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Part I.

The Hertz LBO Case


This case offers us an opportunity to i) familiarize with the process of leveraged buyouts, ii)
discuss how private equity investors affect the options of firms (such as Ford) with respect to
asset sales (i.e., dual-track process), iii) understand the sources of value creation in leveraged
buyouts, and iv) examine the relationship among the value paid for a target, the financing
requirements, and the returns to buyout investors.
Read the case carefully, consider the following two questions, and address them briefly and
qualitatively in your case write-up. Please do not exceed a total of two type-written, doublespaced pages for both questions. Note that this is a preview to the case, so you are not asked to
complete a quantitative exercise. We will discuss the case detail in class.
1. (15%) What are the anticipated sources of value from the proposed LBO transaction?
Which market frictions could be addressed by this type of transaction?

Anticipated Value: operational, management, financial synergies


operation synergies in both business segments
Improvement in any of these drives (number of transactions, the length of the rental, revenue per
day, and fleet utilization) had the potential to yield substantial increases in revenue
Bidding Group could made operational savings: higher EBITDA margins, non-fleet related
operational expenses, rationalize the strategy of off-airport growth strategy, nonfleet capex as
percentage of sales, sg&a percentage of sales (see page 108)
Management team: more expertise through the Bidding group
Financial synergies: debt that could be backed by Hertzs fleet of rental cars (asset backed
securitized debt)
Bidding Group: ABS debt, less expensive, and provided a more flexible financing arrangement
that allowed for the debt to increase and decrease with fleet size.
Hertz has historically been one of the largest and most successful firms in the large
equipment and car rental industries. Since 1967, Hertz has consistently posted pretax
profits every year, in large part due to its strong performance in the car rental segment.
This strength stems from a strong brand name, successful membership programs, and
airport-rental services, and allows the car rental segment to be Hertzs largest source of
revenue.
As Hertz decreased its reliance on Ford production, it decided to increase financing value
by issuing debt backed by the value of its rental car fleet. With a low interest rate for LBO
financing at 4.5% and the ability to increase or decrease debt by changing the size of its
fleet, Hertz was able to create value from its assets through an ABS debt offering. The
bidding group also wanted to improve the companys non-airport revenue growth. Relative

to Avis, one of Hertzs main competitors, Hertz had lower EBITDA margins and very high
non-fleet expenses. Hertz was more fragmented with regards to the equipment rental
industry, but was still able to achieve some success within the industry. There is room for
improvement to increase efficiency, as Hertzs expected returns on the equipment rental
segment were below their main competitors - the bidding group was hoping to allocate
more capital in order to increase returns.
Post 9/11, Hertzs performance suffered due to increased market frictions resulting from
the decline in air travel. As the airport car rental segment was one of Hertzs largest
markets, the reduction in overall air travel due to safety concerns greatly hurt Hertzs
revenue in that segment. Compared to competitors such as Enterprise, who relied less on
the airport rentals and invested more in everyday car rentals, Hertzs overall value was
greatly hurt by the general social and economic environment. Therefore, Hertz made
several attempts to grow their non-airport car rental operations to offset the losses from the
airport rentals, but these actions cost Hertz more money than they gained. Thus, the
Bidding Group must re-evaluate their operating strategy in order to reduce operating
expenses while increasing revenue to regain lost value.
In this case, Hertz has already been established as one of the largest equipment and car rental
industry. Ever since 1967, it has posted pretax profits every single year and owes it to the car
rental segment as their major source of revenue. The car rental segment was Hertzs largest
source of revenue and had a very strong brand name. In the car rental industry, Hertz has had the
most success through its membership programs and airport-rental services. As Hertz decreased
its reliance on Ford production, it decided to add financing value by issuing debt backed by the
value of its rental car fleet. With a low interest rate for LBO financing at 4.5% and the ability to
increase or decrease debt by changing the size of its fleet, this created value from Hertzs assets
through an ABS debt offering. The bidding group was also looking to improve Hertzs nonairport revenue growth. Relative to Avis, one of Hertzs main competitors, Hertz had lower
EBITDA margins and very high non-fleet expenses. In terms of the equipment rental industry, it
is much more fragmented but still saw some success within the industry. There is room for
efficiency increases but Hertzs expected returns on the equipment rental segment were below
their main competitors. The bidding group was hoping to allocate more capital and increase the
returns.
Post 9/11, Hertz was experiencing one of the most difficult market frictions due to the decline of
air travel. Since airport car rentals was one of its biggest markets, the decline in air travel hurt its
revenue significantly. Enterprise relied less on the airport rentals and was a big player in
everyday car rentals, so the decline in air travel hurt Hertz much more than Enterprise. As a
result, made several attempts at growing their non-airport car rental operations but it ended up
losing Hertz more money than it gained. This is where Bidding Group steps in and is given the
opportunity to reevaluate the strategy. Overall, revenues were being overtaken by operating
expenses which was a problem needed to be tackled by the Bidding Group.

