Question

Describe what a leveraged buyout is and why managers of a public corporation may want to use this type of corporate restructure.

Answer 1

A leveraged buyout (LBO) refers to the purchase of a company using funds that are borrowed.In an LBO almost 90% of the funds would be debt.this amount of money raised through borrowing is used to meet the cost of acquiring the company.Theses funds are raised by pledging the assets of the company being acquired as collateral.The amount borrowed for the purpose of acquisition is then repaid from the future cash flows generated by the firm that's being acquired.An LBo is a costly affair as it involves interest payments,valuations and legal fees.Companies that have a strong historical cash flow are considered ideal for an LBO.A Leveraged buyout maybe done to make a public company private and thereby increasing the equity stake the management has in a firm.Management of public corporations prefer an LBO due to this reason, when the company becomes private the management gets a larger share of the benefit of managerial performance .This financial incentive will result in enhanced performance from the part of management.If the employees of the company are also involved in the buy out then this acts as a boost to their performance and loyalty to the company.Another advantage of a LBO is the tax shield that arises due to the interest payments .Another reason why managers of a public corporation prefer an LBO is the fact that it will breathe new life into a well established company and thereby creating more value to the parties involved.