Using the Equity Residual Approach to Valuation: An Example

Abstract

This note provides a detailed explanation of how to apply the equity residual valuation method when the debt/equity mix is changing. An example is provided that works through levering betas. The note can be used to accompany cases on leveraged buyouts.

Excerpt

UVA-F-1267

Rev. Jan. 24, 2017

Using the Equity Residual Approach to Valuation: An Example

Planned changes in capital structure over time increase the complexity of valuing a company. In particular, the analyst has to accommodate the potential changes in a firm's debt/equity mix. Such changes can affect shareholders' exposure to risk. This note provides one method of incorporating a changing capital structure into the equity residual valuation of a company. While such an analytical technique is useful, careful application must be wary of the approximations made in implementing the approach.

The Situation

To illustrate the issue, consider an example: NEWTIME Inc. is the target of an LBO attempt. Exhibit 1 contains the forecasted net income and debt schedule under the proposed LBO. The proposed purchase price is $ 1.6 billion, which includes $ 1.2 billion in debt with an interest rate of 11.5%. The owners plan to pay down the debt over the next eight years with the aim of achieving a steady state debt-to-capital ratio (in market value terms) of 35% at the end of year 8. After year 8, the steady-state free cash flows are anticipated to have a zero growth rate. At that time, the firm will refinance the existing debt to achieve the target capital structure of 35% debt. Exhibit 2 contains relevant market data.

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Keywords: capital structure, leveraged buyouts, valuation