Simple LBO Model - Case Study and Tutorial
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- čas přidán 28. 06. 2024
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In this LBO Model tutorial, you'll learn how to build a very simple LBO model "on paper" that you can use to answer quick questions in PE (and other) interviews.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
This matters because in many cases, they'll ask you to calculate numbers such as IRR and multiple of invested capital very quickly and will not actually ask you to build a more complex model until later in the process.
You should always START this exercise by looking at the actual question or set of questions they are asking you:
"Calculate the purchase price required for ABC Capital to obtain a 3.0x multiple of invested capital (MOIC) if it plans to sell OpCo after five years at an EV / EBITDA multiple of 6.0x."
So they're giving you the exit multiple and the return on investment that the PE firm is targeting, and you have to figure out the initial purchase price by "working backwards."
Here's how we interpret each line in this case study and use it in the model:
"OpCo currently has EBITDA of $250mm, and ABC believes that the new management team could keep EBITDA flat for the next 5 years."
This tells you to make the initial EBITDA $250mm and keep it at that level for 5 years - skip revenue, COGS, OpEx, and everything else because none of that matters if this is all they give you.
"ABC Capital has obtained debt financing of $750mm at 10% interest, and OpCo expects working capital to be a source of funds at $6mm per year."
The initial debt balance is $750mm and there's a 10% interest rate, so the interest expense will be $75mm per year.
In the "Cash Flow Statement Adjustments", since Working Capital is a SOURCE of funds it will add $6mm to cash flow each year.
"OpCo requires capital expenditures of $35mm per year, and it has a tax rate of 40%. Assume no transaction fees, zero minimum cash required, and that PP&E on the balance sheet remains constant for the next 5 years."
Also in the CFS section, CapEx = $35mm per year, and Depreciation also equals $35mm per year since the PP&E balance does not change at all. So you can also fill in the Depreciation figure on the Income Statement.
No transaction fees and no minimum cash requirement simplify the purchase price and debt repayment - although we don't even have debt repayment here.
"Assume that excess cash is NOT used to repay debt, and instead simply accumulates on the Balance Sheet."
This makes the final numbers easier to calculate, since interest expense will never change and you can simply add up cash generated to get to the final cash number at the end.
PROCESS:
1. Start with the Income Statement - EBITDA is $250mm per year.
Subtract Depreciation of $35mm per year, and interest of $75mm per year.
So EBIT = $140mm. Taxes = $140mm * 40%, so Net Income = $140mm - $56mm = $84mm.
2. On the simplified CFS, Net Income = $84mm, Depreciation = $35mm, Change in Working Capital = $6mm, CapEx = ($35mm), so Cash Generated per year = $90mm.
3. EBITDA Exit Multiple = 6.0x, and final year EBITDA = $250mm, so Exit EV = $1.5B.
Subtract the outstanding debt of $750mm and add the cash generated in this period of $450mm, so Equity Proceeds = $1.2B.
4. Targeted MOIC = 3.0x so the PE firm would have to invest $400mm in the beginning.
$400mm equity + $750mm debt = $1.150B, so the purchase multiple is $1,150 / $250 = 4.6x.
Further Resources
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This channel is probably way under-rated! very useful, really enjoy the logic flow, simple to understand yet informative :)
Thanks! Glad to hear it.
The comment section is very informative too as M&I takes time on answering them. Thanks again 😊
Thanks for watching!
Thank you for this video, it's really useful!
Thanks for watching!
Great video
The video is just great! Thanks a lot and keep it up!!
Thanks for watching!
Hi Brain. I love your videos. Could you please do a sample model for impact investing? Some useful metrics and how to basically measure value in these investment ideas.
Unfortunately, we just don't know much about that area and have very little information on it. There are a few interviews about impact investing on M&I.
Outstanding video!Thanks very much.
Thanks for watching!
Just dropping a big thanks for this tutorial
Thanks for watching!
Thanks for the helpful video!
Thanks for watching!
Thank you very much for your help !
Glad it helped!
Heeey Learning from Colombia! Great content!
Thanks for watching! I lived in Medellín for a bit and had a great time there.
For less confusions on the change in working capital topic you could have put "Less : Change in working capital" with (6) for all years and subtract it in the FCF calculation. Thanks for the video, except for that point it is very clear.
I agree that would have been clearer, but the goal here was to mimic a real-life case study. The instructions in such case studies are often unclear, whether intentionally or unintentionally. In this case, we pretty much copied one case study word-for-word but changed the numbers and setup a bit. You'll often see concepts and assumptions presented in different ways, some of which are clearer than others, and that's just part of the game.
