LBO MODELING EXAM QUESTIONS AND
CORRECT ANSWER
LATEST UPDATE
Unlike a merger model, you do not assume that the PE firm keeps the company
for
. If it did that, then you would not realize super high returns - CORRECT
ANSWER the long term
The Mechanics of an LBO -- Step 1 - CORRECT ANSWER PE firm calculates
how much it will cost to acquire all of the shares outstanding (public comp) or
simply buy the company (private comp)
The Mechanics of an LBO -- Step 2 - CORRECT ANSWER To raise the funds,
the PE firm will use a small amount of cash on-hand (usually less than 50% of
the company's total value) and then raise debt from investors to pay the rest
The Mechanics of an LBO -- Step 3 - CORRECT ANSWER It can raise debt
from investors bc they can say, "we're using debt to buy an income generating
asset. and we'll repay everything because "we will sell this company in the
future and use the proceeds to pay you back"
Page 1 of 107
,The Mechanics of an LBO -- Step 4 - CORRECT ANSWER PE firm raises debt
from investors, and then it combines that cash with its own cash to acquire the
company
The Mechanics of an LBO -- Step 5 - CORRECT ANSWER PE firm operates
the company for years into the future, and uses its cash flow to pay the interest
and repay the debt that it borrowed The Mechanics of an LBO -- Step 6 -
CORRECT ANSWER At the end of 3-5 years, the PE firm sells the company or
takes it public via an IPO in order to realize a return
Walk me through an LBO - CORRECT ANSWER Step 1, Purchase Price, Debt
and Equity,
Interest Rate on Debt, and other variables such as the company's revenue
growth and margins. Step 2, you create a Sources & Uses schedule to show how
much Investor Equity the PE firm contributes and how items like the transaction
fees and the company's Cash balance affect this contribution.
Step 3, you project the company's Income Statement and its partial Cash Flow
Statement down to Free Cash Flow. Step 4, you use the Free Cash Flow,
Beginning Cash, and Minimum Cash to determine how much Debt principal the
company repays each year. You then link the Interest Expense on this changing
Debt balance to the Income Statement so that FCF deducts the Interest. Step 5,
you make the exit calculations, usually assuming an EBITDA Exit Multiple,
and you calculate the IRR and Money-on-Money multiple based on the
proceeds the PE firm earns at the end vs.
its Investor Equity in the beginning."
Page 2 of 107
,LBO VS DCF Intentions - CORRECT ANSWER DCF: "What could this
company be worth, based on the Present Value of its future cash flows over the
next 5, 10, or 20 years?" • LBO: "What's the maximum we could pay for this
company if we want to achieve an IRR of 20% or 25% over 5 years?"
How A PE firm can boost returns in LBO - CORRECT ANSWER Reduce
purchase multiple Increase revenue growth by cutting expenses
Use more leverage
Do debt paydown
what intuitivley is sellers yield - CORRECT ANSWER Sellers yield is same as
cost of
equity
(E/P or net income/equity value)
This is why if its all stock you can just compare pe ratios because weight cost of
acuisition is just cost of equity
Sellers yield is the yield gained by the aquirer after the merger
The 3 key reasons that an LBO works - CORRECT ANSWER 1. By using debt,
you reduce upfront cash payment for the company, which increases your returns
2. Using the company's cash flows to pay interest and repay debt principal
produces a better return than keeping the cash flow
Page 3 of 107
, 3. You sell the company in the future, which allows you to gain back the
majority of the funds used to acquire the company in the first place
What makes a good LBO candidate? - CORRECT ANSWER - stable and
predictable cash flows - undervalued relative to peers in the industry
- low risk business
- not much need for ongoing investments such as CapEx
- Has an opportunity to cut costs and increase margins
- has a strong management team
- solid base of assets to use as collateral for debt
the first point is the most important -- its why LBOs rarely happen in oil &
gas/other
commodities industries ... the price of commodities is volatile and can push cash
flows up or down from year to year
How much cash do we have to repay debt each year after we have already paid
operating expenses and interest expense
Can all types of debt be repaid early ? - CORRECT ANSWER No - bank debt
can, but high yield debt cannot
