WHO ARE THE KEY PLAYERS AND WHAT ARE THEIR MOTIVATIONS?

WHY IS HERBERT DOING THE RECAP AND WHAT WILL HE GAIN IN TERMS OF CONTROL ? Key Players: Herbert and his family members Their motivations are to (i) avoid divulging information to the public; (ii) command the share price of the Kohler Company; (iii) save taxes by setting a conservative share price; and (iv)maintain authority to make investment and acquisition decisions. Outside shareholders and dissenters The motivation is to either prevent the recapitalization or sell their shares at a high price.

Why Recap? Squeezing out the outside shareholders and avoid disclosing inside information to the public Eliminating some competition from public-listed competitors Maintaining controls of investments and acquisitions

IF YOU WERE AN ADVISOR TO HERBERT, WHAT WOULD YOU ADVISE HIM AS TO THE PROS /CONS OF CHANGING HIS LONG HELD PHILOSOPHY AND TAKING THE COMPANY PUBLIC ? Pros: Access to a much more capital through IPO Use new capital to expand scale, improve R&D, and gain more market shares Cons: Important decisions would be affected by outside investors Forced to disclose inside information to the public More expenditure on compliance, reporting, and regulation Increasing dividend requirement would adversely affect the investment in future projects

WHAT WOULD BE THE ADVANTAGE TO OUTSIDE SHAREHOLDERS IF KOHLER WENT PUBLIC ? Outside investors would be highly likely to enjoy large capital gains associated with the IPO More voting rights would be realized Increasing chance of requiring and receiving dividends

VALUE THE COMPANY EQUITY ON A MARKETABLE CONTROL BASIS. NOTE THAT FOR LARGE PROFITABLE COMPANIES LIKE KOHLER, CONTROL POSITIONS ARE TYPICALLY ASSUMED TO BE MARKETABLE BECAUSE THE OWNER CAN IPO OR SELL THE ENTIRE COMPANY . T O VALUE KOHLER : (A) ESTIMATE A WACC NOTING THAT KOHLER HAS 2 DIFFERENT DIVISIONS AND USE OUR TYPICAL PROCEDURE OF USING COMPARABLE BETAS . T HE CASE WRITER ARGUES THAT SINCE KOHLER IS A LARGE COMPANY AND THAT THE SHAREHOLDERS ARE NOT DIVERSIFIED , THAT THE STANDARD CAPM IS NOT APPROPRIATE AND THAT A TOTAL BETA SHOULD BE USED RATHER THAN THE TYPICAL BETA. T HE TOTAL BETA IS CALCULATED AS ( STD DEV OF THE INVESTMENT )/ ( STD DEV OF THE MARKET ). C OMPARE THE WACC THAT YOU GET USING EACH APPROACH .
Standard CAPM 57% 30% 0.85 0.99 6.00% 6.00% 11.93% 6.07% 0.23 0.77 9.99% Total Beta 57% 30% 0.85 1.76 6.00% 6.00% 16.55% 6.07% 0.23 0.77 13.56%

(1-t) D/E u l Rf Rm Ke Pre-tax Kd Wd We WACC

First, we used the standard CAPM method to calculate WACC. Weighted-average (80%/20%) unlevered beta is acquired from Exhibit 7b. Then we calculated the re-levered beta as 0.99. Assuming both the risk free rate and market risk premium as 6%, we worked out the cost of capital as 11.93%. Pre-tax cost of debt is calculated by dividing the expected interest expense in 2002 over the corresponding total debt. Finally, we obtained the WACC as about 10%. Second, we used the total beta method to calculate WACC. The only difference is the re-levered beta. We used the standard deviation of the investment over that of the market to acquire the re-levered beta as 1.76 (5.8%/3.3% in Exhibit 7b). Similarly, we worked out the WACC as 13.56%.

