RJR Nabisco Some genius invented the Oreo. We’re just living off of the inheritance. F. Ross Johnson

Fair Market Value Fair Market Value: “…the price at which the asset would trade between two rational individuals, each in command of all of the information necessary to value the asset, and neither under any pressure to trade.” Rocky Higgins Analysis for Financial Management (p. 318)

Capital Budgeting 101 Step 1: Estimate Discount Rate Step 2: Project Cash Flows Cash flows for 1989-98 in tables Terminal value Step 3: Compute Net Present Value (NPV) Accept positive NPV projects

Discount Rate where t = tax rate, As we discussed, the discount rate is the weighted average cost of capital (WACC). where t = tax rate, E(rd) = expected cost of debt D = amount of debt in capitalization E(re) = expected cost of equity E = amount of equity capitalization

Discount Rate To calculate the WACC using 1989 figures under the three strategies: NOTE: since the capital structure changes over time, we need to recompute the WACC each year to reflect the change in capital structure.

Projected Cash Flows Projected cash flows for 1989 are calculated as follows:

Projected Cash Flow The following cash flow represent the cash flow computed from the tables:

Terminal Value To estimate a terminal value, we need to make an assumption about future growth after 1998. If cash flows grow by 2.5% per year (and the WACC remains constant), then for the pre-bid strategy: For the Management Group scenario: For the KKR scenario:

Terminal Value Results will depend on the growth rate assumption. Values in 1998 of cash flows for 1999 and beyond for different assumptions are (“Sensitivity Analysis”): Growth Rate

Present Value The present value of the cash flows for the prebid strategy is (using the 2.5% growth rate assumption after 1998): ($ millions) This represents the total value of RJR Nabisco (ASSETS).

Present Value To figure out the value per share of RJR Nabisco to the CURRENT shareholders, consider the pre-bid valuation: Total Assets = 22,607 Current Debt = 5,204 Equity = 17,403

Valuation Estimates of the value per share under the alternatives (again, using the 2.5% growth rate assumption):

Sources of Value The company is worth substantially more under either the KKR or the Management Group plan. There are smaller differences between the KKR value and the management value. The buyout plans propose to increase debt trim excesses decrease capital expenditures sell food assets decrease operating profits All gains are based on projections.

What Happened? Per share bids: Case (11/18) 11/29/88 MGMT $100 $101 KKR 94 106 FB 98-110 103-115

Activities of Special Committee Concluded that First Boston bid was impractical. Began to negotiate terms with KKR. Letter from Management Group protesting negotiations with KKR, offering to negotiate all aspects of its proposal. Special Committee decided to consider new bids.

Activities of Special Committee Summary of final bids (substantially equivalent): Bid Valuation MGMT $112 $108 KKR 109 108 Chose KKR: more equity (25% vs 15% for mgmt) retain more businesses fewer PIK securities more benefits to terminated employees.

Summary: RJR Nabisco Fundamentals of firm valuation: discounted cash flow techniques. Relation between managerial decisions and firm cash flows. Operating decisions can create or destroy value. Role of a corporate governance system that encourages value-enhancing decisions.