Question

In a leveraged buyout where investors (usually private equity firms) form a new entity with an acquired company, it is still very important to determine the optimal debt capacity for a potential LBO target.

Even though most theories of capital structure were designed to explain public firms’ capital structures, they could’ve been applied to private firms’ as well.

As we can recall from the corporate finance course, Franco Modigliani and Merton Miller in their M&M Proposition I initially claimed that in a perfect financial market there’s no difference between debt or equity financing, and the company value would remain the same no matter of its capital structure. They later on updated their highly controversial proposition with a more constructive approach stating that the value of a levered firm will always be higher than the value of an unlevered firm due to the tax shield benefits which led to a conclusion that the companies should rely entirely on debt financing. That could easily be used to define the main concept behind a LBO: leverage magnifies returns.However, everything comes with a price. The static trade-off theory uses the most realistic approach toward firm’s capital structure, stating that the leverage is beneficial up to the point until the cost of debt such as bankruptcy and financial distress cost is offset by its benefits. Despite all advantages of LBO’s, the main issue behind debt financing is its inherently risky nature. The cost of equity goes up with the rise of leverage which under tough economic conditions could turn into a big problem. While during the boom having an extra cash on company’s balance incurs in most times an opportunity cost, during recession while everyone strives for it, large payments to meet LBO related debt obligations could easily turn into a disaster.

Do you agree with above statement? why or why not ? write at least 250-300. Also, give example

Answer 1

I do agree with the statements. Leverage buyout is one of the strategies used by private equity firms where they believe there is high possibility of turnaround and they can benefit by changing the management, bringing more efficiency in the capital structure. There are many advantages of leverage buyout, if your venture is successful then within a short period of time you can earn significantly high returns on your investment than otherwise. It is also true that in a perfect capita environment in the absence of tax rate the value of a levered firm should be equal to the value of an unlevered firm but if there is tax rate then the value of levered firm will increase by the tax rate multiplied by the debt, so having debt in the capital structure in the real world does make sense because in real world there is tax rate applicable almost everywhere. The benefit of LBO by private equity firms is also that they can raise a large amount of debt easily at favorable amount of rates, having said that having a large amount of debt in the capital structure the financial distress cost will exceed the benefit of taxation on interest payment and at that time it can create bankruptcy situations for the company. It is highly useful that the company use a level of debt in the capital structure where the WACC is least, the financial distress cost is low and the benefit of debt is high otherwise when the economy is going through a recession at that time the company has to make payment on debt and if it does not then bankruptcy situation will arise. Take the case of retail companies in the US. A large number of them filed for bankruptcy where private -equity firms have invested in them with high debt and they were not able to make the periodic payment on debt and had to file for bankruptcy. So, having an optimal level of debt is important.