I saw this question on an interview review:
"If you had a COE of 20% and a WACC of 15% would you do a LBO with an IRR of 20%?"
Wouldn't it be yes, because if the LBO produces an IRR > 20%, the investment would be value creating? The guy that responded said "No, because it is an equity investment."
To the best of my knowledge, you wouldn't do the LBO because your equity investors require a return of 20% (cost of equity). An LBO is essentially an equity investment for the company and you wouldn't pursue an IRR that is the same as the cost of equity since you would not receive additional value.
Well it would essentially breakeven, would it not? Plus, I don't understand the writer's answer I put in the original post.
But say for the sake of the question the LBO has an IRR of 21%. Would that not be value creating?
Yes it would be breakeven, but it wouldn't add any additional value so why do it? The writer means that you would compare the LBO's IRR to the cost of equity since you're investing equity into the LBO transaction.
Ok gotcha, I think I just misunderstood the writer's explanation/question. It sounds like if an LBO model shows an IRR > COE, then it's a worthwhile investment. If not, then it's not a worthwhile investment.
The interviewer is correct, but if his response to your question is verbatim, it's not well worded. "It" is not just an equity investment. It is an equity and debt investment. The sources of debt capital would gladly make the investment, but the PE fund wouldn't (because as previously stated, it's breakeven...to them).
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