Question

5. Trigeorgis Partners, a leveraged buyout firm, is considering an investment in a national retail bookseller. The target is attractive to Trigeorgis because of its low level of debt, which at present makes up just 9.5 percent of the company’s total capital. The partners at Trigeorgis believe that the debt level can be raised to as much as 30 percent of capital. Although this might mean a lowering of the credit rating from AAA to AA, or even to A, the Trigeorgis partners believe that the interest tax shields would more than offset higher costs of borrowing. The bookseller’s average beta for the past year has been 0.98, and its marginal tax rate is 35 percent. (30%)

a. How would beta change if Trigeorgis completed the acquisition and raised the bookseller’s debt to 30 percent? (10%)

b. See the forecasts for the next five years given here. Assume that the new debt level will total $400 million at an interest rate of 6 percent and that this debt will be the perpetual amount of debt of the firm.

($ MM)	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	3,271.2	3,387.9	3,537.4	3,777.5	3,966.4
EBIT	171.4	191.9	210.3	235.9	238.0
Depreciation and amortization	83.5	95.3	96.2	103.0	112.0
Changes in working capital	(32.7)	(37.3)	(17.7)	(41.6)	(39.7)
Capital expenditures	(159.2)	(141.2)	(90.7)	(100.0)	(120.0)
Risk free rate	5%	5%	5%	5%	5%
Risk premium	6%	6%	6%	6%	6%
Terminal value growth rate	3%	3%	3%	3%	3%
Shares outstanding	75 million	75 million	75 million	75 million	75 million

Calculate the equity value of the bookseller to Trigeorgis using the adjusted present value approach. (20%)

Answer 1

A) How would beta change if Trigeorgis completed the acquisition and raised the bookseller’s debt to 30 percent?

Solution:

An Increase in the total amount of a company's debt will increase the value of its levered beta.

If a company increases its debt to the point where its levered beta is greater than 1, the company's stock is more volatile than the market. If a company decreases its debt to the point where its levered beta is less than 1, the company's stock is less volatile than the market. If a company has no debt, its unlevered beta and levered beta would be equal.

formula for calculation of Levered Beta:

using the above formula we can find out the unlevered beta of the company

Beta Unlevered = Beta Levered / [ 1+ ( (1-tax rate) * debt)/Equity)]

therefore the unlevered beta of the firm

= 0.98 / [ 1+ ((1-0.30)*9.5)/90.5]

=

Putting the above Unlevered Beta in the formula we can find the levered beta of the company if the debt ration changes from 9.5:90.5 to 30:70

Levered Beta

= 0.912918 * [ 1+ ( (1-0.30) * 0.3)/0.7)]

=

B) Calculation of equity value of the bookseller to Trigeorgis using the adjusted present value approach.

Introduction

Adjusted Present Value Application

APV method is very similar to traditional discounted cash flow (DCF) model. However, instead of weighted average cost of capital(WACC), cash flows would be discounted at the cost of assets, and tax shields at the cost of debt. Technically, an APV valuation model combined impact of both growth and the tax shield of debt on the cost of capital, the cost of equity, and systematic risk. Thus it is a more flexible way of approaching valuation than other method. However, APV method has some flaws. Company value will be overstated when adding the tax benefits to un-levered company value to get the levered company value, especially for some companies with high debt ratios.

Calculation

= 5 + 0.912918 * 6

= 10.477508 %

Value of Equity