Great Content loved it 🙂
Thanks for watching!
best private equity content channel on youtube
Thanks for watching!
Hi Brian, thanks for the informative video. Quick question: when we consider the "interest expense", why do we consider this as pre-tax?If the PE firm took on the the additional liability to buy OpCo, would it not show up on their balance sheet instead, meaning you don't get the tax shield? Thx in advance !
EDIT: Might the answer be that the PE firm incorporates it under their own balance sheet, so it all falls under the same umbrella, thus allowing for the tax shield?
PE firms always form separate holding companies to acquire other companies. "Tax shield" just means the company can deduct interest expense and save a bit on its taxes. It has nothing to do with consolidating the financials of a target company with those of the PE firm.
Great video!
One little cuestión. I've always used the following formula to calculate the Unlevered Cash Flows: FCF = EBIT (1-T) + Depreciation - CAPEX - Increase in WC.
I used this formula both to valuate projects and to calculate the Enterprise Value of different firms using the FCF valuation method.
Could you quickly explain why in the example you are taking into account the tax savings originated by the payment of the interests debt as free cash flow? When do we need to include them into the ecuation and when would we exclude them?
Thank you!
Different contexts. Your formula is for Unlevered FCF in a valuation/DCF context. Our formula here is not for valuation but rather for assessing a company's ability to repay Debt principal. As such, both interest expense and the tax effect of interest factor in because they both impact Debt repayment capacity. Or, in simpler terms, we are calculating just "Free Cash Flow" while you are calculating "Unlevered Free Cash Flow."
Understood. Thank you for your answer!
Hi I just wanted extend my thanks for creating this video, I was wondering why we don't compound the debt with interest with forecasting debt after year 1?
Standard Debt has an interest rate and principal repayments (or, sometimes no principal repayments at all). You do not add the interest to the Debt balance unless the interest is "accrued" or "paid-in-kind" (PIK).
Thanks for the video, found it very useful. I had a question though, when calculating the FCF, why did you not use: EBIT * (1-t) + D&A - CAPEX - change in working capital? if we use operating cash flow - CAPEX, doesn't that give us the FCF to equity only? Thank you
The first formula is for Unlevered FCF. You use that to value a company. But in a leveraged buyout model, i.e. not valuation, you use "Free Cash Flow" instead, which includes the interest expense, because you're assessing a company's ability to repay Debt.
@@financialmodeling I had the same question and I'm glad I saw this. Thanks Brian!
If we are getting funds from the change in NWC, shouldn't it decrease the cash flow?
No. If Working Capital acts as a "Source of Funds," it means that you get money from it, which increases cash flow. See the dozens of other comments below on this point.
Hey M&I,
I've really been enjoying the quality content. These might be stupid questions, but how do you copy cells across excel without dragging the box in the bottom right hand corner? Also, when you enter values why do you enter it as =+(number)? Do you have any excel tips, hacks or videos you could recommend I watch? I have experience with excel but i've never seen that. Thanks again!
Double click on the cell left corner, and for =+ number it's nothing it's just normal =, but maybe the instructor came from a programming platform that use this equation in order to perform the = sign, so he is just used to it.
Great video ✌🏻
Thanks for watching!
Great video! A couple of questions, is this assuming that all debt repayments before exit are just interest repayments and not repaying the principal? What would the effect of factoring in principal repayments be?
Yes, it’s a term loan with a bullet repayment structure. Voluntary principal repayments in the interim would not make a difference in the end result as you’d still end up with repaying all outstandings in year 5 using generated cash
Yes, it's a simplified model without principal repayments. Principal repayments would reduce the interest expense in each year and the amount of Debt to be repaid upon exit, but they would also reduce the company's cash flow during the holding period. But there probably wouldn't be a big difference in the IRR with modest principal repayments.
Great video! Just want to confirm: the calculation of initial price indicates if the purchase price is less than 1,150, then at a sales price of 6x EBITDA multiple, this investment can generate more than 3x MOIC? Thank you.
Yes.
@Ricardo De Villa ??? Not sure what you are asking. A 3x multiple over 5 years is normally a good deal, but it has to be measured in the context of the purchase and exit assumptions and whether they are plausible.
I am confused as to why you do not add back Interest*(1-T) in the adjustments, since we are calculating Unlevered CFs, no?
+Anthony D Uh... no. In an LBO model you are calculating "Free Cash Flow" or "Levered Free Cash Flow" because you have to factor in the interest expense. The goal is to figure out how much cash flow the company can use to repay debt principal, and interest paid on debt will impact that. Therefore, you have to factor in the interest expense on debt.
thank you!!
Thanks for watching!
