A Real Options Model of Debt Ratio in Leveraged Buyouts

Abstract

This study investigates the ideal timing for acquiring a target firm and the optimal capital structure of the newly formed entity in a leveraged buyout (LBO) transaction using a real options model. We examine the strategic decision-making process involved in determining the most advantageous moment for executing the acquisition, considering market conditions and firm-specific factors. The real options model provides a sophisticated framework that enables us to capture the value of managerial flexibility in making these timing decisions.Additionally, we analyze a scenario under which the target firm independently alters its capital structure by issuing bonds. This investigates the implications of such a decision on the firm's financial health and operational efficiency. We consider the potential benefits and drawbacks of self-initiated capital restructuring, while also evaluating how it compares to the capital structure resulting from an LBO transaction.This comparative analysis reveals significant differences between the two scenarios. Specifically, we demonstrate that the leverage ratio of the LBO firm is significantly higher. This finding highlights the aggressive financial strategies typically employed in LBO transactions, which often involve substantial debt financing to maximize returns. Our study thus contributes to the understanding of capital structure optimization in the context of LBOs and provides valuable insights for both practitioners and scholars in the field of corporate finance.