to reverse the LBo within three to seven years by way of a public offering or sale of the company to another firm. a buyout is therefore likely to be successful only if the firm generates enough cash to serve the debt in the early years, and if the company is attractive to other buyers as the buyout matures In a leveraged buyout, the equity investors are expected to pay off outstanding principal according to a specific timetable. The owners know that the firm's debt-equity ratio will fall and can forecast the dollar amount of debt needed to finance future operations. Under these circumstances,the adjusted - present-value (APV) approach is more practical than the weighted-average-cost-of-capital(WACC) approach because the capital structure is changing The APv method can be used to value companied as well as projects. Applied in this way, the maximum value of a levered firm(Vi)is its value as an all-equity entity(Vu) plus the discounted value of the interest tax shields from the debt its assets will support (PVTS). This relation can be stated as V =l,+Pvts UCF+>IcBB, 1+)台(1+r In the second part of this equation, UCFt is the unlevered cash flow from operations for year t iscounting these cash flows by the required return on assets, ro, yields the all-equity value of the company. Bt-1 represents the debt balance remaining at the end of year(t-1). Because interest in a given year is based on the debt balance remaining at the end of the previous year, the interest paid in year t is rBBt-1. The numerator of the second term, TcrBBi-1, is therefore the tax shield for year t We discount this series of annual tax shields using the rate at which the firm borrows, rB The following RR Nabisco transaction, the largest LBO in history, gives an example. The RJR Nabisco Buyout. In the summer of 1998, the price of RJR stock was hovering around $55 a share. The firm had s5 billion of debt The firms ceo. acting in concert with some other senior management of the firm, announced a bid of $75 per share to take the firm private in a management buyout. Within days of managements offer, Kohlberg, Kravis and Roberts(KKR) entered the fray with a $90 bid of their own. By the end of November, KKR emerged from the ensuing bidding process with an offer of $109 a share, or $25 billion total If succeeded, KKR planned to sell several of RUR's food divisions and operate the remaining parts of the firm more efficiently. Table 4.1 presents KKR's projected cash flows for RR under the buyout, adjusting for operational efficiencies and including planned asset sal TABLE 4.1 RJR Operating Cash Flows(in Millions except for tax rate) 1989 1990 1992 1993 Operating income $2.620 3410 $3.645 3950 $4.310 Tax rate on operating income 34% 34% Depreciation Capital expenditures 522 512 538 Change in working capital Proceeds from asset sales 1.805 With respect to financial strategy, KKR planned a significant increase in leverage with accompanying tax benefits. Specifically, KKR issued almost $24 billion of new debt to completeto reverse the LBO within three to seven years by way of a public offering or sale of the company to another firm. A buyout is therefore likely to be successful only if the firm generates enough cash to serve the debt in the early years, and if the company is attractive to other buyers as the buyout matures. In a leveraged buyout, the equity investors are expected to pay off outstanding principal according to a specific timetable. The owners know that the firm’s debt-equity ratio will fall and can forecast the dollar amount of debt needed to finance future operations. Under these circumstances, the adjusted-present-value (APV) approach is more practical than the weighted-average-cost-of-capital (WACC) approach because the capital structure is changing. The APV method can be used to value companied as well as projects. Applied in this way, the maximum value of a levered firm (VL) is its value as an all-equity entity (VU) plus the discounted value of the interest tax shields from the debt its assets will support (PVTS). This relation can be stated as ( )  ( )  =  = − + + + = = + 1 1 1 t 1 0 t 1 t B C B t t t L U r T r B r UCF V V PVTS In the second part of this equation, UCFt is the unlevered cash flow from operations for year t. Discounting these cash flows by the required return on assets, r0, yields the all-equity value of the company. Bt-1 represents the debt balance remaining at the end of year(t-1). Because interest in a given year is based on the debt balance remaining at the end of the previous year, the interest paid in year t is rBBt-1. The numerator of the second term, TCrBBt-1, is therefore the tax shield for year t. We discount this series of annual tax shields using the rate at which the firm borrows, rB. The following RJR Nabisco transaction, the largest LBO in history, gives an example. The RJR Nabisco Buyout. In the summer of 1998, the price of RJR stock was hovering around $55 a share. The firm had $5 billion of debt. The firm’s CEO, acting in concert with some other senior management of the firm, announced a bid of $75 per share to take the firm private in a management buyout. Within days of management’s offer, Kohlberg, Kravis and Roberts(KKR) entered the fray with a $90 bid of their own. By the end of November, KKR emerged from the ensuing bidding process with an offer of $109 a share, or $25 billion total. If succeeded, KKR planned to sell several of RJR’s food divisions and operate the remaining parts of the firm more efficiently. Table 4.1 presents KKR’s projected cash flows for RJR under the buyout, adjusting for operational efficiencies and including planned asset sales. TABLE 4.1 RJR Operating Cash Flows (in $millions except for tax rate) With respect to financial strategy, KKR planned a significant increase in leverage with accompanying tax benefits. Specifically, KKR issued almost $24 billion of new debt to complete 1989 1990 1991 1992 1993 Operating income $2,620 $3,410 $3,645 $3,950 $4,310 Tax rate on operating income 34% 34% 34% 34% 34% Depreciation 449 475 475 475 475 Capital expenditures 522 512 525 538 551 Change in working capital 203 275 -200 -225 -250 Proceeds from asset sales 3,545 1,805