Fin 620: Financial Administration Policies

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

I Problem Statement 3 II Analysis of Economic and Industry Data 3 II.1 What is LBO? 3 II.2 RJR and Smoking 3 III Analysis of Alternative Solutions 4 III.1 Strengths of KKR: 4 III.2 Weaknesses of KKR 5 III.3 Opportunities for KKR 5 III.4 Threats for KKR 5 III.5 Share Value: Pre-Bid offer 5 III.6 Share Value: Management group offer 6 III.7 Share Value: KKR offer 6 IV Recommendations 7 V Appendix – Exhibits 8

Problem Statement
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
However, we considered these betas to be too high, the cause of which we traced to the high level of debt. We then looked at the beta for Philip Morris (.88) in 1988 as a pure play substitute. This was an appropriate decision, as MG’s strategy was to sell the food division and maintain the tobacco division alone. After group discussion, we opted to use a beta of 1.2, lower than 2.77, as that was unreasonably high, but higher than 1, as a company with that much debt will inherently have more risk than the market as a whole (see Exhibit