Series 79 practice questionhardLeveraged Buyouts
Which of the following is a key risk associated with the high leverage used in LBO transactions?
- AThe target company's tax liability increases due to the loss of interest deductions
- BLeveraged companies are prohibited from making acquisitions
- CThe PE sponsor's liability is unlimited in the event of default
- DThe company may face financial distress if cash flows decline and it cannot service its debt obligations✓ Correct answer
Explanation
Why D — The company may face financial distress if cash flows decline and it cannot service its debt obligations
The primary risk of high leverage in an LBO is that the company may be unable to meet its debt service obligations if operating performance deteriorates or if there is an economic downturn. This can lead to covenant violations, debt restructuring, or bankruptcy. While interest expense provides a tax shield that benefits the company, this advantage is meaningless if the company cannot generate sufficient cash flow to make its required debt payments.
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