Special Appendix 2 Leveraged Buyouts SA2 Leveraged buyouts

Special Appendix 2 Leveraged Buyouts SA#2

Leveraged buyouts u “Shell corporation” is formed to acquire existing company u Investor group often includes existing employees u Heavy debt financing used to provide funds for stock purchase u Purchase accounting methods are applied with modifications SA#2 2

Valuing an LBO Fair value block + Equity-Adjusted block + Book Value block SA#2 3

Fair value block u Shares of new shareholders and u Shares held in prior company if residual interest does not exceed 5% in new company – subject to constraints Residual interest: all outstanding common stock and those preferred shares that do not have liquidation or redemption features. SA#2 4

Fair value block, continued Constraints on inclusion of prior company shares: u. Individual’s residual ownership percentage has increased – does not exceed 5% of new company SA#2 5

Fair value block, continued Constraints on inclusion (continued): u. Individual’s residual ownership percentage has decreased – individual's voting interest in common stock < 20% and – individual supplied < 20% of new company’s total capital (debt + equity) – individual’s new residual interest < 5% and – residual interest of all owners whose interest decreased < 20% SA#2 6

Fair value block, continued Limitation on number of shares to include in fair value block: u If monetary consideration < 80% – shares comprising market value block is limited – total common shares outstanding times the monetary consideration percentage u If monetary consideration 80% – no limitation Monetary consideration: cash + debt-type securities SA#2 7

Equity-adjusted cost block u Shares that do not qualify for the fair value block u Recorded at their simple-equity-adjusted cost basis u Shareholders are referred to as “continuing” SA#2 8

Book value block u Shares that qualified for the market block but were eliminated by the monetary consideration constraint – for example, if 85% of the shares met the market block test, but monetary consideration was 70%, this would be the 15% disqualified block. SA#2 9

Recording a leveraged buyout u The transaction is recorded as a modified direct asset acquisition using purchase rules u Accounts are recorded at the sum of 3 possible values SA#2 10

Recording a leveraged buyout, continued Assume the blocks are 70% market, 20% equity, 10% book Market Portion - a 70% D&D schedule will assign the market value available to each account. Equity Portion - a 20% D&D schedule will assign the equity adjusted cost available to each account. Book Value Portion - 10% of each account remains at book value SA#2 11