What is the breakeven return needed in an LBO scenario if the cost of debt is 10% with a tax rate of 40%?

In a leveraged buyout (LBO) scenario, calculating the breakeven return involves understanding the cost of debt and the impact of taxes. The breakeven return is essentially the return that must be generated from the investment to cover the costs associated with debt financing and taxes.

Given that the cost of debt is 10%, this rate reflects the interest the company must pay on its borrowed funds. However, because interest payments are tax-deductible, the effective cost of debt is reduced by the tax shield provided by the interest expense. The formula for the after-tax cost of debt is:

After-tax cost of debt = Cost of debt × (1 - Tax rate)

In this scenario, substituting the values gives:

After-tax cost of debt = 10% × (1 - 0.40) = 10% × 0.60 = 6%

This 6% represents the effective cost of debt that the firm will need to ensure it can cover through its returns. As a result, in order for the LBO scenario to break even (meaning the firm covers its cost of debt after accounting for tax considerations), the return on equity must equal or exceed the effective after-tax cost of debt. This establishes the breake