Nabisco

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Case Analysis on
RJR Nabisco

Towards a course in Finance – FIN 620: Financial Administration Policies Submitted by Benjamin T. Schultz, Gail Olsen & Raj K Bhutani

To Dr. Susan E. Moeller
Eastern Michigan University, Ypsilanti, Michigan

Table of Contents

IProblem Statement3
IIAnalysis of Economic and Industry Data3
II.1What is LBO?3
II.2RJR and Smoking3
IIIAnalysis of Alternative Solutions4
III.1Strengths of KKR:4
III.2Weaknesses of KKR5
III.3Opportunities for KKR5
III.4Threats for KKR5
III.5Share Value: Pre-Bid offer5
III.6Share Value: Management group offer6
III.7Share Value: KKR offer6
IVRecommendations7
VAppendix – Exhibits8

Problem Statement
On October 20, 1988, Charles E. Hugel, chairman of RJR Nabisco, was appointed to consider a proposal to purchase the company for $17 billion, at $75 a share, by Management Group, consisting of F. Ross Johnson, President and CEO of RJR Nabisco; Edward A. Horrigan, Vice Chairman of RJR Nabisco and CEO of RJ Reynolds Tobacco Company; and investment banking firm of Shearson Lehman Hutton. Within four days, Kohlberg, Kravis, Roberts & Co. (KKR) announced a competing offer of $90 a share.

Determining the value of RJR Nabisco is the crux of this case. Refer to the case “RJR Nabisco” from text book “Case Problems in Finance” by Kester, Carl W., Ruback, Richard S. and Tufano, Peter, ISBN: 0-07-294551-6, pp 667-676.

The question central to this case is: What is the true value of RJR Nabisco?

Analysis of Economic and Industry Data
The concept of leveraged buy-outs (LBO) was relatively new in 1988. The first LBO occurred in 1964 when Jerome Kohlberg, Jr. and Henry Kravis acquired the Orkin Extermination Company. Since then there had been an accelerating trend of LBO’s (See Exhibit 1)

What is LBO?
LBO’s allow a small group of investors or other private parties to purchase large firms using the purchased firm’s debt potential to raise the funding necessary for the purchase. The disadvantage of this process is that it leaves the buyers with a company that has an enormous amount of debt on its books. Despite this, LBO’s have been successfully transacted in the past with substantial profits ending up in the pockets of the buyers. It is for this reason that companies with little existing debt and an undervalued stock price become the target for a leveraged buyout.

RJR and Smoking
RJR Nabisco was considered by many to be undervalued in 1988. At that time there was increasing public pressure to regulate tobacco more stringently, as well as more and more data coming to the fore describing the health risks inherit in using tobacco products.

In the years immediately preceding the buyout of RJR Nabisco, there were several prevalent news stories that painted a very poor picture of the tobacco industry.

* The grandson of RJR’s founder, Patrick Reynolds, urged at a House Congressional hearing that he believed that tobacco advertising should be banned and described watching his father die of emphysema. * In 1987, the “Marlboro Man” David Millar Jr. died of emphysema. * In 1988 Surgeon General C. Everett Coop famously and exhaustively reported on the negative health effects of tobacco use. * Cities had begun banning smoking in restaurants and federal regulatory agencies had begun banning smoking in government buildings and airline travel.

All of these factors generated a very negative view regarding tobacco in general and tobacco companies in particular.

Despite the country’s increasingly negative opinion of tobacco, sales had remained strong enough to generate significant profits. While overall cigarette production was down from its peak in 1981, it had remained steady for the five years leading up to 1988 (see Exhibit 2).

Perhaps the clearest indication of potential profit in the tobacco industry at that time was the manufacture value added (equal to...
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