LEVERAGED BUYOUTS

This research examines the effects of leveraged buyouts (LBOs) and junk bonds on current economic conditions. A background discussion on LBOs and junk bonds follows this discussion, and in turn is followed by a discussion of the concepts of leverage and risk. The effects of LBOs and junk bonds on current economic conditions then are assessed.

During the 1980s, corporate mergers and acquisitions occurred at historically high levels in the American economy (Drucker, 1986, p. 17). Prior significant episodes of merger and acquisition activity in the American economy were primarily motivated by corporate diversification strategies in which the principal goal was growth (Glueck, 1994, p. 297). By contrast,the hostile takeover (wherein the strategic goal often had little relevance to the primary business activity of the acquired corporation) characterized much of the merger and acquisition activity of the 1980s (Edmonds & Lindbeck, 1990, pp. 66-69).

As the decade of the eighties progressed, an increasing proportion of the acquisition and merger activity was of the LBO variety (Greenwald, 1993, p. 16). An LBO is a sale in which the cost of the purchase is largely borne by the firm being acquired. In most instances, these deals were structured to be financed by so-called junk bonds. Junk bond is the term used to describe an (1) original issue, (2)

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disadvantages to high leverage (Brigham, p. 480). A primary advantage is that high leverage permits a firm to, so to speak, operate on someone else's money. In finance, the process is called trading on the equity. Another advantage is that a firm can obtain additional capital at a time when it might be difficult to attract new equity investors. Yet another advantage, which is exceptionally important to shareholders in some instances, is that additional capital may be obtained for a company, without diluting the equity interests of the existing shareholders (Brealey & Myers, 1995, p. 448). Leverage may be severely detrimental to a company in a situation where profitability, for whatever reason, deteriorates (Brigham, p. 496). At noted above, leverage is based on fixed-interest debt. Fixed-interest debt carries with it fixed-interest charges. While the level of profits may deteriorate, the fixed-interest debt charges do not. Depending on the severity of a profit deterioration, a highly leveraged position may cause a company to become illiquid. A second disadvantage of high leverage is that such a position may cause investors and potential investors to perceive a greater risk associated with the company's equity and debt i
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Approximate Word count = 2764
Approximate Pages = 11 (250 words per page)

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