In valuing the target company Congoleum after an LBO by First Boston found the expected free cash flows generated by this firm from 1980 to 1984. These numbers were based on values provided in the case. From there, we employed the Adjusted Present Value method to discount these cash flows because we assumed that Congoleum was varying its Debt to Equity ratio during those years. We discounted these cash flows by the required return on assets that was in turn calculated through use of the Modigliani-Miller unlevering formula (to derive the Asset Beta) and the Capital Asset Pricing Model. The required return on Congoleum debt was calculated by the expected return of the average CCC-company’s debt and the expected return of debt under default. Then, the present value of financial side effects was taken into account by discounting the interest tax shield by the required return on debt. Finally, we calculated the terminal value of cash flows by assuming a constant 4.14% growth rate in perpetuity and a constant D/E ratio for the years after 1984. Thus, these cash flows were initially discounted under WACC-ME. From there, we factored in prior debt and cash that Congoleum had generated to calculate the total equity value of the firm after the LBO had taken place. Background
Congoleum is a firm active in three product market segments: home furnishings, shipbuilding, automotive, and industrial distribution. In the summer of 1979, First Boston Corporation with the help of Prudential Insurance Company proposed a purchase of Congoleum by private and institutional investors. The day before the issuance of the tender offer, Congoleum closed at $25.375 per share with 12.2 million shares outstanding. Assumptions:
During the preparation of this case, multiple assumptions have been made in order to facilitate the analysis requested. Below is a list of the assumptions made and our reasoning for their validity. * Tax rate of 48%
* The D/V ratio from 1979 to 1984 and was best estimated through the mean of the expected D/V ratios of Congoleum’s separate divisions by the metric of percentage of total identifiable assets provided in this case * The D/V ratio from 1984+ was assumed to be constant and could be estimated via one of two methods: * It could be estimated by looking at the D/V ratio of comparable, BB rated companies * It could be estimated by looking at the D/V ratio of firms that are comparable to the various “subsets” of Congoleum (home furnishing, ship building, and automotive) and taking the average of those companys’ D/V ratio * The return on debt from 1984+ can be assumed through two methods: * The arithmetic average of comparable BB rated companies’ returns on debt * The weighted average of the returns on debt
* The market risk premium was expected to be 8.6% and the risk free rate was assumed to be 9.5% as provided in the case * The risk of default for Congoleum is expected to be 15.25% and the expected return to debt holders in case of default is 6% (we assume that at least some payments to debt holders have occurred prior to default) * The growth rate of cash flows after 1984 is expected to be 22.50% over 5 years as provided in exhibit 9 of this case and that growth rate is expected to continue in perpetuity
Discussion of Figures
Figure is the actual income statement for Congoleum in 1978 and estimates of its income statement from 1980 to 1983. The free cash flows used in the calculation of the NPV of this company was the Free Cash Flow to All Capital because the cash flows employed by APV/WACC assume no interest. Thus, our interest expenses had to be added back to the cash flows to shareholders to make them free cash flows. From purchasing Congoleum, investors receive outstanding cash from the company, a term not from a bank, strip-securities, and equity from First Boston and Congoleum Management. Its outflows include...
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