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NBA 5111 Financial Modeling

Fall 2024

Group project due by end of day on Friday, December 13

Modeling a leveraged recap transaction of a real company is likely to be challenging. This exercise will allow you to apply the tools and techniques developed in this course to a modeling task relevant to today’s business environment. So, keep in mind the following:

1. Devote a reasonable amount of time to the project so that you can do your best.
2. Attractive candidates for  LBO generally  have the following financial characteristics among: (1) strong, stable free cash flows (definitions vary, but generally CFO net of CFI); (2) low/no debt; (3) low market capitalizations. Strong free cash flows will allow the target to service the new debt issued in the transaction, whereas low/no existing debt and a low market cap reduces the capital the specialist needs to commit to the transaction.
3. Download the financial statements from Capital IQ. Please keep all worksheets from your downloaded file. Create a new worksheet for the LBO where you may paste in the historical income statement and balance sheet. Please develop the other parts of your model from scratch. You may use the course model as a guide, but only as a guide. Constructing the model from a blank workbook (or Capital IQ download) is the best way to learn the material.
4. Your first model will not be your  last. Once  you have the model working  correctly, clean the model up and reconstruct the model so that it works as efficiently and logically as possible.
5. The market for corporate control is relatively efficient. Therefore, your selected company may not offer attractive returns to a buyout specialist. Please do not worry if the IRRs on your proposed transaction are less than stellar. You will be evaluated on the quality and functionality of your model, not your ability to find a good LBO target.

Your job:

Work in groups of four or less (no exceptions). Once you have identified a company that you believe will make a good candidate for a leveraged recap transaction, put together a working model (Assumptions, I/S, B/S, SCF).

The forecast horizon should extend six years  beyond the  most recent balance sheet date.  Most balance sheet and income statement assumptions should appear in the common-size income statement and common-size balance sheet for the period covering the forecast horizon. Create schedules to forecast sales (e.g., annual growth rates or a sales build-up) and any line item not forecast as a percent of same year sales. Examples include tax expense, debt balances, and interest expense.

You must build a CapEx schedule for property, plant, and equipment and depreciation expense as part of this assignment.

Once you have a working model, begin modeling the transaction. Assume the following:

1. An LBO shop like  KKR  is considering  acquiring  your company in a transaction  structured  as a leveraged recapitalization.  For simplicity assume the transaction will take place at the start of business in fiscal year +2 in the forecast  horizon.  For  example, if the  latest 10-K covers  the fiscal  year ending  December  2023,  assume  the transaction takes place January 1, 2025 (day +1 of year +2).
2. Start by assuming 90% of the original shares outstanding will be repurchased for a 10% premium over the current stock price.  You can assume the stock price on the transaction date will be the same as it is today.
3. The banks will allow the transaction to be partially financed with debt, as follows:

a.   The company will pay off any existing debt (a “Use” in the “Sources and Uses” schedule).

b.   The  company  will  be permitted to  borrow new (term) debt, but with limits. Based on your pro formas incorporating the effects of the transaction, Debt/EBITDA may not exceed 6.0x in any year from the year of the transaction to the time of exit, nor may EBIT/ Interest be less than 2.0x in any year from the year of the transaction to the time of exit. For these calculations, include a revolver balance as debt and include any interest on the revolver.

c.  The company  must amortize the term debt on a straight-line basis over a period of seven years, i.e., in addition to the interest due each year, it must make principal repayments each year equal to 1/7 of the new term debt taken on, until completely paid off.

d.     Interest will be paid annually on the average outstanding term debt balance during the year at an interest rate of SOFR plus 4%. Assume that the current SOFR holds for the entire period.

4.     Set up a current liabilities account titled “Revolving Line of Credit” to be your plug (be sure to incorporate an error- trapping approach,  i.e.,  IFERROR or circuit  breaker).  Maximum  availability  (i.e.,  max  ending  balance) each year should be based on the larger or the following two calculation: (1) 85% of accounts receivable (average balance over year) plus 50% of inventory (average balance over year), or (2) 60% of non-cash current assets.  Calculate this availability level for each year and compare it to the ending balances you find by using the revolving line of credit as the plug in your model.  These comparisons might constrain the maximum amount of term debt the firm can take on. You do not need to model this as a hard constraint. Instead, it is acceptable to monitor compliance with this constraint over the  holding  period  (i.e.,  similar  to the  debt  limits  identified  in  3b,  above).  Interest  on  the outstanding revolving line of credit will be payable annually based on the average balance and an interest rate of SOFR plus 5%.

A zero balance in the revolving line of credit would indicate that your firm is generating more than enough cash to meet its obligations. You might want to consider increasing the level of debt taken on to finance the transaction, if other constraints make this a viable option. Else, use the excess cash to pay down your term debt faster. If the revolver and transaction debt are paid down to zero, any remaining excess cash should be paid out to equity holders pro rata as a dividend. Remember, other equity holders remain after the initial transaction, so the buyout specialist does not receive 100 percent of any equity distributions the target company makes.

Suggestions:

Create a separate section entitled “Debt Schedule” and use this section to calculate (1) your annual term debt balances;

(2) your annual revolving line of credit availability and balances; and (3) your interest expense on both balances.

Additionally, you should calculate and include on the “Debt Schedule” the following coverage ratios, and determine that the firm is not in violation of either of these covenants in any year :

1.     Interest coverage ratio (EBIT / total interest expense exceeds 2.0x in every year).

2.     Leverage test (total debt / EBITDA does not exceed 6.0x in any year).

3.     Revolver availability test (revolver balance does not exceed maximum availability, described above). Leveraged Recap Exit:

1. Make the following assumption about KKR’s exit strategy:   KKR will exit the investment five years after the time of the transaction (end of year +6 in the forecast horizon). They will be able to sell at an EBITDA multiple equal to what they  paid  initially.  For  example, if paying a  10%  premium  on  1/1/2025  translates  into  paying  an  10.0x  EBITDA multiple, assume that they will be able to sell at an 10.0x EBITDA valuation on 12/31/2029. Use trailing multiples for entry and exit.
2. If KKR’s target IRR for portfolio investments is 25%, would your company offer an attractive acquisition opportunity What would KKR’s target IRR have to be for your company to be an attractive proposition? Model the effect of exit multiple scenarios on expected IRRs.