2012

Leveraged Buy Out of Revco D S Inc.

Group - 4
Department of Finance, University of Dhaka
9/9/2012

Leverage Buyout of Revco D S Inc

Submitted To: Dr. Md. Sadiqul Islam Professor Department of Finance University of Dhaka

Submitted By: Group no. 4 13th batch Department of Finance University of Dhaka

Date of Submission: 09 September, 2012

Group Members

Name Mohammed Robiul Alam ASM Zakariya Rokeya Mahzavin Md. Shah Naoaj Taslima Akter

Roll 13-643 13-578 13-588 13-686 13-666

Letter of Transmittal
Dr. Md. Sadiqul Islam Professor Department of Finance University Of Dhaka

Subject: Submission of Case Report.

Dear Sir: With great pleasure and honor we are submitting our case report on Leverage Buy Out of Revco D S Inc. The case study includes analysis of LBO of Revco. We analyzed the LBO from different viewpoints by using various financial tools and software.

We have tried our best to accommodate as much information and relevant issues as possible and follow the instructions that you have given.

We would like to thank you for providing us with the opportunity to prepare this case report.

Sincerely Yours

Group -04 13th batch Department of Finance University of Dhaka

Table of Contents
1. Introduction .................................................................................................................................................... 1 1.1. 1.2. 1.3. 1.4. 1.5. 1.6. 1.7. 1.8. 2. 2.1. 2.2. 2.3. 2.4. 2.5. 3. 3.1. 3.2. 3.3. 4. 5. The Company ........................................................................................................................................ 1 Competition ........................................................................................................................................... 1 Origin and Terms of the Buyout ........................................................................................................... 1 Management of New Revco .................................................................................................................. 2 Strategy and Restructuring Plans .......................................................................................................... 2 Outlook ................................................................................................................................................. 3 Comparative Analysis ........................................................................................................................... 4 Capital Adequacy .................................................................................................................................. 5 PESTEL ................................................................................................................................................ 6 HEPTALYSIS ....................................................................................................................................... 8 SWOT ................................................................................................................................................. 10 Porters Five Forces Model ................................................................................................................. 12 SCRS ................................................................................................................................................... 14 Profitability Ratio: ............................................................................................................................... 16 Liquidity Ratio: ................................................................................................................................... 17 Efficiency Ratio .................................................................................................................................. 19

Business Analysis .......................................................................................................................................... 6

Time Series Ratio Analysis of Revco D.S. Inc. ........................................................................................... 16

Cross Sectional Ratio Analysis of Revco D.S. Inco. ................................................................................... 20 Bankruptcy Risk .......................................................................................................................................... 21 5.1. 5.2. 5.3. 5.4. Altman Z-score ................................................................................................................................... 21 Estimation of the formula .................................................................................................................... 22 Accuracy and effectiveness ................................................................................................................. 22 Z-score estimated for private firms ..................................................................................................... 22

6. 7. 8.

DuPont Analysis .......................................................................................................................................... 23 ROA and ROE ratio ....................................................................................................................................... 24 Case Analysis ............................................................................................................................................... 26 Valuation...................................................................................................................................................... 26 8.1. 8.2. 8.3. 8.4. Assumptions: ....................................................................................................................................... 27 Calculation WACC: ............................................................................................................................ 28 Comparative Analysis with Peer Company: ....................................................................................... 31 Possible Reasons for Going LBO: ...................................................................................................... 33 The Variables ...................................................................................................................................... 35 Results ................................................................................................................................................. 37 Conclusions and Implications ............................................................................................................. 39

9.

Capital Adequacy:........................................................................................................................................ 34 9.1. 9.2. 9.3.

1. Introduction
In December 1986 the management of Revco D.S. and a group of investors took the company private in a leveraged buyout (LB0). Revco was the operator of the largest chain of discount drug stores in the United States. The buyers paid a 48 percent premium for the shares compared to the price in January 1986, before the announcement of plans for the buyout. In addition to the large acquisition premium, this buyout arrested\ tj1e attention of investors and analysts because of its unusual financing terms. Goldman Sachs advising the board of directors, had declared that the purchase price was "fair." Salomon Brothers, advising the buyout group, had designed the transaction and employed its considerable bond-trading muscle to promote it-indeed, this was Salomon's first major "done deal" acting simultaneously as buyout advisor, underwriter, and merchant banker. On the other hand, Moody's and Standard & Poor's, the bond rating agencies, declared Revco's LBO to have a "negative outlook" and downgraded their ratings of Revco's public bonds to "speculative" categories. Analysts noted that debt repayment in the first few years depended significantly on asset sales, an especially uncertain source of cash. More importantly, the operating performance of the firm had been declining over recent quarters.

1.1. The Company

In 1986 Revco was the nation's largest discount drugstore chain, operating 2,049 stores in 30 states. Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956 and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Strip centers in small cities were the primary location of Revco stores, with approximately 70 percent of the company's stores located in cities with a population of less than 25,000. Over the previous 5 years, the number of stores had grown at an annual compound rate of 6.24 percent, from 1,514 stores in 1981. The average cost of opening a new store was approximately $300,000, with inventory comprising approximately $200,000 of this tota1.

1.2. Competition
Revco competed with health maintenance organizations, hospital pharmacies, mail-order organizations, discount drugstores, combination food-and-drug stores, mass .merchandisers, and the rapidly emerging "deep discount" drugstores. Deep discounters were large "super" drug stores relying on volume to compensate for the unusually low prices they charged. Consequently, deep discount drugstores were located primarily in cities with populations over 250,000 and were not seen as a major threat to Revco. The drugstore industry exhibited little cyclicality since most sales were necessity items and few substitute products existed.

1.3. Origin and Terms of the Buyout

Since April 1984 chief executive officer and chairman of the board Sidney Dworkin had been concerned with' possible takeover threats following a series of highly publicized mishaps at Revco. Revco's common stock price had not recovered from the negative impact of these adversities. Rumours of an impending hostile takeover attempt on Revco had ebbed through the financial
Page 1 of 44

community in 1984, 1985, and 1986. On March 11, 1986, Dworkin struck first by submitting a buyout proposal to Revco's board of directors, He later raised the offer price to a cash payment of $38.50 per share. The board accepted tho offer on August 15. The buyout closed on December 29, 1986. The buyout would require nearly $1.5 billion, to be placed through the issuance of nine different classes of securities, the bulk of them being debt and preferred stock. Salomon Brothers, the buyout group's investment banker and a part-equity owner, had lined up the required financing from a variety of sources.

1.4. Management of New Revco

Once the LBO was completed, Sidney Dworkin became chairman of the board and Chief executive officer of the "new" Revco, the same positions he had held at Reyco D. S. As in the old entity, Dworkin did not control a majority ofthe outstanding shares ofsto.ck; he owned 'about 15.4 percent. However, these shares were subject to a voting trust of which he was a member. Apparently, Mr. Dworkin would have more control in the "new" Rcvco than he had had at Rcvco D. S., where his ownership percentage was only 2.32 percent. Dworkin received $29.6 million for the stock and stock options that he held in the old. Revco. He invested about $8 million in the "new" Revco. '

1.5. Strategy and Restructuring Plans

If the merger had occurred on June 2, 1985, earnings before depreciation, amortization, interest, and income taxes would have been $161 .8 million for the year ended May 31, 1986, just sufficient to cover pro-forma interest expense-of $155 million. Revco managers believed that the company's results since the beginning of fiscal 1985 were not indicative of future prospects and that Revco's performance in 1987 and beyond would be more in line with pre-1985 results. Nevertheless, because the interest-coverage ratio would be very low, management adopted a program to increase the margin of safety. Elements of the program included the following: Focus on drugstore business. Management planned to divest virtually Revcos entire nondrugstore businesses plus 100 drugstores, thus permitting management to concentrate on expanding its drugstore operations and improving drugstore gross margins and profitability. Management had earmarked $230 million in assets for sale by the end of June 1987 and had, in principle, reached agreements to sell $89 million of those assets by the time the company went private. At least four months would be needed to consummate these agreements. First, management devised a divestiture program to dispose of all of the non-drugstore subsidiaries. The credit agreement with the major banks called for Revco to make principal payments in 1987, 1988, and 1989, that would reduce the term loan to $150 million from $455 million. Of the $305 million In payments, $255 million were expected to occur through the divestiture program. Duff & Phelps had been engaged to value Revco's seven subsidiaries, and an analysis dated October 17, 1986 estimated the aggregate market value of these subsidiaries at $224.5 million. Book value of these subsidiaries was $178 million. Expand. Future expansion plans included opening or acquiring approximately 100 stores per year over the subsequent five years. This expansion would be financed by working capital from operations. Most of this expansion was to be in small communities. Management believed that Revco's presence

