October 2004
Valuing a Highly Leveraged ESOP
Dr. Stanley J. Feldman
Axiom Valuation ("Axiom") recently completed a valuation assignment for a uniquely structured, highly leveraged ESOP. Prior to the ESOP, the company’s shareholders executed two transactions, a sizeable withdrawal from the Accumulated Adjustments account ("AA") and the redemption of Treasury stock. Both transactions were financed with limited recourse, 30 year amortizing notes bearing interest at prime + 1.00% placed with the shareholders. The ESOP then purchased the remaining shares from the shareholders, who accepted another limited recourse, 30 year amortizing note, bearing interest at prime + 1.00%, and guaranteed by the company.
Each of the two transactions prior to the ESOP effectively recapitalized the company. The value of the shares purchased by the ESOP was determined by valuing the company at three distinct intervals: as a 100% equity financed firm, before any recapitalization; after the withdrawal from the AA account; and finally, after the Treasury stock redemption. The changing capital structure prompted by these transactions invariably complicates the valuation. The traditional valuation approach, the discounted cash flow method, is impractical in this case since an underlying assumption of the model is a constant capital structure.
To circumvent the problem, Axiom employed a method known as the Adjusted Present Value approach. Under this methodology, the value of the company is equal to the value of a 100% equity financed firm plus the present value of the interest tax shield. The tax savings from the amortizing debt securities are modeled and discounted at the cost of common equity, the present value of which is then added to the value of the company modeled as an all-equity financed firm using the traditional discounted cash flow method. This process was repeated for each interval (i.e. recapitalization) and allowed for changing debt levels between recapitalizations and over-time, effectively remedying the shortcomings of discounted cash flow.