lecture 10 - more on apv

8/10/2019 Lecture 10 - More on APV

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Lecture 10

More on APV



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Objectives

• We now focus on the case you would use APV and not

WACC or FTE: Debt financing has a f ixed schedule !

• Illustrate how financing effects other than interest taxshields can be incorporated in the APV valuation.

– Flotation costs – Financing subsidies

• Show how APV is useful to identify a project’s sources of

value and discuss how you could use that information.

• Illustrate a realistic setting where industry specialistsoften use APV and why. The case of LBOs.



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Chrysler’s Acquisition of Delphi (I made this up!)

Mr. Lufkin, Chairman and CEO of Chrysler, is considering theacquisition of Delphi, the privately held auto-parts supplierfully owned by General Motors.

Inefficiencies in the production process made Delphi’s

products more expensive than those of competing auto-partsuppliers, and management failed to successfully restructureits operations to gain competitiveness.

At the same time, the workers’ strike at GM is imposing

losses on the firm, which now needs liquidity to continuefunding its auto production.

Thus, GM has publicly announced that Delphi is up for salefor $150,000.



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Delphi’s Pro-Forma Income Statement

Delphi’s current management reports the Income Statementfor the last year (year 0) and their estimates assuming nobig change in operations for the following 4 years as follows:

Year 0 Year 1 Year 2 Year 3 Year 4

Revenues 20,000 18,000 18,005 19,005 24,005COGS (12,000) (10,800) (10,803) (11,403) (14,403)

Depreciation (1,000) (1,000) (1,000) (1,000) (1,000)

EBIT 7,000 6,200 6,202 6,602 8,602

Interest expense (2,000) (1,999) (1,998) (1,997) (1,996)Pre-tax income 5,000 4,201 4,204 4,605 6,606

Taxes @ 34% (1,700) (1,428) (1,429) (1,566) (2,246)

Net income 3,300 2,773 2,775 3,039 4,360



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Other Information to Value Delphi

Based on their previous experience with their own auto-suppliers, Mr. Lufkin believes that Chrysler’s managementcan rationalize Delphi’s production line, which would result ina reduction of operating costs to about 50% of sales.

He estimates that additions to net working capital will be

$500 and capital expenditures will be $1000 for each of thefollowing four years (years 1 to 4), and negligible afterwards.

He estimates that depreciation will be negligible after year 4.

He estimates that Delphi’s free cash flow will grow at aconstant rate of 2% per year starting in year 5.

Delphi, as well as other auto-part suppliers in the industry,faces a tax rate of 34%.



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Other Information to Value Delphi

Delphi is not a traded company, so no market value of equityor cost of equity is available.

However, there are two other major auto-parts suppliers thatare publicly traded and are similar to Delphi in terms of their

asset size.

One of them has a historical debt-to-equity ratio of about 1.26and beta of .6. The other usually maintains a debt-to-equityratio of .8 and has a beta of .4.

The annualized yield on the 3-month Treasury Bills is 4%,while the average return on the value-weighted market indexduring the last 50 years is 15%.



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The Financing of Delphi’s Acquisition

Chrysler can raise a total of $60,000 in debt:

$40,000 (gross proceeds) with a 15-year bond at 14%.Flotation costs for this bond are 2% of the gross proceeds,and can be amortized straight-line over the life of the bond.

$20,000 (gross proceeds) with a 10-year government-sponsored bond at 8%, which will have the same risk as the10-year Treasury Bonds that yield 10% per year. The

government would absorb the flotation costs (2% as well).

Both bonds have annual interest payments and principal isdue in the last year.



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Outline of Exercise

• What is Delphi’s all-equity value under current

management?

• What is Delphi’s all-equity value under Chrysler’smanagement?

• What are the financing-side effects? – Flotation costs

– Financing subsidies

• What is Delphi’s APV and should Chrysler buy it for$150,000?

• What are the sources of value?



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1. All-equity value under current management

• What are the steps we need to follow?

• Calculate Delphi’s unlevered cost of capital

• Assume that cash flows starting in year 1 will accrue tothe buyer and that we want the value as of date 0.

