CHAPTER 9
Leveraged Buyouts Questions

  1. 1) What is a leveraged buyout?

    A leveraged buyout is an acquisition of a company using a significant amount of debt to meet the cost of the acquisition.

  2. 2) Name three core components that contribute to the success of a leveraged buyout.
    1. Cash availability, interest, and debt pay-down
    2. Operation (EBITDA) improvements
    3. Multiple expansion
  3. 3) Name four exit strategies to a leveraged buyout.
    1. Strategic sale
    2. Sale to another financial sponsor
    3. IPO
    4. Dividend recapitalization
  4. 4) What are some characteristics of a company that make a good LBO candidate?
    1. Steady cash flows
    2. Opportunities for earnings growth or cost reductions
    3. A high asset base—collateral to raise more debt
  5. 5) What are the three main steps to conducting a leveraged buyout analysis?
    1. Step 1: Obtaining a purchase price
    2. Step 2: Estimating sources and uses of funds
    3. Step 3: Calculating investor rate of return (IRR)
  6. 6) What is the purpose of a leveraged buyout analysis?

    A leveraged buyout analysis helps determine the annualized returns (IRRs) of an investor's equity investment in a business after a specific time horizon.

  7. 7) Walk me through a leveraged buyout analysis.

    In order to determine the IRR of a particular investment after a certain number of years, one first needs to establish the purchase price of the business. After estimating purchase price, one needs to determine the entire uses of funds (purchase price, net debt, and transaction fees) and the sources used to fund the acquisition (some combination of term loans, high yield debts, mezzanine, and equity). One can then construct a simple unlevered free cash flow analysis that will provide a projected EBITDA for estimating an exit and total cash produced for paying down debt. The projected EBITDA is multiplied by a multiple to get an estimated exit value. Often the purchase multiple is used as an estimated exit multiple. In order to establish return, one needs to calculate the final debt. The original debt raised to fund the acquisition plus the total interest incurred is calculated. One can estimate total interest by taking each annual interest expense multiplied by the number of years and multiplied by 1 – tax%. The sum of the original debt raised and the total interest expense less the sum of the unlevered free cash flow is the final debt balance. The return is the exit value (from the EBITDA times the multiple) less this final debt number. One can then compare the return with the equity originally invested in the business to calculate the IRR.

  8. 8) What are some major differences between a basic LBO analysis and full-scale LBO model?

    There are many differences between a basic and full-scale LBO model. One major difference is that simple analysis would just contain a simple cash flow build-up, whereas a full-scale model would contain complete projections. This would include the income statement, cash flow statement, balance sheet, as well as the supporting schedules. A full-scale analysis would also include balance sheet adjustments—a more detailed look at the balance sheet post-transaction adjustments. Another major difference to highlight is the simple analysis estimates interest in one year and multiplies by the number of transaction years to estimate total interest obligations. In reality, if a company is paying down debt each year, the interest expense should also be reducing. Because a full-scale model contains a debt schedule, it will more properly associate declining interest in line with debt paydown.

  9. 9) What are some common types of debts raised in a leveraged buyout?

    Although there is a vast range of possible securities utilized in funding a particular LBO transaction, they can come in several major categories: bank debt, high yield debt, and mezzanine debt. Bank debt, or a term loan, is the most fundamental type of debt. It usually carries 5 percent to 12 percent interest and can be backed by the core assets of the business. Such debt can be a revolving line of credit, a term loan, and other subordinated loans or notes.

    High yield debt is a more aggressive type of debt borrowed at much higher interest rates to compensate for additional risk of defaulting on such debts. Interest in such debt can be upwards of 15 percent, but it varies depending on the situation at hand.

    Mezzanine (or convertible) lending is a hybrid between debt and equity. The general concept of a mezzanine security is that it is initially considered debt that will convert to equity after a certain amount of time or after certain hurdles are met.

  10. 10) What are the most common variables in an LBO analysis?
    1. Purchase price. The higher the purchase price, the more costly the investment may be to the investor, and therefore the lower the IRR.
    2. Sources of cash. The amount of debt that can be raised to make such an investment will also affect the IRR. The more debt we can raise, the less equity we have to put in, and so the higher our expected returns will be.
    3. Interest rate. A lower interest rate would lower our costs, which would increase our cash, which would allow us to pay down debt faster and increase the IRR.
    4. Time frame. Typically, a shorter time frame would produce a higher IRR.
    5. Operations performance (EBITDA projections). The more we can improve EBITDA, the higher our potential sale value, which would increase IRR. Also, a higher EBITDA would improve our cash flow.
    6. Cash flow (UFCF projections). Improved cash flow performance will allow us to pay down debt faster and will improve our IRR.
    7. Exit multiple. The higher our exit multiple (exit value), the higher our return.
  11. 11) Name four sources of funds in a leveraged buyout from least to most risky.
    1. Bank debt (term loan, notes)
    2. High-yield debt
    3. Mezzanine funding (convertible securities)
    4. Equity
  12. 12) Name the three methods of acquiring a business.
    1. Asset acquisition
    2. Stock acquisition
    3. 338(h)10 election
  13. 13) Name the core uses of funds categories.
    1. Purchase price
    2. Net debt
    3. Transaction fees
  14. 14) What is one way to conservatively estimate an exit multiple?

