Has anyone ever been asked to do an LBO and M&A models off the top of their head? Pen & Paper given with financials on a sheet but not much time (around 3 minutes) to calculate and walk through answer. Basically you have to calculate as you go through.

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## Comments (28)

You should be able to do an LBO on paper within a few minutes. I've been asked to do this in an interview scenario myself. However, assuming you are not given a calculator, it is unlikely they will expect you find the NPV of each cash flow. Rather, they will give you the assumptions you need to setup the formulaic structure of the analysis (exit EBITDA and multiple, starting equity investment, ending equity ownership percentage, target IRR, etc.). Once you've setup the formula, they will give you assumed NPVs to fill-in. The rest is basic algebra.

Keep in mind, the structure of an LBO analysis is essentially the same as a DCF.

I cannot see someone asking you do to a merger model on-the-fly. It just isn't possible. They might, however, ask you explain how you calculate goodwill or accretion/dilution. Those are not hard to do, however.

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LBO on Paper is actually really easy once you get the hang of it. Calculating everything in your head on the fly while talking might be an issue, depending on the atmosphere created by your interviewer.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

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Once you understand the big picture and can make reasonable assumptions, doing an LBO in your head becomes incredibly easy. Essentially, just estimate cash flow generated over the course of five years (generally EBITDA less debt/interest payments less taxes), use that to calculate debt at exit. Keep that number in your pocket. Calculate Enterprise Value by multiplying EBITDA by exit multiple, subtract out the debt -- this leaves you with equity value. Multiply equity value by your percentage ownership and divide by dollars invested. This will give you your cash-on-cash multiple after five years, at which point you can ballpark the IRR.

This may seem daunting the first few times you go through it. However, after awhile it will become second nature and you'll be able to estimate returns on the fly.

CompBanker

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And here's a SB for you...yet another really useful post from compbanker. A real asset.

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To add to CompBanker's post: Out of experience I can tell you that you should really get a hold of the IRR's for different cash-on-cash multiples and memorize them. Nothing's more embarrassing if you did everything well and then you over oder under estimate the IRR at the end.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

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don't forget CapEx....

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yea I just did the math out and it's actually very easy - I was in fact able to break it down into a single formula based off of the important numbers, EBITDA FCF, Ebitda multiple etc.. the rest like interest and financing structure can be improvised with easy numbers like 10% for interest etc.

The same is with merger models and in some sense a DCF.... I highly reccomend everyone try to figure out based on what compbanker said.

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How do you deal with the issue of circularity (i.e. how do you calculate interest payments)? Do you just assume interest is based off of the previous period's ending debt balances as opposed to the average of the two periods?

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Well you would calculate interest based on an assumption you make about the interest rate which you then multiply by your debt amount and subtract out of EBIT.

Regarding how you can use the excess cash (if there is any), you can either sum all years up and subtract that from the total amount of debt you assumed in the beginning, or you can make the assumption that after interest is paid, the excess cash will be used to pay back principal. This will require you to calculate with different interest numbers etc. for every year.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

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Ok, I get the point about assuming an interest rate, but how do you come up with an interest expense line (how do you know what your debt amount is)? You should be multiplying your interest rate by the average debt balance between the two periods for which the income statement is applicable, but you can't know the latter debt balance unless you know how much debt was paid off during this period, which depends on your excess cash, which depends in turn on your interest expense, which then depends on your average debt balance, so you're still running into a circularity issue (which excel solves through iteration, but I don't know how you would figure this out by hand within a reasonable timeframe - probably could do it through some tricky algebra though).

Maybe there's an easier way to circumvent circularity (such as just using the debt balance from the previous period as an assumption) but this is how I have been doing it.

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If you're worrying about calculating the exact amount of interest, then you're too in the weeds. Ballpark it. The objective isn't to come up with a perfect answer, it is to demonstrate a strong understanding of how LBOs work.

CompBanker

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\

Assume bond financing - no paydown. Assume 0% cash balance interest income (pretty close to reality right now). Keeps the cash tax math very reasonable for headwork.

See my other WSO blog posts

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so is it reasonable to assume we do not pay down any of the principal during the 5-year period for easy calculation? also, do we assume a ebitda growth through time?