2. (15%) Do you think Hertz is a good candidate for a high debt level? Why or why not?
Think about the nature of their assets and cash flow properties.

Ideal LBO Candidate has: Low-risk, stable cash flows, low CapEx, strong asset base
Stable cash flows - yes
Asset base = cars
A good candidate for a high debt level has relatively low risk as well as a strong base of assets
and stable cash flows. Based on these criteria, Hertz is a good candidate for a high debt level.
Car rental, while somewhat correlated to air travel, is not too risky of a business. Additionally,
Hertzs revenues have shown growth substantial compounded growth from 1985-2005. This
suggests that their cash flows will likely be able to cover the interest payments associated with
high debt levels. Perhaps most significant is Hertzs asset base--they own a great deal of vehicles
and equipment, which makes them a more preferable candidate for high debt levels since they
have greater means to pay off their debt.

Part II. Related Analytical Problems


1. (30 points) Signaling with Repurchases
Sunrise Technologies Corporation had aftertax preinvestment cash flows (EBIAT +
Depreciation) of $100 million in 2004. The board met on December 31, 2004 and decided
that any cash that would not be used for investment purposes in the next few years should
be paid out in the form of a repurchase. The CEO, Miller Rock, expected Sunrise to
generate the same operating cash flows in 2005 as in 2004. The board set about
determining how much to pay out.
Sunrise Technologies and its main competitor Sunset Technologies were both facing
lawsuits that could potentially force settlements of $20 million at each company in 2005.
Sunrises lawyers were certain that Sunrise would be acquitted and would not have to pay
anything, but Sunrise was having trouble convincing the market of its innocence. Sunset
was making the same claim to the market, but insiders knew they were guilty. Investors
believed the probability of a $20 million judgment against either firm was onehalf.
Sunset otherwise had identical cash flows to Sunrise, and was facing the same payout
decision.
Sunrise and Sunset both expected to have two mutually exclusive investment
opportunities in 2005 (all figures in millions, required investment expenditures may be
paid at year-end):

Project

Investment (2005)

EBIAT + Depreciation (2006)

NPV (2005)

$160

$240

$80

$180

$270

$90

Assume that the discount rate is zero, that neither company can raise additional capital
through debt or equity issues in 2005, that there are no personal taxes, that neither
company pays dividends, and that both companies are 100% equity financed.
(a) (6 points) Suppose managers are interested in maximizing the intrinsic (true, long
run) value of the company. How much equity will each company repurchase in
January, 2005?
Sunrise:
Investors: 50:50 chance pay $20M (insiders 100% wont pay)
Good Firm (g)
cost of lawsuit (g)= 0
Sunset:
Investors: 50:50 chance pay $20M (insiders 100% will pay)
Bad Firm (b)
Cost of lawsuit(b)= 20
Probability of each firm=, p(g) = p(b)=
CF of each firm = 200
P1: 160, npv=80
P2: 180, npv=90 they both want to invest in this project
v(firm) = 100+100 + cost(20 or 0) + NPV(given project they can afford
V(g) = 100+100-0+npv(P2)= 100+ 100+ 90=290
V(b) = 100+100-20 +npv(P2) = 100 + 100 - 20 +90= 270
Since both want P2,
100+100+ cost-180 = repurchase amount

Good: 100+100- 180 20 left to repurchase


Bad: 100+100-20-180 0 left to repurchase
Sunrise (g) will repurchase 20, while Sunset (b) will repurchase 0.

(b) (6 points) What will be the market value of outstanding equity in each firm before
and after they announce their repurchase decisions (but before they make the
repurchase)?
Before Repurchase Decision: value is the same
Beforehand E[V] = V = p(g)*V(g) + p(b)*v(b) = 0.5*290 + 0.5*270 = 280
After Repurchase: Value is changed due to signalling
p(g|r(g)) = p(b|r=0) = 1
E[V|r] = p(g|r)*V(g) + p(b|r)*V(b)
Sunset (b, r=0)
E[V|r=0] = 0*v(g) + 1*v(b)--> if r=0 0 + 1*v(b)--> 0 + 1*270= 270
Sunrise (g, r=20)
E[V|r=20] =1* v(g)+ 0*v(b)--> 290
Due to the announcement of whether or not there is a repurchase, the market responds by being
able to tell if the firm is good or bad.