– Calculate unlevered cash flows for early years

– Calculate cash flows for later years – these will lead

to a terminal value estimate

• Discount cash flows back to year 0 using the unleveredcost of equity



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Delphi’s Unlevered Cost of Equity

• Assume debt beta=0 for sup 1, sup 2, and for Chrysler

• Supplier 1’s βU = .6/[1+1.26×(1-.34)]= 0.3276

• Supplier 2’s βU = .4/[1+.8×(1-.34)]= 0.2618

• Delphi’s βU = [0.3276+0.2618]/2 = 0.2947

• Into CAPM gives:

r U = 4% + 0.2947×[15%-4%] = 7.24%



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Delphi’s Future Free Cash Flows

Year 1 2 3 4

+ EBIT(1- τC) 4,092 4,093 4,357 5,677

+ Depr 1,000 1,000 1,000 1,000

= OCF 5,092 5,093 5,357 6,677

- ΔNWC (500) (500) (500) (500)

- CapEx (1,000) (1,000) (1,000) (1,000)

= FCF 3,592 3,593 3,587 5,177

Recall FCF = EBIT × (1-τC) + Dep. – ∆NWC – CapEx

Recall Mr. Lufkin believes the FCF will grow at 2% per yearstarting in year 5, so this will lead to a terminal value estimate.



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All-equity value under currentmanagement

• VU0(FCFs yrs 1-4) = 3,592/1.0724 + 3,593/1.07242 + 3,857/1.07243 + 5,177/1.07244 = $13,515.4

• VU4(CFs yrs 5 on) = (5,177×1.02)/(.0724-.02)= $100,773.7

• VU0(CFs yrs 5 on) = $100,773.7/1.07244

= $76,193.8

• VU0 = $13,515.4 + $76,193.8 = $89,709.2



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2. All-equity value under NEW management

Year 1 2 3 4

+ EBIT(1-τC) 5,280 5,282 5,612 7,262

+ Depr 1,000 1,000 1,000 1,000

= OCF 6,280 6,282 6,612 8,262- ΔNWC (500) (500) (500) (500)

- Capex (1,000) (1,000) (1,000) (1,000)

= FCF 4,780 4,782 5,112 6,762

Recalculate your future FCFs using COGS=50% of sales to get:

VU0= 4,780/1.072 + 4,782/1.0722 + 5,112/1.0723 + 6,762/1.0724 + (1/1.0724)×(1.02×6,762)/(.072-.02) = $118,326.9

Chrysler’s managers add $28,617.7 to Delphi’s all-equity value



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3. Financing-Side Effects

• 15-year regular debt for $40,000 at 14% (RD) – Flotation costs

– Interest tax shields

• 10-year govt. sponsored debt for $20,000 at 8% (GSD)

– No flotation costs

– Interest tax shields

– Subsidy (i.e., borrow at below-market rates!)



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Regular Debt – Flotation Costs

• Flotation costs (FC) are 2% of the $40,000 raised. Amortized straight-line over 15 years. r D = 14%; τC = 34%.

• FC = 0.02×40,000 = $800

• Annual amortization = $800/15• How to discount tax shields from flotation costs? Assume

they have the same risk as debt – you will cease to getthem if you default on debt payments.

• A(15 yrs,14%) = [1-1/(1.1415)]/.14 = 6.1422

• V0(FC) = -800 + (800/15)×.34×6.1422 = -$688.6



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Regular Debt – Interest Tax Shields

V0(D) = D – D×r D× A(r D,t) – D/(1+r D)t + D×r D×τC× A(r D,t)

= D – D×r D×(1-τC)× A(r D,t) – D/(1+r D)t

How to discount debt payments and interest tax shields?

Two ways to compute the debt’s NPV:

V0(RD) = 40,000 – 40,000×.14×(1-.34)×6.1422 - 40,000/1.1415 = $11,694.7

OR

V0(RD) = + 40,000×.14×.34×6.1422 = $11,694.7



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Regular Debt – Total Financing Effect

• Value of flotation costs = -$688.6

• Value of interest tax shields = + $11,694.7

• Total Value of regular debt = + $11,006.1



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Government-Sponsored Debt

What is peculiar about this debt? Calculate its NPV.

The debt carries interest tax shields & a subsidy (8%<10%) .

How to discount debt payments and interest tax shields?

A(10 yrs,10%) = [1-1/(1.1010)]/.1 = 6.1446

V0(GSB) = 20,000 – 20,000×.08×(1-.34)×6.1446 - 20,000/1.1010 = $5,800.5

Is its NPV equal to the PV of tax shields? Why?

