Lbo Note

Note on Leveraged Buyouts Case #5-0004

Updated September 30, 2003

Note on Leveraged Buyouts

A leveraged buyout, or LBO, is the acquisition of a company or division of a
company with a substantial portion of borrowed funds. In the 1980s, LBO firms
and their professionals were the focus of considerable attention, not all of it
favorable. LBO activity accelerated throughout the 1980s, starting from a basis of
four deals with an aggregate value of $1.7 billion in 1980 and reaching its peak in
1988, when 410 buyouts were completed with an aggregate value of $188 billion1.

In the years since 1988, downturns in the business cycle, the near-collapse of the
junk bond market, and diminished structural advantages all contributed to dramatic
changes in the LBO market. In addition, LBO fund raising has accelerated
dramatically. From 1980 to 1988 LBO funds raised approximately $46 billion;
from 1988 to 2000, LBO funds raised over $385 billion2. As increasing amounts of
capital competed for the same number of deals, it became increasingly difficult for
LBO firms to acquire businesses at attractive prices. In addition, senior lenders
have become increasingly wary of highly levered transactions, forcing LBO firms
to contribute higher levels of equity. In 1988 the average equity contribution to
leveraged buyouts was 9.7%. In 2000 the average equity contribution to leveraged
buyouts was almost 38%, and for the first three quarters of 2001 average equity

1
Securities Data Corporation
2
Venture Economics

This case was prepared by John Olsen T’03 and updated by Salvatore Gagliano T’04 under the
supervision of Adjunct Assistant Professor Fred Wainwright and Professor Colin Blaydon of the
Tuck School of Business at Dartmouth College. It was written as a basis for class discussion and not
to illustrate effective or ineffective management practices.

Copyright © 2003 Trustees of Dartmouth College. All rights reserved. To order additional copies,
please call (603) 646-0522. No part of this document may be reproduced, stored in any retrieval
system, or transmitted in any form or by any means without the express written consent of the Tuck
School of Business at Dartmouth College.


contributions were above 40%3. Contributing to this trend was the near halt in
enterprise lending, in stark comparison to the 1990s, when banks were lending at up
to 5.0x EBITDA. Because of lenders’ over-exposure to enterprise lending, senior
lenders over the past two years are lending strictly against company asset bases,
increasing the amount of equity financial sponsors must invest to complete a
transaction.4

These developments have made generating target returns (typically 25 to 30%)
much more difficult for LBO firms. Where once they could rely on leverage to
generate returns, LBO firms today are seeking to build value in acquired companies
by improving profitability, pursuing growth including roll-up strategies (in which
an acquired company serves as a “platform” for additional acquisitions of related
businesses to achieve critical mass and generate economies of scale), and improving
corporate governance to better align management incentives with those of
shareholders.

History of the LBO

While it is unclear when the first leveraged buyout was carried out, it is generally
agreed that the first early leveraged buyouts were carried out in the years following
World War II. Prior to the 1980s, the leveraged buyout (previously known as a
“bootstrap” acquisition) was for years little more than an obscure financing
technique.

In the years following the end of World War II the Great Depression was still
relatively fresh in the minds of America’s corporate leaders, who considered it wise
to keep corporate debt ratios low. As a result, for the first three decades following
World War II, very few American companies relied on debt as a significant source
of funding. At the same time, American business became caught up in a wave of
conglomerate building that began in the early 1960s. In some cases, corporate
governance guidelines were inconsistently implemented.5 The ranks of middle
management swelled and corporate profitability began to slide. It was in this
environment that the modern LBO was born.

In the late 1970s and early 1980s, newly formed firms such as Kohlberg Kravis
Roberts and Thomas H. Lee Company saw an opportunity to profit from inefficient

3
S&P / Portfolio Management Data
4
Private Placement Newsletter, January 6, 2003.
5
George P. Baker and George David Smith, The New Financial Capitalists: Kohlberg Kravis
Roberts and the Creation of Corporate Value, (Cambridge: Cambridge University Press, 1998).

Center for Private Equity and Entrepreneurship 2


and undervalued corporate assets. Many public companies were trading at a
discount to net asset value, and many early leveraged buyouts were motivated by
profits available from buying entire companies, breaking them up and selling off the
pieces. This “bust-up” approach was largely responsible for the eventual media
backlash against the greed of so-called “corporate raiders”, illustrated by books
such as The Rain on Macy’s Parade and films such as Wall Street and Barbarians
at the Gate, based on the book by the same name.

As a new generation of managers began to take over American companies in the
late 1970s, many were willing to consider debt financing as a viable alternative for
financing operations. Soon LBO firms’ constant pitching began to convince some
of the merits of debt-financed buyouts of their businesses. From a manager’s
perspective, leveraged buyouts had a number of appealing characteristics:

Tax advantages associated with debt financing,
Freedom from the scrutiny of being a public company or a captive division
of a larger parent,
The ability for founders to take advantage of a liquidity event without
ceding operational influence or sacrificing continued day-to-day
involvement, and
The opportunity for managers to become owners of a significant percentage
of a firm’s equity.