    Often, one can conservatively assume the purchase multiple will be the exit multiple.

  15. 15) Name one way to calculate IRR.

    IRR can be calculated as: (Exit Equity Value/Equity Invested) ^ (1/Years) − 1

  16. 16) What are the major variables to an LBO analysis? Name at least four.
    1. Purchase price
    2. Sources of cash
    3. Interest rate
    4. Time frame
    5. Operations performance (EBITDA projections)
    6. Cash flow (UFCF projections)
    7. Exit multiple
  17. 17) What are some advantages of LBO financing?
    1. The more debt used to make the purchase, the less equity needed, which can maximize potential returns.
    2. Interest payments on debt are tax deductible.
  18. 18) What is the advantage to using leverage when making an acquisition?

    The more leverage used to fund an acquisition, the less equity needed. Less equity invested will maximize your return.

  19. 19) How can one determine the amount of debt raised?

    One can use debt multiples as comparable metrics to other similar leveraged buyouts.

  20. 20) Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?

    You would rather have the extra dollar of EBITDA because of the multiple. At exit, the sale price is dependent on the EBITDA times the exit multiple. So, an extra dollar of debt paydown increases your equity value by only one dollar; an extra dollar of EBITDA is multiplied by the exit multiple.

  21. 21) Name several strategies to maximize returns in an LBO.
    1. Minimize equity invested (this can be done by increasing the debt used).
    2. Reduce the purchase price.
    3. Increase the sale price (exit).
    4. Increase EBITDA (cutting costs or boosting revenue).
    5. Maximize cash flow.
  22. 22) What is a dividend recapitalization?

    In a dividend recap, the company re-levers (raises debt on) the balance sheet. The new money raised is often paid out as a dividend.

  23. 23) What is the advantage of performing a dividend recap?

    A dividend recap could have several advantages in maximizing returns. One common advantage is to extend the holding period of the company while still raising cash to expend for the fund's needs. If the market environment is not the best for target company exit, a dividend recap would allow the fund more time to look for the right exit opportunity.

  24. 24) What cost of equity discount rate would you use to value a target company in a leveraged buyout using a discounted cash flow analysis?

    You would often use a rate that reflects the expected equity return of the fund. If the fund is expecting a 25% return, this could be the rate to use.

  25. 25) What is a PIK security?

    A PIK security is a paid-in-kind security. The periodic interest obligations are satisfied “in kind,” meaning in something other than currency. Typically, when the interest obligation comes due, more debt is raised to meet that obligation. This results in interest-on-interest, which can get costly. On the other hand, it reserves cash for other beneficial uses.

  26. 26) What is the purpose of a seller note in a leveraged buyout?

    A seller note is a loan to the purchased business from the seller. If a certain purchase price is negotiated in an acquisition, a certain amount is of course paid immediately, and the rest can be deferred as a seller note payable in certain terms. This can be used to prevent the seller from starting a competing business or can incentivize the seller to continue to support the business.

PRACTICE QUESTIONS

Use the space available to answer the following examples. The answers are at the end of the chapter.

  1. 27) We have evaluated and would like to acquire a public company. The company is trading at $12 per share and has a total of 150 million diluted shares outstanding. We have negotiated a 25 percent purchase premium. The company has an LTM EBITDA of $50 million, $100 million of net debt outstanding. We will also assume $5 million of transaction fees. The net debt cannot carry over. What are the total uses of funds?
  2. 28) We have evaluated and would like to acquire a private business, so we look to public comparable companies (if they exist) to assess a proper value. We assume the comparable company analysis results in a range of 4.0× to 6.0× EBITDA. The company has an LTM EBITDA of $15 million and $7MM of net debt outstanding. If we assume $1 million of transaction fees and a 5.0× EBITDA purchase price, what are the total uses of funds?
  3. 29) You would like to invest in a company that has an LTM EBITDA of $25 million. The entry multiple is 8×; leverage is 5×. At time of exit, you have generated cash flow after interest payments of $100 million, which will go toward debt paydown. You generate a 4× return, but 25 percent of the business is given to management. At what price must you sell the business?
  4. 30) Which is the better investment opportunity based on this information? Assume everything about the companies is the same except for what is given in the information, and assume the exit multiple is the same as the entrance multiple.
    1. Company A:
      1. EBITDA: $100 million
      2. Projected annual revenue growth: 5 percent for the next five years
      3. Purchase price: 6× EBITDA/5× Debt
    2. Company B:
      1. EBITDA: $100 million
      2. Projected annual revenue growth: 10 percent for the next five years
      3. Purchase price: 7× EBITDA/5× Debt
  5. 31) A company has $250MM of EBITDA. It grows to $400MM in five years. Each year you paid down $50MM of debt. Let's say you bought the company for 8.0× and sold it for 9.0×. How much equity value did you create? How much is attributed to each strategy of creating equity value?

