Question 1

Which of the following is true of the cost of capital method of valuation?

Accepted Answer

The cost of capital method of valuation usually involves multiple steps and requires the estimation of various variables, making it more tedious to calculate than other valuation methodologies.

Answer: D 
 The cost of capital method of valuation assumes a constant discount rate throughout the life of the project and does not adjust the discount rate as debt is repaid, making it a limitation of this method.

Therefore, the correct answer is A and D.

Question 2

An LBO model is used to determine what a firm is worth in a highly leveraged transaction and is applied when there is the potential for a financial buyer or sponsor to acquire the business.

Accepted Answer

An LBO model is indeed used to determine the value of a firm in a highly leveraged transaction, typically when a financial buyer or sponsor is seeking to acquire the business.

Question 3

While the DCF approach often is more theoretically sound than the IRR approach (which can have multiple solutions),IRR is more widely used in LBO analyses since investors often find it more intuitively appealing,that is,the higher an investment's IRR,the better the investment's return relative to its cost The IRR is the discount rate that equates the projected cash flows and terminal value with the initial equity investment.

Accepted Answer

The statement accurately reflects the differences and popularity between the DCF and IRR approaches in LBO analyses.

Question 4

Using the cost of capital method to value an LBO involves all of the following steps except for which of the following?

Accepted Answer

The cost of capital method to value an LBO involves adjusting the discount rate to reflect changing risk, calculating a terminal value, projecting annual debt-to-equity ratios and projecting annual cash flows. However, it does not involve adding the present value of future tax savings to the present value of annual free cash flows to equity.

Question 5

The primary advantage of the cost of capital method is its relative computational simplicity.

Accepted Answer

The answer of The primary advantage of the cost of...

Question 6

The DCF analysis solves for the present value of the firm,while the LBO analysis solves for the discount rate or internal rate of return.

Accepted Answer

DCF analysis calculates the present value of a firm by discounting future cash flows, while LBO analysis determines the internal rate of return (IRR) by assessing the returns on equity investment in a leveraged buyout.

Question 7

LBO analyses are similar to DCF valuations in that they require projected cash flows,present values,and discount rates; however,LBO models do not require the estimation of terminal values.

Accepted Answer

LBO analyses do require the estimation of terminal values, as they are used to determine the exit value of the investment at the end of the holding period.

Question 8

The adjusted present value approach takes into account the effects of leverage on risk as debt is repaid.

Accepted Answer

The answer of The adjusted present value approach takes into...

Question 9

Which of the following are steps often found in developing a LBO model?

Accepted Answer

Developing a LBO model typically involves cash flow projections to determine if the leverage taken on to buy a company can be serviced, determining a firm's borrowing capacity based on its cash flow and assets as collateral, and determining a financial sponsor's equity contribution to the purchase price. Therefore, all of the choices are steps often found in developing a LBO model.

Question 10

An LBO model helps define the amount of debt a firm can support given its assets and cash flows.

Accepted Answer

An LBO model, or leveraged buyout model, is specifically designed to determine how much debt a company can take on to fund a purchase or acquisition. The model calculates the company's cash flows, assets, and liabilities to determine an appropriate level of debt that can be supported. Therefore, the statement that an LBO model helps define the amount of debt a firm can support given its assets and cash flows is true.

Question 11

An LBO can be valued from the perspective of which of the following?

Accepted Answer

An LBO can be valued from the perspective of equity investors, lenders, and all those supplying funds to finance the transaction. Each group has a different interest and expectation in the success or failure of the transaction and therefore will value it differently. Equity investors will be interested in the potential return on their investment, lenders will be interested in the ability of the borrower to make timely payments, and all those funding the transaction will be interested in the potential risks and rewards of the LBO. Therefore, considering all three perspectives is important for a comprehensive valuation of an LBO.