The Theory of the Leveraged Buyout

While every leveraged buyout is unique with respect to its specific capital structure,
the one common element of a leveraged buyout is the use of financial leverage to
complete the acquisition of a target company. In an LBO, the private equity firm
acquiring the target company will finance the acquisition with a combination of
debt and equity, much like an individual buying a rental house with a mortgage (See
Exhibit 1). Just as a mortgage is secured by the value of the house being purchased,
some portion of the debt incurred in an LBO is secured by the assets of the acquired
business. The bought-out business generates cash flows that are used to service the
debt incurred in its buyout, just as the rental income from the house is used to pay
down the mortgage. In essence, an asset acquired using leverage helps pay for itself
(hence the term “bootstrap” acquisition).

In a successful LBO, equity holders often receive very high returns because the debt
holders are predominantly locked into a fixed return, while the equity holders
receive all the benefits from any capital gains. Thus, financial buyers invest in
highly leveraged companies seeking to generate large equity returns. An LBO fund



will typically try to realize a return on an LBO within three to five years. Typical
exit strategies include an outright sale of the company, a public offering or a
recapitalization. Table 1 further describes these three exit scenarios.

Table 1. Potential investment exit strategies for an LBO fund.

Exit Strategy Comments
Sale Often the equity holders will seek an outright sale to a strategic
buyer, or even another financial buyer
Initial Public Offering While an IPO is not likely to result in the sale of the entire entity,
it does allow the buyer to realize a gain on its investment
Recapitalization The equity holders may recapitalize by re-leveraging the entity,
replacing equity with more debt, in order to extract cash from the
company

LBO Candidate Criteria

Given the proportion of debt used in financing a transaction, a financial buyer’s
interest in an LBO candidate depends on the existence of, or the opportunity to
improve upon, a number of factors. Specific criteria for a good LBO candidate
include:

Steady and predictable cash flow Divestible assets
Clean balance sheet with little debt Strong management team
Strong, defensible market position Viable exit strategy
Limited working capital requirements Synergy opportunities
Minimal future capital requirements Potential for expense reduction
Heavy asset base for loan collateral

Transaction Structure

An LBO will often have more than one type of debt in order to procure all the
required financing for the transaction. The capital structure of a typical LBO is
summarized in Table 2.



Table 2. Typical LBO transaction structure.

Percent of Cost of
Offering Transaction Capital Lending Parameters Likely Sources
Senior Debt 50 – 60% 7 – 10% 5 – 7 Years Payback Commercial
2.0x – 3.0x EBITDA banks
2.0x interest coverage Credit companies
Insurance
companies

Mezzanine 20 – 30% 10 – 20% 7 – 10 Years Payback Public Market
Financing 1.0 – 2.0x EBITDA Insurance
companies
LBO/Mezzanine
Funds

Equity 20 – 30% 25 – 40% 4 – 6 Year Exit Management
Strategy LBO funds
Subordinated debt
holders
Investment banks

It is important to recognize that the appropriate transaction structure will vary from
company to company and between industries. Factors such as the outlook for the
company’s industry and the economy as a whole, seasonality, expansion rates,
market swings and sustainability of operating margins should all be considered
when determining the optimal debt capacity for a potential LBO target. For a
detailed illustration of the mechanics of an LBO transaction, see Exhibit 2, which
models a hypothetical buyout scenario.

Pros and Cons of Using Leverage

There are a number of advantages to the use of leverage in acquisitions. Large
interest and principal payments can force management to improve performance and
operating efficiency. This “discipline of debt” can force management to focus on
certain initiatives such as divesting non-core businesses, downsizing, cost cutting or
investing in technological upgrades that might otherwise be postponed or rejected
outright. In this manner, the use of debt serves not just as a financing technique, but
also as a tool to force changes in managerial behavior.



Another advantage of the leverage in LBO financing is that, as the debt ratio
increases, the equity portion of the acquisition financing shrinks to a level at which
a private equity firm can acquire a company by putting up anywhere from 20-40%
of the total purchase price.

Interest payments on debt are tax deductible, while dividend payments on equity are
not. Thus, tax shields are created and they have significant value. A firm can
increase its value by increasing leverage up to the point where financial risk makes
the cost of equity relatively high compared to most companies.

Private equity firms typically invest alongside management, encouraging (if not
requiring) top executives to commit a significant portion of their personal net worth
to the deal. By requiring the target’s management team to invest in the acquisition,
the private equity firm guarantees that management’s incentives will be aligned
with their own.

The most obvious risk associated with a leveraged buyout is that of financial
distress. Unforeseen events such as recession, litigation, or changes in the
regulatory environment can lead to difficulties meeting scheduled interest
payments, technical default (the violation of the terms of a debt covenant) or
outright liquidation, usually resulting in equity holders losing their entire
investment on a bad deal.

The value that a financial buyer hopes to extract from an LBO is closely tied to
sales growth rates, margins and discount rates, as well as proper management of
investments in working capital and capital expenditures. Weak management at the
target company or misalignment of incentives between management and
shareholders can also pose threats to the ultimate success of an LBO. In addition,
an increase in fixed costs from higher interest payments can reduce a leveraged
firm’s ability to weather downturns in the business cycle. Finally, in troubled
situations, management teams of highly levered firms can be distracted by dealing
with lenders concerned about the company’s ability to service debt.

Buyout Firm Structure and Organization

The equity that LBO firms invest in an acquisition comes from a fund of committed
capital that has been raised from institutional investors, such as corporate pension
plans, insurance companies and college endowments, as well as individual
“qualified” investors. A qualified investor is defined by the SEC as (i) an individual
with net worth, or joint net worth with spouse, over $1 million, or (ii) an individual
with income over $200,000 in each of the two most recent years or joint income



with spouse exceeding $300,000 for those years and a reasonable expectation of the
same income level in the current year. Buyout funds are structured as limited
partnerships, with the firm’s principals acting as general partner and investors in the
fund being limited partners. The general partner is responsible for making all
investment decisions relating to the fund, with the limited partners responsible for
transferring committed capital to the fund upon notice of the general partner.

