Rjr Nabisco Essay Example

a strength in order to be used as a collateral for new debt. For the new management this company has a lot of potential for operational improvement as for it diversification in product range.

To calculate the value of RJR Nabisco under the three proposed operating plans could be used three different approaches: the adjusted present value (APV), flows to equity (FTO), or weighted average cost of capital (WACC).In theory, if all information is provided, all three methods lead to the same value. As a guide line, one should use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over its life time, and one should use APV if the project’s level of debt is known over the life of the project.

In Exhibits 5, 6 and 7, it is given information about the level of debt during the time of the project, and debt-to-value ratio is not constant. The optimal decision was to use APV approach. The first step was to calculate R0. As the asset beta is not given, we used CAPM to calculate the equity cost of capital. To calculate the equity beta, we used an arithmetic average of the historical betas (from 1982 to 1987).

Because beta is a very volatile quantity, the beta of 1987 may not fully represent the real equity beta of RJR Nabisco. We obtained ? S=0. 89. The risk-free rate and the market premium are assumed to be 9% and 8%, respectively, so we obtained an equity cost of capital of (RS) of 16. 15%. To obtain R0, we solved the equation in MM II Proposition:Note that we want to calculate the value of RJR

Nabisco for the year of 1987, so we used exhibit 3 to get the debt-equity ratio in 1987 and exhibit 2 to calculate the value of taxes paid in the same year. We assume that Net income is operational Income minus Interest and minus taxes, which leads to the following formula: T=1-Net Income/(Operational Income-Interest). We obtained T=0. 33%, B/S= 1. 79 an R0=16. 15%. Note that we considered RB = Rf since no other information was given about the cost of debt.The unlevered cash flows are given by operating income – taxes plus depreciation. In Annex A we present the table with all the calculations used to obtain APV.

The value of RJR Nabisco under each of the proposed operating plans is shown in Table 2. 1. In the same table, we have also included the maximum value that each of the proposals would be willing to pay (in equity) for RJR Nabisco. These values are obtained subtracting the assumed $5,204 million debt from APV. PrebidM GroupKKRAPV24445,3420675,0445353,14 Max Value19241,3415471,0440149,14 Table 2. 1 3.

The lower APV is for the Management Group Bid, probably due to the fact that the Management Group pretends to sell off RJR Nabisco food business. The projections show that, in comparison to the other proposals, market did not react optimistically to this intention. The food business was formed during 1967, so it was a consolidated business of the firm with 20 years and with positive profits (exhibit 4 of the case).Although, the positive profits were much smaller that the profits of the tobacco business, selling off all food assets and taking the tobacco business private probably seemed to be a very risky operation.

For the Prebid offer, APV value is greater than the Management bid.

We know from the case that the major investment in the tobacco business was extending development and test marketing of the smokeless cigarette Premier. The company had already approved plans to modernize Nabisco bakeries, to construct two new bakeries, do retrofit completely four and to close five.So there was a plan to innovate, ready to be put on action. The KKR strategy for RJR Nabisco contrasted sharply with the Management Group’s strategy, as KKR did not contemplate to dismember the company’s operations. The higher value of KKR’s APV is probably due to higher projections of net income and much higher depreciation than the two other proposals (depreciation has a positive impact in the calculation of APV).

The improvement of net income can be explained by a better management of RJR Nabisco businesses by KKR.