Case solution
65
Leveraged Buy Out of Revco D S Inc.
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Finance
Transcript of Case solution
Leveraged Buy Out of Revco D S Inc.
Leverage Buyout of Revco D S Inc
Submitted To:Dr. Md. Sadiqul Islam
ProfessorDepartment of Finance
University of Dhaka
Submitted By:Group no. 413th batch
Department of FinanceUniversity of Dhaka
Date of Submission: 09 September, 2012
Group Members
Name Roll
Mohammed Robiul Alam 13-643
ASM Zakariya 13-578
Rokeya Mahzavin 13-588
Md. Shah Naoaj 13-686
Taslima Akter 13-666
Letter of Transmittal
Dr. Md. Sadiqul Islam
Professor
Department of Finance
University Of Dhaka
Subject: Submission of Case Report.
Dear Sir:
With great pleasure and honor we are submitting our case report on “Leverage Buy Out of
Revco D S Inc”. The case study includes analysis of LBO of Revco. We analyzed the LBO
from different viewpoints by using various financial tools and software.
We have tried our best to accommodate as much information and relevant issues as possible
and follow the instructions that you have given.
We would like to thank you for providing us with the opportunity to prepare this case report.
Sincerely Yours
Group -04
13th batch
Department of Finance
University of Dhaka
Table of Contents1. Introduction.....................................................................................................................................................1
1.1. The Company..........................................................................................................................................1
1.2. Competition............................................................................................................................................1
1.3. Origin and Terms of the Buyout.............................................................................................................1
1.4. Management of New Revco...................................................................................................................2
1.5. Strategy and Restructuring Plans............................................................................................................2
1.6. Outlook...................................................................................................................................................3
1.7. Comparative Analysis.............................................................................................................................4
1.8. Capital Adequacy....................................................................................................................................5
2. Business Analysis............................................................................................................................................6
2.1. PESTEL..................................................................................................................................................6
2.2. HEPTALYSIS........................................................................................................................................8
2.3. SWOT...................................................................................................................................................10
2.4. Porter’s Five Forces Model...................................................................................................................12
2.5. SCRS.....................................................................................................................................................14
3. Time Series Ratio Analysis of Revco D.S. Inc..............................................................................................16
3.1. Profitability Ratio:................................................................................................................................16
3.2. Liquidity Ratio:.....................................................................................................................................17
3.3. Efficiency Ratio....................................................................................................................................19
4. Cross Sectional Ratio Analysis of Revco D.S. Inco......................................................................................20
5. Bankruptcy Risk............................................................................................................................................21
5.1. Altman Z-score.....................................................................................................................................21
5.2. Estimation of the formula.....................................................................................................................22
5.3. Accuracy and effectiveness..................................................................................................................22
5.4. Z-score estimated for private firms.......................................................................................................22
6. DuPont Analysis............................................................................................................................................23
ROA and ROE ratio.........................................................................................................................................24
7. Case Analysis................................................................................................................................................26
8. Valuation.......................................................................................................................................................26
8.1. Assumptions:........................................................................................................................................27
8.2. Calculation WACC:..............................................................................................................................28
8.3. Comparative Analysis with Peer Company:.........................................................................................31
8.4. Possible Reasons for Going LBO:........................................................................................................33
9. Capital Adequacy:.........................................................................................................................................34
9.1. The Variables........................................................................................................................................35
9.2. Results...................................................................................................................................................37
9.3. Conclusions and Implications...............................................................................................................39
1. Introduction
In December 1986 the management of Revco D.S. and a group of investors took the company private
in a leveraged buyout (LB0). Revco was the operator of the largest chain of discount drug stores in the
United States. The buyers paid a 48 percent premium for the shares compared to the price in January
1986, before the announcement of plans for the buyout. In addition to the large acquisition premium,
this buyout arrested\ tj1e attention of investors and analysts because of its unusual financing terms.
Goldman Sachs advising the board of directors, had declared that the purchase · price was "fair."
Salomon Brothers, advising the buyout group, had designed the transaction and employed its
considerable bond-trading muscle to promote it-indeed, this was Salomon's first major "done deal"
acting simultaneously as buyout advisor, underwriter, and merchant banker. On the other hand,
Moody's and Standard & Poor's, the bond rating agencies, declared Revco's LBO to have a "negative
outlook" and downgraded their ratings of Revco's public bonds to "speculative" categories. Analysts
noted that debt repayment in the first few years depended significantly on asset sales, an especially
uncertain source of cash. More importantly, the operating performance of the firm had been declining
over recent quarters.
1.1. The Company
In 1986 Revco was the nation's largest discount drugstore chain, operating 2,049 stores in 30 states.
Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956
and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Strip
centers in small cities were the primary location of Revco stores, with approximately 70 percent of the
company's stores located in cities with a population of less than 25,000. Over the previous 5 years, the
number of stores had grown at an annual compound rate of 6.24 percent, from 1,514 stores in 1981.
The average cost of opening a new store was approximately $300,000, with inventory comprising
approximately $200,000 of this tota1.
1.2. Competition
Revco competed with health maintenance organizations, hospital pharmacies, mail-order
organizations, discount drugstores, combination food-and-drug stores, mass .merchandisers, and the
rapidly emerging "deep discount" drugstores. Deep discounters were large "super" drug stores relying
on volume to compensate for the unusually low prices they charged. Consequently, deep discount
drugstores were located primarily in cities with populations over 250,000 and were not seen as a
major threat to Revco. The drugstore industry exhibited little cyclicality since most sales were
necessity items and few substitute products existed.
1.3. Origin and Terms of the Buyout
Since April 1984 chief executive officer and chairman of the board Sidney Dworkin had been
concerned with' possible takeover threats following a series of highly publicized mishaps at Revco.
Revco's common stock price had not recovered from the negative impact of these adversities.
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Rumours of an impending hostile takeover attempt on Revco had ebbed through the financial
community in 1984, 1985, and 1986. On March 11, 1986, Dworkin struck first by submitting a buyout
proposal to Revco's board of directors, He later raised the offer price to a cash payment of $38.50 per
share. The board accepted tho offer on August 15. The buyout closed on December 29, 1986.
The buyout would require nearly $1.5 billion, to be placed through the issuance of nine different
classes of securities, the bulk of them being debt and preferred stock. Salomon Brothers, the buyout
group's investment banker and a part-equity owner, had lined up the required financing from a variety
of sources.
1.4. Management of New Revco
Once the LBO was completed·, Sidney Dworkin became chairman of the board and Chief executive
officer of the "new" Revco, the same positions he had held at Reyco D. S. As in the old entity,
Dworkin did not control a majority ofthe outstanding shares ofsto.ck; he owned 'about 15.4 percent.
However, these shares were subject to a voting trust of which he was a member. Apparently, Mr.
Dworkin would have more control in the "new" Rcvco than he had had at Rcvco D. S., where his
ownership percentage was only 2.32 percent. Dworkin received $29.6 million for the stock and stock
options that he held in the old. Revco. He invested about $8 million in the "new" Revco. '
1.5. Strategy and Restructuring Plans
If the merger had occurred on June 2, 1985, earnings before depreciation, amortization, interest, and
income taxes would have been $161 .8 million for the year ended May 31, 1986, just sufficient to
cover pro-forma interest expense-of $155 million. Revco managers believed that the company's
results since the beginning of fiscal 1985 were not indicative of future prospects and that Revco's
performance in 1987 and beyond would be more in line with pre-1985 results.
Nevertheless, because the interest-coverage ·ratio would be very low, management adopted a program
to increase the margin of safety. Elements of the program included the following:
Focus on drugstore business. Management planned to divest virtually Revco’s entire nondrugstore
businesses plus 100 drugstores, thus permitting management to concentrate on expanding its
drugstore operations and improving drugstore gross margins and profitability. Management had
earmarked $230 million in assets for sale by the end of June 1987 and had, in principle, reached
agreements to sell $89 million of those assets by the time the company went private. At least four
months would be needed to consummate these agreements. First, management devised a divestiture
program to dispose of all of the non-drugstore subsidiaries. The credit agreement with the major
banks called for Revco to make principal payments in 1987, 1988, and 1989, that would reduce the
term loan to $150 million from $455 million. Of the $305 million In payments, $255 million were
expected to occur through the divestiture program. Duff & Phelps had been engaged to value Revco's
seven subsidiaries, and an analysis dated October 17, 1986 estimated the aggregate market value of
these subsidiaries at $224.5 million. Book value of these subsidiaries was $178 million. ·
Expand. Future expansion plans included opening or acquiring approximately 100 stores per year
over the subsequent five years. This expansion would be financed by working capital from operations.
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Most of this expansion was to be in small communities. Management believed that Revco's presence
in prime locations in these small markets discouraged entry by other large drugstore chains. In
addition; the small size of the market tended to bar entry for deep discount stores, which generally
required a larger population base to support profitable operations.
