LBO Practice Questions with Clear, Explained Answers

LBO Practice Questions with Clear,
Explained Answers




Walk me through a basic LBO model. - correct answers"In an LBO Model, Step 1 is making assumptions about
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the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume
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something about the company's operations, such as Revenue Growth or Margins, depending on how much
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information you have. n n




Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and what you use
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the capital for; this also tells you how much Investor Equity is required.
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Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also add in Goodwill &
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Other Intangibles on the Assets side to make everything balance.
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In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and
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determine how much debt is paid off each year, based on the available Cash Flow and the required Interest
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Payments.

Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit
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Multiple, and calculate the return based on how much equity is returned to the firm."
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Why would you use leverage when buying a company? - correct answersTo boost your return.
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Remember, any debt you use in an LBO is not "your money" - so if you're paying $5 billion for a company, it's
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easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3
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billion of your own money and $2 billion of borrowed money.
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, A secondary benefit is that the firm also has more capital available to purchase other companies because
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they've used leverage. n n




What variables impact an LBO model the most? - correct answersPurchase and exit multiples have the biggest
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impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact,
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followed by operational characteristics such as revenue growth and EBITDA margins.
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How do you pick purchase multiples and exit multiples in an LBO model? - correct answersThe same way you
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do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO
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transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity n n n n n n n n n n n n n n n n n




tables.

Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but
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this is just for valuation purposes if you're using an LBO model to value the company.
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What is an "ideal" candidate for an LBO? - correct answers"Ideal" candidates have stable and predictable cash
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flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an
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opportunity for expense reductions to boost their margins. A strong management team also helps, as does a
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base of assets to use as collateral for debt.
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The most important part is stable cash flow.
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How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor
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valuation" for the company? - correct answersYou use it to value a company by setting a targeted IRR (for
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example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to
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achieve that IRR. n n




This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than
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strategic acquirers would. n n




Give an example of a "real-life" LBO. - correct answersThe most common example is taking out a mortgage
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when you buy a house. Here's how the analogy works:
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-Down Payment: Investor Equity in an LBO n n n n n n




-Mortgage: Debt in an LBO n n n n




-Mortgage Interest Payments: Debt Interest in an LBO n n n n n n n




-Mortgage Repayments: Debt Principal Repayments in an LBO n n n n n n n