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OK, I think there is some confusion about this. First thing you have to understand is that Paper LBO Cases in Interviews only cover so much as the people just want to know that you understand the mechanics and can make reasonable assumptions.

For any Paper LBO they will either provide you with relevant info or give you bits and pieces and you need to ask for or make assumptions about other pieces. For illustrative purposes, let's assume that the interviewer gives you Revenue in Year 1 (100), Revenue Growth (5%), EBITDA Margin (40%, constant across investment horizon), as well as the investment horizon (5 years - but you can usually just take that for granted unless they point it out that they want it to be shorter).

Now you need to figure out what info you are missing. What's the entry multiple (depending on the fund or the type of firm that they are trying to simulate, they may ask you what you think would be a good multiple at the moment)? What's the exit multiple (assume same as entry usually)? What's the Debt to Equity Ratio (from my experience, 60:40 D:E works quite well for these cases)? Interest Rate on the Debt (10% works well for this as well)? What's the D&A (sometimes its a % of sales or a steady number)? What's CapEx (usually % of sales)? What's the change in Net Working Capital (this can get tricky, but more on this below)? What's the tax rate (Europe 30% works good, USA I believe 40% is good)? Now that you know all this, you can come up with your basic assumptions. For our company up there (assuming that we pay Forward 12 Months EBITDA for entry):

Entry Multiple: 5.0x

EBITDA (Year 1): 40

Price Paid: 200

Interest Rate: 10.0%

Now this gives you an equity investment of 80 and debt raised of 120 (40% vs 60%). At this point you have all that set up and you would start calculating the Free Cash Flow for every year in accordance with the growth etc that they gave you. In our example this would mean the following (I will just compute 2 years to show you):

Year 1

Revenue: 100

EBITDA (40% margin): 40

D&A (assume it's 20 for this example): (20)

EBIT: 20

Interest Expense (Debt Raised * Interest Rate - 120*10%): (12)

EBT: 8

Taxes (using 40% here): (3)

Net Income: 5

Free Cash Flow

Net Income: 5

+D&A: 20

-CapEx (assume 15% of sales every year for this example): 15

-Change in NWC (assume 0 for this example): 0

FCF: 10

Year 2

Revenue: 110 (10% growth y-o-y)

EBITDA (40% margin): 44

D&A: (20)

EBIT: 24

Interest Expense: (12)

EBT: 12

Taxes (using 40% here): (5)

Net Income: 7

Free Cash Flow

Net Income: 7

+D&A: 20

-CapEx (assume 15% of sales every year for this example): 17

-Change in NWC (assume 0 for this example): 0

FCF: 11

Now for this example, you would then do this for all 5 years and would then add up all the FCFs for every year. For our example you would arrive at a total of 59. Now you would do the following:

Exit Multiple: 5.0x

EBITDA Yr 6 (Forward 12 Months): 64

Ending TEV: 320

Beginning Debt: 120

Total FCF Generated: 59

Ending Debt: 61

Ending Equity: 259

Beginning Equity: 80

Cash-on-Cash Multiple: ~3.2x -> >25% IRR

Now there are several variations to this. One may be that they ask you to assume that the FCF is used every year to pay down principal. It would look like this:

Year 1

Revenue: 100

EBITDA (40% margin): 40

D&A (assume it's 20 for this example): (20)

EBIT: 20

Interest Expense (Debt Raised * Interest Rate - 120*10%): (12)

EBT: 8

Taxes (using 40% here): (3)

Net Income: 5

Free Cash Flow

Net Income: 5

+D&A: 20

-CapEx (assume 15% of sales every year for this example): 15

-Change in NWC (assume 0 for this example): 0

FCF: 10

Year 2

Revenue: 110 (10% growth y-o-y)

EBITDA (40% margin): 44

D&A: (20)

EBIT: 24

Interest Expense: (11) -> WE SUBTRACT 120-10 = 110*10% = INTEREST OF (11)

EBT: 13

Taxes (using 40% here): (5)

Net Income: 8

Free Cash Flow

Net Income: 8

+D&A: 20

-CapEx (assume 15% of sales every year for this example): 17

-Change in NWC (assume 0 for this example): 0

FCF: 11

and then repeat this again for the rest of the years. This is not really much harder, you will just need to calculate more and keep track of more numbers.

