Abstract: Buyouts greatly depend on leverage. Therefore, it is crucial to price the corresponding debt and equity when taking buyout activity. However, buyouts generally adopt the multiple tranches of debt to raise external funds to cover the budget deficit and targeted firms are usually exposed to undiversifiable idiosyncratic risks. As a result, the classical Leland model fails to price debt in buyouts. Therefore, a model is proposed to price the debt and equity in buyouts with multiple-tranches debt structureand analyzes the corresponding effects on bankruptcy policy and default probability. Based on calibrated parameters, internal rate of return to equity and default probability predicted by the model are consistent with those in empirical studies. As the value of underlying asset in the target firm approaches default boundary, the leverage ratio of target firm rises sharply, and the value of debt with lower priority falls quickly, which can explain the incentive for flight-to-quality. Furthermore, the comparisons among different kinds of debt show the single debt structure leads to higher financing costs and erosion in equity value, which actually provides theoretical support for the wide use of multiple-tranches debt structure. Finally, comparative static analysis is conducted about the effects of volatility of underlying asset and the interest rate in financial markets on debt and equity valuation and default strategy. The results show that reducing risk-free rate can boost buyouts, which is consistent with empirical findings.

Key words: buyouts, multiple-tranches debt structure, default strategy