(c) (10 points) Suppose managers have large amounts of stock options that will expire
in January 2005, such that they are only interested in maximizing the shortterm
share price. Is it still a possible outcome (equilibrium) that both Sunrise and
Sunset will behave as in (a)? Hint: Think of this as a conjecture and see if
Sunsets behavior is incentive compatible.
Suppose Sunset (b) mimics Sunsrise (g), and repurchases r(b) = 20
V(g) = 100+100+90 = 290
V(b) = 100+100-20+npv(P1=80 bc they can only afford that with repurchase) = 260
E[v|r =20] = p(b)*V(g)+p(b)*V(b) = (290+ 260)= 275
This is a possible outcome because Sunset (b) has incentive to send a signal by copying the
repurchase of Sunrise (g). The expected market value is not 275 compared to the 270 in the
previous question where their repurchase r=0.

(d) (8 points) Is it a possible outcome (equilibrium) that Sunrise repurchases $40


and Sunset repurchases zero?
Option 1: Good repurchases r= 40, Bad repurchase r=0
v(g) = 100 + 100 + 80 = 280 (with r=40, can only afford P1, npv=80)
v(b)= 100 + 100 - 20 + 90 = 270 (with r=0, can still afford P2, npv=90)

Option 2: Good repurchases 40, b mimics


V(g) = 100+100+80 = 280 (with r=40, can only afford P1, npv=80)
V(b) = 100+100-20= 180 (with r=40, cannot afford either project)
E[v|r =40] = p(b)*V(g)+p(b)*V(b) = (280 + 180)= 230

Option 1 is an equilibrium/ possible outcome. The expected value for Sunset (b) is
actually greater for them if they repurchase r=0, rather than attempt to signal at r=40
because 270 is greater than 230. Therefore, Sunset (b) would prefer the first option.
1. (25%) Risk Shifting for RiskAdventure
RiskAdventure is a newly established company that organises corporate events with a special
thrill. The range of activities goes from helioski to paragliding and various other outdoor events.
The major risk faced by the company is the possibility that an event goes wrong. Beyond the
possibly severe legal consequences, such a tragic event would also ruin the company's reputation
and long-term profitability. Under the helm of its owner, Bob Ituary, RiskAdventure has been
careful so far to take maximum precautions by hiring only experienced instructors, developing a
culture of safety first and subscribing to a comprehensive range of insurance policies.
Recent financial forecasts by RiskAdventure's management show the following. The
end-of-year value of the company will basically take 3 possible values with probabilities
as described in Table 1:

The values above are obtained under the assumption that the existing cautious strategy is
maintained. For the purpose of the exercise, those sums should be understood as all the cashflows available to make payments to either equity-holders or debt-holders at the end of the year.

There are no further cash flows after or before that. It is convenient to assume that
RiskAdventure is not subject to corporate taxation, due for instance to past losses carried
forward. We are considering the decision making process of Bob Ituary and the company's
managers at the beginning of the year. Time is short and we ignore discounting.
A newly recruited junior manager has identified what he sees as a major possibility of boosting
company's value. He reckons that the company should take a more aggressive profile, cancel all
insurance policies, replace experienced instructors by younger ones at a lower cost and so
on...Under this alternative strategy, the end of year cash flows values and their likelihood are
described in Table 2:

RiskAdventure is facing some immediate liquidity needs: unless 750,000 are immediately
invested at the beginning of the year, those end-of-year value realisations (as given in Tables 1
and 2) do not materialise and instead the company is worthless. It is therefore essential to invest
those funds to keep RiskAdventure as a going concern.
Please answer the following questions:
a)
Internal Financing:
Cautious strategy:
Expected CF = 10%(0) + 60% (1) + 30% (3)= 1.5 M
NPV = -750,000 + 1,500,000 = + 750,000
Jr Manager:
Expected CF = 33.3%(0) + 33.3% (1.1)+ 33.3% (3.3)= 1.4652M
NPV = -750,000 + 1,465,200 = +715,200
With internal financing, Bob should go with the cautious strategy since it results in a higher
positive NPV.
Equity Financing:
= equity participation of Bobs friend
Bob retains (1-)* E(CF), so Bob wants to choose the option that gives him
the maximum CF.

