-A low leverage capital structure will leave management with considerable discretion respecting the investment of excess earnings generated by the firm's operations. As a result, the management can reinvest capital in suboptimal projects. From an investor's point of view, this is bad.
-High leverage, on the other hand, will reduce the discretion of management.
-In order to keep current with debt payments and avoid bankruptcy, the managers of a firm must run an efficient operation.
-As a result, high leverage has the effect of being associated with good governance.
-Management is concerned with their loss of independence and control that which falls into the hands of the banks as debt rises (due to covenants).
How much debt is optimal?
-Management's desire to be self sufficient as well as to be secure comes at a cost to the maximum return on the capital invested.
-Debt does more than merely perform a financial signaling function.
Managers have incentives to make their firms to grow beyond the optimum size. Such growth increases the power of managers by increasing the resources that they have control of. This growth is also associated with increases in manager's compensation. This is because changes in compensation are positively correlated to the growth in sales.
-Conflicts of interest between shareholders and managers over payout policies of the firm are most severe when the organization creates substantial free cash flow.
-Debt can be an effective substitute for dividends.
-By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way which can not be accomplished by a simple dividend increase.
-Managers, by doing the above, give shareholder recipients of the debt the right to take the company to bankruptcy court if the managers do not maintain their promise to make the payments on interest and principal.
-Debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at management's discretion.
Costs of increased leverage
-As leverage increases, the usual agency costs of debt also increases (which includes bankruptcy costs).
-Optimal debt equity ratio is the point at which firm value is maximized. This is the point where the marginal costs of debt just offset the marginal benefits.
What is a leveraged buyout?
A leveraged buyout (LBO) is defined as an acquisition of a company (also known as the target) which is financed by borrowed funds.
-Targets assets are used to secure the loans.
-Parties bought out are the target company's common stockholders.
-Target can be either: wholly owned subsidiary of a larger firm, a close corporation, or a publicly held corporation (if this is the case, the LBO is sometimes called a 'going private' transaction).
-Often the target's managers will have a substantial participation in the acquiring partnership and will stay on as managers after closing. These transactions are known as management buyouts (MBOS) and make up a large subset of LBOs.