BCI Growth III: May 1993 – Harvard Case Study Analysis

Managing Partner: Helen Hsu

Associates: Radha Panchap, Jaden Faunce, Isshaa Tusnial

Executive Summary

BCI Growth, a mezzanine fund, was considering making a $5 million investment in Casella Waste System, a solid waste hauling and disposal company. While Casella seemed to be an attrative opportunity for BCI, BCI was concerned about the overvaluation and a relatively high risk of investing in CWS. After calculating the intrinsic value of Cassella and NPV of the investment in Cassella, we believe that BCI should continue the transaction of funding CWS.


As the regulatory change in the solid waste industry and the recession in 1990-91 posed a substantial financing pressure on the small waste hauling companies, there were attractive opportunities for Casella Waste System (CWS) to expand their business through consolidation. However, to acquire small competitors and make up for the shutdown of their two unlined landfills, CWS needed to raise funds for these investments. Since it’s harder and more expensive to borrow from the bank after the recession, CWS sought to raise $5 million from PE firms while selling no more than 25% of its shares.

BCI Advisor, the potential investor in this deal, was a PE group that focused on mezzanine investing. By targeting established, non-tech firms with stable cashflows but needed funds for expansion, BCI could take on lower risk than straight equity investing while reaping a higher return than straight debt investing. Cassella’s management team and their competitive advantages in consolidating the solid waste industry in the New England region had made CWS an appealing opportunity for BCI to invest. However, BCI was concerned about the early-phase nature of Caseells’ business and the high risk involved in Cassella’s plan on acquiring the two lined landfills. Moreover, BCI believed that CWS’s non-audited financial accounts and the projection prepared by non-expert might cause over-optimistic forecast on the growth of revenue and thus lead to overvaluation of the company.

Key Considerations

One of the key considerations in this case was that this proposed transaction was in an earlier stage than BCI’s typical mezzanine investments. Early negotiations had called for Casellas to issue 900,000 convertible preferred shares at $5.55/share. Once converted, these shares would represent 22.5% of the total shares in the firm. These preferred shares would allow the investor to participate in the upside of the investment while protecting against downside risk. Depending on whether they chose to convert, the investor would get either the equity or redemption amounts. In private equity, the payouts would be capital-gains-based rather than dividend-based.

Remey initially thought the $5.55 valuation was far too high; however, proposing a lower valuation would mean considerable dilution for Casellas. In the new negotiations, Casella pays out warrants with anti-dilution protection to give up no more than 25% of the firm while still being entitled to $5 million in investment from BCI. Warrants provide the same opportunity to participate in the upside of the investment but not the downside as convertible preferred shares did. However, this seemed to address Remey’s initial concern with the valuation being too high while also protecting against Casella’s concern with dilution. Casella wants to create value as an early-stage company, and anti-dilution would work as an incentive to help create value for the company. Furthermore, anti-dilution is used here for Casella to maintain a constant fraction of equity control.

  1. The pro forma projections by the Cassella Management reasonably forecast the growth of Cassella’s future cash flows, with a terminal growth rate of 3%, the same as the average GDP growth rate.
  2. The interest rate for the outstanding debt of the merged company would be the average rate of 9%. 
  3. The risk-free rate (Rf) would be 5.96%, the same as the ten-year treasury rate in 1993. 
  4. The beta is assumed to be 1.19, the average beta of comparable public solid waste firms in 1993. 
  5. The market risk premium would be 3.17%, the equity market risk premium in 1993 (Prof. Damodaran’s website from NYU). 
  6. The interest rate of BCI’s counterproposal is 7.5%, payable monthly on the amount drawn down. The maturity of the note is 7 years. 
  7. 10% of the note principal would be paid down semiannually starting in 42 months, with the 30% balance due at the end of the 7th year. 
  8. The shares outstanding were 4,000,000, excluding the warrants in BCI’s counterproposal.

To evaluate whether $5.55/share is overvalued, we use the APV method to calculate the intrinsic value of Cassella since leverage was used. We calculated the cost of capital Ra to be 9.7%. To calculate the free cash flow (FCF), we subtracted the change in net working capital and capital expenditure from the net income and added back non-cash expenses. The present value (PV) of the terminal value (TV) is $19,355,167. Adding the PV of all FCFs and TV, we obtained the PV of the unlevered firm, which was worth $27,142,958. For the levered value of the firm, we calculated the tax shield by multiplying the interest expense by the tax rate (38%). After discounting back the future tax shield, we summed up the PV of the tax shield and got the value of the levered firm, which is worth $4,825,333. Therefore, the enterprise value of Cassella is $31,968,291, the combined value of the unlevered and levered part of the firm. Then, we subtracted the total debt from the enterprise value and got the equity value of $22,831,243. Dividing the equity value by the 4 million shares outstanding, we calculated the price per share to be $5.71, higher than Cassella’s proposed valuation of $5.55. 

To calculate whether the value of the warrants is sufficient to justify the reduced rate on the debt, we first compared the NPV and IRR of the investment for BCI under different interest rates (the market average of 9% and BCI’s proposal 7.5%). We added up the interest BCI received and the down payment for the principal as the cash flow back to BCI and discounted them back to PV. Using its below-market loan rate, BCI had an NPV of $185,775 and an IRR of 10.6%, while they could have achieved an NPV of $623,500 and an IRR of 12.6% with the average market loan rate. Building upon the equity value of Cassella as calculated above, we estimated that the $5.71/share would be diluted to $5.04/share after Cassella received a cash inflow of $3,212,916 from the 1,168,333 exercised warrants at the warrant price of $2.75. Therefore, if BCI exercised the warrants at $5.71, the payoff/warrant would be $2.29, resulting in the total payoff of BCI’s warrant holdings of $2,674,524.

Overall, we do believe that the warrants justified the below-market loan rate. To break even with the NPV of the average market loan, BCI needed to gain $437,725 on the payoff of warrants or a profit of $0.37/warrant. In other words, the break-even stock price for BCI would be $3.12/share. However, since the exercise of warrants would lead to dilution, we calculated the pre-money price/share to be $3.23 by dividing the pre-money value of equity by the original number of shares. In other words, the break-even point for BCI to exercise the warrants is at $3.23/share, after which the shares would be diluted to $3.12/share.

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