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Measuring Default Risk in Leveraged Buyouts is a Master Thesis in Finance written at the Stockholm School of Economics written by Patrik Teste and Adam Samuelsson, tutored by Professor Bertil Näslund, published in September 1998.
We investigate the measurement of default risk in Leveraged Buyout transactins (LBOs). Default risk is defined as the probability that the post LBO-firm will not be able to service its debt. After a review of research on LBOs and different methods of estimating default and distress risk, we develop a spreadsheet model predicting the annual cash flow coverage ratio for the proposed LBOs of two case firms, Kinetic Concepts Inc and Mediq Inc. Using Monte Carlo simulation software, we estimate the probability that the case firms will survive without recapitalization the first three years after the LBOs, and conclude that both companies stand a substantial risk of default on their respective debt service obligations. We find that the risk levels of the LBOs are highly dependent on the projections of management regarding sales and EBIT margins, and that the single most influential factor determining the survival of the LBOs is the companies' future EBIT margins. We also find that the risk of default can be reduced by altering the characteristics of some of the debt instruments used in the LBOs without changing the overall leverage of the case firms.