As a general rule, funds raised by private equity firms have a number of fairly
standard provisions:

Minimum Commitment: Prospective limited partners are required to commit a
minimum amount of equity. Limited partners make a capital commitment, which is
then drawn down (a “takedown” or “capital call”) by the general partner in order to
make investments with the fund’s equity.

Investment or Commitment Period: During the term of the commitment period,
limited partners are obligated to meet capital calls upon notice by the general
partner by transferring capital to the fund within an agreed-upon period of time
(often 10 days). The term of the commitment period usually lasts for either five or
six years after the closing of the fund or until 75 to 100% of the fund’s capital has
been invested, whichever comes first.

Term: The term of the partnership formed during the fund-raising process is
usually ten to twelve years, the first half of which represents the commitment period
(defined above), the second half of which is reserved for managing and exiting
investments made during the commitment period.

Diversification: Most funds’ partnership agreements stipulate that the partnership
may not invest more than 25% of the fund’s equity in any single investment.

The LBO firm generates revenue in three ways:

Carried Interest: Carried interest is a share of any profits generated by acquisitions
made by the fund. Once all the partners have received an amount equal to their
contributed capital any remaining profits are split between the general partner and
the limited partners. Typically, the general partner’s carried interest is 20% of any
profits remaining once all the partners’ capital has been returned, although some
funds guarantee the limited partners a priority return of 8% on their committed
capital before the general partner’s carried interest begins to accrue.

Management Fees: LBO firms charge their limited partners a management fee to
cover overhead and expenses associated with identifying, evaluating and executing



acquisitions by the fund. The management fee is intended to cover legal,
accounting, and consulting fees associated with conducting due diligence on
potential targets, as well as general overhead. Other fees, such as lenders’ fees and
investment banking fees are generally charged to any acquired company after the
closing of a transaction. Management fees range from 0.75% to 3% of committed
capital, although 2% is common. Management fees are often reduced after the end
of the commitment period to reflect the lower costs of monitoring and harvesting
investments.

Co-Investment: Executives and employees of the leveraged buyout firm may co-
invest along with the partnership on any acquisition made by the fund, provided the
terms of the investment are equal to those afforded to the partnership.

See exhibits 1 and 2 below for detailed examples and analyses of leveraged
transactions.

Valuation

The valuation of established companies that are the usual acquisition targets of
LBO funds can be done using two primary methods:
Market comparisons. These are metrics such as multiples of revenue, net
earnings and EBITDA that can be compared among public and private
companies. Usually a discount of 10% to 40% is applied to private
companies due to the lack of liquidity of their shares.
Discounted cash flow (DCF) analysis. This is based on the concept that the
value of a company is based on the cash flows it can produce in the future.
An appropriate discount rate is used to calculate a net present value of
projected cash flows.6

6
Since interest is tax deductible, a more refined DCF analysis can calculate the value of interest tax
shields and the value of cash flows assuming the firm had no debt. The sum of the two values results
in the value of the enterprise. This is a methodology known as Adjusted Present Value, or APV, and
it shows explicitly the value contributed by debt. For further details see Corporate Finance, Ross,
Westerfield and Jaffe, 5th Edition, p. 455-459.



Exhibit 1. Leveraged Buyout: A Simple Example

The following example is intended to demonstrate the effect of leverage when
making an acquisition. Suppose you bought an apartment house on December 31,
2003 as an investment for $750,000 with a down payment of 10%, or $75,000. The
remaining $675,000 of the purchase price was financed through a bank loan with an
interest rate of 7.5%. Your annual rental income from the house is $250,000 and
your annual expenses are $50,000 in maintenance charges and $10,000 in property
taxes. For simplicity, assume there are no income taxes, all cash flows occur at the
end of each year, and the value of the rental property remains fixed.

Your income for the next five years can be summarized as follows:

Income Statement
Year Ending December 31, 2003 2004 2005 2006 2007 2008

Rental Income $250,000 $250,000 $250,000 $250,000 $250,000

Maintenace Charges 50,000 50,000 50,000 50,000 50,000
Property Taxes 10,000 10,000 10,000 10,000 10,000
Rental Income 190,000 190,000 190,000 190,000 190,000

Interest Payments 50,625 40,172 28,935 16,855 3,869

Free Cash Flow Used to Repay Debt 139,375 149,828 161,065 173,145 186,131

Assuming that all free cash flow each year is used to repay debt and the value of the
property remains fixed, your equity ownership in the house should steadily increase
over the period as you pay down your mortgage:


Mortgage
Beginning Balance $675,000 $675,000 $535,625 $385,797 $224,732 $51,587
(Payments) / Borrowings 0 (139,375) (149,828) (161,065) (173,145) (51,587)
Ending Balance 675,000 535,625 385,797 224,732 51,587 0
Interest Expense at 50,625 40,172 28,935 16,855 3,869

Capitalization
Debt $675,000 $535,625 $385,797 $224,732 $51,587 $0
Equity 75,000 214,375 364,203 525,268 698,413 750,000
Total Capitalization 750,000 750,000 750,000 750,000 750,000 750,000

Ownership
Debt 90.0% 71.4% 51.4% 30.0% 6.9% 0.0%
Equity 10.0% 28.6% 48.6% 70.0% 93.1% 100.0%
Total Capitalization 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%



At the end of five years, your equity ownership as a percentage of total
capitalization increases from 10% to 100%.

