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LBO Training

I/ Basic of an LBO Model


During a private equity interview, analyst and associate interview candidates may be asked to build an LBO
model at various stages of the interview process. Therefore, a well-prepared interview candidate must be able to
successfully complete any variation of a LBO model prior to his or her interview process.
1. Leveraged Buyouts: Basic Overview
A leveraged buyout is the acquisition of a public or private company with a significant amount of borrowed
funds. A private equity firm (or group of private equity firms) acquires a company using debt instruments as the
majority of the purchase price. After the purchase of the company, the debt/equity ratio is generally greater than
1.0x (debt generally constitutes 50-80% of the purchase price). During the ownership of the company, the
companys cash flow is used to service and pay down the outstanding debt. The overall return realized by the
investors in an LBO is determined by the exit cash flow of the company (EBIT or EBITDA), the exit multiple
(of EBIT or EBITDA), and the amount of debt that has been paid off over the time horizon of the investment.
Companies of all sizes and industries can be targets of leveraged buyout transactions, although certain types of
businesses, as discussed earlier, make better LBO targets than others.
A sample LBO model given to candidates during interviews can be used to test on a variety of issues:
-

Determining a fair valuation for a company (including an ability-to-pay analysis)


Determining the equity returns (through IRR calculations) that can be achieved if a company is taken
private, grown, and ultimately sold or taken public
Determining the effect of recapitalizing the company through issuance of debt to replace equity
Determining the debt service limitations of a company from its cash flows

In order to prepare for an LBO modeling test, the first step is to understand the key assumptions and the
process. These are provided in the tables below:

In order to correctly complete the test, you must understand the basic assumptions and steps to create an LBO
because most modeling tests will only provide a few of the assumptions you will need. You will need to make
other basic assumptions based on what you know about the private equity firm youre interviewing with, and
use that to create the model. To make the accurate assumptions, you will have to understand the types of
companies the sponsor likes to invest in and their investment strategy, such as the purchase price, capital
structure, growth and margin assumptions, and exit strategy. Whenever you have to make assumptions that are
not given or standard, document the assumptions that you make and be prepared to defend them.
To prepare for this test, practice creating the different types of LBO tests you may receive from scratch (paper
LBOs, short-form excel LBOs, long-form detailed 3-statement LBOs). This will help you become more
familiar with modeling, but it also will give you a better idea of how an LBO works. For example, one of your
goals should be to comprehend how an investments IRR is affected if you adjust the values of key levers such
as the purchase price, the amount of leverage, revenue growth rates, and the exit multiple. This is especially
important for investment banking analysts and consultants who havent had a lot of exposure to LBO modeling.
The more you practice these tests, the more prepared youll be, so spend as much time on this as you can.
In the following chapters, we will walk through variations of an LBO modeling test and case study.
II/ Paper LBO Model Example
An illustrative example of a paper LBO is provided below in 5 simple steps. In a paper LBO exercise, you will
be expected to complete the important components of a working LBO model with the use of paper and pencil
and without the use of a computer.
Given LBO Parameters and Assumptions:
-

XYZ Private Equity Partners purchases ABC Target Company for 5.0x Forward 12 months (FTM)
EBITDA at the end of Year 0.
The debt-to-equity ratio for the LBO acquisition will be 60:40.
Assume the weighted average interest rate on debt to be 10%.
ABC expects to reach $100M in sales revenue with an EBITDA margin of 40% in Year 1.
Revenue is expected to increase by 10% year-over-year (y-o-y).
EBITDA margins are expected to remain flat during the term of the investment.
Capital expenditures are expected to equal 15% of sales each year.

Operating working capital is expected to increase by $5 million each year.


Depreciation is expected to equal $20 million each year.
Assume a constant tax rate of 40%.
XYZ exits the target investment after Year 5 at the same EBITDA multiple used at entry (5.0x FTM
EBITDA).
Assume all debt pay-down occurs at the moment of sale at the end of Year 5 (this eliminates the
iterative/circular dependency between debt pay-down/cash balances and interest expense in a
computer-based LBO model).

