What is an LBO? When firm acquires a company using a combination of debt and minimal equity, operates it for several years and then sells it. With leverage amplifying returns.
Why would you use leverage when buying a company? 1) To amplify returns. 2) Have capital available for other purchases
Re...
LBO Practice Test Questions and
Correct Answers
What is an LBO? ✅When firm acquires a company using a combination of debt and
minimal equity, operates it for several years and then sells it. With leverage amplifying
returns.
Why would you use leverage when buying a company? ✅1) To amplify returns. 2)
Have capital available for other purchases
Remember, any debt you use in an LBO is not "your money" - easier to earn a high
return on $100 of your own money and $10,000 borrowed from elsewhere
What variables impact an LBO model the most? ✅Purchase price, EBITDA growth,
Exit multiple, Amount of debt
How do you pick purchase multiples and exit multiples in an LBO model? ✅1) LBO
Comps and Precedent Transactions
2) Show a range of purchase and exit multiples using sensitivity tables.
What is an "ideal" candidate for an LBO? ✅0) Low Price
1) Stable and predictable cash flows
2) Low-risk business
3) Low/No Capital Expenditures required
4) Realistic path to exit (same EBITDA multiple, market with buyers/sellers)
5) Strong management team
6) Base of assets for collateral.
How do you use an LBO model to value a company, and why do we sometimes say that
it sets the "floor valuation" for the company? ✅1) Set target IRR (for example, 25%)
and then back-solve to determine max purchase price to achieve that IRR.
2) "Floor valuation" because PE firms almost always pay less for a company than
strategic acquirers.
Give an example of a "real-life" LBO. ✅1) Taking a mortgage to purchase a Home .
Down Payment = Equity Investor
Mortgage = Debt
Interest Payments = Debt Interest
Mortgage Repayments = Principal Repayments
Selling the House = Selling Company or Taking It Public
,Can you explain how the Balance Sheet is adjusted in an LBO model? ✅1) Assets:
Adjust for cash & Goodwill.
2) Liabilities: New debt is added on.
3) Shareholders' Equity: replaced by the equity the PE firm is contributing.
Why are Goodwill & Other Intangibles created in an LBO? ✅1) Represent the premium
paid to the "fair market value" of the company.
2) Created to balance the Balance Sheet, act as a "plug"
We saw that a strategic acquirer will usually prefer to pay for another company in cash -
if that's the case, why would a PE firm want to use debt in an LBO? ✅1) PE firm
intends to sell company in a few years
2) Amplify returns by reducing contribution
3) Debt is "owned" by the company, so they assume much of the risk.
Do you need to project all 3 statements in an LBO model? Are there any shortcuts?
✅1) Income Statement
2) Something to track how the Debt balances change
3) Some type of Cash Flow Statement to show how much cash is available to repay
debt.
How would you determine how much debt can be raised in an LBO and how many
tranches there would be? ✅1) Use Comp. LBOs (size, range, Industry)
2) See terms of the debt and how many tranches were used.
Let's say we're analyzing how much debt a company can take on, and what the terms of
the debt should be. What are reasonable leverage and coverage ratios? ✅1)
Dependends on the company and industry
2) Look at "debt comps" showing the types of tranches, and terms of debt .
General rules: Never lever a company at 50x EBITDA
What is the difference between bank debt and high-yield debt? ✅1) Bank Debt: floating
interest rates, amortized over time, require collateral, maintenance covenants requiring
minimum financial performance (Debt/EBITDA ratio must be below 5x).
2) High-yield debt: higher interest rates, usually fixed, Bullet Payment, Incurrence
covenants prevent you from doing something (such as selling an asset, buying a
factory, etc.)
Why might you use bank debt rather than high-yield debt in an LBO? ✅1) Don't want to
be restricted by incurrence covenants (CapEx expansion)
2) Concerns about meeting interest payments
Why would a PE firm prefer high-yield debt instead? ✅1) PE firm intends to refinance
the company at some point
, 2) Returns are not sensitive to interest payments
3) Don't have plans for major CapEx
Why would a private equity firm buy a company in a "risky" industry, such as
technology? ✅1) Mature, cash flow-stable companies in almost every industry.
2) PE firm has very specific goals like industry consolidation, turnarounds, and
divestitures
Industry consolidation - buying competitors in a similar market and combining them to
increase efficiency and win more customers.
Turnarounds - taking struggling companies and making them function properly again.
Divestitures - selling off divisions of a company or taking a division and turning it
into a strong stand-alone entity.
How could a private equity firm boost its return in an LBO? ✅1. Lower the Purchase
Price in the model.
2. Raise the Exit Multiple / Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company's growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees, consolidating
buildings, etc.).
What is meant by the "tax shield" in an LBO? ✅The Interest paid on debt is tax-
deductible - save money on taxes against their interest expense and increase their cash
flow.
What is a dividend recapitalization ("dividend recap")? ✅1) Company takes on new
debt solely to pay a special dividend out. .
It would be like if you made your friend take out a personal loan just so he/she could
pay you a lump sum of cash with the loan proceeds.
Why would a PE firm choose to do a dividend recap of one of its portfolio companies?
✅1) PE firm is "recovering" some of its equity investment in the company.
2) Boost Returns
How would a dividend recap impact the 3 financial statements in an LBO? ✅1) Income
Statement: No changes.
2) Balance Sheet: Debt increases and
Retained Earnings declines.
3) Cash Flow Statement: No Change to Net Change in Cash.
How would an asset write-up or write-down affect an LBO model? / Walk me through
how you adjust the Balance Sheet in an LBO model. ✅1) Assets: Adjust PP&E and
Goodwill
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