Pre-LBO Capital Structure
Two companies have the same Enterprise Value but Company A has a 50% debt-to-total capitalization and Company B is unlevered. Assuming these companies have exactly the same growth prospects and financial profile, wouldn't Company A generate a higher IRR?
My thoughts -> You only need to pay a control premium on equity, and since Company A has a lower market cap, you will be paying a lower premium and the effective purchase price will be lower
You're on the right track! When you're looking at two companies with the same Enterprise Value, but different capital structures, the one with more debt (Company A in this case) could indeed generate a higher IRR. This is because, as you've pointed out, the control premium is paid on equity, not on total enterprise value.
So, if Company A has a lower market cap due to its higher debt level, the equity purchase price would be lower. This lower initial investment could lead to a higher IRR, assuming the companies have the same growth prospects and financial profile.
However, it's important to remember that while debt can increase IRR, it also increases the risk of the investment. If the company runs into any cash flow issues, it might struggle to service its debt, which could lead to financial distress or even bankruptcy. So, while the potential returns might be higher, the risk is also higher.
In the end, the decision between investing in a more levered versus a less levered company would come down to the investor's risk tolerance and return expectations.
Sources: 21 Finance Interview Questions and Answers, Winning at a Loser's Game? Control, Synergy and the ABInBev/SABMiller Merger, M&A Interview Questions - Beginner to Advanced Questions, Corp Dev LBO returns question: Levered and Unlevered IRR
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