Capital Budgeting: Leverage Buy Out Analysis

This assignment provides a comprehensive analysis of capital budgeting, focusing on the concept of leverage buy out (LBO) and its application in private equity. A case study is presented to illustrate the process of determining enterprise value, net present value (NPV), and adjusted present value (APV). The calculation of financing benefits, including tax benefits, is also discussed. The importance of not solely relying on internal rate of return (IRR) as a benchmark for project acceptance or rejection is highlighted.

PRIVATE EQUITY

Table of Contents
INTRODUCTION...........................................................................................................................1
Forecasted Cash Flows for Wilcox Industries for Project Sponsor........................................1
Internal Rate of Return...........................................................................................................4
Issues in considering IRR as benchmark................................................................................5
Adjusted Net Present Value (APV)........................................................................................5
CONCLUSION................................................................................................................................6
REFERENCES................................................................................................................................7

INTRODUCTION
Leverage Buy Out or LBO is a type of acquisition strategy employed by businesses
wherein a substantial amount of money is borrowed so as to finance such a strategic move. The
acquired company as well as its assets are used as collateral to repay the loans taken by the
acquiring company (Amess and Wright, 2012). This report aims to analyse the LBO of Wilcox
Industries Pty Ltd to ascertain whether they meet Private Equity Fund's return criteria or not. For
this purpose, Equity Free Cash Flow forecasts, Internal Rate of Return (IRR) are utilized and
inferences have been made thereof.
Forecasted Cash Flows for Wilcox Industries for Project Sponsor
From the given information of Wilcox Industries, the following Cash Flow Statement has
been forecasted to ascertain Equity Free Cash Flows:
Project Details (years/$'m) 0 1 2 3 4
Revenue 600 615 633.45 655.62 681.85
EBIT (% of Revenue) 5.00% 5.25% 5.38% 5.45% 5.50%
EBIT 30 32.29 34.08 35.73 37.5
Less: Net Capital Expenditure2 -1 -3 -5 -7
30 31.29 31.08 30.73 30.5
Less: Increase in Working Capital -0.75 -0.92 -1.11 -1.31
Free Cash Flows To Equity 30 30.54 30.16 29.62 29.19
Present Value of future FCFE @ 15%4 30 26.57 22.92 19.55 16.64
NPV4 115.68
Assumptions:
1. Annual Depreciation Expense = $15m
2. Required Return on Equity for an all equity funded firm (p) = 15% p.a.
3. Any Surplus Cash Flows available after debt servicing are available as dividends to the
project sponsors
4. No Debt Exists.
It is important to note that the aforementioned figures in regards to FCF and NPV are
based on Equity. These Free Cash Flows to Equity are Unlevered in nature as they do not include
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payment of financial expenses such as interest and taxes. While Unlevering the firm's cash flows,
the company is assumed to be debt-free. However, in reality, this may not be the case. In order to
ascertain the Enterprise Value, these cash flows are Relevered so as to include the effect of both
debt as well as equity. Based on the following assumptions, the rest of the calculations are
carried out:
Assumptions:
1. Interest Rate = 7%
2. Interest expense on debt used to fund investment is deductible against project income
3. Corporate Tax Rate = 30%
For this, the following calculations are carried out:
Free Cash Flows To Equity 30 30.54 30.16 29.62 29.19
Less: Debt Paid -9 -9 -9 -9
30 21.54 21.16 20.62 20.19
Less: Interest Expense @ 7% -2.1 -1.51 -1.48 -1.44 -1.41
27.9 20.03 19.68 19.18 18.78
Less: Tax @ 30% -8.37 -6.01 -5.9 -5.75 -5.63
Levered Cash Flows to Firm5 19.53 14.02 13.78 13.43 13.15
PV of Cash Flows to Firm6 19.53 11.64 9.51 7.79 6.31
NPV6 54.78
Working Notes:
Less: Interest Expense 6.3 5.67 5.04 5.67 3.78
EBT 23.7 26.62 29.04 30.06 33.72
1Changes in Working Capital:
Project Details 0 1 2 3 4
Revenue 600
Revenue growth rate (%) 2.50% 3.00% 3.50% 4.00%
Revenue 600 615 633.45 655.62 681.85
Working Capital (% of revenue) 5.00% 5.00% 5.00% 5.00% 5.00%
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Working Capital 30 30.75 31.67 32.78 34.09
Changes in Working Capital 0.75 0.92 1.11 1.31
Changes in Working Capital is the difference in working capital for year 1 and year 0, year 2 and
year 1 and so on.
2 Capital Expenditure:
Particulars 0 1 2 3 4
Capital Expenditure (given) 16 18 20 22
Less : Annual Depreciation Expense 15 15 15 15
Net Capital Expenditure 1 3 5 7
Capital Expenditure already includes Depreciation Expense, however, such a charge has already
been made on the net income previously (Bernstein and et.al., 2016). In order to eliminate its
double effect, the relevant amount of Annual Depreciation Expense has been subtracted from the
Gross Capital Expenditure Value, that is, $15 million.
3Debt Repaid:
0 1 2 3 4
Opening Debt 0 90 81 72 63
Issued 90 0 0 0 0
Repaid 0 9 9 9 9
Closing Balance (given) 90 81 72 63 54
Debt Repaid = Opening Debt Balance + Issued – Closing Debt Balance
