Describe the mechanical flow of an LBO operating model from revenue down to levered free cash flow, naming each line item in order.
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The answer
The flow begins with revenue, built from the sponsor's specific growth thesis including organic initiatives, pricing, and add-on acquisitions. From revenue I subtract direct costs and operating expenses using the projected EBITDA margin to arrive at EBITDA. Then I subtract cash taxes computed on a levered basis as EBIT minus interest expense, capturing the deal's actual tax shield.
Next I deduct capex, both maintenance and growth, and adjust for changes in net working capital. I also subtract the sponsor's annual management fee, which is a real cash outflow. Purchase-accounting and financing-fee amortization never gets subtracted in this build because I started from EBITDA; its only effect is cutting taxable income, which lowers cash taxes.
That produces levered free cash flow, the number that feeds the debt schedule's cash sweep. Interest expense itself sits inside that build and creates the model's defining circularity, because interest depends on the debt balance which depends on how much was swept, which depends on free cash flow, which depends on interest.
I handle that by using average debt balances with iterative calculation turned on or by simplifying to beginning-of-period balances. Underneath all of this, the operating model remains a standard three-statement model where the income statement drives retained earnings and cash on the balance sheet, and the balance sheet must balance every period.
Sources & uses
| Term Loan B | 400 |
| Senior notes | 250 |
| Sponsor equity | 370 |
| Total sources | 1,020 |
| Purchase of equity | 900 |
| Refinance existing debt | 100 |
| Financing & advisory fees | 20 |
| Total uses | 1,020 |
Also asked as
- Why is interest expense in an LBO model circular, and what are two practical ways to resolve that circularity in Excel?
- Why does the LBO operating model compute cash taxes on a levered basis (EBIT less interest expense) while a DCF computes them on an unlevered basis?
- Name two LBO-specific line items that a standard three-statement model for a stable public company would not typically include, and explain what each represents.
- Year 4 EBITDA is $58mm, D&A is $14mm, interest expense is $19mm, CapEx is $9mm, NWC increase is $2mm, and the tax rate is 25%. Build the levered free cash flow for the year.
- Explain why the sequencing of sources & uses before the operating model matters, and what specifically the operating model needs from sources & uses to run.
- A company has pre-deal NOLs of $20mm. Year 1 taxable income (pre-NOL) is $15mm. Compute cash taxes paid in year 1 and the remaining NOL balance entering year 2, and explain how this changes the year's levered free cash flow versus a model that ignored the NOL.
- Beginning term debt is $180mm at 8.0%. Levered free cash flow before interest and tax (EBITDA less D&A, capex, and NWC change) is $50mm, tax rate is 25%, and all after-tax cash sweeps to debt. Solve for interest expense using the average-balance method (set up and solve the circular equation), and compare it to the naive beginning-balance-only estimate.
- A target has $40mm of pre-deal NOLs. Purchase accounting creates $50mm of incremental intangible write-up amortized over 10 years on top of $8mm of pre-existing D&A. The sponsor charges a 2% of EBITDA management fee. Year 1 EBITDA is $45mm, interest expense is $15mm, CapEx is $6mm, NWC increase is $1mm, tax rate 25%. Build levered free cash flow for year 1, showing the NOL's cash tax impact, and state the remaining NOL balance entering year 2.
- The sponsor is deciding between two operating plans for the same platform: Plan A assumes 4% annual revenue growth with flat margins; Plan B assumes flat revenue but 300bps of cumulative margin expansion over 5 years from cost cuts, funded by $15mm of one-time restructuring cash costs in year 1 (a use of cash not reflected in EBITDA). Starting revenue and EBITDA are $150mm and $30mm respectively. Project EBITDA under both plans through year 5, incorporate the year 1 cash cost's effect on free cash flow (not EBITDA) for Plan B, and discuss which plan you would expect to produce a better return given the debt paydown driver from Lesson 27.
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The rest of this topic
Building an LBO, start to finish