Giddy: Case study

1. The John M Case Leveraged Buy-Out

The owner of a small, privately held company decides to sell out, and a group of the company's top managers structures a leveraged buyout.
Questions :

1. What are the most important operating and financial characteristics of the Case Company ?

2. Is the company worth Mr Case's $20 million asking price ?

3. Can the $20 million purchase be financed so that management can retain at least 51% ownership ? What sources should management tap ? In what amounts? Is the return being sought by the venture capital reasonable ?

4. How compelling a buyout opportunity is this proposition for the four managers ?

5. Would you, as a commercial banking lender, provide the loan needed to finance the seasonal buildup in accounts receivable and inventory ? On what terms ?

6. Would you, as the venture capital firm, provide the balance of the funds needed ? If so, on what terms ?

Note : Mr Case is willing to take a note with a face value of $ 6 million and an interest rate of 4%. However, the note's economic value due to the low interest rate, is only $ 4 million; the $20 million sale price is based on receiving the note plus $ 16 million in cash.

2. The Leveraged Buy-Out of Infox

Describes an opportunity for Apax, a private equity firm, to

invest in a travel-related print-materials distribution business

in Germany. Infox is typical of many buyout opportunities.

One of the founders seeks to exit the business, and recently-

hired managers will have to assume an increased level of

responsibility. To make its investment decision, Apax has to

value the company and secure debt financing. In this

context Apax has to assess not only the growth

opportunities for Infox but also whether remaining

management is up to the job.

Questions :

1. Should the partners recommend this investment ?
2. What price range would be acceptable ?

3. What financing structure would you propose ?

- Amount of debt financing
- Kind of debt and equity

3. Sealed Air Corp.'s Leveraged Recapitalization (A)
                 Less than a year after Sealed Air embarked on a program to
                 improve manufacturing efficiency and product quality, the
                 company borrowed almost 90% of the market value of its
                 common stock and paid it out as a special dividend to
                 shareholders. Management purposefully and successfully
                 used the leveraged recapitalization as a watershed event,
                 creating a crisis that disrupted the status quo and promoted
                 internal change, which included establishing a new
                 objective, changing compensation systems, and
                 reorganizing manufacturing and capital budgeting
                 processes. Provides a context in which
                 to explore how financing decisions affect organizational
                 structure, management decision making, and firm value.
                 The concept of free cash flow, its effect on stock market prices and firm value,
                 and the disciplinary role of high leverage can be analyzed.

Questions :

1. Why did Sealed Air undertake a leverage recapitalization ? Do you think that it was a good idea ? For whom ?
2. How much value was created ? Where did it come from ?

Sealed Air's business threw off a lot of cash. Prior to the recap the company had over $ 50 million in cash and short-term investments and Dunphy expected cash on hand to more than double over the next year and a half. Bruce Cruickshank described the company's situation, stating "there were no good acquisitions and we had nothing to do with the cash. Just increasing the dividend over the years was admitting defeat. We didn't want to be a public utility."

Sealed Air's management faced many alternative uses for the company's cash. Among them were launching a capital expenditure program, buying another company, increasing the regular dividend, or starting to manage a portfolio of securities. Some students will argue that the decision to recapitalize demonstrates a failure on the part of the top management team ; they should have been able to find something productive to do with the money. This line of discussion is useful and can be enouraged by a question like :

- Dunphy was an MBA (HBS class of '56), shouldn't any self-respecting MBA be able to find a way to spend several hundred million dollars ?

In fact, Dunphy felt strongly that his job was not to be a portfolio manager, nor did he want to waste shareholders' money on a second-rate acquisition. He decided not only to pay out the cash on hand, but to borrow against the company's future cash flows and pay the $ 40 special dividend. Dunphy felt the market was "substantially undervaluing" the company's stock and seriously considered paying out $ 45 - almost the entire stock price - to demonstrate that there was excess value to be realized.

One reason that Sealed Air's stock was "undervalued" was because the company was generating "free cash flow". Free cash flow in excess of that required to fund all the company's positive net present value investment opportunities. [Jensen (1986)]. Free cash flow tempts companies to waste cash. Pete Funkhouser, Senior Vice President, described this problem at Sealed Air, "We didn't need to manufacture efficiently, we didn't need to worry about cash. At Sealed Air, capital tended to have limited value attached to it - cash was perceived as being free and abundant." The most productive use of free cash flow is to distriubute it to shareholderss and allow them to reinvest of spend it as they choose. The market applied a discount to Sealed Air's stock because manaagers could not make a believable promise to disgorge the cash. Paying out today's cash balance ($54 million) would not solve the problem. Borrowing and paying the proceeds to shareholders served to bond managements's decision not to retain excess cash. Future cash flows were committed to lenders who had a legally enforceable claim on a specified cash flow stream.

4. K-III: A Leveraged Build-Up
                    Explores the strategy, financing, and governance of a
                    new type of organizational form, dubbed the Leveraged
                    Build-Up by its inventor, Kohlberg, Kravis, Roberts.

5. Times Mirror Co.
                 Times Mirror Co. (TMC) owns a substantial block of
                 Netscape common stock purchased prior to Netscape's
                 IPO, on which it has substantial unrealized gains. TMC is
                 restricted from selling the stock in a public offering, and is
                 therefore considering a proposal by Morgan Stanley to issue
                 Premium Equity Participating Securities (PEPS) to
                 monetize its Netscape holdings. These PEPS would pay
                 interest quarterly and be redeemable in five years at a price
                 tied to the value of Netscape shares, subject to certain
                 formulas and call provisions effectively apportioning the
                 upside in Netscape stock between TMC and the PEPS
                 investors. The tax treatment of the PEPS, while unclear, is
                 of significant importance.

Allows one to explore the use of functionally-equivalent financial strategies to carry out a tax-efficient disposal of appreciated stock
Allows one to deconstruct and value an embedded derivative security.

Questions :
1. Describe the most important features of the PEPS proposal.
2. How can you describe the PEPS in terms of simple "building blocks" contracts - e.g. stock, puts, etc. ?
3. How would you price these, in order to help the company assess the cost of financing ?
4. How large is Times Mirror's net benefit from issuing the PEPS, compared to other alternatives ?

6. Enron
                 Investigates an innovative bond issue by Enron Corp. The
                 coupon on the bond is indexed to the company's credit
                 rating, making it a credit derivative structure.