Question 12

Case Study Short Essay Examination Questions
"Grave Dancer" Takes Tribune Corporation Private in an Ill-Fated Transaction
At the closing in late December 2007, well-known real estate investor Sam Zell described the takeover of the Tribune Company as "the transaction from hell." His comments were prescient in that what had appeared to be a cleverly crafted, albeit highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise of 2008. The end came swiftly when the 161-year-old Tribune filed for bankruptcy on December 8, 2008.
On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded shares would be acquired in a multistage transaction valued at $8.2 billion. Tribune owned at that time 9 newspapers, 23 television stations, a 25% stake in Comcast's SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75% of the firm's total $5.5 billion annual revenue, with the remainder coming from broadcasting and entertainment. Advertising and circulation revenue had fallen by 9% at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune, and Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs, Tribune's stock had fallen more than 30% since 2005.
The transaction was implemented in a two-stage transaction, in which Sam Zell acquired a controlling 51% interest in the first stage followed by a backend merger in the second stage in which the remaining outstanding Tribune shares were acquired. In the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of total shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250 million of the $315 million provided by Sam Zell in the form of subordinated debt, plus additional borrowing to cover the balance. Stage 2 was triggered when the deal received regulatory approval. During this stage, an employee stock ownership plan (ESOP) bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell providing the remaining $65 million of his pledge. Most of the ESOP's 121 million shares purchased were financed by debt guaranteed by the firm on behalf of the ESOP. At that point, the ESOP held all of the remaining stock outstanding valued at about $4 billion. In exchange for his commitment of funds, Mr. Zell received a 15-year warrant to acquire 40% of the common stock (newly issued) at a price set at $500 million.
Following closing in December 2007, all company contributions to employee pension plans were funneled into the ESOP in the form of Tribune stock. Over time, the ESOP would hold all the stock. Furthermore, Tribune was converted from a C corporation to a Subchapter S corporation, allowing the firm to avoid corporate income taxes. However, it would have to pay taxes on gains resulting from the sale of assets held less than ten years after the conversion from a C to an S corporation (Figure 13.4).  Tribune deal structure.
The purchase of Tribune's stock was financed almost entirely with debt, with Zell's equity contribution amounting to less than 4% of the purchase price. The transaction resulted in Tribune being burdened with $13 billion in debt (including the approximate $5 billion currently owed by Tribune). At this level, the firm's debt was ten times EBITDA, more than two and a half times that of the average media company. Annual interest and principal repayments reached $800 million (almost three times their preacquisition level), about 62% of the firm's previous EBITDA cash flow of $1.3 billion. While the ESOP owned the company, it was not be liable for the debt guaranteed by Tribune.
The conversion of Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of $348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then pay taxes on these distributions. Since the ESOP was the sole shareholder, Tribune was expected to be largely tax exempt, since ESOPs are not taxed.
In an effort to reduce the firm's debt burden, the Tribune Company announced in early 2008 the formation of a partnership in which Cablevision Systems Corporation would own 97% of Newsday for $650 million, with Tribune owning the remaining 3%. However, Tribune was unable to sell the Chicago Cubs (which had been expected to fetch as much as $1 billion) and the minority interest in SportsNet Chicago to help reduce the debt amid the 2008 credit crisis. The worsening of the recession, accelerated by the decline in newspaper and TV advertising revenue, as well as newspaper circulation, thereby eroded the firm's ability to meet its debt obligations.
By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve from its creditors while it attempted to restructure its business. Although the extent of the losses to employees, creditors, and other stakeholders is difficult to determine, some things are clear. Any pension funds set aside prior to the closing remain with the employees, but it is likely that equity contributions made to the ESOP on behalf of the employees since the closing would be lost. The employees would become general creditors of Tribune. As a holder of subordinated debt, Mr. Zell had priority over the employees if the firm was liquidated and the proceeds distributed to the creditors.
Those benefitting from the deal included Tribune's public shareholders, including the Chandler family, which owed 12% of Tribune as a result of its prior sale of the Times Mirror to Tribune, and Dennis FitzSimons, the firm's former CEO, who received $17.7 million in severance and $23.8 million for his holdings of Tribune shares. Citigroup and Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees. Morgan Stanley received $7.5 million for writing a fairness opinion letter. Finally, Valuation Research Corporation received $1 million for providing a solvency opinion indicating that Tribune could satisfy its loan covenants.
What appeared to be one of the most complex deals of 2007, designed to reap huge tax advantages, soon became a victim of the downward-spiraling economy, the credit crunch, and its own leverage. A lawsuit filed in late 2008 on behalf of Tribune employees contended that the transaction was flawed from the outset and intended to benefit Sam Zell and his advisors and Tribune's board. Even if the employees win, they will simply have to stand in line with other Tribune creditors awaiting the resolution of the bankruptcy court proceedings.
:
-Describe the firm's strategy to finance the transaction?

