ShmoopTube

00:00

principles of finance a la shmoop. tax deduction math. alright with this

00:07

light introduction to taxes let's work through a corporate leverage problem. [girl holds tax textbook in school hallway]

00:12

sounds fun you know to the guys in thick glasses in the front row. and here's our

00:16

lemonade stands our US company, a wildly successful decade later.

00:21

all right the company has in our very theoretical example here no cash and no

00:26

debt. you the wily CEO wonder gee whiz what if we bought lemonade lovers for

00:33

fifteen billion we'd be really big we'd get cheaper prices for our cups and

00:38

sugar and rent and be the brand in lemonade. well because you took this

00:43

course on Finance from your fine loving people at shmoop here you can easily do

00:48

the math. pro forma doesn't mean you get paid making a living as a former. pro

00:53

forma means combined. so all this would be great if you could use a high [pro forma explained]

00:58

multiple stock of your own to buy them. but your stock trades at only ten times

01:02

earnings and to be bought they want 20 times their earnings .you would suffer

01:07

huge dilution if you used your own stock. if you pay cash well they'll take a

01:12

lower multiple. 15 ish times earnings well cash always has less risk obviously

01:17

than stock, so you try to figure out how you can raise fifteen billion dollars of

01:22

cash. we've been through the basics of Investment Banking 101, but here the

01:26

focus is on free cash flow and debt repayment. so let's dream a little dream

01:31

and say we borrow all fifteen billion dollars in cash. well some idiot or

01:36

visionary is willing to loan us all that money for the leveraged buyout of

01:41

lemonade lovers and charge us five percent interest on the loan. yes we are

01:46

massively simplifying here. Throeau has nothing on us. quick math tells us that [Henry David Thoreau pictured]

01:51

five percent interest on fifteen billion dollars is seven hundred fifty million

01:55

dollars a year of interest. but that interest will shrink as we pay down our

01:59

principal, right? and we know that if we can swing year one and start to really

02:04

pay down that principal, well this LBO for leveraged buyout should work great.

02:09

so let's look at year one right here well look how different things compare

02:12

here with the first iteration with no debt. in the no debt scenario we were

02:18

paying 420 million dollars in taxes. now we're paying just a hundred ninety five

02:24

million, because interest is deductible from taxes. the government essentially

02:29

split our interest costs with us. nice of them and in doing so it made the LBO [uncle sam asks for more taxes]

02:33

work mathematically. you can assume that most of the net income of four hundred

02:38

fifty five million there is free cash, and our lemonade business has very

02:42

little capital expenditures which would cloud the net income a versus free cash

02:46

flow story, so in year one we can take say four hundred million dollars of our

02:51

free cash and pay down our debt principle to just fourteen point six

02:56

billion. well in year two with less principle to pay down our interest

03:00

expenses go down, and by year five we're sitting pretty fat and happy even

03:04

assuming no growth or additional synergies from the merger that we just

03:08

did here it's an acquisition, and note that we only included a relatively small

03:13

expense savings of two hundred million dollars by way of being able to buy our [spreadsheet showing expenses before and after merger]

03:16

supplies a bit cheaper with huge wal-mart like scale and the lemonade biz.

03:21

it's likely that there are more savings we'll be able to find and more revenue

03:25

growth opportunities to be had as well. [fizzy lemonade next to regular lemonade pictured on a shelf]

Full Transcript