1. Calculate the purchase price of ABC.


Using a 5.0x entry multiple, calculate the price paid by multiplying by Year 1 EBITDA. $40 million in
EBITDA (which represents a 40% EBITDA margin on $100 million in revenue) multiplied by 5. The purchase
price is $200 million.
2. Calculate the debt and equity funding amounts used for the purchase price.
The given information assumes debt to equity ratio of 60:40 for the purchase price.
Debt portion = 60% $200 million, or $120 million.
Equity portion = 40% $200 million, or $80 million.

3. Build the Income Statement.

(Notice that, because the exit value at the end of Year 5 will be based on a forward EBITDA multiple, we must
calculate six years worth of income statement, not 5. Also note that the numbers might not agree perfectly
because of rounding. It is reasonable to round your intermediate calculations to the nearest integer in carrying
over calculations to the next step.)
a) Project revenue: Revenue is expected to grow 10% annually.
-

$100 million Year 1 sales (1 + 10% growth rate) = $110 million sales in Year 2.
$110 million Year 2 sales (1 + 10% growth rate) = $121 million sales in Year 3.
$121 million Year 3 sales (1 + 10% growth rate) = $133.1 million sales in Year 4.
$133 million Year 4 sales (1 + 10% growth rate) = $146.3 million sales in Year 5.
$146 million Year 5 sales (1 + 10% growth rate) = $160.6 million sales in Year 6.

b) Use EBITDA margin to calculate EBITDA.


-

$100 million Year 1 sales 40% EBITDA margin = $40 million Year 1 EBITDA.
$110 million Year 2 sales 40% EBITDA margin = $44 million Year 2 EBITDA.
$121 million Year 3 sales 40% EBITDA margin = $48 million Year 3 EBITDA.
$133 million Year 4 sales 40% EBITDA margin = $53 million Year 4 EBITDA.
$146 million Year 5 sales 40% EBITDA margin = $59 million Year 5 EBITDA.
$161 million Year 6 sales 40% EBITDA margin = $64 million Year 6 EBITDA.

c) Subtract Depreciation & Amortization (D&A) to get EBIT.


-

$40 million Year 1 EBITDA $20 million D&A = $20 million Year 1 EBIT. (etc. for Years 2-6)

d) Calculate interest expense using the debt amount used for purchase multiplied by the interest rate to
calculate the yearly interest expense line item.
-

$120 million of debt 10% interest rate = $12 million interest expense per year.

e) Calculate Earnings Before Tax (EBT).


-

$20 million Year 1 EBIT $12 million int. exp. = $8 million Year 1 EBT. (etc. for Years 2-6)

f) Subtract taxes using the tax rate to get to tax-effected EBT (a proxy for Net Income).
- $8 million Year 1 EBT 40% tax rate = $3 million taxes, so $5 million Year 1 t/e EBT.
- $12 million Year 2 EBT 40% tax rate = $5 million taxes, so $7 million Year 2 t/e EBT.
- $16 million Year 3 EBT 40% tax rate = $6 million taxes, so $10 million Year 3 t/e EBT.
- $21 million Year 4 EBT 40% tax rate = $8 million taxes, so $13 million Year 4 t/e EBT.
- $27 million Year 5 EBT 40% tax rate = $11 million taxes, so $16 million Year 5 t/e EBT.
- $32 million Year 6 EBT 40% tax rate = $13 million taxes, so $19 million Year 6 t/e EBT.
4. Calculate cumulative levered free cash flow (FCF).

a) Start with EBT (Tax-effected) and then add back non-cash expenses (D&A).
-

$5 million Year 1 tax-effected EBT + $20 million D&A.

b) Subtract capital expenditures (Capex).


(NOTE: We do not need Year 6 capital expenditures, or Free Cash Flow for that matter, because EBITDA does
not incorporate capex and because only FCF in Years 1-5 can be used to pay down debt.)
- $100 million Year 1 sales 15% capex/sales = $15 million Year 1 capital expenditures.
- $110 million Year 2 sales 15% capex/sales = $17 million Year 2 capital expenditures.
- $121 million Year 3 sales 15% capex/sales = $18 million Year 3 capital expenditures.
- $133 million Year 4 sales 15% capex/sales = $20 million Year 4 capital expenditures.
- $146 million Year 5 sales 15% capex/sales = $22 million Year 5 capital expenditures.

c) Subtract the annual increase in operating working capital to get to Free Cash Flow (FCF).
-

