Leveraged Buyouts Advantages And Disadvantages

Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.

In general, using external funds, i.e. debt or equity, to finance increasing growth is riskier to the corporation. When issuing debt the company needs to be certain to cover both the repayment of the principal and the interest payments on time (because if they do not this could cause them to have problems securing financing in the future). When issuing additional shares of stock (equity) the value of existing traded stock is diluted (in proportion) and as such the current ownership might lose control (and may even be voted out by shareholders if dilution is substantial enough). Furthermore, with both debt and equity financing, a fast growing company needs to be aware that payments to either may hamper future expansion because payments that need to be send out in the forms of dividends or interest cannot be retained and invested in future projects.

What are the advantages of leveraging this company? The disadvantages? How would leveraging up affect the company’s taxes? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?

Aside from the two aforementioned proposals the company can raise its leverage in other ways. By conducting DuPont analysis and understanding operating leverage we see that purchasing fixed assets and decreasing stockholder’s equity will raise the equity multiplier and the firm’s operating leverage. In this instance we recommend against this approach as the firm already has a large amount of excess cash above what they require to fund new positive NPV projects and purchase new assets. Investors would rather see their capital returned to them in the form of share repurchases and dividends as it is evident by the company’s cash stockpile that they can

Firstly there is a significant Ethical and morale lapse in a share floated company when the CEO engages in related party transactions. The moral issues arise

Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of a Biggerstaff & Biggerstaff (B&B), a privately held company owned by two brothers, each with 5 million shares of stock. B&B currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&B’s financial statements report marketable securities of $100 million, debt of $200 million, and preferred stock of $50 million.

Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.

On the basis of risk and return, how does the increased leverage affect a company and the individual shareholder?

Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars.

A capital structure policy aims to balance the trade-off between the benefits of debt financing (interest tax shield) and the costs of debt financing (financial distress and agency costs). Every firm should set its target capital structure such that its cost and benefits of leverage ultimately maximise the firm’s value. Graham and Harvey asked 392 firms’ chief financial officers whether they use target debt ratios. Results show that the majority of them do, although the level of strictness of the target policy varies across different companies. Only 19% of the firms avoid target ratios, of which most are likely to be the relatively smaller firms. This clearly

| The risks of becoming a victim of hostile acquisition and stocks speculations, causing problems with financing.

It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs

From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.

Nevertheless, firms have used leverage even before corporate taxes have been introduced (Maris and Elayan, 1990). This implies the existence of some market imperfections, which benefit the use of debt financing, thus enable a trade-off of the cost and benefits of debt resulting in an optimal capital structure, where marginal cost equal marginal benefits.

The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance. After exhausting both of these possibilities, the final and least preferred source of finance is