Investment Banking Interview Guide

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Investment Banking Interview Guide, Basic LBO Model – Quiz Questions

Answers in bold.

Table of Contents:

• Concept and Overview Questions

• Assumptions, Debt, and Sources & Uses
• Projecting and Adjusting the Financial Statements
• Calculating Returns

Concept and Overview Questions

1. Which of the following statements below are TRUE regarding why an LBO works
conceptually?
a. By using debt, the PE firm reduces up-front cash required, thereby
boosting returns
b. Using cash flows produced by the company to pay down debt and make
interest payments produces a better return for the PE firm than simply
keeping the cash flows
c. Since the PE firm sells the entire company in the future, it’s guaranteed to at
least get back 100% of its original capital
d. The PE firm sells the company in the future, which allows it to get back (at
least some of) the funds that it used to acquire the company in the first
place
i. Explanation: Statements A, B, and D are all true. By using little of its
own cash and borrowing heavily to purchase the company, the PE
fund significantly boosts its returns for the simple reason that money
today is worth more than money tomorrow due to the interest that it
could earn. In an LBO, the PE fund uses the cash flows of the company
it acquires to pay debt principal and debt interest, which is a much
better use of those funds than keeping the money for itself, again
boosting returns. The other reason LBOs work in practice and earn
such high returns is because the PE fund only operates the company

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for 3 to 5 years before it sells it off and regains its money plus profit; if
the PE fund were to keep the companies it purchased indefinitely, it
would not be possible to earn the returns that PE funds seek. C is
incorrect because there’s no “guarantee” that the PE fund will get back
100% of its original capital – if the company’s EBITDA declines or if
the exit multiple declines significantly, for example, that may not
happen.

2. What’s the best analogy to use when thinking of how a leveraged buyout works?
a. A homeowner buys a house to live in with a down payment and mortgage,
and then sells the house in the future once the mortgage is repaid
b. An investor buys a house to rent out to tenants, using a down payment and
mortgage, then uses the rental income to repay the mortgage, and then sells
the house in the future
c. A person buys a car using cash and a car loan, drives it for several years,
repays the debt, and then sells the car
d. None of the above
i. Explanation: B is correct because that is exactly what happens in an
LBO – you buy a company that generates cash flows, you use the cash
flows to repay debt, and then sell it off at the end of several years. A is
incorrect because a house that you live in is not an income-generating
asset. So it is not the best way to think of an LBO. C is incorrect
because unlike a house, cars always depreciate in value and you’ll
likely lose a lot of money after buying it, running it, and selling it…
plus cars do not generate income, unlike rental houses.

3. All of the following characteristics make for a good LBO target EXCEPT:
a. High PP&E and/or Fixed Assets on the Balance Sheet
b. Relatively low Capital Expenditures
c. Non-volatile, non-cyclical, cash flow producing business
d. Early-stage fast growth company
i. Explanation: The correct answer choice is D. Answer choice A
represents an asset-rich company which can pledge its current assets
and PP&E as collateral for high levels of bank debt (which is necessary

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for an LBO). Answer choice B refers to companies with negligible large

cash outflows in the form of capital expenditures; that is a good sign
since the company can use those cash flows to pay interest and debt
principal post-LBO instead. Answer choice C represents companies
that produce lots of cash flow and exhibit no volatility in those cash
flows from year to year. Usually, PE firms prefer very mature
companies and industries, sometimes even if they are in the decline
phase of their lifecycle. Something very early-stage with high growth
would probably produce cash flows that are too volatile to make
consistent and periodic interest payments and debt repayment.
Usually early-stage hyper growth companies are not cash-flow
positive businesses, and the majority of their value is not comprised of
‘hard assets’ such as PP&E which can be used as collateral for the large
sums of debt that need to be raised.