PRACTICE CASES

These next few examples are designed to be 45-minute cases and answered on paper. I have provided blank pages to work out answers on your own. The solutions are provided at the end of the chapter.

  1. 32) You are an analyst at a private equity firm. You have been tasked with analyzing a leveraged buyout opportunity of a retail company. Does this look like a good investment for the fund?

    Key Assumptions:

    1. The fund expects to hold the company for five years.

    2. Comparable analysis puts the company value at 5× EBITDA.

    3. We have been able to negotiate a Term A loan at 3.0× LTM EBITDA (5 percent interest rate).

    4. We have also been able to negotiate a high-yield loan for 0.5× LTM EBITDA at a 10 percent interest rate.

    5. Assume no transaction fees.

    Company Assumptions:

    1. The company has an LTM EBITDA of $5 million.

    2. Management expects the company to grow at 5 percent per year.

    3. The company has a $20 million asset that will be evenly depreciated over 20 years.

    4. The company's working capital is steadily increasing at $100k per year (resulting in a $100k cash flow decrease).

    5. The company will maintain CAPEX spend at $1MM per year and will be depreciated over 20 years.

    6. The tax rate is 40 percent.

  2. 33) What is the IRR of the following leveraged buyout investment?

    Key Assumptions:

    1. The fund expects to hold the company for five years.
    2. Comparable analysis puts the company value at 4× EBITDA.
    3. We have been able to negotiate a Term A loan at 2.5× LTM EBITDA (10% interest rate).
    4. We have also been able to negotiate a Term B loan at 15% of the total uses of funds (12% interest rate).
    5. Assume transaction fees to be 1% of the purchase price enterprise value.

    Company Assumptions:

    1. The company has an LTM EBITDA of $7 million.

    2. The company has 100k of existing net debt on its balance sheet.

    3. Management expects the EBITDA to grow at 10 percent per year.

    4. The company has a $20 million asset that will be evenly depreciated over 20 years.

    5. The company will maintain CAPEX spend at $1.25MM per year, and it will be depreciated over 20 years.

    6. Assume the company's working capital is projected at 30 days on EBITDA.

    7. The tax rate is 40 percent.

  3. 34) You are an analyst at a private equity firm. You have been tasked with analyzing the following leveraged buyout opportunity. What is the expected IRR?

    Key Assumptions:

    1. The fund expects to hold the company for five years.
    2. Comparable analysis puts the company value at 5× EBITDA.
    3. We have been able to negotiate a Term A loan at 3.5× LTM EBITDA (10 percent interest rate).
    4. We have also been able to negotiate a high-yield loan for 0.5× LTM EBITDA at a 15 percent interest rate.
    5. Transaction fees are assumed to be 0.5% of the purchase price.

    Company Assumptions:

    1. The company has an LTM EBITDA of $10 million.
    2. Management expects the company's EBITDA to grow at 5 percent per year.
    3. The company has 250k of net debt on its balance sheet.
    4. The company has a $40 million asset that will be evenly depreciated over 10 years.
    5. The company will maintain CAPEX spend at $1.1MM per year and will be depreciated over 10 years.
    6. The company's working capital is projected at 15 days off of EBITDA.
    7. The tax rate is 40 percent.
  4. 35) An investor is looking into buying out the following business. What is the expected IRR given the following scenario?

    Key Assumptions:

    1. The fund expects to hold the company for five years.
    2. Comparable analysis puts the company value at 6× EBITDA.
    3. The investor has been able to negotiate a Term A loan at 25% of the total uses (10 percent interest rate).
    4. He has also been able to negotiate a Term B loan at 2× EBITDA (12 percent interest rate) and a high-yield loan for 1× LTM EBITDA at a 15 percent interest rate.
    5. Transaction fees are assumed to be 1% of the purchase price.

    Company Assumptions:

    1. The company has revenue of $10 million.
    2. Management expects the company's revenue to grow at 2 percent per year.
    3. The company is projecting total operating expenses at 30% of revenue each year.
    4. The company has a $50 million asset that will be evenly depreciated over 20 years.
    5. The company will maintain CAPEX spend at $1MM per year, and it will be depreciated over 10 years.
    6. The company's working capital consists of accounts receivable (projected at 30 days) and accrued expenses (projected at 10 days).
    7. The tax rate is 40 percent.
  5. 36) You are an associate assigned to assessing the potential IRR of the following company. Please calculate the IRR.