Page 4 of 107
CORRECT ANSWER
LATEST UPDATE
Unlike a merger model, you do not assume that the PE firm keeps the company
for
. If it did that, then you would not realize super high returns - CORRECT
ANSWER the long term
The Mechanics of an LBO -- Step 1 - CORRECT ANSWER PE firm calculates
how much it will cost to acquire all of the shares outstanding (public comp) or
simply buy the company (private comp)
The Mechanics of an LBO -- Step 2 - CORRECT ANSWER To raise the funds,
the PE firm will use a small amount of cash on-hand (usually less than 50% of
the company's total value) and then raise debt from investors to pay the rest
The Mechanics of an LBO -- Step 3 - CORRECT ANSWER It can raise debt
from investors bc they can say, "we're using debt to buy an income generating
asset. and we'll repay everything because "we will sell this company in the
future and use the proceeds to pay you back"
Page 1 of 107
,The Mechanics of an LBO -- Step 4 - CORRECT ANSWER PE firm raises debt
from investors, and then it combines that cash with its own cash to acquire the
company
The Mechanics of an LBO -- Step 5 - CORRECT ANSWER PE firm operates
the company for years into the future, and uses its cash flow to pay the interest
and repay the debt that it borrowed The Mechanics of an LBO -- Step 6 -
CORRECT ANSWER At the end of 3-5 years, the PE firm sells the company or
takes it public via an IPO in order to realize a return
Walk me through an LBO - CORRECT ANSWER Step 1, Purchase Price, Debt
and Equity,
Interest Rate on Debt, and other variables such as the company's revenue
growth and margins. Step 2, you create a Sources & Uses schedule to show how
much Investor Equity the PE firm contributes and how items like the transaction
fees and the company's Cash balance affect this contribution.
Step 3, you project the company's Income Statement and its partial Cash Flow
Statement down to Free Cash Flow. Step 4, you use the Free Cash Flow,
Beginning Cash, and Minimum Cash to determine how much Debt principal the
company repays each year. You then link the Interest Expense on this changing
Debt balance to the Income Statement so that FCF deducts the Interest. Step 5,
you make the exit calculations, usually assuming an EBITDA Exit Multiple,
and you calculate the IRR and Money-on-Money multiple based on the
proceeds the PE firm earns at the end vs.
its Investor Equity in the beginning."
Page 2 of 107
,LBO VS DCF Intentions - CORRECT ANSWER DCF: "What could this
company be worth, based on the Present Value of its future cash flows over the
next 5, 10, or 20 years?" • LBO: "What's the maximum we could pay for this
company if we want to achieve an IRR of 20% or 25% over 5 years?"
How A PE firm can boost returns in LBO - CORRECT ANSWER Reduce
purchase multiple Increase revenue growth by cutting expenses
Use more leverage
Do debt paydown
what intuitivley is sellers yield - CORRECT ANSWER Sellers yield is same as
cost of
equity
(E/P or net income/equity value)
This is why if its all stock you can just compare pe ratios because weight cost of
acuisition is just cost of equity
Sellers yield is the yield gained by the aquirer after the merger
The 3 key reasons that an LBO works - CORRECT ANSWER 1. By using debt,
you reduce upfront cash payment for the company, which increases your returns
2. Using the company's cash flows to pay interest and repay debt principal
produces a better return than keeping the cash flow
Page 3 of 107
, 3. You sell the company in the future, which allows you to gain back the
majority of the funds used to acquire the company in the first place
What makes a good LBO candidate? - CORRECT ANSWER - stable and
predictable cash flows - undervalued relative to peers in the industry
- low risk business
- not much need for ongoing investments such as CapEx
- Has an opportunity to cut costs and increase margins
- has a strong management team
- solid base of assets to use as collateral for debt
the first point is the most important -- its why LBOs rarely happen in oil &
gas/other
commodities industries ... the price of commodities is volatile and can push cash
flows up or down from year to year
How much cash do we have to repay debt each year after we have already paid
operating expenses and interest expense
Can all types of debt be repaid early ? - CORRECT ANSWER No - bank debt
can, but high yield debt cannot
Page 4 of 107
