Hi everyone:
In the sensitivity portion of an LBO model, why would IRR decline after increasing leverage beyond a certain point? For example, if I increase leverage from 2x to 4x and during the increase, see increasing IRR; but if I keep increasing leverage from 4x to 6x, then my IRR is actually lower at 6x? Why would that be the case please? is this common?
Thanks!
Does your cost of debt increase as leverage increases?
Wouldn’t cost of debt not be included in an LBO? As in, you don’t have a WACC since its the output
To elaborate*
If cost of debt increased, wouldn’t that instead be reflected in your firms target IRR instead of in the model?
OP is asking about levered IRR i.e. the cash on cash return to the equity. If you've got cash pay interest, and that cash interest increases if leverage increases, equity would get less of a cash on cash return after breaking the optimal cost of debt.
Agree that IRR is an output but in a levered IRR cost of debt does matter. Any LBO should be NPV positive as long as Kd is lower than Ke but I'm pretty sure that the sensitivities could decrease at higher leverage levels if cash pay interest increases.
Granted my comments are based on directional mental math and may well be wrong, but this was my knee jerk reaction.
Yes it does, thank you so much bobbybonilla ! Thanks for helping a new monkey out...how can newbies like me improve? Thanks!
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