Page 2 of 44

in prime locations in these small markets discouraged entry by other large drugstore chains. In addition; the small size of the market tended to bar entry for deep discount stores, which generally required a larger population base to support profitable operations. Reduce capital expenditures. Because approximately 75 percent of all Revco drugstores either were new or had been remodeled since the beginning of fiscal I 981, management believed that Revco's program of remodeling its existing stores could be implemented each year within a modest budget. Reduce inventory and selling expense. As part of its efforts to increase Revco's profitability, management implemented an inventory-reduction program, which was to be substantially completed by the end offiscal1987. Assuming a ratio of inventory-to-sales consistent with past experience, management anticipated that inventory levels would be reduced by approximately $129 million from the levels that would otherwise exist. In addition, management initiated a program designed to reduce selling, general, and administrative expenses by approximately $24 million during 1987 from the levels that would otherwise have existed. Maintain current marketing strategy. Management would continue to build on two of Revco's fundamental strengths: its many convenient locations and its "everyday low prices" pricing strategy. Dworkin believed that these two strengths would continue to frame consumers' perceptions of Revco as a convenience drugstore, selling quality products at low prices at all times. Increase sales of non-prescription items. Revco's merchandising and marketing strategy was to maintain its strong prescription sales as the company" increased sales of and improved margins on non-prescription items. This would entail rearranging store layouts to draw the customer through aisles of non-prescription items as the customer proceeded to the drug counter. Non-prescription merchandise would include; lawn furniture, kitchen appliances, small consumer electronic items, etc.

1.6. Outlook
Sales for the stub period (from the closing on December 26, 1986 to the next fiscal year end, May 31, 1987) were expected to be about $990 million, resulting in an operating profit of about $47 million. This would leave an operating profit of$147 million for the 1987 fiscal year ending May 31, modestly higher than for 1986's operating profit of $125 million. In making their assessments of the transaction, outside analysts considered historical financial performance (Exhibits 1 and 2), projected financial performance (Exhibits 3 and 4), information on comparable companies (Exhibit 5), and current capital market rates and indices (Exhibit 6). Analysts identified a number of key assumptions: Growth rate of sales per store: The forecast assumed 6 percent annual growth in sales per store, reflecting an anticipated 5 percent inflation rate and a 1 percent real growth rate. Analysts wondered about the appropriateness of the real-growth-rate assumption, especially given the very low (or even negative) population growth rates in small communities. Cost of goods sold (COGS)/sales: The forecast assumed Revco's 5-year historical average, 73 percent. Analysts compared Revco with other drug retailers, whose COGS/sales ratio averaged 71 percent (see Exhibit 5). Acknowledging the difficulty of achieving a 1 percentage point improvement in this ratio (especially with a policy of discount pricing, analysts wondered whether Dworkin could
Page 3 of 44

realize some economics following the buyout. Selling, general, and administrative expenses/sales: The forecast assumed Revco's 5 year historical average of 20.8 percent, as opposed to an industry average of23.6 percent. Analysts also wondered whether economies were possible in this area. Timing of asset sales: Consistent with Dworkin's plan (and bankers' expectations), the forecast assumed the sale of $230 million in assets in 1988. However any softening in the acquisitions market might delay the sale until 1989 or even 1990. Timing and volume of new store openings: The forecast assumed that Revco would open 100 new stores each year for the next five years and would then stop expanding as the target market became saturated. Some analysts questioned Dworkin's ambitious store-opening plans, especially in light of Revco's high leverage. Dworkin countered that the next few years offered a temporary window to gain dominance in certain markets, and that the cash-flow growth afforded by this expansion would assist in the amortization of debt and boost returns to the equity investors.

1.7. Comparative Analysis

Analysts considered the experience of another major drug store retailer, Jack Eckerd Corporation, which had been taken private in an LBO in April 1986. In most respects the two companies were quite similar: Eckerd had been taken private, however, at a multiple of only 21.3 times, compared with Revco's 24.8 times earnings. Eckerd was also financed at a debt-equity ratio of 11.5 times, compared with Revco's 37.6 times. Exhibit 7 presents a forecast of how well Revco and Eckcrd could cover their financial obligations in the next three years, the period over which analysts perceived the greatest possible risk of default. For each company, the financial obligations included interest expense, principal payments, and preferred stock dividend payments. The "coverage'' of these obligations was estimated as a multiple compared with earnings before interest and taxes (EBIT); and "cash flow," which consisted of earnings before interest, taxes, depreciation, and amortization (EBlTDA) plus the receipts from any asset sales less capita\ expenditures. (Additions to net working capital are ignored in this calculation. Ordinarily they deserve to be included in an analysis like this. Exclusion of this item biases the estimated coverage rates upward. Analysts acknowledged; however that the comparative figure such as those in Exhibit 7 were point estimates and thus ignored the uncertainty surrounding key assumptions. Revco's financial obligations were well known at the .time of the buyout. Thus, the uncertainty about Revco's comparative standing versus Jack Eckerd and other firms devolved from forecast uncertainty about the following points: Interest rates: Revco's senior debt bore interest that floated at 1.75 percent above prime rate, currently at 7.50 percent Asset sales: Revco had to sell assets to .meet its principal payments. One could give Revco the benefit of the doubt and assume that all $230 million would actually be realized. But analysts were uncertain about the timing18 of that realization. By comparison, Jack Eckerd would try to sell $72 million in assets. Capital expenditures: Capital expenditures could be assumed to be driven by Revco's goal of
Page 4 of 44

opening 100 stores per year at an investment of$1 00,000 per store. Depreciation could be approximated as $20 million for 1987, and thereafter scaled according to the percentage net change of the difference between asset sales and capital expenditures. By contrast, Jack Eckerd envisioned opening no new stores in the foreseeable future. Eckerd's depreciation was forecasted to be $123 million, a much higher figure than Revco's because Eckerd tended to own, rather than lease, its 'stores. Growth: Salomon Brothers contemplated a sales-growth rate no lower than 8 percent; it presented forecasts to commercial bankers that assumed growth at 12 percent. Goldman Sachs, the advisor to Revco's outside directors, determined that a 12 percent growth rate assumption was "too aggressive." Analysts assumed sales growth of mature stores to be equal to the rate of inflation. In addition, "the net growth from opening new stores would yield an annual corporate growth rate of 9 percent. EBIT margin: From 1974to 1986, Revco's mean EBIT margin was 6.62 percent (standard deviation was 1.32 percent). The mean and standard deviation for Jack Eckerd Corporation were 8.11 and 1.42 percent, respectively; a sample of peer companies over the same period indicated that the mean and standard deviation were 5.15 and 1.25 percent, respectively. Salomon Brothers assumed an EBIT margin of 8.0 percent. Goldman Sachs opined that this assumption was "a bit aggressive." Only once over the past 13 years did Revco reach that level, in 1984; thereafter Revco's EBIT margin fell to 3.50 and 4.84 percent. Sales growth and EBIT margin depended in part on the rate at which Revco planned to open new stores analysts challenged the wisdom of this strategy, noting that 70 percent of Revco's stores that had been open for less than one year lost money; the figure dropped to 48 percent for stores Analysts were unable to decide whether to assume any covariance between growth and margins and generally assumed that each year was an independent draw: i.e., that there was no serial covariance in the forecast assumptions that had been open from one to two years.

1.8. Capital Adequacy

Leveraged buyouts were very difficult to, evaluate. Typically the prospective return to creditors and investors were quite high, but were they high enough to compensate for the risk involved? Ultimately the decision of whether to invest or lend in these deals hinged on some Judgment about the likelihood that the buyout firm would survive a arduous financial demand. This judgment necessarily entailed some analysis of the adequacy of the firm's capitalization. The adequacy of Revco's capitalization after the LBO could be judged in several ways. First, one could test whether, at the time that Revco went private, the market value of Revco's assets was greater than the value of Revco's liabilities. This was the classic test of bankrupt firms. If assets were worth less than the face value of liabilities, the creditors would be handed ownership of the firm; but those who used this approach confronted a number of challenging valuations questions. Most importantly, this valuation approach said nothing about the adequacy of capitalization where assets were worth a little more than the face value of liabilities. The key question how much debt could or should the firm carry was poorly answered by the bankruptcy test. A second approach would be to compare Revco's capitalization ratios (e.g. debt/equity) with those of other firms that had gone private in leveraged buyouts and with peer firms. In response to this suggestion, one scholar wrote: ... widely used rules of thumb which evaluate debt capacity in terms of some percentage of balance
Page 5 of 44

sheet values or in terms of income statement ratios can be seriously misleading and even dangerous to corporate solvency .. debt policy in gene.ral and debt capacity in particular cannot be prescribed for individual company by outsiders or by generalized standards; rather, they can and should be determined by management in terms of individual corporate circumstances and objectives and on the basis of observed behavior of cash flows. To focus on "the observed behavior of cash fows" meant asking this question: under the existing capital structure, how likely was Revco to default on servicing its liabilities? If the probability of default were high, one might judge that Revco was too dependent on debt financing and should alter the mix away from debt and toward equity. If the probability of default were extremely low, this analysis would suggest that Revco could bear additional debt.

