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Given a choice between a company B with almost no leverage and company A with a high leverage, all else being equal which company is more attractive for the PE company to buy and why?
Intuitively, the first answer that pops into the head is buy the company with low leverage as we can add debt to make a profit as the cost of debt is lower than that of cost of equity. However, to buy any company investors need to pay a premium on the value of equity which makes a significant difference to the purchase price of the company. Let’s work with a case study to drive the point home.
To buy any company the investor needs to pay a premium, Let’s assume a 30% premium which is customarily the real-life average of what investors pay.
Assuming two companies are for sale – all else being equal the only difference between the two are the capital structures. Company A is on sale with an EV of £100m - £80m of debt and £20m of equity. Company B is on sale also with an EV of £100m but has £20m of debt and £80m of equity. The equity investors are likely going to want a premium of 30%. This translates into a tag price of £106m for company A (£80m Debt + £26m (£20m*1.3)) versus a tag price of £124m for company B (£20m of debt and £104m of Equity (£80m*1.3).
Therefore, investors would chase company A - Kapish?
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