$5mm Y1 t/a EBT + $20mm D&A $15mm Y1 capex $5mm NWC = $5mm Year 1 FCF.
$7mm Y1 t/a EBT + $20mm D&A $17mm Y2 capex $5mm NWC = $6mm Year 2 FCF.
$10mm Y1 t/a EBT + $20mm D&A $18mm Y3 capex $5mm NWC = $7mm Year 3 FCF.
$13mm Y1 t/a EBT + $20mm D&A $20mm Y4 capex $5mm NWC = $8mm Year 4 FCF.
$16mm Y1 t/a EBT + $20mm D&A $22mm Y5 capex $5mm NWC = $9mm Year 5 FCF.

d) Calculate Cumulative Free Cash Flow during the life of the LBO.
Cumulative FCF until exit equals total debt pay-down, if it is assumed that 100% of FCF is used to pay down
debt. (This is a standard assumption for a basic LBO model.)
- $5 mm Year 1 FCF + $5 mm Year 2 FCF + $7 mm Year 3 FCF + $8 mm Year 4 FCF + $9 mm Year 5
FCF = $34 mm Cumulative FCF.
5. Calculate Ending Purchase Price (Exit Value) and Returns.
a) Calculate Total Enterprise Value (TEV) at Exit.
Take Forward EBITDA at exit (Year 6 EBITDA) along with a 5.0x exit multiple to calculate Exit TEV. $64
million Year 6 EBITDA 5.0x multiple = $320 million Enterprise Value at Exit.
b) Calculate Net Debt at Exit (also known as Ending Debt).
Beginning Debt Debt Pay-down = Ending Debt.
$120 million in Beginning Debt $34 million in Cumulative FCF = $86 million in Ending Debt.
c) Calculate ending Equity Value (EV) by subtracting Ending Debt from Exit TEV.
$320 Exit TEV $86 million Ending Debt = $234 million Ending EV.
d) Calculate the Multiple-of-Money (MoM) EV return (Ending EV Beginning EV).
-

$234 million Ending EV $80 Beginning EV = 2.93x MoM.

e) Estimate IRR based on the MoM multiple.


The following table is useful for estimating IRR based upon 5-year MoM multiples:
- 2.0x MoM over 5 years ~15% IRR
- 2.5x MoM over 5 years ~20% IRR
- 3.0x MoM over 5 years ~25% IRR
- 3.7x MoM over 5 years ~30% IRR
Therefore, we can assume that the implied IRR for the paper LBO case study is approximately 25%, or slightly
below. (It is actually very close to 24%.)
The following is the full paper LBO case study exhibit, calculated using Excel rather than pen and paper. As a
result, some of the numbers might be slightly different, as rounding has been eliminated:

6. Final Steps
Make sure to take your time and calculate every formula correctly since this is not a race, and any error that you
make will flow through the model youre building. If you catch a mistake part-way through, you will have to go
back and correct itsometimes causing you to have to recalculate nearly everything, and possibly leading to
compounding mistakes on top of the original one.
In addition, the interviewer will ask you to walk through your thought process and calculations. Thus it is
important to be able to build the proper paper LBO in simple, accurate steps, and make sure you can walk
through the reasoning regarding the process and each calculation. This takes practice, so be sure to practice at
least one more paper LBO before your next private equity interview.
III/ LBO Modeling Test Example
When interviewing for a junior private equity position, a candidate must prepare for in-office modeling tests on
potential private equity investment opportunitiesespecially LBO scenarios. In this module, we will walk
through an example of an in-office LBO modeling test. In-office case studies and modeling tests can occur at
various stages of an interview process, and additional interviews with other members of the private equity team
could occur on the same day. Therefore, you should strive to be able to do these studies effectively and
efficiently without draining yourself so much that you cant quickly rebound and move on to the next interview.
Make sure to take your time and build every formula correctly, since this process is not a race. There are many
complex formulas in this test, so make sure you understand every calculation.