2. Business Analysis
There are a number of generic business techniques that a Business Analyst will use when facilitating business change.

2.1. PESTEL
This is used to perform an external environmental analysis by examining the many different external factors affecting an organization. It never ceases to amaze me why so many businesses fail to take the time to look at the macro and the micro environments when completing their business plans and strategies. These external forces will play a big part in shaping the final outcome of the ultimate corporate achievement. Yet, most managers focus only on internal factors and it is fair to say that sales growth and profits remain high on their agenda. The macro environment tends to have a long term impact and requires extensive research. Couple this with the fact that many managers are over worked and under resourced and we begin to see why the process is often not completed. There is no published evidence to confirm this hypothesis, just anecdotal hearsay. The remainder of this article will illustrate an example of a Macro or PESTLE analysis for the pharmaceutical industry. It is set at a very general level but it can be used as a template or adapted to be more specific if required: The six attributes of PESTLE: Political (Current and potential influences from political pressures) Economic (The local, national and world economy impact) Sociological (The ways in which a society can affect an organization) Technological (The effect of new and emerging technology) Legal (The effect of national and world legislation) Environmental (The local, national and world environmental issues)

Page 6 of 44

Political There is now growing political focus and pressure on healthcare authorities across the world. This means that governments will be looking for savings across the board. Some of the questions the industry should ask are: What pressures will be put on pricing? What services will be cut? Will the same selection of drugs be available to everyone? In addition to this, could there be more harmonization of healthcare systems across Europe or the USA? What impact will reforms have on insurance models?

Economic The global economic crisis still exists yet government reports still show that the spend on healthcare per capital continues to grow. Will the current healthcare models exist tomorrow? The growth in homecare (as seen in the Nutrition sector) demonstrates how nursing services have moved to the private sector and have become a key business offering. The reduction in consumer disposable income will have an impact on those countries using health insurance models particularly where part payment is required. These economic pressures are seeing an increased growth in strategic buying groups who are forcing down prices. Increased pressure from shareholders has caused a consolidation of the industry: more mergers and acquisitions will take place over the coming years. Social / Culture The increasing aging population offers a range of opportunities and threats to the pharmaceutical industry. The trick will be to capitalize on the opportunities. There is also the problem of the increasing obesity amongst the population and its associated health risks. Patients and home carers are becoming more informed. Their expectations have changed and they have become more demanding. Public activism has also increased through the harnessing of new social networking technologies. How can pharmaceutical companies get closer to consumers without over stepping the regulatory boundaries? Technological Technological advancements will create new business prospects both in terms of new therapy systems and service provisions. The online opportunities will see the growth in: New info and Communications technologies. Social Media for Healthcare. Customized Treatments.

Page 7 of 44

Direct to Patient Advertising. Direct to patient communications.

Legislation The pharmaceutical industry has many regulatory and legislative restrictions. There is also a growing culture of litigation in many countries. The evolution of the internet is also stretching the legislative boundaries with patients demanding more rights in their healthcare programmes. Environmental There is a growing environmental agenda and the key stake holders are now becoming more aware of the need for businesses to be more proactive in this field. Pharma companies need to see how their business and marketing plans link in with the environmental issues. There is also an opportunity to incorporate it within their Corporate Social Responsibility programmes. Marketing and new product development should identify eco opportunities to promote as well. Summary

ECONOMIC-good sales growth, moderate operational profit, strong market demand POLITICAL -Market quota, govt. intervention,

SOCIALIncreased aging, informed customers

PESTEL ENVIRONM ENTALDisposal of the debris, eco friendly production system

LEGALStrong restrictions from law, growing culture of litigation

TECHNOLOGICALHigher expenditure in R&D, State of the art facilities

2.2. HEPTALYSIS

Page 8 of 44

This is used to perform an in-depth analysis of early stage businesses/ventures on seven important categories: Market opportunity In 1986 Revco was the nation's largest discount drugstore chain, operating 2,049 stores in 30 states. Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956 and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Strip centers in small cities were the primary location of Revco stores, with approximately 70 percent of the company's stores located in cities with a population of less than 25,000. The company is still holding 6.25% growth rate per annum, which suggests that it has a good opportunity in the market to expand. Product/solution Revco competed with health maintenance organizations, hospital pharmacies, mail-order organizations, discount drugstores, combination food-and-drug stores, mass merchandisers, and the rapidly emerging "deep discount" drugstores. Execution plan Management would continue to build on two of Revco's fundamental strengths: its many convenient locations and its "everyday low prices" pricing strategy. It is believed by the authority of the company that these two strengths would continue to frame consumers' perceptions of Revco as a convenience drugstore, selling quality products at low prices at all times. Financial engine Future expansion plans included opening or acquiring approximately 100 stores per year over the subsequent five years. This expansion would be financed by working capital from operations. Most of this expansion was to be in small communities. Management believed that Revco's presence in prime locations in these small markets discouraged entry by other large drugstore chains. In addition; the small size of the market tended to bar entry for deep discount stores, which generally required a larger population base to support profitable operations. Human capital The forecast assumed Revco's 5 year historical average of 20.8 percent, as opposed to an industry average of23.6 percent. Analysts also wondered whether economies were possible in this area. Potential return Sales for the stub period (from the closing on December 26, 1986 to the next fiscal year end, May 31, 1987) were expected to be about $990 million, resulting in an operating profit of about $47 million. This would leave an operating profit of$147 million for the 1987 fiscal year ending May 31, modestly higher than for 1986's operating profit of $125 million.

Page 9 of 44

Margin of safety

Summary

Market opportunityhigh growth rate in the market Human capital-huge expenditure in the administrative costs

productsDiversified product range

Financial engines- WC operations

Execution plan-every day low price

Margin of safety-

ReturnModerately high

2.3. SWOT
This is used to help focus activities into areas of strength and where the greatest opportunities lie. This is used to identify the dangers that take the form of weaknesses and both internal and external threats. The four attributes of SWOT analysis: Strengths - What are the advantages? What is currently done well? (e.g. key area of bestperforming activities of your company) Weaknesses - What could be improved? What is done badly? (e.g. key area where you are performing poorly) Opportunities - What good opportunities face the organization? (e.g. key area where your competitors are performing poorly) Threats - What obstacles does the organization face? (e.g. key area where your competitor will perform well)

Page 10 of 44

Strengths The strengths of the pharmaceutical industrys SWOT analysis document the internal industry components that are providing value, quality goods and services and overall excellence. The internal industry components can include physical resources, human capital or features the industry can control. For example, the pharmaceutical industrys strengths could include low operating overhead, firm fiscal management, low staff turnover, high return on investment (ROI), state-of-the-art laboratory equipment and an experienced research staff. Weaknesses The weaknesses of the pharmaceutical industrys SWOT analysis document the internal industry components that are not providing significant added value or are in need of improvement. The internal industry components can include physical resources, human capital or features the industry can control. For example, the pharmaceutical industrys weaknesses could include high-risk business modeling, disengaged Board of Directors, dated medical equipment, poor branding, low staff morale or diseconomies of scale. Opportunities The opportunities of the pharmaceutical industrys SWOT analysis document the external industry components that provide a chance for the industry (or factions of the industry) to grow in some capacity or gain a competitive edge. The external industry components should be environmental factors or aspects outside the industrys control, yet reflective of the business marketplace. For example, the pharmaceutical industrys opportunities could include recently published research, an increase in health-conscious consumers, increased demand for pharmaceutical products, changes in Food and Drug Administration standards or decreases in employee health care costs. Threats The threats of the pharmaceutical industrys SWOT analysis document the external industry components that could create an opportunity for the industry (or factions of the industry) to decline, atrophy or lose some competitive edge. The external industry components should be environmental factors or aspects outside the industrys control, yet reflective of the business marketplace. For example, the pharmaceutical industrys threats could include increased government regulation, a declining economy, increasing research and development (R&D) costs or a decrease in the global population.