Accepted Answer

The answer of Case Study Short Essay Examination Questions
"Grave Dancer"...

Question 13

Which of the following is not true about the cost of capital method of valuation?

Accepted Answer

The cost of capital method of valuation does adjust the discount rate for risk as debt is repaid, making option A not true.

Question 14

Which of the following is true of the adjusted present value method of valuation?

Accepted Answer

The adjusted present value (APV) method involves calculating the present value of the firm's cash flows without debt (unlevered firm) and separately calculating the present value of tax benefits from debt. These values are then added together to determine the total value of the firm.

Question 15

Case Study Short Essay Examination Questions
"Grave Dancer" Takes Tribune Corporation Private in an Ill-Fated Transaction
At the closing in late December 2007, well-known real estate investor Sam Zell described the takeover of the Tribune Company as "the transaction from hell." His comments were prescient in that what had appeared to be a cleverly crafted, albeit highly leveraged, deal from a tax standpoint was unable to withstand the credit malaise of 2008. The end came swiftly when the 161-year-old Tribune filed for bankruptcy on December 8, 2008.
On April 2, 2007, the Tribune Corporation announced that the firm's publicly traded shares would be acquired in a multistage transaction valued at $8.2 billion. Tribune owned at that time 9 newspapers, 23 television stations, a 25% stake in Comcast's SportsNet Chicago, and the Chicago Cubs baseball team. Publishing accounts for 75% of the firm's total $5.5 billion annual revenue, with the remainder coming from broadcasting and entertainment. Advertising and circulation revenue had fallen by 9% at the firm's three largest newspapers (Los Angeles Times, Chicago Tribune, and Newsday in New York) between 2004 and 2006. Despite aggressive efforts to cut costs, Tribune's stock had fallen more than 30% since 2005.
The transaction was implemented in a two-stage transaction, in which Sam Zell acquired a controlling 51% interest in the first stage followed by a backend merger in the second stage in which the remaining outstanding Tribune shares were acquired. In the first stage, Tribune initiated a cash tender offer for 126 million shares (51% of total shares) for $34 per share, totaling $4.2 billion. The tender was financed using $250 million of the $315 million provided by Sam Zell in the form of subordinated debt, plus additional borrowing to cover the balance. Stage 2 was triggered when the deal received regulatory approval. During this stage, an employee stock ownership plan (ESOP) bought the rest of the shares at $34 a share (totaling about $4 billion), with Zell providing the remaining $65 million of his pledge. Most of the ESOP's 121 million shares purchased were financed by debt guaranteed by the firm on behalf of the ESOP. At that point, the ESOP held all of the remaining stock outstanding valued at about $4 billion. In exchange for his commitment of funds, Mr. Zell received a 15-year warrant to acquire 40% of the common stock (newly issued) at a price set at $500 million.
Following closing in December 2007, all company contributions to employee pension plans were funneled into the ESOP in the form of Tribune stock. Over time, the ESOP would hold all the stock. Furthermore, Tribune was converted from a C corporation to a Subchapter S corporation, allowing the firm to avoid corporate income taxes. However, it would have to pay taxes on gains resulting from the sale of assets held less than ten years after the conversion from a C to an S corporation (Figure 13.4).  Tribune deal structure.
The purchase of Tribune's stock was financed almost entirely with debt, with Zell's equity contribution amounting to less than 4% of the purchase price. The transaction resulted in Tribune being burdened with $13 billion in debt (including the approximate $5 billion currently owed by Tribune). At this level, the firm's debt was ten times EBITDA, more than two and a half times that of the average media company. Annual interest and principal repayments reached $800 million (almost three times their preacquisition level), about 62% of the firm's previous EBITDA cash flow of $1.3 billion. While the ESOP owned the company, it was not be liable for the debt guaranteed by Tribune.
The conversion of Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of $348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then pay taxes on these distributions. Since the ESOP was the sole shareholder, Tribune was expected to be largely tax exempt, since ESOPs are not taxed.
In an effort to reduce the firm's debt burden, the Tribune Company announced in early 2008 the formation of a partnership in which Cablevision Systems Corporation would own 97% of Newsday for $650 million, with Tribune owning the remaining 3%. However, Tribune was unable to sell the Chicago Cubs (which had been expected to fetch as much as $1 billion) and the minority interest in SportsNet Chicago to help reduce the debt amid the 2008 credit crisis. The worsening of the recession, accelerated by the decline in newspaper and TV advertising revenue, as well as newspaper circulation, thereby eroded the firm's ability to meet its debt obligations.
By filing for Chapter 11 bankruptcy protection, the Tribune Company sought a reprieve from its creditors while it attempted to restructure its business. Although the extent of the losses to employees, creditors, and other stakeholders is difficult to determine, some things are clear. Any pension funds set aside prior to the closing remain with the employees, but it is likely that equity contributions made to the ESOP on behalf of the employees since the closing would be lost. The employees would become general creditors of Tribune. As a holder of subordinated debt, Mr. Zell had priority over the employees if the firm was liquidated and the proceeds distributed to the creditors.
Those benefitting from the deal included Tribune's public shareholders, including the Chandler family, which owed 12% of Tribune as a result of its prior sale of the Times Mirror to Tribune, and Dennis FitzSimons, the firm's former CEO, who received $17.7 million in severance and $23.8 million for his holdings of Tribune shares. Citigroup and Merrill Lynch received $35.8 million and $37 million, respectively, in advisory fees. Morgan Stanley received $7.5 million for writing a fairness opinion letter. Finally, Valuation Research Corporation received $1 million for providing a solvency opinion indicating that Tribune could satisfy its loan covenants.
What appeared to be one of the most complex deals of 2007, designed to reap huge tax advantages, soon became a victim of the downward-spiraling economy, the credit crunch, and its own leverage. A lawsuit filed in late 2008 on behalf of Tribune employees contended that the transaction was flawed from the outset and intended to benefit Sam Zell and his advisors and Tribune's board. Even if the employees win, they will simply have to stand in line with other Tribune creditors awaiting the resolution of the bankruptcy court proceedings.
:
-What is the acquisition vehicle,post-closing organization,form of payment,form of acquisition,and tax
strategy described in this case study?