Very clear. Thank you. The only point of confusion I found was that the invested capital portion of MOIC was only the Equity from the firm. I’m just used to conceptualizing IC as Equity and Debt capital. My wires wouldn’t have crossed if it were MOEP (multiple of equity proceeds), though I’m probably just making up terms now. I’m not in the industry as a professional so please excuse me lol
Edit: the interest rate, should we calculate an after tax rate before calculating tax expense?
MOIC is used in LBO modeling to refer to the multiple of the initial investor equity returned at the end. You only use the after-tax interest rate or yield when calculating WACC for use in a DCF or similar analysis.
@@financialmodeling Thank you for the explanation.
Hello, thank you for this informative video! Just a quick question, why we add increase in WC but not subtract it? In FCFF, we subtract the increase of WC. Many thanks!
It's not an "increase in WC." The case study instructions say that Working Capital is a *source of funds* so it boosts the company's cash flow... which means Working Capital is decreasing.
Great video! congrats. I still have a question on the final part. wouldn't it be necessary to know how much cash the company had in the moment of acquisition? i say this since the $1.150 are considered EV and EV is the sum of EQUITY VALUE + DEBT - CASH..Here you´re assuming there was no cash on the initial moment? thanks for your help! great videos
+Luis Miguel Zuluaga Yes. It is a simplification. We are just following the case study instructions and ignoring the beginning cash balance, if any existed.
+Mergers & Inquisitions / Breaking Into Wall Street thank you!!
Great take on the model, simplified but right on the point. Where you part of Wall street oasis by any chance before opening your website? I mean 10 years ago ?
I posted on WSO back in 2007-2009 when M&I / BIWS were first getting started. Patrick even promoted the BIWS courses for a few years early on. But then we went our separate ways for various reasons (if you're bored, take a look at my "Life Story" Part 3 for more).
Why the Free cashflow to Firm is not discounted. Since we are calculating initial investment based on the future earnings they should be discounted using appropriate discounting rate. Please help me to clarify my concept
You're mixing up different concepts here. You discount the cash flows when you value a company, not when you evaluate it as a potential leveraged buyout candidate. The IRR function already factors in the time value of money, so you don't need to discount anything when you're modeling a company for purposes of calculating its IRR.
im curious what shortcut you used to drag values across w/o using the mouse. thank you
Ctrl + R
Hi, very great and informative video. I have a question though, if a LBO model is great, why normal companies do not go for the same idea (taking a huge amount of debt instead of using equity)?
An LBO isn't "great," it presents significant risks to the company and is not a great long-term idea. But it can work over short periods. Most companies would not do the same thing unless they were backed by a large investor, such as the PE firm executing the LBO.
@@financialmodeling I see thanks
One more question. If shouldn't accrued interest each year be added to the carrying value of debt. Eg Y0, debt= 750 hence at Y1 debt= 750+10%=825 at Y2 debt=825+10% and so on and so forth. Please help
??? There is no accrued interest here. The interest is a simple cash expense, and nothing accrues to the loan principal.
Hi! great video, one doubt though:
when calculating the FCF, shouldn't we add the CHANGE in WC? I assume that, if WC is 6M/year, there's no change so we should add 0 instead of 6. To add 6 every year working capital should grow by six, and not stay flat. If doing it like this was your initial idea i find the assumption a bit confusing.
thanks
The language "source of funds" makes it clear that the Change in Working Capital is positive in this case, meaning that it adds to the company's Free Cash Flow. If it were a "use of funds," it would be negative and do the opposite.
The instructions here were taken from a real case study given in real life. They are a bit confusing. But that's often the purpose of case studies - to assess whether or not you can interpret ambiguous or confusing instructions.
@@financialmodeling Don't think this is correct - 6m source of funds implies that it can effectively 'borrow' 6m at any given time for whatever reason (e.g as you say they may have shorter payables days than receivables days and so normal operation result in buffer in cash) however this is not income and shouldn't be treated as such.
Therefore there would be an initial 6m inflow as a result of 'reduction' in required working capital, but after this working capital would be unchanged each year and in the final year this would be reversed with a 6m outflow.
Cash generated as a result of timing differences is not free cashflow.
@@TM-ei9dj Of course cash generated as a result of timing differences contributes to Free Cash Flow... that's the entire point of the Change in Working Capital section of the CFS. By your logic, a company that consistently collects cash well ahead of product delivery and therefore keeps increasing its Deferred Revenue balance would not have any FCF advantage - which is just not true. Companies that do that, such as in the SaaS sector, have higher FCF and are rewarded for the fact that they collect so much before delivery.
As for the instructions and case study, the exact quote is: "OpCo expects working capital to be a source of funds at $6mm per year."
