When assessing the valuation of RJR Nabisco bids, the Special committee should utilize the Capital Cash Flow method. The Capital Cash Flow method, when applied appropriately, should yield the same valuation when discounting a company’s Free Cash Flow. To get Capital Cash Flows (CCF), Net Income is adjusted by adding back non-cash expenses and other reconciliations to form cash flow, decreasing Capital Expenditures, decreasing changes in Net Working Capital and finally, adding Cash Interest.
The Capital Cash Flow Method is algebraically equivalent to the Free Cash Flow Method because the CCF’s are discounted by the Expected Asset Return (Ka) and not by the Weighted Average Cost of Capital.
The key advantage with the use of the CCF method is that the valuations do not require Year over Year changes in the discount rate if the capital structure of a company is projected to change. In particular, it is useful when valuing Leveraged Buyout Scenarios because the discount rate for each year is the same even though a firm’s capital structure may be go from being extremely to lowly levered over the investment horizon.
As shown in Exhibit 1, 2, and 3, the enterprise values of RJR Nabisco are calculated by summing the discounted capital cash flows with the terminal value. By discounting the CCF’s by the Expected Asset Return of 12. 32% (exhibit 4), the enterprise value of RJR Nabisco under the pre-bid, management-bid, and KKR-bid strategies are $27. 9 billion, $37. 5 billion, and $39. 5 billion, respectively. Difference in Value of the Three Operating Plans The difference between pre-bid, KKR, and the Management Group’s valuations is due to the variations in operating strategies.
The pre-bid strategy assumes that the current company structure is continues into the foreseeable future. Since it is not a leveraged buyout, RJR Nabisco is valued with no added debt in the capital structure. Its enterprise value is simply determined by discounting the projected cash flow. The Management Group’s strategy includes the sale of the food businesses while retaining the tobacco business, which results in a major influx in cash flows in the first year, but less in future years. It is also part of a leveraged buyout, part of which is financed by long term debt, altering the capital structure going forwards.
More debt leads to a greater valuation of the firm. KKR, while still a leveraged buyout, does not plan on selling off the entirety of the food business. Instead it plans on running both the tobacco business and most of the existing food business, resulting in cash flows similar to those of the pre-bid strategy. However, since it is also will result in a new capital structure including more long term debt, the valuation is increased even higher. The three operating plans account for different amounts of assets due to varying operating strategies as well as various amounts of long-term debt.
This reflects the idea that operating decisions are the main motivation behind the value of RJR Nabisco. The Auction Firstly, the use of an auction fulfills Nabisco’s fiduciary duty to the shareholders. Accepting bids from all over will allow competition to drive the price to the highest possible level and will also accept bids from all any willing participants instead of a select few. The auction is also in the best interest of the shareholders in regards to its rules. Ensuring that no seemingly “hostile” takeover will be allowed ensures that the shareholders will get a say in the final decision.
Secondly, the Special Committee’s rules of the auction will prompt a swift acquisition. KKR and Management Group have been considering a joint bid since 1987; after one year, no deal has been finalized. By participating in an auction, companies must submit their proposals by a deadline to enter each round of bidding. Therefore, the deal will be able to close quickly in comparison to separate negotiations. This is especially attractive since the payment is mostly made in cash, and shareholders will want to receive their share of the value in a timely manner.
Conclusion From the company’s point of view, both Management and KKR’s bids result in increased cash flows from the existing operating structure. Therefore, both plans will enhance the company’s performance in the foreseeable future, though KKR’s plan does result in slightly higher cash flows. Also, both plans will be financed in a similar manner (mostly bank debt) and both bidders plan on assuming RJR Nabisco’s preexisting debt. Under KKR’s offer at $92 per share, Nabisco’s operating structure would stay intact, aintaining the image of the company as well as continuing to offer job security for its existing employees.
However, the Special Committee’s fiduciary responsibility is not fulfilled if they do not act in the shareholders’ best interest. Management Group’s bid is $8 higher per share than KKR’s, with less pay-in-kind preferred stock and more cash as payment. The Special Committee should choose Management’s bid of $100 per share in order to best fulfill its duties to the shareholders and also promise cash flows for the company in the upcoming years which are comparable to the KKR bid.
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