A word on Net Working Capital:

I only experienced it once in a LBO Paper Case, but if you have to model out the Net Working Capital, you have to make assumptions about the Days Receivables, Days Inventories and Days Payables to arrive at the Net Working Capital for every year. Then you can calculate the change for the years of your investment horizon. I'd suggest reading up on various industries and getting a feel for what the "industry norm" is for these.

Sorry for the long post, I hope this helps. If not, let me know and I will try to be more specific.

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RE: the circularity.... just use the beginning of period debt balance, obviously you are not expected to perform iterative calculations in your head. Circularity only comes up when using average debt balances because ending balance depends on cash flow which depends on interest which depends on..... average beginning and ending balance.

This is why models have "circ breakers" that switch interest back to beginning of period balances to break the circularity.

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CompBanker's answer is 100% on the money. Just the right level of detail to show that you get it, so to speak. The idea is to perform a sort of quick returns analysis to see if it's even worth digging deeper into the acquisition target.

I think it's also a solid question because it forces you to realize that the LBO model is just one piece of the puzzle. Yes, it is absolutely essential for purposes of corralling lenders and testing various cases, but it is not the end-all, be-all. If anything, it shows you that a company will meet or beat your minimum returns threshold if it meets its budget. If you feel confident in that, then you can start diving into the details and learning the ins-and-outs of the business.

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@Matrick, this is exactly why I love this forum. So much knowledge from the members and willingness to share. Learned a lot from the post. Thanks for the detail!

Blue horseshoe loves Anacott Steel

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Yeah no worries, always glad to help out

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yes, Credit Suisse LA superday

Take it as it comes

JJ

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^that is ridiculous to expect a junior to do that

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If I were a Junior in college and got this question, I probably would've shit my pants. I assume that some banks must be ramping up the difficulty level due to there being fewer spots then there were in the bubble days. That, and there are so many more professional-level resources (like WSO and WSO's guide books) to help you prep for interviews and all the technicals they throw your way.

Still wouldn't be easy. CompBanker's advice is great, once again, for the kind of on the spot thinking you'd want to do. With that said, he's been in PE for some time, so if you're interviewing, be sure to practice a bunch with some easy examples.

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Asking this question of a college student would be incredibly unfair. I would never dream of a college student having the capability of answering it well. However, asking it of an IB analyst seeking a PE job is completely fair game. In fact, I was asked to do an LBO model on the back of my resume in one of my interviews. I wouldn't expect an analyst to be able to complete it effortlessly, but it would be reasonable to expect (s)he would have the general concepts down.

CompBanker

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well as an undergrad I got screwed over but now I can do it even quicker than what the guy above did.

Just remember that your returns come primarily from 1) EBITDA growth and 2) paydown of debt, and you can just add these two cash-returns together.

1) calculate the % increase in EBITDA (hence % Increase in EV) and lever it to account for equity. Think ROE * E/A= ROA

2) calculate % principal paydown and then lever that as well. just lever it by E/D instead of E/A

3) memorize combinations of cash-returns and IRRs, so for 5 year exit, 2x = 15%IRR, 3x = 25% IRR, and 4x = 32% IRR

Again, as i said before - you can make this into 1 formula based off of important assumptions like EBITDA CAGR, entry multiple etc..

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Very interesting approach. What has the reaction been in interviews for you?

What do you mean by "Think ROE * E/A= ROA"?

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On another note, given that some people may read this to prepare for PE interviews: What do you guys usually assume for AR, Inventory and AP Days? I've only seen two types of firms in interviews for this thus far, production and services, so what would you assume for this?

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Looking at the math in the above example and am little confused how you got to FY6 EBITDA of 64. My calculations show 52. Could someone maybe provide some clairty? How do you jump from Year 5 EBITDA of 50 to 64? I believe The 5 year cummulative FCF implies that 50 is indeed the correct Y5 figure and if you grow that at 5% you should get to roughly 52 in Y6. In sum the MOIC I get is 2.5x, not 3.2x

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