LBO Model Quiz Advanced Questions With Solutions

LBO Model Quiz Advanced Questions With Solutions 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. Which of the answer choices below lists the tranches of LBO debt from Lowest to Highest in terms of typical interest rates? a. Term Loan B; Term Loan A; Revolver; Senior Notes; Subordinated Notes; Mezzanine b. Revolver; Senior Notes; Subordinated Notes; Term Loan A; Term Loan B; Mezzanine c. Revolver; Term Loan A; Term Loan B; Senior Notes; Subordinated Notes; Mezzanine d. Revolver; Mezzanine; Senior Notes; Subordinated Notes; Term Loan A; Term Loan B - ANS Explanation: The correct answer choice is C. All of the answer choices above represent the various tranches of LBO debt, but only answer choice C listed them in the correct order of lowest interest rate to highest interest rate. Keep in mind that both the Revolver and Term Loans represent "bank debt" which is the most senior of all the debt, thereby making it the least risky and therefore likely to have the lowest interest rates. Revolvers typically have lower interest rates than Term Loan A because the borrowing is more temporary, and Term Loan A is typically lower than Term Loan B because principal repayments are higher. All other forms of debt - senior notes, subordinated notes, Mezzanine - represent the "high- yield" type debt which is riskier than bank debt and therefore offers a higher yield to investors. Senior Notes are senior to the other two, so rates tend to be lower, and Mezzanine is the most junior of everything above, so interest rates (and risk) tends to be highest there. Which of the following Debt types is MOST likely to offer a Payment-in-Kind (PIK) option for the interest payments? a. Revolver b. Term Loan B c. Senior Notes d. Subordinated Notes e. Mezzanine - ANS Explanation: PIK options do not exist for the Revolver or for Term Loans because PIK always adds to the risk of the Debt, and these are the least risky (and lowest potential return) forms of Debt. PIK is also extremely unlikely for Senior Notes because although they are classified as "High-Yield," they are still less risky than the others in this list. PIK may sometimes exist for Subordinated Notes, but remember that these notes are still senior to Mezzanine - so PIK is definitely the most likely for Mezzanine rather than the others here. In practice, PIK tends to be most common in economic booms when financing is cheap and less common when financing tightens up and it gets harder to borrow money - because it greatly increases the credit risk of the borrower.