"Per year" means that it's not just a one-time change but a recurring one each year.
Files & Resources:
youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com/109-04-Simple-LBO-Model.xlsx
youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com/109-04-Simple-LBO-Model.pdf
Hi, could you tell me why we haven't considered interest on loan as it has impact on cash?. Also, depreciation is a non cash expense. Why have we considered it? thanks
Karan Dewan Interest Expense is included on line 10 of the Excel file. Depreciation reduces taxes so it is listed as an Income Statement expense, but it is not an actual cash expense so we add it back on the CFS. Please see the lesson on Depreciation on the 3 statements elsewhere in our channel.
Thanks for the video! Quick question on the conclusion that the Initial Price Multiple of 4.6x increasing to EV/EBITDA of 6.0x is not an attractive deal even though the multiple expansion is a positive 1.33x. Why is this the case? Is it because the growth is smaller compared to the initial target of increasing the target MOIC from 3.0 to EV/EBITDA of 6.0x? Hence it's the large initial debt (750m) that lowered the multiples expansion?
You generally don't want to bet on multiple expansion in deals because companies' growth rates tend to decrease over time, and slower-growing companies usually trade at lower multiples. There are some exceptions, such as if a company's ROIC or other efficiency metrics improve, but we don't have any information on that here. As it stands, if a company's EBITDA does not change at all over 5 years, it's very aggressive to assume that its multiple will increase from 4.6x to 6.0x by the end, producing the targeted returns. At best, its multiple might stay the same or even decrease because companies with no growth tend to be worth less.
One quick question, when making cash flow adjustments why did you not add back interest charges and adjust for taxes ~ Interest(1- tax rate) ? Thanks
Why would you do that here? The interest is paid in cash and is deductible for tax purposes. You only make adjustments on the CFS if the item is non-cash or is not truly deductible for tax purposes.
Thanks, appreciate the feedback.
Bit late, but I had the same confusion as Dillan (and maybe someone in the future will as well). The difference is that here we calculate the FCF to Equity holders (FCFE) and the Formula that Dillan wants to use is the FCF to the Firm (FCFF). As we are calculating the return for the Equity holders (PE) you only look at FCFE.
if terminal value is given alongside FCFs, should I do TV+PV( of FCFF) - Net Debt or PV - Net Debt ??
I don't understand your question because Terminal Value and the PV of FCFF is typically used in DCF models, not LBO models. But to calculate the exit equity proceeds in an LBO, you always need to subtract Net Debt from the Exit Enterprise Value (or "Terminal Value" or whatever they call it at the end). You normally do not take the PV of anything in an LBO because the IRR function accounts for the time value of money.
Very useful video, though wondering of getting the excel template. I have tried clicking the last link but I think there's some issue with the link.
Thanks
This one may not be available anymore, but we might release a new version soon.
Hi,
I always thank your insightful videos. May I know the excel spreadsheet is available for this? doesn't seems like it..
See the pinned comment.
So just to clarify, we are saying this is a poor investment because the exit multiple isn’t high enough at 6.0x in relation to the purchase multiple of 4.0x. It would be a better investment if the purchase multiple was lower or if the exit multiple was higher?
"Better investment" is not the right way to express this idea. It is more accurate to say that the investment is more likely to meet the targeted returns if the purchase multiple is lower or the exit multiple is higher. These are just the numbers you would use in a quick/simple screen to see if an idea works at a basic level. To actually buy a company or do a deal, you would need to go far beyond this, which is why "better investment" is a stretch without having a lot more information.
Can you do more of these. Let’s say top ten businesses you can buy that are making around 250k net a year you would buy if you were starting over. I’m saving everything I can in my sales role for the next few years and then want to buy a business 🙏
Thanks. it's an interesting topic, but the process of buying an actual business is complex and doesn't lend itself to quick CZcams tutorials (well, at least not if you want to do it correctly rather than losing money on a poor investment). The short answer is that you generally do not want to buy any type of "small business" because there are so many issues and problems with most of them that they can't be run without a huge amount of effort from you. There's a reason why they sell for much lower multiples than public companies. If your goal is passive income or semi-passive income, you should do long-term buy-and-hold investing and aim for assets like REITs, MLPs, real estate funds, etc., that also produce a yield.
Does the firm give you the format of the model beforehand or do you create all the format and do the calculations as well?
It varies based on the case study. For 2-3 hour on-site tests, yes, they'll usually give you a template. For take-home case studies, they may not. And for quick exercises like a paper LBO or other simple LBO, they also won't necessarily give you a template, but the expectations for formatting are non-existent there.
