LBO Model Practice Questions
1. 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: 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 - if the company's EBITDA declines or
if the exit multiple declines significantly, for example, that may not
happen.
,2. 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: 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.
3. 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 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-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.
4. 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
1. 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: 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 - if the company's EBITDA declines or
if the exit multiple declines significantly, for example, that may not
happen.
,2. 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: 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.
3. 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 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-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.
4. 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