Reduce capital expenditures. Because approximately 75 percent of all Revco drugstores either were
new or had been remodeled since the beginning of fiscal I 981, management believed that Revco's
program of remodeling its existing stores could be implemented each year within a modest budget.
Reduce inventory and selling expense. As part of its efforts to increase Revco's profitability,
management implemented an inventory-reduction program, which was to be substantially completed
by the end offiscal1987. Assuming a ratio of inventory-to-sales consistent with past · experience,
management anticipated that inventory levels would be reduced by approximately $129 million from
the levels that would otherwise exist. In addition, management initiated a program designed to reduce
selling, general, and administrative expenses by approximately $24 million during 1987 from the
levels that would otherwise have existed.
Maintain current marketing strategy. Management would continue to build on two of Revco's
fundamental strengths: its many convenient locations and its "everyday low prices" pricing strategy.
Dworkin believed that these two strengths would continue to frame consumers' perceptions of Revco
as a convenience drugstore, selling quality products at low prices at all times.
Increase sales of non-prescription items. Revco's merchandising and marketing strategy was to
maintain its strong prescription sales as the company" increased sales of and improved margins on
non-prescription items. This would entail rearranging store layouts to draw the customer through
aisles of non-prescription items as the customer proceeded to the drug counter. Non-prescription
merchandise would include; lawn furniture, kitchen appliances, small consumer electronic items, etc.
1.6. Outlook
Sales for the stub period (from the closing on December 26, 1986 to the next fiscal year end, May 31,
1987) were expected to be about $990 million, resulting in an operating profit of about $47 million.
This would leave an operating profit of$147 million for the 1987 fiscal year ending May 31, modestly
higher than for 1986's operating profit of $125 million.
In making their assessments of the transaction, outside analysts considered historical financial
performance (Exhibits 1 and 2), projected financial performance (Exhibits 3 and 4), information on
comparable companies (Exhibit 5), and current capital market rates and indices (Exhibit 6). Analysts
identified a number of key assumptions:
Growth rate of sales per store: The forecast assumed 6 percent annual growth in sales per store,
reflecting an anticipated 5 percent inflation rate and a 1 percent real growth rate. Analysts wondered
about the appropriateness of the real-growth-rate assumption, especially given the very low (or even
negative) population growth rates in small communities.
Cost of goods sold (COGS)/sales: The forecast assumed Revco's 5-year historical average, 73
percent. Analysts compared Revco with other drug retailers, whose COGS/sales ratio averaged 71
percent (see Exhibit 5). Acknowledging the difficulty of achieving a 1 percentage point improvement
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in this ratio (especially with a policy of discount pricing, analysts wondered whether Dworkin could
realize some economics following the buyout.
Selling, general, and administrative expenses/sales: The forecast assumed Revco's 5 year historical
average of 20.8 percent, as opposed to an industry average of23.6 percent. Analysts also wondered
whether economies were possible in this area.
Timing of asset sales: Consistent with Dworkin's plan (and bankers' expectations), the forecast
assumed the sale of $230 million in assets in 1988. However any softening in the acquisitions market
might delay the sale until 1989 or even 1990.
Timing and volume of new store openings: The forecast assumed that Revco would open 100 new
stores each year for the next five years and would then stop expanding as the target market became
saturated. Some analysts questioned Dworkin's ambitious store-opening plans, especially in light of
Revco's high leverage. Dworkin countered that the next few years offered a temporary window to gain
dominance in certain markets, and that the cash-flow growth afforded by this expansion would assist
in the amortization of debt and boost returns to the equity investors.
1.7. Comparative Analysis
Analysts considered the experience of another major drug store retailer, Jack –Eckerd Corporation,
which had been taken private in an LBO in April 1986. In most respects the two companies were quite
similar: Eckerd had been taken private, however, at a multiple of only 21.3 times, compared with
Revco's 24.8 times earnings. Eckerd was also financed at a debt-equity ratio of 11.5 times, compared
with Revco's 37.6 times.
Exhibit 7 presents a forecast of how well Revco and Eckcrd could cover their financial obligations in
the next three years, the period over which analysts perceived the greatest possible risk of default. For
each company, the financial obligations included interest expense, principal payments, and preferred
stock dividend payments. The "coverage'' of these obligations was estimated as a multiple compared
with earnings before interest and taxes (EBIT); and "cash flow," which consisted of earnings before
interest, taxes, depreciation, and amortization (EBlTDA) plus the receipts from any asset sales less
capita\ expenditures. (Additions to net working capital are ignored in this calculation. Ordinarily they
deserve to be included in an analysis like this. Exclusion of this item biases the estimated coverage
rates upward.
Analysts acknowledged; however that the comparative figure such as those in Exhibit 7 were point
estimates and thus ignored the uncertainty surrounding key assumptions. Revco's financial obligations
were well known at the .time of the buyout. Thus, the uncertainty about Revco's comparative standing
versus Jack Eckerd and other firms devolved from forecast uncertainty about the following points:
Interest rates: Revco's senior debt bore interest that floated at 1.75 percent above prime rate,
currently at 7.50 percent
Asset sales: Revco had to sell assets to .meet its principal payments. One could give Revco the
benefit of the doubt and assume that all $230 million would actually be realized. But analysts were
uncertain about the timing18 of that realization. By comparison, Jack Eckerd would try to sell $72
million in assets.
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Capital expenditures: Capital expenditures could be assumed to be driven by Revco's goal of
opening 100 stores per year at an investment of$1 00,000 per store. Depreciation could be
approximated as $20 million for 1987, and thereafter scaled according to the percentage net change of
the difference between asset sales and capital expenditures. By contrast, Jack Eckerd envisioned
opening no new stores in the foreseeable future. Eckerd's depreciation was forecasted to be $123
million, a much higher figure than Revco's because Eckerd tended to own, rather than lease, its 'stores.
Growth: Salomon Brothers contemplated a sales-growth rate no lower than 8 percent; it presented
forecasts to commercial bankers that assumed growth at 12 percent. Goldman Sachs, the advisor to
Revco's outside directors, determined that a 12 percent growth rate assumption was "too aggressive."
Analysts assumed sales growth of mature stores to be equal to the rate of inflation. In addition, "the
net growth from opening new stores would yield an annual corporate growth rate of 9 percent. ·
EBIT margin: From 1974to 1986, Revco's mean EBIT margin was 6.62 percent (standard deviation
was 1.32 percent). The mean and standard deviation for Jack Eckerd Corporation were 8.11 and 1.42
percent, respectively; a sample of peer companies over the same period indicated that the mean and
standard deviation were 5.15 and 1.25 percent, respectively. Salomon Brothers assumed an EBIT
margin of 8.0 percent. Goldman Sachs opined that this assumption was "a bit aggressive." Only once
over the past 13 years did Revco reach that level, in 1984; thereafter Revco's EBIT margin fell to 3.50
and 4.84 percent. Sales growth and EBIT margin depended in part on the rate at which Revco planned
to open new stores analysts challenged the wisdom of this strategy, noting that 70 percent of Revco's
stores that had been open for less than one year lost money; the figure dropped to 48 percent for stores
Analysts were unable to decide whether to assume any covariance between growth and margins and
generally assumed that each year was an independent draw: i.e., that there was no serial covariance in
the forecast assumptions that had been open from one to two years.
1.8. Capital Adequacy
Leveraged buyouts were very difficult to, evaluate. Typically the prospective return to creditors and
investors were quite high, but were they high enough to compensate for the risk involved? Ultimately
the decision of whether to invest or lend in these deals hinged on some Judgment about the likelihood
that the buyout firm would survive a arduous financial demand. This judgment necessarily entailed
some analysis of the adequacy of the firm's capitalization.
The adequacy of Revco's capitalization after the LBO could be judged in several ways. First, one
could test whether, at the time that Revco went private, the market value of Revco's assets was greater
than the value of Revco's liabilities. This was the classic test of bankrupt firms. If assets were worth
less than the face value of liabilities, the creditors would be handed ownership of the firm; but those
who used this approach confronted a number of challenging valuations questions. Most importantly,
this valuation approach said nothing about the adequacy of capitalization where assets were worth a
little more than the face value of liabilities. The key question how much debt could or should the firm
carry was poorly answered by the bankruptcy test.
A second approach would be to compare Revco's capitalization ratios (e.g. debt/equity) with those of
other firms that had gone private in leveraged buyouts and with peer firms. In response to this
suggestion, one scholar wrote:
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... widely used rules of thumb which evaluate debt capacity in terms of some percentage of balance
sheet values or in terms of income statement ratios can be seriously misleading and even dangerous
to corporate solvency .. debt policy in gene.ral and debt capacity in particular cannot be prescribed
for individual company by outsiders or by generalized standards; rather, they can and should be
determined by management in terms of individual corporate circumstances and objectives and on the
basis of observed behavior of cash flows.
