LBO Math and Accretion/Dilution

A leveraged buyout funds an acquisition predominantly with debt, so the sponsor's return depends on EBITDA growth, the exit multiple, and how much debt is repaid; returns are reported as an internal rate of return and a multiple of invested capital ^[1][2]. In a strategic merger, accretion/dilution asks whether the buyer's earnings per share rise or fall: in an all-stock deal, EPS rises when the target's P/E is below the buyer's ^[5]. In a cash deal, the test is whether the target's earnings yield exceeds the after-tax cost of the money used — and neither test says whether the deal creates value.

What a leveraged buyout is

When a firm is acquired by its own management or a group of investors and becomes a private business, the deal is called a management buyout if managers are involved and a leveraged buyout if the funds come predominantly from debt ^[1]. Damodaran notes that the debt in most leveraged buyouts exceeds the firm's optimal debt ratio, so some debt has to be paid off quickly to reduce the cost of capital and default risk ^[1]. Because leverage falls over time, he values an LBO by discounting free cash flow to the firm at a cost of capital that changes from year to year rather than a single fixed rate ^[1].

Sources and uses

Every deal starts with a two-column table: where the money comes from and where it goes. The two columns must total the same amount. Leverage is quoted as a multiple of EBITDA — total debt divided by EBITDA — because EBITDA approximates the cash available to service debt.

• Target: $50M of EBITDA, bought at 10.0x = $500M enterprise value (cash-free, debt-free). Fees and expenses: $15M.
• Uses: purchase of enterprise $500M + fees $15M = $515M.
• Sources: senior term loan 4.0x × $50M = $200M; subordinated notes 1.5x × $50M = $75M; sponsor equity = $515M − $275M = $240M.
• Total leverage = $275M ÷ $50M = 5.5x; equity is $240M ÷ $515M ≈ 47% of total sources.

Debt also changes the tax picture. U.S. law caps the deduction for business interest at the sum of business interest income, 30 percent of adjusted taxable income, and floor plan financing interest; disallowed interest carries forward to the next year ^[3]. Adjusted taxable income is computed without deductions for depreciation, amortization, or depletion, among other adjustments ^[3]. In the example, if the term loan costs 8% and the notes 11%, interest is $200M × 8% + $75M × 11% = $16M + $8.25M = $24.25M. Treating adjusted taxable income as roughly the $50M of EBITDA, the cap is about 30% × $50M = $15M, so roughly $9.25M of interest would not be deductible that year — the tax shield is smaller than a simple WACC suggests.

The bank regulatory backdrop also shifted. On December 5, 2025, the OCC and the FDIC rescinded the 2013 Interagency Guidance on Leveraged Lending and its 2014 FAQs, telling banks to manage leveraged lending under general principles for safe and sound lending instead ^[4].

Measuring the return: MOIC and IRR

The CFA Institute's GIPS standards define the investment multiple (TVPI) as total value divided by since-inception paid-in capital, where total value is residual value plus distributions ^[2]. Deal teams usually call this MOIC (multiple on invested capital). GIPS defines a money-weighted return as one that reflects the change in value and the timing and size of external cash flows ^[2]; the internal rate of return — the discount rate at which the present value of all the investor's cash flows nets to zero — is the standard way to compute one. MOIC ignores time; IRR rewards speed.

• Exit after 5 years: EBITDA grows from $50M to $70M; exit at the same 10.0x → EV = $700M.
• Debt paydown: free cash flow repays $125M, so debt falls from $275M to $150M.
• Exit equity = $700M − $150M = $550M.
• MOIC = $550M ÷ $240M = 2.29x.
• IRR (single entry and exit cash flow) = 2.2917^(1/5) − 1 ≈ 18.0%.
• Return attribution: EBITDA growth adds $20M × 10.0 = $200M; debt paydown adds $125M; multiple change adds $0; fees cost $15M. $200M + $125M − $15M = $310M = $550M − $240M. ✓
• Sensitivity: exit at 9.0x instead and EV = $630M, equity = $480M, MOIC = 2.0x, IRR = 2.0^(1/5) − 1 ≈ 14.9%.