Page 11 of 44

Company SWOT

Strong growth, good positioning in the market, low priced products

Streangth

Weakness

increased government regulation, a declining economy, increasing research and development (R&D) costs

Threat

Opportuniti es

severe rivalry from the competitors, govt. intervention, environmental issues

segmented drugstores, country coverage

2.4. Porters Five Forces Model

Threats of entry posed by new or potential competitors LOW High barriers to entry; the company needs to put a lot of capital into research and development, lengthy approval process, marketing before it is able to receive any returns. The big Pharma companies that were able to build global operations are benefiting from economies of scale in terms of manufacturing. They are able to access low-cost supplies, as a result. Challenging regulatory conditions (hurdles to get FDA drug approvals for new products); industry is highly regulated which to some extend protects from new competition. The FDA approvals appear to have slowed during 2007. This could be one measure indicating that the FDA is taking a more cautious position on new drug approvals. In addition, legislative changes in the upcoming years may have a negative impact for the industry. Pharmaceutical companies benefit from continuation of U.S. employer-based health coverage. Customers buy medication that was prescribed by the doctors. Patent expirations may lead to an entry of new competitors (generic competitions), resulting in decreased revenues. High rates of patent expirations are approaching in 2010 through 2012. The ability of a pharmaceutical company to offset loss of revenue from patent expirations depends on growth in existing products as well as successful execution from the new product pipeline. Degree of rivalry among existing firms - HIGH Mature, consolidating, highly competitive industry (many large pharmaceutical acquisitions closed in
Page 12 of 44

2007 including AstraZenecas $15.6Bn purchase of Medlmmune Inc. and Schering-Ploughs $15Bn acquisition of Organon BioSciences). Strong credit profiles: companies operate off of high margins (high 70%), healthy balance sheets, and good liquidity Industry benefits from strong demand from consumers. Weak, small companies usually go out of business (bankruptcy) if they have no potential blockbuster in future pipeline. Others that have some significant research or valuable assets will be bought by big and strong pharmaceutical companies. Bargaining power of suppliers - LOW Suppliers generally have little room for negotiation. Large pharmaceutical companies generally enjoy significant buying power. They can dictate the price they want to buy or take their business elsewhere. Bargaining power of buyers - LOW Generally consumers have very little bargaining power. Most of the medication is prescribed by the doctors. Consumers will have to buy the drug at any given price if they need it. More educated consumers may buy a generic alternative (which have the same impact but less expensive) if available on the market. Pricing pressure The U.S. remains one of the few developed markets where drug manufacturers have significant pricing flexibility, and this is in jeopardy due to increasing pressures from consumers and legislators to control health care costs. Governments in other markets are generally the primary customers, and therefore, enjoy substantial pricing leverage. Shareholders continue to pressure the companies for increases in the share repurchase programs. The companies looking for ways to increase shareholders returns partly because the industry is approaching maturity and is not growing as rapidly, and because many companies have a lot of cash on their balance sheet. Closeness of substitute products MEDIUM Customers can find substitute medicine if the original product has an expired patent. However, if it is a new product the consumer generally will have no choice for an alternative. Over the few years generic drug manufacturers face excellent opportunities for utilization and volume trends. Generic companies are increasing focused on establishing global operations in order to achieve a lower-cost of supplies, thus posing even more threat to non-generic drug manufacturers. Summery Based on Porters model LOW to MEDIUM forces are present among the strong players in the pharmaceutical industry. Thus, the industry is attractive to investors largely due to the high-barriers to entry, purchasing and pricing power, and strong credit profiles of existing firms.

Page 13 of 44

Threats of entry posed by new or potential competitors LOW

Bargainin g power of buyers - LOW

Closeness of substitute products MEDIUM

Degree of rivalry among existing firms HIGH

Bargaining power of suppliers - LOW

2.5. SCRS
The SCRS approach in Business Analysis claims that the analysis should flow from the high level business strategy to the solution, through the current state and the requirements. The SCRS is standing for: Strategy If the merger had occurred on June 2, 1985, earnings before depreciation, amortization, interest, and income taxes would have been $161 .8 million for the year ended May 31, 1986, just sufficient to cover pro-forma interest expense-of $155 million. Revco managers believed that the company's results since the beginning of fiscal 1985 were not indicative of future prospects and that Revco's performance in 1987 and beyond would be more in line with pre-1985 results. Nevertheless, because the interest-coverage ratio would be very low, management adopted a program to increase the margin of safety. Current State In 1986 Revco was the nation's largest discount drugstore chain, operating 2,049 stores in 30 states. Fiscal 1986 sales were $2.7 billion with after-tax profits of $56.9 million. Revco was formed in 1956 and utilized the marketing concept of "every-day, low prices," a concept still in use in 1986. Strip centers in small cities were the primary location of Revco stores, with approximately 70 percent of the company's stores located in cities with a population of less than 25,000. Over the previous 5 years, the number of stores had grown at an annual compound rate of 6.24 percent, from 1,514 stores in 1981. The average cost of opening a new store was approximately $300,000, with inventory comprising approximately $200,000 of this total.

Page 14 of 44

Requirements The company has to mandate the following requirements: Focus on drugstore business Expand Reduce capital expenditures Reduce inventory and selling expense Maintain current marketing strategy Increase sales of non-prescription items

Solution

Summary

Strategyincrease the margin of safety

Solution

SCR

Current StateHigh growth rate, expanded market, opening new drugstores

Requirements- Focus on drugstoer, expand, reduce capital expenditure, maintain current market strategy etc.

Page 15 of 44

3. Time Series Ratio Analysis of Revco D.S. Inc.

The value of a firm is determined by its profitability and growth. Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one company or to compare two or more companies at one point in time. Financial statement ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency. The objective of ratio analysis is to evaluate the effectiveness of the firm's policies in each of these areas. Time series analysis accounts for the fact that data points taken over time may have an internal structure (such as autocorrelation, trend or seasonal variation) that should be accounted for. In the time series ratio analysis of Revco, we have calculated the following ratios Profitability ratio, Liquidity ratio, Debt Management ratio, Efficiency ratio and some other ratios.

3.1. Profitability Ratio:

Profitability ratios measure a company's operating efficiency, including its ability to generate income and therefore, cash flow. Cash flow affects the company's ability to obtain debt and equity financing. Ratios we have considered here are Profit margin. The profit margin ratio, also known as the operating performance ratio, measures the company's ability to turn its sales into net income. To evaluate the profit margin, it must be compared to competitors and industry statistics. It is calculated by dividing net income by net sales. The return on assets ratio (ROA) is considered an overall measure of profitability. It measures how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio. The return on common stockholders' equity (ROE) measures how much net income was earned relative to each dollar of common stockholders' equity. It is calculated by dividing net income by average common stockholders' equity. In a simple capital structure (only common stock outstanding), average common stockholders' equity is the average of the beginning and ending stockholders' equity.

Profitability ratio of Revco: a) Net profit margin

Page 16 of 44

b) Return on asset ratio

c) Return on equity

We see- Revco's profit margin in the year 1986 has decreased and according to their projection the decreasing trend of profitability will continue upto 1991.

3.2. Liquidity Ratio:

Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs. Ratios we have considered here are The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay
Page 17 of 44

its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities. This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory. Cash ratio which indicates cash adequacy in hand in terms of current liabilities.

Liquidity ratio of Revco:

The liquidity ratio of Revco also indicating the liquidity shortfall in the projected years though the company showed an increment of liquidity in the year1986. 1. Debt Management Ratio: Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid financial distress in the long run. These ratios are also known as Long-Term Solvency Ratios. Debt is called Financial Leverage because the use of debt can improve returns to stockholders in good years and increase their losses in bad years. Debt generally represents a fixed cost of financing to a firm. Thus, if the firm can earn more on assets which are financed with debt than the cost of servicing the debt then these additional earnings will flow through to the stockholders. Moreover, our tax law favors debt as a source of financing since interest expense is tax deductible. With the use of debt also comes the possibility of financial distress and bankruptcy. The amount of debt that a firm can utilize is dictated to a great extent by the characteristics of the firm's industry. Firms which are in industries with volatile sales and cash flows cannot utilize debt to the same extent as firms in industries with stable sales and cash flows. Thus, the optimal mix of debt for a firm involves a tradeoff between the benefits of leverage and possibility of financial distress. Ratios we have considered here are-

Page 18 of 44

Debt Management ratio of Revco:

Here we find that the D/E ratio of Revco is indicating Negative D/E ratios in the projected years because we have seen the company's projection says that it will face Net loss from the year 1987 to 1989.

