LBO Study Questions and Complete
Solutions
Changes That Increase IRR ✅Lower Purchase Price, Less Equity, Higher Revenue
Growth, Higher EBITDA Margins, Lower Interest Rates, Lower CapEx
Changes That Reduce IRR: ✅Higher Purchase Price, More Equity, Lower Revenue
Growth, Lower EBITDA Margins, Higher Interest Rates, Higher CapEx
What is a leveraged buyout, and why does it work? ✅In a leveraged buyout (LBO), a
private equity firm acquires a company using a combination of debt and equity (cash),
operates it for several years, possibly makes operational improvements, and then sells
the company at the end of the period to realize a return on investment. During the
period of ownership, the PE firm uses the company's cash flows to pay interest expense
from the debt and to pay off debt principal.
An LBO delivers higher returns than if the PE firm used 100% cash for the following
reasons:
1. By using debt, the PE firm reduces the up-front cash payment for the company, which
boosts returns.
2. Using the company's cash flows to repay debt principal and pay debt interest also
produces a better return than keeping the cash flows.
3. The PE firm sells the company in the future, which allows it to regain the majority of
the funds spent to acquire it in the first place.
Why do PE firms use leverage when buying a company? ✅They use leverage to
increase their returns. Any debt raised for an LBO is not "your money" - so if you're
paying $5 billion for a company, it's easier to earn a high return on $2 billion of your own
money and $3 billion borrowed from other people than it is on $5 billion of your own
money. A secondary benefit is that the firm also has more capital available to purchase
other companies because they've used debt rather than their own funds.
Walk me through a basic LBO model. ✅"In an LBO Model, Step 1 is making
assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and
other variables; you might also assume something about the company's operations,
such as Revenue Growth or Margins, depending on how much information you have.
Step 2 is to create a Sources & Uses section, which shows how the transaction is
financed and what the capital is used for; it also tells you how much Investor Equity
(cash) is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures,
allocate the purchase price, and add in Goodwill & Other Intangibles on the Assets side
to make everything balance.
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