Return on Investment
Equity Value $884,544
Compund Annual Return on Equity 63.81%

Taking into account the value of the apartment house at the end of 2008, your initial
$75,000 investment is worth nearly $900,000, representing a compounded annual
return of 64%. Because you were able to take advantage of leverage in financing
the purchase, you now own an asset of relatively significant equity value relative to
the amount of your initial equity investment.

Financing the purchase of the apartment house with significant amounts of debt will
dramatically influence your return on the investment. To further illustrate this,
consider the effect of varying combinations of debt and equity to make the original
purchase. Furthermore, assume that the real estate market takes a turn for the worse
and that you can only rent the house for $125,000 a year while still having to pay
the same expenses in maintenance and property taxes.

Assuming that you are stuck with this investment for the next five years, your
income stream can be summarized as:

Income Statement

Rental Income $125,000 $125,000 $125,000 $125,000 $125,000

Maintenace Charges 50,000 50,000 50,000 50,000 50,000
Property Taxes 10,000 10,000 10,000 10,000 10,000
Rental Income 65,000 65,000 65,000 65,000 65,000

Interest Payments 50,065 48,901 47,647 46,295 44,837

Free Cash Flow Used to Repay Debt 14,935 16,099 17,353 18,705 20,163

If you eventually sell the house in 2008 for $500,000, $750,000 or $1 million, your
compounded annual return on investment in each financing scenario can be
summarized as:



Five- Year Internal Rates of Return Based on Varying Financing Combinations and Exit Prices

100% Equity 50% Debt / 50% Equity 75% Debt / 25% Equity
Proceeds to Return to Proceeds to Return to Proceeds to Return to
Equity Equity Equity Equity Equity Equity
Sale Price Holders Holders Holders Holders Holders Holders
162,256 100.00% 100.00% 50.00% 50.00% 25.00% 25.00%
$500,000 $825,000 1.92% $348,830 (1.44%) $75,971 (16.53%)
750,000 1,075,000 7.47% 598,830 9.81% 325,971 11.70%
1,000,000 1,325,000 12.05% 848,830 17.75% 575,971 25.16%

The proceeds to you at exit include the repayment of the outstanding mortgage
balance and the proceeds from your exiting sale price. Note how increasing
financing leverage magnifies your IRR, either positively or negatively.

While this example is rather simple, we see that levering up to make an investment
in any asset increases financial risk and significantly influences one’s gain or loss
on the investment.



Exhibit 2. LBO Mechanics

To illustrate the mechanics of a leveraged buyout we will look at an LBO of ABC
Company. The Leveraged Buyout Model shown in the following pages lays out
transaction assumptions, analyses and pro forma financial statements for the
Company. An explanation of each section of the model follows.

Transaction Assumptions
This section includes basic transaction assumptions, including the expected closing
date, the accounting method, amortization for transaction fees and relevant market
interest rates. Within the model, the closing date drives the calculation of internal
rates of returns to the equity investors. The accounting method for the transaction is
either purchase or recapitalization accounting. In an acquisition, the Purchase
Method treats the acquirer as having purchased the assets and assumed the
liabilities of the target, which are then written up or down to their respective fair
market values. The difference between the purchase price and the net assets
acquired is attributed to goodwill. In a recapitalization, the target’s capitalization is
restructured without stepping up the basis of the target’s assets for accounting
purposes, and there is no transaction goodwill. For recapitalization accounting to
be used in a transaction, the Securities and Exchange Commission requires that the
target company be an existing entity that is not formed or altered, such as through
reincorporation, to facilitate the transaction.

Transaction fees, such as lenders’ fees, the equity sponsor’s transaction costs and
investment banking fees are generally charged to the acquired company after the
closing of a transaction, capitalized on the company’s balance sheet (since benefits
from the transaction accrue to the company over multiple years) and typically
amortized over a period of seven years. Market interest rates, primarily Treasury
note rates and the London InterBank Offered rate (LIBOR), are used by lenders to
price the debt lent in the transaction. Finally, the Transaction Summary shows the
equity purchase price of the transaction, calculates the transaction value, and
summarizes the relevant transaction multiples.

Sources and Uses of Funds
This section is used to input the transaction structuring assumptions for debt and
equity sources. The funds raised are then allocated accordingly, including the
purchase of the Company’s common equity, the refinancing of current debt and
payment of transaction fees.