3.3. Efficiency Ratio

We have calculated to estimate the company's efficiency by using the total asset turnover ratio.

The efficiency ratios indicate that over the historical years, the company's efficiency has decreased, but according to their projection it is indicating that the company's efficiency will increase which may be because of their very high growth rate of projection. Other ratio:

Page 19 of 44

Sales growth rate shows the scenario of the Revco in this way that the average historical growth rate of Revco is .45% while the projected average growth rate is 10.99% which is very high than the expected growth rate.

4. Cross Sectional Ratio Analysis of Revco D.S. Inco.

It is the analysis of a financial ratio of a company with the same ratio of different companies in the same industry. For example, one may conduct a cross-sectional ratio analysis of the debt ratios of multiple companies in the telecommunications industry. Quite simply, one does this by taking the debt ratios of each company and comparing them to one another. An analyst does this in order to find the company with healthiest financial status. Here we see the cross sectional ratio analysis of RevcoI. 1986 Sales Growth Rate Big B Eckerd Fay's Drug Long's Drug Perry Drug Rite Aid Thrifty Walgreen Revco (Historical) Revco (Projected) Revco (Assumed) 15.5 13.75 -0.449287 10.98726 73 9.5 12 10 18 17.5 Average

Here we see that the sales growth rate of Revco is very low than the average industry growth rate in the historical years. Projected years growth rate seems very much inconsistent with its past history. II. 1986 D/E Big B Eckerd Fay's Drug 0.22 0.18 0.96 Average

Page 20 of 44

Long's Drug Perry Drug Rite Aid Thrifty Walgreen Revco (Historical) Revco (Projected) 1.27 0.35 1.13 0.12 0.853459 -27.02621 0.604286

Here we find that though the past history says D/E ratio of Revco was more than the industry average, but it is expected that the D/E ratio will decrease largely by 270%.

III. 1986 Beta Big B Eckerd Fay's Drug Long's Drug Perry Drug Rite Aid Thrifty Walgreen Revco 1 1 1 0.85 1.1 1.15 1.1 1.1 1.0375 6.68 Average

The cross sectional beta also indicating that the company's Beta is high enough.

5. Bankruptcy Risk
The risk that. an individual or especially a company may be unable to service its debts. Bankruptcy risk is greater when the individual or firm has little or no cash flow, or when it manages its assets poorly. Banks assess bankruptcy risk when considering whether to make a loan. It is also called insolvency risk.

5.1. Altman Z-score

Page 21 of 44

The Z-score formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.

5.2. Estimation of the formula

The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets). Altman applied the statistical method of discriminant analysis to a dataset of publicly held manufacturers. The estimation was originally based on data from publicly held manufacturers, but has since been re-estimated based on other datasets for private manufacturing, non-manufacturing and service companies. The original data sample consisted of 66 firms, half of which had filed for bankruptcy under Chapter 7. All businesses in the database were manufacturers, and small firms with assets of < $1 million were eliminated.

5.3. Accuracy and effectiveness

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event, with a Type II error (false positives) of 6%. In a series of subsequent tests covering three different time periods over the next 31 years (up until 1999), the model was found to be approximately 8090% accurate in predicting bankruptcy one year prior to the event, with a Type II error (classifying the firm as bankrupt when it does not go bankrupt) of approximately 1520% (Altman, 2000).

In this case, Revco D.S. is a private firm. To assess the bankruptcy risk of this firm we used Altmans Z- score estimation for private firms.

5.4. Z-score estimated for private firms

T1 = (Current Assets Current Liabilities) / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings Before Interest and Taxes / Total Assets T4 = Book Value of Equity / Total Liabilities T5 = Sales/ Total Assets
Page 22 of 44

Z' Score Bankruptcy Model: Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5 Zones of Discrimination: Z' > 2.9 -Safe Zone 1.23 < Z' < 2. 9 -Grey Zone Z' < 1.23 -Distress Zone

Items T1 = NWC / Total Assets T2 = Retained Earnings / Total Assets

1986 0.391 3.285

1987 0.226 -0.265 0.045

1988 0.154 -0.798 0.076

1989 0.126 -1.186 0.084

weights 0.717 0.847 3.107

T3 = Earnings Before Interest and 0.127 Taxes / Total Assets T4 = Book Value of Equity / Total 0.659 Liabilities T5= Sales / Total Assets Z'Score 2.779 6.508016103

-0.006

-0.061

-0.104

0.42

1.228 1.299204

1.452 1.093753

1.580 0.879761

0.998

A low Z-score indicates a company that is likely to go bankrupt. Specifically, a Z-Score of lower than 1.8, indicates a high likelihood of bankruptcy. From our calculation, we can see that in 1986 Revco was in safe position as its z score was 6.508, which is much higher than 2.9. After that, gradually it was entering distress zone with the passes of years.

6. DuPont Analysis
The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). The Du Pont identity, however, is less useful for some industries, such as investment banking, that do not use certain concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they also respect the underlying structure of the Du Pont identity.

Page 23 of 44

High Turnover Industries Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over-performance. High margin industries Other industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of ROE. High leverage industries Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. In contrast, however, many other industries would see high levels of leverage as unacceptably risky. Du Pont analysis enables the third party (relying primarily on the financial statements) to compare leverage with other financial elements that determine ROE among similar companies. ROA and ROE ratio

Page 24 of 44

The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.

The return on equity (ROE) ratio is a measure of the rate of return to stockholders.[2] Decomposing the ROE into various factors influencing company performance is often called the Du Pont system.

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

The DuPont Analysis is important determines what is driving a company's ROE; Profit margin shows the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows how much leverage is being used. The method goes beyond profit margin to understand how efficiently a company's assets generate sales or cash and how well a company uses debt to produce incremental returns.

Items net profit/pretax profit pretax profit/EBIT EBIT/sales sales/assets assets/equity ROE

1986 0.534394 0.76593 0.045693 2.779439 2.51434 0.130701

1987 1.084722 -0.82198 0.03651 1.227565 -193.164 7.718919

1988 1.919534 -0.11997 0.052304 1.451956 -18.8428 0.329522

1989 -3.12441 0.023756 0.053076 1.580434 -10.8559 0.067589

Page 25 of 44

50 0 -50 -100 -150 -200 -250 1986 1987 1988 1989 ROE net profit/pretax profit pretax profit/EBIT EBIT/sales sales/assets assets/equity

7. Case Analysis
We consider three potential sources of problems for buyout investors. The first is the overall price paid to take the company private. Regardless of the details of the capital structure, or the extent to which there are costs of financial distress, it is clear that investors will earn lower returns as the prices paid increase relative to the fundamental value of company assets. A second potential source of problems is a capital structure that is poorly designed in terms of containing costs of financial distress. Even if the price paid to take a company private is a "reasonable' multiple of cash flow, a high probability of costly distress will obviously lower the prospective returns to some classes of investors. In evaluating this possibility, it is important to analysis measure of leverage as total debt to capital and interest coverage or cash flow coverage. These measures can provide useful information about the likelihood that a company will be unable to meet its contractual obligations. Among them cash flow coverage ratio is the most appropriate to analyze the capital adequacy of the LBO firm so that it can payout its required cash obligations in the near years. The third and final source of potential problems concerns the incentives of buyout investors. One of the supposed spurs to improved performance in buyouts is the increased equity stake of management. Managers who invest a large portion of their wealth in and own a large percentage of post-buyout equity might be expected to manage better. Conversely, managers who "cash out" a large fraction of their pre-buyout equity investment at the time of the buyout may have more of an incentive to take part in overpriced or poorly structured deals. We examine whether these and other incentives changed over time. From the above analysis we can say that from the case and LBO transaction we can develop three problem statements, these are: 1. Was the price paid for the LBO correct? 2. What are the incentives of the buyout investors to enter into such a unusually high levered buyout? 3. Is the firm adequately capitalized after the buyout?

8. Valuation
In this part we would like answer some questions. These arePage 26 of 44

What the firm value of the company is. Whether the buyout price 1.5 billion dollar is appropriate for this LBO. Whether the cash offer to stockholder at price 38.5 is appropriate. What is the probability o survival of the firm and what would be the firm value of Revco after considering distress cost. Whether the company can generate enough FCFF to pay off its cash obligations. What will be the return to the equity holder? Whether the LBO will be successful

To answer these questions at first we do valuation using Discounted Cash Flow Method. Following procedures have done to get the firm value.

