Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes.

Sometimes in LBO models, increasing the leverage increases the IRR up to a certain point – but then after that the IRR starts falling as the interest payments or principal repayments become “too big.” 

For this scenario to happen you would need a “perfect storm” of:

1. Relative lack of cash flow / EBITDA growth.

2. High interest payments and principal repayments relative to cash flow.

3. Relatively high purchase premium or purchase multiple to make it more difficult to get a high IRR in the first place.