What is the effect of increasing the purchase price on IRR in an LBO?

• A. It has no effect on IRR
• B. It raises IRR significantly
• C. It lowers IRR
• D. It doubles the IRR

Answer: (C)

In a leveraged buyout (LBO), the internal rate of return (IRR) is a key measure used to evaluate the profitability of the investment. The effect of increasing the purchase price directly impacts the overall return on investment. When the purchase price increases, the initial cash outlay for the investment rises, which can reduce the IRR.

The IRR is calculated based on the cash flows received over the investment's lifecycle compared to the initial equity investment. If the purchase price goes up, while the expected cash inflows remain the same, the percentage return on that higher investment decreases, leading to a lower IRR.

Additionally, a higher purchase price often results in a higher debt burden if the acquisition is still financed through leverage. The increased interest expenses can further reduce the net cash flows that contribute to the IRR calculation, compounding the effect of a higher purchase price.

Thus, the conclusion is that increasing the purchase price in an LBO scenario leads to a lower IRR, as the investment's cost increases while cash flows do not necessarily escalate proportionately, making option C the correct choice.