8.1. Assumptions:
For Base Case: cost of goods sold/sales selling,general and administrative expenses/sales inventories/sales minimum cash balance goodwill amortization growth rate of store sales mature stores new stores interest, working capital debt interest,cash balance days trade payables other payables (days) depreciation/ gross FA tax rate cost of opening each new store new store opening/year year assets divested $100,000 100 1988 6% 6% 9.25% 6% 30 5 5% 36% 73% 20.80% 20% $50,000 $14,056

Page 27 of 44

8.2. Calculation WACC:

To value Revco at first we need to calculate WACC. To do this we have taken cost of equity which is 40.72%, tax rate is 36% Cost of debt is 11.64%. And preferred stock rate is 14.41% and finally we get WACC is 11.40%.

Firm Value: Based on the assumptions and WACC we calculate the firm value of the old Revco. Here we have taken two scenarios. The first is base case. Here he have taken the assumptions of the manager of the new revco. And we get the value is 3581079000 dollar. project ed pro forma 1987 sales cost of sales 2317381 1720525 FY 1988 243614 3 177838 5 657759 506718 10530 8043 5048 127420 81549 105170 10000 167961 1989 27029 30 19731 39 72979 1 56221 0 11030 8043 5048 14346 0 91814 11593 5 10000 1990 29929 62 21848 62 80810 0 62253 6 11530 8043 5048 16094 2 10300 3 12762 4 10000 1993 38846 12 28357 67 10488 45 80799 9 12970 8043 5048 21478 4 13746 2 16352 3 10000 1994 41176 89 30059 13 11117 76 85647 9 13352 8043 5048 22885 4 14646 7 17291 0 7624 19218 5 13390 2 50393 7

gross profit 596856 selling, general and administrative expense 449931 depreciation 62318 amortization of leaseholds amortization of other assets EBIT EBIT*(1-T) Add Noncash Charges Less: Net Inv in Fxd Cap 84607 54148 116466 10125

Less: Inv in Work Capital Interest FCFF Discount rate Terminal Value( Firm Value) Discounting Factor Discounted FCFF Firm Value Cash Out Flow NPV

102291 152064 58199

-42671 14200 146000 0 24042 344680 1 0.114042454 5465785.301

-38047 14641 0 25867 4

-8382 14454 4 29936 7

3581079 1500000 2081079

Page 28 of 44

In this scenario we have seen that the LBO is quite good decision because the firm Value of old Revco is 3581079 thousands where the cost of LBO is 1.5 billion. Nad most importantly the NPV is positive. But NPV is not the final story of the game. We would like to relax some assumptions that are quite rational in the context of economy and industry The new Assumptions areTerminal growth rate is 2% The growth rate is 5% and WCC is 15%. By this assumption we get the firm value is 1694159 thousands. ($ thousands) Projecte d pro forma FY 1987 1988 243325 sales 2317381 0.05 182493 cost of sales 1738035.75 7.538 608312. gross profit 579345.25 5125 selling, general and 535315. administrative expense 509823.82 011 depreciation 62318 10530 amortization of leaseholds 8043 amortization of other assets 5048 62467.5 EBIT 7203.43 015 EBIT*(1-T) 4610 39979 Add Noncash Charges 66928 63600 Less: Net Inv in Fxd Cap 10125 10000 167961 146000 261540 1989 25549 12.55 19161 84.41 63872 8.138 56208 0.762 11030 8043 5048 65617. 3766 41995 66116 10000 1990 26826 58.18 20119 93.64 67066 4.545 59018 4.8 11530 8043 5048 68949. 7454 44128 68749 10000 1992 29576 30.64 22182 22.98 73940 7.661 65067 8.742 12530 8043 5048 76198. 9193 48767 74388 10000 1993 31055 12.18 23291 34.13 77637 8.044 68321 2.679 12970 8043 5048 80195. 3653 51325 77386 10000 1994 32607 87.78 24455 90.84 81519 6.946 71737 3.313 13352 8043 5048 84471. 6335 54062 80505 7624 19218 5 13390 2 31912 8

Less: Inv in Work Capital Interest FCFF . Discount rate Terminal Value( Firm Value) Discounting Factor Discounted FCFF Firm Value Cash Out Flow NPV

102291 152064 -40878

-42671 14200 0 14078 2

-38047 14641 0 14092 4

60217 14391 0 52939 0.15

-8382 14454 4 12709 3

3461311.686

1694159 1500000 194159

Page 29 of 44

Calculate the Distressed Value of the Firm: As we have seen in the calculation of Z score the firm in distress zone so we have assumed the default probability is 55%. And we consider the distress cost is 30% of NPV. By considering these two issues we finally get the distressed value of the firm. Assumption Distress Cost is 30% of Firm Value Probability of Default 55%

FCFF Distress Cost FCFF less Distress Cost Firm Value Cash Out Flow NPV aftr adj of Dist Cost

1694159 508248 1185911 1414623 -1500000 -85377

Here distress cost is 508248 thousands. After deduction and multiplication with the probability we finally get the Farm Value which is 1.41 billion but certainly this figure is lower than the cash outflow. So after considering the distress cost it would not be wise decision to go for LBO.

Simulation Analysis:

Forecast values Trials Mean Median Mode Standard Deviation 1,000 -1562593 -1568104 --100817

Page 30 of 44

Variance Skewness Kurtosis Coeff. of Variability Minimum Maximum Range Width Mean Std. Error

10164100967 0.6557 3.94 -0.0645 -1816442 -1054144 762297 3188

Here we have take input variables are WACC and Growth rate. Here we have seen that the NPV is negative. So by considering simulation we should not make decision to LBO the firm.

8.3. Comparative Analysis with Peer Company:

Revco DS 87 149212 -40878 297590 50% -14% 88 161199 261540 305334 53% 86% 89 175521 140782 208727 84% 67% 90 191656 140924 192252 100% 73%

EBIT Total CF Availabale Total Obligation to be covered Coverage Ratio: EBIT coverage Ratio: total cf

400000 300000 200000 100000 0 -100000 87 88 89 90 Total Obligation to be covered EBIT Total CF Availabale

Jac Eckered 87 EBIT Total CF Availabale Total Obligation to be covered 223844 291864 224594 88 235036 303056 224856 89 246788 278808 199356 90 259127 291147 169319

Page 31 of 44

Coverage Ratio: EBIT coverage Ratio: total cf

100% 130%

105% 135%

124% 140%

153% 172%

350000 300000 250000 200000 150000 100000 50000 0 87 88 89 90

EBIT Total CF Availabale Total Obligation to be covered

Analysts considered the experience of another major drug store retailer, Jack Eckerd Corporation, which had been taken private in an LBO in April 1986. In most respects the two companies were quite similar: Eckerd had been taken private, however, at a multiple of only 21.3 times, compared with Revco's 24.8 times earnings. Eckerd was also financed at a debt-equity ratio of 11.5 times, compared with Revco's 37.6 times. presents a forecast of how well Revco and Eckcrd could cover their financial obligations in the next three years, the period over which analysts perceived the greatest possible risk of default. For each company, the financial obligations included interest expense, principal payments, and preferred stock dividend payments. The "coverage'' of these obligations was estimated as a multiple compared with earnings before interest and taxes (EBIT); and "cash flow," which consisted of earnings before interest, taxes, depreciation, and amortization (EBlTDA) plus the receipts from any asset sales less capita\ expenditures. (Additions to net working capital are ignored in this calculation. Ordinarily they deserve to be included in an analysis like this. Exclusion of this item biases the estimated coverage rates upward. Analysts acknowledged; however that the comparative figure such as those in Exhibit 7 were point estimates and thus ignored the uncertainty surrounding key assumptions. Revco's financial obligations were well known at the .time of the buyout. Thus, the uncertainty about Revco's comparative standing versus Jack Eckerd and other firms devolved from forecast uncertainty about the following points: Interest rates: Revco's senior debt bore interest that floated at 1.75 percent above prime rate, currently at 7.50 percent Asset sales: Revco had to sell assets to .meet its principal payments. One could give Revco the benefit of the doubt and assume that all $230 million would actually be realized. But analysts were uncertain about the timing18 of that realization. By comparison, Jack Eckerd would try to sell $72 million in assets. Capital expenditures: Capital expenditures could be assumed to be driven by Revco's goal of opening 100 stores per year at an investment of$1 00,000 per store. Depreciation could be approximated as $20 million for 1987, and thereafter scaled according to the percentage net change of
Page 32 of 44