4. Since an LBO valuation and a DCF are both based on Free Cash Flows and how
much cash the company generates, they are likely to produce similar implied values.
a. True
b. False
i. Explanation: The correct answer choice is B. The cash-flow metric used
in an LBO model – namely, ‘Free Cash Flow Available for Debt
Service’ (aka CFO – CapEx) – is not identical to Levered Free Cash
Flow used in a DCF, with the latter explicitly subtracting out
mandatory debt repayments. And most of the time in a DCF, you use
Unlevered Free Cash Flow, which is even more different. Furthermore,
an LBO is different from a DCF in that the LBO model does not
explicitly calculate an implied value like a DCF does. Rather, in an
LBO model you work backwards to determine the price that a PE firm
can pay if it is targeting a certain IRR. In other words, a DCF is based
on, “How much could this firm be worth if certain assumptions are
true?” whereas an LBO valuation is based on, “What’s the minimum
price a PE firm could pay to achieve a certain return on their
investment?”

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Assumptions, Debt, and Sources & Uses

5. All of the following represent differences between high-yield (HY) debt and bank
debt EXCEPT:
a. HY debt is riskier and thus has a higher interest rate
b. Bank debt has a “floating” interest rate whereas HY is fixed rate
c. HY debt has maintenance covenants whereas bank debt has incurrence
covenants
d. HY debt does NOT allow early debt repayment whereas bank debt is
amortized
i. Explanation: The correct answer choice is C. All of the above
statements represent factual differences between HY debt and bank
debt except for answer choice C. HY debt is considered much “riskier”
than bank debt, and as a result investors require a higher interest rate
to be compensated. Answer choice B is correct in that most bank debt
does NOT have a fixed interest rate but rather a “floating rate” usually
tied to LIBOR, whereas HY debt is more conventional in that its
interest rate is a fixed percentage. HY debt prohibits early principal
repayment and usually is structured as a “bullet maturity” (meaning it
is paid off in full at maturity). On the other hand, bank debt is
amortized annually and a percentage of the principal is paid off each
year. Answer choice C is incorrect and should be the other way around
– namely, that HY debt has incurrence covenants (which prohibit
against taking certain actions) whereas bank debt has maintenance
covenants (which require maintaining a minimum financial
performance).

6. A PE firm might prefer high-yield debt over bank debt because it’s less expensive
and the company’s CapEx and acquisitions would not be restricted.
a. True
b. False
i. Explanation: The correct answer choice is B. Between HY debt and
bank debt, the latter is a lower cost method of financing. Furthermore,
HY debt does have incurrence covenants, which would prohibit it

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from taking certain actions such as spending additional funds on

Capital Expenditures or on acquisitions. In summary, for a lower cost
option of financing without restrictive incurrence covenants, a PE fund
would chose bank debt rather than HY debt.

7. Under the Sources & Uses section of the LBO model, all of the following would
normally be found under the Sources section EXCEPT:
a. Term Loan Debt
b. Investor Equity (Cash the PE firm pays)
c. Debt Assumed
d. Management “Rollover”
e. Transaction Fees
i. Explanation: Answer choice A represents the “bank debt” used to
finance the purchase. Answer choice B is the cash the PE fund invested
thereby representing its equity stake. Answer choice C represents the
existing outstanding debt of Target Co. that PE fund assumes. Answer
choice D represents the new equity that the PE sponsor shares with the
existing management team to incentivize and align interest. All of
those effectively finance the deal and allow the PE firm to make it
happen, so they count as Sources of Funds. However, Transaction Fees
simply cost the PE firm something extra so they should go in the Uses
section instead.

8. The difference between assuming debt versus refinancing debt in an LBO model is that
the former increases the funds required, whereas the latter has no net effect on the
funds required.
a. True
b. False
i. Explanation: The correct answer choice is B. This statement should be
the other way around – that is, assuming debt has no net effect on funds
required to acquire the target company, and refinancing debt results in
increasing the purchase price for the target as additional funds are
required. Assuming debt simply means that whatever outstanding
debt the target company has remains on the company’s Balance Sheet

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going forward. On the other hand, refinancing debt means that the
existing outstanding target company debt is paid off in full, and
usually that new debt is reissued in its place. This has the effect of
increasing the net funds required for the acquisition. One reason why
debt might have to be refinanced is because target company debt may
have to be paid off in full in a change-of-control scenario, according to
the terms of the debt.