    Key Assumptions:

    1. The fund expects to hold the company for five years.
    2. Comparable analysis puts the company value at 7× EBITDA.
    3. The investor has been able to negotiate a Term A loan at 3.5× EBITDA (10 percent interest rate).
    4. He has also been able to negotiate a Term B loan at 1.5× EBITDA (12 percent interest rate) and a high-yield loan for 0.5× EBITDA at a 15 percent interest rate.
    5. Transaction fees are assumed to be 2% of the purchase price.

    Company Assumptions:

    1. The company has revenue of $12 million.
    2. Management expects the company's revenue to grow at 7 percent per year.
    3. The company is projecting total operating expenses at 25% of revenue each year.
    4. The company has a $50 million asset that will be evenly depreciated over 20 years.
    5. The company will maintain CAPEX spend at $0.5MM per year and that will be depreciated over 20 years.
    6. The company's working capital consists of accounts receivable (projected at 35 days) and accrued expenses (projected at 15 days).
    7. The tax rate is 40 percent.

ANSWERS

  1. 27) $2,355 million: The purchase price is $12 × (1 + 25%) × 150MM = $2,250MM. Because this is a public company, we need to be responsible for the net debt. It is stated that the net debt cannot carry over to the acquirer (us), so we need to pay it down. So, we add the additional $100 in net debt plus the $5 million in transaction fees to get to a purchase price of $2,355 million.
  2. 28) $76MM: The purchase price is 5.0 × $15MM, or $75MM). Since this is based on an EBITDA multiple, this already includes the value of the net debt, so we do not add the $7 million of debt to this. We do, however, add $1 million in transaction fees to get to total uses of $76 million.
  3. 29) To make a 4× return based on the financial parameters, you must sell the business at $425 million. Let's start with calculating the purchase price, which is $25 million × 8× EBITDA, or $200 million. We know 5× EBITDA (leverage) is debt raised to fund the acquisition, so 5 × $25 is $125 million in debt raised. So of the $200 million purchase price, $125 million is funded with debt, which means $75 million (or $200 million – $125 million) is funded with equity. So, if you want a 4× return on equity you need to make 4 × $75, or $300 million. However, the question is what you need to sell the company for. After selling the company you still need to pay down the remaining debt and give 25 percent of the business value to management. So, we back-calculate: $300/(1 – 25%) is $400 million. We then have to increase this value further by the exit net debt, which is $25 million (the $125 million raised less the $100 million cash generated after making interest payments). So the sale price should be $425 million. To look at this another way, if we sell the company for $425 million, we need to pay down the net debt, which is $25 million. This gets us to $400 million. Then, 25 percent goes to management, or $100 million. This leaves us with $300 million—a 4× return on our original investment of $75 million.
  4. 30) The answer is Company B. Hint: If you do not have access to a calculator to compound the interest, you can ignore compounding. You will still be able to get an understanding of what the potential investment opportunity is. So, assuming constant EBITDA margins, EBITDA for Company A in Year 5 will be about $125 million = $100 million * [1 + (5% * 5)], and Company B will be $150 million = $100 million * [1 + (10% * 5)]. If the purchase price was 6× EBITDA for Company A, and 5× of that was leverage, then 1× EBITDA was the equity invested. So $100 million (1 × $100 million) was the equity invested in Company A, and $125 million (1 × $125 million) was the expected equity returned in Company A. The equity investment in Company B is 2× EBITDA. So, $200 million (2 × $200 million) was the equity invested in Company B, and $300 million (2 × $150 million) was the expected equity returned in Company B. So the expected return in Company A is 125/100 or 1.25× versus 300/200 or 1.50×. Notice the question specifically states to assume everything is the same, which includes the debt and equity structure at purchase and at exit. We also did not factor in debt paydown. But given that Company B is producing more EBITDA, and presumably more cash flow, adding debt paydown into the analysis would make Company B look even better. So either way Company B is the better investment opportunity.
  5. 31) Remember, the three ways value is created are (1) EBITDA growth, (2) debt paydown, and (3) multiple expansion. The purchase price is $2,000MM ($250MM * 8.0×). The exit value is $3,600MM ($400MM × 9.0×). This is a profit of $1,600 MM, plus you paid down debt of $250MM ($50 × 5), so your total equity value increased by $1,850MM ($1,600MM + $250MM). $250MM of the total equity value is of course due to debt paydown. The EBITDA growth value is determined by assuming an 8.0× exit (no multiple expansion). So, 8.0 × $400MM ($3,200MM) less the $2,000MM is the value increase based on EBITDA growth, or $1,200MM. The remaining is based on multiple expansion. So (9.0× – 8.0×) × $400MM is the value based on the multiple expansion. $250 + $1,200 + $400 = $1,850MM.
  6. 32) Answer:

