6. Required Rates of Return in MBOs (10 points half page)

Leveraged or management buyouts (LBO/MBO) often are financed with 75% or 80% debt. The rest of the purchase is financed by the private equity firm and the new management team. The company is taken private, so the stock is no longer traded on any stock exchange. Once private the new owners usually sell assets to repay some of the debt. Good buyout candidates have strong stable cash flow and limited growth opportunities. Initially most of the companys cash flow goes to debt reduction. Buyout firms often have a portfolio of dozens of companies, so each company is being added to a diversified portfolio.

1. Buyout firms have very high required rates of return, 30% to 40%. If the average asset beta (that is the average beta of an unlevered firm) is about 0.75, can you explain the high hurdle rate buyout firms apply to their deals? Suppose the historic risk-free rate is about 5% and the historic market risk premium is 7.4%
2. Suppose a buyout company just picked rate say 32% - what sort of problems might this create for the company compared to another firm that used a more analytically determined required rate of return?