Leverage Buy Out Harvard Case Solution & Analysis

 Leverage Buy Out Case Solution

Introduction

Smith field Drugstore is a famous store that deals in household products and it is expected that the drugstore companies are considered to be not affected through economy as the demand of the household products is expected to be increase irrespective of the positive or negative change in economy. The past financials of the company show that despite being in the business of drugstore since many years, the company’s growth is not effective in last two decades which is why it is known as dull with respect to growth but recession proof with respect to its merchandise mix.
Three top managers of the company are considering acquiring the firm through leverage buy-out and it is expected that debt ratio will be 90% after the acquisition of the firm. In order to seek the guidance, the managers hire the investment bank and it is expected that investment bank Thornton, Brock and Edwards will help the mangers in order to make an appropriate bid that could help the company in order to hire the Smith field drugstore at a suitable price.

Q1)
Financial and Economic impact upon EBIT

The management group believes that under their control and by taking the Smith field private, the EBIT of the company will increase. It is expected that drugstore companies have better merchandise mix that is usually composed of cosmetics, tobacco and toiletries which makes them less sensitive to the state of economy, which is why the management group expected that any adverse economical changes could not affect the profitability of their target company. In addition to this, they also considered that the demand of the household products is increasing continuously due to the rapid increase in population therefore; the price of these products will also increase along with the demand which will also help the company by increase the earnings before interest and tax of the company.

Moreover, the management group also considered that acquiring the drugstore through leverage buy out will provide greater tax benefit of the company, as after acquiring the firm through leverage buy out it will increase the debt ratio of the company to 90%. Greater debt in capital structure of the company will provide greater tax benefits, which will also help the company by improving profitability of the company.

Q2)
Difference between Leverage Buy out and typical Acquisitions

It is expected that there are certain factors that make leverage buy out different from normal acquisition mergers and takeovers. First of all in leverage buy out the equity of the target firm is held by smaller number of individuals, which makes the attention of possession is particularly typical of a “going-private” business deal in which the stock is no more publicly traded.
It is also expected that acquisition, mergers and takeovers are financed through multiple sources such as equity, debt, and through other sources of funds in order to obtain rights however in leverage buy out, transactions through multiple sources of debt are used in order to finance the leverage buy out which leaves the target firm in the highly leverages position. In leverage buy out transactions, the debt of the target firm is also financed through new debt which makes it more attractive as compared to normal mergers and acquisitions.
As debt ratio increases to abnormal level, therefore the chances of bankruptcy in leverage buyout firms increase as high gearing ratio demands high interest payments which decreases the level of earn9gns significantly and it increases the firm risk of bankruptcy....................

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