    I will go through this one step by step. Remember the first important task is to calculate the purchase price. A 5MM EBITDA at a 5× multiple gives us a $25MM purchase price. Next, we need to calculate sources and uses of funds. The uses are made up of the purchase price, target net debt, and transaction fees. No fees were assumed, so we can leave that at $0. There was also no mention of target net debt, but it's important to remember that even if the company did have target net debt, it is assumed in the purchase price, as the purchase price of $25MM is effectively an enterprise value. So the total uses of funds are simply $25MM. Now the sources are made up of debt and some equity investment. It is mentioned there will be a Term A loan raised at 3× EBITDA, or $15MM (3 × $5MM). And there will also be a high yield loan at 0.5× EBITDA, or $2.5M. Since there are no more debt assumptions, we assume the remainder is equity, or $25MM − $15MM − $2.5MM = $7.5MM.

    Uses Sources
    Purchase Price $25,000,000 Term A $15,000,000
    Net Debt $0 High Yield $2,500,000
    Transaction Fees $0 Equity $7,500,000
    Total Uses $25,000,000 Total Sources $25,000,000

    Now that we have the purchase price, sources, and uses of funds, we can proceed to the transaction at hand. The two key items needed are exit value (based on final year EBITDA) and the final debt determined to calculate our return. Both of these items depend on a simple cash flow analysis. So we first have to build an unlevered free cash flow for the estimated five years. Starting with the given EBITDA of 5MM at Year 0, we can use the 5% EBITDA growth assumption to project out five years.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 5,000,000 5,250,000 5,512,500 5,788,125 6,077,531 6,381,408
    D&A
    EBIT
    Deferred Tax
    WC
    CAPEX
    Taxes
    Total UFCF

    We now need to fill out the rest of this UFCF table starting with D&A. As with any standard D&A table, we have PP&E and CAPEX to depreciate. The assumptions suggest 20MM in PP&E and 1MM in CAPEX, both with depreciation on a straight-line basis over 20 years.

    Depreciation
    St Line
    Year 1 Year 2 Year 3 Year 4 Year 5
    PP&E $20,000,000
    CAPEX $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
    Years 20 20 20 20 20
    Year 0 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
    Year 1 $50,000 $50,000 $50,000 $50,000 $50,000
    Year 2 $50,000 $50,000 $50,000 $50,000
    Year 3 $50,000 $50,000 $50,000
    Year 4 $50,000 $50,000
    Year 5 $50,000
    Total $1,050,000 $1,100,000 $1,150,000 $1,200,000 $1,250,000

    Notice we didn't bother with Year 0. We only need to know the cash flow from Years 1 to 5, as these are the years the business was actually held by the fund. We can now plug the depreciation into the UFCF and subtract to get EBIT. We need EBIT in order to calculate taxes. Remember, in an UFCF, taxes are EBIT × tax%.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 5,000,000 5,250,000 5,512,500 5,788,125 6,077,531 6,381,408
    D&A 1,050,000 1,100,000 1,150,000 1,200,000 1,250,000
    EBIT 4,200,000 4,412,500 4,638,125 4,877,531 5,131,408
    Deferred Tax
    WC
    CAPEX (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000)
    Taxes (1,680,000) (1,765,000) (1,855,250) (1,951,013) (2,052,563)
    Total UFCF

    There were no assumptions for deferred taxes. The example also mentions working capital is increasing at 100k per year. So a working capital increase results in a cash outflow. This completes our UFCF analysis.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 5,000,000 5,250,000 5,512,500 5,788,125 6,077,531 6,381,408
    D&A 1,050,000 1,100,000 1,150,000 1,200,000 1,250,000
    EBIT 4,200,000 4,412,500 4,638,125 4,877,531 5,131,408
    Deferred Tax 0 0 0 0 0
    WC (100,000) (100,000) (100,000) (100,000) (100,000)
    CAPEX (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000)
    Taxes (1,680,000) (1,765,000) (1,855,250) (1,951,013) (2,052,563)
    Total UFCF 2,470,000 2,647,500 2,832,875 3,026,519 3,228,845

    Now that we have UFCF, we can proceed with calculating our exit. Assuming no multiple expansion, we can apply the 5× purchase multiple to the Year 5 projected EBITDA to get our exit value, giving us $31,907,039 (5 × $6,381,308). This is our exit value but it's not the money the investor receives as a return. We need to figure out how much debt is left at Year 5 and subtract from the exit value to get our return. To calculate final debt, we take the debt raised to fund the acquisition and add in five years of after-tax interest. We then use all the cash generated during the five years to pay down as much debt and interest as possible. So based on our sources, we've raised 15MM in Term A loans and 2.5MM in high yield. We need to calculate the interest on each and multiply by 1 – tax% and the number of years to get the total interest incurred. So for Term A:

    equation

    And for the high yield:

    equation

    So there's a total of 3,000,000 in interest incurred (2,250,000 + 750,000).

