LBO Fundamentals: 400 Practice Questions With Correct Answers

LBO Fundamentals: 400 Practice Questions
With Correct Answers




1. Walk me through a basic LBO model. - correct answers"In an LBO Model, Step 1 is making assumptions about
s s s s s s s s s s s s s s s s s s s




the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume
s s s s s s s s s s s s s s s s s




something about the company's operations, such as Revenue Growth or Margins, depending on how much
s s s s s s s s s s s s s s s




information you have. s s




Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and what you use the
s s s s s s s s s s s s s s s s s s s s s s




capital for; this also tells you how much Investor Equity is required.
s s s s s s s s s s s




Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also add in Goodwill &
s s s s s s s s s s s s s s s s s s s s s s




Other Intangibles on the Assets side to make everything balance.
s s s s s s s s s




In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and
s s s s s s s s s s s s s s s s s




determine how much debt is paid off each year, based on the available Cash Flow and the required Interest
s s s s s s s s s s s s s s s s s s s




Payments.

Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit
s s s s s s s s s s s s s s s s s s




Multiple, and calculate the return based on how much equity is returned to the firm."
s s s s s s s s s s s s s s




2. Why would you use leverage when buying a company? - correct answersTo boost your return.Remember,
s s s s s s s s s s s s s s s s




any debt you use in an LBO is not "your money" - so if you're paying $5 billion for a company, it's easier to earn a
s s s s s s s s s s s s s s s s s s s s s s s s s s




high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own
s s s s s s s s s s s s s s s s s s s s s




money and $2 billion of borrowed money. s s s s s s




A secondary benefit is that the firm also has more capital available to purchase other companies because
s s s s s s s s s s s s s s s s s




they've used leverage. s s




3. What variables impact an LBO model the most? - correct answersPurchase and exit multiples have the
s s s s s s s s s s s s s s s s s




biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant
s s s s s s s s s s s s s s s s s s s s




impact, followed by operational characteristics such as revenue growth and EBITDA margins.
s s s s s s s s s s s

, 4. How do you pick purchase multiples and exit multiples in an LBO model? - correct answersThe same way you
s s s s s s s s s s s s s s s s s s s s




do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO
s s s s s s s s s s s s s s s s s s




transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity tables. s s s s s s s s s s s s s s s s s




Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but s s s s s s s s s s s s s s s s s s s s




this is just for valuation purposes if you're using an LBO model to value the company.
s s s s s s s s s s s s s s s




5. What is an "ideal" candidate for an LBO? - correct answers"Ideal" candidates have stable and predictable
s s s s s s s s s s s s s s s s s




cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well
s s s s s s s s s s s s s s s s




as an opportunity for expense reductions to boost their margins. A strong management team also helps, as
s s s s s s s s s s s s s s s s s




does a base of assets to use as collateral for debt.
s s s s s s s s s s




The most important part is stable cash flow.
s s s s s s s




6. How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor
s s s s s s s s s s s s s s s s s s s s s s s




valuation" for the company? - correct answersYou use it to value a company by setting a targeted IRR (for s s s s s s s s s s s s s s s s s s s




example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to
s s s s s s s s s s s s s s s s s s




achieve that IRR.This is sometimes called a "floor valuation" because PE firms almost always pay less for a
s s s s s s s s s s s s s s s s s s




company than strategic acquirers would. s s s s




7. Give an example of a "real-life" LBO. - correct answersThe most common example is taking out a mortgage
s s s s s s s s s s s s s s s s s s s




when you buy a house. Here's how the analogy works:
s s s s s s s s s




Down Payment: Investor Equity in an LBO s s s s s s




Mortgage: Debt in an LBO s s s s




Mortgage Interest Payments: Debt Interest in an LBO s s s s s s s




Mortgage Repayments: Debt Principal Repayments in an LBO s s s s s s s




Selling the House: Selling the Company / Taking It Public in an LBO
s s s s s s s s s s s s




8. Can you explain how the Balance Sheet is adjusted in an LBO model? - correct answersFirst, the Liabilities &
s s s s s s s s s s s s s s s s s s s s




Equities side is adjusted - the new debt is added on, and the Shareholders' Equity is "wiped out" and replaced
s s s s s s s s s s s s s s s s s s s s




by however much equity the private equity firm is contributing.
s s s s s s s s s




On the Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Other
s s s s s s s s s s s s s s s s s s s s




Intangibles are used as a "plug" to make the Balance Sheet balance. s s s s s s s s s s s




Depending on the transaction, there could be other effects as well - such as capitalized financing fees added to s s s s s s s s s s s s s s s s s s s




the Assets side. s s