LOS q: Explain and calculate the value of the equity investment in an LBO company under the target IRR and equity cash flow methods of valuation.

Q1. A private equity firm estimates that the terminal value of its equity stake in a leveraged buyout (LBO) investment in four years will be $285.61 million. The firm initially funded the LBO with $100 million senior and $180 million junior debt. Management’s initial equity was $7 million and initial transaction costs totalled $9 million.

Using a target IRR of 30%, the firm’s Enterprise Value is closest to (in millions):

A)   $364.

B)   $378.

C)   $100.

Q2. If a firm has debt on its balance sheet, its equity beta will be:

A)   lower than its asset beta.

B)   higher than its asset beta.

C)   the same as its asset beta.

Q3. A private equity investor estimates its terminal equity value in a leveraged buyout (LBO) investment in six years at $220 million. Outstanding total debt at termination is $95 million. It also estimates enterprise beta at 1.0, risk-free rate at 5% and the equity risk premium at 8%. The firm’s equity beta and the present value of the investor’s equity investment at year 5, respectively, is closest to:

         Equity beta       PV of equity investment at year 5

A)    1.00                                     $220.00 million

B)    1.43                                    $210.30 million

C)    1.43                                    $188.94 million

Q4. The pre- and post-money valuation, and the equity cash flow method, respectively, are most appropriate for valuing:

        Pre- and post-money valuation                    Equity cash flow method

A)      Leveraged buyout                                           Venture capital

B)        Venture capital                                            Venture capital

C)        Venture capital                                            Leveraged buyout

LOS q: Explain and calculate the value of the equity investment in an LBO company under the target IRR and equity cash flow methods of valuation. fficeffice" />

Q1. A private equity firm estimates that the terminal value of its equity stake in a leveraged buyout (LBO) investment in four years will be $285.61 million. The firm initially funded the LBO with $100 million senior and $180 million junior debt. Management’s initial equity was $7 million and initial transaction costs totalled $9 million.

Using a target IRR of 30%, the firm’s Enterprise Value is closest to (in millions):

A)   $364.

B)   $378.

C)   $100.

Correct answer is B)

Calculating ffice:smarttags" />Enterprise value requires two steps:

Step 1: The terminal value of the equity stake must first be discounted at the target IRR rate to arrive at the present value of the equity investment:

PV of equity investment = ($285.61) / (1 + 0.30)⁴ = $100

Step 2: The second step is to determine the firm’s enterprise value by aggregating the PV of equity investment, junior and senior debt and management’s equity, less transaction costs:

< >>	PV of equity investment	$100.0
+	Junior debt	$180.0
+	Senior debt	$100.0
+	Management’s equity	$7.0
?	Transaction costs	$9.0
=	Enterprise value	$378.0

Q2. If a firm has debt on its balance sheet, its equity beta will be:

A)   lower than its asset beta.

B)   higher than its asset beta.

C)   the same as its asset beta.

Correct answer is B)

The formula for calculating equity beta is:

When a firm has debt, ?_Equity will exceed ?_Asset. For firms with no debt, the two betas will be equal.

Q3. A private equity investor estimates its terminal equity value in a leveraged buyout (LBO) investment in six years at $220 million. Outstanding total debt at termination is $95 million. It also estimates enterprise beta at 1.0, risk-free rate at 5% and the equity risk premium at 8%. The firm’s equity beta and the present value of the investor’s equity investment at year 5, respectively, is closest to:

         Equity beta       PV of equity investment at year 5

A)    1.00                                     $220.00 million

B)    1.43                                    $210.30 million

C)    1.43                                    $188.94 million

Correct answer is C)

The calculation requires three steps:

Step 1: Equity in year 6 is $220 million, with debt outstanding at $95 million. The firm’s equity beta will thus be:

Step 2: Using CAPM, calculate the expected return of the firm’s equity:

E(R_Equity) = 5% + 1.43(8%) = 16.44%

Step 3: Discount the terminal equity value at year 6 back one year to year 5:

PV of equity investment at year 5 = $220 million / (1 + 0.1644) = $188.94 million

Q4. The pre- and post-money valuation, and the equity cash flow method, respectively, are most appropriate for valuing:

        Pre- and post-money valuation                    Equity cash flow method

A)      Leveraged buyout                                           Venture capital

B)        Venture capital                                            Venture capital

C)        Venture capital                                            Leveraged buyout

Correct answer is C)

The pre- and post-money valuation is most appropriate for venture capital investments where debt does not factor into the calculations. The valuation method is a factor of the firm’s future value, the discount rate and the venture capital investment.
The equity cash flow method is most appropriate for leveraged buyouts. Under this method the equity beta is calculated first from the asset beta, followed by the cost of equity each year to arrive at the proper discount rate for the firm’s present value calculations.

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