    We can add the total interest to the debt raised to get total obligations 15,000,000 + 2,500,000 + 3,000,000 = 20,500,000.

    We can now add up the five years of cash calculated in the UFCF analysis, giving us $14,205,738. This cash will be used to pay down all obligations.

    So, $20,500,000 – $14,205,738 = $6,294,262. This is the final debt. So, subtracting the final debt from the exit gives us our return:

    equation

    We can now calculate our IRR:

    equation
  7. 33) Answer:

    The purchase price should be straightforward at $28,000,000 (4 × $7,000,000). Now for the sources and uses. Remember, although the example suggests 100k target company net debt, we do not add this net debt to the uses of cash. As the purchase price is an enterprise value, it already included the assumption of net debt. We do, however, need to take 1% of the purchase price for transaction fees.

    Uses
    PP $28,000,000
    Debt 0
    Fees $280,000
    Total $28,280,000

    Notice the Term B loan in the sources is estimated at 15% of the total uses of funds. The remainder is Equity (Total Uses less Term A less Term B).

    Sources
    Term A $17,500,000
    Term B $4,242,000
    Equity $6,538,000
    Total $28,280,000

    Next we can start to lay out the unlevered free cash flow. Most components are straightforward.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 7,000,000 7,700,000 8,470,000 9,317,000 10,248,700 11,273,570
    D&A 1,062,500 1,125,000 1,187,500 1,250,000 1,312,500
    EBIT 6,637,500 7,345,000 8,129,500 8,998,700 9,961,070
    Deferred Tax 0 0 0 0 0
    Working Capital
    CAPEX (1,250,000) (1,250,000) (1,250,000) (1,250,000) (1,250,000)
    Taxes (2,655,000) (2,938,000) (3,251,800) (3,599,480) (3,984,428)
    Total UFCF

    The example suggests to estimate total working capital at 30 days on EBITDA. So we can use the working capital formula (30/360 × EBITDA) to make our annual working capital estimates. We then need to calculate the year-over-year changes for our cash flow.

    Working Capital Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 7,000,000 7,700,000 8,470,000 9,317,000 10,248,700 11,273,570
    Days 30 30 30 30 30 30
    Total Working Capital 583,333 641,667 705,833 776,417 854,058 939,464
    Changes in Working Capital (58,333) (64,167) (70,583) (77,642) (85,406)

    We can now use these changes in our UCFC and calculate the total.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 7,000,000 7,700,000 8,470,000 9,317,000 10,248,700 11,273,570
    D&A 1,062,500 1,125,000 1,187,500 1,250,000 1,312,500
    EBIT 6,637,500 7,345,000 8,129,500 8,998,700 9,961,070
    Deferred Tax 0 0 0 0 0
    Working Capital (58,333) (64,167) (70,583) (77,642) (85,406)
    CAPEX (1,250,000) (1,250,000) (1,250,000) (1,250,000) (1,250,000)
    Taxes (2,655,000) (2,938,000) (3,251,800) (3,599,480) (3,984,428)
    Total UFCF 3,736,667 4,217,833 4,744,617 5,321,578 5,953,736

    With this information we can calculate our exit and return. Final EBITDA times 4 gives us an exit of $45,094,280. Applying interest to the Term A and B loans multiplied by 5 years and then multiplied by (1 − tax%) give us:

    equation

    Total obligations are $28,519,120 ($17,500,000 + $4,242,000 + $5,250,000 + $1,527,120).

    The total cash generated is $23,974,431. Reducing the obligations with cash leaves us with $4,544,689 in final debt.

    So the return is the exit less final debt, or $40,549,591. Applying the IRR formula (($40,549,591/$6,538,000) ^ (1/5) −1) gives a return of 44.05%.

  8. 34) Answer:

    The purchase price, sources, and uses should be straightforward.

    Uses Sources
    PP $50,000,000 Term A $35,000,000
    Debt $0 Term B $5,000,000
    Fees $250,000 Equity $10,250,000
    Total $50,250,000 Total $50,250,000

    Next we can start to lay out the unlevered free cash flow. Most components are straightforward.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 10,000,000 10,500,000 11,025,000 11,576,250 12,155,063 12,762,816
    D&A 4,110,000 4,220,000 4,330,000 4,440,000 4,550,000
    EBIT 6,390,000 6,805,000 7,246,250 7,715,063 8,212,816
    Deferred Tax 0 0 0 0 0
    Working Capital
    CAPEX (1,100,000) (1,100,000) (1,100,000) (1,100,000) (1,100,000)
    Taxes (2,556,000) (2,722,000) (2,898,500) (3,086,025) (3,285,126)
    Total UFCF

    The example suggests to estimate total working capital at 15 days on EBITDA. So we can use the working capital formula (30/360 × EBITDA) to make our annual working capital estimates. We then need to calculate the year-over-year changes for our cash flow.

