LBO MODELING EXAM QUESTIONS AND ANSWERS
VERIFIED GRADED A++ LATEST UPDATE
Walk me through the mechanics of building an LBO model.
1. Entry valuation
2. Sources & uses table
3. Free cash flow build
4. Exit valuation & returns
5. Sensitivity analysis
What is the purpose of the "sources & uses" section of an LBO?
Outlines the amount of capital required to complete the transaction and how the
proposed deal will be funded.
From the private equity firms perspective, the key component being quantified is the
amount of equity required to be contributed.
How would you measure the credit health of a pre-LBO target company?
Leverage ratios and interest coverage ratios.
- The leverage ratio parameters will depend on the industry and the lending
environment. The leverage ratio typically ranges between 5.0x - 7.0x, with senior debt
ratio around 3.0x
, - For interest coverage ratio parameters, as a general rule of thumb: the higher the
interest coverage ratio, the better. The interest coverage ratio should be at least 2.0x in
the first year post-buyout.
Why is an LBO analysis often referred to as a "floor valuation"?
This is due to the risks associated with leverage and relatively short investment
horizons, as well as the return expectations from the funds LPs. These hurdle rates are
usually higher than the cost of equity capital on the same business without those LBO-
specific risks. Thus, the present value implied, given those higher hurdle rates, will be
lower than the valuation of the company when analyzed through the traditional DCF and
comps approaches.
An LBO is called a "floor valuation" because it's used to determine the maximum a
financial sponsor can pay for a company, allowing them to achieve the fund's minimum
IRR threshold.
When analyzing the viability of undertaking an LBO, how do PE firms estimate the
company's value in the exit year?
The most common approach is to assume that the PE firm will exit at the same
EV/EBITDA multiple at which the target company was acquired.
If you had to choose two variables to sensitize in an LBO model, which ones
would you pick?
Entry and exit multiples. No other variables have the same level of impact on the returns
in an LBO.
VERIFIED GRADED A++ LATEST UPDATE
Walk me through the mechanics of building an LBO model.
1. Entry valuation
2. Sources & uses table
3. Free cash flow build
4. Exit valuation & returns
5. Sensitivity analysis
What is the purpose of the "sources & uses" section of an LBO?
Outlines the amount of capital required to complete the transaction and how the
proposed deal will be funded.
From the private equity firms perspective, the key component being quantified is the
amount of equity required to be contributed.
How would you measure the credit health of a pre-LBO target company?
Leverage ratios and interest coverage ratios.
- The leverage ratio parameters will depend on the industry and the lending
environment. The leverage ratio typically ranges between 5.0x - 7.0x, with senior debt
ratio around 3.0x
, - For interest coverage ratio parameters, as a general rule of thumb: the higher the
interest coverage ratio, the better. The interest coverage ratio should be at least 2.0x in
the first year post-buyout.
Why is an LBO analysis often referred to as a "floor valuation"?
This is due to the risks associated with leverage and relatively short investment
horizons, as well as the return expectations from the funds LPs. These hurdle rates are
usually higher than the cost of equity capital on the same business without those LBO-
specific risks. Thus, the present value implied, given those higher hurdle rates, will be
lower than the valuation of the company when analyzed through the traditional DCF and
comps approaches.
An LBO is called a "floor valuation" because it's used to determine the maximum a
financial sponsor can pay for a company, allowing them to achieve the fund's minimum
IRR threshold.
When analyzing the viability of undertaking an LBO, how do PE firms estimate the
company's value in the exit year?
The most common approach is to assume that the PE firm will exit at the same
EV/EBITDA multiple at which the target company was acquired.
If you had to choose two variables to sensitize in an LBO model, which ones
would you pick?
Entry and exit multiples. No other variables have the same level of impact on the returns
in an LBO.
