lonestar graphite Case Solution

Introduction

Lonestar Graphite was founded in 1994 and is an independent subsidiary of United Oil Company of Texas, the company manufactures and markets premium quality graphite and silicon carbide materials. The Company operates in three global regions which are North America, Europe, and Asia, however, it was the market leader in North America in the premium graphite segment. Approximately 350 individuals were employed by the company at its headquarter in Henderson, Texas and the company’s product portfolio comprised of Electrical Discharge Machining (EDM), Semiconductor and industrial products, Glass container and development of Thermal management products.

The company’s competence to convert graphite into silicon carbide provided it a competitive advantage and the company’s main competitors include large international firms such as HGH, Fieldco, Pyrotek,Le Carbone Lorraine, Schunk, Dura Temp, and Toyo Tanso. HGH. The company revenue amounted to $46 million whereas the cash amounted to $0.4 million in the year 1999. The major customers of the company included Belmont Equipment Co., Graphel Corporation, EDM Sales & Supplies, LAM Researchand Bullen Ultrasonics, Inc.

Problem Statement

Due to the vast geographical reach and market leadership of the company, it is considered as an ideal target for acquisition by any company. Hamilton Capital Partners (HCP) which is a middle market private equity firm is considering purchasing Lonestar Graphite, however, the price which should be offered to acquire Lonestar is still undecided. Therefore, a number of valuation techniques shall be used to estimate the value and offer price to execute the acquisition considering the operations of the firm and funds available to finance the acquisition.

Financial Analysis

APV and IRR analysis:The valuation of Lone Star have been done through Adjusted present value (APV) valuation method which includes the net present value (NPV) of all the acquiring company’s cash flows plus the present value (PV) of debt financing costs such as senior debt financing cost, Mezzanine financing and revolving credit financing along with the cost of debt issue, cost of financial distress and cost of financial subsidies and the tax shield benefits.

For this purpose, firstly, the weighted average cost of capital has been calculated. The market risk premium that has been used for the WACC calculation has been picked up from Exhibit 9 of the case which is 6 percent. From the same exhibit, the one year US government bond has been picked up as risk free rate which is 6.13 percent. For beta (risk of the company), the average has been taken for four companies that are comparable with Lone Star from Exhibit 7 of the case. The four beta’s average of comparable companies for Lone Star represents the beta for acquiring the company is around 0.82, which represents the risk associated with the company is lower than the market. These things give the weighted average cost of capital for cash flows discounting purposes of around 11 percent.

For the management case scenario, the potential cash flows of Lone Star that starts from the year 2000 and end in 2004, the growth rate assumed is 3 percent. For the calculations of net present value (NPV) of Lone Star, the earnings before interest and tax are projected by the management in which the depreciation and amortization had added to get the operating cash flows. Further in operating cash flows, the changes in net working capital and capital expenditure had been deducted in order to get the free cash flows (FCF) for LoneStar from the year 2000 to 2004. These FCF has been discounted back at the start of the year 2000 in order to find the net present value of the company by using the hurdle rate of almost 11 percent. The NPV is 139.61 million dollars. Furthermore, in order to find out the tax shield benefits for the company, the yearly interest payments have been multiplied with the corporate tax rate and discounted back at the start of the year 2000 in order to find the present value of the benefits that are associated with the tax shield on yearly interest payments which is 4.23 million dollars. The present value of tax shield benefits has been added in the net present value of the company in order to get the adjusted present value (APV) of the company which is 143.84 million dollars. (Exhibit 1)

After that, for the downsizing case scenario, the potential case flows of Lone Star that starts from the year 2000 and end in 2004, the growth rate assumed is 3 percent. For the calculations of net present value (NPV) of Lone Star, the earnings before interest and tax are projected by the management in which the depreciation and amortization had added to get the operating cash flows. Further in operating cash flows, the changes in net working capital and capital expenditure had been deducted in order to get the free cash flows (FCF) for Lone Star from the year 2000 to 2004. These FCF has been discounted back at the start of the year 2000 in order to find the net present value of the company by using the hurdle rate of almost 11 percent. The NPV is 74.66 million dollars. Furthermore, in order to find out the tax shield benefits for the company, the yearly interest payments have been multiplied with the corporate tax rate and discounted back at the start of the year 2000 in order to find the present value of the benefits that are associated with the tax shield on yearly interest payments which is 4.23 million dollars. The present value of tax shield benefits has been added in the net present value of the company in order to get the adjusted present value (APV) of the company which is 78.89 million dollars. (Exhibit 2)

Debt Repayment Schedule:In order to finance the acquisition of Lonestar, HCP will borrow loan of $6.8 million at the interest rate of 8.5% from the bank, borrow senior debt worth $30 million at the interest rate of 8.5% and mezzanine loan worth $15 million at the interest rate of 11.5%. It is assumed that each source of debt will be borrowed for a period of six years as HCP investment projects last for five to seven years………..

 

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