Lecture 7 - Leveraged Transactions Flashcards
LBO
when lots of debt is used by investors to buy the firm from shareholders and take the firm private
firm assets used as collateral for debt
debt paid back over a few years; then firm becomes public again
reasons for LBO
- market undervalues firm
- mgmt wants to preserve control
- LBO increases firm value
how can LBO investors make profit if firm is undervalued?
by offering between current stock value & firm worth to existing shareholders, then reselling firm for firm value
risky bc uncertainty of future resale value
how does LBO increase firm value?
- reduces taxes (shifts value from gov back to shareholders)
- better alignment of manager incentives w/ shareholder value
- misc. cost advantages (doesn’t have to abide by public disclosure rules, which could affect comp. adv)
how does LBO reduce taxes?
- increase interest TS - more debt increases interest payments, reducing taxable income
for firms with stable FCF & large debt capacity - increase depr TS - if BV of assets
agency conflict
caused by separation of ownership and control
shareholders own firm, but mgmt makes decisions on daily basis; mgmt’s goals might not align with shareholder’s
examples of agency conflicts
FCF problem - more cash available, the more is spent
quiet life - taking it easy
potential downsides of LBO
- conflict of interest in MBO (managers might want to drive price low b4 MBO, to buy low, sell high)
- leverage increases exposure to adverse shock and potential bankruptcy (possibility of cost of financial distress)
recapitalization
change of firm’s financing to achieve a new target D/E
internal recap achieved by:
incr. D/E : issue debt, use proceeds to buy equity
decr. D/E : issue equity, use proceeds to repay debt
LBO vs. Recap
Recap: about achieving new D/E target to optimize tax shields of debt and fin. side effects
LBO: changes D/E temporarily, has other benefits
strip financing
basically repackage/pool different types of financing into one security
sometimes used to finance LBOs
value of strip financing = value of each component
advantages of strip financing
- can help resolve conflicts of interest b/w holders of diff types of financing
- can structure D & E combo (equity kicker); improves mgmt incentives to increase overall firm value
debt overhang problem
when equity holders might be against projects that generate +NPV for firm, but not for equity
equity kicker
has both D&E
improves mgmt’s incentives to increase overall firm value
when expected return on equity component offsets loss on debt (from having coupon rate below the going market rate)
promising higher return on equity for lower coupon payments
for LBO use…
APV bc temporary D/V
for APV use…
WACC bc constant D/V
WACCme =
rA - T * rD * (D/V) * [(1+rA) / (1+rD)]
WACCme
risk adjusted discount rate
expresses WACC in terms of rA, rather than rE, since rA doesn’t change even if you change the capital structure
WACC = WACCme if…
- unlevered cost of capital is constant
- cost of debt is constant
- tax rate is constant
- MV leverage ratio is constant
how to determine if firm is undervalued
- find firm value using Σ (FCF) / (1 + WACC)
- equity value = firm - debt
- stock price = equity value / # of shares
why might an outsider be necessary to implement a recap?
- manager’s might not like taking on so much debt
2. outside co may have higher debt capacity (aka lower expected cost of financial distress) due to diversification
valuing an LBO; APV fin side effects
break up into pre-sale and post-sale
pre-sale: Σ (T*I) / (1+rD)
post-sale: PV of tax shields = TV WACCme - TV rA, DISCOUNTED BY rD (!!)