To calculate the cash generated at exit shouldn't the excess cash in years 1, 2, 3, 4 be adjusted for the time value of money? Instead of the vanilla summing of the 90 million across all years?
Would love to get your opinion.
No, the IRR function if you run it already factors in the time value of money.
One more question, sorry. In the case you weren't told anything about MOIC and instead were given an entry EBITDA multiple and a debt-equity ratio, would the initial Equity value be the initial investment?
The Initial Investment would be Entry EBITDA * Entry EBITDA Multiple * (1 - % Debt Used) there.
7:45 why are we using net income instead of NOPAT (EBIT - tax) as basis for the FCF part?
Because you need to factor in interest expense in an LBO. You can't just ignore it because interest expense directly reduces a company's cash flow and ability to repay debt or accumulate cash. NOPAT is used mostly in a DCF to value the entire company to all investors.
I have a question, do you need to discount those cash flows? Isn't money today not the same as money next year? I may be wrong, it's just what I've been learning in school
MrKingofkicks In this context, no. This is not a company valuation - it's an analysis to see what type of return you could get with an initial investment and series of cash flows. You discount cash flows when using them to determine a company's value.
Mergers & Inquisitions / Breaking Into Wall Street Thank You!
Hi, what if the company had initial debt and cash on its balance sheet? How do we then go about doing this?
Then you have to assume extra funding to refinance the debt (so either use additional debt or equity), and see what the case study wants you to do with cash... if it's minimal it may be left alone, if not, it could potentially be used to fund the deal and reduce the upfront price. See the Dell case study.
I wonder where I can get the excel sheet?
Click "Show More". Scroll to the bottom.
Hey, great video! What is the IRR here? I calculated that with 3x multiple the IRR is like 200% but it seems impossible. My logic here is Initial Investment (equity) Y0 -400 and in the Y5 equity is like 1200. So the CoC/MoM is in fact 3x but the IRR seems too high. Please help :)
It's a 3x multiple of the initial investment over 5 years, so the IRR is 25%. =(K32/K36)^(1/5)-1
One simple question, how do you leave a "x" sign after entering a multiple value?
We're using custom number formats for that here (In Excel, press Ctrl + 1, go to Number, Custom, and then enter 0.0 x).
Mergers & Inquisitions / Breaking Into Wall Street thanks
Thank you very much for this instructive video. Just have one doubt:
If WC is a source of fund, then the change in WC ought to be negative right? Meaning that it will decrease or stay negative as time goes on (year 2 figure has to be lower than year 1 figure, year 3 figure has to be lower than year 2 figure and so on). In the FCF calculation, since the formula is EBIT (1-T) + D&A - Change in WC - Capex, the negative signs will cancel out, thus yielding a positive number and ultimately increasing your FCF. Is this why you add WC in your FCF formula?
I think you are over-thinking this and relying too much on the formula rather than understanding what the Change in Working Capital actually means: as the company grows, does it *spend* more money than expected, or does it *generate* more money than expected? The instructions here say that Working Capital acts as a source of funds, which means that the company gets extra cash from items like deferred revenue and accrued expenses (for example) as its revenue grows.
Thanks for your reply.
Hey Criticalperspective: This is a bit confusing. Yes, you are right, change in working capital itself is negative, since it is a source of funds. But look at the text in fat above: "Cash Flow Statement Adjustments". So how does a negative change in working capital affect cash flow? Positively!
Because I initially thought that since it is a source of fund, it is negative, and since the equation for FCF is Ebit (1-T)+D&A-Capex-Change in working capital, the two minuses give you a plus, so hence why it's added
WC is Current Assets - Current Liabilities so if CA increases faster than CL then WC increases and is expanded on the balance sheet. Therefore its clear that WC being a source of funds means that WC increases.
Is there a difference between an LBO analysis and an LBO model
No
May I ask which free cash flow you mean when you talk about Free cash flow? Unevered free cash flow (FCFF) or levered free cash flow (FCFE)? Thanks :)
Here, it is more like just "Free Cash Flow," i.e., Cash Flow from Operations - CapEx before any debt issuances/repayments. The whole point of a debt schedule or debt projections in an LBO model is to take that number and then figure out how much debt principal a company can repay based on that.
How does MOIC related to desired IRR?
You can relate MOIC and IRR roughly with a simple formula... see our Interview Guide or the LBO Interview Question video here.
One question, am confused if we should use net income or NOPAT to calculate the free cash flow
In an LBO, you use Net Income because FCF is used to calculate the company's debt repayment capacity.
In a (Unlevered) DCF, you use NOPAT because FCF is used to estimate the company's value to *all* investors (its Implied Enterprise Value), which means that FCF should be before items available only to specific investors, such as debt investors, have been factored in.