Accepted Answer

The answer of Case Study Short Essay Examination Questions
"Grave Dancer"...

Question 16

The riskiness of highly leveraged transactions declines overtime due to which of the following factors?

Accepted Answer

As debt is gradually reduced over time through principal payments, the leverage of the transaction decreases, which in turn reduces the overall riskiness of the transaction.

Question 17

Using the cost of capital method to value an LBO involves which of the following steps?

Accepted Answer

All of the given steps are involved in using the cost of capital method to value an LBO. Projection of annual cash flows is necessary to estimate the expected returns, projection of annual debt-to-equity ratios is helpful in understanding the financing structure of the LBO, calculation of a terminal value is necessary to estimate the enterprise value at the end of the projection period, and adjusting the discount rate to reflect changing risk is necessary to account for changes in the market and industry conditions. Therefore, all the given steps are important in this method.

Question 18

Which of the following is not true about LBO models?

Accepted Answer

The answer of Which of the following is not true...

Question 19

Which of the following are often viewed as disadvantages of the adjusted present value method?

Accepted Answer

All three options - A) ignoring the effects of leverage on the discount rate as debt is repaid, B) requiring estimation of the cost and probability of financial distress, and C) ambiguity in defining the proper discount rate - are often viewed as disadvantages of the adjusted present value method.

Question 20

Financial buyers often will attempt to determine the highest amount of debt possible (i.e.,the borrowing capacity of the target firm)to maximize their equity contribution in order to maximize the IRR.

Accepted Answer

The answer of Financial buyers often will attempt to determine...

Quiz 14: Highly Leveraged Transactions: Lbo Valuation and Modeling Basics