Ungeared vs geared IRR
Is the geared IRR typically higher than the ungeared IRR of a company? In what scenarios would it not be the case?
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Referring to leverage as gear from now on thx
Man, I would hope so. Leveraged IRR should be higher than unleveraged, unless ... the cost of debt was higher than the cost of equity? I don't know when that would ever be the case.
Just remember leverage amplifies returns. Here's a simple example:
Example A: 100% Equity
Pre-debt service cash flow: 50
Equity: 100
Return: 50%
Example B: 50/50 Debt and Equity
Pre-debt service cash flow: 50
Debt service: -10 (assuming 5 year am. excl. interest)
Post-debt service cash flow: 40
Equity: 50
Return: 80%
mathematically, back of envelope gives:
Levered IRR=unlevered IRR + (unlevered IRR - cost of financing) * (leverage to cap)/(1-leverage to cap)
the ratio is non-negative. in order for levered IRR to be less, you’d need cost of financing to exceed the unlevered IRR.
theoretically financing decisions do not affect value of company excluding tax shielding and bankruptcy costs.
however, more practically the effects of leverage may affect business value (thru future cash flow strain) in certain ways.
anyhow, levering equity that yields lower return....this is just unusual though
it should basically never be, as debt is cheaper than equity. However, your question may be going past me. What do you mean? Can you add context?
Leverage is used judiciously to boost returns nowadays so this really wouldn't apply--- maybe the company would take on too much debt, go into bankruptcy, and idk while less leverage would have allowed the company to survive and improve cash flows to equity (blah blah blah, u know what I mean here)
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