To focus on "the observed behavior of cash fows" meant asking this question: under the existing
capital structure, how likely was Revco to default on servicing its liabilities? If the probability of
default were high, one might judge that Revco was too dependent on debt financing and should alter
the mix away from debt and toward equity. If the probability of default were extremely low, this
analysis would suggest that Revco could bear additional debt.
2. Business Analysis
There are a number of generic business techniques that a Business Analyst will use when facilitating
business change.
2.1. PESTEL
This is used to perform an external environmental analysis by examining the many different external
factors affecting an organization.
It never ceases to amaze me why so many businesses fail to take the time to look at the macro and the
micro environments when completing their business plans and strategies. These external forces will
play a big part in shaping the final outcome of the ultimate corporate achievement. Yet, most
managers’ focus only on internal factors and it is fair to say that sales growth and profits remain high
on their agenda.
The macro environment tends to have a long term impact and requires extensive research. Couple this
with the fact that many managers are over worked and under resourced and we begin to see why the
process is often not completed. There is no published evidence to confirm this hypothesis, just
anecdotal hearsay.
The remainder of this article will illustrate an example of a Macro or PESTLE analysis for the
pharmaceutical industry. It is set at a very general level but it can be used as a template or adapted to
be more specific if required:
The six attributes of PESTLE:
Political (Current and potential influences from political pressures)
Economic (The local, national and world economy impact)
Sociological (The ways in which a society can affect an organization)
Technological (The effect of new and emerging technology)
Legal (The effect of national and world legislation)
Environmental (The local, national and world environmental issues)
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Political
There is now growing political focus and pressure on healthcare authorities across the world. This
means that governments will be looking for savings across the board. Some of the questions the
industry should ask are:
What pressures will be put on pricing?
What services will be cut?
Will the same selection of drugs be available to everyone?
In addition to this, could there be more harmonization of healthcare systems across Europe or
the USA?
What impact will reforms have on insurance models?
Economic
The global economic crisis still exists yet government reports still show that the spend on healthcare
per capital continues to grow. Will the current healthcare models exist tomorrow? The growth in
homecare (as seen in the Nutrition sector) demonstrates how nursing services have moved to the
private sector and have become a key business offering.
The reduction in consumer disposable income will have an impact on those countries using health
insurance models particularly where part payment is required.
These economic pressures are seeing an increased growth in strategic buying groups who are forcing
down prices.
Increased pressure from shareholders has caused a consolidation of the industry: more mergers and
acquisitions will take place over the coming years.
Social / Culture
The increasing aging population offers a range of opportunities and threats to the pharmaceutical
industry. The trick will be to capitalize on the opportunities.
There is also the problem of the increasing obesity amongst the population and its associated health
risks.
Patients and home carers are becoming more informed. Their expectations have changed and they
have become more demanding. Public activism has also increased through the harnessing of new
social networking technologies. How can pharmaceutical companies get closer to consumers without
over stepping the regulatory boundaries?
Technological
Technological advancements will create new business prospects both in terms of new therapy systems
and service provisions. The online opportunities will see the growth in:
New info and Communications technologies.
Social Media for Healthcare.
Customized Treatments.
Direct to Patient Advertising.
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Direct to patient communications.
Legislation
The pharmaceutical industry has many regulatory and legislative restrictions. There is also a growing
culture of litigation in many countries. The evolution of the internet is also stretching the legislative
boundaries with patient’s demanding more rights in their healthcare programmes.
Environmental
There is a growing environmental agenda and the key stake holders are now becoming more aware of
the need for businesses to be more proactive in this field. Pharma companies need to see how their
business and marketing plans link in with the environmental issues. There is also an opportunity to
incorporate it within their Corporate Social Responsibility programmes. Marketing and new product
development should identify eco opportunities to promote as well.
Summary
2.2. HEPTALYSIS
This is used to perform an in-depth analysis of early stage businesses/ventures on seven important
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PESTEL
ECONOMIC-good sales growth, moderate operational profit, strong market demand
SOCIAL-Increased aging,
informed customers
TECHNOLOGICAL-Higher expenditure in R&D, State of the
art facilities
LEGAL-Strong restrictions from
law, growing culture of litigation
ENVIRONMENTAL-Disposal of the debris, eco friendly production system
POLITICAL-Market quota,
govt. intervention,
categories:
Market opportunity
In 1986 Revco was the nation's largest discount drugstore chain, operating 2,049 stores in 30 states.
Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956
and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Strip
centers in small cities were the primary location of Revco stores, with approximately 70 percent of
the company's stores located in cities with a population of less than 25,000. The company is still
holding 6.25% growth rate per annum, which suggests that it has a good opportunity in the market to
expand.
Product/solution
Revco competed with health maintenance organizations, hospital pharmacies, mail-order
organizations, discount drugstores, combination food-and-drug stores, mass merchandisers, and the
rapidly emerging "deep discount" drugstores.
Execution plan
Management would continue to build on two of Revco's fundamental strengths: its many convenient
locations and its "everyday low prices" pricing strategy. It is believed by the authority of the company
that these two strengths would continue to frame consumers' perceptions of Revco as a convenience
drugstore, selling quality products at low prices at all times.
Financial engine
Future expansion plans included opening or acquiring approximately 100 stores per year over the
subsequent five years. This expansion would be financed by working capital from operations. Most of
this expansion was to be in small communities. Management believed that Revco's presence in prime
locations in these small markets discouraged entry by other large drugstore chains. In addition; the
small size of the market tended to bar entry for deep discount stores, which generally required a larger
population base to support profitable operations.
Human capital
The forecast assumed Revco's 5 year historical average of 20.8 percent, as opposed to an industry
average of23.6 percent. Analysts also wondered whether economies were possible in this area.
Potential return
Sales for the stub period (from the closing on December 26, 1986 to the next fiscal year end, May 31,
1987) were expected to be about $990 million, resulting in an operating profit of about $47 million.
This would leave an operating profit of$147 million for the 1987 fiscal year ending May 31, modestly
higher than for 1986's operating profit of $125 million.
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Margin of safety
Summary
2.3. SWOT
This is used to help focus activities into areas of strength and where the greatest opportunities lie. This
is used to identify the dangers that take the form of weaknesses and both internal and external threats.
The four attributes of SWOT analysis:
Strengths - What are the advantages? What is currently done well? (e.g. key area of best-
performing activities of your company)
Weaknesses - What could be improved? What is done badly? (e.g. key area where you are
performing poorly)
Opportunities - What good opportunities face the organization? (e.g. key area where your
competitors are performing poorly)
Threats - What obstacles does the organization face? (e.g. key area where your competitor
will perform well)
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products- Diversified
product range
Financial engines- WC operations
Return-Moderately
high
Margin of safety-
Execution plan-every
day low price
Human capital-huge
expenditure in the
administrative costs
Market opportunity-high growth rate in the
market
Strengths
The strengths of the pharmaceutical industry’s SWOT analysis document the internal industry
components that are providing value, quality goods and services and overall excellence. The internal
industry components can include physical resources, human capital or features the industry can
control. For example, the pharmaceutical industry’s strengths could include low operating overhead,
firm fiscal management, low staff turnover, high return on investment (ROI), state-of-the-art
laboratory equipment and an experienced research staff.
Weaknesses
The weaknesses of the pharmaceutical industry’s SWOT analysis document the internal industry
components that are not providing significant added value or are in need of improvement. The internal
industry components can include physical resources, human capital or features the industry can
control. For example, the pharmaceutical industry’s weaknesses could include high-risk business
modeling, disengaged Board of Directors, dated medical equipment, poor branding, low staff morale
or diseconomies of scale.
Opportunities
The opportunities of the pharmaceutical industry’s SWOT analysis document the external industry
components that provide a chance for the industry (or factions of the industry) to grow in some
capacity or gain a competitive edge. The external industry components should be environmental
factors or aspects outside the industry’s control, yet reflective of the business marketplace. For
example, the pharmaceutical industry’s opportunities could include recently published research, an
increase in health-conscious consumers, increased demand for pharmaceutical products, changes in
Food and Drug Administration standards or decreases in employee health care costs.
Threats
The threats of the pharmaceutical industry’s SWOT analysis document the external industry
components that could create an opportunity for the industry (or factions of the industry) to decline,
atrophy or lose some competitive edge. The external industry components should be environmental
factors or aspects outside the industry’s control, yet reflective of the business marketplace. For
example, the pharmaceutical industry’s threats could include increased government regulation, a
declining economy, increasing research and development (R&D) costs or a decrease in the global
population.
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Company SWOT
2.4. Porter’s Five Forces Model
Threats of entry posed by new or potential competitors – LOW
High barriers to entry; the company needs to put a lot of capital into research and development,
lengthy approval process, marketing before it is able to receive any returns. The “big Pharma”
companies that were able to build global operations are benefiting from economies of scale in terms
of manufacturing. They are able to access low-cost supplies, as a result.
