Table of Contents

Modelling Dynamic Redemption and Default Risk for LBO Evaluation: A Boundary Crossing Approach

Alexander D.F. Lahmann, HHL Leipzig Graduate School of Management
Maximilian Schreiter, HHL Leipzig Graduate School of Management
Bernhard Schwetzler, HHL Leipzig Graduate School of Management - Department of Finance


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ALEXANDER D.F. LAHMANN, HHL Leipzig Graduate School of Management
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MAXIMILIAN SCHREITER, HHL Leipzig Graduate School of Management
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BERNHARD SCHWETZLER, HHL Leipzig Graduate School of Management - Department of Finance
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In this paper, we develop a model that allows evaluating the financial effects of leveraged buyouts (LBOs) from the perspective of the investor. We provide explicit form solutions for all payoffs from acquisition to exit, and therefore feature the determination of net present value (NPV) and internal rate of return (IRR). The model is based on a boundary crossing approach where the default of the target firm is represented as a lower piecewise linear barrier. Those default barriers either consist of debt repayment and interest expenses, or are contractually-fixed by covenants like debt-to-EBITDA. Our approach features the typical LBO debt repayment schedules: fixed and cash sweep. Furthermore, the model captures all drivers of performance and leverage identified by empirical studies: firm-specific ones like profitability, cash flow growth, volatility and liquidation value, as well as external ones like credit risk spreads and pricing discounts for debt overhang.

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