Capitalization: Most leveraged buyouts make use of multiple tranches of debt to
finance the transaction. Looking at the sources and uses of funds of funds in
Exhibit 2 it can be seen that the LBO of Target is financed with only two tranches



of debt, senior and junior. In reality, a large leveraged buyout will likely be
financed with multiple tranches of debt that could include (in decreasing order of
seniority) some or all of the following:

Bank Debt is usually provided by one of more commercial banks lending to
the transaction. It is usually comprised of two components: a revolving
credit facility and term debt, which sit pari passu to each other. Bank lenders
have the most senior claim against the cash flows of the business. As such,
bank debt has the senior claim on the assets of the Company, with bank debt
principal and interest payments taking precedence over other, junior sources
of debt financing.
- A revolving credit facility (“bank revolver”) is a source of funds
that the bought-out firm can draw upon as its working capital needs
dictate. A revolving credit facility is designed to offer the bought-
out firm some flexibility with respect to its capital needs. It serves as
a line of credit that allows the firm to make certain capital
investments, deal with unforeseen costs, or cover increases in
working capital without having to seek additional debt or equity
financing. Credit facilities usually have maximum borrowing limits
and conservative repayment terms. The model below assumes that
the company uses excess cash flow to repay outstanding borrowings
against its credit facility.
- Term debt, which is often secured by the assets of the bought-out
firm, is also provided by banks and insurance companies in the form
of private placement investments. Term debt is usually priced with a
spread above treasury notes and has maturities of five to ten years.
The amortization of term debt is negotiable and can be a straight-line
amortization or interest-only payments during the first several years
with full amortization payments thereafter.

Mezzanine Financing is so named because it exists in the middle of the
capital structure and generally fills the gap between bank debt and the equity
in a transaction. Mezzanine financing is junior to the bank debt incurred in
financing the leveraged buyout and can take the form of subordinated notes
from the private placement market or high-yield bonds from the public
markets, depending on the size and attractiveness of the deal. Mezzanine
financing is compensated for its lower priority and higher level of risk with
higher interest rates, either cash, paid-in-kind (PIK) or both, and, at times,
warrants to purchase typically 2% to 5% of the pro forma company’s
common equity.



Each tranche of debt financing will likely have different maturities and repayment
terms. For example, some sources of financing require mandatory amortization of
principal in addition to scheduled interest payments. There are a number of ways
private equity firms can adjust the target’s capital structure. The ability to be
creative in structuring and financing a leveraged buyout allows private equity firms
to adjust to changing market conditions.

In addition to the debt component of an LBO, there is also an equity component in
financing the transaction.

Private equity firms typically invest alongside management to ensure the
alignment of management and shareholder interests. In large LBOs, private
equity firms will sometimes team up to create a consortium of buyers,
thereby reducing the amount of capital exposed to any one investment. As a
general rule, private equity firms will own 70-90% of the common equity of
the bought-out firm, with the remainder held by management and former
shareholders.

Another potential source of financing for leveraged buyouts is preferred
equity. Preferred equity is often attractive because its dividend interest
payments represent a minimum return on investment while its equity
ownership component allows holders to participate in any equity upside.
Preferred interest is often structured as PIK dividends, which means any
interest is paid in the form of additional shares of preferred stock. LBO
firms will often structure their equity investment in the form of preferred
stock, with management, employees and warrant holders receiving common
stock.

Capitalization Information and Summary Coverage & Leverage Statistics
Buyout funds pay close attention to the Company’s ability to service the principal
and interest payments following the transaction. This section estimates the
Company’s pro forma ability to service its debt and amount of leverage it takes on
in the transaction.

Balance Sheet Transaction Adjustments
This section depicts the changes in the Company’s balance sheet as a result of the
LBO. The “Actual” column shows the Company’s most recent balance sheet before
the transaction. The “Adjustments” columns adjust the balance sheet to take into
account the capital raised, repayment of current Company debt, and purchase of the
Company’s common equity. This section also depicts the capitalization of



transaction goodwill and transaction costs. Finally, the “LBO Pro Forma” column
shows the balance sheet after the transaction.

Pro Forma Financial Statements
The model also describes the Company’s revised financial projections post-LBO.
Certain line items to take note of on the income statement and balance sheet
include:

Transaction Fee Amortization: This line item reflects the amortization of
capitalized financing, legal, and accounting fees associated with the transaction.
Transaction fee amortization, like depreciation, is a tax-deductible non-cash
expense. In most cases the allowable amortization period for such fees is five to
seven years (although in some cases LBO firms may choose to expense all such
fees in year one so as to present the “cleanest” set of numbers possible going
forward).

Management Fees: In addition to transaction fees, LBO shops will often charge a
transaction closing fee to the company, usually around 3% of the equity provided.
Also, in many deals the LBO shop will charge an ongoing management fee of
approximately $1 to $4 million annually, depending on the size of the company and
the magnitude of the role of the LBO shop.

Interest Expense: Interest expense for each tranche of debt financing is calculated
based upon the average yearly balance of each tranche. This method of calculating
interest expense attempts to resemble the quarterly interest payments that are often
made in reality.

Transaction Goodwill: When the purchase method of accounting is used,
transaction goodwill, or the amount in excess of tangible book value the acquirer
paid for the Company, is capitalized at closing and adjusted each year for any
impairment.

Cash Sweep Assumption: For the purpose of simplicity, the model assumes a cash
sweep, or Excess Cash Flow Recapture, on the bank revolver and senior term debt.
A cash sweep is a provision of certain debt covenants that stipulates that a portion
of excess cash (namely free cash flow available after mandatory amortization
payments have been made) generated by the bought-out business will be used to
pay down principal by tranche in the order of seniority. In reality, a cash sweep
usually applies to the bank facility and senior term debt but not to mezzanine and
high-yield financing. Note that term debt is not a credit line. Once paid down, term
debt cannot be “reborrowed” by the company. Usually, subordinated debt holders
charge a significant prepayment penalty, or “make-whole premium,” for any



prepayments. Note that if a cash sweep was not mandated by banks and the
Company was able to reinvest its available cash flow in projects whose internal rate
of return was higher than the cost of debt, the overall return to the LBO investors
would be higher.

