LBO VALUATION

The evaluation of LBO transactions involves the same analysis as for mergers
and acquisitions. The DCF approach is used to value an LBO. As LBO
transactions are heavily financed by Debts , the risk of lender is very high.
Therefore in most deals they require a stake in the ownership of the acquired
firm. The following example provides an example of a leveraged buy-out and
also explains the methodology for estimating the return and the share of
ownership of the lender in such deals.

CASE

Hindustan chemical’s is a small size private limited company. The company

manufactures a specialized industrial chemical. The large and medium size
industrial companies are its buyers and it commands about three-fourths of the
market due to its excellent quality, prompt delivery and reasonable price.

Suraj gupta and Mahesh goyal own the company ,both are chemical engineers
and are college friends. The current sales of the company is Rs 99.8 lakh and the
annual sales growth rate in the past years has been 12-13 %. The company has
been showing good profits. It has been retaining profits and financing its
activities internally without resorting to any external funding. Its earnings before
interest and tax (EBIT) are Rs 18.41 lakhs for the current year, giving a profit
margin of 18.5% and a 25% return on assets.

The Profit and Loss Statement for the year ending 31.3.xxxx

(in lakhs)

2005 2006 2007 2008 2009

Net Sales 62.80 65.32 76.49 92.15 99.76
Less:COGS 38.76 40.18 47.72 60.43 64.32
GROSS PROFIT 24.04 25.14 28.77 31.72 35.44
Selling & admn (10.35) (11.78) (13.97) (16.78) (18.05)
expenses
Non-operating income .36 .97 .65 1.10 1.02
PBT 14.05 14.33 15.45 16.04 18.41
Less: Tax 7.25 7.65 7.60 8.00 9.10
PAT 6.80 6.68 7.85 8.04 9.31

Both Suraj and Mahesh have decided to retire from business. The general
manager of the business Brij has agreed to purchase the business for Rs
10,000,000. Brij has only a personal saving of Rs 10,00,000. He wish to raise
the balance from the market as debts and loans. He is confident that he wold be
able to get these required external financing on the basis of the company’s
strong financial showing.
He talked to a finance company for the required amount on the pre-condition of
good return on investment.

The finance company may grant him a loan of Rs 90,00,000@10% per annum
plus warrant to buy enough equity shares when the company goes public to earn
at least a return of 25%.

Brij knows that the finance company would expect him to go public after about
four or five years. He is also required to repay all the investments (principals)
between 8 to 10 years in equal annual instalments.

Balance Sheet as on 31.3.2009

(in lakhs)

Liabilities Assets
Capital 8.5 Net fixed assets 41.28
Reserves 59.50 Other non-current
Assets 2.13 43.41
= Net Worth 68.00 Inventory 4.12
Debtors 9.15
Creditors 4.35 Cash 18.50
O/S Expenses 2.36 Other CA 1.32 33.09
Provision for Tax 1.79
=CL 8.50
Total funds 76.50 Total Assets 76.50

Brij expects that for the next 10 years sales would grow at 25% , and afterwards
the growth rate may slow down.

He expects EBIT as a percentage of sales @25%. In order to maintain the sales

growth, he would have to incur some capital expenditure that is likely to
increase from the 4th year onwards. The tax depreciation and capital
expenditures are estimated as given in the following table.

He also expects the net working capital to sales ratio to remain approximately at
its present level, say, at about 24%. Should Mr Brij borrow the said amount of
Rs 90,00,000 to out Hindustan chemicals.

The industry’s current P/E Ratio is 12.5.

Tax rate is 50%.

Other details are as follows:

DEPR 1.6 1.7 1.8 1.9 2.1 2.5 2.9 3.6 4.4 5.4
CHANGE IN 5.3 7.5 9.4 11.8 14.5 18.2 22.9 28.6 35.7 44.6
NWC
CHANGE IN .8 .8 1 1.3 2.1 3.5 4.6 6.2 8.0 10.2
CAPEX
Solution

Let us analyse the performance of the company in the year 2009.

Net Sales to Net 99.76/68.00 1.467

Assets ratio
EBIT/NET SALES 18.41/99.76 18.45%
EBIT/TOTAL ASSETS 18.41/76.5 24.07%
PAT/EBIT 9.31/18.41 50.57%
TOTAL ASSETS/NET 76.5/68.0 1.13%
WORTH
PAT/NET WORTH 9.31/68 13.70%
CA/CL 33.09/8.50 3.89 times
NWC/NET SALES (33.09-8.50)/99.76 24.65%
Debt –Equity Ratio 0 0

The company is highly profitable and employs no debt. The only liabilities are its
current liability.

