PE interview technical question - please help!

see other post..

If I'm not mistaken you use EBIT x (1-Tax Rate) then + D&A -capex - change in NWC...

Anyone else?

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Newbiebanker, are you interviewing straight out of unddergrad or after 1 year in banking?

Mine is off cycle hiring. Have spent one year as analyst in banking.

I'm not a banker nor a PEer but you're calculation for Free Cash Flow is slightly off. What you have to realise is that when you are evaluating the repayment of interest on debt, you are dealing with FCF to the Enterprise, not FCF to equity. Thus you use:

EBIT(1 - T) + D - Capex +/- Chg in WC

This figure will give you Enterprise FCF or, also known as Cash Flow Available for Debt Servicing (CFADs) in a PE context.

In response to the technical question you gave, I'm not sure if I'm right but I'll have a go. Since you are required to estimate the amount of debt that can be used for the target you would need to make an assumption on the interest rate that would be charged on the debt. Let's say (for ease of calculation purposes) that 10% was the chosen rate. If you are required to pay 10% each year, you could take year 1 FCF and backsolve it to work out how much debt could be supported based on that level of FCF and interest at 10%. This would be sufficient for year 1 and assuming that FCF's are increasing (or at least staying the same) in year 2, then you will be able to meet interest payments and maybe even pay back some principle in year 2.

Also note that for year 1 I have assumed no principle is paid back, but if principle is required to be repaid in year 1, then you would need to adjust accordingly. I'm not sure how it works for an LBO, as in is debt paid back throughout the life of the project or is it repaid as a lump-sum bullet payment when the target is exited?

If anyone can correct me that would be great. Thanks

You wouldn't include the tax in your FCF calculation.

It would be:

EBITDA - CapEx - NWC Increase - (Total Debt / 5)

Thats youre CF available for debt service after mandatory amortization. Make sure you say, you're assuming that you're required to amortize equally across the maturity of the loan. Or you can say you're required to keep a sinking fund cash reserve for debt maturity.

You take that figure above and divide by your WACD and thats the leverage you can take on.

Anyone disagree?

Ok, although I am not an expert on this, but I will give it a try as well. There are a number of key assumptions you need to make in order to arrive at the max debt level.

1. assume 100% cash sweep, i.e all excess cash generated each year will be used to pay back down debt. This assumption is key because if assume you dont pay down debt each year and you keep your cash on your balance sheet, the return you earn on it is likely to be around 3%, however by paying down your debt, the excell cash you got each year is effectively earning cost of debt which in reality have to be greater than 3%. This assumption make sure you can have a higher debt level to begin with since you are paying it down quicker.

2. assume that debt is paid down to zero by end of year 5. (although in reality, debt is never paid off fully)

3. make an assumption on the cost of debt

4. assume that interest expense is the cost of debt * beginning period debt level, not average of beginning and end period debt level in order to aviod circular reference......, this is an reasonable assumption if you assume that you are only paying down debt at the end of a period

5. you need to make assumptions on year 4 and year 5 free cash flow, i.e growth year 3 free cash flow by 3% each year

Now, lets get the cash flow element right: in LBO situation, all we care about is CASH, therefore forget about fcf to enterprise value, it is irrelevant here. the correct formula is:

EBIT*(1-t)+depreciation+ change in net working capital - capex + interest expense tax shield (interest expense * tax rate) - interest expense = cash flow available for debt repayment

another way to arrive at this is: net income + depreciation + change in net working capital - capex

next is to determine the max debt level. typically in a leverage buyout situation if the credit market is normal (i.e average) you can get 5x your ebitda, if the credit market is really good you can get away with 7 to 8x ebitda.

There is a trial and error involved in this, even in BB bank's LBO template there is a trial and error involved. However you can start off with say 6x ebitda level and see if you can pay off all debt by end of period 5.

Finally, tell your interviewer that during the 5 year period, in reality the firm should be watching out for possible breach of debt convanents etc.

I hope this helps. anyone feel free to correct me if i am wrong

Ok, although I am not an expert on this, but I will give it a try as well. There are a number of key assumptions you need to make in order to arrive at the max debt level.

1. assume 100% cash sweep, i.e all excess cash generated each year will be used to pay back down debt. This assumption is key because if assume you dont pay down debt each year and you keep your cash on your balance sheet, the return you earn on it is likely to be around 3%, however by paying down your debt, the excell cash you got each year is effectively earning cost of debt which in reality have to be greater than 3%. This assumption make sure you can have a higher debt level to begin with since you are paying it down quicker.

2. assume that debt is paid down to zero by end of year 5. (although in reality, debt is never paid off fully)

3. make an assumption on the cost of debt

4. assume that interest expense is the cost of debt * beginning period debt level, not average of beginning and end period debt level in order to aviod circular reference......, this is an reasonable assumption if you assume that you are only paying down debt at the end of a period

5. you need to make assumptions on year 4 and year 5 free cash flow, i.e growth year 3 free cash flow by 3% each year

Now, lets get the cash flow element right: in LBO situation, all we care about is CASH, therefore forget about fcf to enterprise value, it is irrelevant here. the correct formula is:

EBIT*(1-t)+depreciation+ change in net working capital - capex + interest expense tax shield (interest expense * tax rate) - interest expense = cash flow available for debt repayment

another way to arrive at this is: net income + depreciation + change in net working capital - capex

next is to determine the max debt level. typically in a leverage buyout situation if the credit market is normal (i.e average) you can get 5x your ebitda, if the credit market is really good you can get away with 7 to 8x ebitda.

There is a trial and error involved in this, even in BB bank's LBO template there is a trial and error involved. However you can start off with say 6x ebitda level and see if you can pay off all debt by end of period 5.

Finally, tell your interviewer that during the 5 year period, in reality the firm should be watching out for possible breach of debt convanents etc.

I hope this helps. anyone feel free to correct me if i am wrong

Though I'm not totally sure but you could look at the maximum debt you can take in terms of the target IRR required on the equity by the PE firm. You can use the financial statement information to estimate the present value of the equity given the target IRR and then subtract it from the price paid for the LBO to calculate the amount of debt to take on...

Also as mentioned above, In an LBO situation, the correct CF metric is,

= NI+NCC+Dep+Amortization charges- CapEx- Inc. NWC

Just how I would approach it in an interview

http://www.nkaramouzis.gr/files/7teac/DB%20LBO%20Analysis.pdf