School of Business

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 di? rently 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 ? tc )EBIT + Depreciation ? Change in NWC ? Capital Expenditures. Note that there is a di? erence between UFCF de? ed 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. – Congoleum’s equity beta is known (see Exhibit 9). Do you need to rely on comparable companies’ data to obtain Congoleum’s asset beta? – For the borrowing cost in the LBO years and the borrowing cost in the post-1984 period, 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 rD 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 don’t forget that part of the value. For the post-1984 period, should we expect the bond rating to improve (and rD 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 Congoleum’s competitors (in Exhibit 9).

You can use the 1 denti? able 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 Congoleum’s debt cost: principal receipts, principal repayments, interest payments, interest tax shields. Indeed, as mentioned above, it is not su? cient 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.