Rjr Acquisition

RJR Nabisco, a provider of tobacco and food products, received multiple bids from potential acquirers to go private. The bids, coming from Nabisco’s management team and private equity firm KKR, were attractive to RJR Nabisco’s shareholders and were much higher than the original unaffected share price in which the company was trading. However, the two firms differed greatly in their plans to operate RJR Nabisco, which ultimately affected their valuations.

The maximum price the KKR Group would offer would be based on the present value of the cash flows that KKR believed they could extract from the business. This includes all restructuring efforts and asset sales. Assuming a WACC based on their new capital structure (77% D/V), we arrived at an enterprise valuation of $32B, implying a maximum price of $107.23 per share.

Debt to total capitalization for RJR was 32%, 29%, and 27% for 1986, 1987, and 1988, respectively. For 1988, we did not have the balance sheet so we assumed total debt of $5.2B (given as the amount the acquirers would assume), a stock price of $55.88 (last known unaffected stock price disclosed in the case), and shares outstanding of 247 (assuming the share count remains flat from 1987). See Exhibit 1.

The target capital structure we would choose for RJR Nabisco is one that optimizes the capital structure by increasing the interest tax shield for RJR Nabisco, but ensures that the company does not face financial distress. Therefore, we targeted an interest coverage ratio of 1 based on 1998 EBITDA and came up with an allowable debt of $30.1B, assuming an 11.0% cost of debt. This implied a debt to total capitalization of 69%. We believe that anything beyond this would require high confidence in the management’s ability to extract more EBITDA through restructuring and sales growth. See Exhibit 2. One thing to note is that companies in the food industry have an average debt to total capitalization ratio of 21%.

WACC at pre-bid is 13.6%...