Technical interview q
This was given at a PE interview. If you have an IRR of 20% in an LBO and 20% WACC in DCF, which valution method gives you the highest value?
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Tricky. I am not sure here but think the WACC one would produce higher value. WACC here implied a blended cost of capital to both debt, equity holders and is 20%. In the case of a LBO, IRR implies the cost of just equity, which is ~20% and if you combine that with debt - regardless of the interest and % of debt used - it'll come out to greater than 20%, not least because in LBOs the company's generally tend to be levered to the core capacity. As a result, the firm value under LBO would be lower because of a higher overall discount rate than the one used for WACC.
I don’t think IRR necessarily implies cost of equity
IRR just means discount rate needed to make NPV = 0
my guess is this is a trick question and they both produce the same value
if WACC = IRR, then the discount rate would be the IRR and you’d be using the same R throughout and therefore get the same value
could be wrong though
It is the expected return for equity holders though, no? So I think it would make sense to use it as a proxy for the cost of equity.
I was think that as well at first. But, remember than in a DCF, you are discounting unlevered cash flows to get to EV. If we by LBO IRR are referring to the IRR to the sponsor (i.e. equity holder), this levered IRR should be higher than the WACC as equity investors will require a higher return to compensate for risk added by the debt to their cash flows. As such, the "WACC" in the LBO should be lower and thus LBO should give higher value IMO. Am I wrong?
best way to do this is to just build a quick model
but I mean it wouldn’t matter either way. cuz if you value a firm using cost of equity you’re valuing the equity, and it should theoretically give you the same as if you used WACC and just subtracted the net debt
Lob would give a higher valuation unless you use a) 0 debt in the LBO model b) your debt package has an average cost >20% and both scenarios are so unlikely that they are almost purely theoretical.
In the LBO model your cost of equity is 20% and your blended cost of debt should be single digits so your WACC in LBO scenario should always come out as less than 20%. As the WACC is lower in the LBO model the valuation is higher (the lower the discount rate the higher the valuation).
Highly theoretical question that doesn't make you a bad investor if you get it wrong.
Agree with the above. WACC of 20% implies cost of equity > 20% in a levered scenario. If you discount equity cashflows at a discount rate > 20%, your present value of equity will be lower compared to that discounted at 20%.
How would the time value of money apply here though? DCF you are seeing cash throughout the period, LBO you see it only at the end
Agree that LBO generates a higher valuation. Maybe we can start out first by defining what the IRR on an LBO refers to - it is the rate of return on an equity position and not a debt position. If the IRR is already 20%, then the less risky debt position can arguably be said to be less than 20%. Therefore we might say that the company's WACC is less than 20% and has a higher valuation.
But I am confused. I can understand IRR>WACC in this case. But why LBO has a higher valuation? I mean LBO (use IRR) and DCF (use WACC). Given the inverse correlation between discount rate and valuation, LBO should have a lower valuation.
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