Ice Cream Machines Inc. achieves an average EBIT of $10m per year, has no debt, faces a cost of unlevered equity of 9% and is subject to a 28% tax rate. XYZ Partners, a cut-throat private equity firm, is considering a so-called leveraged buyout (LBO), a magic little trick in the world of finance: They buy the target firm with mostly debt (and a little bit of their own money) and saddle the company with the debt, while paying themselves high dividends. Assume perpetuities in all valuations.

 1. What is the value of the company before the LBO?

 2. Assume XYZ convinces a consortium of banks to lend them $60.6m at 4% forever, what will the equity in the target firm be worth?  

3. What is the levered cost of equity after the LBO? 

4. What will be the annual return on equity for XYZ, assuming they pay themselves 100% of annual net income in the form of dividends? 

5. One of the key benefits of an LBO is the lowering of the effective overall cost of capital (just like with any debt). What is the after-tax WACC?
 

Answer rating: 100% (QA)

1 The value of the company before the LBO can be calculated using the unlevered free cash flow FCF and the unlevered cost of equity Since we dont have ... View the full answer