John M. Case Company

ote for the noncash component of the deal, with a fair value of $4 million. This would be junior to all other debt obligations, including a $6 million term bank loan granted for the sole purpose of purchasing the company. The amount of the bank loan was the maximum the bank would commit; therefore the remainder of the financing would need to be obtained through venture capitalists or other risky debt offering.

Issues

The company must be able to service the debt that will be incurred during the purchase including the generation of an adequate rate of return on the venture capital investment. In order to generate the 20-25% return required for the venture capital, the company would issue bonds with a coupon rate of 9% and make up the additional return through issuing warrants to buy shares in the new corporation at $1.00. These options could be exercised in either cash, or Case debentures, but would probably generate the greatest return if exercised for stock if the company goes public. These long-term call options will be used to induce the venture capitalists to purchase the bonds at the 9% interest rate, which is much lower than what they require as an overall return. Effectively, the company will issue the bonds at a discount in the amount of the value of the warrants. The management team must to retain control of the company and thus the warrants and a future public offering must be utilized with this in mind.

Business as Usual

The purchase of the John M. Case Company results in the purchase of $1,2084,000 of Goodwill. The company incurs $21 million in debt, which results in a capital structure of approximately 96% debt to equity. Equity includes $500,000 of Common Stock and $500,000 of Common Stock Warrants. Cash flows are adequate to service the debt with an interest coverage ratio of approximately 2.05 times for 1985, which rises to 4.97 times in 1990. Excess cash flows are used to pay down the term bank loan within 4 years, and to accelerate partial payment of Mr. Case's note in year 1988 and the remainder in 1989.

The effective internal rate of return on Mr. Case's note is 14.01%, the cost of debt attributable to the bank loan is 12%, Venture Capitalists' rate of return is 25%, and 30% for the management team. This results in a weighted average cost of new capital of 19.03%. When Free Cash Flows are discounted at this rate, the present value is approximately $12,056,000. When allocated between the management team and the Venture Capitalists, as if they have exercised their warrants, results in a value per share of $12.06. This is $0.67 higher than the implied value of the warrants at the time of the deal of $11.39. The bonds were effectively issued at a discount of $632.62 per $1,000 9%, 20-year bond.

If we use the comparable public companies to Case, we obtain an average multiple of 15.12 per diluted