Congoleum Corporation has three product market segments: home furnishings, shipbuilding and automotive and industrial distribution. In 1979, First Boston Corporation bid for an LBO of Congoleum for a price per share of $38. The purpose of this analysis is to assess Congoleum as a LBO candidate and determine whether the offer made by First Boston Corporation is fair. 1. Is Congoleum a good LBO candidate? In other words, does this company have a lot of debt capacity? The company was identified as a good LBO candidate as it had: (i) a minimal outstanding level of debt estimated at 5-7%; (ii) steady cash flows as a result of its operations which would enable it to meet higher debt obligations. The steps below further support this conclusion. Step 1: We calculated debt as a percentage of assets for the Congoleum pre-LBO * We extracted the value of the current portion of long-term debt and long-term debt for 1977 and 1978 from Exhibit 3
Step 2: We calculated Congoleum’s debt capacity
* Based on research papers, the typical debt capacity required for an LBO is between 4 and 5 times EBIT * Using an average of 4.5 times, we calculated the debt capacity for Congoleum to be $ 365.99 Million * As additional measures, we calculated the debt service and debt service ratio
As such, Congoleum is a good LBO candidate as it has sufficient debt capacity 1. How can you explain the 50% premium paid to the shareholders of Congoleum? Step 1: We calculated the free cash flows (FCF) for Congoleum before the LBO based on the data in Exhibit 2. In calculating FCF, it was assumed that no material change would occur to Congroleum’s operations as a result of the capital restricting; more precisely the following two assumptions were made in order to leverage the data in Exhibit 13 in the calculations: * Net working capital remains unchanged
* Capital expenditures are independent of the LBO; the same capex charges will be incurred without the LBO.
Step 2: We calculated the appropriate cost of capital to discount the free cash flows * We calculated the Ru from data given in Exhibit 9 for Congoleum (ß=1.25, MRP=8.6% and Rf=9.5%) * Rd was assumed to be 7.5% – the rate used to discount Congoleum’s old debt at the time of acquisition (Exhibit 16). The discount factor of other long-term debt is calculated from the interest payments to be 7% and the weighted average is taken to be 7.5% for simplicity. * Furthermore, the debt % was assumed to remain stable in the future. * D*/E*: D is calculated by adding Congoleum’s 1978 LT debt and the current portion of LT debt. D* is then D+ITS where ITS is D times the tax rate of 48%. E is Congoleum’s net worth in Exhibit 3 and E* is E+ITS. * RL is calculated as Ru + (Ru-Rd)*D*/E*
* WACC is Ru*(1- (D*TC*Rd)/V*Ru = 19.54%
Step 3: We calculated the value of the levered firm VL pre-LBO using the FCF and the calculated WACC * We assumed a FCF real growth rate of 0% in perpetuity in order to calculate the terminal value of the firm in 1984 based on FCF in 1984. The assumption is supported by opinions in the case. * Free cash flows for 1980-1984 and the terminal value were discounted at WACC = 19.54% * We added back cash of $ 77.25 million to obtain the total value of the levered firm pre-LBO 0%
Step 4: We deducted the present value of ITS in order to obtain the value of the unlevered firm Vu pre-LBO The outstanding value of long-term debt in 1979 is $15,409 (from Question 1). We applied the tax rate of 48% to calculate the ITS, assuming debt is perpetual and that the ITS is as risky as the debt (discounted at the cost of debt). The present value of ITS in 1979 is 15.409*0.48 = $7.396 million As per the MM proposition (APV Method)VL = Vu + PV (ITS)
Vu = VL – PV (ITS) = 373.93 -7.396 = $ 366.53 Million
Step 5: We calculated the ITS, assuming there is an LBO
Using Exhibit 16, we identified all the outstanding debt and payments for Congoleum. For each outstanding debt, we calculated interest payments until maturity. We then applied the 48% tax rate on interest to obtain the value of ITS and discounted each of the ITS figures at the appropriate cost of debt * We assumed that the cost of debt and ITS for each contract, is equal to the interest rate (e.g. cost of debt and ITS for senior notes is 11.25%) * In addition, we assumed that all debt outstanding will have matured by 2000 and no new debt is issued * The present value of the ITS is equal to $ 96.64 Million
Step 6: We calculated the additional tax savings related to depreciation changes after the LBO Step 7: We calculated the value of the levered firm by adding the ITS and additional tax savings to the value of the unlevered firm and checked the price per share of Congoleum VL = 366.53 + 96.64 + 37.15 = $ 475.9 Million
Value per Share = 475.9/12.2 = $39
Based on our valuation of the firm after the LBO, the fair value per share is $39. As such, the 50% premium paid to the shareholders of Congoleum in the LBO can be explained by the additional value brought by the interest tax shields related to the added leverage from the LBO. It can even be argued that the price per share that should be offered is $39.