9 Pages Posted: 21 Oct 2008
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.
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.
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
Suggested Citation: Suggested Citation
Harris, Robert S. and Conroy, Robert M., Using the Equity Residual Approach to Valuation: An Example. Darden Case No. UVA-F-1267. Available at SSRN: https://ssrn.com/abstract=909676
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