For Year 0 it has been assumed that the company raised finance through a debt issue of
$90 million.
For Year 1: 90+0-81 = 9
For Year 2: 81+0-72 = 9
For Year 3: 72+0-63 = 9
For Year 4: 63+0-54 = 9
4PV Factors @ 15% p.a. and NPV:
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Years (1+r)^n 1/(1+r)^n FCFE PV of FCFE [=FCFE*(1/(1+r)^n)]
0 1.00 1.00 30 30
1 1.15 0.87 30.54 26.57
2 1.32 0.76 30.16 22.92
3 1.52 0.66 29.62 19.55
4 1.75 0.57 29.19 16.64
NPV 115.68
5Levered Cash Flows to Firm:
They are called Levered Cash Flows to Firm as both Debt and Equity form the capital
structure of the company. Hence, Wilcox Industries' Levered Cash Flows would amount to
$19.53m instead of $30m as they have paid their financial obligations. Thus, incorporating the
effect of debts and other legal liabilities. The Free Cash Flows to Equity (Unlevered) have been
used for this purpose.
6PV of Cash Flows to Firm and NPV
Years (1+r)^n 1/(1+r)^n FCFE PV of FCFE [=FCFE*(1/(1+r)^n)]
0 1 1 19.53 19.53
1 1.2 0.83 14.02 11.64
2 1.44 0.69 13.78 9.51
3 1.73 0.58 13.43 7.79
4 2.07 0.48 13.15 6.31
NPV 54.78
For the purpose of calculating NPV after re-levering the firm, the Private Equity Fund's
Hurdle IRR is taken as the discounting rate as it is equivalent to the Cost of Capital of firm
which, in this case, equals 20% per annum.
Internal Rate of Return
Internal Rate of Return of a project is a tool of investment appraisal that helps a project
manager and sponsor to determine the feasibility of a given project. In the context of Wilcox
Industries, the free cash flow to equity and firmhave been calculated in the previous section
(Gilligan and Wright, 2014). Assuming that the Present Value of Free Cash Flow to Equity of
Year 0 is the initial Outlay for the entire project, Internal Rate of Return has been carried out as
follows:
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IRR = [ra + (NPVa / (NPVa - NPVb)) * (rb-ra)] where,
ra = lower discount rate
rb = higher discount rate
NPVa = NPV at ra
NPVb = NPV at rb
In the case of Wilcox Industries, Equity IRR will be ,
IRR = [ 0.15 + (115.68 / (115.68-54.78))* (0.20-0.15)]
IRR = [0.15 + (115.68 / 60.90)* (0.05)]
IRR = [0.15 + (1.8995)*(0.05)]
IRR = [0.15 + 0.095]
IRR = 0.245
or
IRR = 24.5%
Here, the two discounting rates are cost of equity as well as the hurdle IRR of the Fund
that is 15% and 20% respectively. This helps in reaching at two NPV values, one without debt
and other including it. A 24.5% IRR is a good sign of investment for the business as it surpasses
the hurdle IRR of 20%. A hurdle rate is assumed to be the benchmark which needs to be fulfilled
by a project opportunity in order for it to be accepted (Puche, Braun and Achleitner, 2015).
Hence, for project sponsor, IRR will be equal to the one calculated above.
Issues in considering IRR as benchmark
Even though Internal Rate of Return is one of the most widely used investment appraisal
techniques, there are some issues in considering it as a sole benchmark for a given project. IRR
assumes reinvestment which can result in major budgetary distortions and blunders while making
budgeting decisions (Tåg, 2012). Hence, without considering the reinvestment rates, accepting or
rejecting a project solely on IRR can result in adoption of projects that may cause major lock-in
of company's valuable financial resources looking at the fact that capital budgeting decisions
tend to be irreversible and long-term. Therefore, IRR should not be used as the sole variable to
decide the fate of a project or investment opportunity.
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Adjusted Net Present Value (APV)
Financing benefits include Interest Tax Shields as they reduce the taxable income of the
firm. Adjusted Net Present Value is calculated using the following formula so as to demonstrate
whether or not IRR can be used to produce a positive NPV for Wilcox Industries:
APV = NPV of equity + PV of financing benefits
NPV of Equity (given) 115.68
Financing Benefits1 6.3 6.3 6.3 6.3 6.3
PV @ 15% 1.59 9.46 7.87 5.87 5.31
APV 145.78
APV = NPV of equity + PV of financing benefits
APV = 115.68+ 1.59+9.46+7.87+5.87+5.31
APV = 145.78
As per the APV Calculated, the tax benefits of taking this project are higher than the
Equity NPV calculated. Hence, it is one opportunity that project sponsor should not miss out on.
Working Notes:
1Financing Benefits:
Year 0 1 2 3 4
Opening Debt 0 90 81 72 63
Issues 90 0 0 0 0
Repaid 0 9 9 9 9
Tax benefits 6.3 6.3 6.3 6.3 6.3
Present Value of Benefits
discounted @ 15% 6.3 5.48 4.79 4.16 3.59
PV Calculation:
Years (1+r)^n 1/(1+r)^n FCFE PV of FCFE [=FCFE*(1/(1+r)^n)]
0 1.00 1.00 6.3 6.3
1 1.15 0.87 6.3 5.48
2 1.32 0.76 6.3 4.79
3 1.52 0.66 6.3 4.16
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4 1.75 0.57 6.3 3.59
CONCLUSION
From above discussions it can be observed that capital budgeting is an important part of
decision-making process. Leverage Buy Out, as seen in the context of given case scenario, can
help in determining what synergies can be made, finances can be received as well as
contributions are made by both Equity Financiers and Debt providers towards the Enterprise
Value of the business. In addition to this, it is required that IRR should not be completely trusted
as the sole benchmark to accept or reject projects.
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