LBO technical quesion

Ok. So right now I am building two LBO models for the exact same company with the exact same projections. In one of the models, I have all availible FCF paying off debt and exiting in 5 years. In the other, I have a constant debt load of 2x EBITDA (so debt basically grows every year as ebitda does, generating more cash flow for the firm)and all availible cash being paid out in dividends every year, and exiting in 5 years.

My IRR for for the non-dividend model is significantly higher then my IRR for the constant debt-dividend model even without taxes.

Why is this? I thought that without taxes, the dividend paying model would have a higher IRR because it is returning cash to the sponsor startng the first year as opposed to waiting 5 years. Am I doing something wrong?

 
Best Response

Why would you keep the TD/EBITDA multiple constant? It's not like they would be raising debt every year...unless that debt consists of a revolver that matures several years from your projections...

Also, you need to see what is driving your IRR. I personally don't use the IRR formula in Excel, use the NPV formula then normalize earnings and take the IRR.

 

The non-dividend model will give you higher IRR because of delevering - you'll be using cash to pay-off debt as quick as you can which will reduce your interest expense and consequently you will have more cash available to pay off debt as well. The other thing is that in the exit year, assuming you will not apply any multiple expansion (entry multiple = exit multiple), your TEV at exit will be deducted by a lower debt figure which will consequently result in a higher equity value at exit - driving higher IRR.

Whereas in the dividend model, although you keep paying yourself dividends every year, you are also contracting more debt each year as EBITDA grows (to keep the TD/EBITDA ratio constant), and therefore your interest expense will be higher and cash to pay off debt will be limited - the ending balance of all that is that you will have higher levels of debt at exit which will reduce the equity value available to sponsors and consequently lower IRR.

Remember we have 3 important factors driving IRR in an LBO model: - Operating improvement (EBITDA margin, etc) - De-levering - Multiple expansion / contraction (arbitrage)

Hope this helps.

 

Replying to lui

Yes, I agree. But in a world with no taxes, transaction costs etc., capital structure does not impact the value of the firm. Therefore, the dividend paying model should have higher value then the non dividend model in my case because you just realizing gains a lot earlier.

Anyways it doesn't matter. I found my error.

 

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