase price of $200 million, the LBO has the potential to create $82
million of value

Hawawini & Viallet Chapter 12 47

 EXHIBIT 12.11a:
Estimated Leveraged Buyout (LBO) Value of OS
Distributors’ Assets at the Beginning of January 2001.
Figures in millions of dollars.

2001 2001 2002 2003 2004 2005 2006

Value of unlevered assets
Unlevered cost of equity = 11.6%
1. Cash flow from assets (Exhibit 12.8) $28.7 $17.2 $20.5 $24.3 $26.9 $30.5
2. Residual value of assets at end of $354.6
year 2005
3. DCF value of unlevered assets $290.0
Value of tax savings on additional
depreciation expenses
Discount rate = 9.5%
4. Additional depreciation expenses for $10.0 $10.0 $10.0 $10.0 $10.0 $10.0
10 years
5. Tax savings on depreciation (tax rate $4.0 $4.0 $4.0 $4.0 $4.0 $4.0
= 40%)
6. Residual value of tax savings $15.4
7. DCF value of tax savings from $25.1
deprecation
Hawawini & Viallet Chapter 12 48
 EXHIBIT 12.11a:
Estimated Leveraged Buyout (LBO) Value of OS
Distributors’ Assets at the Beginning of January 2001.
Figures in millions of dollars.

2001 2001 2002 2003 2004 2005 2006

Value of tax savings on interest expenses
Cost of debt = 9.5%
8. Debt outstanding at the beginning of the $160.0 $145.0 $130.0 $115.0 $100.0 $85.0
year
9. Debt repayment $15.0 $15.0 $15.0 $15.0 $15.0
10. Debt outstanding at the end of the year $145.0 $130.0 $115.0 $100.0 $85.0 $87.6
11. Interest Expenses (interest rate = 9.5%) $15.2 $13.2 $12.4 $10.9 $9.5 $8.3
12. Tax savings on interest expenses (tax rate $6.1 $5.5 $5.0 $4.4 $3.8 $3.3
= 40%)

13. Residual value of tax savings $50.8

14. DCF value of tax savings from interest $51.7
expenses
15. DCF value of overall tax savings (7+14) $76.8
16. DCF value of levered assets 3+15 $366.8

Hawawini & Viallet Chapter 12 49

 EXHIBIT 12.12a:
Financing OS Distributors’ Leveraged Buyout.
Figures in millions of dollars.

2001 2001 2002 2003 2004 2005 2006

I. Cash flow implications
1. Total cash flows from assets
1.1 Cash flow from assets $28.7 $17.2 $20.5 $24.3 $26.9 $30.5
1.2 Tax savings on additional depreciation 4.0 4.0 4.0 4.0 4.0 4.0
1.3 Total cash flow from assets $32.7 $21.2 $24.5 $28.3 $30.9 $34.5
2. Cash flow to debtholders
2.1 Debt outstanding at the end of the year $145.0 $130.0 $115.0 $100.0 $85.0 $87.6
2.2 Aftertax interest payment 9.1 8.3 7.4 6.5 5.7 5.0
2.3 Debt repayment 15.0 15.0 15.0 15.0 15.0 Zero
2.4 Total aftertax cash flow to debtholders $24.1 $23.3 $22.4 $21.5 $20.7 $5.0
3. Cash flow to equity holders $8.6 ($2.1) $2.1 $6.8 $10.2 $29.5
4. Cumulative cash flow to equity holders $8.6 $6.5 $8.6 $15.4 $25.6 $55.1

Part I of Exhibit 12.12 reports the impact on cash flows of the LBO deal.

Hawawini & Viallet Chapter 12 50

 EXHIBIT 12.12b:
Financing OS Distributors’ Leveraged Buyout.
Figures in millions of dollars.

2001 2001 2002 2003 2004 2005 2006

II. Pro forma income statements
Earnings before interest and tax (EBIT) $24.0 $35.9 $40.3 $45.7 $50.4 $53.7 $55.5
Additional depreciation (0) (10.0) (10.0) (10.0) (10.0) (10.0) (10.0)
Interest expenses (7.0) (15.2) (13.8) (12.4) (10.9) (9.5) (8.3)
Earnings before tax (EBT) $17.0 $10.7 $16.5 $23.3 $29.5 $34.2 $37.2
Tax (40%) (6.8) (4.3) (6.6) (9.3) (11.8) (13.7) (14.9)
Earnings after tax (EAT) $10.2 $6.4 $9.9 $14.0 $17.7 $20.5 $22.3
III. Capital and debt ratios
Debt outstanding (from above) $61.0 $145.0 $130.0 $115.0 $100.0 $85.0 $87.6
Equity capital $77.0 $46.4 $56.3 $70.3 $88.0 $108.5 $130.8
Total capital $138.0 $191.4 $186.3 $185.3 $188.0 $193.5 $218.4
Ratio of debt to total capital 44% 76% 70% 62% 53% 44% 40%

Part II presents the proforma income statements of OS Distributors based on current expectations.
Part III estimates the impact of the LBO on the firm’s debt ratio from 1998 to 2003. The analysis
shows that if the management team is confident that it can rapidly improve the firm’s performance,
it should go ahead with the deal.
Hawawini & Viallet Chapter 12 51
Will OS Distributors Be Able
to Service Its Debt?
 Although the LBO deal makes sense from a
value-creation perspective
 OS management must still meet the challenge of
servicing an inordinate amount of debt
• Particularly the heavy burden of early and rapid principal
repayment
 Good candidates for an LBO acquisition
 Underperforming firms in stable and predictable
industries
 Ultimately, the key to a successful LBO is a rapid
restructuring of the firm’s assets

Hawawini & Viallet Chapter 12 52

EXHIBIT 12.13:
Alternative Equity Valuation Models.

Hawawini & Viallet Chapter 12 53