PV(TS) = + 20,000×.08×.34×6.1446 = $3,342.7 < $5,800.5

V0(GSB) = D – D×r Ds× A(r D,t) – D/(1+r D)t + D×r Ds×τC× A(r D,t)



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Total Financing Side Effects

+ Total Value of regular financing + $11,006.1

+ Value of government-sponsored debt + $5,800.5

Total financing side effects $16,806.6



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Delphi’s Total APV Value

Should Chrysler buy Delphi for $150,000?

How would you use the information in the table above?

All-equity valueUnder current management 89,709.2 66.4%

Created by new managers 28,617.7 21.2%

Financing side effects 16,806.6 12.4%

Total APV under new management 135,133.9 100.0%



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What is a Leveraged Buyout (LBO)?

• A group of investors buys a company and finances the buyout

partly with their own money and partly with debt.

• Shareholders service the interest and principal payments withcash flow (ideally buy out a “cash cow”) and with asset sales.

• Shareholders hope to reverse the LBO within 3 to 7 years byways of a public offering or sale of the company to another firm.

• In a LBO shareholders are expected to pay off outstandingprincipal according to a specific timetable.

• Owners know that the debt-to-equity ratio will fall and canforecast the dollar amount of debt needed to finance operations.

• In this situation APV is the most practical valuation approachbecause the capital structure is changing.



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The Mechanics of a LBO

• First, the buyout group creates a “shell company” , with no

real operations, that holds the investors’ equity.

• Second, the shell company issues debt for an amountequal to the target’s purchase price minus its equity.

• Third, the shell company acquires the “target”, and the twofirms are legally unified in a merger.

• The new entity’s assets are identical to those of the targetfirm, but the new firm now carries all the debt inherited from

the buying shell company.

• Usually, the new entity quickly repays its debt from cashflows, until within a few years it reaches a “target capitalstructure” that is chosen for the company.



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Time-Pattern of Debt-Ratio in a LBO

0 1 2 3 4 5 Year

D/V

Target

For example, if the LBO company repays debt and

reaches its new target capital structure in 5 years, thepattern of D/V would look like the picture below:



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APV in the RJR Nabisco LBO• The LBO of RJR Nabisco by KKR (Kohlberg, Kravis, &

Roberts) in 1988 was the largest LBO in history.

• RJR had $5 bn in debt (at market values) and 229 millionshares trading at around $55 per share.

• Check that its debt-to-value ratio before the events that led to

the acquisition was about 28.4%.

• In fact, RJR’s target capital structure was thought to be a debt-to-value ratio of about 25%.

• RJR’s management offered $75 per share to take the firmprivate in a management buyout (MBO).

• Within days of the offer, KKR entered the bidding and finallypaid $25 billion for RJR Nabisco’s equity or $109 per shareand it assumed the $5 billion in debt (at market values).



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APV in the RJR Nabisco LBO

Shell Co.’s

Balance Sheet

RJR Nabisco’s

Balance SheetD = $24 bn D = $5 bn

A= $25 bn E = $1 bn A = $30 bn E = $25 bn

Merged Firm’s

Balance SheetD = $29 bn

A = $30 bn E = $1 bn

To finance the transaction, KKR issued $24 billion in new debt

and contributed equity from its investors for $1 billion.

Intuitively, the merger deal can be represented as follows:



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APV in the RJR Nabisco LBO

• Note that RJR Nabisco dramatically increased its financial

leverage as a result of the LBO. Is this good in the long run?

• KKR plans to bring RJR back to a 25% debt ratio by 1993and then maintain that ratio. How? Through to the exchangeof convertible debt or by issuing equity to retire debt.

• Think of the debt’s pattern over time – it is pre-determinedfor the first few years (until 1993) as the schedule ofrepayment has been set in agreement with the lenders.

• Valuing this acquisition using WACC is doable, butcomplicated because it requires computing market valuecapital structure weights that differ in each year.

• But debt has a fixed schedule and thus APV is easy to use!



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Summary & Conclusions• APV is the most useful method when we need to value a

company or project with a pre-determined debt schedule.

• APV can easily accommodate some other financing sideeffects, including flotation costs, financing subsidies, andother market imperfections.

• APV breaks down the value of a project into its fundamentalcomponents and thus it provides useful information to refinethe transaction and monitor its execution.

• Another good thing is that APV forces you to carefully thinkabout the risk of each specific element you want to considerin the valuation.

• LBOs are one classical situation where APV is used.

lecture 10 - more on apv

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