the difference between asset sales and capital expenditures. By contrast, Jack Eckerd envisioned opening no new stores in the foreseeable future. Eckerd's depreciation was forecasted to be $123 million, a much higher figure than Revco's because Eckerd tended to own, rather than lease, its 'stores. Growth: Salomon Brothers contemplated a sales-growth rate no lower than 8 percent; it presented forecasts to commercial bankers that assumed growth at 12 percent. Goldman Sachs, the advisor to Revco's outside directors, determined that a 12 percent growth rate assumption was "too aggressive." Analysts assumed sales growth of mature stores to be equal to the rate of inflation. In addition, "the net growth from opening new stores would yield an annual corporate growth rate of 9 percent. EBIT margin: From 1974to 1986, Revco's mean EBIT margin was 6.62 percent (standard deviation was 1.32 percent). The mean and standard deviation for Jack Eckerd Corporation were 8.11 and 1.42 percent, respectively; a sample of peer companies over the same period indicated that the mean and standard deviation were 5.15 and 1.25 percent, respectively. Salomon Brothers assumed an EBIT margin of 8.0 percent. Goldman Sachs opined that this assumption was "a bit aggressive." Only once over the past 13 years did Revco reach that level, in 1984; thereafter Revco's EBIT margin fell to 3.50 and 4.84 percent. Sales growth and EBIT margin depended in part on the rate at which Revco planned to open new stores analysts challenged the wisdom of this strategy, noting that 70 percent of Revco's stores that had been open for less than one year lost money; the figure dropped to 48 percent for stores Analysts were unable to decide whether to assume any covariance between growth and margins and generally assumed that each year was an independent draw: i.e., that there was no serial covariance in the forecast assumptions that had been open from one to two years.

8.4. Possible Reasons for Going LBO:

Management: Much of the controversy regarding LBOs has resulted from the concern that senior executives negotiating the sale of the company to themselves are engaged in self-dealing. On one hand, the managers have a fiduciary duty to their shareholders to sell the company at the highest possible price. On the other hand, they have an incentive to minimize what they pay for the shares. Accordingly, it has been suggested that management takes advantage of superior information about a firm's intrinsic value. The evidence, however, indicates that the premiums paid in leveraged buyouts compare favorably with those in inter-firm mergers that are characterized by arm's-length negotiations between the buyer and seller. Once the LBO was completed, Sidney Dworkin became chairman of the board and Chief executive officer of the "new" Revco, the same positions he had held at Reyco D. S. As in the old entity, Dworkin did not control a majority ofthe outstanding shares ofsto.ck; he owned 'about 15.4 percent. However, these shares were subject to a voting trust of which he was a member. Apparently, Mr. Dworkin would have more control in the "new" Rcvco than he had had at Rcvco D. S., where his ownership percentage was only 2.32 percent. Dworkin received $29.6 million for the stock and stock options that he held in the old. Revco. He invested about $8 million in the "new" Revco. ' Moreover manger assumes to enjoy tax savings. Existing Share Holder:

Page 33 of 44

Purchase cost price No of Shares premium market price Book Value equity Book value per share Earnings EPS P/E P/E based share price

1253315 38.5 32553.64 0.48 26.01351 392530 12.05795 51304 1.575984 21.2375 33.46995

Existing Share holders get 48% premium over the price on last trade. The stock holder gets price 38,5 dollar per share but its market price was 26.012$. Its book value were 12.055$ and P/E based price is 33.46$. In every respect shareholder becomes gainer. Debt holder: The debt holders bear the risk of default equated with higher leverage as well, but since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investments, even in bankruptcy. In the case of Revco the debt holders gets 10-113% interest rate which are attractive, The bear default risk so they commensurate themselves by charging higher interest rate. Not all LBOs are successful, however, so there are also some potential disadvantages to consider. If the company's cash flow and the sale of assets are insufficient to meet the interest payments arising from its high levels of debt, the LBO is likely to fail and the company may go bankrupt. Another disadvantage is that paying high interest rates on LBO debt can damage a company's credit rating. Finally, it is possible that management may propose an LBO only for short-term personal profit. So in the case of Revco it has high probability of becoming default and high probability of being unsuccessful as well.

9. Capital Adequacy:
We have used Monte Carlo simulation to test the ability of Revoc to meet its financial cash obligation, particularly we have done simulation to get probability of successfully covering the firms cash interest, debt principal and preferred dividend payments over the first three calendar years following the buyout. At issue is the sensitivity of the probability of survival based on variations in the operating assumptions by Revoc versus assumptions consistent with the historical performance or comparable companies and Revco.

Page 34 of 44

9.1. The Variables

The simulation model forecasts a cash-flow debt-service coverage ratio ("CF Coverage") for 1987, 1988, and 1989, the first three years following the LBO. Revco used a fiscal year end of May 31, but, because the LBO was consummated on December 29, 1986, we adopted the convention of using the calendar year as the fiscal year to coincide with the LBO date. Thus, each of the projected years contains 12 months of sales covering the calendar years 1987,1988, and 1989. The structure of the financing makes a longer forecast period unnecessary, because the first three years following the buyout represent the maximum risk exposure for Revco. Cash-flow coverage ratio was calculated as EBIT (earnings before interest and taxes) plus proceeds from asset sales (AS) less capital expenditures on new stores (CAPE plus depreciation (DEPR), divided by cash interest payments (INT) plus principal payments (PRIN) plus cash dividends (DIV), i.e.,

The ratios were modeled in a Excel spreadsheet and simulated 1000 times using "Cryatal Ball" simulation software. For the most part, Revco's financial obligations (INT, PRIN , and DIV) were known at the time of the buyout and were, therefore, entered in the model as fixed numbers. Exhibit below summarizes Revco's cash payment obligations for the simulation period, 1987-1989. Interest on fixed coupon debt, principal and preferred dividend payments was determined according to the schedules provided in the case. Only cash payments were included in the simulation; no consideration was given to noncash obligations such as payment-in-kind (PIK) preferred stocks. Of the three preferred issues used in the buyout, two, the 15.25% cumulative exchangeable and the 17.62% cumulative junior preferred, were PIKs. The 12.0% cumulative convertible preferred stock with a face value of $85 million is responsible for the $10.2 million of preferred dividends. Reported in the case there are fixed and floating rate interest payments. Of the $1,331 million of debt used in the LBO, $455 million had a floating interest rate, and the remaining $876 million had fixed rates. The fixed- rate debt obligations had an average interest rate of 12.9% with no principal payments due during the study period. The term loan was structured in such a way that Revco could choose interest payments as either 1.75% over the prime rate or 2.75% over LIBOR (London Interbank Offer Rate). The floating interest payments reported in case assume that the prime-rate option is chosen and that prime remains at the December 1986 rate (7.50%) for the entire three years. The only payments of principal during the study period are for the term loan, as specified by its amortization schedule. Thus, the floating interest payments decline over time as the term loan is retired, whereas the fixed interest payment remains constant at $112 million. To simulate the floating rate interest payments, we modeled all the prime rate (PRIME) as a normal distribution with mean equal to the December 1986 rate of 7.50% and a standard deviation of 3.60%, as estimated from historical data. EBIT, AS, and DEPR remain as the stochastic variables needed to compute the coverage ratios. To
Page 35 of 44

