In this episode, I will show the example of how value is being created through an LBO. Or namely, how participants in this LBO, MBO transaction can enjoy a very nice return. That example will be sort of an illustration, but it does pick up all the most important issues. There will be quite a few numbers, and it's kind of long, and clearly, all these numbers are given in your handouts. But it's worthwhile seeing the logic behind that. All right, so we will study the following case, so this is LBO and MBO 2, an example. So the company that, we talk about a small company that is nicely managed, and at some point, and it is part of a larger corporation. But at some point in time, the management of the company decides to buy it back. Because although it's doing fine, but for some reason, there's an intrinsic conflict between the top management of the corporation. Just because they are targeting industries that produce higher returns. Because in some industries, even if you do your job great, you can not reach higher returns if this is just a low growth industry or just a steady industry. So we will take an example that the company is like this, the sales of the company is $8 million. I will cut three zeros, so we will count in thousands. That results in a steady earning before interest and taxes of 700,000. And the net income of 412, this is at 40% tax rate, so we can make it here. Now, and after negotiations with the owners of the company, the management agrees on a price, Of, $2.5 million, that corresponds to P/E of about 6. Now, well, we do not discuss whether it's a good price or a bad price. But the problem is that the management would love to buy the company back at this price, but they lack the money. Now in what follows, I will show the balance sheet of the company, and how this purchase is being financed. So first of all, these are total assets that are $2.5 million. Now, how this money is being raised? Well, first of all, the biggest part Is the bank loan. And this bank loan is secured by all company's assets, because this company is a steady one, and is doing fine. So the bank agrees to give the $1.5 million, but the terms of this loan are quite tough. Well, first of all, the loan is at 12% a year, it's given for six years. But the bad thing is that it's amortized like a mortgage. So you have to redeem the loan by equal annual payments that we will calculate in just a few minutes. So 60% of financing done, we have to find another million. Now the people approach the investment fund, That also gives a loan, and this loan is $800,000, but it's a subordinate loan, so it carries a 15% interest, again, for six years. And the same term of redemption as a mortgage, in annual payments. So it's 2.3 million down, 200,000 to go, and the remainder is equity, but this equity is broken down in two parts. This is the management equity, so this is the amount of cash that the management puts up, so this is management equity of 100,000. The remaining 100,000 up here, this is the investment fund equity, because they would like to take an equity position here as well. But this equity can be bought back by the management, so I'll put it here, buy back option, At 30% a year. So we will see that if you buy it back in two years, this is 1.3 squared, and so on and so forth. So this is all the set of assumptions, and some numbers that go in the analysis of this case. Equipped with this, the first thing we'll do, we will study how much money you have to pay to your creditors, to the bank and to the investment fund. Well, first of all, annual payments, this is what we did in our corporate finance course. So for the bank loan, this is 364,839, so I'll put it in thousands, 365K. And for an investment fund loan, This is going to be 211,390, so this is about 211. So that gives us the total amount that we'll have to pay every year. This is the sum of the two, this is just 576K. Now, the key story here is that interest on these loans is tax deductible. So it's not enough to see just these numbers, we have to break them down. And what part of this goes to the redemption of the interest, and what part reduces the principal. So in the next kind of long and specified table, we see exactly what goes on here. So this table shows through here, we have years, And again, this starts with, 1, 2, 3, 4, 5 and 6, this is all the life of both loans. This is just easier to follow. And here, first of all, in blue, I put the bank loan, And here we have interest. And principle. Then goes the investment fund loan. Again, interest and principle. And here are the totals. Interest and principle. Now, to make it easier to follow, I will put just these small lines so that you would not. So see what happens. You paid 12% on 1.5 million loan. In the first year, you have this 12% of this 1.5 million. That gives you 180. And the remainder, which is 185 is, your principle. Now, together it's clearly this totals of the bank loan. Now, I will do that for all others, it's an easy way to do, but I will give just the results. It's 158 and 207. For the second year it's 133 and 232. For the third year, 105 and 260. For fourth year, 74,291 and 39,326. Well, as the time goes by, you can see that you more principle and your interest accrues on a smaller and smaller principle. By the same token, I put just numbers here. 120 and 91, 106, 105, 90, 121, 72, 139, 51, 160, and then finally 28, 184. Well, sometimes numbers don't add up, this is because of rounding. And the total amount will be 300 here, and 276, 264, and 312, 224, 352, 178, 398, 125, 451, and finally, 67 and 509. Well, all these numbers, so we will be using these red numbers in the next table that shows to us what's going on with the cash flows of this company. Now, we have to make just a little bit more assumptions here. Well, first of all, tax rate, it's not an assumption. We just saw that it is 40%. But then, we say that out of $2.5 million, depreciable assets. They are 2.2 million. And we use the straight-line depreciation For 15 years. So basically, we just divide that by that, and get that the annual depreciation is about 147,000 a year. So now, we're all set, and we create the pro-forma cash flows. Because we have to see whether we are able to really pay off this debt, because the debt is quite high, and also is given on tough terms. Now we prepare, so here we have year. Now we have, I'll put like this, just creating a table right away. So we start with EBIT, and then we subtract interest. The next line is that we get earnings before taxes, and we subtract taxes. So that leads us to the net income. Then we add back depreciation, and get an important line. That is, I'll put it