LBO Model Quiz Basic Questions and Answers
Which of the following Explanation: Statements A, B, and D are all true. By using
statements below are TRUE little of its own cash and borrowing heavily to purchase the
regarding why an LBO company, the PE fund significantly boosts its
works returns for the simple reason that money today is worth more
conceptually? 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
a. By using debt, the PE firm
acquires to pay debt principal and debt interest, which is a
reduces up- front cash
much
required, thereby boosting
better use of those funds than keeping the money for itself,
returns
again boosting returns. The other reason LBOs work in
practice and earn such high returns is because the PE fund
b. Using cash flows
only operates the company for 3 to 5 years before it sells it
produced by the company
off and regains its money plus profit; if the PE fund were
to pay down debt and
to keep the companies it purchased
make
indefinitely, it would not be possible to earn the returns that PE funds
interest payments produces a seek. C is
incorrect because there's no "guarantee" that the PE fund
better return for the PE firm
will get back 100% of its original capital - if the
than simply keeping the cash
company's EBITDA declines or if the exit multiple
flows
declines significantly, for example, that may not
Since the PE firm sells the
c.
happen.
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
,What's the best analogy to use Explanation: B is correct because that is exactly what happens in an
when LBO - you buy a company that generates cash flows, you use
thinking of how a leveraged the cash flows to repay debt, and then sell it off at the end
buyout works?
of several years. A is incorrect because a house
a. A homeowner buys a that you live in is not an income-generating asset. So it is not
house to live in with a the best way to think of an LBO. C is incorrect because
down payment and unlike a house, cars always depreciate in value and you'll
mortgage, likely lose a lot of money after buying it, running it, and
and then sells the house in the selling it... plus cars do not generate income, unlike rental
future once the mortgage is houses.
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
All of the following represents an asset-rich company which can pledge its current assets
characteristics make for a and PP&E as
collateral for high levels of bank debt (which is necessary for
good LBO target EXCEPT:
an LBO). Answer choice B refers to companies with
a. High PP&E and/or Fixed negligible large cash outflows in the form of capital
Assets on the Balance expenditures; that is a good sign since the company can use
Sheet those cash flows to pay interest and debt principal post-
LBO instead. Answer choice C represents
, b. Relatively low Capital companies that produce lots of cash flow and exhibit no
Expenditures volatility in those cash flows from year to year. Usually, PE
firms prefer very mature companies and industries,
c. Non-volatile, non-
sometimes even if they are in the decline phase of their
cyclical, cash flow
lifecycle. Something very
producing business
early-stage with high growth would probably produce
cash flows that are too volatile to make consistent and
d. Early-stage fast growth
company periodic interest payments and debt repayment.
Usually early-stage hyper growth companies are not cash-
flow positive 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.
Explanation: The correct answer choice is B. The cash-flow
metric used in an LBO model - namely, 'Free Cash Flow
Since an LBO valuation and a
Available for Debt Service' (aka CFO - CapEx) - is not
DCF are both based on Free
identical to Levered Free Cash Flow used in a DCF, with
Cash Flows and how much
the latter explicitly
cash the company generates,
subtracting out mandatory debt repayments. And most of the
they are likely to produce
time in a DCF, you use Unlevered Free Cash Flow, which is
similar implied values.
even more different. Furthermore, an LBO is different
from a DCF in that the LBO model does not explicitly
a. True
calculate an implied value like a DCF does. Rather, in an
b. False 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?"
Which of the following Explanation: Statements A, B, and D are all true. By using
statements below are TRUE little of its own cash and borrowing heavily to purchase the
regarding why an LBO company, the PE fund significantly boosts its
works returns for the simple reason that money today is worth more
conceptually? 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
a. By using debt, the PE firm
acquires to pay debt principal and debt interest, which is a
reduces up- front cash
much
required, thereby boosting
better use of those funds than keeping the money for itself,
returns
again boosting returns. The other reason LBOs work in
practice and earn such high returns is because the PE fund
b. Using cash flows
only operates the company for 3 to 5 years before it sells it
produced by the company
off and regains its money plus profit; if the PE fund were
to pay down debt and
to keep the companies it purchased
make
indefinitely, it would not be possible to earn the returns that PE funds
interest payments produces a seek. C is
incorrect because there's no "guarantee" that the PE fund
better return for the PE firm
will get back 100% of its original capital - if the
than simply keeping the cash
company's EBITDA declines or if the exit multiple
flows
declines significantly, for example, that may not
Since the PE firm sells the
c.
happen.
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
,What's the best analogy to use Explanation: B is correct because that is exactly what happens in an
when LBO - you buy a company that generates cash flows, you use
thinking of how a leveraged the cash flows to repay debt, and then sell it off at the end
buyout works?
of several years. A is incorrect because a house
a. A homeowner buys a that you live in is not an income-generating asset. So it is not
house to live in with a the best way to think of an LBO. C is incorrect because
down payment and unlike a house, cars always depreciate in value and you'll
mortgage, likely lose a lot of money after buying it, running it, and
and then sells the house in the selling it... plus cars do not generate income, unlike rental
future once the mortgage is houses.
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
All of the following represents an asset-rich company which can pledge its current assets
characteristics make for a and PP&E as
collateral for high levels of bank debt (which is necessary for
good LBO target EXCEPT:
an LBO). Answer choice B refers to companies with
a. High PP&E and/or Fixed negligible large cash outflows in the form of capital
Assets on the Balance expenditures; that is a good sign since the company can use
Sheet those cash flows to pay interest and debt principal post-
LBO instead. Answer choice C represents
, b. Relatively low Capital companies that produce lots of cash flow and exhibit no
Expenditures volatility in those cash flows from year to year. Usually, PE
firms prefer very mature companies and industries,
c. Non-volatile, non-
sometimes even if they are in the decline phase of their
cyclical, cash flow
lifecycle. Something very
producing business
early-stage with high growth would probably produce
cash flows that are too volatile to make consistent and
d. Early-stage fast growth
company periodic interest payments and debt repayment.
Usually early-stage hyper growth companies are not cash-
flow positive 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.
Explanation: The correct answer choice is B. The cash-flow
metric used in an LBO model - namely, 'Free Cash Flow
Since an LBO valuation and a
Available for Debt Service' (aka CFO - CapEx) - is not
DCF are both based on Free
identical to Levered Free Cash Flow used in a DCF, with
Cash Flows and how much
the latter explicitly
cash the company generates,
subtracting out mandatory debt repayments. And most of the
they are likely to produce
time in a DCF, you use Unlevered Free Cash Flow, which is
similar implied values.
even more different. Furthermore, an LBO is different
from a DCF in that the LBO model does not explicitly
a. True
calculate an implied value like a DCF does. Rather, in an
b. False 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?"
