HW2-FINA7A33

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University of Houston *

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Feb 20, 2024

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Homework 2 (Leverage Buyouts) NOTE: The purpose of the homework is to help you assess your understanding of the concepts covered in class, and to prepare you for the tests. There is no need to turn in the homework, and it will not be graded. Use the Excel answer key available on Canvas to grade yourself. Practice the HW using a calculator and a “cheat-sheet” because you will not have access to lecture notes and Excel on the tests (the spreadsheet supplement on Respondus Lockdown browser is clunky and doesn’t have the functionality of Excel). Problem 1 : Wall-Mart is a small retail firm. The company generated unlevered free cash flow (FCF) of $50 million in the most recent year (i.e., Year 0). The management expects FCF to grow at a rate of 10% per year for the next 4 years, and then to grow at a constant rate of 4% per year into perpetuity. The firm’s effective tax rate is 25%. The firm also has cash and equivalents of $200 million . Given its cash reserves and attractive growth prospects, the firm’s management feels that the firm should receive a much higher valuation than its current market valuation. To correct the perceived undervaluation, management plans to undertake a leveraged buyout (LBO) in partnership with a private equity firm. The LBO team plans to use $900 million of debt to finance the LBO. Out of this, $300 million will be from a 4-year term loan and will be repaid in full at the end of the 4 th year. The management expects to maintain a constant D/V ratio beyond year 4. Assume that interest expense each year is 6% of debt at the beginning of the year, and that the firm’s unlevered cost of capital is 10%. For convenience, we will ignore interest income in this problem (so you don’t have to keep track of future cash balances). Part (a): What’s Wall-Mart’s enterprise value under the proposed LBO plan? Part (b): What will Wall-Mart’s market value of equity be immediately after the LBO? Assume that interest tax shields are as risky as the firm’s unlevered assets. Ignore the expected costs of financial distress. Problem 2: A PE fund is contemplating a leveraged buyout (LBO) of TARGETCO, which operates a chain of pharmacy stores in Texas. TARGETCO is expected to generate FCF of $100 million, $125 million, and $150 million, respectively, in the first three years after the transaction. After the third year, management expects the FCF to grow at a constant rate of 4% per year into perpetuity. Currently, TARGETCO has no debt or excess cash. Its unlevered cost of capital is 10% and effective tax rate is 25%. The PE fund plans to use $1500 million of debt to finance the LBO. Out of this, $1000 million will be from a 3-year term loan, and will be repaid in full at the end of the third year. The remaining debt balance of $500 million will grow at the rate of 3% per year in perpetuity.

Assume that interest expense each year is 5% of debt at the beginning of the year. For convenience, we will ignore interest income in this problem (so you don’t have to keep track of future cash balances). Part (a): Compute TARGETCO’s standalone enterprise value and MV of equity. Part (b): Compute TARGETCO’s enterprise value and MV of equity under the proposed LBO? Assume that interest tax shields are as risky as the firm’s unlevered assets. Ignore the expected costs of financial distress. Use this information for Problems 3 through 5: TARGETCO has 50 million shares outstanding and is currently trading at $20 per share. It has debt of $300 million and no excess cash. A PE fund is contemplating a leveraged buyout of TARGETCO. As part of the LBO, the PE fund plans to buy all shares outstanding of TARGETCO and repay its existing debt. The PE fund wants the post-LBO company to have an initial cash balance of $200 million. LBO transaction costs are expected to be $100 million. The LBO will be financed using a combination of debt and the PE fund’s equity contribution. The PE fund expects to exit from TARGETCO after 6 years at an EV/EBITDA multiple of 20. It estimates TARGETCO’s EBITDA in year 6 to be $130 million. The debt and cash balances at exit are estimated to be $900 million and $100 million, respectively. Problem 3. Suppose the PE fund offers $30 per share to existing shareholders of TARGETCO and uses debt financing of $1,500 million. Part (a): How much equity will the PE fund have to contribute to complete the LBO? Part (b): Estimate TARGETCO’s MV of equity at exit and the PE fund’s IRR from the deal? Problem 4: Suppose the PE fund offers $28 per share to existing shareholders of TARGETCO and uses debt financing of $1,600 million. Part (a): How much equity will the PE fund have to contribute to complete the LBO? Part (b): Estimate TARGETCO’s MV of equity at exit and the PE fund’s IRR from the deal? Problem 5: Suppose the PE fund desires an IRR of 30% per year from the deal and plans to use debt financing of $1,500 million. Compute the offer price per share that it should offer to TARGETCO shareholders? What’s the offer premium at this price?

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