(B) DEVELOP A CASH FLOW FORECAST AND RESIDUAL VALUE . DISCOUNT THESE TO PRESENT VALUE . USE A MID-PERIOD DISCOUNT FACTOR AS APPROPRIATE . T EST SENSITIVITY OF VALUE TO CHANGES IN DISCOUNT RATE AND EXIT VALUE ASSUMPTIONS . U SE MARKET COMPARABLE ANALYSIS TO ARRIVE AT THE VALUE OF THE STOCK. USE THE FOLLOWING MULTIPLES ( SALES, EBITDA, EBIAT, AND CASH FLOW DEFINED AS EBIAT + DEPR). USING THESE DCF AND MARKET COMPARABLE VALUE INDICATIONS, ARRIVE AT A FINAL CONCLUSION FOR KOHLER STOCK . DCF Model
Net Income Dividends Paid Div. Payout Ratio Total Shareholders' Equity $ 48,590 $ 1,765 3.63% 60,032 $ 5,403 9.00% 86,860 $ 7,817 9.00% 98,314 $ 8,848 9.00% 108,229 9,741 9.00% 1,091,582

1998 (Increase) Decrease in Accounts Receivable (Increase) Decrease in Inventory (Increase) Decrease in Future Income Tax Benefits (Incr.) Decr. in Prepaid Expenses and Other Assets Incr. (Decr.) in Accounts Payable and Accrued Exp. 9,097 6,644 (15,744) 21,707 (23,139)

1999 (3,410) (2,707) (450) 1,463 (658)

2000 (21,803) (10,396) (2,570) (9,072) 16,136

2001 (17,002) (9,485) (966) (4,201) 13,952

2002 (16,631) (12,711) (1,989) (3,649) 11,835

Less: Increase in NWC

12/31/1998 12/31/1999 12/31/2000

(1,435)
12/31/2001

(5,762)

(27,705)

(17,702)

(23,145)

EBIT Less: Taxes Debt-free earning (NOPAT) Plus Depreciation Less CAPEX Less WC FCF Discount period Discount factor Discounted FCF to end of 1998

96,389.00 (41,447.27) 54,941.73 56,113.00 (87,691.00) (1,435.00) 21,928.73 0.5 0.94 20,577.89

115,859.00 (49,819.37) 66,039.63 87,661.00 (97,205.00) (5,762.00) 50,733.63 1.5 0.83 41,923.53

160,836.00 (69,159.48) 91,676.52 91,786.00 (96,971.00) (27,705.00) 58,786.52 2.5 0.73 42,777.39

176,548.00 (75,915.64) 100,632.36

12/31/2002 Assumptions 189,488.00 Valuation Date 6/30/1998 (81,479.84) WACC 13.56% 108,008.16 EV/EBITDA 8

ROE

9.91%

94,593.00 97,355.00 Div. payout ratio 9.00% (96,811.00) (106,647.00) Growth Rate 9.02% (17,702.00) (23,145.00) TV(GGM) TV(EV/EBITDA) 80,712.36 75,571.16 1,815,748.59 2,294,744.00 3.5 4.5 4.5 4.5 0.64 0.56 0.56 0.56 51,719.13 42,642.42 1,024,569.65 1,294,851.65

GGM
PV of EV Less: Debt Plus: Non-operating Cash Implied Total Equity Value # of Shares Share Price (in thousands)

EV/EBITDA

UP

DOWN

1,224,210.01 1,494,492.01 1,787,736.85 1,237,653.31 (232,444.00) (232,444.00) (232,444.00) (232,444.00) 2,454.00 2,454.00 2,454.00 2,454.00 994,220.01 1,264,502.01 1,557,746.85 1,007,663.31 7,587.89 7,587.89 7,587.89 7,587.89 131.03 166.65 205.29 132.80

######### 11.56% 12.56% 13.56% 14.56% 15.56%

7.0x 1,437,077.06 1,383,605.84 1,332,635.56 1,284,027.89 1,237,653.31

7.5x 1,524,742.01 1,467,820.15 1,413,563.79 1,361,825.41 1,312,466.87

8.0x 1,612,406.95 1,552,034.46 1,494,492.01 1,439,622.92 1,387,280.44

8.5x 1,700,071.90 1,636,248.76 1,575,420.24 1,517,420.44 1,462,094.01

9.0x 1,787,736.85 1,720,463.07 1,656,348.47 1,595,217.96 1,536,907.57

Assumptions: We set the valuation date as 6/30/1998 and the discount period as 0.5 for 1998. We calculated the terminal value by two methods: Gordon Growth model and EV/EBITDA multiple. We used the weighted-average EV/EBITDA (Exhibit 7b). We calculated the growth rate (g) by timing ROE with the retention rate in 2002. Tax rate was obtained as 43%. D&A, CAPEX, and increase in NWC were all acquired from Exhibit 6c. Since Kohler is a large private company and not well-diversified, we decided to use the total beta WACC (13.56%) as the discount rate.