here in blue, cash flow before principal repayment. So this is how much money we have before we have paid the principle. Now, we subtract principle. And then we get the cash flow cushion. So I'll put it in red here, cash flow cushion. So whether we have any cash left. And then, the lower part of this table just gives us, first will be equity over time. Then, for us, the important thing is debt. Then, total assets. And then, finally, in red, percent of debt and total assets. So these are the things that we will be studying. So I will put some lines here, not to really make Mix things up. And now we go and proceed. I will not produce all six years. But I will put year zero, year one, year two. Then we'll make a pause, then year four. And then the final year six. So here, I'll put like this, showing that this is just the table is broken. In our handouts there is a full table for all these years. Now, let's see what happens. In the zeroth year, we have 700 of EBIT. We do not make any payments, and we go down here and we have equity of 200,000. We have debt of This, and then total assets of 2.5 million. And the bad thing is that the percentage of that is an astounding 92%. So this is the starting point. And from here, we go ahead and try to reduce this debt sharply. And if we succeeded, then we will have created value. Let's see. First year, 700,000. We subtract interest from the previous table, which is 300. That gives us earnings before taxes of 400. Then, we subtract tax, which is 40% of that. And we arrive at net income of 240. This is our first interim stop. Then we add back depreciation, which is 147, we take it from here and we get 387. So, this is the important number. This is cash flow before debt repayment. We subtract 276 again from the previous page in your flip chart. And we get a nice cash flow cushion of 110. But see what happens? This 240 plus this 200, that contributes to equity. So, I will put these two arrows. So now, it's 440. Now, with debt, it's another story. First of all, we come from here, and this is the amount that we need. So here, it's 2,024. Now, total assets dropped to 2,464. But now, the percentage of that is, well, it's not yet just, it's 82%. It has gone down. Now, if we proceeded, I'll put just numbers here. So this is the same, this is the same everywhere. This is the same. But now, interest goes down. So here is just 264. Here it will be just 178. And in the 6th year it will be just 67. Now Earnings before taxes grow. By the way, in this model we do not assume any growth whatsoever. So this is kind of a conservative one. So it's here. 522, 633, 174, 209, this is I think from the previous table. And that gives us the growing net income of 262313 and 380 here. Depreciation is the same throughout. So we added that to get the final cash flow. And this gives us 408, 460, and then 527. And we subtract greater and greater principle. Here it's 510. So you can see that cash flow quotient goes progressively down. Here it's 926, 61, and only 17 here but still is positive. But see what happens with equity debt and total assets. This is 7021301 and then 2026. Debt goes progressively down. 1712, here it's 960, and here it's nothing. And then total assets, they go down a little bit. Arrive at the same 2026. But see what happens with that. Here that is 71%, here that is just 42%, and here there is no debt at all. So in this pro forma cash flows we show that if we, first of all, we were able to make the payments of both interest and principal. And at the end of the sixth year we have no debt at all. Well, let's see what return does that produce. First of all, remember with equity part of that is ours as a measure and part of that is investment fund. So the first thing is we say that return on equity, that goes both to the management and to the investment fund, is 2026 is the final equity, 200 is the initial equity. Then it's over six years less one. That gives a nice 47% compounded rate of return. But it's not only that. Remember that we the management have the option to buy back half of the set with the added 30% rate. So what is buyback here? Buyback, so at 30%. This is 100 times 1.3 to the 6th power, that is 483. And now if we did buyback then our return on equity, I'll put it over management owed. Is now we have 2026, we subtract 483, that goes to the investment fund. But we now divide only by 100, this is our contribution, and then 16 minus 1, and that's an astounding 58% per year. So if we did that in accordance with these pro forma cash flows, we would be able to earn a 58% compounded rate of return. Well we don't have to wait until the sixth year or even till the fourth year. Even in the second or third year when our percent of debt goes down significantly, we can refinance. Maybe at that time we will be able to replace loans that we have to pay with the ones that can low interest and maybe even structure in less aggressive way so we don't have to pay them in the form of a mortgage. So clearly, by the way, at that time this is 2026 and the management can go public back again. By the same token, you can refinance at any stage if you see some progress and then you can go public even earlier. So you can see that although this is just an example, and these numbers, they have to be not only observed but achieved. So if whatever happens to the company, and you cannot ensure this EBIT, or if it goes down, for example, then you may not be able to make these payments. But if you can make these payments, then this whole venture becomes a project with a 58% compounded rate of return. So this is quite a bit. And I produced this example, and I tortured you with all these numbers, all these pages of flip charts, with just one goal, to see exactly the mechanics of that. How these arrows show what exactly happens to your equity and what happens to your debt. And that explains why total assets, they go down progressively because there is no growth. And all the money, all the blood of this company is, it's channeled to reduce the debt burden. So that gives us, although an illustrative example, but that is sort of self explanatory. And in the next final episode of this week I will produce another very well known example of a real transaction that took place many years ago but that still became one of the legendary ones. And then, although we will use the model for the age, but we'll also use some historic numbers that were taken from how this transaction was actually completed. And then we will see that sometimes, although the potential is great, but the result may be kind of thin if people are competing for the purchase, or in that case, the leverage buyout of this company.