1. Why Use Debt
So we want to shift gears now within the capital stock and transition
from a discussion of equity over to debt and in particular,
why would we use debt? Well, usually the reason that it's used is
because it allows us to increase the equity returns.
So let's now bring in a capital stack on the one side here,
and then imagine at some point in the future that that company has
grown to be larger here on the right hand side. Well,
you can see the difference in the height of the capital stack or
the size of the enterprise is actually not that much larger on the
right hand side in that future state. But now, if we focus our
attention to the equity in navy blue, we can see that there's been
substantial growth in the equity over that three to five year period.
In fact, we're showing here an internal rate of return or an IRR
over that period of 28%. So this is actually showing us the type
of time frame of three to five years and the type of return
of 28% that a private equity fund may be interested in achieving.
And the reason that it achieved this high rate of return was because
it used debt in the capital structure to leverage the investment.
2. Let's practice!