9. What is the true cost of buying a company in a Leveraged Buyout?

a. Its Enterprise Value
b. Its Equity Value
c. Neither of the above
i. Explanation: The correct answer choice is C. Strictly speaking, neither
Equity Value nor Enterprise Value represents the true cost of buying
out the company. The true cost to buy the company depends on what
you do with the company’s existing debt. If you assume the existing
debt, then the effective purchase price will be closer to the Equity
Value (but not exactly). On the other hand, if you refinance the
existing debt, the effective purchase price will be closer to the
Enterprise Value (but again, not exactly). In summary, the true cost to
buy out a company depends on whether you assume or refinance the
existing debt outstanding.

10. Which of the following leverage and coverage ratios below are NOT reasonable?
a. Total Debt / EBITDA cannot exceed 3.0x
b. EBITDA / Interest Expense cannot fall below 5.0x
c. EBITDA / Cash Interest Expense must exceed 20.0x
d. Senior Debt / EBITDA cannot fall below 0.1x
i. Explanation: The correct answer choices are C and D. Answer choices
A and D are examples of leverage ratios, whereas B and C represent
interest coverage ratios. Both A and B are very reasonable leverage and
coverage ratio levels. The coverage ratio in answer choice C is
unreasonable for the reason that it is too high and thus indicates the
company in question has unused debt capacity, which could increase

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the IRR return even higher. The leverage ratio in answer choice D is
also nonsensical – 0.1x is barely even meaningful, and normally
leverage ratios are framed in terms of “cannot exceed” rather than
“cannot fall below” – because the concern is what happens when debt
gets too high.

Projecting and Adjusting the Financial Statements

11. Which of the following statements is TRUE regarding revenue growth in an LBO
model?
a. Projecting revenue growth in an LBO model is very similar to doing so in a
traditional DCF
b. Due to revenue synergies, in an LBO model one assumes increases in Year-
Over-Year revenue growth rates, even in the final years
c. Revenue growth rates are much higher in LBO models versus M&A models
due to such high levels of debt
d. In a DCF, you want to show declining revenue growth over time, but in an
LBO model you want to show constant revenue growth from year to year
i. Explanation: The correct answer choice is A. All of the above
statements with the exception of answer choice A are false. Projecting
top-line revenue growth in an LBO is similar to a DCF in that you
assume a higher growth rate in earlier years that decreases annually
until the terminal year where it is at a steady state. Answer choice B is
false because you never assume higher revenue growth rates in the
final years, especially in the terminal year – as companies get bigger, it
gets harder to grow at the same rate. Answer choice C is false as well –
revenue growth has nothing to do with the high levels of leverage
used in an LBO. The borrowed funds enhance the returns earned, but
they do not accelerate the top-line revenue growth rates per se. D is
false because in both models you want to show declining revenue
growth over time.

12. When building an LBO model, it is best to keep the EBIT and EBITDA margins
within the same range every year throughout the projection period.

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a. True
b. False
i. Explanation: The correct answer choice is A. It is a more conservative
assumption to keep the EBIT / EBITDA margins constant throughout
the projection period in an LBO model. The reason this is a
conservative assumption is because an increasing EBIT / EBITDA
margin will result in a much higher exit value and thus a higher IRR
return. It certainly can be the case that due to operational
improvements, the PE fund is able to enhance the portfolio company’s
operating margin to make it more profitable and thus make the
company itself worth more. However, it is very difficult to enhance
profit margins in the real world, and thus a more conservative
assumption is that they remain constant so as not to unduly enhance
the assumed exit value of the portfolio company.

13. Which of the following fees are CAPITALIZED rather than expensed in an LBO?
a. Financing Fees
b. Transaction Advisory Fees
c. Legal Fees
i. Explanation: The correct answer choice is A. The accounting treatment
is slightly different for transaction fees. All legal and advisory fees –
namely, fees paid to investment bankers, M&A lawyers, and other deal
participants – are paid out in cash at transaction close. This decreases
cash on the balance sheet and decreased Shareholder’s Equity on the
other side of the balance sheet so both sides remain in balance.
Financing fees, which arise due to the additional debt that is issued to
fund the LBO purchase, are also paid out in cash. However, the
amount paid then is capitalized on the balance sheet as an Asset, and
amortized each period as an expense, which then flows through to the
income statement (similar to how depreciation and amortization
expense hit the income statement).

