Hello guys,
I just went for a first round PE interview (my first ever) and got stuck on one question. Basically I was given the EBITDA, EBIT, Capex and change in net working capital for a target for the next 3 years, and was asked how do I determine the maximum leverage that I can pile on this company in an LBO? Interviewer mentioned that debt has to be paid down in 5 years (even though only 3 year projections given).
When I went home and thought about it, I am really stuck on two points:
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FCF available to pay down debt is net income + D&A - capex - change in net working capital. If you know the FCF for 5 years, you can calculate the max debt level. However, net income depends on interest and interest is dependent on debt amount. Isn't there a circularity there?
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Given only the projections for 3 years, how do I determine the leverage given a 5-year debt paydown schedule?
Please help me on this. Welcome responses from all, but especially from bankers / PE guys who have actually calculated it in the course of their work. Thanks.!
Unlevered FCF = EBIT - Tax (35%) + D&A (EBITDA - EBIT) +/- WC - Capex...
Assume a Weighted Average Cost of Debt of I'd say 9% (Senior & Sub)
UFCF - Interest (on principal left) = Excess cash available for repayment
Use all excess cash to sweep the outstanding balance... eg total debt = $50m, $10m cash sweep = $40m balance (clalcuate next years interest off of this balance)...
You can assume a flat assumptions for the next two years or more conservative (as long as you can justify, it is ok, that's what they're looking for, your ability to forecast figures)....
Hi Mezzkat, Thanks. you said "UFCF - Interest (on principal left) = Excess cash available for repayment" - but the problem is, I don't know what the interest is, because interest is dependent on the amount of debt...that's where the circularity lies. In excel, the circularity can be resolved but in the interview, I don't have that, only pen and paper...
Perhaps someone can help me drive to a numerical answer given the facts below - what is the maximum leverage? Assume debt has to be paid down in 5 years.
EBITDA: $20mm a year for next 5 years D&A: 5mm a year Capex: $5mm a year No change in net working capital Interest cost of 10% Tax rate of 40%
The variable you are trying to nail down is how much amortization you can afford each year over the five year period given the assumptions above. UFCF in this example is $9mm each year. Assuming no amortization, you could afford $90mm of debt, or UFCF/Cost of Debt/Interest Coverage, with coverage in this case assumed to be 1:1. Solve for the appropriate coverage ratio that leaves you with a zero debt balance at the end of year five, and that's your answer.
That's somewhat of a backwards approach. Does anyone know a best practice for determining this?
SCLID, your solution would appear to give the answer to how much debt the Company could afford to cover interest on at 1:1 but makes no provision for amortization. Am I wrong?
Newbie, out of curiosity, in what form were you given this question? If they let you build a quick schedule in excel, I don't think you'd have a circularity problem because you could just assume an interest rate and solve for the beginning debt balance. I just did a quick one with your assumptions and got ~$40.5mm of debt or 2.0x leverage. But I don't know how I would have gotten to this in my head or with pen and paper. I'm about to start interviews so I'm curious.
just pen and paper, no calculator and no excel and that's why I had a problem
The example I mentioned solved for the debt level with an interest coverage ratio of 1:1, but my point was that once you have that, you solve for the interest coverage ratio that gets you to a 5 year amortization. I ended up with interest coverage of ~2.6 and total debt of ~$40mm, so we're pretty close. Still not sure how you would come up with that with a pen and paper, so maybe it's one of those questions they want to see how you think through without necessarily expecting a numerical answer.
I got something pretty close using basic algebra, the answer is $34 million but using pen and paper you can get $30m...then I'd give a range an of +/- $3m and state that depending on the final terms of the debt, this would be a rough idea of what we could load on...
you know that if sweeps weren't available, year one would need to be 20% amortization (100% / 5 years)... so basic algebra says:
y= total debt 9 - 10%y = 20%y y= 30 = total debt
If you want to convert that to a ratio then UFCF / Interest = 1.5x for year one...
Like every interview, I think they're looking for the thought process more than the correct answer as it is a circular reference...
SCLD, if you can solve this with that formula it seems like the best way to do this. But could you clarify how you incorporate an amortization period answer into UFCF/Cost of Debt/Coverage = Initial Debt Balance? Maybe it's early in the morning but it seems like this relationship changes as the debt balance declines and I don't see how you could use this formula to calculate the number of years it would take to amortize your debt to zero.
Ok, I think this one is impossible to solve unless anyone knows how to do solve polynomials to the 4th power on paper. If you can't than I think this is what they wanted:
The UFCF for each year could than be modeled by 11-.06d. If you assume that the UFCF is equal to .2d, you would end up with:
9-.06d = .2d 9 = .26d 9/.26 = 34.61
If I didn't have a calculator on me, I would have just done 9/.25 which is obviously 36.
Using the declining debt balance in excel I got roughly 37.91 . If this is the right answer than I think this is what they might have been looking for.
If you start with 9 as your UFCF and set the interest payment equal to 10% times your previous years balance. Use your amortization payments as the difference between your UFCF (9) and interest payments (in effect having a cash flow of zero). Then you can goal-seek by setting your final debt balance to zero by changing your original debt balance cell.
I got 34.12
Don't know how to do it with only pen and paper, but I would go with 9 - .1D = .2D ....in order to set yearly cashflows to zero.
Gives you 30
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