In the mid-1980s, Michael Milken and his firm, Drexel Burnham Lambert, made the term “junk bonds” a household word. Many of Drexel’s clients issued junk bonds (bonds with low credit ratings) to the public to raise money to conduct a leveraged buyout (LBO) of a target firm. After the LBO, the target firm would have an extremely high debt-to-equity ratio, with only a small portion of equity financing remaining. Many politicians and members of the financial press worried that the increase in junk bonds would bring about an increase in the risk of the U.S. economy because so many large firms had become highly leveraged. Merton Miller disagreed. See if you can follow his argument by assessing whether each of the statements below is true or false:
a. The junk bonds issued by acquiring firms were riskier than investment-grade bonds.
b. The remaining equity in highly leveraged firms was more risky than it had been before the LBO.
c. After an LBO, the target firm’s capital structure would consist of very risky junk bonds and very risky equity. Therefore, the risk of the firm would increase after the LBO.
d. The junk bonds issued to conduct the LBO were less risky than the equity they re-placed.