Mergers & Inquisitions My doubt is should we not use NOPAT( unlevered dcf) as net income already factors in debt investors. As EV is the value of the company to all investors, shouldn't NOPAT be our starting point
No, because in an LBO you are not valuing the company. You are assessing potential returns to the equity investors (the private equity firm), not all the investors.
We would need to estimate the market value of debt to use the NOPAT (because it would factor the interest rate).
Would you not factor in the interest expense repaying the principal debt portion? Also, do usual LBOs ignore discounting cash flows when calculating EVs or is it not done here for simplicity's sake?
The interest expense is deducted in row 10 and reduces Net Income, which reduces the cash flow available for debt repayment. You do not discount the cash flows in an LBO because the IRR calculation already factors in the time value of money. There is no need to "discount" the exit Enterprise Value if that is what you're asking because you're not valuing the company, you are estimating the annualized return from buying, operating, and selling the company.
@@financialmodeling thanks! Do you know if we would need to memorize the templates for these types of modeling questions or would we have access to one?
@@arjunarun9174 You will encounter both types. Actual modeling tests are not common in entry-level/internship interviews, but they do come up in lateral and buy-side interviews quite frequently. "Memorizing the templates" is not an effective learning method. You should aim to learn the concepts by practicing with companies and deals you pick.
Unless they specifically ask you to model this out, why not just back into purchase price with EBITDA and the money multiple? To make sure the debt doesn't put the company's cash generation underwater?
Yes, you could do that if you wanted. But we wanted to illustrate the mechanics of a simple LBO model here. If you know how to approximate IRR, MoM multiples, etc., you could easily do this exercise without writing anything down or using Excel.
great! Could you please share the files on your video ?
Click "More" and scroll to the links at the bottom.
Great vid - could you please explain 1) when to use Net Income vs NOPAT and 2) how you modeled impact of interest on cash flow. Thanks!
You always use Net Income in an LBO model because you can't just "ignore" interest expense. NOPAT is used in DCFs because you want to value a company, ignoring its capital structure. Interest is already reflected in cash flow if you start the calculation with Net Income.
Time value of money not considered for 5 year constant cash flow
The IRR function factors in the time value of money. No idea what you're even trying to say here.
Thanks! Quick question: why it is not s good deal based on the multiple? I m confused, we bought it for4.6x, sell it by 6.0x, earn30% in five years, does that mean the earning is too low? Right?
Our point is that this deal only works because there is significant multiple expansion, which is dangerous to bet on. It's like buying a house and planning to sell it for a big gain under the assumption that home prices in the area will jump up significantly in a short period of time. Possible, yes, but risky.
So that means if we have to take on this amount of risk, we are requiring a much bigger profit, right? In this case, if we bought it for 4.6x, we better sell it for 8.0x,not 6.0x. right? Since we only can sell it for 6.0x in the future, 4.6x to buy it is not a good deal considering the risk we will be taking,right?
No. It's too long/complicated to explain here, and I don't think you understand the main idea behind it, so please email us or go through our help desk for a longer explanation. Or look at some of the lessons here on valuation multiples and what they mean.
come on man, please just explain it here. You can simplify it.
A multiple is realted to a company's cash flow growth rate. Higher cash flow growth rate = higher multiple. If a company sells for a HIGHER multiple than you BUY it for, it implies that the company's cash flow growth rate is higher in the future. But that rarely happens in real life - for most companies, growth rates slow down over time. It's not impossible to realize a higher exit multiple (sort of like selling a home for a higher value very quickly after you buy it), but it's unlikely, and you shouldn't bank a deal on it.
Is this beneficial to watch as a freshman in college?
If you want an internship and a possible long-term career in investment banking or private equity, yes. If not, no.
the formula of fcff = net income + non-cash charges + int(1-t) - capex - WCinv. why we didn't add up the int(1-t) to find fcff?
??? You are adding Interest * (1 - Tax Rate) in your formula, so I'm not sure what you're asking. You always need to add back or exclude the tax-effected interest when calculating FCFF.
Because we are not calculating the FCFF here but the FCFE (Free Cash Flow to Equity)
Easy peesy!!
Thanks for watching!
Tax shield not considered?
It is included because the Interest Expense is subtracted to calculate Pre-Tax Income... so the Interest Expense directly reduces Pre-Tax Income and, therefore, the company's Taxes.
You subtract Change in net working capital... so FCF should be 78, not 90
No, that is not correct.
"The Change in Working Capital" could be either positive or negative depending on whether operating assets are increasing by more than operating liabilities (negative), or whether operating liabilities are increasing by more than operating assets (positive).
