Leveraged Buyouts (LBOs)

Leveraged buyouts (LBOs) are also called “bootstrap” transactions or highly-leveraged transactions (HLT). It occurs when a lot of debt, which is also referred to as leverage or borrowing, is used to acquire an organization or controlling percentage of shares of the organisation. As much as 90% or more of debt is used to finance a leveraged buyout.

The assets of the target company are typically used as collateral to finance the merger. Leveraged buyouts often involve situations when a public company is taken private. LBOs are examples of financial mergers.

Due to the nature of the acquisition, certain organizations are especially attractive candidates for leveraged buyouts. Such characteristics include under priced stock, healthy liquidity position, low debt level, inefficient current management of the organization which can be rectified by the new owners, consistent stable earnings of the target company, strong cash flow or the possibility of stronger cash-flows and a good position within the industry and availability of assets to account for sufficient collateral.

Repurchase of stock is sometimes undertaken by companies to decrease attractiveness of the company as a leveraged buyout target. Takeovers can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another strategy that management of the target company may use to protect itself against hostile takeover via leveraged buyout is defensive acquisition. The purpose of such an action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such an acquisition through debt. Due to increased debt of the target company, the acquiring company, which previously planned the hostile takeover, may lose interest in acquiring a highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with acquiring company which pursues hostile takeover.

The nature of leveraged buyouts changed over the last 30 years. Whereas before, LBOs were mostly used to finance hostile takeovers, currently leveraged buyouts are predominantly used to finance management buyouts.

 

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Financial leverage

Financial leverage is the relationship between operating profit and EPS (earnings per share). In short, it measures the level of debt. It is a measure of how the potential use of fixed financial costs (e.g. interest on debt) can enlarge the effect that change in operating profit (EBIT) has on EPS (earnings per share).

When does a firm have financial leverage?

If a firm has mixed financial costs, it has financial leverage. Due to financial leverage (existence of fixed financial costs), any increase in EBIT will result in even larger increases in EPS and any decrease in EBIT will result in even larger decreases in EPS.

How to calculate degree of financial leverage (DFL) of the firm?

To calculate degree of financial leverage, which is just a way to measure financial leverage of the firm, we can follow the following formula:

DFL =% change in EPS/% change in EBIT

Therefore, if the degree of financial leverage is greater than 1, then financial leverage exists (which is the case as long as the company has fixed financial costs). Also, any increase in financial leverage results in an increase in risk and any decrease in financial leverage results in a decrease in risk.

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Leverage

In finance, leverage (which is also called gearing or levering) refers to the use of debt rather than equity as a source of capital to finance investments and reinvestments. The more debt the business uses the more leverage it has.

As leverage increases, the risks also increase and so does the return on investment. However, as leverage decreases, the risks also decrease as well as the return on investment. Management have almost total control over the risk introduced by increased leverage.

There are three types of leverage:

  • Operating leverage – refers to the relationship between sales revenue and operating profit (which is also called EBIT (earnings before interest and taxes))
  • Financial leverage – refers to the relationship between operating profit and EPS (earnings per share)
  • Combined or total leverage – refers to the relationship between sales revenue and EPS

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Capital structure decisions analysis with debt ratios

When analyzing capital structure decisions, external stakeholders can obtain an approximate idea of the capital structure of the particular firm by using information in the firm’s financial statements to calculate various debt ratios.

When analyzing capital structure decisions of firms as outsiders, we need to consider two types of debt measures:

The first type of debt ratio measures the degree of indebtedness. This refers to how much debt the firm has relative to other balance sheet’s amounts. The debt ratio will measure the degree of indebtedness.

The second type of debt ratio measures the ability to service debts. This type of debt ratios measures the ability of the business to meet its obligations associated with debt, as they come due. Times Interest Earned Ratio and Fixed Payment Coverage Ratio will be considered to measure the ability to service debts.

Both techniques are very simple to use and effective at analysing capital structure decisions.