For example, if CF1 is better for Bob, the following equation must hold true
(for all ):
(1-)* Expected(CF1) > (1-)* Expected (CF2) E(CF1) > E(CF2)
Where CF1 = CF using the cautious strategy
CF2 = CF using managers strategy
From previous part of question, we find E(CF1) = 1,500,000 > 1,465,200 = E(CF2)
To solve for Bobs optimal :
Max (1-)* E(CF1) *E(CF1)= 0.75
* E(CF1)= 0.75
* 1.5M= 0.75
= 1/2
With equity financing, Bob should go with the cautious strategy and = 50%
b)
(20 points) Consider an alternative to the previous scenario: the funds needed to cover the
liquidity needs are borrowed from a bank. The bank designs a debt contract that stipulates an
amount to be repaid at the end of the year, whenever possible, senior to any other claim. Can the
company secure the funds needed by financing the liquidity shock with debt? What strategy will
the company follow then? Compare your answer to the solution obtained under equity finance
and discuss. [Hint: suppose that Bob raises debt by promising his creditors that he will invest in
the cautious strategy. Will he keep his promise? If not, what happens?]
Given a level of debt, the strategy must: (1) result in a project choice that is optimal for person,
and (2) have a level of debt that lets the lender break even
Cautious Strategy
Step 1: Find debt value under the cautious strategy
Min(D,0)*0.1 + min(D,1)*0.6 + min(D,3) *0.3 = 0.75
Assume D <=1
0 + D*0.6 + D*0.3 = 0.75 D = 0.834 < 1, so assumption holds.
Step 2: given the debt, check that you would pick that strategy
Let: P1 = project under cautious strategy
P2 = project under junior managers strategy
P1: 0*0.1 + (1-0.834)*0.6 + (3-0.834)*0.3= 0.7494
P2: 0*0.3333 + (1.1 - 0.834)*0.3333 + (3.3 - 0.834)*0.3333= 0.910667
Because P2 > P1, P1(aka the cautious strategy) would not be implemented.
Junior Managers Strategy

Step 1: Find debt value under junior manager strategy


min(D,0)*0.3333 + min (D,1.1) *0.3333 + min (D,3.3) *0.3333 = 0.75
Assume D <= 1.1
0 + D*0.3333 + D*0.6667 = 0.75 D = 1.125 >1.1
Since the assumption does not hold, we know Debt is greater than 1.1
So assume D>1.1
0+ 1.1*0.3333 + D*0.6667 = 0.75 D = 1.15 (face value of debt).
Step 2: given the debt, check that you would pick the strategy
P1: 0*0.1 + (1-1.15)*0.6 + (3 - 1.15)*0.3= 0.555
P2: 0*0.3333 + (1.1-1.15)*0.3333 + (3.3 - 1.15)*0.3333= 0.716
Because Project 2 (Junior Managers Strategy) is greater than the original, the company will
always choose this strategy if they are borrowing money from the bank.

c)
(10 points) Suppose that in fact Bob Ituary immediately (and in a visible and public
manner) rejected the risky strategy and fired the junior manager. True to its business model,
RiskAdventure chose the safe strategy and negotiated with its bank a loan on that basis (i.e., the
debt is negotiated after the risky strategy has been eliminated), to finance the 750,000. Consider
now a situation that arises at some intermediate date, that is after the sums needed to cover the
liquidity needs (750,000) have been invested and the operating strategy (the safe one) has been
chosen, but before final cash flows are realized. It now appears that, at an extra cost of 50,000,
all cash flows described in Table 1 can be increased by 54,000. Their respective chances are
unaffected and remain as described in Table 1. Assume that unexpectedly Bob has access to some
personal funds just equal to 50,000. If the sum of 750,000 was initially financed by debt, does
Bob want to inject his own 50,000 in RiskAdventure? Comment on your result and describe
what kind of negotiation could take place between the bank and Bob Ituary in relation to this
further investment.
Bob will choose to reject the project now even though it yields a positive NPV. In this case, Bob
is faced with a lot of risk and only receives some of the gains, which is debt overhang.

New CFs:
10% 0.054 million
60% 1.054 million
30% 3.054 million
0.1(0.054) + 0.6(1.054) + 0.3(3.054)= 1.554 million.

Bob only benefits from the additional cashflows received by the company. His
investment is 0.05 million.
Benefit: [0 * 10%] + [0.054*30%] + [0.054 *60%]= 0.0486
Cost: 0.05
0.0486 < 0.05 Therefore, Bob should not invest right now.
However, if Bob was able to renegotiate the terms with the bank, he might be able to get
a greater benefit and choose to event. Because this cashflow is less risk than the original
situation (making >0 in all three scenarios), the bank should be willing to give up some
face value of the debt, making Bobs benefit greater.

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