Equity Sponsor IRR Calculation
This section summarizes the returns the buyout fund should expect three to five
years after closing the transaction assuming the company is acquired at a multiple
of EBITDA. As a general rule, leveraged buyout firms seek to exit their
investments in 5 to 7 years. Financial projections that rely solely on “multiple
arbitrage” to build enterprise value are suspect, since the expansion or contraction
of valuation multiples is dictated partly by the financial markets and partly by the
sector focus and competitive strengths of the individual company. An exit usually
involves either a sale of the portfolio company, an IPO, a recapitalization, or a sale
to another LBO firm.

[See next page]



Leveraged Buyout Analysis

Transaction Assumptions Sources and Uses of Funds
Transaction Date 12/31/03 Sources of Funds Interest Rates Uses of Funds
Leveraged Recap? (Yes = 1, No = 0) 1 Debt & Preferred Stock Amount Percent Cash PIK Amount Percent
Transaction Accounting Method Recap Bank Revolver $5.0 0.1% 6.5% Purchase Common Equity $3,631.0 82.3%
Transaction Fee Rate 3.00% Acquisition Senior Debt 2,205.8 50.0% 6.5%
Transaction Fee Amortization Years 7 Acquisition Mezzanine Financing 661.8 15.0% 15.0% 1.0% Refinance Short-term Debt 5.0 0.1%
Treasury Notes 4.47% Acquisition PIK Preferred 0.0 0.0% 0.0% 0.0%
Total Debt & Preferred Stock 2,872.6 65.1% Refinance Senior Debt 689.5 15.6%
Transaction Summary @ Deal Equity Amount Percent % Equity
Equity Purchase Price per Share $32.00 Management $10.0 0.2% 0.6% Refinance Mezzanine Debt 0.0 0.0%
Common Shares Outstanding 113.5 Rollover Equity 0.0 0.0% 0.0%
Equity Value $3,631.0 Equity Sponsor 1,529.0 34.7% 99.4% Transaction Fees 86.2 2.0%
Plus: Total Debt 694.5 Total Equity 1,539.0 34.9% 100.0%
Less: Cash (148.6) Total Sources of Funds 4,411.7 100.0% Total Uses of Funds $4,411.7 100.0%
Transaction Value $4,176.9
Capitalization Information Summary Coverage & Leverage Statistics
Transaction Multiples Analysis @ Deal Current @ Deal LTM PF 2003 PF 2004 PF
LTM EBITDA 7.7x Total Debt $694.5 $2,872.6 EBITDA / Interest Expense 2.3x 2.6x 3.3x
LTM EBIT 10.7x Total Stockholders Equity 1,579.5 (512.5) (EBITDA - Capex) / Interest Expense 0.6x 0.9x 1.4x
FYE 2003 E EBITDA 6.8x Total Capitalization $2,274.0 $2,360.2 EBITDA / Fixed Charges (1) 2.3x 2.6x 3.3x
FYE 2003 E EBIT 14.2x Total Debt / Equity 44.0% (560.5%) (EBITDA - Capex) / Fixed Charges 0.6x 0.9x 1.4x
FYE 2004 E EBITDA 5.4x Total Debt / Total Cap. 30.5% 121.7% Total Debt / EBITDA 5.3x 4.7x 3.6x
FYE 2004 E EBIT 11.2x Total Net Debt / Total Cap. 24.0% 115.4% Total Debt / (EBITDA - Capex) 19.1x 13.2x 8.4x

(1) Fixed charges defined as cash interest plus PIK preferred dividends.



Balance Sheet Transaction Adjustments

Actual Adjustments LBO
06/29/03 Sources Uses Pro Forma
Assets
Cash and Cash Equivalents $148.6 $4,411.7 ($4,411.7) $148.6
Accounts Receivable 96.5 0.0 0.0 96.5
Inventory 49.8 0.0 0.0 49.8
Other Current Assets 21.8 0.0 0.0 21.8
Total Current Assets 316.6 4,411.7 (4,411.7) 316.6

Net Property, Plant & Equipment 1,948.3 0.0 0.0 1,948.3
Transaction Goodwill 0.0 0.0 0.0 0.0
Transaction Costs 0.0 0.0 86.2 86.2
Goodwill 279.5 0.0 0.0 279.5
Intangibles 47.1 0.0 0.0 47.1
Other Assets 193.3 0.0 0.0 193.3
Total Assets $2,784.8 $4,411.7 ($4,325.5) $2,871.0

Liabilities and Shareholders' Equity
Bank Revolver $5.0 $5.0 ($5.0) $5.0
Accounts Payable 91.0 0.0 0.0 91.0
Other Current Liabilities 218.8 0.0 0.0 218.8
Total Current Liabilities 314.8 5.0 (5.0) 314.8

Other Liabilities 201.0 0.0 0.0 201.0
Senior Debt 689.5 2,205.8 (689.5) 2,205.8
Subordinated Debt 0.0 661.8 0.0 661.8
Total Liabilities 1,205.3 2,872.6 (694.5) 3,383.5

Existing Preferred Stock 0.0 0.0 0.0 0.0
Acquisition PIK Preferred 0.0 0.0 0.0 0.0
Common Equity 1,579.5 1,539.0 (3,631.0) (512.5)
Total Liabilities and Equity $2,784.8 $4,411.7 ($4,325.5) $2,871.0