Measuring the degree of indebtedness


THE DEBT RATIO

A direct measure of debt is a debt ratio. Debt ratios provide direct information on the financial leverage of an enterprise. Debt ratios measure how many of the firm’s assets are financed by debt. The higher the debt ratio, the higher the degree of financial leverage (amount of debt) and the higher the risk. The formula for the debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

Example:

For example, assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Measuring the ability to service debts


TIME INTEREST EARNED RATIO (INTEREST COVERAGE RATIO)

The Times Interest Earned Ratio (TIER or Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due).

When analyzing capital structure decisions, we can use the Times Interest Earned Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Times Interest Earned Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Times Interest Earned Ratio is as follows:

Times Interest Earned Ratio =EBIT/interest charges

EBIT refers to the earnings before interest and taxes, which is also called operating profit (refer to the Income Statement format to see how it is calculated).

EXAMPLE:

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000.

The TIER of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

When using the Times Interest Earned Ratio, it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio. It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest. The calculation above excludes the principal amount borrowed.

Generally, the higher the Times Interest Earned Ratio the lower the risk an enterprise will not be able to meet its contractual interest obligations on time. Therefore, generally, a higher Times Interest Earned Ratio is the better.

However, cognizance needs to be taken of the fact that the higher the Times Interest Earned Ratio, the lower the risk and lower the return. Therefore, at some point, the Times Interest Earned Ratio may be too high. This will occur if the business is unnecessarily careful with taking up debt as a source of financing, which results in very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

FIXED PAYMENT COVERAGE RATIO

Fixed Payment Coverage Ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. When analyzing capital structure decisions, we can use the Fixed Payment Coverage Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Fixed Payment Coverage Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Fixed Payment Coverage Ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT – earnings before interest and tax (operating profit)

LP – lease payments

I – interest charges

PP – principal payments

PSD – preferred stock dividends

T – tax rate

EXAMPLE:

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The Fixed Payment Coverage Ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The Fixed Payment Coverage Ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, Fixed Payment Coverage Ratio should be compared to industry average before any conclusions are drawn. Generally, the higher the Fixed Payment Coverage Ratio the lower the risk that enterprise will not be able to meet its fixed-payment obligations on time. Therefore, a higher Fixed Payment Coverage Ratio is the better.

However, as with Times Interest Earned ratio, cognizance needs to be taken of the fact that the higher the Fixed Payment coverage ratio the lower the risk and lower the return. Therefore, at some point, the Fixed Payment Coverage Ratio may be too high. This will occur if the business is unnecessarily careful with taking up more debt which results in a very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

***

When analyzing capital structure decisions with the help of debt ratios, one should compare debt ratios of individual firms to industry averages. There is a large variability of debt ratios’ industry averages between industries. This is because different industries have different operations requirements. There is no one perfect ratio. Appropriate ratios to use should determined by the company in question, taking into account company’s ‘s strategy, operating environment, competitive environment and finances.

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Degree of total leverage (DTL)

The degree of total leverage, which is a way to measure the total leverage of the firm, refers to the relationship between sales revenue and EPS. It (financial and operating leverage) is a measure of how potential total fixed costs (fixed operating costs and fixed financial costs) can enlarge the effect that change in sales (P*Q) has on EPS (earnings per share).

When does a firm have total leverage?

If the (DTL) is greater than 1, than total leverage exists (which is the case as long as the company has fixed operating or/and financial costs). Due to total leverage (existence of fixed operating or/and financial costs), any increase in sales will result in an even larger increase in EPS and any decrease in sales will result in an even larger decrease in EPS. The higher the fixed financial and operating costs, the higher the (DTL). There are three approaches to calculate the (DTL):

1st approach to calculate the (DTL)


To calculate the (DTL), we can utilize the following formula:

(DTL) =% change in EPS / % change in sales

Test yourself

ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.

Required:

Find the degree of operating leverage, the degree of financial leverage and the degree of total leverage.

Solution:

Degree of operating leverage:

DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17

Degree of financial leverage:

DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43

(DTL):

DTL =% change in EPS / % change in sales DTL =310%/60% DTL =5.17

2nd approach to calculate the (DTL)


If we have data on the degree of operating leverage and degree of financial leverage, then the (DTL) can be calculated as follows:

(DTL) = DOL * DFL

Test yourself:

ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.

Required:

Find the (DTL) using the second approach.

