LBO Model Quiz Advanced Questions and
Answers
1. A company has $200 million of debt with a 7% cash interest rate, 4% PIK interest rate,
and amortization of 12% per year. Interest is based on the beginning debt balance. What
happens in Year 1?
a. $14M cash interest and $8M PIK interest for a total of $22M interest expense on the
Income Statement
b. Add back $8M to CFO (from PIK interest) and subtract out $24M from CFF (from 12%
amortization) on the Cash Flow Statement
c. Debt is up by $8M due to PIK interest but also down by $24M due to principal
repayment so Debt is down by $16M overall - ANS-Explanation: All of the above
answer choices are correct. This question tests your knowledge of how the
various debt structures affect the financial statements. On the income statement,
there would be a total of $22M in interest expense - $14M in cash and $8M from
PIK. Since the PIK interest is a non-cash expense, we would add back the $8M in
the CFO section. Under Cash flow from Financing, we repaid $24M of debt
principal due to the 12% amortization, so CFF would decrease. On the Balance
Sheet, debt would initially increase by the $8M in PIK interest. However, we repaid
$24M in principal, so the Debt on the Balance Sheet would be reduced by $16M.
Note that we do not need the tax rate for any of this because the question doesn't
ask us for the COMPLETE set of effects in Year 1 - it's only asking which changes
here actually happen in Year 1.
2. All of the following could show up as adjustments to the Income Statement as a result of
a LBO analysis EXCEPT:
a. Cost savings
b. Additional amortization expense
c. Additional interest expense
d. Additional depreciation expense
e. False and misleading question - all of these could show up as
adjustments - ANS-Explanation: The correct answer choice is E. All of the answer
choices constitute adjustments made to the income statement during an LBO
analysis. Answer choice A would represent a decrease in annual COGS expense
, or SG&A (e.g. if the PE firm decides to cut spending or lay off employees). Answer
choice B represents not only additional amortization from newly created
Intangible Assets, but also annual amortization for Capitalized Financing Fees
(which gets created as an asset on the balance sheet). Answer choice C
represents all the cash interest (as well as PIK interest) that needs to be paid on
all the new debt issued as part of the LBO. Answer choice D represents the
write-ups to fair market value of PP&E and the additional incremental depreciation
associated with them.
3. All of the following types of debt are typically "floating-rate" instruments used to finance
an LBO EXCEPT:
a. Subordinated Notes
b. Term Loan A
c. Term Loan B
d. Revolver
e. None of the above - ANS-Explanation: The correct answer choice is A. All of the
answer
choices listed above with the exception of A are floating-rate debt instruments,
meaning that its interest rate is not fixed (e.g. 8% each year until maturity) but
rather tied to something like LIBOR (e.g. LIBOR + 3%). Both Term Loans and
Revolvers have interest rates that fluctuate, whereas subordinated notes - also
referred to as high-yield debt - have fixed interest rates that do not change over
time.
4. An LBO could be financed with 100% Term Loan A, 100% Senior Notes, OR 100% PIK
Mezzanine. All else being equal, which one produces the highest IRR?
a. 100% PIK Mezzanine
b. 100% Senior Notes
c. 100% Term Loan A - ANS-Explanation: The correct answer choice is C. The most
tempting answer might be 100% PIK Mezzanine since there would be no actual
cash interest to be paid. Since it is PIK debt, the interest would accrue to the
principal balance, so cash flow available for debt service would be the highest
since there would be no mandatory or optional debt repayments. However, we
need to keep in mind that Mezzanine debt is the highest risk form of high- yield
debt, and thus carries the highest interest expense associated with it, even if it is
not actually paid out in cash. Bank debt is the least risky form of LBO financing
and thus commands the lowest interest rates. Also, only bank debt allows for
prepayments, so even more debt could be retired earlier during the
Answers
1. A company has $200 million of debt with a 7% cash interest rate, 4% PIK interest rate,
and amortization of 12% per year. Interest is based on the beginning debt balance. What
happens in Year 1?
a. $14M cash interest and $8M PIK interest for a total of $22M interest expense on the
Income Statement
b. Add back $8M to CFO (from PIK interest) and subtract out $24M from CFF (from 12%
amortization) on the Cash Flow Statement
c. Debt is up by $8M due to PIK interest but also down by $24M due to principal
repayment so Debt is down by $16M overall - ANS-Explanation: All of the above
answer choices are correct. This question tests your knowledge of how the
various debt structures affect the financial statements. On the income statement,
there would be a total of $22M in interest expense - $14M in cash and $8M from
PIK. Since the PIK interest is a non-cash expense, we would add back the $8M in
the CFO section. Under Cash flow from Financing, we repaid $24M of debt
principal due to the 12% amortization, so CFF would decrease. On the Balance
Sheet, debt would initially increase by the $8M in PIK interest. However, we repaid
$24M in principal, so the Debt on the Balance Sheet would be reduced by $16M.
Note that we do not need the tax rate for any of this because the question doesn't
ask us for the COMPLETE set of effects in Year 1 - it's only asking which changes
here actually happen in Year 1.
2. All of the following could show up as adjustments to the Income Statement as a result of
a LBO analysis EXCEPT:
a. Cost savings
b. Additional amortization expense
c. Additional interest expense
d. Additional depreciation expense
e. False and misleading question - all of these could show up as
adjustments - ANS-Explanation: The correct answer choice is E. All of the answer
choices constitute adjustments made to the income statement during an LBO
analysis. Answer choice A would represent a decrease in annual COGS expense
, or SG&A (e.g. if the PE firm decides to cut spending or lay off employees). Answer
choice B represents not only additional amortization from newly created
Intangible Assets, but also annual amortization for Capitalized Financing Fees
(which gets created as an asset on the balance sheet). Answer choice C
represents all the cash interest (as well as PIK interest) that needs to be paid on
all the new debt issued as part of the LBO. Answer choice D represents the
write-ups to fair market value of PP&E and the additional incremental depreciation
associated with them.
3. All of the following types of debt are typically "floating-rate" instruments used to finance
an LBO EXCEPT:
a. Subordinated Notes
b. Term Loan A
c. Term Loan B
d. Revolver
e. None of the above - ANS-Explanation: The correct answer choice is A. All of the
answer
choices listed above with the exception of A are floating-rate debt instruments,
meaning that its interest rate is not fixed (e.g. 8% each year until maturity) but
rather tied to something like LIBOR (e.g. LIBOR + 3%). Both Term Loans and
Revolvers have interest rates that fluctuate, whereas subordinated notes - also
referred to as high-yield debt - have fixed interest rates that do not change over
time.
4. An LBO could be financed with 100% Term Loan A, 100% Senior Notes, OR 100% PIK
Mezzanine. All else being equal, which one produces the highest IRR?
a. 100% PIK Mezzanine
b. 100% Senior Notes
c. 100% Term Loan A - ANS-Explanation: The correct answer choice is C. The most
tempting answer might be 100% PIK Mezzanine since there would be no actual
cash interest to be paid. Since it is PIK debt, the interest would accrue to the
principal balance, so cash flow available for debt service would be the highest
since there would be no mandatory or optional debt repayments. However, we
need to keep in mind that Mezzanine debt is the highest risk form of high- yield
debt, and thus carries the highest interest expense associated with it, even if it is
not actually paid out in cash. Bank debt is the least risky form of LBO financing
and thus commands the lowest interest rates. Also, only bank debt allows for
prepayments, so even more debt could be retired earlier during the
