LBO Model Quiz Basic
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1. Which of the following state- Explanation: Statements A, B, and D are all true. By using little of
ments below are TRUE re- its own cash and borrowing heavily to purchase the company,
garding why an LBO works the PE fund significantly boosts its returns for the simple reason
conceptually? that money today is worth more than money tomorrow due to the
interest that it could earn. In an LBO, the PE fund uses the cash
a. By using debt, the PE flows of the company it acquires to pay debt principal and debt
firm reduces up-front cash interest, which is a much better use of those funds than keeping
required, thereby boosting the money for itself, again boosting returns. The other reason
returns LBOs work in practice and earn such high returns is because the
PE fund only operates the company for 3 to 5 years before it
b. Using cash flows produced
sells it off and regains its money plus profit; if the PE fund were
by the company to pay down
to keep the companies it purchased indefinitely, it would not be
debt and make interest pay-
possible to earn the returns that PE funds seek. C is incorrect
ments produces a better re-
because there's no "guarantee" that the PE fund will get back
turn for the PE firm than sim-
100% of its original capital - if the company's EBITDA declines or
ply keeping the cash flows
if the exit multiple declines significantly, for example, that may
not happen.
c. Since the PE firm sells the
entire company in the future,
it's guaranteed to at least get
back 100% of its original cap-
ital
d. The PE firm sells the com-
pany in the future, which al-
lows it to get back (at least
some of) the funds that it
used to acquire the company
in the first place
2. What's the best analogy to Explanation: B is correct because that is exactly what happens in
use when thinking of how a an
, LBO Model Quiz Basic
Study online at https://quizlet.com/_3k093v
leveraged buyout works? LBO - you buy a company that generates cash flows, you use
the cash flows to repay debt, and then sell it off at the end of
a. A homeowner buys a several years. A is incorrect because a house that you live in is
house to live in with a down not an income-generating asset. So it is not the best way to think
payment and mortgage, of an LBO. C is incorrect because unlike a house, cars always
and then sells the house in depreciate in value and you'll likely lose a lot of money after
the future once the mortgage buying it, running it, and selling it... plus cars do not generate
is repaid income, unlike rental houses.
b. An investor buys a house
to rent out to tenants, using
a down payment and mort-
gage, then uses the rental in-
come to repay the mortgage,
and then sells
the house in the future
c. A person buys a car using
cash and a car loan, drives it
for several years, repays the
debt, and then sells the car
d. None of the above
3. All of the following character- Explanation: The correct answer choice is D. Answer choice A
istics make for a good LBO represents an asset-rich company which can pledge its current
target EXCEPT: assets and PP&E as collateral for high levels of bank debt (which
is necessary for an LBO). Answer choice B refers to companies
a. High PP&E and/or Fixed As- with negligible large cash outflows in the form of capital expen-
sets on the Balance Sheet ditures; that is a good sign since the company can use those
cash flows to pay interest and debt principal post-LBO instead.
b. Relatively low Capital Ex-
Answer choice C represents companies that produce lots of cash
penditures
flow and exhibit no volatility in those cash flows from year to year.
, LBO Model Quiz Basic
Study online at https://quizlet.com/_3k093v
Usually, PE firms prefer very mature companies and industries,
c. Non-volatile, non-cyclical, sometimes even if they are in the decline phase of their lifecycle.
cash flow producing busi- Something very early-stage with high growth would probably
ness produce cash flows that are too volatile to make consistent
and periodic interest payments and debt repayment. Usually
d. Early-stage fast growth
early-stage hyper growth companies are not cash-flow positive
company
businesses, and the majority of their value is not comprised of
'hard assets' such as PP&E which can be used as collateral for
the large sums of debt that need to be raised.
4. Since an LBO valuation and a Explanation: The correct answer choice is B. The cash-flow metric
DCF are both based on Free used in an LBO model - namely, 'Free Cash Flow Available for
Cash Flows and how much Debt Service' (aka CFO - CapEx) - is not identical to Levered Free
cash the company generates, Cash Flow used in a DCF, with the latter explicitly subtracting
they are likely to produce out mandatory debt repayments. And most of the time in a DCF,
similar implied values. you use Unlevered Free Cash Flow, which is even more different.
Furthermore, an LBO is different from a DCF in that the LBO
a. True model does not explicitly calculate an implied value like a DCF
does. Rather, in an LBO model you work backwards to determine
b. False
the price that a PE firm can pay if it is targeting a certain IRR. In
other words, a DCF is based on, "How much could this firm be
worth if certain assumptions are true?" whereas an LBO valuation
is based on, "What's the minimum price a PE firm could pay to
achieve a certain return on their investment?"