Subtracting the debt in April 1998 and adding back the non-operating cash, we obtained the implied total equity value of Kohler. Dividing the total shares (7,588), we worked out the implied share price as $131,030 and $166,650 per share under the GGM and EV/EBITDA, respectively. Then we created the sensitivity table as shown above, from which we concluded that Kohlers stock price would be $132,800 in the worst scenario and $205,290 in the best scenario. Relative Valuation
EV / Sales EV / EBITDA 8.95 EV / EBIAT 19.29 EV / EBIATD 13.01

Ratio Denominator Enterprise Value Less: Debt Plus: Cash Equity Value # of Shares Share Price (in thousands)

1.33

2,269,661.00 3,029,856.28 (232,444.00) 2,454.00 2,799,866.28 7,587.89 368.99

185,979.00 1,665,070.02 (232,444.00) 2,454.00 1,435,080.02 7,587.89 189.13

94,160.01 1,815,914.97 (232,444.00) 2,454.00 1,585,924.97 7,587.89 209.01

114,946.01 1,495,939.64 (232,444.00) 2,454.00 1,265,949.64 7,587.89 166.84

We calculated the weighted-average ratios by setting 80% in Kitchen and Bath division and 20% in the engine division. By timing those ratios with the LTM1998 income statement data, we obtained the estimated enterprise values. Deducting debt and adding cash, we then got the equity value. Finally, we worked out the share price as $368,990, $189,130, $209,010, $166,840 accordingly under the four multiples.
Relative Valuation
EV / Sales EV / EBITDA EV / EBIAT EV / EBIATD

DCF Valuation
GGM

EV/EBITDA

Share Price (in thousands)

368.99

189.13

209.01

166.84

131.03

Avg. Share Price 166.65 172.53

Comparing the results of DCF model with those of the relative valuation model, we excluded the outlier $368,990 and averaged the rest to arrive a final stock price for Kohler as $172,530.

THE FIRST TRIAL WAS BASED ON FAIR VALUE , WHICH IS DETERMINED BY STATE LAW , WHICH WAS AMBIGUOUS IN THIS CASE . KOHLER WOULD ARGUE THAT THE APPROPRIATE PREMISE OF VALUE UNDER WISCONSIN FAIR VALUE FOR THE DISSENTERS SHARES IS ON A MINORITY NON -MARKETABLE BASIS . T HE DISSENTERS WOULD ARGUE THAT FAIR VALUE SHOULD BE ON A CONTROL , MARKETABLE BASIS . BRIEFLY DISCUSS WHAT A PREMIUM FOR CONTROL IS AND HOW IT IS GENERALLY CALCULATED. WHAT LEADS TO A PREMIUM FOR CONTROL ? Control premium is an amount that a buyer is willing to pay in excess over the current market price of a company. Normally, the control premium is industry-specific and amounts to 2050% of a companys most recent market capitalization. Primary reasons that lead to a control premium are as following: Acquirers can obtain control over the size and timing of the cash flows of the target company. Acquirers can improve its revenue or reduce its expenditure through acquisition synergies.
WHAT IS A DISCOUNT FOR LACK OF MARKETABILITY (DLOM) AND HOW IS IT GENERALLY CALCULATED ?