1. Net Worth is 89% (1-10/90) of the total funds.

2. Net working capital to sales ratio is 24.7% is quite high.

The company can reduce its current assets and realise them to finance future
expansion programmes.

The purchase price of Rs 100,00,000 is quite reasonable and at the 2009 profit
after tax, it gives a price multiple of 5.43 only.(10,000,000/18,41,000)

At the present proposed structure , the company would have an equity of Rs

10,00,000 and an debt of Rs 90,00,000 and thus it will have an Debt-Equity
ratio of 9:1.

In conventional sense this is very high amount leverage and therefore the
traditional financiers will not provide any funds tote company as it entails high
risk.

However the company is very sound and it has the capacity to service a high
level of debt.

It is a market leader with 3/4th of the market share ,its products have excellent
quality and it has an assured market.

Hindustan chemicals estimation of cash flows

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
NET SALES 124.7 155.9 194.8 243.6 304.6 380.6 475.7 594.7 743.4 929.2
incr@25%
EBIT @25% 31.2 39 48.7 60.9 76.1 95.2 118.9 148.7 185.8 232.3
of sales
INTEREST 9.0 9 9 9 9 9 9 9 6 3
 PBT 22.2 30 39.7 51.9 67.1 86.2 109.9 139.7 179.8 229.3
TAX@50% 11 15 19.9 26 33.6 43.1 55 69.9 90 114.7
PAT 11 15 19.8 25.9 33.5 43.1 54.9 69.8 89.9 114.6
+DEPR 1.6 1.7 1.8 1.9 2.1 2.5 2.9 3.6 4.4 5.4
CFO 12.7 16.7 21.6 27.8 35.6 45.6 57.8 73.4 94.3 120
-CHANGE IN 5.3 7.5 9.4 11.8 14.5 18.2 22.9 28.6 35.7 44.6
NWC
-CHANGE IN .8 .8 1 1.3 2.1 3.5 4.6 6.2 8.0 10.2
CAPEX
NCF 6.6 8.4 11.2 14.7 19 23.9 30.3 38.6 50.6 65.2
REPAYMENT - - - - - - - 30 30 30
CF TO 6.6 8.4 11.2 14.7 19 23.9 30.3 8.6 20.6 35.2
OWNERS

The company’s earnings are predictable and the performance is expected to

improve due to cost reduction and operating efficiency. The above table shows
the company’s expected earnings and cash flows. This reveals that it would be in
a very comfortable position to service its debts.

One of the important consideration in this deal is that the financier is expected a
return of 25% and the issue of shares to him in the year 2014 when the
company is likely to go public.

The value of the business should be sufficiently high so that Mr Brij’s ownership
is not diluted below 50%.

But it remains to be seen how much shall be the company’s profit so

that it could earn 25% return.

The fiancé company invests Rs 90,00,000 and its cash inflows are interest
received , repayments of principals and the value of shares in HCC in the year
2014.

Its return would be 25% if the present value of its investment @25% were equal
to the present value of its inflows (NPV=0).

NPV = PV of interest + PV of repayments + Pv of shares – Investments

=0

The financier company would get an Interest of Rs 900,000 for the first
8 years and Rs 600,000 & Rs 300,000 in the 9 th and 10th years
respectively.

PV OF INTEREST

INTEREST PVF@25% PV
1 9 0.800 7.2
2 9 0.640 5.76
3 9 0.512 4.608
4 9 0.410 3.6864
 5 9 0.328 2.94912
2.35929
6 9 0.262 6
1.88743
7 9 0.210 7
1.50994
8 9 0.168 9
0.80530
9 6 0.134 6
0.32212
10 3 0.107 3
31.0876
PV OF INTEREST 3

PV OF REPAYMENTS

REPAYMENT OF
LOAN PVF@25% PV
1 0 0.800 0
2 0 0.640 0
3 0 0.512 0
4 0 0.410 0
5 0 0.328 0
6 0 0.262 0
7 0 0.210 0
5.03316
8 30 0.168 5
4.02653
9 30 0.134 2
3.22122
10 30 0.107 5
12.2809
PV OF REPAYMENTS 2

Also it is expected to get Rs 30,00,000 each back in the last three years
as repayment of debt principal.

Value of the shares =

HOW MUCH SHARES CAN HINDUSTAN CHEMICALS ISSUE TO THE
LENDERS?

The answer to this Question lies in the Value of the shares of the company after
5 years?

Because Hindustan chemicals is a growing company, we can safely assume that

the P/E ratio of the company in 5 years (2014) would be 15. The current
industry average is 12.5.

In that case the value of the company’s shares would be:

So the company is expected to give or allot approximately 28% of the ownership

shares to the Lenders.

But if the company’s P/E ratio decreases and is expected to be only 10 then
more shares has to be allotted to the Lenders.