Using the Equity Residual Approach to Valuation: An Example (Abridged)

5 Pages Posted: 5 Apr 2010

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Robert M. Conroy

University of Virginia - Darden School of Business

Abstract

This note provides an example of the equity residual valuation method to a company. The note can be used to accompany cases on private equity acquisitions or other levered transactions. It provides a simple fact set to focus on the essentials of the method.

Excerpt

UVA-F-1609

November 20, 2009

Using the Equity Residual Approach to Valuation:An Example (Abridged)

The equity residual approach to valuing a company highlights cash flows to the suppliers of equity. These “equity residual cash flows” are what is left once all debt service (e.g., interest payments and principal repayments) has been subtracted from the cash flows generated by the company. This approach is particularly useful in settings such as private equity, where the supplier of equity funds will be using considerable debt to finance an acquisition.

The Situation

To illustrate the approach, consider an example: NEWTIME, Inc., is being considered for purchase by a private equity firm. Exhibit 1 contains the forecast net income and debt schedule under the proposed transaction. The proposed purchase price is $ 1.6 billion, which includes$ 1.2 billion in debt with an interest rate of 11.5%. The new owners will supply $ 0.4 billion of equity capital up front and plan to pay down much of the debt over the next eight years from cash flows generated by the business. They also aim to sell the company at the end of year 8. Based on comparable companies, the new owners' best guess is that they can then sell the company for 5.95 times EBIT. The private equity firm wants to achieve at least a 20% return on its equity investment based on the inherent risks in the projected cash flows and financing plan. Over and above industry risks in NEWTIME's business are uncertainties about planned cost savings built into the forecasts. In addition, there is uncertainty around the timing and value of NEWTIME's future sale.

. . .

Keywords: levered transactions, valuation, levered buyouts, equity residual method

Suggested Citation

Harris, Robert S. and Conroy, Robert M., Using the Equity Residual Approach to Valuation: An Example (Abridged). Darden Case No. UVA-F-1609, Available at SSRN: https://ssrn.com/abstract=1583757

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Robert M. Conroy

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

HOME PAGE: http://www.darden.virginia.edu/faculty/conroy.htm

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