CHAPTER 18 CASE C-1
CHAPTER 18
THE LEVERAGED BUYOUT OF CHEEK
PRODUCTS, INC.
In this leveraged buyout, the debt level of the company changes through time. Since the debt level changes
through time, the APV method is appropriate for evaluating the LBO. The steps we must undertake are:
Step 1: Calculating the present value of unlevered cash flows for the first five years.
Step 2: Calculating the present value of the unlevered cash flows beyond the first five years.
Step 3: Calculating the present value of interest tax shields for the first five years.
Step 4: Calculating the present value of interest tax shields beyond the first five years.
Step 1: Calculating the present value of unlevered cash flows for the first five years.
The income statement presented does not include interest, so it is the projected unlevered cash flows of the
company. To find the cash flows each year, we find the operating cash flow by adding depreciation back to
net income. Next, we subtract any capital expenditures, subtract or add changes in net working capital, and
add the asset sales. So, the unlevered cash flows each year will be:
2019
2020
2021
2022
2023
Sales
$3,024.00
$3,391.00
$3,654.00
$3,740.00
$3,893.00
Tax
354.06
371.28
410.13
403.20
419.16
Net income
$1,331.94
$1,396.72
$1,542.87
$1,516.80
$1,576.84
Capital expenditures
$307
$266
$334
$339
$334
Change in NWC
–134
–205
111
105
119
Asset sales
Unlevered cash flows
$3,252.94
$3,034.72
$1,688.87
$1,692.80
$1,756.84
Dep
EBT
$1,686.00
$1,768.00
$1,953.00
$1,920.00
$1,996.00
CHAPTER 18 CASE C-2
Step 2: Calculating the present value of the unlevered cash flows beyond the first five years.
The assumption given is that the cash flows will grow at 3.5 percent into perpetuity. Again, we discount
these cash flows at the unlevered return on equity. So, the value of these cash flows in Year 5 will be:
Unlevered CF value in Year 5 = [$1,756.84(1 + .035)]/(.14 – .035)
Step 3: Calculating the present value of interest tax shields for the first five years.
The interest tax shield each year is the interest paid times the tax rate. To find the present value of the
interest tax shield, we need to discount these at the pretax cost of debt, so the present value of the interest
tax shield for the first five years is:
Step 4: Calculating the present value of interest tax shields beyond the first five years.
Finally, we must calculate the value of tax shields associated with debt used to finance the operations of
the company after the first five years. The assumption given in the case is that debt will be reduced and
maintained at 25 percent of the value of the firm from that date forward. Under this assumption, it is
appropriate to use the WACC method to calculate a terminal value for the firm at the target capital structure.
This, in turn, can be decomposed into an all-equity value and a value from tax shields. Note that we need
to use the interest rate on the debt beyond Year 5 in these calculations. If the capital structure changes after
the first five years, the levered cost of equity can be found with Modigliani-Miller Proposition II with
corporate taxes:
RS = R0 + (B/S)(R0 – RB)(1 – TC)
CHAPTER 18 CASE C-3
Using Modigliani-Miller’s valuation of a levered firm:
we can value the interest tax shield as:
$17,777.96 = $17,317.42 + Interest tax shield
Interest tax shield = $460.53
This is the value of the interest tax shield beyond Year 5. Discounting this at the cost of debt over the first
five years, we find the value today is:
1
And the value of the interest tax shield today is:
Value of interest tax shield = $1,854.92 + 255.56
Value of interest tax shield = $2,110.48
So, the total value of the company today is: