Questions & Hints Case Study #3

Congoleum
FNCE 203
Prof. Vito D. Gala
This case illustrates a leveraged buyout and highlights some of its value-creating aspects. You will
combine the valuation principles and methods discussed in the course so far to evaluate a complex
transaction from the perspectives of various participants. Here are some guidelines for your
analysis.

It is useful for valuation purposes to treat the 1980-1984 period differently from the
post-1984 period. [In fact, the case writer hinted at the possibility of going public again
in 1984 (note at bottom of page 18), and you should assume this occurs].
Make sure that you notice the changing debt ratios in 1980-1984 and predictable
interest expenses. Which is the best valuation approach to deal with this situation?
It is convenient, for valuation purposes, to assume that all debts (old & new) are paid off
at the end of 1984 when the LBO group takes the company public and sells it, and that
the newly sold company will have some constant debt-to-value ratio after 1984.
For the debt-to-value ratio after 1984, we can either rely on a weighted average of the
capital structure of Congoleums competitors in Exhibit 9 or use Congoleums capital
structure as of the end of 1984. You should probably explore several debt-to-value
ratios in your sensitivity analysis.
Congoleums equity beta is known and reported in Exhibit #9. Given this, do you need to
rely on comparable companies data to obtain Congoleums asset beta?
In your analysis, you should not rely on the free cash flow calculations given in Line 16 of
Exhibit 13. There is a problem with how this FCF was calculated (can you see what it
is?), and you should use the information in Exhibit 13 to instead calculate your own FCF.
For the LBO years and the post-1984 period, you may assume that the companys debt
would have similar risk characteristics as CCC-rated corporate bonds. For CCC-rated
corporate bonds you may assume an annual default probability of 2% and that bond
holders return in the event of default is -55%. Would it be appropriate to use yields or
the coupon rates on the notes as the cost of debt?
Wherever the case mentions Debt % capital, you can treat that as the correct D/V
[Though, it actually looks like these are measured incorrectly using book equity].
When valuing the firm as a whole, you need to make some further adjustments to
reflect the firms excess cash. These are mentioned in Exhibit 7.
It looks like there is a slight typo on page 18 of the case The senior and subordinated
notes should be amortized at 7,666,666 per year, not 7,636,000 as written.

Please see next page for points your analysis should address

In your analysis, you should address the following points. (As always, your report should not be
written in the form of answers to the below questions, but instead, it should be written as a
recommendation to the manager that touches upon all of the below key issues. Further, it is
strongly recommended that your report not be confined to the below issues).
1. Provide an assessment of what makes Congoleum a good LBO target.
2. Evaluate the LBO proposal and determine the value of the firm if it undertakes the LBO
and compare this to the existing value of the firm. Your valuation analysis (based on the
assumptions above) should be the bulk of your report and serve to answer this
question. Provide sensitivity analysis.
3. Quantify the incremental effects of the LBO (as compared to no LBO) on Congoleum as a
whole, and attribute portions of the sizable purchase premium to: the cost savings in
corporate expenses, the step-up of asset values for depreciation, and the interest tax
shields. In addition, if any of the value added from the LBO is unexplained by these
three factors, explain where you think this additional value may be coming from.
4. Quantify the gains/losses to the various parties to this deal, and render an opinion as to
the appropriateness of the $38 offer price received by old shareholders.
5. Analyze the roles of the equity kicker and strip financing.