This type of LBO test will not be mastered in a day or even a week. You must therefore begin practicing this
technique in advance of meeting with headhunters. Repeated practice, checking for errors and difficulties and
learning how to correct them, all the while enhancing your understanding of how an LBO works, is the key to
success.
In the following LBO Case Study module, we will cover the following key areas:
-

Investment Scenario Overview


Given Information (Parameters and Assumptions)
Exercises
o Step 1: Income Statement Projections
o Step 2: Transaction Summary
o Step 3: Pro Forma Balance Sheet
o Step 4: Full Income Statement Projections
o Step 5: Balance Sheet Projections
o Step 6: Cash Flow Statement Projections
o Step 7: Depreciation Schedule
o Step 8: Debt Schedule
o Step 9: Returns Calculations

1. Given Information (Parameters and Assumptions)


Below we provide the given information from a real-life LBO test that was given to a pre-MBA associate
candidate at a large PE firm. We will use it as an example of how to build an LBO model from scratch during
the interview. Remember that candidates will receive a laptop and a printout with key information regarding the
transaction to complete this assignment.
ABC Company, Inc.
2. Scenario Overview and Revenue Assumptions:
ABC Company, Inc. is a developer of software applications for smartphone devices. The company sells two
products for the various smartphones. The first is a software application called Cloud that tracks weather data.
The second application, Time, acts as a calendar that keeps track of a users schedule. ABC Company prices
Cloud at $16.00 and Time at $36.00 per software license. ABC Company sold 1.5 million copies of Cloud and
3 million copies of Time in 2010. That was the first year ABC Company generated any revenue.
Each software application requires the payment of a $5.00 renewal fee every year. ABC Company renews
approximately 25% of the licenses it sold in the prior year; this renewal fee acts as a source of recurring
revenue. To simplify, assume that renewals happen for only one additional year and that the recurring revenue
stream is based on the prior years new licenses. Note that ABC Company does not incur any additional costs
for renewals.
3. COGS assumptions (assume constant throughout the projection period):
-

Packaging costs = $1.50 per unit


Royalties to technology patent owners = $3.00 per unit
Marketing expense = $3.00 per unit
Fulfillment expense = $4.00 per unit
Fees to smartphone companies = 15% of sale price (does not include renewal fees)
ABC Company incurs a 15% bad debt allowance on total revenues (consider this as part of cost of
sales, wherein ABC Company is unable to collect from customers credit card companies).

4. G&A and other assumptions (assume constant throughout the projection period):
-

Rent of development property and warehouse facilities = $350,000 annually


License fee to telecom internet providers = $1.5 million annually
Salaries and benefits = $1.75 million annually
Sales commissions = 5% of all sales including renewals
Offices and other administrative costs = $750,000 annually
CEO salary and bonus = $1.25 million annually + 3% of all sales including renewals
Federal tax rate = 35% and state tax rate = 5% on EBT

5. Starting Balance Sheet

6. Investment Assumptions:
Due to the depressed macroeconomic and investing environment, the PE fund is able to acquire ABC Company
for the inexpensive purchase price of 5.0x 2011 EBITDA (assuming a cash-free debt-free deal), which will be
paid in cash. The transaction is expected to close at the end of 2011.
Assumptions include the following:
-

Senior Revolving Credit Facility: 3.0x (2.0x funded at close) 2011 EBITDA, LIBOR + 400bps, 2017
maturity, commitment fee of 0.50% for any available revolver capacity. RCF is available to help fund
operating cash requirements of the business (only as needed).
Subordinated Debt: 1.5x 2011 EBITDA, 12% annual interest (8% cash, 4% PIK interest), 2017
maturity, $1 million required amortization per year. (Hint: add the PIK interest once you have a fully
functioning model that balances.)
Assume that existing management expects to roll-over 50% of its pre-tax exit proceeds from the
transaction. Existing managements ownership pre-LBO is 10%.
Assume a minimum cash balance (Day 1 Cash) of $5 million (this needs to be funded by the financial
sponsor as the transaction is a cash-free / debt-free deal).
Assume that all remaining funding comes from the financial sponsor.
Assume that all cash beyond the minimum cash balance of $5 million and the required amortization of
each tranche is swept by creditors in order of priority (i.e. 100% cash flow sweep).
Assume that LIBOR for 2012 is 3.00% and is expected to increase by 25bps each year.
The M&A fee for the transaction is $1.5 million. Assume that the M&A fee cannot be expensed
(amortized) by ABC and will be paid out of the sponsor equity contribution upon close.
In addition, there is a financing syndication fee of 1% on all debt instruments used. This fee will be
amortized on a five-year, straight-line schedule.
Assume New Goodwill equals Purchase Equity Value less Book Value of Equity.