Balance Sheet Check 0.0000 0.0000 0.0000 0.0000



Pro Forma Income Statement
Estimated Projected
Fiscal Year End 12/31 2003 PF 2004 2005 2006 2007 2008

Sales $3,139.8 $3,532.3 $3,973.8 $4,410.9 $4,852.0 $5,288.7
Cost of Goods Sold 1,591.2 1,766.1 1,947.2 2,117.2 2,304.7 2,512.1
Gross Profit 1,548.6 1,766.1 2,026.6 2,293.7 2,547.3 2,776.6

SG&A 273.4 282.6 317.9 352.9 388.2 423.1
Other Operating Expenses 664.5 706.5 755.0 838.1 921.9 1,004.9
EBITDA 610.7 777.1 953.7 1,102.7 1,237.3 1,348.6

Depreciation 309.9 398.2 497.6 607.8 729.1 782.9
Amortization 5.9 5.9 5.9 5.9 5.9 5.9
EBIT 294.9 373.0 450.2 489.0 502.2 559.8

Amortization of Transaction Fees 12.3 12.3 12.3 12.3 12.3 12.3
Management Fees 1.0 1.0 1.0 1.0 1.0 1.0
Interest Expense (net) 236.0 236.0 229.2 216.4 198.1 175.3
Other (Income) / Expense 6.9 6.9 6.9 6.9 6.9 6.9
Pre-Tax Income 38.7 116.8 200.8 252.3 283.9 364.4

Provision for Taxes 14.2 42.9 73.8 92.7 104.3 133.9
Net Income 24.5 73.8 127.0 159.6 179.6 230.5

Preferred Dividends 0.0 0.0 0.0 0.0 0.0 0.0
Net Income to Common $24.5 $73.8 $127.0 $159.6 $179.6 $230.5

Margin & Growth Rate Analysis
Revenue Growth -- 12.5% 12.5% 11.0% 10.0% 9.0%
COGS as a % of Sales 50.7% 50.0% 49.0% 48.0% 47.5% 47.5%
Gross Margin 49.3% 50.0% 51.0% 52.0% 52.5% 52.5%
SG&A as a % of Sales 8.7% 8.0% 8.0% 8.0% 8.0% 8.0%
Other Op. Exp. as a % of Sales 21.2% 20.0% 19.0% 19.0% 19.0% 19.0%
EBITDA Margin 19.5% 22.0% 24.0% 25.0% 25.5% 25.5%
EBIT Margin 9.4% 10.6% 11.3% 11.1% 10.4% 10.6%
Effective Tax Rate 36.8% 36.8% 36.8% 36.8% 36.8% 36.8%
Net Margin 0.8% 2.1% 3.2% 3.6% 3.7% 4.4%
Net Income Growth -- 202.0% 72.0% 25.6% 12.5% 28.3%



Pro Forma Balance Sheet
Estimated Projected
2003 2004 2005 2006 2007 2008
Assets
Cash and Cash Equivalents $148.6 $155.3 $162.0 $168.8 $175.6 $182.5
Accounts Receivable 96.5 96.8 108.9 120.8 132.9 144.9
Inventory 49.8 58.9 64.9 70.6 76.8 83.7
Other Current Assets 21.8 24.5 27.6 30.6 33.6 36.7
Total Current Assets 316.6 335.4 363.3 390.8 419.0 447.8

Net Property, Plant & Equipment 1,948.3 1,991.7 1,990.8 1,934.4 1,811.7 1,690.0
Transaction Goodwill 0.0 0.0 0.0 0.0 0.0 0.0
Transaction Costs 86.2 73.9 61.6 49.2 36.9 24.6
Goodwill 279.5 279.5 279.5 279.5 279.5 279.5
Intangibles 47.1 41.1 35.2 29.3 23.4 17.4
Other Assets 193.3 193.3 193.3 193.3 193.3 193.3
Total Assets $2,871.0 $2,914.8 $2,923.7 $2,876.4 $2,763.8 $2,652.6

Liabilities and Shareholders' Equity
Bank Revolver $5.0 $0.0 $0.0 $0.0 $0.0 $0.0
Accounts Payable 91.0 96.8 106.7 116.0 126.3 137.7
Other Current Liabilities 218.8 246.1 276.9 307.4 338.1 368.5
Total Current Liabilities 314.8 342.9 383.6 423.4 464.4 506.2

Other Liabilities 201.0 201.0 201.0 201.0 201.0 201.0
Senior Debt 2,205.8 2,141.1 1,975.5 1,722.1 1,382.1 991.7
Subordinated Debt 661.8 668.4 675.1 681.9 688.8 695.7
Total Liabilities 3,383.5 3,353.5 3,235.3 3,028.4 2,736.2 2,394.6

Existing Preferred Stock 0.0 0.0 0.0 0.0 0.0 0.0
Acquisition PIK Preferred 0.0 0.0 0.0 0.0 0.0 0.0
Common Equity (512.5) (438.6) (311.6) (152.0) 27.6 258.0
Total Liabilities and Equity $2,871.0 $2,914.8 $2,923.7 $2,876.4 $2,763.8 $2,652.6