    Working Capital Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 10,000,000 10,500,000 11,025,000 11,576,250 12,155,063 12,762,816
    Days 15 15 15 15 15 15
    Total Working Capital 416,667 437,500 459,375 482,344 506,461 531,784
    Changes in Working Capital (20,833) (21,875) (22,969) (24,117) (25,323)

    We can now use these changes in our UCFC and calculate the total.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    EBITDA 10,000,000 10,500,000 11,025,000 11,576,250 12,155,063 12,762,816
    D&A 4,110,000 4,220,000 4,330,000 4,440,000 4,550,000
    EBIT 6,390,000 6,805,000 7,246,250 7,715,063 8,212,816
    Deferred Tax 0 0 0 0 0
    Working Capital (20,833) (21,875) (22,969) (24,117) (25,323)
    CAPEX (1,100,000) (1,100,000) (1,100,000) (1,100,000) (1,100,000)
    Taxes (2,556,000) (2,722,000) (2,898,500) (3,086,025) (3,285,126)
    Total UFCF 6,823,167 7,181,125 7,554,781 7,944,920 8,352,366

    With this information we can calculate our exit and return. Final EBITDA times 5 gives us an exit of $63,814,078. Applying interest to the Term A and B loans multiplied by 5 years and then multiplied by (1 − tax%) give us:

    equation

    Total obligations are $52,750,000 ($10,500,000 + $2,250,000 + $35,000,000 + $5,000,000).

    The total cash generated is $37,856,360. Reducing the obligations with cash leaves us with $14,893,640 in final debt.

    So the return is the exit less final debt, or $48,920,438. Applying the IRR formula (($48,920,438/$10,250,000) ^ (1/5) − 1) gives a return of 36.7%.

  9. 35) Answer:

    The purchase price is based on EBITDA, which needs to be calculated from revenue and costs. Costs are projected at 30% of the $10MM revenue, so EBITDA is $7MM ($10MM − $3MM). This gives us a $42MM purchase price ($7MM × 6). From here, sources and uses should be straightforward. Note the Term A loan assumption at 25% of the total uses.

    Uses Sources
    Purchase Price $42,000,000 Term A $10,605,000
    Debt 0 Term B $14,000,000
    Fees $420,000 High Yield $7,000,000
    Total $42,420,000 Equity $10,815,000
    Total $42,420,000

    Next we can start to lay out the unlevered free cash flow.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    Revenue 10,000,000 10,200,000 10,404,000 10,612,080 10,824,322 11,040,808
    Operating Expenses 3,000,000 3,060,000 3,121,200 3,183,624 3,247,296 3,312,242
    EBITDA 7,000,000 7,140,000 7,282,800 7,428,456 7,577,025 7,728,566
    D&A 2,600,000 2,700,000 2,800,000 2,900,000 3,000,000
    EBIT 4,540,000 4,582,800 4,628,456 4,677,025 4,728,566
    Deferred Tax 0 0 0 0 0
    Working Capital
    CAPEX (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000)
    Taxes (1,816,000) (1,833,120) (1,851,382) (1,870,810) (1,891,426)
    Total UFCF

    For working capital, the example provides guidance on accounts receivable and accrued expenses. These items should be based on revenue and operating expenses, respectively. So we can use the working capital formula, 30/360 × revenue, to make our annual accounts receivable estimates, and the formula, 10/360 × expenses, for the accrued expenses estimates. We then need to subtract assets less liabilities and calculate the year-over-year changes for our cash flow.

    Working Capital Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    Accounts Receivable 833,333 850,000 867,000 884,340 902,027 920,067
    Days 30 30 30 30 30 30
    Accrued Expenses 83,333 85,000 86,700 88,434 90,203 92,007
    Days 10 10 10 10 10 10
    Total Working Capital 750,000 765,000 780,300 795,906 811,824 828,061
    Changes in Working Capital (15,000) (15,300) (15,606) (15,918) (16,236)

    We can now use these changes in our UCFC and calculate the total.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    Revenue 10,000,000 10,200,000 10,404,000 10,612,080 10,824,322 11,040,808
    Operating Expenses 3,000,000 3,060,000 3,121,200 3,183,624 3,247,296 3,312,242
    EBITDA 7,000,000 7,140,000 7,282,800 7,428,456 7,577,025 7,728,566
    D&A 2,600,000 2,700,000 2,800,000 2,900,000 3,000,000
    EBIT 4,540,000 4,582,800 4,628,456 4,677,025 4,728,566
    Deferred Tax 0 0 0 0 0
    Working Capital (15,000) (15,300) (15,606) (15,918) (16,236)
    CAPEX (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000)
    Taxes (1,816,000) (1,833,120) (1,851,382) (1,870,810) (1,891,426)
    Total UFCF 4,309,000 4,434,380 4,561,468 4,690,297 4,820,903

    With this information we can calculate our exit and return. Final EBITDA times 6 gives us an exit of $46,371,394. Applying interest to the loans multiplied by 5 years and then multiplied by (1 − tax%) gives us:

    equation

    Total obligations are $42,976,500 ($10,605,000 + $14,000,000 + $7,000,000 + $3,181,500 + $5,040,000 + $3,150,000).

