Modelling Interest in Quarterly LBO
Hi all, quick question on the right way to calculate interest in a quarterly model. Assuming there is a debt instrument at 10% annual interest rate:
Do you just calculate this as 2.5% of average outstanding debt balance each quarter? If there's a cash sweep such that there's an irregular amount of paydown each quarter, wouldn't you arrive at an annual interest rate that is actually different than 10%? Is that okay?
Thanks!
EDIT TO ADD: One other thing I was thinking about - since interest is usually paid semi-annually, would you calculate interest as 5% off average balance from beginning and ending of 6 month period, and then divide by 2 to get the quarterly interest expense? Sorry, just confused about the right way to think about this
Let's assume you have term loans.
Mandatory repayments happen on the last day of each quarter. There is no reason to assume anything other than a voluntary repayment on the last day of each quarter in your model *(more on this later).
As a result, for quarterly models, you do not average out principal balances and apply a rate, you take the balance at the beginning of the quarter and apply the rate.
*Most PE backed companies don't sweep excess cash quarterly, its just a modeling thing you do to juice returns. They have a mandatory excess cash flow sweep after they deliver their annual audit (which means this paydown occurs sometime in April / May). Then the company looks for good uses of non-swept cash (M&A, corporate projects, dividends, etc.).
Super helpful, thanks. To confirm, the interest rate you'd use then would be annual interest rate / 4?
Be careful because if you are doing that the effective rate would be higher than 10% annually
Apply some financial maths (1+r)^1 equal to (1+r4)^4, but definitely you could use 10%/4 if its a fast case study.as a proxy. Otherwise you would need to understand if the interest are compound or not... Some more context would help to understand the specific case.
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