Challenging regulatory conditions (hurdles to get FDA drug approvals for new products); industry is
highly regulated which to some extend protects from new competition. The FDA approvals appear to
have slowed during 2007. This could be one measure indicating that the FDA is taking a more
cautious position on new drug approvals. In addition, legislative changes in the upcoming years may
have a negative impact for the industry.
Pharmaceutical companies benefit from continuation of U.S. employer-based health coverage.
Customers buy medication that was prescribed by the doctors. Patent expirations may lead to an entry
of new competitors (generic competitions), resulting in decreased revenues. High rates of patent
expirations are approaching in 2010 through 2012. The ability of a pharmaceutical company to offset
loss of revenue from patent expirations depends on growth in existing products as well as successful
execution from the new product pipeline.
Degree of rivalry among existing firms - HIGH
Mature, consolidating, highly competitive industry (many large pharmaceutical acquisitions closed in
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segmented drugstores, country coverage
severe rivalry from the competitors, govt. intervention, environmental issues
increased government regulation, a declining economy, increasing research and development (R&D) costs
Strong growth, good positioning in the market, low priced products
Streangth
Weakness
Opportunities
Threat
2007 including AstraZeneca’s $15.6Bn purchase of Medlmmune Inc. and Schering-Plough’s $15Bn
acquisition of Organon BioSciences). Strong credit profiles: companies operate off of high margins
(high 70%), healthy balance sheets, and good liquidity
Industry benefits from strong demand from consumers. Weak, small companies usually go out of
business (bankruptcy) if they have no potential “blockbuster” in future pipeline. Others that have
some significant research or valuable assets will be bought by big and strong pharmaceutical
companies.
Bargaining power of suppliers - LOW
Suppliers generally have little room for negotiation. Large pharmaceutical companies generally enjoy
significant buying power. They can dictate the price they want to buy or take their business elsewhere.
Bargaining power of buyers - LOW
Generally consumers have very little bargaining power. Most of the medication is prescribed by the
doctors. Consumers will have to buy the drug at any given price if they need it. More educated
consumers may buy a generic alternative (which have the same impact but less expensive) if available
on the market.
Pricing pressure – The U.S. remains one of the few developed markets where drug manufacturers
have significant pricing flexibility, and this is in jeopardy due to increasing pressures from consumers
and legislators to control health care costs. Governments in other markets are generally the primary
customers, and therefore, enjoy substantial pricing leverage.
Shareholders continue to pressure the companies for increases in the share repurchase programs. The
companies looking for ways to increase shareholders returns partly because the industry is
approaching maturity and is not growing as rapidly, and because many companies have a lot of cash
on their balance sheet.
Closeness of substitute products – MEDIUM
Customers can find substitute medicine if the original product has an expired patent. However, if it is
a new product the consumer generally will have no choice for an alternative.
Over the few years generic drug manufacturers face excellent opportunities for utilization and volume
trends. Generic companies are increasing focused on establishing global operations in order to achieve
a lower-cost of supplies, thus posing even more threat to non-generic drug manufacturers.
Summery
Based on Porter’s model LOW to MEDIUM forces are present among the strong players in the
pharmaceutical industry. Thus, the industry is attractive to investors largely due to the high-barriers to
entry, purchasing and pricing power, and strong credit profiles of existing firms.
Page 13 of 45
2.5. SCRS
The SCRS approach in Business Analysis claims that the analysis should flow from the high level
business strategy to the solution, through the current state and the requirements. The SCRS is standing
for:
Strategy
If the merger had occurred on June 2, 1985, earnings before depreciation, amortization, interest, and
income taxes would have been $161 .8 million for the year ended May 31, 1986, just sufficient to
cover pro-forma interest expense-of $155 million. Revco managers believed that the company's
results since the beginning of fiscal 1985 were not indicative of future prospects and that Revco's
performance in 1987 and beyond would be more in line with pre-1985 results. Nevertheless, because
the interest-coverage ratio would be very low, management adopted a program to increase the margin
of safety.
Current State
In 1986 Revco was the nation's largest discount drugstore chain, operating 2,049 stores in 30 states.
Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956
and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Strip
centers in small cities were the primary location of Revco stores, with approximately 70 percent of the
company's stores located in cities with a population of less than 25,000. Over the previous 5 years, the
number of stores had grown at an annual compound rate of 6.24 percent, from 1,514 stores in 1981.
The average cost of opening a new store was approximately $300,000, with inventory comprising
approximately $200,000 of this total.
Page 14 of 45
Closeness of substitute products – MEDIUM
Threats of entry posed by new or potential competitors – LOW
Degree of rivalry among existing firms - HIGH
Bargaining power of suppliers - LOW
Bargaining power of
buyers - LOW
Requirements
The company has to mandate the following requirements:
Focus on drugstore business
Expand
Reduce capital expenditures
Reduce inventory and selling expense
Maintain current marketing strategy
Increase sales of non-prescription items
Solution
Summary
Page 15 of 45
SCR
Strategy-increase the margin of safety
Current State-High growth rate,
expanded market, opening new drugstores
Requirements- Focus on drugstoer, expand, reduce capital
expenditure, maintain current market strategy etc.
Solution
3. Time Series Ratio Analysis of Revco D.S. Inc.
The value of a firm is determined by its profitability and growth. Ratio analysis is used to evaluate
relationships among financial statement items. The ratios are used to identify trends over time for one
company or to compare two or more companies at one point in time. Financial statement ratio analysis
focuses on three key aspects of a business: liquidity, profitability, and solvency. The objective of ratio
analysis is to evaluate the effectiveness of the firm's policies in each of these areas.
Time series analysis accounts for the fact that data points taken over time may have an internal
structure (such as autocorrelation, trend or seasonal variation) that should be accounted for.
In the time series ratio analysis of Revco, we have calculated the following ratios
Profitability ratio,
Liquidity ratio,
Debt Management ratio,
Efficiency ratio and some other ratios.
3.1. Profitability Ratio:
Profitability ratios measure a company's operating efficiency, including its ability to generate income
and therefore, cash flow. Cash flow affects the company's ability to obtain debt and equity financing.
Ratios we have considered here are-
Profit margin. The profit margin ratio, also known as the operating performance ratio,
measures the company's ability to turn its sales into net income. To evaluate the profit margin,
it must be compared to competitors and industry statistics. It is calculated by dividing net
income by net sales.
The return on assets ratio (ROA) is considered an overall measure of profitability. It measures
how much net income was generated for each $1 of assets the company has. ROA is a
combination of the profit margin ratio and the asset turnover ratio. It can be calculated
separately by dividing net income by average total assets or by multiplying the profit margin
ratio times the asset turnover ratio.
The return on common stockholders' equity (ROE) measures how much net income was
earned relative to each dollar of common stockholders' equity. It is calculated by dividing net
income by average common stockholders' equity. In a simple capital structure (only common
stock outstanding), average common stockholders' equity is the average of the beginning and
ending stockholders' equity.
Profitability ratio of Revco:
a) Net profit margin
Page 16 of 45
b) Return on asset ratio
c) Return on equity
We see- Revco's profit margin in the year 1986 has decreased and according to their projection the
decreasing trend of profitability will continue upto 1991.
3.2. Liquidity Ratio:
Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected
cash needs. Ratios we have considered here are-
The current ratio is also called the working capital ratio, as working capital is the difference
between current assets and current liabilities. This ratio measures the ability of a company to
Page 17 of 45
pay its current obligations using current assets. The current ratio is calculated by dividing
current assets by current liabilities. This ratio indicates the company has more current assets
than current liabilities. Different industries have different levels of expected liquidity. Whether
the ratio is considered adequate coverage depends on the type of business, the components of its
current assets, and the ability of the company to generate cash from its receivables and by
selling inventory.
Cash ratio which indicates cash adequacy in hand in terms of current liabilities.
Liquidity ratio of Revco:
The liquidity ratio of Revco also indicating the liquidity shortfall in the projected years though the
company showed an increment of liquidity in the year1986.
1. Debt Management Ratio:
Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid
financial distress in the long run. These ratios are also known as Long-Term Solvency Ratios. Debt is
called Financial Leverage because the use of debt can improve returns to stockholders in good years
and increase their losses in bad years. Debt generally represents a fixed cost of financing to a firm.
Thus, if the firm can earn more on assets which are financed with debt than the cost of servicing the
debt then these additional earnings will flow through to the stockholders. Moreover, our tax law
favors debt as a source of financing since interest expense is tax deductible.
With the use of debt also comes the possibility of financial distress and bankruptcy. The amount of
debt that a firm can utilize is dictated to a great extent by the characteristics of the firm's industry.
