BUYOUT RESEARCH

Buyout Research



Buyout Research

Business Overview

Several features of RJR Nabisco made it a particularly attractive LBO candidate. Its operations exhibited moderate and consistent growth, required little capital investment and carried low debt levels. Its problems-a declining return on assets and falling inventory turnover-appeared fixable. And it offered significant break-up value. Valuing RJR's equity at the time of the LBO requires detailed knowledge of the company's operations and extensive number crunching. The analysis is obviously quite dependent on the assumptions made about cash flow in the post-LBO period, as well as the long-term, steady-state growth rate. Nevertheless, the figures suggest that, even assuming a high, 5 per cent level of steady-state growth, RJR's cash flows would have to grow at a rate of at least 18 per cent per year to justify KKR's bid of £109 per share. RJR's board played a prominent role in the bidding process. By setting the bidding rules, the board successfully minimized the possibility of collusion and thus increased potential gains to stakeholders. The decision to accept KKR's offer over RJR management's higher bid appears to reflect the board's concern for employees and existing shareholders.

Valuation of the Seller

All the inputs needed to value RJR are now available. We performed the following sequence of calculations.

First, using 12.06 per cent as the cost of capital, we discounted each of the projected cash flows for the 10 years 1989-98 (from Table III) back to 1988. This calculation yielded a value of £15,633.77 million. (Putnam and Henning 1989 12-140 )

Second, we had to make some assumptions about the period following 1998. A review of the different assessments made by the acquiring group could lead us, for example, to select 3 per cent as the steady-state compound growth rate for the period following 1998. As Table VIII shows, the present value of post-1998 cash flows, given a 3 per cent growth rate, is £16,952 million.

Finally, in order to derive the value of RJR's equity, we added the present value of the cash flows for the 1989-98 period (£15,633.77 million) to the present value of the cash flows following 1998 (£16,952.00 million). This gave a total firm value of £32,585.77. From this value we subtracted RJR's existing long-term debt (£5,390.20 million), which yielded an equity value of £27,195.37 million. Given RJR's 223.52 million shares of common stock, this resulted in a value of £121.66 per share.

Obviously, the valuation is dependent on the projected growth rate. As Table VIII shows, a conservative assumption of no growth following 1998 yields a value per share of £101.10. At the other extreme, a post-1998 growth rate of 5 per cent gives a share value of £145.04, Most analysts pointed to the 2 to 3 per cent range as the most likely steady-state scenario, implying a value in the range of £113 to £121. (Putnam 1988 427-60 )

The per-share valuation analysis in Table VIII is based on KKR's 21.7 per cent projected annual cash flow growth rate for the first 10 years (1989-98) and alternative ...