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If solely viewing incremental debt capital as a form of positive financial leverage...
As an example, if your cost of equity is 12%, and the incremental cost of debt is 7%, you should take on more debt. This is obviously an oversimplification as increasing leverage in a business comes with its own risks and considerations.
Hi so to clarify is the cost of equity the return LPs are looking for. Maybe they can earn 8-9% in stocks today and so on RE you offer them 12% for their money for the higher risk?
Also to confirm this 12% is ideally/has to be lower than your unlevered IRR for the project? So you send a model to the investor showing say you can conservatively get a 15% return and say look to give us some room we'll offer you 12-13% higher than stocks today and to justify the risk?
So that 12% is now your cost of equity in the deal right and whatever debt is will blend it lower - so is that the hurdle you want your unlevered IRR to be above and is there a margin?
The cost of equity in its most simplified sense is the initial preferred return rate in a equity waterfall. For example, if the first hurdle return rate to common equity holders is 8%, your cost of equity is 8%. In terms of targeted project-level returns, you would want to exceed 8% unlevered IRR in order for your investor's equity capital to be accretive to your returns as a sponsor. In other words, if your waterfall allowed you as sponsor to receive a promote above an 8% unlevered return, and your deal returned 7%, both you and your investor would receive 7% (since you would not have entered the waterfall tier which allowed you to receive your promote / carried interest / disproportionate cash flow split). However, if you received a project-level 10%, and you were to receive a promote when clearing the 8% hurdle, that is when you (sponsor) would receive diverging returns from your investors. In concept, this is accretive equity leverage.
The same concept applies to debt being accretive; however, instead you pay a interest rate instead of sharing excess cash flows.
Just keep increasing LTV in your model until you go bankrupt
Just think of it in terms of trying to measure two different loan sizes with two different rates, and how you could compare them.
For example let's say you got a term sheet from Lender A offering $40M at a rate of 8%, and another term sheet from Lender B for $50M at a rate of 9%, well the question is how much is that extra $10M of proceeds costing you? So $40M x 8% = $3.2M annually, and $50M x 9% = $4.5M annually. So if you take $4.5M-$3.2M, you are paying $1.3M more a year for that extra $10M of proceeds, or say differently $1.3M/$10M = 13% cost for that incremental capital of $10M.
Now you can use that $10M at 13% to compare to other types of capital, for example, if you could find a mezz lender who would give you that $10M at 10% then it's better to do the $40M loan from Lender A + that Mezz lender, or if the Mezz lender was 15% then Lender B would be a better option, and can compare that $10M at 13% to equity, etc.
Once you get that concept, then you can start comparing that to your target yield, risks associated, etc. but that's a good starting point to get the concept before you start bring in equity so you get how to shift those dollars around.
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