VALUING A LEVERAGED BUYOUT CANDIDATE. Experian Information Solutions (Experian) is a wholly owned subsidiary of TRW, a publicly traded company. The subsidiary has (in thousands) total assets of $555,443, long-term debt of $1,839, and common equity at book value of $402,759.
An equity buyout group is planning to acquire Experian from TRW in an LBO as of the beginning of Year 6. The group plans to finance the buyout with 60 percent debt that has an interest cost of 10 percent per year and 40 percent common equity. Analysts for the buy- out group project free cash flows to all debt and equity capital stakeholders as follows (in thousands): Year 6, $52,300; Year 7, $54,915; Year 8, $57,112; Year 9, $59,396; and Year 10, $62,366. Because Experian is not a publicly traded firm, it does not have a market equity beta. The company most comparable to Experian is Equifax. Equifax has an equity beta of 0.86. The market value of Equifax's debt is $366.5 thousand, and its common equity is $4,436.8 thousand. Assume an income tax rate of 35 percent throughout this problem.
This problem sets forth the steps the analyst might follow in valuing an LBO candidate.
Required:
a. Compute the unlevered market equity (asset) beta of Equifax. [See Chapter 11.]
b. Assuming that the unlevered market equity beta of Equifax is appropriate for Experian, compute the equity beta of Experian after the buyout with its new capital structure.
c. Compute the weighted average cost of capital of Experian after the buyout. Assume a risk-free interest rate of 4.2 percent and a market risk premium of 5.0 percent.
d. The analysts at the buyout firm project that free cash flows for all debt and equity capital stakeholders of Experian will increase 5.0 percent each year after Year 10. Compute the present value of the free cash flows at the weighted average cost of capi- tal. Ignore the midyear adjustment related to the assumption that cash flows occur, on average, over the year. In computing the continuing value, apply the 5.0 percent projected growth rate directly to the free cash flows of Year 10.
e. Assume that the buyout group acquires Experian for the value determined in Part d. Assuming that actual free cash flows to all debt and equity capital stakeholders coin- cide with projections, will Experian generate sufficient cash flow each year to service the debt? Explain.
Text Book: Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective By James Wahlen, Stephen Baginski, Mark Bradshaw.