Finance: Case Study - Tango Vs. Victor

Tango vs. Victor

A group of financial investors (the Tango group) is considering whether or

not they should invest in a Leveraged Buy-Out. The target of the Buy-Out

would be Victor, a company in the soft drinks industry. The soft drinks

industry is considered a mature business with steady cash flows, and this

makes Victor an attractive candidate for a LBO. The directors of Tango

believe that Victor's shares are currently undervalued in the market, and

that there is room for realizing a substantial value by way of stand-alone

improvements and divestiture of a non-strategic division. Moreover, the

top 20 managers at Victor will invest in the Buy-Out and they will commit

themselves to remain with the company for the next five years.

Exhibit 1 shows the estimate of the Income Statement of Victor for the year

ending 31st December 2003.

The share price of Victor in the market is currently € 14 per share and,

according to Tango's investment bankers, a tender offer at € 16.50 per share

will be accepted by Victor's shareholders. There are 20,000,000 (twentymillion)

shares outstanding.

Tango plans to take over Victor through a leveraged vehicle ("New

Victor"). "New Victor" will be financed through a mixture of debt and

equity. The debt will be composed of Senior Debt and Mezzanine

(Subordinated Debt). The Senior Debt is provided by a group of banks: it will

amount to € 210 million and it will carry an interest rate of 10%. The

repayment of the principal (Senior Debt) will be linear over three years (in

other words "New Victor" will have to repay the principal of the Senior

Debt from year 1 onwards in three equal installments). The Subordinated

Debt will be provided by a group of financial institutions: it will amount to

€ 80 million and it will carry an interest rate of 12.50%. The principal of the

Subordinated Debt will be repaid with the free cash flow generated by Victor,

after the repayment of the annual installments of the Senior Debt (i.e. there

is no pre-set repayment schedule for the Subordinated Debt). The Equity will

be provided by the Tango group and by the management. The management

team will buy € 10 million worth of shares in "New Victor": they will

actually invest € 5 million and they will borrow an additional € 5 million

from the Tango group at an interest rate of 11.50% per annum. The principal

on this loan will be repayable when New Victor will be sold. The Tango

group will then invest in the equity of "New Victor" the balance required

for the acquisition of Victor. Once the acquisition is completed, "New

Victor" will be merged with Victor. Due to the covenants imposed by the

lenders, it will not be possible to pay any dividend until both the Senior

Debt and the Subordinated Debt will have been repaid completely.

The analysts at Tango estimate that:

- Victor has excess cash of € 35 million that can be used to finance

the Buy-Out;

- the Senior Debt which is on Victor's Balance Sheet prior to the

Buy-out (as we will see here below) has to be repaid in order to

complete the acquisition: this Debt amounts to € 40 million;

- the transaction cost (investment banking and legal fees) will be € 5

million to be paid out at the time of the Buy-Out;

- at the end of year 5 (2008) it will be possible to sell (the shares of)

New Victor for 6 times the Free Cash Flow to Equity in that year

(that is the cash flow earmarked for the Equity holders).

The analysts at Tango have made a number of estimates and projections for

the next 5 years (2004/2008). If Victor stays independent (Scenario 1) Sales are

expected to grow at 6% in 2004, and then: 5% in 2005 and 2006; 4.5% in 2007

and 4% in 2008. EBITDA Margin (which is estimated at 20% in 2003) is

expected to stay at 20% in 2004, but then to slide to 17% in 2005 and 2006; and

further to 15% in 2007 and 2008. Working Capital should stay at 15% of

Sales, as in 2003. Victor has recently completed an investment program to

renew the plant and equipment, and, therefore, estimated Capital

Expenditures will be limited: € 5 million in 2004 and in 2005, € 8 million in

2006, and € 10 million in 2007 and 2008. Total Depreciation charges

(inclusive of old and new equipment) will be: € 15 million in 2004, 2005 and

2006; € 20 million in 2007 and 2008. At 31st December 2003, Victor will have €

40 million of Senior Debt on the Balance Sheet, carrying an interest rate of

9%: the repayment of the principal will be linear over four years.

On the other hand,