Question on debt paydown
Would appreciate if someone could tell me where I've gone wrong:
In a scenario where a borrower has the option to paydown debt regularly or bullet payment at maturity, which option yields a better IRR for the debt investor?
My thinking is:
1) Bullet payment at maturity: just yields an IRR equal to the pricing of the debt (quick blank sheet model confirms this
2) Amortising paydowns: allows the debt investor to get earlier cash flows in the form of paydowns, but lower interest in the future due to reduced debt balance. So these two should net off [to give the same IRR as #1 above?]
However when I did this simple modelling in a blank sheet - #2 gives a lower IRR for debt investors than #1, could someone please rationalise why?
Based on previous WSO threads, here's what you need to know:
Bullet Payment at Maturity:
Amortizing Paydowns:
Rationalization for Lower IRR in Amortizing Paydowns:
Example from WSO Context:
In the context of the "Failed Real Estate Acq Assoc Candidate Case Study" thread, it was noted that discrepancies in IRR calculations can arise from structural differences in the model. Ensuring that the model accurately reflects the cash flow timing and amounts is crucial for correct IRR computation.
Conclusion:
The lower IRR in the amortizing paydown scenario is due to the combination of reduced future interest payments and the time value of money. The bullet payment structure maintains a higher IRR because the principal remains outstanding for the entire term, accruing more interest.
If you need further clarification or have additional questions, feel free to ask!
Sources: Modelling Test - Please tear it apart :), Multi-Family Acquisitions Excel Test, Why even use EBITDA?, Failed Real Estate Acq Assoc Candidate Case Study, Modeling Question: IRR goes down but CoC goes up over time
Conceptually, you are correct in your thinking but I think this relies on the underlying variables and so some of these things are "it depends". All else equal an amortizing piece of paper returns a higher IRR than bullet payment just given the timing of cash flows, but this is not always the case.
You are correct that an investor electing higher amortization foregoes future interest income on the share of paper repaid and therefore the IRR equals out in the end, but this assumes the deal is purchased at par, which many aren't. While the IRR is these scenarios would be the same, the MOIC wouldn't be - the investor with no amortization will have a higher MOIC and the investor with amortization will have the a lower MOIC, but each the same IRR. Is one better than the other? This is a stylistic choice...an investor may actually prefer the same IRR but lower MOIC if their preference is a security with lower duration, which higher amortization provides given the lower WAL.
Issuance price is also a determining factor. Most deals in the BSL / private credit market will have an OID component to some degree, perhaps a point. Take a 7Y deal at S+500 featuring 5% annual amortization paid quarterly with a 99 OID...the IRR on this deal will be slightly higher (like, 5 basis points) with the amortization than without because the investor realizes the face discount faster which is not fully offset by the lost interest income. As the OID grows so does the IRR delta.
Molestias non repudiandae ut. Voluptas accusamus voluptas ut architecto vel voluptas. Nobis aut delectus molestias enim perferendis.
Sit molestias voluptates saepe velit dolorem voluptates vero. Velit sed nihil perferendis excepturi in cupiditate dolorem. Ratione facilis veniam voluptas aut harum aliquam natus. Eum at explicabo illo porro.
Qui culpa sint aperiam magni. Sed nihil eum aut est excepturi. Incidunt aut amet omnis maiores itaque aut aut. Qui et qui inventore corporis.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...