Solution:

Firstly, we need to find the degree of operating leverage and the degree of financial leverage.

Degree of operating leverage:

DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17

Degree of financial leverage:

DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43

Now, we can calculate the degree of total leverage.

(DTL):

DTL=DOL*DFL

DTL=1.17*4.43

DTL=5.18

Note that this is aligned with the answer that we obtained while using 1st approach above for calculation of the degree of total leverage.

3rd approach to calculate the (DTL)


There is another formula that can be used to calculate the (DTL). A third approach to calculate the (DTL) is a more direct technique. The formula is as follows:

(DTL) at base sales level Q =

Q*(P-VC)/Q*(P-VC)-FC-I-(PD*1/1-T)

WHERE:

Q – sale quantity in units

P – sale price per unit

VC – variable operating cost per unit

FC – fixed operating cost per unit

I – interest

PD – preferred stock dividends

T – tax rate

Test yourself:

ABC Corporation ascertained that Q=1800, P=$8, VC=$3, FC=$1300, I=$1,800, PD=$3,000 and the tax rate is 40%.

Required:

Find the (DTL) using a more direct formula for calculation.

Solution:

The calculation of the (DTL) of ABC Corporation will be as follows:

Degree of total leverage at base sales level Q = 1800*(8-3)/1800*(8-3)-1300-1800-(3000*1/1-.4)

Degree of total leverage at base sales level Q = 9000/900

Degree of total leverage at base sales level Q = 10

Since the result is greater than 1, ABC Corporation has total leverage.

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Fixed Payment Coverage Ratio

The fixed payment coverage ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. In other words, the fixed payment coverage ratio measures the ability to service debts.

As outsiders, when analyzing the capital structure decisions of firms, we can use the fixed payment coverage ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk.

The formula for the fixed payment coverage ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT = earnings before interest and tax (operating profit)

LP = lease payments

I = interest charges

PP = principal payments

PSD = preferred stock dividends

T = tax rate

Test yourself


Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The fixed payment coverage ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The fixed payment coverage ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, the ratio should be compared to the industry average before any conclusions are drawn.

Note the following


Generally, the higher the ratio the lower the risk that  enterprise will not be able to meet its fixed-payment obligations on time. Therefore, generally, a higher ratio is better. However, as with times interest earned ratio, cognizance needs to be taken of the fact that the higher the ratio the lower the risk and lower the return.

Therefore, at some point, the fixed payment coverage ratio may be too high. This will occur if a business is unnecessarily careful with taking up more debt. This will result in very low risk, but also in lower return. This, of course, is not aligned with the overall goal of the enterprise, which is the maximization of the wealth of its shareholders.

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Debt-equity ratio analysis

Debt-equity ratio analysis is one of several debt ratio analyses. Debt ratios measure the degree or financial leverage of the firm. The more debt the firm uses, the higher its financial leverage, the higher its financial risk (the risk of bankruptcy) and the higher the potential returns.

It measures the degree of indebtedness of the enterprise. It measures how much of equity and how much of debt a company uses to finance its assets. It is also referred to as leverage or gearing.

The formula is as follows:

Debt-equity ratio = Total liabilities/Shareholders equity

This formula is sometimes presented simply as:

Debt-equity ratio = Debt/Equity

Example of a debt-equity ratio analysis


Assume Gold Co. currently has total debt of $1,000,000 and shareholders equity of $1,800,000. The debt-equity ratio for the Gold Company is conducted as follows:

$1,000,000/$1,800,000=0.56

The result is less than 1 and indicates that business uses mainly equity to finance its operations. The financial risk of Gold Company seems to be under control. However, it is possible that company may have lower than possible returns due to being too careful with using debt financing. However, a closer investigation is required before any conclusions can be made.

Things to note about this ratio


If the debt-equity ratio shows a result of less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that the debt is mainly used for financing of operations. If the result of debt-equity ratio analysis is equal to one, then it means that a half of financing comes from debt and a half comes from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher the potential return. Financial risk refers to the risk of the firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

The results should be compared to industry averages, to the firm’s past ratio trends and to a similar analysis of leading competitors within the industry.

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