Lecture 7 - Leveraged Transactions

Question 1

LBO

Answer 1

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

Question 2

reasons for LBO

Answer 2

1. market undervalues firm
2. mgmt wants to preserve control
3. LBO increases firm value

Question 3

how can LBO investors make profit if firm is undervalued?

Answer 3

by offering between current stock value & firm worth to existing shareholders, then reselling firm for firm value

risky bc uncertainty of future resale value

Question 4

how does LBO increase firm value?

Answer 4

1. reduces taxes (shifts value from gov back to shareholders)
2. better alignment of manager incentives w/ shareholder value
3. misc. cost advantages (doesn’t have to abide by public disclosure rules, which could affect comp. adv)

Question 5

how does LBO reduce taxes?

Answer 5

1. increase interest TS - more debt increases interest payments, reducing taxable income
   for firms with stable FCF & large debt capacity
2. increase depr TS - if BV of assets

Question 6

agency conflict

Answer 6

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

Question 7

examples of agency conflicts

Answer 7

FCF problem - more cash available, the more is spent

quiet life - taking it easy

Question 8

potential downsides of LBO

Answer 8

1. conflict of interest in MBO (managers might want to drive price low b4 MBO, to buy low, sell high)
2. leverage increases exposure to adverse shock and potential bankruptcy (possibility of cost of financial distress)

Question 9

recapitalization

Answer 9

change of firm’s financing to achieve a new target D/E

Question 10

internal recap achieved by:

Answer 10

incr. D/E : issue debt, use proceeds to buy equity

decr. D/E : issue equity, use proceeds to repay debt

Question 11

LBO vs. Recap

Answer 11

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

Question 12

strip financing

Answer 12

basically repackage/pool different types of financing into one security

sometimes used to finance LBOs

value of strip financing = value of each component

Question 13

advantages of strip financing

Answer 13

1. can help resolve conflicts of interest b/w holders of diff types of financing
2. can structure D & E combo (equity kicker); improves mgmt incentives to increase overall firm value

Question 14

debt overhang problem

Answer 14

when equity holders might be against projects that generate +NPV for firm, but not for equity

Question 15

equity kicker

Answer 15

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

Question 16

for LBO use…

Answer 16

APV bc temporary D/V

Question 17

for APV use…

Answer 17

WACC bc constant D/V

Question 18

WACCme =

Answer 18

rA - T * rD * (D/V) * [(1+rA) / (1+rD)]

Question 19

WACCme

Answer 19

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

Question 20

WACC = WACCme if…

Answer 20

1. unlevered cost of capital is constant
2. cost of debt is constant
3. tax rate is constant
4. MV leverage ratio is constant

Question 21

how to determine if firm is undervalued

Answer 21

1. find firm value using Σ (FCF) / (1 + WACC)
2. equity value = firm - debt
3. stock price = equity value / # of shares

Question 22

why might an outsider be necessary to implement a recap?

Answer 22

1. 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

Question 23

valuing an LBO; APV fin side effects

Answer 23

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 (!!)