Why does leverage increase IRR?
Leveraged finance is done with the goal of increasing an investment's potential returns, assuming the investment increases in value. Private equity firms and leveraged buyout firms will employ as much leverage as possible to enhance their investment's internal rate of return or IRR.
Because debt is cheaper than equity. As a result, all else being equal, the more debt you use in a transaction, the higher your internal rate of return (“IRR”).
Investors can conduct a similar analysis to identify which funds in their portfolios contribute the most to their returns and why. For example, separating leverage components reveals which funds boost their IRR by aggressive debt funding and are therefore more exposed to changes in underlying business results.
Levered or leveraged IRR uses the cash flows when a property is financed, while unlevered or unleveraged IRR is based on an all cash purchase. Unlevered IRR is often used for calculating the IRR of a project, because an IRR that is unlevered is only affected by the operating risks of the investment.
Simply put, the use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE) and internal rate of return (IRR), assuming all goes according to plan.
On an unlevered basis, returns are lower because the upfront investment is higher. On a levered basis, the reverse is true. The upfront investment is lower and the returns are higher.
The 3 most common ways to increase IRR are: growing EBITDA, paying off debt, and increasing the exit multiple. Growing EBITDA is the most common way to increase IRR. Most PE firms plan to grow EBITDA either by increasing revenues, cutting costs, or some combination of the two.
In addition to the portion of the metric that reflects momentum in the markets or the strength of the economy, other factors—including a project's strategic positioning, its business performance, and its level of debt and leverage— also contribute to its IRR.
A company's return on equity increases at an optimum level of financial leverage because the use of leverage increases the stock volatility, increasing the level of risk which then increases the returns. Financially over-leveraged companies may face a decrease in return on equity.
Again, the reason why our outstanding initial investment decreases is because we are receiving more cash flow each year than is needed to earn the IRR for that year. This extra cash flow results in capital recovery, thus reducing the outstanding amount of capital we have remaining in the investment.
How does debt boost equity returns?
By taking on debt, a company increases its assets, thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE, in turn, gets a boost.
Impact on Return on Equity
A company's return on equity increases at an optimum level of financial leverage because the use of leverage increases the stock volatility, increasing the level of risk which then increases the returns.
IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.
A disadvantage of using the IRR method is that it does not account for the project size when comparing projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows.