Firms which are in industries with volatile sales and cash flows cannot utilize debt to the same extent
as firms in industries with stable sales and cash flows. Thus, the optimal mix of debt for a firm
involves a tradeoff between the benefits of leverage and possibility of financial distress. Ratios we
have considered here are-
Page 18 of 45
Debt Management ratio of Revco:
Here we find that the D/E ratio of Revco is indicating Negative D/E ratios in the projected years
because we have seen the company's projection says that it will face Net loss from the year 1987 to
1989.
3.3. Efficiency Ratio
We have calculated to estimate the company's efficiency by using the total asset turnover ratio.
The efficiency ratios indicate that over the historical years, the company's efficiency has decreased,
but according to their projection it is indicating that the company's efficiency will increase which may
be because of their very high growth rate of projection.
Other ratio:
Page 19 of 45
Sales growth rate shows the scenario of the Revco in this way that the average historical growth rate
of Revco is .45% while the projected average growth rate is 10.99% which is very high than the
expected growth rate.
4. Cross Sectional Ratio Analysis of Revco D.S. Inco.
It is the analysis of a financial ratio of a company with the same ratio of different companies in the
same industry. For example, one may conduct a cross-sectional ratio analysis of the debt ratios of
multiple companies in the telecommunications industry. Quite simply, one does this by taking the
debt ratios of each company and comparing them to one another. An analyst does this in order to find
the company with healthiest financial status.
Here we see the cross sectional ratio analysis of Revco-
I.
1986 Average
Sales Growth Rate Big B 17.5
Eckerd
Fay's Drug 9.5
Long's Drug 12
Perry Drug 10
Rite Aid 18
Thrifty
Walgreen 15.5 13.75
Revco (Historical) -0.449287
Revco (Projected) 10.98726
Revco (Assumed) 73
Page 20 of 45
Here we see that the sales growth rate of Revco is very low than the average industry growth rate in
the historical years. Projected years growth rate seems very much inconsistent with its past history.
II.
1986 Average
D/E Big B 0.22
Eckerd 0.18
Fay's Drug 0.96
Long's Drug
Perry Drug 1.27
Rite Aid 0.35
Thrifty 1.13
Walgreen 0.12 0.604286
Revco (Historical) 0.853459
Revco (Projected) -27.02621
Here we find that though the past history says D/E ratio of Revco was more than the industry average,
but it is expected that the D/E ratio will decrease largely by 270%.
III.
1986 Average
Beta Big B 1
Eckerd 1
Fay's Drug 1
Long's Drug 0.85
Perry Drug 1.1
Rite Aid 1.15
Thrifty 1.1
Walgreen 1.1 1.0375
Revco 6.68
The cross sectional beta also indicating that the company's Beta is high enough.
5. Bankruptcy Risk
Page 21 of 45
The risk that. an individual or especially a company may be unable to service its debts. Bankruptcy
risk is greater when the individual or firm has little or no cash flow, or when it manages its assets
poorly. Banks assess bankruptcy risk when considering whether to make a loan. It is also called
insolvency risk.
5.1. Altman Z-score
The Z-score formula may be used to predict the probability that a firm will go into bankruptcy within
two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for
the financial distress status of companies in academic studies. The Z-score uses multiple corporate
income and balance sheet values to measure the financial health of a company.
5.2. Estimation of the formula
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients.
The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then
collecting a matched sample of firms which had survived, with matching by industry and approximate
size (assets).
Altman applied the statistical method of discriminant analysis to a dataset of publicly held
manufacturers. The estimation was originally based on data from publicly held manufacturers, but has
since been re-estimated based on other datasets for private manufacturing, non-manufacturing and
service companies. The original data sample consisted of 66 firms, half of which had filed for
bankruptcy under Chapter 7. All businesses in the database were manufacturers, and small firms with
assets of < $1 million were eliminated.
5.3. Accuracy and effectiveness
In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two
years prior to the event, with a Type II error (false positives) of 6%. In a series of subsequent tests
covering three different time periods over the next 31 years (up until 1999), the model was found to
be approximately 80–90% accurate in predicting bankruptcy one year prior to the event, with a Type
II error (classifying the firm as bankrupt when it does not go bankrupt) of approximately 15–20%
(Altman, 2000).
In this case, Revco D.S. is a private firm. To assess the bankruptcy risk of this firm we used Altman’s
Z- score estimation for private firms.
5.4. Z-score estimated for private firms
Page 22 of 45
T1 = (Current Assets − Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
Z' Score Bankruptcy Model:
Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
Zones of Discrimination:
Z' > 2.9 -“Safe” Zone
1.23 < Z' < 2. 9 -“Grey” Zone
Z' < 1.23 -“Distress” Zone
Items 1986 1987 1988 1989 weights
T1 = NWC / Total Assets 0.391 0.226 0.154 0.126 0.717
T2 = Retained Earnings / Total Assets 3.285 -0.265 -0.798 -1.186 0.847
T3 = Earnings Before Interest and
Taxes / Total Assets
0.127 0.045 0.076 0.084 3.107
T4 = Book Value of Equity / Total
Liabilities
0.659 -0.006 -0.061 -0.104 0.42
T5= Sales / Total Assets 2.779 1.228 1.452 1.580 0.998
Z'Score 6.508016103 1.299204 1.093753 0.879761
A low Z-score indicates a company that is likely to go bankrupt. Specifically, a Z-Score of lower than
1.8, indicates a high likelihood of bankruptcy. From our calculation, we can see that in 1986 Revco
was in safe position as its z score was 6.508, which is much higher than 2.9. After that, gradually it
was entering distress zone with the passes of years.
6. DuPont Analysis
The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from
Page 23 of 45
the firm) into three distinct elements. This analysis enables the analyst to understand the source of
superior (or inferior) return by comparison with companies in similar industries (or between
industries).
The Du Pont identity, however, is less useful for some industries, such as investment banking, that do
not use certain concepts or for which the concepts are less meaningful. Variations may be used in
certain industries, as long as they also respect the underlying structure of the Du Pont identity.
High Turnover Industries
Certain types of retail operations, particularly stores, may have very low profit margins on sales, and
relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a
significant multiple of their assets per year. The ROE of such firms may be particularly dependent on
performance of this metric, and hence asset turnover may be studied extremely carefully for signs of
under-, or, over-performance.
High margin industries
Other industries, such as fashion, may derive a substantial portion of their competitive advantage from
selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales
without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which
of the elements is dominant in any change of ROE.
High leverage industries
Page 24 of 45
Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. In
contrast, however, many other industries would see high levels of leverage as unacceptably risky. Du
Pont analysis enables the third party (relying primarily on the financial statements) to compare
leverage with other financial elements that determine ROE among similar companies.
ROA and ROE ratio
The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms
to evaluate how effectively assets are used. It measures the combined effects of profit margins and
asset turnover.
The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2] Decomposing
the ROE into various factors influencing company performance is often called the Du Pont system.
ROE = Tax burden x Interest burden x Margin x Turnover x Leverage
The DuPont Analysis is important determines what is driving a company's ROE; Profit margin shows
the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows how
much leverage is being used.
The method goes beyond profit margin to understand how efficiently a company's assets generate
sales or cash and how well a company uses debt to produce incremental returns.
Items 1986 1987 1988 1989
net profit/pretax profit 0.534394 1.084722 1.919534 -3.12441
pretax profit/EBIT 0.76593 -0.82198 -0.11997 0.023756
EBIT/sales 0.045693 0.03651 0.052304 0.053076
sales/assets 2.779439 1.227565 1.451956 1.580434
assets/equity 2.51434 -193.164 -18.8428 -10.8559
ROE 0.130701 7.718919 0.329522 0.067589
Page 25 of 45
1986 1987 1988 1989
-250
-200
-150
-100
-50
0
50
ROEnet profit/pretax profitpretax profit/EBITEBIT/salessales/assetsassets/equity
7. Case Analysis
We consider three potential sources of problems for buyout investors. The first is the overall price
paid to take the company private. Regardless of the details of the capital structure, or the extent to
which there are costs of financial distress, it is clear that investors will earn lower returns as the prices
paid increase relative to the fundamental value of company assets.
A second potential source of problems is a capital structure that is poorly designed in terms of
containing costs of financial distress. Even if the price paid to take a company private is a "reasonable'
multiple of cash flow, a high probability of costly distress will obviously lower the prospective returns
to some classes of investors. In evaluating this possibility, it is important to analysis measure of
leverage as total debt to capital and interest coverage or cash flow coverage. These measures can
provide useful information about the likelihood that a company will be unable to meet its contractual
obligations. Among them cash flow coverage ratio is the most appropriate to analyze the capital
adequacy of the LBO firm so that it can payout its required cash obligations in the near years.
The third and final source of potential problems concerns the incentives of buyout investors. One of
the supposed spurs to improved performance in buyouts is the increased equity stake of management.
Managers who invest a large portion of their wealth in and own a large percentage of post-buyout
equity might be expected to manage better. Conversely, managers who "cash out" a large fraction of
their pre-buyout equity investment at the time of the buyout may have more of an incentive to take
part in overpriced or poorly structured deals. We examine whether these and other incentives changed
over time.
