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This case illustrates a leveraged buyout of Congoleum Corporation and provides guidelines for valuing the transaction. Key aspects to consider include:
- Treating 1980-1984 differently from the post-1984 period due to changing debt ratios and a potential reorganization in 1984.
- Calculating unlevered free cash flows and using an adjusted present value approach to account for the value of financing decisions.
- Determining an appropriate terminal value and growth rate at the end of 1984, then discounting the terminal value and cash flows to value the overall transaction.
This case illustrates a leveraged buyout of Congoleum Corporation and provides guidelines for valuing the transaction. Key aspects to consider include:
- Treating 1980-1984 differently from the post-1984 period due to changing debt ratios and a potential reorganization in 1984.
- Calculating unlevered free cash flows and using an adjusted present value approach to account for the value of financing decisions.
- Determining an appropriate terminal value and growth rate at the end of 1984, then discounting the terminal value and cash flows to value the overall transaction.
This case illustrates a leveraged buyout of Congoleum Corporation and provides guidelines for valuing the transaction. Key aspects to consider include:
- Treating 1980-1984 differently from the post-1984 period due to changing debt ratios and a potential reorganization in 1984.
- Calculating unlevered free cash flows and using an adjusted present value approach to account for the value of financing decisions.
- Determining an appropriate terminal value and growth rate at the end of 1984, then discounting the terminal value and cash flows to value the overall transaction.
FINANCE 351 - CORPORATE FINANCE Hint Sheet: Congoleum Corporation Prof. Simon Gervais Fall 2011 Term 2 This case illustrates a leveraged buyout and highlights some of its value-creating aspects. You are invited to combine the valuation principles and methods discussed in the course to evaluate a complex transaction from the perspectives of the various participants. Here are some guidelines for your valuation analysis. Overview of the Valuation Process. Given the nature of the forecast data, it is useful for valuation purposes to treat the 1980-1984 period dierently from the post-1984 period. In fact, the case writer hinted at the possibility of another reorganization at the end of 1984 in the note to Exhibit 14. Throughout, assume that time 0 is year 1979. Make sure that you notice the changing debt ratios in 1980-1984. Which is the best valuation approach to deal with this? Free Cash Flow. As usual, the following (unlevered) free-cash-ow formula should prove useful: EBIT = Operating Income Corporate Expenses Depreciation, UFCF = (1 t c )EBIT + Depreciation Change in NWC Capital Expenditures. Note that there is a dierence between UFCF dened above and what are referred to as free cash ows in Exhibit 13 (on line 14)? Discount Rates. As we mentioned when discussing the Marriott case, the choice of discount rates is an important part of any valuation procedure. It is worthwhile to spend some time thinking carefully about these issues. Congoleums equity beta is known (see Exhibit 9). Do you need to rely on comparable companies data to obtain Congoleums asset beta? For the borrowing cost in the LBO years and the borrowing cost in the post-1984 pe- riod, you may use an average of the yields on corporate bonds of appropriate ratings (Exhibit 10). In particular, in this case, it would probably not be legitimate to use the coupon rates on the new LBO debts as r D in the LBO years. Why? Of course, this means that the loans have a positive net present value (the coupon rate is less than the discount rate), so dont forget that part of the value. For the post-1984 period, should we expect the bond rating to improve (and r D to decrease)? Why or why not? For the debt-to-value ratio (i.e., debt capacity) after 1984, feel free to rely on an average of the debt-to-value ratios of Congoleums competitors (in Exhibit 9). You can use the 1 identiable assets of each division as of 1978 (from Exhibit 4) for the relative weights. You should also explore a few additional debt-to-value ratios around this number in your sensitivity analysis. Feel free to use the information in the footnote to Exhibit 9 as your inputs (risk-free rate and market premium) to the CAPM. Feel free to do all your levering/unlevering assuming a debt beta of zero. Also, let us assume that all debt is permanent (i.e., not rebalanced). Wherever the case mentions Debt % capital, you can treat this as the correct (i.e., market) debt-to-value ratio. Adjusted Present Value (APV). The present value of nancing decisions is obtained by discounting all relevant debt cash ows at Congoleums debt cost: principal receipts, principal repayments, interest payments, interest tax shields. Indeed, as mentioned above, it is not sucient to just include the tax shields in your valuation, as the coupon rate on the debt is smaller than the proper (i.e., market) discount rate; that is, the loan has a positive net present value. Also note the following. Preferred stock can be thought of as a type of debt that does not create any interest tax shields. Do not forget that some old long-term debt remains after 1979 and the new owners need to service it even though no cash is received on this debt in 1979. It is convenient, for valuation purposes, to assume that all debts (old, new, preferred stock) are paid o at the end of 1984 when the LBO group takes the company public again and sells it for its terminal value. 1 Terminal Value. Obtaining an accurate measure of the terminal value is critical in this case. You may start with the following as an approximation: Terminal Value as of 1984 = (1 + g) (Avg UFCF) 1980-1984 (Discount Rate) post 1984 g , where g is a growth rate and the discount rate is WACC (or RADR, as in the article by Inselbag and Kaufold). Based on your understanding of the case facts, what growth rate would you use? How sensitive is your result to the choice of growth rate (e.g., try a few rates between g = 0% and g = 10%)? How does your choice of g compare to the ination rate at that time (which is not mentioned in the case)? What discount rate would you use to bring this terminal value back to 1979? How sensitive is your result to this choice? How would you split the terminal value between unlevered assets and value of nancing, and how should each part be discounted back to 1979? 1 If these debts are not paid o, then the new buyer of the company will pay a price equal to the terminal value minus the value of outstanding debts. 2 Adjustments. To value the rm as a whole, you need some further adjustments that re- ect the rms current cash and liability situation (UFCF during 1979 is not part of LBO valuation): V Congoleum = 1979 adjustments
post-1984 period . Feel free to use the same numbers as in Exhibit 7 for the 1979 adjustments. Objective. A primary objective of this case is for you to evaluate the LBO proposal and render an opinion as to the appropriateness of the $38 oer price. In addition, however, you need to quantify (in terms of their impact on the companys after-tax cash ows and their impact on the share price) the incremental eects of LBO (as compared to no LBO) on Congoleum as a whole, i.e., what portions of the sizable purchase premium (or of your calculated share price) are attributable to: the cost savings in corporate expenses for 1980-1984? (Use the savings mentioned at the top of Exhibit 14; note that these are pre-tax savings.) the step-up of asset values for depreciation for 1980-1984? (Use footnote b in Exhibit 13 to gure out the increment in depreciation and amortization.) the interest tax shields? (Use footnote a in Exhibit 13 to gure out the increment in tax shields.) The rest of the value probably has to do with the unrecognized value/growth or other improvements in Congoleums operations after the LBO. Report. As usual, your write-up should address and defend the assumptions that underlie the inputs to your analysis (cash ow projections, the dierent discount rates, leverage ratio, growth rate, etc.) before you proceed to present your results. Sensitivity analysis could be done at the end. The nal report should consist of 2-4 pages of text, followed by spreadsheet exhibits that are referred to in the text. The following questions serve to organize your discussion. What makes Congoleum an LBO target? Based on your analysis, what do you think of the $38 per share oer? Your valuation analysis (as described above on this hint sheet) should make the bulk of your report and serve to answer this question. What are the roles of the equity kicker and strip nancing? 3