LBO MODELING EXAM FROM WALL STREET (VERSION 1 & 2) -
COMPLETE QUESTIONS AND DETAILED SOLUTIONS LATEST UPDATE
THIS YEAR JUST RELEASED
Question 1: What is the difference between bank debt and high
yield debt?
Answer:
High yield debt tends to have higher interest rates than bank debt
since its riskier for investors
High yield debt interest rates are usually fixed; whereas bank debt
interest rates are floating and they depend on LIBOR
High yield debt has incurrence covenants while bank debt has
maintenance covenants. Incurrence covenants prevent you from
doing something (e.g. selling an asset or building a factory) while
maintenance covenants require that you maintain a minimum
financial performance (for example, total debt/EBITDA must be
below 5x at all times)
Bank debt is usually amortized --- the principal must be paid off
over time -- whereas, the high yield debt principal is due at the end
(bullet maturity) and early principal repayments are not allowed
Question 2: If High-Yield Debt is "riskier," why are early principal
repayments not allowed? Shouldn't investors want to reduce their
risk?
Answer:
, Investors need to be compensated for the risk they take. Think
about what happens if early repayments are allowed:
-Initially, the investors might earn $100mm in interest on $1bil in
debt at a 10% interest rate
-Without early repayment, the investors keep getting that $100 mm
in interest per year paid directly to them
-With early repayment, the interest payment drops each year and
the investors receive increasingly less each year, which drops their
effective return
Question 3: Why might you use bank debt rather than high-yield
debt in an LBO?
Answer:
If the PE firm is concerned about the company making its interest
payments and wants a lower-cost option they may use bank debt.
May also use bank debt if they have CapEx/expansion plans and do
not want the company to be restricted by incurrence covenants
Question 4: Why would a PE firm prefer high-yield debt instead?
Answer:
If the PE firm intends to refinance its debt or believes its returns are
not as sensitive to interest payments, then it may use high yield
debt.
Question 5: They may also use it if they do not have expansion
plans or plans to sell of any assets
How does refinancing versus assuming debt work in an LBO
,model?
Answer:
If it assumes the debt, the debt shows up on the BS and must be
paid off. It has no net effect on the funds required to buy the
company. Shows up in both columns of the sources and uses table.
Question 6: If it refinances the debt, it pays it off, usually replacing
it with new debt used to acquire the company. This means that
additional funds are required, so the effective purchase price goes
down. In this case, the existing debt only shows up in the uses
column
How do transaction and financing fees factor into the LBO model?
Answer:
Pay for all these upfront in cash but the accounting treatment is
different:
- legal & advisory fees: come out of cash and RE immediately after
the transaction closes
- financing fees: amortized over time (for as long as debt remains
outstanding), very similar to how CapEx and PPE work: you pay for
them upfront in cash, create a new asset on the BS, and reduce the
value over time as fees are recognized on the IS
Question 7: What's the point of assuming a minimum cash balance
in an LBO?
Answer:
, the point is so the company cannot use 100% of its cash flow to
repay the debt each year -- it always needs to maintain a min cash
balance to pay employees, pay for GS&A, and so on
So you normally set assumptions such that any extra cash flow
beyond its min cash balance is used to pay debt
Question 8: Can you explain how the Balance Sheet is adjusted in
an LBO model?
Answer:
For the acquired company --
1. new debt is added to liabilities side and the SE is wiped out and
replaced by however much investor equity the PE firm is
contributing
On the assets side, cash is adjusted for any cash used to finance
the transaction and for the transaction fees and then goodwill and
other intangibles are used as a "plug" to make the BS balance
Question 9: There will also be the usual effects you see in
transactions: asset write ups and write Downs, DTLs, DTAs,
capitalized financing fees etc.
Why are Goodwill & Intangibles created in an LBO?
Answer:
These both represent the premium paid to the SE of the company. In
an LBO, they act as a "plug" and ensure that the changes to the
Liabilities & Equity side are balanced by changes to the Assets side.
so if the company's SE was worth $1bil and the PE firm pays $1.5bil
for it, roughly $500mm in goodwill will be created
COMPLETE QUESTIONS AND DETAILED SOLUTIONS LATEST UPDATE
THIS YEAR JUST RELEASED
Question 1: What is the difference between bank debt and high
yield debt?
