In valuing the target company Congoleum after an LBO by First Boston found the expected free cash flows generated by this firm from 1980 to 1984. These numbers were based on values provided in the case. From there, we employed the Adjusted Present Value method to discount these cash flows because we assumed that Congoleum was varying its Debt to Equity ratio during those years. We discounted these cash flows by the required return on assets that was in turn calculated through use of the Modigliani-Miller unlevering formula (to derive the Asset Beta) and the Capital Asset Pricing Model.
The required return on Congoleum debt was calculated by the expected return of the average CCC-company’s debt and the expected return of debt under default. Then, the present value of financial side effects was taken into account by discounting the interest tax shield by the required return on debt. Finally, we calculated the terminal value of cash flows by assuming a constant 4.14% growth rate in perpetuity and a constant D/E ratio for the years after 1984. Thus, these cash flows were initially discounted under WACC-ME. From there, we factored in prior debt and cash that Congoleum had generated to calculate the total equity value of the firm after the LBO had taken place. Background
Congoleum is a firm active in three product market segments: home furnishings, shipbuilding, automotive, and industrial distribution. In the summer of 1979, First Boston Corporation with the help of Prudential Insurance Company proposed a purchase of Congoleum by private and institutional investors. The day before the issuance of the tender offer, Congoleum closed at $25.375 per share with 12.2 million shares outstanding. Assumptions:
During the preparation of this case, multiple assumptions have been made in order to facilitate the analysis requested. Below is a list of the assumptions made and our reasoning for their validity. * Tax rate of 48%
* The D/V ratio from 1979 to 1984 and was best estimated through the mean of the expected D/V ratios of Congoleum’s separate divisions by the metric of percentage of total identifiable assets provided in this case * The D/V ratio from 1984+ was assumed to be constant and could be estimated via one of two methods: * It could be estimated by looking at the D/V ratio of comparable, BB rated companies * It could be estimated by looking at the D/V ratio of firms that are comparable to the various “subsets” of Congoleum (home furnishing, ship building, and automotive) and taking the average of those companys’ D/V ratio * The return on debt from 1984+ can be assumed through two methods: * The arithmetic average of comparable BB rated companies’ returns on debt * The weighted average of the returns on debt
* The market risk premium was expected to be 8.6% and the risk free rate was assumed to be 9.5% as provided in the case * The risk of default for Congoleum is expected to be 15.25% and the expected return to debt holders in case of default is 6% (we assume that at least some payments to debt holders have occurred prior to default) * The growth rate of cash flows after 1984 is expected to be 22.50% over 5 years as provided in exhibit 9 of this case and that growth rate is expected to continue in perpetuity
Discussion of Figures Figure 1 Figure is the actual income statement for Congoleum in 1978 and estimates of its income statement from 1980 to 1983. The free cash flows used in the calculation of the NPV of this company was the Free Cash Flow to All Capital because the cash flows employed by APV/WACC assume no interest. Thus, our interest expenses had to be added back to the cash flows to shareholders to make them free cash flows. From purchasing Congoleum, investors receive outstanding cash from the company, a term not from a bank, strip-securities, and equity from First Boston and Congoleum Management. Its outflows include its purchase of Bath Iron works, Congoleum’s other assets and executive stock. It also includes general LBO expenses. Additionally, attached is our sensitivity analysis that looks at how our assumptions regarding the growth rate and D/V ratio of our firm in years post 1984 impacts our calculations of the firm’s value Post-LBO. Figure 2
Figure 2 shows the value of the long-term debt and equity for the firm from 1974 to 1978. The total value of the firm in at any time is equal to the sum of the debt and equity for a given year. The D/E and D/V ratios for the firm over those 5 years were then averaged in this figure. Figure 3
This table displays the D/V ratio of firms that are representative one of the three “subsets” of Congoleum (Furnishings, Ship Building, or Automotive). Each of these ratios was then averaged to get the weighted average debt to value ratio of comparable companies; this was performed by using the ratio of Identifiable Assets per division to Total Identifiable Assets. Finally, the average D/V ratio of the firms representing each subset was also listed. Alternatively, the Debt to Value ratio of the provided BB firms is listed and those ratios were then averaged to get the mean Debt to Value ratio that could be used for the target Debt to Value ratio for Congoleum post-1984. Figure 4
The equity beta for the firm was provided in the case. We also are making the assumption that the Debt Beta is 0 (i.e. risk free). The Debt to Equity ratio was also calculated in Figure 2. Through the Modigliani-Miller unlevering formula, we then were able to derive our Asset Beta. Then, using our calculated Asset Beta and the provided market risk premium and risk free rate, we were able to calculate the required return on assets with the Capital Asset Pricing Model. From there, we employed the Miles-Ezzell cost of capital formula with the Debt to Equity ratio derived by looking at comparable “BB-rated firms” to derive our WACC. Additionally, the expected cash flow growth is forecasted to be 22.50% over the 5 years following 1984. Hence, we expect an annual growth rate of 4.14%. Figure 5
The free cash flows (calculated in figure 1) are listed from between 1980 and 1984. They are each discounted at the required return on assets calculated in figure 4 because are calculating the APV of cash flows from between 1980 and 1984. The required return on debt was then calculated by looking at the returns of comparable debt of other CCC firms. The average return on the debt of those firms was 15.19%. We then had to factor in the 15.25% probability of default by Congoleum and its expected return of 6% on debt in the case of default. The expected return on weight weights these two potential returns on debt by their probability of occurring. The side effects of financial distress were then calculated from between 1980 and 1984 by multiplying the annual interest expense by the tax rate and then discounting the interest tax shield by the required return on debt calculated above. Figure 6
Next, we had to calculate the present value of terminal value. We did this by first calculating the expected 1985 cash flow by multiplying the 1984 cash flow by the expected 4.1% growth rate (calculated in figure 4). Given, we expect the generate cash flows that grow at 4.1% in perpetuity, we calculated the present value of those cash flows by taking our 1985 cash flow and discounting by the WACC-ME (calculated in figure 4). This was performed by using the Gordon Dividend Growth Model because the firm would now be a publicly traded equity and the free cash flows are representative of the firm’s dividends. This gave us the value of the TV at 1984, so we then discounted by the return on assets to receive the present value of the TV. Figure 7
The value of the firm post LBO is thus equal to the sum of its discounted terminal value, tax shields, and free cash flows from 1980 to 1984. However, to calculate the total equity value of the firm, we must also factor in the cash and debt that Congoleum held prior to the LBO. That includes adding in 95.10 million in cash and subtracting out 15.6 million in debt and 34.5 million in previous pension liabilities. If you divide the equity value pre and post LBO by the number of shares outstanding, you then receive the companies’ price per share pre and post LBO. Figure 8
Shareholders thus gain the difference between the initial share price and the post-LBO share price multiplied by the number of shares outstanding. Debt holders are paid off entirely with no gain or loss.
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