Module IV· InterestAdvanced
Question
How does the interest deductibility limit (~30% of EBITDA) actually affect LBO cash flow?
Answer
Mechanics
Interest deduction is capped at 30% of tax EBITDA (once net interest exceeds a de-minimis threshold, e.g. ~$3m). Any excess expense is carried forward as an interest carryforward.
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Example
A company with EBITDA $50m and gross interest of $22m.
| Item | Value |
|---|---|
| Tax EBITDA | $50.0m |
| Interest-deduction limit (30%) | $15.0m |
| Gross interest | $22.0m |
| Immediately deductible | $15.0m |
| Interest carryforward (not deductible this year) | $7.0m |
| Tax shield at a 30% corporate rate | 15 × 30% = $4.5m |
| "Without the limit" tax shield | 22 × 30% = $6.6m |
| Cash lost to the limit | $2.1m cash p.a. |
Impact in the LBO
- The limit bites at aggressive leverage (>4x EBITDA almost always)
- The interest carryforward accumulates over time and can be used later as EBITDA grows
- Change-of-ownership rules (that restrict loss/interest carryforwards) can wipe out the carryforward at exit
Common pitfalls
- Naive modeling: 30% × interest = tax shield (ignores the limit)
- Correct modeling: test the limit each year and carry the excess forward
Pitch tip
Question: "What would your interest-carryforward effect be after 5 years?"
Answer: "At a steady $7m non-deductible p.a. you build a $35m interest carryforward, which can be used again as you de-lever and EBITDA grows in years 4-5. In effect the tax shield is only deferred, not lost — as long as the change-of-ownership rules don't bite"