Hi Guys,
I was asked the following question in an internship interview recently and still don't feel like I have fully understood it: "If we conduct both a DCF and an LBO with a WACC and IRR of 20% - which will yield the higher valuation?"
I believe that the answer would be, that both would yield the same valuation, all else being equal?
Thanks!
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Seems like a trick question how you framed it. As WACC includes the cost of equity and cost of debt whilst the IRR refers to the cost of equity in an LBO case. If the WACC is 20% the cost of equity should be more than 20% for the DCF. In this case a LBO would warrant a higher valuation mathematically as the cost of debt would be lower than 20% putting the WACC lower than 20%. If you meant WACC and IRR are also equal in the LBO case then it wouldn't be an LBO given you have 0 debt in the buy out.
If I give you a random price I can generate a random IRR. So you also need to know it’s not just ANY case LBO but the specific case of the LBO where you are actually paying max price, meaning cost of equity = equity IRR = 20%. There’s a fine distinction in that you can bid much lower / higher for a company than what your PE fund cost of equity could provide / withstand and still generate a 20% equity IRR.
In the prescribed case above, the WACC of that buyout target would be lower than 20% which means your valuation is higher than for a DCF with 20% WACC.
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