5. All of the following rep- Explanation: The correct answer choice is C. All of the above
resent differences between statements represent factual differences between HY debt and
high-yield (HY) debt and bank bank debt except for answer choice C. HY debt is considered
debt EXCEPT: much "riskier" than bank debt, and as a result investors require
a higher interest rate to be compensated. Answer choice B is
a. HY debt is riskier and thus correct in that most bank debt does NOT have a fixed interest
has a higher interest rate rate but rather a "floating rate" usually tied to LIBOR, whereas
Study online at https://quizlet.com/_3k093v
1. Which of the following state- Explanation: Statements A, B, and D are all true. By using little of
ments below are TRUE re- its own cash and borrowing heavily to purchase the company,
garding why an LBO works the PE fund significantly boosts its returns for the simple reason
conceptually? that money today is worth more than money tomorrow due to the
interest that it could earn. In an LBO, the PE fund uses the cash
a. By using debt, the PE flows of the company it acquires to pay debt principal and debt
firm reduces up-front cash interest, which is a much better use of those funds than keeping
required, thereby boosting the money for itself, again boosting returns. The other reason
returns LBOs work in practice and earn such high returns is because the
PE fund only operates the company for 3 to 5 years before it
b. Using cash flows produced
sells it off and regains its money plus profit; if the PE fund were
by the company to pay down
to keep the companies it purchased indefinitely, it would not be
debt and make interest pay-
possible to earn the returns that PE funds seek. C is incorrect
ments produces a better re-
because there's no "guarantee" that the PE fund will get back
turn for the PE firm than sim-
100% of its original capital - if the company's EBITDA declines or
ply keeping the cash flows
if the exit multiple declines significantly, for example, that may
not happen.
c. Since the PE firm sells the
entire company in the future,
it's guaranteed to at least get
back 100% of its original cap-
ital
d. The PE firm sells the com-
pany in the future, which al-
lows it to get back (at least
some of) the funds that it
used to acquire the company
in the first place
2. What's the best analogy to Explanation: B is correct because that is exactly what happens in
use when thinking of how a an
, LBO Model Quiz Basic
Study online at https://quizlet.com/_3k093v
leveraged buyout works? LBO - you buy a company that generates cash flows, you use
the cash flows to repay debt, and then sell it off at the end of
a. A homeowner buys a several years. A is incorrect because a house that you live in is
house to live in with a down not an income-generating asset. So it is not the best way to think
payment and mortgage, of an LBO. C is incorrect because unlike a house, cars always
and then sells the house in depreciate in value and you'll likely lose a lot of money after
the future once the mortgage buying it, running it, and selling it... plus cars do not generate
is repaid income, unlike rental houses.
b. An investor buys a house
to rent out to tenants, using
a down payment and mort-
gage, then uses the rental in-
come to repay the mortgage,
and then sells
the house in the future
c. A person buys a car using
cash and a car loan, drives it
for several years, repays the
debt, and then sells the car
d. None of the above
3. All of the following character- Explanation: The correct answer choice is D. Answer choice A
istics make for a good LBO represents an asset-rich company which can pledge its current
target EXCEPT: assets and PP&E as collateral for high levels of bank debt (which
is necessary for an LBO). Answer choice B refers to companies
a. High PP&E and/or Fixed As- with negligible large cash outflows in the form of capital expen-
sets on the Balance Sheet ditures; that is a good sign since the company can use those
cash flows to pay interest and debt principal post-LBO instead.
b. Relatively low Capital Ex-
Answer choice C represents companies that produce lots of cash
penditures
flow and exhibit no volatility in those cash flows from year to year.
, LBO Model Quiz Basic
Study online at https://quizlet.com/_3k093v
Usually, PE firms prefer very mature companies and industries,
c. Non-volatile, non-cyclical, sometimes even if they are in the decline phase of their lifecycle.
cash flow producing busi- Something very early-stage with high growth would probably
ness produce cash flows that are too volatile to make consistent
and periodic interest payments and debt repayment. Usually
d. Early-stage fast growth
early-stage hyper growth companies are not cash-flow positive
company
businesses, and the majority of their value is not comprised of
'hard assets' such as PP&E which can be used as collateral for
the large sums of debt that need to be raised.
4. Since an LBO valuation and a Explanation: The correct answer choice is B. The cash-flow metric
DCF are both based on Free used in an LBO model - namely, 'Free Cash Flow Available for
Cash Flows and how much Debt Service' (aka CFO - CapEx) - is not identical to Levered Free
cash the company generates, Cash Flow used in a DCF, with the latter explicitly subtracting
they are likely to produce out mandatory debt repayments. And most of the time in a DCF,
similar implied values. you use Unlevered Free Cash Flow, which is even more different.
Furthermore, an LBO is different from a DCF in that the LBO
a. True model does not explicitly calculate an implied value like a DCF
does. Rather, in an LBO model you work backwards to determine
b. False
the price that a PE firm can pay if it is targeting a certain IRR. In
other words, a DCF is based on, "How much could this firm be
worth if certain assumptions are true?" whereas an LBO valuation
is based on, "What's the minimum price a PE firm could pay to
achieve a certain return on their investment?"
5. All of the following rep- Explanation: The correct answer choice is C. All of the above
resent differences between statements represent factual differences between HY debt and
high-yield (HY) debt and bank bank debt except for answer choice C. HY debt is considered
debt EXCEPT: much "riskier" than bank debt, and as a result investors require
a higher interest rate to be compensated. Answer choice B is
a. HY debt is riskier and thus correct in that most bank debt does NOT have a fixed interest
has a higher interest rate rate but rather a "floating rate" usually tied to LIBOR, whereas