Balance Sheet Check 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000



Pro Forma Cash Flow Statement
Projected
2004 2005 2006 2007 2008
Cash Flow from Operations
Net Income $73.8 $127.0 $159.6 $179.6 $230.5
Depreciation 398.2 497.6 607.8 729.1 782.9
Amortization 5.9 5.9 5.9 5.9 5.9
Amortization of Deferred Financing Fees 12.3 12.3 12.3 12.3 12.3
Change in Working Capital 21.0 19.5 19.1 19.6 19.9
Change in Other Assets 0.0 0.0 0.0 0.0 0.0
Change in Other Liabilities 0.0 0.0 0.0 0.0 0.0
Cash Provided / (Used) by Operating Activities $511.3 $662.3 $804.8 $946.6 $1,051.4

Cash Flow From Investing Activities
Capital Expenditures ($441.5) ($496.7) ($551.4) ($606.5) ($661.1)
Cash Provided / (Used) by Investing Activities ($441.5) ($496.7) ($551.4) ($606.5) ($661.1)

Cash Flow From Financing Activities
Change in Revolver (5.0) 0.0 0.0 0.0 0.0
Change in Senior Debt (64.7) (165.6) (253.4) (340.1) (390.4)
Change in Subordinated Debt 6.7 6.7 6.8 6.9 6.9
Existing Preferred Stock 0.0 0.0 0.0 0.0 0.0
Plus: Non-cash Dividend 0.0 0.0 0.0 0.0 0.0
Less: Common Dividend Paid 0.0 0.0 0.0 0.0 0.0
Cash Provided / (Used) by Investing Activities ($63.1) ($158.9) ($246.6) ($333.2) ($383.4)

Beginning Cash Balance $148.6 $155.3 $162.0 $168.8 $175.6
Change in Cash 6.7 6.7 6.8 6.9 6.9
Ending Cash Balance $155.3 $162.0 $168.8 $175.6 $182.5



Pro Forma Debt Schedule
Estimated Projected
2003 2004 2005 2006 2007 2008

Cash Available to pay down Bank Revolver $69.8 $165.6 $253.4 $340.1 $390.4

Bank Revolver
Beginning Balance $5.0 $0.0 $0.0 $0.0 $0.0
Borrowings / (Payments) (5.0) 0.0 0.0 0.0 0.0
Ending Balance $0.0 $0.0 $0.0 $0.0 $0.0
Interest Expense @ 6.47% $0.2 $0.0 $0.0 $0.0 $0.0

Cash Available to pay down Existing Senior Debt $64.7 $165.6 $253.4 $340.1 $390.4

Senior Debt
Beginning Balance $2,205.8 $2,141.1 $1,975.5 $1,722.1 $1,382.1
Borrowings / (Payments) (64.7) (165.6) (253.4) (340.1) (390.4)
Ending Balance $2,141.1 $1,975.5 $1,722.1 $1,382.1 $991.7

Subordinated Debt
Borrowings / (Payments) 0.0 0.0 0.0 0.0 0.0
Plus: PIK Accruals 6.7 6.7 6.8 6.9 6.9
Ending Balance $668.4 $675.1 $681.9 $688.8 $695.7
PIK Accruals @ 1.00% $6.7 $6.7 $6.8 $6.9 $6.9

Cash and Cash Equivalents
Borrowings / (Payments) 6.7 6.7 6.8 6.9 6.9
Ending Balance $155.3 $162.0 $168.8 $175.6 $182.5
Interest Income @ 3.00% $4.6 $4.8 $5.0 $5.2 $5.4

Net Interest Expense
Bank Revolver $0.2 $0.0 $0.0 $0.0 $0.0
Senior Debt 140.6 133.2 119.6 100.4 76.8
Subordinated Debt 99.8 100.8 101.8 102.8 103.8
Cash and Cash Equivalents (4.6) (4.8) (5.0) (5.2) (5.4)
Total $236.0 $229.2 $216.4 $198.1 $175.3



Returns Analysis

Exit Year 12/30/2006 12/30/2007 12/29/2008
Exit multiple: 5.0x 5.5x 6.0x 5.0x 5.5x 6.0x 5.0x 5.5x 6.0x
Exit Year EBITDA $1,102.7 $1,102.7 $1,102.7 $1,237.3 $1,237.3 $1,237.3 $1,348.6 $1,348.6 $1,348.6

Exit Year Enterprise Value: $5,513.7 $6,065.0 $6,616.4 $6,186.3 $6,805.0 $7,423.6 $6,743.1 $7,417.4 $8,091.7
Less: Net Debt (2,235.3) (2,235.3) (2,235.3) (1,895.2) (1,895.2) (1,895.2) (1,504.9) (1,504.9) (1,504.9)
Common Equity Value: $3,278.4 $3,829.7 $4,381.1 $4,291.1 $4,909.7 $5,528.4 $5,238.2 $5,912.5 $6,586.9

% Initial
Equity Source / Holder Ownership Investment Equity Value of Holding and Implied IRR

Management 0.6% $10.0 $21.3 $24.9 $28.5 $27.9 $31.9 $35.9 $34.0 $38.4 $42.8

IRR 28.7% 35.5% 41.7% 29.2% 33.6% 37.7% 27.8% 30.9% 33.7%

Rollover Equity 0.0% 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IRR NM NM NM NM NM NM NM NM NM

Equity Sponsor 98.4% 1,529.0 3,224.5 3,766.8 4,309.1 4,220.6 4,829.1 5,437.5 5,152.2 5,815.4 6,478.6

IRR 28.2% 35.1% 41.3% 28.9% 33.3% 37.3% 27.5% 30.6% 33.5%

Warrant Holders
PIK Preferred 0.0% 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Book Value of PIK 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Total 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

IRR NM NM NM NM NM NM NM NM NM


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