What's wrong with the house analogy for LBOs?
Here's a common analogy people use to explain LBOs to laymen:
A house costs $100 to buy - financed using 90% of debt and 10% of equity. The owners buy the house and then rent it out for $25 dollars a year and use those $25/year to pay down debt. After 3 years, the owners sell the house for 100 dollars and now get $25 of equity. So MoM is 2.5x since they started out with $10 of equity.
However, I was recently told that there were issues with this analogy but wasn't told why.
What's the reason?
The analogy is right, your math is wrong...
You pay down $25 of debt per year...how does that get you to $25 of equity at the end of 3 years?
You start off with $90 of debt and $10 of equity. $25*3 = $75 so you're able to pay down $75 of debt. $90 - $75 = $15. If the house is sold for $100, the remainder is the equity...or $85.
Picky backing off of this answer, but it comes off to me as if you are going too fast through the problem and therefore missed the numerical issue that Infidel explained. The interviewer probably took this as lack of understanding.
Slow down and understand each part!
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