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LBO Model Quiz Basic graded A+
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LBO Model Quiz Basic graded A+
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LBO Model Quiz BasicWhich 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 - ANSExplanation: 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.
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 - ANSExplanation: 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.
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 - ANSExplanation: 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.
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
b. False - ANSExplanation: The correct answer choice is B. The cash-flow metric used in an
LBO model - namely, 'Free Cash Flow Available for Debt Service' (aka CFO - CapEx) - is not
identical to Levered Free Cash Flow used in a DCF, with the latter explicitly subtracting out
mandatory debt repayments. And most of the time in a DCF, you use Unlevered Free Cash
Flow, which is even more different. Furthermore, an LBO is different from a DCF in that the LBO
model does not explicitly calculate an implied value like a DCF does. Rather, in an 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?"
All of the following represent differences between high-yield (HY) debt and bank debt EXCEPT:
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