ACCA Strategic Professional · Advanced Financial Management · Business re-organisation
Which feature of a typical LBO capital structure is the main reason the sponsor's equity return is sensitive to operating cash flow performance?
High gearing makes LBO equity returns sensitive to cash flow because fixed interest and debt repayments rank ahead of equity. Small changes in operating cash flow therefore cause large changes in equity value, amplifying both gains and losses for the sponsor.
- AA high proportion of debt with fixed interest and repayment obligations ahead of equityCorrect
- BThe use of ordinary shares only in the structure
- CA very low gearing level to protect lenders
- DPayment of all profits as dividends to managers
Explanation
High gearing means fixed interest and capital repayments rank ahead of equity, so small changes in cash flow produce large changes in equity value. This amplifies both gains and losses. Low gearing would reduce, not create, this sensitivity.
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