Assume Interest Income on average cash balances is 1%.

Hint: The first forecast year for the model will be 2012. However, you will need to build out the income
statement for 2010 and 2011 to forecast the financial statements for years 2012 through 2016.
6. Exercises:
As part of the in-person LBO test, pre-MBA and post-MBA candidates are expected to complete the following
exercises in their entirety. Please note the assumptions given here apply for multiple scenarios:
-

Build an integrated three-statement LBO model including all necessary schedules (see below).
Build a Sources and Uses table.
Make adjustments to the closing balance sheet of ABC Company post-acquisition.
Build an annual operating forecast for ABC Company with the following scenarios (using 2010 as the
first year for the revenue forecast; note that 2010 EBITDA should be approximately $25 million).
Assume that in 2011 there is 5% growth in units sold (both Cloud and Time units).
2012-2016 assumptions include:
o Upside Case: 5% annual growth in units sold (both Cloud and Time units)
o Conservative Case: 0% annual growth in units sold (both Cloud and Time units)
o Downside Case: 5% annual decline in units sold (both Cloud and Time units)
Build a Working Capital schedule using Accounts Receivable Days, Accounts Payable Days, Inventory
Days, and other assets and liabilities as a percentage of Revenue. Assume working capital metrics stay
constant throughout the projection period and assume 365 days per year.
Build a Depreciation Schedule that assumes that existing PP&E depreciates by $1 million per year, and
that new capital expenditures of $1.5 million per year depreciate on a five-year, straight-line basis.
Build a Debt schedule showing the capital structure described earlier. Use average balances for
calculating Interest Expense (except for PIK interestassume that PIK interest is calculated based on
the beginning year Subordinated Debt balance and not the average over the year).
Create an Exit Returns schedule (including both cash-on-cash and IRR) showing the returns to the PE
firm equity based on all possible year-end exit points from 2012 to 2016, with exit EBITDA multiples
ranging from 4.0x to 7.0x.
Display the results of all of these calculations using the Upside Case.

Note that the above description incorporates all of the information, assumptions and assignments that were
given in this LBO in-person test example.
Step 1: Income Statement Projections
As part of the first step, build out the core operating Income Statement line items for years 2010 through 2016.

Based on the provided assumptions, the Upside Case estimates an annual increase of 5.0% for Revenue from
2012-2016. Next, you should build the following exhibit in Excel in order to be able to change the case
scenarios easily (with the selected case driving the revenue growth numbers in the operating model).
-

Make a distinction between 2011 assumptions and 2012-2016 assumptions


Take the provided assumptions and make the revenue and cost build based upon them.

Note that the highlighted 1 is the input to the operating model, and the 5.0% in grey background represents
the formula that is built to pick up the appropriate case. We use the =OFFSET() function in Excel to drive this
formula.
- OFFSET is a simple Excel formula that is used commonly to interchange scenarios, especially if the
model becomes very complex. It simply reads the value in a cell that is located an appropriate number
of rows/columns away, based on the parameters given to the function. Thus, for example,
=OFFSET(A1, 3, 1) will read the value in cell B4 (3 rows and 1 column after A1).
Next, build the costs related to Revenue based upon the information given in the case.

Then, build the G&A expenses from the given information.

Finally, build a simple summary schedule for the above projections.

Step 2: Transaction Summary


As part of the second step, build out the transaction summary section which will consist of the Purchase Price
Calculation, Sources and Uses, and the Goodwill calculation.

