LBO Model Quiz Basic questions and
complete answers
Explanation: Statements A, B, and D are all true. By using little of its own cash and borrowing
heavily to purchase the company, the PE fund significantly boosts its returns for the simple
reason 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 flows of the company it acquires to pay debt principal
and debt interest, which is a much better use of those funds than keeping the money for itself,
again boosting returns. The other reason 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 sells it off and regains
its money plus profit; if the PE fund were to keep the companies it purchased indefinitely, it
would not be possible to earn the returns that PE funds seek. C is incorrect because there's no
"guarantee" that the PE fund will get back 100% of its original capital - - answers✔✔Which of
the following statements below are TRUE regarding why an LBO works conceptually?
a. By using debt, the PE firm reduces up-front cash required, thereby boosting returns
b. Using cash flows produced by the company to pay down debt and make interest payments
produces a better return for the PE firm than simply keeping the cash flows
c. Since the PE firm sells the entire company in the future, it's guaranteed to at least get back
100% of its original capital
d. The PE firm sells the company in the future, which allows it to get back (at least some of) the
funds that it used to acquire the company in the first place
,Explanation: B is correct because that is exactly what happens in an
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 several years. A is incorrect because a house that you live in is not
an income-generating asset. So it is not the best way to think of an LBO. C is incorrect because
unlike a house, cars always depreciate in value and you'll likely lose a lot of money after buying
it, running it, and selling it... plus cars do not generate income, unlike rental houses. -
answers✔✔What's the best analogy to use when thinking of how a leveraged buyout works?
a. A homeowner buys a house to live in with a down payment and mortgage,
and then sells the house in the future once the mortgage is repaid
b. An investor buys a house to rent out to tenants, using a down payment and mortgage, then
uses the rental income 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
Explanation: The correct answer choice is D. Answer choice A
represents an asset-rich company which can pledge its current assets and PP&E as collateral for
high levels of bank debt (which is necessary for an LBO). Answer choice B refers to companies
with negligible large cash outflows in the form of capital expenditures; that is a good sign since
the company can use those cash flows to pay interest and debt principal post-LBO instead.
Answer choice C represents companies that produce lots of cash flow and exhibit no volatility in
those cash flows from year to year. Usually, PE firms prefer very mature companies and
industries, sometimes even if they are in the decline phase of their lifecycle. Something very
early-stage with high growth would probably produce cash flows that are too volatile to make
consistent and periodic interest payments and debt repayment. Usually early-stage hyper
growth companies are not cash- - answers✔✔All of the following characteristics make for a
good LBO target EXCEPT:
, a. High PP&E and/or Fixed Assets on the Balance Sheet
b. Relatively low Capital Expenditures
c. Non-volatile, non-cyclical, cash flow producing business
d. Early-stage fast growth company
Explanation: The correct answer choice is B. The cash-flow metric used in an LBO model -
namely, 'Free Cash Flow Available for Debt Service' (aka CFO - CapEx) - is not identical to
Levered Free Cash Flow used in a DCF, with the latter explicitly subtracting out mandatory debt
repayments. And most of the time in a DCF, you use Unlevered Free Cash Flow, which is even
more different. Furthermore, an LBO is different from a DCF in that the LBO model does not
explicitly calculate an implied value like a DCF does. Rather, in an LBO model you work
backwards to determine 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?" - answers✔✔Since an LBO valuation and a DCF
are both based on Free Cash Flows and how much cash the company generates, they are likely
to produce similar implied values.
a. True
b. False
Explanation: The correct answer choice is C. All of the above statements represent factual
differences between HY debt and bank debt except for answer choice C. HY debt is considered
much "riskier" than bank debt, and as a result investors require a higher interest rate to be
compensated. Answer choice B is correct in that most bank debt does NOT have a fixed interest
rate but rather a "floating rate" usually tied to LIBOR, whereas HY debt is more conventional in
complete answers
Explanation: Statements A, B, and D are all true. By using little of its own cash and borrowing
heavily to purchase the company, the PE fund significantly boosts its returns for the simple
reason 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 flows of the company it acquires to pay debt principal
and debt interest, which is a much better use of those funds than keeping the money for itself,
again boosting returns. The other reason 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 sells it off and regains
its money plus profit; if the PE fund were to keep the companies it purchased indefinitely, it
would not be possible to earn the returns that PE funds seek. C is incorrect because there's no
"guarantee" that the PE fund will get back 100% of its original capital - - answers✔✔Which of
the following statements below are TRUE regarding why an LBO works conceptually?
a. By using debt, the PE firm reduces up-front cash required, thereby boosting returns
b. Using cash flows produced by the company to pay down debt and make interest payments
produces a better return for the PE firm than simply keeping the cash flows
c. Since the PE firm sells the entire company in the future, it's guaranteed to at least get back
100% of its original capital
d. The PE firm sells the company in the future, which allows it to get back (at least some of) the
funds that it used to acquire the company in the first place
,Explanation: B is correct because that is exactly what happens in an
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 several years. A is incorrect because a house that you live in is not
an income-generating asset. So it is not the best way to think of an LBO. C is incorrect because
unlike a house, cars always depreciate in value and you'll likely lose a lot of money after buying
it, running it, and selling it... plus cars do not generate income, unlike rental houses. -
answers✔✔What's the best analogy to use when thinking of how a leveraged buyout works?
a. A homeowner buys a house to live in with a down payment and mortgage,
and then sells the house in the future once the mortgage is repaid
b. An investor buys a house to rent out to tenants, using a down payment and mortgage, then
uses the rental income 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
Explanation: The correct answer choice is D. Answer choice A
represents an asset-rich company which can pledge its current assets and PP&E as collateral for
high levels of bank debt (which is necessary for an LBO). Answer choice B refers to companies
with negligible large cash outflows in the form of capital expenditures; that is a good sign since
the company can use those cash flows to pay interest and debt principal post-LBO instead.
Answer choice C represents companies that produce lots of cash flow and exhibit no volatility in
those cash flows from year to year. Usually, PE firms prefer very mature companies and
industries, sometimes even if they are in the decline phase of their lifecycle. Something very
early-stage with high growth would probably produce cash flows that are too volatile to make
consistent and periodic interest payments and debt repayment. Usually early-stage hyper
growth companies are not cash- - answers✔✔All of the following characteristics make for a
good LBO target EXCEPT:
, a. High PP&E and/or Fixed Assets on the Balance Sheet
b. Relatively low Capital Expenditures
c. Non-volatile, non-cyclical, cash flow producing business
d. Early-stage fast growth company
Explanation: The correct answer choice is B. The cash-flow metric used in an LBO model -
namely, 'Free Cash Flow Available for Debt Service' (aka CFO - CapEx) - is not identical to
Levered Free Cash Flow used in a DCF, with the latter explicitly subtracting out mandatory debt
repayments. And most of the time in a DCF, you use Unlevered Free Cash Flow, which is even
more different. Furthermore, an LBO is different from a DCF in that the LBO model does not
explicitly calculate an implied value like a DCF does. Rather, in an LBO model you work
backwards to determine 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?" - answers✔✔Since an LBO valuation and a DCF
are both based on Free Cash Flows and how much cash the company generates, they are likely
to produce similar implied values.
a. True
b. False
Explanation: The correct answer choice is C. All of the above statements represent factual
differences between HY debt and bank debt except for answer choice C. HY debt is considered
much "riskier" than bank debt, and as a result investors require a higher interest rate to be
compensated. Answer choice B is correct in that most bank debt does NOT have a fixed interest
rate but rather a "floating rate" usually tied to LIBOR, whereas HY debt is more conventional in
