Mature Industries Such as Tobacco and Food Business

Why is RJR Nabisco a good candidate for an LBO?

RJR Nabisco was in mature industries such as tobacco and food business with stable and predictable cash flows at that time, and it was undervalued, underlevered and inefficient. According to the expected cash flows of pre-bid strategy, we calculate the equity value of RJR is $24.73 billion, while the current market value of equity is calculated as $12.59 billion at the pre-offer price of $55.875, which is much smaller than the implied value. Also, food industry was undergoing a major restructuring and revaluation at that time, so get rid of food business and focus on tobacco business would generate substantial gains. Furthermore, the management believed that the market undervalued the strong cash flows from tobacco business and did not fully value RJR’s food businesses because of its association with tobacco, which means the tobacco business had negative externalities in food business, causing an inefficiency operation. Finally, since the company was underlevered, acquiring firms could issue enough debt to buy.

Comparison of each LBO plan

Pre-bid strategy: When calculating the pre-bid valuation for RJR, cash flow available for capital payments are discounted back at return of equity to result in the present value of the firm’s equity. βe is assumed as the average of past 6 years, and then using CAPM, we get Re of 15.25%. Terminal growth rate is set at 5%. Adding back current debt and subtracting cash, pre-bid RJR is valued at a total enterprise value of $27,992 million ($96.32 per share). (Appendix 3)

MBO: APV should be used as a better valuation method since the case provides us with forecast interest expenses in the following years and the debt ratio will change. The calculation of Rd is based on interest expense on Exhibit 6, using interest/ total debt; we get an average interest rate of 12.59%. Assume a constant D/E ratio for the past years, according to the equation ReL= Ru + (Ru - Rd)(1 - tx)(D/E), Ru is computed at 14.7%. Also, FCFF=Cash Flow available for capital payments + interest*(1-tax rate). Each year’s FCF is discounted at Ru, and Interest Tax Shield is discounted at Rd. Finally, the present enterprise value of RJR under MBO is $34,125 million, $8,309 million (32.19%) higher than pre-bid valuation. (Appendix 3)

KKR’s Bid: Based on KKR’s interest expense forecast, we calculated a new Rd, which would further influence the derived Ru and PV of ITS. Finally, RJR’s total enterprise value is estimated at $34,585 million, $8,768 million (33.96%) higher than pre-bid valuation. The amortization of goodwill of $338 million per year from the proposed acquisition of RJR Nabisco at 22.9billion compared with a book value of $7.4 billion at the end of 1988. The tax shield from the amortization can be calculated at $801million. (Appendix 3)

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