Assumptions of LBO Models

Private equity firms and investment banks advising them on a deal use LBO models to analyze the attractiveness of leveraged buyouts. Financial analysts use similar models to screen for potential LBO candidates. Valuation models are well constructed if they are simple and realistic and help investors to gain insights. Like any other model, LBO models are based on simplifying assumptions. To model the attractiveness of a potential LBO transaction several assumptions must be made:

  • (1) Transaction value and control premium: Private equity firms seeking to acquire attractive target companies compete with other financial and strategic investors. Acquiring firms usually have to pay a premium above the current market price to gain control of a target company. Table 32.1 reflects the deal premia paid in the largest global M&A deals in history.

    An acquiring firm can offer cash, stock, debt or a combination of financial instruments to acquire a target company from selling shareholders. On Monday, January 10, 2000, America Online (AOL) announced that it was buying Time Warner. At the time, AOL, which was later renamed Time Warner Inc., had a market capitalization of about USD 164 billion, while Time Warner had a market capitalization of just USD 83 billion. AOL offered 1.5 own shares for each share of Time Warner (Historic TW INC) which equated to a “deal premium” of 81.13% according to Bloomberg.1 More recently the German sports car manufacturer Porsche AG offered ...

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