    The total cash generated is $22,816,047. Reducing the obligations with cash leaves us with $20,160,453 in final debt.

    So the return is the exit less final debt, or $26,210,941. Applying the IRR formula (($26,210,941/$10,815,000) ^ (1/5) – 1) gives a return of 19.4%.

  10. 36) Answer:

    The purchase price is based on EBITDA, which needs to be calculated from revenue and costs. Costs are projected at 25% of the $12MM revenue, so EBITDA is $9MM ($12MM – $3MM). This gives us a $63MM purchase price ($9MM × 7). From here, sources and uses should be straightforward.

    Uses Sources
    PP $63,000,000 Term A $31,500,000
    Debt 0 Term B $13,500,000
    Fees $1,260,000 HY $4,500,000
    Total $64,260,000 Equity $14,760,000
    Total $64,260,000

    Next we can start to layout the unlevered free cash flow.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    Revenue 12,000,000 12,840,000 13,738,800 14,700,516 15,729,552 16,830,621
    Operating Expenses 3,000,000 3,210,000 3,434,700 3,675,129 3,932,388 4,207,655
    EBITDA 9,000,000 9,630,000 10,304,100 11,025,387 11,797,164 12,622,966
    D&A 2,525,000 2,550,000 2,575,000 2,600,000 2,625,000
    EBIT 7,105,000 7,754,100 8,450,387 9,197,164 9,997,966
    Deferred Tax 0 0 0 0 0
    Working Capital
    CAPEX (500,000) (500,000) (500,000) (500,000) (500,000)
    Taxes (2,842,000) (3,101,640) (3,380,155) (3,678,866) (3,999,186)
    Total UFCF

    For working capital, the example provides guidance on accounts receivable and accrued expenses. We then need to subtract assets less liabilities and calculate the year-over-year changes for our cash flow.

    Working Capital Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    Accounts Receivable 1,166,667 1,248,333 1,335,717 1,429,217 1,529,262 1,636,310
    Days 35 35 35 35 35 35
    Accrued Expenses 125,000 133,750 143,113 153,130 163,850 175,319
    Days 15 15 15 15 15 15
    Total Working Capital 1,041,667 1,114,583 1,192,604 1,276,086 1,365,413 1,460,991
    Changes in Working Capital (72,917) (78,021) (83,482) (89,326) (95,579)

    We can now use these changes in our UCFC and calculate the total.

    Unlevered Free Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
    Revenue 12,000,000 12,840,000 13,738,800 14,700,516 15,729,552 16,830,621
    Operating Expenses 3,000,000 3,210,000 3,434,700 3,675,129 3,932,388 4,207,655
    EBITDA 9,000,000 9,630,000 10,304,100 11,025,387 11,797,164 12,622,966
    D&A 2,525,000 2,550,000 2,575,000 2,600,000 2,625,000
    EBIT 7,105,000 7,754,100 8,450,387 9,197,164 9,997,966
    Deferred Tax 0 0 0 0 0
    Working Capital (72,917) (78,021) (83,482) (89,326) (95,579)
    CAPEX (500,000) (500,000) (500,000) (500,000) (500,000)
    Taxes (2,842,000) (3,101,640) (3,380,155) (3,678,866) (3,999,186)
    Total UFCF 6,215,083 6,624,439 7,061,750 7,528,972 8,028,200

    With this information we can calculate our exit and return. Final EBITDA times 7 gives us an exit of $88,360,759. Applying interest to the loans multiplied by 5 years and then multiplied by (1 – tax%) gives us:

    equation

    Total obligations are $65,835,000.

    The total cash generated is $35,458,445. Reducing the obligations with cash leaves us with $30,376,555 in final debt.

    So the return is the exit less final debt, or $57,984,204. Applying the IRR formula (($57,984,204/$14,760,000) ^ (1/5) – 1) gives a return of 31.5%.

CONCLUSION

As mentioned in the beginning, this book was designed to allow practice of technical questions and exercises representing the knowledge one would require in an investment banking interview. Of course, the technical aspect is one of several required to be a strong interview candidate. The ability to communicate these questions effectively, to present oneself effectively, in addition to behavior and fit are among the attributes assessed in an interview. I hope this book proves to be one of many useful tools in helping achieve your investment banking career goals.

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