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Learning Objectives
Primary Learning Objective: To provide students with a knowledge of how to analyze, structure, and value highly leveraged transactions. Secondary Learning Objectives: To provide students with a knowledge of The motivations of and methodologies employed by financial buyers; Advantages and disadvantages of LBOs as a deal structure; Alternative LBO models; The role of junk bonds in financing LBOs; Pre-LBO returns to target company shareholders; Post-buyout returns to LBO shareholders, and Alternative LBO valuation methods Basic decision rules for determining the attractiveness of LBO candidates
Financial Buyers
In a leveraged buyout, all of the stock, or assets, of a public corporation are bought by a small group of investors (financial buyers), usually including members of existing management. Financial buyers: Focus on ROE rather than ROA. Use other peoples money. Succeed through improved operational performance. Focus on targets having stable cash flow to meet debt service requirements. Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks)
Valuing LBOs
A LBO can be evaluated from the perspective of common equity investors or of all investors and lenders LBOs make sense from viewpoint of investors and lenders if present value of free cash flows to the firm is greater than or equal to the total investment consisting of debt and common and preferred equity However, a LBO can make sense to common equity investors but not to other investors and lenders. The market value of debt and preferred stock held before the transaction may decline due to a perceived reduction in the firms ability to Repay such debt as the firm assumes substantial amounts of new debt and to Pay interest and dividends on a timely basis.
Recalculate each successive periods with the D/E ratio for that period, and using that periods , recalculate the firms cost of equity for that period.
Things to Remember
LBOs make the most sense for firms having stable cash flows, significant amounts of unencumbered tangible assets, and strong management teams. Successful LBOs rely heavily on management incentives to improve operating performance and a streamlined decision-making process resulting from taking the firm private. Tax savings from interest expense and depreciation from writing up assets enable LBO investors to offer targets substantial premiums over current market value. Excessive leverage and the resultant higher level of fixed expenses makes LBOs vulnerable to business cycle fluctuations and aggressive competitor actions. For an LBO to make sense, the PV of cash flows to equity holders must equal or exceed the value of the initial equity investment in the transaction, including transaction-related costs.