Note the language in the case study document:
"ABC Capital has obtained debt financing of $750mm at 10% interest, and OpCo expects working capital to be a source of funds at $6mm per year."
Since Working Capital is a SOURCE of funds, it actually increases the company's Free Cash Flow here.
This is very likely a scenario where inventory and AR are minimal and where the company has deferred revenue from upfront cash collection, which boosts FCF.
If the document had said "Use of Funds" rather than "Source of Funds," we would be subtracting the Change in Working Capital instead.
Where can I find the excel file?
Click "Show More." Scroll to the bottom. Click the links.
Brian rules
Thanks for watching!
Wow
Thanks for watching!
can i get this excel sheet please....
Click "Show More". Scroll to the bottom. Click the links.
Very useful video, maybe a little fast, but it is not a big deal.
DOUBT: what are some requirements for a company to be chosen for an LBO? Thanks
czcams.com/video/Y2q-7kBHIxw/video.html
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I know this video is from a long time ago, but just attempting to hop into finance and have an interview this Friday. How do we know that D&A is equal to the CapEx/Depreciation value?
"Assume no transaction fees, zero minimum cash required, and that PP&E on the balance sheet remains constant for the next 5 years." --> If PP&E stays constant, CapEx must equal D&A because those are the main two items that affect it. CapEx increases it, and D&A reduces it.
how can we find the excel sheet ?
Click "Show More" and scroll down to the links at the bottom.
For NWC to be a source of funds, NWC needs to decline. Saying NWC increases is saying that your current assets increased, which is a use of funds, not a source.
We are not tracking whether NWC increases or decreases here, just its impact on the Cash Flow Statement. If Working Capital is a source of funds, then it increases the company's cash flow. See all the other comments on this point.
What about IRR?
You can use (Exit Equity Value / Initial Investor Equity) ^ (1 / # Years) - 1 to calculate it here. But the instructions didn't ask for it, so we didn't show it. Plenty of the other LBO tutorials in this channel show the IRR calculation.
Great Video, Quick two questions: (1)Why do you subtract "Cash Generated" from the "Exit EV", it's becasue you assume that the CF is excess? (2)In the end of the video, why do you mention that this is not good deal based on the EBITDA multiples? it looks like a great deal, thay raised the investment from 400 to 1200 in five years, which account to about 25% yield per year.
1) You always subtract Net Debt to calculate the Exit Equity Proceeds at the end. This is because the standard assumption is that the PE firm has to repay the remaining Debt upon exit and can use the company's Cash balance to do so. This is not always true in real life and depends on the company, deal terms, etc., but is the standard assumption in models.
2) Our point is that this deal only works because there is significant multiple expansion, which is dangerous to bet on. It's like buying a house and planning to sell it for a big gain under the assumption that home prices in the area will jump up significantly in a short period of time. Possible, yes, but risky.
How long were the participants given to complete the case study?
Did they have the template to begin with, or did they start with a completely blank excel file?
Helps to know what we should be benchmarking against - thank you!
So this is a very old video in this channel and was produced before we designed case studies according to strict time criteria, and so I don't have answers for you. But since this is such a simple model, I would assume 30 - 60 minutes to complete with no template and no real formatting expected other than $ vs. % in the cells. For better coverage, see some of the more recent case study / LBO examples.
There is one weakness in this case model. If the final buyer invests 1,200 M and get access to 300 M debt financing with the same interest rate of 10% (in order to retain all the assets minus the accumulated cash), and manage to maintain the same EBITDA, its net income will be 105 M (250 - 35 - 30 - 40%), which is miserable 8.75% ROI (less than lenders' ROI in the same enterprise). It means you probably may not expect to sell this company with the EBITDA exit multiple of 6.0 x, right?
+Alex Uriatin Uh I think you might be over-thinking this. It's called "Simplified." "Simplified" tends to imply that the model doesn't handle every possible scenario or outcome, and is instead designed for a time-pressured scenario in which you have to complete something quickly to answer a question. ROI and Net Income, while interesting to look at, have very little to do with the price the PE firm could get for the company in most industries... buyers will look at revenue growth, margins, EBITDA, and FCF, but tend not to pay as much attention to Net Income.
+Mergers & Inquisitions / Breaking Into Wall Street . I agree that reasonable expectations that the ROI is going to grow over time will make the buyer currently "overpay" for the assets. But in this case, I take into account the fact that even the very good management team assigned by the private equity firm was only able to stabilize the operating profit (not to increase it), therefore I assume that there is no reason to expect it is going to increase in the near future. I also agree that the industry plays a role in the pricing. But I do believe that under no circumstances, can expected equity ROI be lower than the lenders' ROI for the very same company. If investors believe the risk of investing in the equity of this firm (with a flat expected operating profit during next years) justifies the ROI of 8.75%, with no better opportunities on the capital market, then why does the company offer 10% to its lenders?! The reversal of the risk-return trade-off makes even a simplified case rather unrealistic.
