I don't understand how minimizing cash and maximizing leverage leads to higher returns? I mean, how does using $2B of equity and $3B of debt boost your returns more so than $3B of equity and $2B of debt? I keep reading explanations about this online but it's not clicking for me.. Maybe I need to understand it in simplest terms?
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Essentially it's because the cost of debt is lower than unleveraged yield. The debt and equity should have a weighted yield equal to the unleveraged yield and therefore if debt is low equity is high. Similarly increasing the debt weighting means equity yield goes up.
If you have a 1000 dollar portfolio paying 10 dollars every year, and you finance it with 800 dollars of debt paying 3 percent coupon and 200 dollars of equity clearly here the equity yield goes down because of the leverage rather than up.
Simply put, it is because your cash outflow is less. When calculating IRR, the lower the cash outflow, the higher the IRR. So, if the purchase price is the same, lowering your percent of equity (cash) raises your IRR.
Obviously this is not correct.
You obviously need to go back and re-learn the LBO and its basics, especially if you plan to go through SA or FT recruiting. Look at it from a basic math standpoint. When you calculate IRR, if the initial cash outflow goes down, the IRR goes up (assuming that cash inflow stays the same). So, if you use more debt, your initial cash outflow goes down, and like I said, IRR goes up. It's just a basic math problem. I suggest buying the WSO or M&I interview guide.
And, no, I'm not the one who MSed you.
Yup, like what the people above have mentioned, it has a lower cost than equity and it reduces the upfront cash payment (time value of money). If you compare 2 scenarios, lets say 1 with 5B equity and 1 with 2B equity and 3B debt, you may find that while in the first scenario, you may get higher absolute value of return, the 2nd scenario will get you higher returns in terms of %.
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