From the above analysis we can say that from the case and LBO transaction we can develop three
problem statements, these are:
1. Was the price paid for the LBO correct?
2. What are the incentives of the buyout investors to enter into such a unusually high levered
buyout?
3. Is the firm adequately capitalized after the buyout?
8. Valuation
Page 26 of 45
In this part we would like answer some questions. These are-
What the firm value of the company is.
Whether the buyout price 1.5 billion dollar is appropriate for this LBO.
Whether the cash offer to stockholder at price 38.5 is appropriate.
What is the probability o survival of the firm and what would be the firm value of Revco after
considering distress cost.
Whether the company can generate enough FCFF to pay off its cash obligations.
What will be the return to the equity holder?
Whether the LBO will be successful
To answer these questions at first we do valuation using Discounted Cash Flow Method. Following
procedures have done to get the firm value.
8.1. Assumptions:
For Base Case:
cost of goods sold/sales 73%
selling,general and administrative expenses/sales 20.80%
inventories/sales 20%
minimum cash balance $50,000
goodwill amortization $14,056
growth rate of store sales
mature stores 6%
new stores 6%
interest, working capital debt 9.25%
interest,cash balance 6%
days trade payables 30
other payables (days) 5
depreciation/ gross FA 5%
tax rate 36%
cost of opening
each new store $100,000
new store opening/year 100
year assets divested 1988
Page 27 of 45
8.2. Calculation WACC:
To value Revco at first we need to calculate WACC. To do this we have taken cost of equity which is
40.72%, tax rate is 36% Cost of debt is 11.64%. And preferred stock rate is 14.41% and finally we get
WACC is 11.40%.
Firm Value:
Based on the assumptions and WACC we calculate the firm value of the old Revco. Here we have
taken two scenarios. The first is base case. Here he have taken the assumptions of the manager of the
new revco. And we get the value is 3581079000 dollar.
projected
pro forma FY 1987 1988 1989 1990 1993 1994
sales 23173812436143
2702930
2992962
3884612
4117689
cost of sales 17205251778385
1973139
2184862
2835767
3005913
gross profit 596856657759
729791
808100
1048845
1111776
selling, general and administrative expense 449931
506718
562210
622536
807999
856479
depreciation 62318 10530 11030 11530 12970 13352amortization of leaseholds 8043 8043 8043 8043 8043amortization of other assets 5048 5048 5048 5048 5048
EBIT 84607127420
143460
160942
214784
228854
EBIT*(1-T) 54148 81549 91814103003
137462
146467
Add Noncash Charges 116466105170
115935
127624
163523
172910
Less: Net Inv in Fxd Cap 10125 10000 10000 10000 10000 7624
Less: Inv in Work Capital 102291
-167961
-42671
-38047 -8382
-192185
Interest 152064146000
142000
146410
144544
133902
FCFF 58199344680
240421
258674
299367
503937
Discount rate 0.114042454Terminal Value( Firm Value) 5465785.301Discounting FactorDiscounted FCFFFirm Value 3581079Cash Out Flow 1500000NPV 2081079
Page 28 of 45
In this scenario we have seen that the LBO is quite good decision because the firm Value of old
Revco is 3581079 thousands where the cost of LBO is 1.5 billion. Nad most importantly the NPV is
positive. But NPV is not the final story of the game. We would like to relax some assumptions that
are quite rational in the context of economy and industry
The new Assumptions are-
Terminal growth rate is 2% The growth rate is 5% and WCC is 15%. By this assumption we get the
firm value is 1694159 thousands.
($ thousands)
Projected
pro forma FY 1987 1988 1989 1990 1992 1993 1994
sales 23173812433250.05
2554912.55
2682658.18
2957630.64
3105512.18
3260787.78
cost of sales 1738035.751824937.538
1916184.41
2011993.64
2218222.98
2329134.13
2445590.84
gross profit 579345.25608312.5125
638728.138
670664.545
739407.661
776378.044
815196.946
selling, general and administrative expense 509823.82
535315.011
562080.762
590184.8
650678.742
683212.679
717373.313
depreciation 62318 10530 11030 11530 12530 12970 13352amortization of leaseholds 8043 8043 8043 8043 8043 8043amortization of other assets 5048 5048 5048 5048 5048 5048
EBIT 7203.4362467.5015
65617.3766
68949.7454
76198.9193
80195.3653
84471.6335
EBIT*(1-T) 4610 39979 41995 44128 48767 51325 54062Add Noncash Charges 66928 63600 66116 68749 74388 77386 80505Less: Net Inv in Fxd Cap 10125 10000 10000 10000 10000 10000 7624
Less: Inv in Work Capital 102291-167961 -42671 -38047 60217 -8382
-192185
Interest 152064 146000142000
146410
143910
144544
133902
FCFF -40878 261540140782
140924 52939
127093
319128
.
Discount rate 0.15
Terminal Value( Firm Value) 3461311.686
Discounting Factor
Discounted FCFF
Firm Value 1694159
Cash Out Flow 1500000
NPV 194159
Page 29 of 45
Calculate the Distressed Value of the Firm:
As we have seen in the calculation of Z score the firm in distress zone so we have assumed the default
probability is 55%. And we consider the distress cost is 30% of NPV. By considering these two issues
we finally get the distressed value of the firm.
Assumption Distress Cost is 30% of Firm Value Probability of Default 55% FCFF 1694159Distress Cost 508248FCFF less Distress Cost 1185911Firm Value 1414623Cash Out Flow -1500000NPV aftr adj of Dist Cost -85377
Here distress cost is 508248 thousands. After deduction and multiplication with the probability we
finally get the Farm Value which is 1.41 billion but certainly this figure is lower than the cash
outflow. So after considering the distress cost it would not be wise decision to go for LBO.
Simulation Analysis:
Forecast values
Trials 1,000
Mean -1562593
Median -1568104
Mode ---
Standard Deviation 100817
Page 30 of 45
Variance 10164100967
Skewness 0.6557
Kurtosis 3.94
Coeff. of Variability -0.0645
Minimum -1816442
Maximum -1054144
Range Width 762297
Mean Std. Error 3188
Here we have take input variables are WACC and Growth rate. Here we have seen that the NPV is
negative. So by considering simulation we should not make decision to LBO the firm.
8.3. Comparative Analysis with Peer Company:
Revco DS
87 88 89 90EBIT 149212 161199 175521 191656Total CF Availabale -40878 261540 140782 140924Total Obligation to be covered 297590 305334 208727 192252
Coverage Ratio: EBIT 50% 53% 84% 100%coverage Ratio: total cf -14% 86% 67% 73%
87 88 89 90-100000
-500000
50000100000150000200000250000300000350000
EBITTotal CF AvailabaleTotal Obligation to be covered
Jac Eckered
87 88 89 90
EBIT 223844 235036 246788 259127
Total CF Availabale 291864 303056 278808 291147
Total Obligation to be covered 224594 224856 199356 169319
Coverage Ratio: EBIT 100% 105% 124% 153%
Page 31 of 45
coverage Ratio: total cf 130% 135% 140% 172%
87 88 89 900
50000
100000
150000
200000
250000
300000
350000
EBITTotal CF AvailabaleTotal Obligation to be covered
Analysts considered the experience of another major drug store retailer, Jack –Eckerd Corporation,
which had been taken private in an LBO in April 1986. In most respects the two companies were quite
similar: Eckerd had been taken private, however, at a multiple of only 21.3 times, compared with
Revco's 24.8 times earnings. Eckerd was also financed at a debt-equity ratio of 11.5 times, compared
with Revco's 37.6 times.
presents a forecast of how well Revco and Eckcrd could cover their financial obligations in the next
three years, the period over which analysts perceived the greatest possible risk of default. For each
company, the financial obligations included interest expense, principal payments, and preferred stock
dividend payments. The "coverage'' of these obligations was estimated as a multiple compared with
earnings before interest and taxes (EBIT); and "cash flow," which consisted of earnings before
interest, taxes, depreciation, and amortization (EBlTDA) plus the receipts from any asset sales less
capita\ expenditures. (Additions to net working capital are ignored in this calculation. Ordinarily they
deserve to be included in an analysis like this. Exclusion of this item biases the estimated coverage
rates upward.
Analysts acknowledged; however that the comparative figure such as those in Exhibit 7 were point
estimates and thus ignored the uncertainty surrounding key assumptions. Revco's financial obligations
were well known at the .time of the buyout. Thus, the uncertainty about Revco's comparative standing
versus Jack Eckerd and other firms devolved from forecast uncertainty about the following points:
Interest rates: Revco's senior debt bore interest that floated at 1.75 percent above prime rate,
currently at 7.50 percent
Asset sales: Revco had to sell assets to .meet its principal payments. One could give Revco the
benefit of the doubt and assume that all $230 million would actually be realized. But analysts were
uncertain about the timing18 of that realization. By comparison, Jack Eckerd would try to sell $72
million in assets.