Answer:
High yield debt tends to have higher interest rates than bank debt
since its riskier for investors
High yield debt interest rates are usually fixed; whereas bank debt
interest rates are floating and they depend on LIBOR
High yield debt has incurrence covenants while bank debt has
maintenance covenants. Incurrence covenants prevent you from
doing something (e.g. selling an asset or building a factory) while
maintenance covenants require that you maintain a minimum
financial performance (for example, total debt/EBITDA must be
below 5x at all times)
Bank debt is usually amortized --- the principal must be paid off
over time -- whereas, the high yield debt principal is due at the end
(bullet maturity) and early principal repayments are not allowed
Question 2: If High-Yield Debt is "riskier," why are early principal
repayments not allowed? Shouldn't investors want to reduce their
risk?
Answer:
, Investors need to be compensated for the risk they take. Think
about what happens if early repayments are allowed:
-Initially, the investors might earn $100mm in interest on $1bil in
debt at a 10% interest rate
-Without early repayment, the investors keep getting that $100 mm
in interest per year paid directly to them
-With early repayment, the interest payment drops each year and
the investors receive increasingly less each year, which drops their
effective return
Question 3: Why might you use bank debt rather than high-yield
debt in an LBO?
Answer:
If the PE firm is concerned about the company making its interest
payments and wants a lower-cost option they may use bank debt.
May also use bank debt if they have CapEx/expansion plans and do
not want the company to be restricted by incurrence covenants
Question 4: Why would a PE firm prefer high-yield debt instead?
Answer:
If the PE firm intends to refinance its debt or believes its returns are
not as sensitive to interest payments, then it may use high yield
debt.
Question 5: They may also use it if they do not have expansion
plans or plans to sell of any assets
How does refinancing versus assuming debt work in an LBO
,model?
Answer:
If it assumes the debt, the debt shows up on the BS and must be
paid off. It has no net effect on the funds required to buy the
company. Shows up in both columns of the sources and uses table.
Question 6: If it refinances the debt, it pays it off, usually replacing
it with new debt used to acquire the company. This means that
additional funds are required, so the effective purchase price goes
down. In this case, the existing debt only shows up in the uses
column
How do transaction and financing fees factor into the LBO model?
Answer:
Pay for all these upfront in cash but the accounting treatment is
different:
- legal & advisory fees: come out of cash and RE immediately after
the transaction closes
- financing fees: amortized over time (for as long as debt remains
outstanding), very similar to how CapEx and PPE work: you pay for
them upfront in cash, create a new asset on the BS, and reduce the
value over time as fees are recognized on the IS
Question 7: What's the point of assuming a minimum cash balance
in an LBO?
Answer:
, the point is so the company cannot use 100% of its cash flow to
repay the debt each year -- it always needs to maintain a min cash
balance to pay employees, pay for GS&A, and so on
So you normally set assumptions such that any extra cash flow
beyond its min cash balance is used to pay debt
Question 8: Can you explain how the Balance Sheet is adjusted in
an LBO model?
Answer:
For the acquired company --
1. new debt is added to liabilities side and the SE is wiped out and
replaced by however much investor equity the PE firm is
contributing
On the assets side, cash is adjusted for any cash used to finance
the transaction and for the transaction fees and then goodwill and
other intangibles are used as a "plug" to make the BS balance
Question 9: There will also be the usual effects you see in
transactions: asset write ups and write Downs, DTLs, DTAs,
capitalized financing fees etc.
Why are Goodwill & Intangibles created in an LBO?
Answer:
These both represent the premium paid to the SE of the company. In
an LBO, they act as a "plug" and ensure that the changes to the
Liabilities & Equity side are balanced by changes to the Assets side.
so if the company's SE was worth $1bil and the PE firm pays $1.5bil
for it, roughly $500mm in goodwill will be created