DLOM is an amount that a companys stock price would be reduced to entice buyers to purchase it. It presumes that after they buy the stock, they will probably have difficulty in selling it as there is no large, liquid market for them to sell. Generally, DLOM is set between 25% and 50%. FOR PURPOSES OF THIS CASE ASSUME THE DLOM IS 35% AND THE PREMIUM FOR CONTROL WOULD BE 25%. VALUE KOHLER SHARES USING THE KOHLER PREMISE AND THE DISSENTER PREMISE . NOTE THE BIG DISPARITY. Using the average stock price, $172,530, we concluded in question 4, we calculated the effect of the DLOM and the control premium. Specifically, Kohler DLOM 35% 172,530*(1-35%) = $112,145

Dissenter Control Premium 25% 172,530*(1+25%) = $215,663

Disparity = 215,663 112,145 = $103,518

KOHLER OFFERED $55,400 FOR THE SHARES AND THE DISSENTERS CLAIMED $273,000. PRETEND YOU ARE THE EXPERT FOR KOHLER. HOW MIGHT YOU ARRIVE AT AROUND $55,400? ASSUME YOU ARE THE EXPERT FOR THE DISSENTERS. CAN YOU GET CLOSE TO THE $273,000 VALUE ? Expert for Kohler Assuming a minority and non-marketable basis, we divided the given stock price $55,400 by (1-DLOM) to get Kohlers expected stock price as $85,230. Looking through all the estimated stock value in question 4, we found the expected Kohlers stock price is smaller than any of the estimated values. To arrive at the $85,230 figure, the company would probably reduce its expected growth rate from the assumed 9.91% to about 7.5% and then use the estimated stock price under the DCF-GGM method. Expert for Dissenters Similarly, assuming a control and marketable basis, we divided the offered stock price $273,000 by (1+ Control Prem.) to get Kohlers expected stock price as $218,400, which is close to the estimated value, $209,010, acquired under the EV/EBIAT method. Thus, its likely to get Kohlers stock price close to $273,000 value by using the EV/EBIAT method.

CASE B NOTES THAT THE DISPUTE SETTLED FOR A PRICE OF AROUND $135,000 PER SHARE . WHEN THE CASE B LITIGATION WITH THE IRS TAKES PLACE , THE LAW WAS FAIR MARKET VALUE , WHERE A DLOM AND PREMIUM CAN CLEARLY BE CONSIDERED . ANOTHER VALUATION METHOD , ESPECIALLY FOR MINORITY POSITIONS , IS THE PRESENT VALUE OF DIVIDENDS INTO PERPETUITY . C ALCULATE THE VALUE OF KOHLER EQUITY UNDER THIS METHOD . PRETEND THAT THE IRS OFFERS TO SETTLE THE CASE FOR $135,000 PER SHARE . WOULD YOU SETTLE OR GO TO TRIAL ? WHY ? ASSUME THAT THE TRIAL WOULD BE EXPENSIVE , SAY $5 MILLION, IF THAT IS A FACTOR .
1998 1999 2000 2001 2002 TV

Dividends Discount period Discount factor PV of Dividends (6/30/98) Implied Total Equity Value Number of Shares Stock Price (in thousands)

1,765 5,403 0.5 1.5 0.94 0.83 1,656.27 4,464.75 155,040.80 7,588 $ 20.43

7,817 8,848 9,741 234,047 2.5 3.5 4.5 4.5 0.73 0.64 0.56 0.56 5,688.22 5,669.65 5,496.54 132,065.37

Using the dividend discount method, we got estimated stock price as $20,430, which is much smaller than the settled price $135,000. Here we used the formula TV = Dividend in 02/ (WACC-g) to obtain the terminal value. Similar with the DCF valuation method, we discounted all expected future dividends and TV back to 6/30/98 and added them up to get the equity value as $155,040,080. Since outside investors only occupy 4% of the total shares, the total buyout price would be $40,975,200 if Kohler bought shares from outsiders at the court given price $135,000. However, the buyout price would be only $16,815,008 or $6,200,914 if Kohler bought shares at its current given price $55,400 or at the price obtained by using the dividend discount method $20,430. Adding the $5 million trial fee to the previous two prices, the total expenditure for Kohler would be $21,815,008 or $11,200,914 that are also lower than the price buying at $135,000 per share. Therefore, we would suggest Kohler go to trial.