Using this graphic, you should be able to understand and build all the formulas. Be sure to think through each
number and how it is calculated, as this is the main summary of the LBO transaction as a whole. A few points
worth noting:
-

This model assumes a debt-free/cash-free balance sheet pre-transaction for simplification. Without debt
or cash, the transaction value is simply equal to the offer price for the equity (before fees and minimum
cashdiscussed below).
The funding for this model is fairly simple: the funded credit facility is 2.0x 2011E EBITDA, the
subordinated debt is 1.5x, and the remaining portion is the equity funding, which is a combination of
management rollover equity and sponsor (PE firm) equity. (Note that the 5.0x 2011E EBITDA is the
offer value for the equity before the M&A and financing fees and the minimum cash balance, not after.
After fees/cash, it ends up being 5.25x.)
The management rollover is simply half of the management teams proceeds from selling the company.
Since management owned 10% of the company before the transaction, it constitutes 5% of the offer
price for the original equity.
The sponsor equity is the plug in this calculation. In other words, it is the amount that is solved for
once all other amounts are known (offer price + minimum cash + fees debt instruments
management rollover equity).
The total equity (including management rollover) represents about 30-35% of the funding for the deal,
which is about right for a typical LBO transaction.
Goodwill is simply the excess paid for the original equity (offer price book value of equity).

Step 3: Pro Forma Balance Sheet


As a next step, build out the Pro Forma Balance Sheet using the given 2011 balance sheet. To do this, you need
to incorporate all the transaction and financing-related adjustments needed to produce the Pro Forma Balance
Sheet. Each adjustment is discussed in detail below.

Since this is a cash-free and debt-free deal to start, there are no Pro Forma adjustments for the
cancelling or refinancing of debt.
Cash increases by $5 million upon close because the sponsor is funding the minimum cash balance
(minimum cash that is assumed to be needed to run the business).
The New Goodwill is simply the purchase value of the equity (not including fees) less the original book
value of the equity.
The adjustment for Debt Financing Fees reflects the cost of issuing the new debt instruments to buy the
company. This fee is considered an asset, and is capitalized and amortized over 5 years.
The Debt-related adjustments reflect the new debt instruments for the new capital structure.
The Equity adjustment reflects the fact that the original equity is effectively wiped out in the
transactionthe adjustment amount shown here is simply the difference between the new equity
value and the old one. The new equity value will equal the amount of the total equity funding for the
transaction (sponsor plus managements rollover) less the M&A fee, which is accounted for as an off
balance-sheet cost.
VERY IMPORTANT: This stage of the LBO model development (once Pro Forma adjustments have
been made to reflect the impact of the transaction on the balance sheet) is a very good time to check to
make sure that everything in the model so far balances and reflects the given assumptions. This
includes old and new assets equaling old and new liabilities plus equity; new sources of capital
equaling the transaction value, which equals the offer price for the original equity (adjusting for cash,
old debt and fees), etc.

Step 4: Full Income Statement


Next, build the full Income Statement projections all the way down to Net Income. Note that a few line items
(especially Interest Expense!) will be calculated in later steps. Once the Cash Flow section and other schedules
are built, link all the final line items to complete the integrated financials.

You can link the Revenue, COGS and SG&A calculations to the operating model (built in Step 1) to
get to EBITDA.
To get from EBITDA to Net Income, set up the framework first (include line items to subtract D&A,
and to subtract Interest and fees, to get to EBT. Then subtract taxes to get Net Incomebut keep in
mind for now that calculating D&A and Interest will come a bit later, from other schedules you have
not yet created).
o D&A will be linked to the Depreciation Schedule that you will need to build (schedule of the
Depreciation of the existing PP&E and new Capital Expenditures made over the projection
period).
o Interest Expense and Interest Income will be linked to the Debt Schedule that you will need to
build. There will be a natural circular reference because of the cash flow sweep feature of the
LBO model, combined with the fact that Interest Expense is dependent upon Cash balances.
This is usually one of the last things you should build in an LBO model.
o The amortization of Deferred Financing Fees is fairly straightforward: it uses a straight-line, 5
year amortization of the fees described in the case write-up and computed in Step 2.
o The tax rates apply to EBT after all of these expenses have been subtracted out. They are given
in the case write-up.

Step 5: Balance Sheet Projections


Next, forecast the Balance Sheet from 2011 to 2016. Note that we start with the 2011 Pro Forma Balance Sheet
from Step 3, not the original Balance Sheet.

