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Investing in Sponsors-Backed IPOs: The Case of Hertz

- Jeetpal Jain- Katarzynaborys - Nidhi Poddar - Mansi Thakar- Shreya Gupta

CASE OVERVIEW

- Case Issue

- Lease structure

- Hertz Capital Structure

- IPO Valuation

- Decision

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MAJOR ISSUE IN THE CASE

• Hertz Corporation was a car rental Co. owned by Ford

• Ford Motor decided to sell Hertz in 2005 because - Ford core US auto business was facing trouble - Monetize Hertz to improve Ford balance sheet

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Clayton, Dubilier, and Rice CD&R)

CarlyleGroup

Merrill Lynch Global private equity

Three PE firms combined to purchase Hertz for $15 billion.

PE firms invested some funds and accepted large outstanding debt which resulted in the deal being a “leveraged buyout (LBO)” deal

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FINANCING STRUCTURE OF ACQUISITION

29%68%

3 %

Equity

Debt

Transaction Fees & Ex-penses

PE firms contributed to equity by the way of bringing cash

Accepted Hertz’s debt (68%). Later restructured the debt portfolio by refinancing the old debt

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POST ACQUISITION - Time Line to IPO

PE firm acquired Hertz from Ford

December 2005 November 2006July 2006

Initiated IPO – Road show

Listing

7 Months later of acquisition PE firm initiated for Hertz

IPO

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HERTZ IPO PROFILE

No. of common stock issued 88.235 Million Shares

% of shares offered Diluting 27.5% of the total stock after the offering

Share Price Initial file price range $16 to $18, but then lowered to $15

Net Proceeds from IPO Approximately $1260.3 Million

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Skepticism of IPO

Questions raised how much value could PE

created in 7 months time

Borrowed $1000 million to pay special dividend of

$4.32 per share

immediately after

acquisition

IPO proceeds ( $1260.3 M) used to repay $1000 M to

debt

Remaining would be used to pay special cash dividend

to stockholders

on IPO record date

Nil IPO proceeds

planned to be used for

improving operating efficiency

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CASE ISSUE

Alec Berg faced with a decision whether to invest in

IPO of Hertz Corporation?

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BUSINESS REVENUE SEGMENTS

Segment Business B/S effect

Car rental (RAC)

Bought fleet assets on lease from its own subsidiary company and run on rental

Finance lease accounting in its book of accounts

Equipment rental (HERC)

Directly bought the equipment of various type and give on rental

Normal accounting treatment

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Investor

Vehicles & Rights under manufacturers

program

Manufacturers & Dealers

Lessee/Servicer

The Hertz Corporation

Issuer/Lessor

Hertz Vehicle Financing

LLC

Notes$

Lease of Vehicles

Monthly Lease Payment

$

Investor

RAC fleet assets taken on lease from subsidiary company

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Selected Items of Financial Performance (Dollars in Millions, unless otherwise noted)

  Year Ended December 31, 2005 (Millions)

    Cash and equivalent 844

RAC fleet assets (Finance lease asset) 8391

Total Assets 18581

    Fleet debt (Lease payment due) 7223

Non-fleet debt (Corporate debt) 5292

Total Debt 12515

Equity 2262

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HERTZ’s LEVERAGED CAPITAL STRUCTURE

   2005

BV Debt/Capital 85%

BV Equity/Capital 15%

Debt/Equity 552% 85%

15%

Debt/CapitalEquity/Capital

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VALUATION

Using Discounted Cash Flow Valuation to value Hertz IPO

-Calculating cost of equity (CAPM)

-Calculating cost of debt

-Calculating WACC of Hertz

-Finding FCFF

-Finding FCFE

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Calculation of Beta 

Industry Name Auto & Truck

Number of Firms 25

Average Beta (Regression beta) 1.08

Market average D/E Ratio 189.97%

Tax Rate 22.94%

Unlevered Beta 0.44

Cash/Firm Value 11.14%

Unlevered Beta 0.49

Hertz D/E Ratio 552%

Hertz Marginal Tax Rate 40%

Levered Beta Hertz 2.13

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Calculation of Risk Premium  2005        S&P Index 1248.29

       Dividend Yield 3.34%

       Estimated Growth rate 8% 

       T-Bond rate 4.39% 

       High growth period 5 years 

       Growth rate in Terminal Year

4.39%        

             1248.29 = 45.03 48.63 52.52 56.72 61.26 63.95

  (1+r) (1+r)^2 (1+r)^3 (1+r)^4 (1+r)^5 (r-4.39%)*(1+r)^5             

Required (ROE) ( r) =  8.47%

Risk Premium =Required return on equity - risk free rate

Risk Premium =  4.08%

+ ++ ++

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Cost of Equity ( Hertz) = using CAPM

Risk free rate + beta * (Market Risk premium)

  4.39% + 2.31 * (4.08%) = 13.08% 

 Risk Free Rate        

US treasury 10-year bond (2005) = 4.39%              

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Calculation of cost of debt – Using synthetic ratings     Interest Coverage Ratio = EBIT  Interest Expenses   EBIT (2005) 1041.67   Interest Expense (2005) 500   Interest Coverage Ratio = 2.08   Estimated Bond rating B   Default Spread 2005 4.00%   Risk Free rate (US treasury 10-year bond (2005) 4.39%   Pre-tax cost of debt (Risk free rate + Default spread) 8.39%   Marginal Tax Rate (2005) 40%   After tax cost of debt 5.03%

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Calculation of Weighted average cost of capital (WACC)   BV of Equity 2266.2

Cost of Equity 13.08%

Equity/ capital 15.33%

BV of Debt 12515

After tax cost of debt 5.03%

Debt/capital 84.67%

   WACC of Hertz 6.27%

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Income Statement 2005, (Millions)

Revenues 7469

Direct Operating expenses 4189

SG & A expenses 639

EBITDA 2641

Depreciation 1600

EBIT 1042

Interest Expense 500

Provision, benefits for taxes on income -179

Minority Interest -13

Net Income 350

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Calculation of FCFF for Year 0 2005

EBIT 1041.67

Tax 33.89%

EBIT (1-t) 688.65

Add: Depreciation 1599.69

Less: CAPEX 2015

Less: Change in Working Capital 29.00

Free cash flow to firm (FCFF) for Year 0 244.35

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Net CAPEX – ∆ WC = (444.3)

Cost of Equity = 13.08%k

Cost of Debt = 5.03% Weights Equities = 15.33% Debt = 84.67%

Discount at cost of capital (WACC) = (15.33%)*(13.08%) + ( 84.67%)*(5.03%) = 6.27%k

Risk Free RateUS $ risk free rate = 4.39%

Beta = 2.13 Risk Premium = 4.08%+ *

Unlevered Beta for the sector = 0.49

Hertz's D/E = 552%

Current cash flow to firmEBIT (1-t) = 688.65- CAPEX = 2015+ Depreciation = 1599.69- Chg WC = 29.0= FCFF = 244.35

k

Firm Value = 13685 + Cash = 843 - Debt = 12515 = Equity = 2013

k

Terminal Value = (287)/ (5.61%-4.39%)

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  0 1 2 3 4 5 TerminalEBIT (1-t) 688.6 741.7 798.8 860.3 926.5 997.9 1074.7Net CAPEX – ∆ WC 444.3 488.7 537.6 591.4 650.5 715.5 787.1FCFF 244.3 252.9 261.2 268.9 276.0 282.3 23574.3PV FCFF   223.7 204.3 186.0 168.8 152.7 12750.0

Terminal Year - Cost of capital = 5.61Growth rate = 4.39%

Decision

Free cash flow to equity investor is positive

Thank you

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