Capital expenditures: Capital expenditures could be assumed to be driven by Revco's goal of
opening 100 stores per year at an investment of$1 00,000 per store. Depreciation could be
approximated as $20 million for 1987, and thereafter scaled according to the percentage net change of
Page 32 of 45
the difference between asset sales and capital expenditures. By contrast, Jack Eckerd envisioned
opening no new stores in the foreseeable future. Eckerd's depreciation was forecasted to be $123
million, a much higher figure than Revco's because Eckerd tended to own, rather than lease, its 'stores.
Growth: Salomon Brothers contemplated a sales-growth rate no lower than 8 percent; it presented
forecasts to commercial bankers that assumed growth at 12 percent. Goldman Sachs, the advisor to
Revco's outside directors, determined that a 12 percent growth rate assumption was "too aggressive."
Analysts assumed sales growth of mature stores to be equal to the rate of inflation. In addition, "the
net growth from opening new stores would yield an annual corporate growth rate of 9 percent. ·
EBIT margin: From 1974to 1986, Revco's mean EBIT margin was 6.62 percent (standard deviation
was 1.32 percent). The mean and standard deviation for Jack Eckerd Corporation were 8.11 and 1.42
percent, respectively; a sample of peer companies over the same period indicated that the mean and
standard deviation were 5.15 and 1.25 percent, respectively. Salomon Brothers assumed an EBIT
margin of 8.0 percent. Goldman Sachs opined that this assumption was "a bit aggressive." Only once
over the past 13 years did Revco reach that level, in 1984; thereafter Revco's EBIT margin fell to 3.50
and 4.84 percent. Sales growth and EBIT margin depended in part on the rate at which Revco planned
to open new stores analysts challenged the wisdom of this strategy, noting that 70 percent of Revco's
stores that had been open for less than one year lost money; the figure dropped to 48 percent for stores
Analysts were unable to decide whether to assume any covariance between growth and margins and
generally assumed that each year was an independent draw: i.e., that there was no serial covariance in
the forecast assumptions that had been open from one to two years.
8.4. Possible Reasons for Going LBO:
Management:
Much of the controversy regarding LBOs has resulted from the concern that senior executives
negotiating the sale of the company to themselves are engaged in self-dealing. On one hand, the
managers have a fiduciary duty to their shareholders to sell the company at the highest possible price.
On the other hand, they have an incentive to minimize what they pay for the shares. Accordingly, it
has been suggested that management takes advantage of superior information about a firm's intrinsic
value. The evidence, however, indicates that the premiums paid in leveraged buyouts compare
favorably with those in inter-firm mergers that are characterized by arm's-length negotiations between
the buyer and seller.
Once the LBO was completed·, Sidney Dworkin became chairman of the board and Chief executive
officer of the "new" Revco, the same positions he had held at Reyco D. S. As in the old entity,
Dworkin did not control a majority ofthe outstanding shares ofsto.ck; he owned 'about 15.4 percent.
However, these shares were subject to a voting trust of which he was a member. Apparently, Mr.
Dworkin would have more control in the "new" Rcvco than he had had at Rcvco D. S., where his
ownership percentage was only 2.32 percent. Dworkin received $29.6 million for the stock and stock
options that he held in the old. Revco. He invested about $8 million in the "new" Revco. ' Moreover
manger assumes to enjoy tax savings.
Existing Share Holder:
Purchase cost 1253315
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price 38.5
No of Shares 32553.64
premium 0.48
market price 26.01351
Book Value equity 392530
Book value per share 12.05795
Earnings 51304
EPS 1.575984
P/E 21.2375
P/E based share price 33.46995
Existing Share holders get 48% premium over the price on last trade. The stock holder gets price 38,5
dollar per share but its market price was 26.012$. Its book value were 12.055$ and P/E based price is
33.46$. In every respect shareholder becomes gainer.
Debt holder:
The debt holders bear the risk of default equated with higher leverage as well, but since they have the
most senior claims on the assets of the company, they are likely to realize a partial, if not full, return
on their investments, even in bankruptcy. In the case of Revco the debt holders gets 10-113% interest
rate which are attractive, The bear default risk so they commensurate themselves by charging higher
interest rate.
Not all LBOs are successful, however, so there are also some potential disadvantages to consider. If
the company's cash flow and the sale of assets are insufficient to meet the interest payments arising
from its high levels of debt, the LBO is likely to fail and the company may go bankrupt. Another
disadvantage is that paying high interest rates on LBO debt can damage a company's credit rating.
Finally, it is possible that management may propose an LBO only for short-term personal profit. So in
the case of Revco it has high probability of becoming default and high probability of being
unsuccessful as well.
9. Capital Adequacy:
We have used Monte Carlo simulation to test the ability of Revoc to meet its financial cash obligation,
particularly we have done simulation to get probability of successfully covering the firm’s cash
interest, debt principal and preferred dividend payments over the first three calendar years following
the buyout. At issue is the sensitivity of the probability of survival based on variations in the operating
assumptions by Revoc versus assumptions consistent with the historical performance or comparable
companies and Revco.
9.1. The Variables
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The simulation model forecasts a cash-flow debt-service coverage ratio ("CF Coverage") for 1987,
1988, and 1989, the first three years following the LBO. Revco used a fiscal year end of May 31, but,
because the LBO was consummated on December 29, 1986, we adopted the convention of using the
calendar year as the fiscal year to coincide with the LBO date. Thus, each of the projected years
contains 12 months of sales covering the calendar years 1987,1988, and 1989. The structure of the
financing makes a longer forecast period unnecessary, because the first three years following the
buyout represent the maximum risk exposure for Revco.
Cash-flow coverage ratio was calculated as EBIT (earnings before interest and taxes) plus proceeds
from asset sales (AS) less capital expenditures on new stores (CAPE° plus depreciation (DEPR),
divided by cash interest payments (INT) plus principal payments (PRIN) plus cash dividends (DIV),
i.e.,
CF Coverage= EBIT+ AS−CAPEX+DEPR
∫+PRIN +¿
The ratios were modeled in a Excel spreadsheet and simulated 1000 times using "Cryatal Ball"
simulation software.
For the most part, Revco's financial obligations (INT, PRIN , and DIV) were known at the time of the
buyout and were, therefore, entered in the model as fixed numbers. Exhibit below summarizes
Revco's cash payment obligations for the simulation period, 1987-1989. Interest on fixed coupon debt,
principal and preferred dividend payments was determined according to the schedules provided in the
case. Only cash payments were included in the simulation; no consideration was given to noncash
obligations such as payment-in-kind (PIK) preferred stocks. Of the three preferred issues used in the
buyout, two, the 15.25% cumulative exchangeable and the 17.62% cumulative junior preferred, were
PIKs. The 12.0% cumulative convertible preferred stock with a face value of $85 million is
responsible for the $10.2 million of preferred dividends.
Reported in the case there are fixed and floating rate interest payments. Of the $1,331 million of debt
used in the LBO, $455 million had a floating interest rate, and the remaining $876 million had fixed
rates. The fixed- rate debt obligations had an average interest rate of 12.9% with no principal
payments due during the study period. The term loan was structured in such a way that Revco could
choose interest payments as either 1.75% over the prime rate or 2.75% over LIBOR (London
Interbank Offer Rate). The floating interest payments reported in case assume that the prime-rate
option is chosen and that prime remains at the December 1986 rate (7.50%) for the entire three years.
The only payments of principal during the study period are for the term loan, as specified by its
amortization schedule. Thus, the floating interest payments decline over time as the term loan is
retired, whereas the fixed interest payment remains constant at $112 million. To simulate the floating
rate interest payments, we modeled all the prime rate (PRIME) as a normal distribution with mean
equal to the December 1986 rate of 7.50% and a standard deviation of 3.60%, as estimated from
historical data.
EBIT, AS, and DEPR remain as the stochastic variables needed to compute the coverage ratios. To
calculate EBIT, we multiplied sales by an EBIT margin defined as
Page 35 of 45
Margin = EBIT
SALES
Margin was modeled as normal with mean and variance estimated from historical performance data
for Revco and ECKRD. The sale of existing stores and other assets (AS) was modeled as the appraisal
figure given in the case ($230 million). Consistent with the case, we assumed that the company could
realize 100% of the divestiture proceeds during the first two years of the LBO. AS for 1987 was
assumed to be uniformly distributed over 25 to 75%; i.e. The model assumed that Revco could sell
with equal probability anywhere from $57.5 million to $172.5 million of the $230 million of assets in
the first year. For 1988, the second year after the buyout, AS equals the $230 million less the
realization of 1987 asset sales. Because of holding the total asset sales constant at $230 million, the
only uncertainty introduced into the model is the timing of the asset sales.