Laying out the Balance Sheet is similar to laying out the Income Statementyoull have to set up the
framework for some line items and leave the formulas blank at first, as they will be calculated in the
other schedules you will create.
Cash remains at $5 million throughout the life of the model, as were assuming a 100% cash flow
sweep and that the minimum cash balance is $5 million. (Cash would only start to increase if we
project out long enough that all outstanding Debt is paid off.)
Youll need to build out the Operating Working Capital line items (Accounts Receivable, Inventory,
Other Current Assets, Accounts Payable, Other Current Liabilities) according to the assumptions stated
in the case write-up.
o Accounts Receivable (AR): Calculate AR days (AR Total Revenue 365) for 2011 and keep
it constant throughout the projection period.
o Inventory: Calculate Inventory days (Inventory COGS 365) for 2011 and keep it constant
throughout the projection period.
o Other Current Assets: Keep this line item as a constant percentage of revenue throughout the
projection period.
o Accounts Payable (AP): Calculate AP days (AP COGS 365) for 2011 and keep it constant
throughout the projection period.
o Other Current Liabilities: Keep this line item as a constant percentage of revenue throughout
the projection period.
Total Deferred Financing Fees are computed based upon the Debt balances and percentage assumptions
given in the model. Deferred financing fees are then amortized, straight-line, over 5 years.
The Credit Facility and Subordinated Debt line items will link to your Debt schedule. Their balances
will decrease over time as a function of the cash available for Debt paydown (since the case write-up
specifies a 100% cash sweep function).
Equity (specifically Retained Earnings) will increase each year by the same amount as Net Income,
because there are no dividends being declared. If dividends were to be added into the model, you would
calculate ending Retained Earnings as Beginning Retained Earnings + Net Income Dividends
Declared.

As discussed earlier, the balance sheet has the pleasing feature that if it balances, the model is probably
operating correctly! Now is another good time to make sure everything balances before proceeding.

Step 6: Cash Flow Statement Projections


Next, forecast the Cash Flow Statement as requested in the Exercises section.

The primary purpose of the Cash Flow Statement in the integrated financial model is to calculate the Levered
Free Cash Flow (LFCF) being generated by the business. This is for obvious reasons: cash generation is very
important in the eyes of PE investors, as it is used to pay down debt and thereby increase equity value (and
thereby decrease future interest burdens on the business, which helps to decrease risk over time).
-

Start with Net Income and add back non-cash expenses from the Income Statement, such as D&A,
Non-Cash Interest (PIK), and Deferred Financing Fees.
Next, subtract uses of Cash that are not reflected in the Income Statement. These include the increase in
Operating Working Capital (which you calculated using your balance sheet) and Capital Expenditures
(which is calculated here or, alternatively, could be calculated in the Depreciation Schedule to be built
shortly).
Next, calculate the change in cash, which will be interconnected with the Debt schedule. In this case,
the model is assuming a 100% cash flow sweep (after mandatory debt amortization payments), so cash
should not change after the 2011PF Balance Sheet amount of $5 million.
Even though the amount is not changing, the Cash line item should link back to the Balance Sheet. This
is because the model could later be used to relax the assumption that 100% of excess cash is swept to
pay down Debt. If its less than 100%, Cash would accumulate, and that would need to tie in to the
other financial statements.

Step 7: Depreciation Schedule


Next, forecast the Depreciation schedule as requested in the Exercises section.

Step 8: Debt Schedule


Next, forecast the Debt Paydown and Interest Expenses for each year via the Debt Schedule, as requested in the
Exercises section.

We need to build this schedule correctly! The Debt Schedule is probably the trickiest part of the LBO
model to buildespecially for anyone who has not built an LBO model before. The Debt Schedule will
create the circular (iterative) reference that is the defining characteristic of a true LBO model. Before
linking the Debt, Cash, and Interest calculations to one another in the Debt schedule, be sure to turn
Iterations on in the Formulas section of Microsoft Excels Options menu.
o WARNING: Be very careful about changing formulas once you have built the iterative
calculation. If you do so and introduce an error, it could bust your entire model if youre not
careful. This is because the error will travel all the way through the iterative calculations and
end up everywhere! If you run into this problem, break the circular reference entirely (by
deleting it), reconstruct the calculations for the first forecast year (2012), and then copy and
paste them across the columns, one year at a time (2013, then 2014, etc.). Many PE
professionals have spent late nights in the office trying to recover from an accidental error
introduced into a circular LBO model formula!
To compute the changes in Debt balances, calculate LFCF (the framework for this started already on
the Statement of Cash Flows). This determines how much debt is going to be paid down (both
discretionary and non-discretionary).
o The non-discretionary portion is the required amortization payments made on debt (in this case,
there is only required pay-down for subordinated debt).
o The discretionary portion is the sweep portion of the remaining LFCF less required
amortization. Since were assuming a 100% cash flow sweep, all of the LFCF is used to pay
down debtfirst the Senior Credit Facility, then the Subordinated Debt. The cash flow sweep
and required payments will help you calculate the beginning and ending balances of both of the
debt tranches.
o The Senior/Revolving Credit Facility (S/RCF) is the first priority to get paid off via the cash
flow sweep. It should be completely paid off before later tranches receive any discretionary
principal repayment in the Debt Schedule.
Also note that we need to include a fee for the availability of the unused portion of the
RCF, even if the business never uses itthis is a typical, annual commitment fee
arrangement for revolving credit facilities.