+Alex Uriatin Hey, point taken, but I'm not going to say much more on this topic - PE firms do not buy companies based on ROI or Net Income. They buy based on growth rates, margins, FCF, and various other metrics and qualitative criteria. So yes, this is perhaps not a "realistic" example, but that's not the point. What you've done here is sort of like looking at an algebra or geometry problem and then saying that calculus or PDEs disprove the premise of the problem - maybe, sure, but for the specific level of student completing the problem, that point is not relevant. Incidentally, this example was taken from a real case study given by a real finance firm to one of our customers - so as "unrealistic" as it is, it's also very representative of what you might receive in real life...
+Mergers & Inquisitions / Breaking Into Wall Street Your video is extremely helpful anyway. I liked it a lot. Everybody likes to earn money. When your only asset is financial capital and capability to assess investment opportunities, an ROI is the only indicator relevant to what you ultimately need - all others are just technical tools to calculate investing where you're gonna get the best ROI matching your personal risk tolerance. When I am said there is an opportunity to triple my capital in a couple of years, and there is a model that supports that, I am like: "really?", and tend to look for pitfalls of that model that led to those too optimistic projections.
I know this is a very noob question. Why is depreciation a positive cash flow?
Depreciation is a non-cash expense that reduces the company's taxes but does not represent an actual cash outflow in the current period. Subtract it to reduce Pre-Tax Income for the tax deduction, but then add it back on the cash flow statement or projections so that the actual expense does not affect anything other than the tax reduction.
Thanks a lot for your answer and for the tutorial!@@financialmodeling
7:13... how??? The debt cannot be that flat over the years, Y1 is debt *interest rate but for the years after you have to calculate the % interest previous year's payments deducted
I'm not really sure of your question, but it is 100% possible for a company in an LBO to not repay any Debt over the holding period. For example, the Debt to fund the deal might be high-yield bonds with no principal repayments or subordinated notes or mezzanine or something else like that.
In practice, yes, there will usually be a Term Loan or other Senior tranche with some principal repayment, which might be a small percentage such as 5-10% of the original principal. But in a quick/simple model, you can ignore this for ease of calculation unless they ask you to account for it. Please see all the other LBO tutorials here for more examples.
@@financialmodeling Ah ok, it wasn't that clear, This type of loan is called in Fine ( pronounced : in fee-nay it's latin it's means literally: at the end )
Unbelievably simple, smh.
W. Lutaaya Thanks for watching!
So basically, in this model, the return on investment is purely attributable to the accumulation of excess cash on the balance sheet? Is this even remotely close to how PE firms operate in the real world?
+hurf_durf I guess my question is: would a company behaving similar to this model really see its equity value increase at all?
+hurf_durf No, a company that does not grow its EBITDA at all would be unlikely to see multiple expansion from 4.6x to 6.0x. So that part is not realistic.
To clarify, however, the returns here do not exactly come from excess cash - they come from the fact that the company generates a certain amount of cash flow each year, which might be used to pay down the debt, but which also might be left to accumulate on the Balance Sheet. In this case they chose to let the cash accumulate, or rather they were restricted from repaying the debt earlier on.
That part is very much accurate and debt pay-down / cash generation are major sources of returns for PE firms in many deals.
The goal of this exercise was not to present a realistic view of how a real company operates and earns returns - it was to give you a representative example of a "quick test" that might be given in an interview. We know it is representative because we copied and pasted it from an actual test given it a real PE firm and changed it around a bit.
When something here is marked "simple" or "simplified," you can assume that the purpose of the tutorial is to prepare you for similar tests, not to give instructions on how real-life deals take place.
+Mergers & Inquisitions / Breaking Into Wall Street Thanks for the response! I totally get it now. One of the issues I had as a macroeconomics student in university was needing to tell a story in my head to make sense of data and analyse it (I'm not a numbers guy), so when the story didn't make sense at the end I'd start to doubt my answers and wonder if I made a mistake somewhere. You're probably the first to straight up admit problems can be unrealistic [my econs profs and tutors would give some wishy-washy reply about 'oh, well the relative magnitude of factor A on the gdp/ER tends to be greater than factor B's pressure in the opposite direction' whenever I raised questions about the assumptions in the models (while never actually explaining why)] . Thanks for the candor :D