calculate EBIT, we multiplied sales by an EBIT margin defined as Margin = Margin was modeled as normal with mean and variance estimated from historical performance data for Revco and ECKRD. The sale of existing stores and other assets (AS) was modeled as the appraisal figure given in the case ($230 million). Consistent with the case, we assumed that the company could realize 100% of the divestiture proceeds during the first two years of the LBO. AS for 1987 was assumed to be uniformly distributed over 25 to 75%; i.e. The model assumed that Revco could sell with equal probability anywhere from $57.5 million to $172.5 million of the $230 million of assets in the first year. For 1988, the second year after the buyout, AS equals the $230 million less the realization of 1987 asset sales. Because of holding the total asset sales constant at $230 million, the only uncertainty introduced into the model is the timing of the asset sales. We modeled AS as described,for several reasons. Unlike most other variables in the analysis, no historical data exist to guide us in the modeling of AS. The lack of data makes our modeling choices for AS somewhat arbitrary and, hence, easy prey to criticism. Faced with such a challenge, we chose to model AS in a way that the model would be biased in favor of finding a high survival probability. The first step in this direction was to assume, as Revco did at the time, that Salomon Brothers would be able to sell the assets within the first two years following the LBO. In our view, this assumption represents a best-case scenario for Revco. The second step was to recognize that allowing the total amount of asset sales to vary around $230 million would, in fact, act to reduce Revco's computed probability of survival. As was true for most LBOs, the Revco financial structure contained a covenant in the term loan that required any excess proceeds of the divestiture to be used as prepayments of the loan. Thus, if Revco should happen to be lucky enough to realize more than the $230 million for the assets at the end of the second year, the extra cash could not be used to service the third year's cash flow obligations. Rather. the money would have to be used as a prepayment of the term loan, which would only slightly reduce the interest payments in the third year. On the other hand, if Revco should realize a shortfall in the sale of the assets, the reduced inflow would significantly reduce the firm's ability to service its obligations in the first and/or second years. The overall effect of allowing the $230 million figure to vary is that the downside fluctuations hurt the survival of the LBO more than the upside fluctuations help it. Thus, our assumptions about AS are conservative and bias the model toward the conclusion that the LBO would succeed. An offset to AS is CAPEX, the outlay required for starting new stores each year. To model this variable, we assumed new stores would open at a rate of 100 per year, consistent with the goals stated in the prospectus. We assumed that $100,000 per store would cover the investment in fixtures, systems, and other assets unrelated to inventory and that, consistent with Revco's past practice, new store buildings and land would be leased. As new stores are added and existing stores sold in the model, total revenue is adjusted according to the assumed sales per year figure. These sales figures are increased each year by a growth rate (GROWTH), assumed to be inflation, which was modeled as a normal distribution with a mean of 6.0% and standard deviation of 3.90% as measured from a time series of historical inflation rates. Depreciation expense (DEPR) was approximated as $33.7 million for 1987 and was scaled according to the percentage net change of (AS - CAPEX).

Page 36 of 44

Assets Sale Uniform distribution with parameters: Minimum 25.00% Maximum 75.00% Margin Normal distribution with parameters: Mean Std. Dev. Growth Rate Normal distribution with parameters: Mean Std. Dev. Prime Rate Normal distribution with parameters: Mean Std. Dev.

6.60% 1.32%

5.00% 3.90%

7.50% 2.50%

9.2. Results
To illustrate the inputs and outputs of the model, Exhibit presents a series of histograms of variable distributions as modeled for the base case. Exhibit below displays the CF coverage ratio distributions for 1987, 1988, and 1989. For these basecase scenarios, the mean coverage ratios are 0.97 in 1987, 0.98 in 1988, and 0.96 in 1989. The mass of the distribution to the right of 1.0 represents the probability of surviving a given year. Thus, the cumulative probability of survival is computed as the product of each of the three annual probabilities of realizing a ratio greater than 1.0. For the base case, the three annual probabilities of survival are 0.47, 0.45, and 0.45, and the cumulative probability of survival is 0.10 (0.43*0 .45 *0.27). Each Year Annual Cash Flow Coverage Ratio (%) Cumulative 1987 1988 1989 Probability of Survival 97.24 98.55 96.56 10% (47.2) (45.2) (45.3) Changed Margin (Base Case 6.6%) 78.78 79.11 65.59 0.017 (7.8) (8.0) (2.8) Three Year Cash Flow Coverage Ratio (AM) 1987-89 97.45 Probability of Survival 45.9

Particulars

Base Case Revcos 84-85 margin (4.17%)

74.49

6.2

Page 37 of 44

Changed Growth (Base Case 5% 96.76 97.55 94.18 1% below base (4%) 6.8 (41.5) (44.8) (37.0) 97.72 99.56 98.98 1% over base (6%) 10.88 (46.1) (49.1) (48.1) Changed Store (Base Case 100/year) 97.91 97.45 92.63 50/year 4.6 (43.4) (39.1) (27.6) 96.58 99.65 100.44 150/year 8.9 (46.3) (43.6) (44.5) 1.32 1.34 1.18 Debt/Equity 3.84 times 65.19 (93.6) (93.0) (74.9) 1.215 1.23 1.122 Debt/Equity 6.8 times 52.85 (88.0) (86.8) (69.2) 129.95 134.78 139.85 Jack Eckerd Corporation 84.46 (93.0) (95.2) (95.4) Value in () are probability of survival of the respective data

96.16 98.75

41.1 47.76

96 98.89 1.28 1.189 134.86

36.7 44.8 87.1 81.33 94.5

Exhibit also shows the distribution of the three-year cash-flow-coverage ratio i.e., the probability that the sum of the cash flows for 1987-1989 is sufficient to cover the surn of the obligations for the period. This ratio assumes that past and future cash flows are available to service the financial obligations for any year. Thus, the ratio represents a best-case measure of the model's estimate of Revco' s ability to pay. The area to the tight of 1.0 is the probability of survival. Because the ratio has a mean less than I .0 (0.97) and the variance of the distribution is small, the probability of survival is approximately 45%, much larger than the product of the three independent-year probabilities. To test the robustness of the model to our assumptions, we performed two comparisons. First, we conducted a sensitivity analysis on the means of the stochastic variables. As revealed in the Exhibit, the coverage ratios for Revco are consistently less than 1.0, and the probability of successful coverage remains low regardless of variations in assumptions for MARGIN, GROWTH, and STORES (the number of new-store openings per year). The three-year ratio probabilities in Exhibit are consistently higher than the cumulative independent probabilities for the three years. For example, the base-case probability is 45% for the three-year ratio compared to only 10% assuming independent cash flows. The reader should keep in mind that the three-year ratio is a strong upwardly biased measure of survival and that the base-case probability of 45% is, in itself, a very low survival probability. The three-year probability rises to 47.76% if increased margin of 8.0% is used, but for every other scenario reported in Exhibit , the three-year probability is less than that. Interestingly,' when MARGIN is assumed to equal Revco's average performance for 1984-1985 of 4.17%, the probability of survival is virtually zero under either probability measure. Thus, the model yields consistently low survival probabilities for Revco. As a second check of the model's robustness, we applied the simulation to the Jack Eckerd Corporation, one of Revco's competitors in discount-drugstore retailing and itself the subject of a leveraged buyout in 1986. As with Revco, we used historical performance data as the basis for EBIT projections and case data for financial obligation projections. Over the period 1974-1986, Eckerd's MARGIN averaged 8.11% with a standard deviation of 1.42% compared to Revco's 6.60% and 1.32%. A more important difference from Revco, however, was that Eckcrd's interest and principal

Page 38 of 44

payment schedules were substantially deferred. The simulations for Eckerd produced coverage ratios of 1.30, 1.34, and 1.39 for the first three years following the buyout. These individual probabilities imply a cumulative probability of survival of 84% and a three-year probability of 94.5%.

9.3. Conclusions and Implications

The analysis in this study suggests that Revco had a probability of between 10% and 45% of successfully servicing its financial obligations in the first three years after going private. These survival possibilities are so low as to suggest that Revco was undercapitalized in the sense that the new debt obligations exceeded its expected cash flow and hence, the buyout was doomed to fail from the start. It is only when Revco's earning power is assumed at almost double that of its recent past that the survival probability (assuming independence of cash flows) approaches 50%. The survival probabilities are relatively insensitive to assumptions concerning asset sales and growth of sales suggesting that it was the leveraged buyout and the restructuring strategy rather than flawed execution of the strategy by management. Ironically, the strategy of the newly Ovate Revco was to focus on asset sales and growth, and only secondarily to focus on profitability, The deteriorating environment for retailers in late 1987 and 1988 could be chalked up as bad luck, but we believe the hallmark of a good strategy is the ability to withstand unforeseen adversities. We leave it for others to speculate as to why the deal was consummated. A simulation-based research methodology, such as that used here, has its weaknesses. Our strategy has been to address the weaknesses by stating them plainly and then to construct the model .so that it is biased in favor of survival. The base-case assumptions were reasonable in that they were consistent with information a financial analyst would have had in December 1986, when Revco went private. Other assumptions for which there was no strong bate of public information Or historical experience (e.g., tax exposure, asset sales, working capital requirements) were tilted in Revco's favor. Despite the model being biased in favor of survival, however, we consistently found low survival probabilities and conclude that they arise because of Revco's onerous payment schedule and anemic earning power rather than as an artifact of our methodology. Our sensitivity analysis revealed that even granting the optimistic assumptions used by Revco's financial advisers and bankers produces survival probabilities of less than 50%. In addition, testing our methodology on another drug retailer taken private at about the same time, Jack Eckerd Corporation produced high probabilities of survival. In other words, our ex ante approach produced results that are consistent to date with the fates of Revco and Eckcrd. Thus, we conclude that the model discriminates reasonably well and is not prone to predict disaster for every LBO.

Page 39 of 44