The interest rate on the debt is a floating rate (this means an interest rate that is
dependent on LIBOR, according to the assumptions provided). We need to calculate
interest based on this rate times the average S/RCF balance over the year.
o Subordinated debt is the second priority to get paid off through the cash flow sweep. Other
than required amortization, none of the Subordinated Debt gets paid off before the S/RCF is
fully paid off.
The 8% cash interest is calculated based upon the average of the debt balance, just like
with the S/RCF.
However, the 4% PIK (non-cash) interest will accrue based upon the beginning debt
balance, not the average.
Because of this difference (and the fact that one source of interest uses cash and the
other does not), we need to make sure were using separate line items for the two types
of Interest Expense.
We also need to be aware of the mandatory amortization payment of $1 million per
year, provided in the assumptions. This amount will get paid down out of LFCF no
matter what.
o Interest Income on Cash is fairly easy to calculateit is the Cash interest rate (1%) times the
average balance throughout the year. This amount will increase Cash.
When weve finished with these calculations, we need to link these line items to various line items in
the integrated financial statement.
o Total Interest needs to be linked to the Income Statement.
o Non-Cash Interest needs to be added back to Net Income in the Statement of Cash Flows to
assist in deriving LFCF (its a non-cash expense).
o Any LFCF that is not used to pay down Debt needs to link to the Cash line item of the Balance
Sheet. (In this model none will, but you should include this measure in case the model is later
used to either relax the 100% cash sweep assumption, or to project financials beyond the point
at which all debt has been paid off).
o All Debt balances paid down by LFCF need to link to the Debt line items on the Balance Sheet.

Step 9: Returns Calculations


In the final step of the LBO test, build out the Returns calculation required in the Exercises section.

The last portion of the model to complete is the Equity Returns schedule. This is essentially a simple
calculation based upon the outputs generated by rest of the model.
o For each year, we simply take EBITDA multiplied by a range of purchase multiples to get to a
total Exit Value for the company (Transaction Enterprise Value, or TEV).
o Next, we subtract out Net Debt (which is dependent on the 3-statement model you just created)
to get to Equity Value.
o Next, we calculate the portion of the Equity Value that belongs to the management and the
sponsor by using the initial equity breakdown for each party.
From there its important to calculate both the internal rate of return (IRR) and the cash-on-cash returns
(also known as the Multiple of Money or Multiple of Invested Capital). The only tricky part of this
calculation is to make sure that youre calculating IRR correctly, by using the correct Net Present
Value or IRR formula and that, very importantly, youre discounting by the right number of years!
After all the mental energy youve expended to get to this point, its easy to make this mistake.
o Put simply, the IRR is equal to the cash-on-cash returns compounded by the number of years,
minus 1. Thus, for example, for the 5-year, 5.0x Exit Multiple scenario:

LBO Case Study: Conclusion and Final Comments


We hope that this case study provides some insight into all of the considerations that need to be made in
building a realistic LBO model based on a case study in a Private Equity interview, and that the 9-step
breakdown helps you simplify the task into easy-to-replicate and easy-to-execute steps.
No one becomes an expert LBO modeler overnight, so the key to doing well in this portion of the process is
practice, practice, and more practice. With enough sample LBO cases, you should be able to master the steps
needed to confidently build a fully functioning, professional LBO model on interview day.