Paper LBO question
Heard a friend got this in an interview and we are debating the answer:
How is IRR and MOIC affected if FCF is used to pay back interest after each year rather than all of the interest being paid back at the end altogether?
When Free Cash Flow (FCF) is used to pay back interest after each year rather than deferring all interest payments to the end, the impact on IRR (Internal Rate of Return) and MOIC (Multiple on Invested Capital) can be summarized as follows:
1. IRR (Internal Rate of Return):
2. MOIC (Multiple on Invested Capital):
Key Intuition:
This distinction is crucial in LBO modeling, as IRR is often more sensitive to the timing of cash flows, while MOIC reflects the overall profitability of the investment.
Sources: EBITDA vs. Operating Cash Flow vs. Free Cash Flow, EBITDA vs. Operating Cash Flow vs. Free Cash Flow, Relationship among Cap Rate, IRR, Discount rate and NPV, How do you get from EBITDA to free cash flow?, LBOs - Why repay debt instead of keeping cash flow?
Lol, cash paid sooner is better for IRR. MOIC unchanged. Come on intern…
But you're paying the lender, not an equity dividend.
To me, the question seems incomplete. Like for the PIK option, is it compounding or non-compounding? Are dividends allowed or no?
If you actually PIKed the interest, dividended the cash instead, and just repaid the debt (principal + PIK interest) out of exit proceeds, I think your IRR is actually better in that scenario than paying the interest as you going along. Both IRR and MOIC outcomes would depend on whether the PIK interest compounded or not during this time.
If the debt compounds and dividends aren't allowed by the credit docs, you're probably better off paying annually since the interest rate on the debt is highly likely to exceed the rate of the company's money market accounts for it's cash. On the other hand, if you can re-invest the FCF and generate a better overall return (i.e., larger company/ higher EV), then there's another variable for ya.
Given the context that it's a paper LBO question, I think your no-dividend compounding (and no reinvestment) is probably the scenario interviewers have in mind. Baseline paper LBOs assume cash kind of just sticks around for a debt reduction at the end as opposed to a pure sweep. I think the "take on PIK in order to do mini dividend recaps every year" is...pretty far-fetched for a lender to agree to.
I’d agree. I couldn’t tell if it was a true paper LBO or more conceptual question.
If paper, I’d argue that most folks just model straight interest for simplicity (non-compounding), but PIK interest is almost always compounding, so this quickly gets complicated to math by hand.
Imagine working somewhere that thinks it valuable to have candidates model pik interest by hand
Do you mean debt pay down not interest pay down?
If so, then your interest payments in forward years are lower so both MOIC and IRR are higher assuming a 2CF investment.
If you mean paying interest annually (usually it’s quarterly btw) as opposed to in one bullet payment at the end of the investment, which is uncommon, then, uh..
There is no impact without extra assumptions. For example — you could dividend out the excess fcf and that would increase irr and not impact moic. You could invest the fcf in stuff that creates equity value through either increasing the valuation metric (EBITDA or rev) or the multiple, or even unlocks cash flow by paying a big 4 to reduce working capital for example (I’m sure they’d love that).
If you instead mean a PIK thing,
Then paying cash interest instead of letting it PIK will increase MOIC because the PIK compounds, and also increase IRR for the same reason. There’s no time effect since there are no new investment CFs
Ipsa aut neque minus similique adipisci quia. Qui voluptas qui nulla velit. Atque a eaque ut est ducimus.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...