Question

How are the following valuation parameters related to each other? How do they affect the general free cash flow valuation model? Revenues, Investment, Net operating income, Profitability rate, Growth rate?

How were these developments corrected during the resurgence of the LBO market after 1992?

What were some of the unsound developments in the LBO market that began to take place in the late 1980s?

Answer 1

Revenue is the amount of money that the company will earn over a period of time from its operations. Investment is the amount of money that has been initially invested in the company to start the business. Net operating income is the amount of money earned from the operations of the company after deducting the amount of money spent on operations i.e. revenue minus operating expenses. Profitability rate is the rate at which the company has been earning profits. It can be calculated by finding out the return on assets, return on investment etc. Growth rate is the rate at which the company has been growing over the years.

Leveraged Buyout is the process by which a company is purchased using a combination of debt and equity. The arrangement is such that the cash flows of the company will be used as collateral security for the debt. This practice was prevalent more during 1980s by the private equity firms. It was later realized that was not a good practice as the ownership rights of the company will be in the hands of an external company and the debt portion of the company was funded from the equity portion of the company. It led to improvement in the operating leverage of the company but it also led to the creation of junk bonds which are not suitable for investment. The unsound developments of LBO were corrected by the intervention of regulatory bodies.