Accretion and dilution in strategic deals

Earnings per share is net income divided by the number of outstanding shares ^[7]. Damodaran defines an accretive acquisition as one where the acquirer's EPS increases after the deal and a dilutive acquisition as one where it decreases ^[5]. In an all-stock deal, accretion requires buying a company with a lower price-earnings ratio than the acquirer: a buyer at 30x acquiring a target at 20x sees EPS rise, while acquiring a target at 40x lowers it ^[5]. Acquirers can pay with accumulated cash, with cash raised by issuing stock, or with their own shares in a stock swap ^[1].

• Buyer: net income $200M, 100M shares, EPS $2.00, share price $40 (P/E 20). Target: net income $30M, purchase price $480M (P/E 16). Ignore synergies and fees.
• Stock deal: shares issued = $480M ÷ $40 = 12M. Pro forma EPS = ($200M + $30M) ÷ 112M = $2.054 → accretive by about 2.7%.
• Cash deal funded with debt at 6%: after-tax cost = 6% × (1 − 0.21) = 4.74%, so after-tax interest = $480M × 4.74% = $22.75M. Pro forma EPS = ($200M + $30M − $22.75M) ÷ 100M = $2.072 → accretive by about 3.6%. (The 21% is the U.S. federal corporate rate ^[6].)
• Rules of thumb: a stock deal is accretive if the target's earnings yield (here $30M ÷ $480M = 6.25%) exceeds the buyer's (1 ÷ 20 = 5.0%); a cash deal is accretive if the target's earnings yield exceeds the after-tax cost of the cash (4.74%).
• Same buyer paying $750M (P/E 25) in stock: shares issued = 18.75M; EPS = $230M ÷ 118.75M = $1.937 → dilutive by about 3.2%.

Damodaran argues the accretion test is a poor guide to value: the target presumably had a lower P/E for good reasons, such as higher risk or lower growth, so a forward-looking market should lower the combined firm's P/E, and what matters is whether the price paid exceeds the target's value ^[5]. He also notes that the stock-or-cash choice signals something — managers who think their stock is overvalued are more likely to use it as currency, and target shareholders may demand a larger premium when paid entirely in the acquirer's stock ^[1].

Key terms

Leveraged buyout (LBO)

An acquisition funded predominantly with debt, usually taking the target private.

Sources and uses

A table matching the funding raised for a deal (debt, equity) to how it is spent (purchase price, refinancing, fees).

Leverage multiple

Total debt divided by EBITDA.

MOIC / TVPI

Total value (distributions plus residual value) divided by capital invested.

Internal rate of return (IRR)

The annualized discount rate at which the present value of an investment's cash flows nets to zero.

Interest deduction limit (§163(j))

The U.S. cap on deductible business interest, generally 30% of adjusted taxable income plus business interest income and floor plan interest.

Accretive / dilutive

A deal that raises / lowers the acquirer's earnings per share.

Stock swap

Paying for a target with shares of the acquirer at an agreed exchange ratio.

Check your understanding

Sources

1. [1]Aswath Damodaran, NYU Stern School of Business, “Investment Valuation, Chapter 25: Acquisitions and Takeovers,” Accessed November 2026.
2. [2]CFA Institute, “Global Investment Performance Standards (GIPS) for Firms, 2020,” 2019 (effective January 1, 2020).
3. [3]Legal Information Institute, Cornell Law School, “26 U.S. Code § 163 - Interest,” Accessed November 2026.
4. [4]Office of the Comptroller of the Currency, “Interagency Statement on OCC and FDIC Withdrawal from the Interagency Leveraged Lending Guidance Issuances,” December 5, 2025.
5. [5]Aswath Damodaran, NYU Stern School of Business, “The Value of Synergy,” October 2005.
6. [6]Legal Information Institute, Cornell Law School, “26 U.S. Code § 11 - Tax imposed,” Accessed November 2026.
7. [7]U.S. Securities and Exchange Commission, “Beginners' Guide to Financial Statements,” February 6, 2017.

Educational content only — not legal, tax, or investment advice, or an offer to sell or a solicitation of an offer to buy any security. Rules and data are described as of November 2026 and may change. Securities offered through Umergence LLC, Member FINRA/SIPC.