LBO MODELS EXAM ACTUAL QUESTIONS AND ANSWERS
WITH COMPLETE SOLUTIONS VERIFIED 2024/2025
Leveraged buyout
Leveraged buyout is like buying a hose to rent out to other people.
Ie; You want to buy your first property, a home for 500,000. You want to operate it for a
few years, and then sell it for a higher value in the future.
You have a lot of money but also have a high-paying job so there are two ways to buy
the house:
1. Pay 100% cash, ie; 500,000 in cash upfront.
2. Pay for it with 30% cash (150,000) as the down payment and take out a mortgage for
the rest (350,000). The mortgage has an interest rate of 5% and you'll need to repay the
principal evenly over 40 years.
Looks like 1 may be better, but you will also earn income from this property and you can
use that income to pay the interest on the debt and repay the debt itself.
So the real question is: Are you better off paying less in cash upfront and using the
property's income to pay off interest and debt principle, or better off paying more in cash
, upfront and keeping all of that income for yourself?
In example 1 we get 1.5x our money back over 5 years and end up with a 9% IRR. We
would have to have invested 500k and earned 9% interest compound annually to
achieve the same result otherwise. Not bad.
Now consider example 2 using only 30% cash used: 1.9x returns with an IRR of 15%
because we paid only 150k in cash rather than 500k.
The returns go up significantly because reducing the amount of cash you pay up front
for an asset has a disproportionate effect on your returns since money today is worth
more than money tomorrow.
PE firms buy a company using a combination of debt and equity (cash) and then they
sell it 3-5 years into the future to realize a return. The PE firm uses the company's cash
flows to pay off interest and debt principal.
Why does an LBO work?
1. By using debt, you reduce the up-front cash payment for the company, which boosts
returns.
2. Using the company's cash flows to repay debt principal and pay interest also
produces a better return than keeping the cash flow.
3. You sell the company in the future, which allows you to gain back the majority of the
funds you spent to acquire it in the first place.
WITH COMPLETE SOLUTIONS VERIFIED 2024/2025
Leveraged buyout
Leveraged buyout is like buying a hose to rent out to other people.
Ie; You want to buy your first property, a home for 500,000. You want to operate it for a
few years, and then sell it for a higher value in the future.
You have a lot of money but also have a high-paying job so there are two ways to buy
the house:
1. Pay 100% cash, ie; 500,000 in cash upfront.
2. Pay for it with 30% cash (150,000) as the down payment and take out a mortgage for
the rest (350,000). The mortgage has an interest rate of 5% and you'll need to repay the
principal evenly over 40 years.
Looks like 1 may be better, but you will also earn income from this property and you can
use that income to pay the interest on the debt and repay the debt itself.
So the real question is: Are you better off paying less in cash upfront and using the
property's income to pay off interest and debt principle, or better off paying more in cash
, upfront and keeping all of that income for yourself?
In example 1 we get 1.5x our money back over 5 years and end up with a 9% IRR. We
would have to have invested 500k and earned 9% interest compound annually to
achieve the same result otherwise. Not bad.
Now consider example 2 using only 30% cash used: 1.9x returns with an IRR of 15%
because we paid only 150k in cash rather than 500k.
The returns go up significantly because reducing the amount of cash you pay up front
for an asset has a disproportionate effect on your returns since money today is worth
more than money tomorrow.
PE firms buy a company using a combination of debt and equity (cash) and then they
sell it 3-5 years into the future to realize a return. The PE firm uses the company's cash
flows to pay off interest and debt principal.
Why does an LBO work?
1. By using debt, you reduce the up-front cash payment for the company, which boosts
returns.
2. Using the company's cash flows to repay debt principal and pay interest also
produces a better return than keeping the cash flow.
3. You sell the company in the future, which allows you to gain back the majority of the
funds you spent to acquire it in the first place.