We modeled AS as described,for several reasons. Unlike most other variables in the analysis, no
historical data exist to guide us in the modeling of AS. The lack of data makes our modeling choices
for AS somewhat arbitrary and, hence, easy prey to criticism. Faced with such a challenge, we chose
to model AS in a way that the model would be biased in favor of finding a high survival probability.
The first step in this direction was to assume, as Revco did at the time, that Salomon Brothers would
be able to sell the assets within the first two years following the LBO. In our view, this assumption
represents a best-case scenario for Revco.
The second step was to recognize that allowing the total amount of asset sales to vary around $230
million would, in fact, act to reduce Revco's computed probability of survival. As was true for most
LBOs, the Revco financial structure contained a covenant in the term loan that required any excess
proceeds of the divestiture to be used as prepayments of the loan. Thus, if Revco should happen to be
lucky enough to realize more than the $230 million for the assets at the end of the second year, the
extra cash could not be used to service the third year's cash flow obligations. Rather. the money would
have to be used as a prepayment of the term loan, which would only slightly reduce the interest
payments in the third year. On the other hand, if Revco should realize a shortfall in the sale of the
assets, the reduced inflow would significantly reduce the firm's ability to service its obligations in the
first and/or second years. The overall effect of allowing the $230 million figure to vary is that the
downside fluctuations hurt the survival of the LBO more than the upside fluctuations help it. Thus,
our assumptions about AS are conservative and bias the model toward the conclusion that the LBO
would succeed.
An offset to AS is CAPEX, the outlay required for starting new stores each year. To model this
variable, we assumed new stores would open at a rate of 100 per year, consistent with the goals stated
in the prospectus. We assumed that $100,000 per store would cover the investment in fixtures,
systems, and other assets unrelated to inventory and that, consistent with Revco's past practice, new
store buildings and land would be leased. As new stores are added and existing stores sold in the
model, total revenue is adjusted according to the assumed sales per year figure. These sales figures are
increased each year by a growth rate (GROWTH), assumed to be inflation, which was modeled as a
normal distribution with a mean of 6.0% and standard deviation of 3.90% as measured from a time
series of historical inflation rates. Depreciation expense (DEPR) was approximated as $33.7 million
for 1987 and was scaled according to the percentage net change of (AS - CAPEX).
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9.2. Results
To illustrate the inputs and outputs of the model, Exhibit presents a series of histograms of variable
distributions as modeled for the base case.
Exhibit below displays the CF coverage ratio distributions for 1987, 1988, and 1989. For these base-
case scenarios, the mean coverage ratios are 0.97 in 1987, 0.98 in 1988, and 0.96 in 1989. The mass
of the distribution to the right of 1.0 represents the probability of surviving a given year. Thus, the
cumulative probability of survival is computed as the product of each of the three annual probabilities
of realizing a ratio greater than 1.0. For the base case, the three annual probabilities of survival are
0.47, 0.45, and 0.45, and the cumulative probability of survival is 0.10 (0.43*0 .45 *0.27).
Particulars
Each Year Annual Cash Flow Coverage Ratio (%)
Three Year Cash Flow Coverage Ratio (AM)
1987 1988 1989Cumulative Probability of Survival
1987-89Probability of Survival
Base Case97.24(47.2)
98.55(45.2)
96.56(45.3)
10% 97.45 45.9
Changed Margin (Base Case 6.6%)Revco’s 84-85 margin (4.17%)
78.78(7.8)
79.11(8.0)
65.59(2.8)
0.017 74.49 6.2
Changed Growth (Base Case 5%
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1% below base (4%)96.76(41.5)
97.55(44.8)
94.18(37.0)
6.8 96.16 41.1
1% over base (6%)97.72(46.1)
99.56(49.1)
98.98(48.1)
10.88 98.75 47.76
Changed Store (Base Case 100/year)
50/year97.91(43.4)
97.45(39.1)
92.63(27.6)
4.6 96 36.7
150/year96.58(46.3)
99.65(43.6)
100.44(44.5)
8.9 98.89 44.8
Debt/Equity 3.84 times1.32
(93.6)1.34
(93.0)1.18
(74.9)65.19 1.28 87.1
Debt/Equity 6.8 times1.215(88.0)
1.23(86.8)
1.122(69.2)
52.85 1.189 81.33
Jack Eckerd Corporation129.95(93.0)
134.78
(95.2)
139.85(95.4)
84.46 134.86 94.5
Value in () are probability of survival of the respective data
Exhibit also shows the distribution of the three-year cash-flow-coverage ratio— i.e., the probability
that the sum of the cash flows for 1987-1989 is sufficient to cover the surn of the obligations for the
period. This ratio assumes that past and future cash flows are available to service the financial
obligations for any year. Thus, the ratio represents a best-case measure of the model's estimate of
Revco' s ability to pay. The area to the tight of 1.0 is the probability of survival. Because the ratio has
a mean less than I .0 (0.97) and the variance of the distribution is small, the probability of survival is
approximately 45%, much larger than the product of the three independent-year probabilities.
To test the robustness of the model to our assumptions, we performed two comparisons. First, we
conducted a sensitivity analysis on the means of the stochastic variables. As revealed in the Exhibit,
the coverage ratios for Revco are consistently less than 1.0, and the probability of successful coverage
remains low regardless of variations in assumptions for MARGIN, GROWTH, and STORES (the
number of new-store openings per year).
The three-year ratio probabilities in Exhibit are consistently higher than the cumulative independent
probabilities for the three years. For example, the base-case probability is 45% for the three-year ratio
compared to only 10% assuming independent cash flows. The reader should keep in mind that the
three-year ratio is a strong upwardly biased measure of survival and that the base-case probability of
45% is, in itself, a very low survival probability. The three-year probability rises to 47.76% if
increased margin of 8.0% is used, but for every other scenario reported in Exhibit , the three-year
probability is less than that. Interestingly,' when MARGIN is assumed to equal Revco's average
performance for 1984-1985 of 4.17%, the probability of survival is virtually zero under either
probability measure. Thus, the model yields consistently low survival probabilities for Revco.
As a second check of the model's robustness, we applied the simulation to the Jack Eckerd
Corporation, one of Revco's competitors in discount-drugstore retailing and itself the subject of a
leveraged buyout in 1986. As with Revco, we used historical performance data as the basis for EBIT
projections and case data for financial obligation projections. Over the period 1974-1986, Eckerd's
MARGIN averaged 8.11% with a standard deviation of 1.42% compared to Revco's 6.60% and
1.32%. A more important difference from Revco, however, was that Eckcrd's interest and principal
Page 38 of 45
payment schedules were substantially deferred. The simulations for Eckerd produced coverage ratios
of 1.30, 1.34, and 1.39 for the first three years following the buyout. These individual probabilities
imply a cumulative probability of survival of 84% and a three-year probability of 94.5%.
9.3. Conclusions and Implications
The analysis in this study suggests that Revco had a probability of between 10% and 45% of
successfully servicing its financial obligations in the first three years after going private. These
survival possibilities are so low as to suggest that Revco was undercapitalized in the sense that the
new debt obligations exceeded its expected cash flow and hence, the buyout was doomed to fail from
the start. It is only when Revco's earning power is assumed at almost double that of its recent past that
the survival probability (assuming independence of cash flows) approaches 50%. The survival
probabilities are relatively insensitive to assumptions concerning asset sales and growth of sales
suggesting that it was the leveraged buyout and the restructuring strategy rather than flawed execution
of the strategy by management. Ironically, the strategy of the newly Ovate Revco was to focus on
asset sales and growth, and only secondarily to focus on profitability, The deteriorating environment
for retailers in late 1987 and 1988 could be chalked up as bad luck, but we believe the hallmark of a
good strategy is the ability to withstand unforeseen adversities. We leave it for others to speculate as
to why the deal was consummated.
A simulation-based research methodology, such as that used here, has its weaknesses. Our strategy
has been to address the weaknesses by stating them plainly and then to construct the model .so that it
is biased in favor of survival. The base-case assumptions were reasonable in that they were consistent
with information a financial analyst would have had in December 1986, when Revco went private.
Other assumptions for which there was no strong bate of public information Or historical experience
(e.g., tax exposure, asset sales, working capital requirements) were tilted in Revco's favor. Despite the
model being biased in favor of survival, however, we consistently found low survival probabilities
and conclude that they arise because of Revco's onerous payment schedule and anemic earning power
rather than as an artifact of our methodology. Our sensitivity analysis revealed that even granting the
optimistic assumptions used by Revco's financial advisers and bankers produces survival probabilities
of less than 50%. In addition, testing our methodology on another drug retailer taken private at about
the same time, Jack Eckerd Corporation produced high probabilities of survival. In other words, our
ex ante approach produced results that are consistent to date with the fates of Revco and Eckcrd.
Thus, we conclude that the model discriminates reasonably well and is not prone to predict disaster
for every LBO.
Page 39 of 45
