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anonymous

  • 5 years ago

Hi Aswath, one quick question: In the case of an extrme LBO, if a company has 100% debt, what is the ROE?

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  1. anonymous
    • 5 years ago
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    My guess would be (ROCE - (Total Debt x Cost of debt(1-tax rate))).

  2. anonymous
    • 5 years ago
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    but then in % terms it would be infinite % profit (coz of division by zero.) so return would only be defined in $ terms

  3. anonymous
    • 5 years ago
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    OK, I see this equation in Tim Koller's (McKinsey & Co) Valuation book, Chapter 7: ROE=ROIC + [ROIC-(1-T)K]D/E where K is cost of debt and T is tax rate. When E is zero, D/E will be infinity. Hence the right hand side will be infinity. Basically, even if ROIC is negative, ROE will be infinity. What gives? Professor, can you help explain this?

  4. anonymous
    • 5 years ago
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    Correction: If ROIC is negative, then right hand side will be negative infinity. Ok, I think, I get it.

  5. anonymous
    • 5 years ago
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    Can you really have a number for the ROE when there is no equity? Return on equity is a number that tells you how much equity holders get in earnings for every equity dollar invested. If there is no equity, how could there be a meaningful number for the return on equity?

  6. anonymous
    • 5 years ago
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    Your question has a fundamental flaw. The purpose of equity is to bear the residual risk. If there is no one to bear the residual risk, how can debt get a guaranteed payment. Who is guaranteeing the payment to them? In other words, debt ratios can be high and approach 100% but not be 100%.

  7. anonymous
    • 5 years ago
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    Great point professor. You have rightly exposed the flaw in the business model of some house-flippers. During the recent housing boom, some house flippers got 95% loan from the bank and 5% from friends and relatives. Thay had put in zero equity. Some of them made money ( infinite ROI) and many of them lost ( infinite ROI).

  8. anonymous
    • 5 years ago
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    The 5% from friends and relatives is equity.

  9. anonymous
    • 5 years ago
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    Aha ! May be it is not sweat-equity.

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