LBO MODEL EXAM QUESTIONS AND ANSWERS WITH
COMPLETE SOLUTIONS GRADED A++
Walk me through a basic LBO model.
"In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity
ratio, Interest Rate on Debt and other variables; you might also assume something
about
the company's operations, such as Revenue Growth or Margins, depending on how
much information you have.
Step 2 is to create a Sources & Uses section, which shows how you finance the
transaction and what you use the capital for; this also tells you how much Investor
Equity is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures,
and
also add in Goodwill & Other Intangibles on the Assets side to make everything
balance.
In Step 4, you project out the company's Income Statement, Balance Sheet and Cash
Flow Statement, and determine how much debt is paid off each year, based on the
available Cash Flow and the required Interest Payments.
Finally, in Step 5, you make assumptions about the exit after several years, usually
assuming an EBITDA Exit Multiple, and calculate the return based on how much equity
is returned to the firm."
,Why would you use leverage when buying a company?
To increase your returns.
Remember, any debt you use in an LBO is not "your money" - so if you're paying $5
billion for a company, it's easier to earn a high return on $2 billion of your own money
and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion
of borrowed money.
A secondary benefit is that the firm also has more capital available to purchase other
companies because they've used leverage.
What variables impact an LBO model the most?
Purchase and exit multiples have the biggest impact on the returns of a model. After
that, the amount of leverage (debt) used also has a significant impact, followed by
operational characteristics such as revenue growth and EBITDA margins.
How do you pick purchase multiples and exit multiples in an LBO model?
The same way you do it anywhere else: you look at what comparable companies are
trading at, and what multiples similar LBO transactions have had. As always, you also
show a range of purchase and exit multiples using sensitivity tables.
Sometimes you set purchase and exit multiples based on a specific IRR target that
you're
trying to achieve - but this is just for valuation purposes if you're using an LBO model
to value the company.
What is an "ideal" candidate for an LBO?
"Ideal" candidates have stable and predictable cash flows, low-risk businesses, not
much need for ongoing investments such as Capital Expenditures, as well as an
, opportunity for expense reductions to boost their margins. A strong management team
also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
How do you use an LBO model to value a company, and why do we sometimes
say
that it sets the "floor valuation" for the company?
You use it to value a company by setting a targeted IRR (for example, 25%) and then
back-solving in Excel to determine what purchase price the PE firm could pay to
achieve
that IRR.
This is sometimes called a "floor valuation" because PE firms almost always pay less
for
a company than strategic acquirers would.
Can you explain how the Balance Sheet is adjusted in an LBO model?
First, the Liabilities & Equities side is adjusted - the new debt is added on, and the
Shareholders' Equity is "wiped out" and replaced by however much equity the private
equity firm is contributing.
On the Assets side, Cash is adjusted for any cash used to finance the transaction, and
then Goodwill & Other Intangibles are used as a "plug" to make the Balance Sheet
balance.
Depending on the transaction, there could be other effects as well - such as capitalized
financing fees added to the Assets side.
Give an example of a "real-life" LBO.
COMPLETE SOLUTIONS GRADED A++
Walk me through a basic LBO model.
"In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity
ratio, Interest Rate on Debt and other variables; you might also assume something
about
the company's operations, such as Revenue Growth or Margins, depending on how
much information you have.
Step 2 is to create a Sources & Uses section, which shows how you finance the
transaction and what you use the capital for; this also tells you how much Investor
Equity is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures,
and
also add in Goodwill & Other Intangibles on the Assets side to make everything
balance.
In Step 4, you project out the company's Income Statement, Balance Sheet and Cash
Flow Statement, and determine how much debt is paid off each year, based on the
available Cash Flow and the required Interest Payments.
Finally, in Step 5, you make assumptions about the exit after several years, usually
assuming an EBITDA Exit Multiple, and calculate the return based on how much equity
is returned to the firm."
,Why would you use leverage when buying a company?
To increase your returns.
Remember, any debt you use in an LBO is not "your money" - so if you're paying $5
billion for a company, it's easier to earn a high return on $2 billion of your own money
and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion
of borrowed money.
A secondary benefit is that the firm also has more capital available to purchase other
companies because they've used leverage.
What variables impact an LBO model the most?
Purchase and exit multiples have the biggest impact on the returns of a model. After
that, the amount of leverage (debt) used also has a significant impact, followed by
operational characteristics such as revenue growth and EBITDA margins.
How do you pick purchase multiples and exit multiples in an LBO model?
The same way you do it anywhere else: you look at what comparable companies are
trading at, and what multiples similar LBO transactions have had. As always, you also
show a range of purchase and exit multiples using sensitivity tables.
Sometimes you set purchase and exit multiples based on a specific IRR target that
you're
trying to achieve - but this is just for valuation purposes if you're using an LBO model
to value the company.
What is an "ideal" candidate for an LBO?
"Ideal" candidates have stable and predictable cash flows, low-risk businesses, not
much need for ongoing investments such as Capital Expenditures, as well as an
, opportunity for expense reductions to boost their margins. A strong management team
also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
How do you use an LBO model to value a company, and why do we sometimes
say
that it sets the "floor valuation" for the company?
You use it to value a company by setting a targeted IRR (for example, 25%) and then
back-solving in Excel to determine what purchase price the PE firm could pay to
achieve
that IRR.
This is sometimes called a "floor valuation" because PE firms almost always pay less
for
a company than strategic acquirers would.
Can you explain how the Balance Sheet is adjusted in an LBO model?
First, the Liabilities & Equities side is adjusted - the new debt is added on, and the
Shareholders' Equity is "wiped out" and replaced by however much equity the private
equity firm is contributing.
On the Assets side, Cash is adjusted for any cash used to finance the transaction, and
then Goodwill & Other Intangibles are used as a "plug" to make the Balance Sheet
balance.
Depending on the transaction, there could be other effects as well - such as capitalized
financing fees added to the Assets side.
Give an example of a "real-life" LBO.