14. Which of the following items is LEAST likely to be adjusted on the company’s
Balance Sheet in an LBO?

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a. Shareholder’s Equity
b. PP&E
c. Goodwill and Other Intangible Assets
d. Long-Term Debt
e. All of the above will always be adjusted
i. Explanation: Answer choice A is definitely wrong because
Shareholders’ Equity always gets wiped out and replaced by the PE
firm’s equity contribution in an LBO. C is also wrong because
Goodwill & Other Intangibles also get replaced by the premium the PE
firm pays over the company’s Book Value – and it’s exceptionally
unlikely that there will be no premium. D is incorrect because Debt is
added to the company in 99.9% of all LBOs – otherwise there would be
no point in even conducting an LBO. That leaves B as the correct
choice – in many cases, PP&E will be written up to fair market value…
but that doesn’t necessarily happen all the time. Especially in cases
where the company’s PP&E is minimal or relatively new, you may not
see this adjustment at all.

15. Which of the following statements are TRUE regarding how debt repayment and
interest payment work in an LBO model?
a. Normally you assume existing outstanding debt on the Balance Sheet gets
repaid first
b. Optional Debt Repayments only take place AFTER Mandatory Debt
Repayments have been made
c. The Revolver, Term Loans, and Senior Notes are all repaid under “Optional
Debt Repayments”
d. The Revolver is drawn only when the cash required for Mandatory Debt
Repayments exceed the cash flow you have available to repay them
i. Explanation: The correct answer choices are A, B, and D. Answer
choice A is true as the assumption is made that existing debt is repaid
first. Answer choice B is true as after mandatory debt repayments have
been made, excess cash flows can be used for optional debt
repayments. Answer choice C is false as only the revolver and term
loans are paid under optional debt repayments; senior notes do NOT

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allow for prepayments before maturity. Answer choice D is true and

explains the purpose of the revolver – a source of financing to draw
upon when shortfalls in cash flows for mandatory debt repayments
occur.

16. Which of the following statement are TRUE regarding the debt schedule in an LBO
model and how interest is calculated?
a. The formula for Revolver Borrowing = MAX (0, Total Mandatory Debt
Repayment – Cash Flow Available to Repay Debt)
b. You subtract any Revolver Borrowing from your cash flow available for debt
repayment balance before calculating Mandatory and Optional Debt
Repayments
c. You repay any drawn down Revolver amount before making Optional
Debt Repayments for Term Loans
d. Up to 100% of cash flows generated in a given year can be used to make
Mandatory and Optional Debt Repayments
i. Explanation: The correct answer choices are A and C. The formula
listed in answer choice A is correct for the Revolver. Answer choice B
is false because you are supposed to ADD (not subtract) any Revolver
Borrowing to your cash flow available for debt repayments. Answer
choice C is true in that Revolvers get repaid first always before Term
Loans in for Optional Debt Repayments. Answer choice D is false
because LESS than 100% of cash flows can be used, due to the
minimum cash balances required for operating the business.

17. Which of the following effects are you likely to see in an LBO model following a
Dividend Recapitalization (Dividend Recap)?
a. Additional interest expense and debt repayments
b. Additional financing fees
c. A reduced IRR, due to the burden of additional debt
d. None of the above
i. Explanation: You will certainly get additional interest expense and
have to make additional debt repayments, because in a Dividend
Recap the company itself takes on additional debt and issues a large

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dividend to the PE firm using that debt. Financing fees are also
inevitable because it will cost something to raise that debt, and you
need to pay bankers to make it happen. C is incorrect because all else
being equal, a Dividend Recap increases the IRR – remember that
more debt used in the initial period generally increases returns, and
the same applies here. The PE firm gets some of its cash investment
back early, and money received earlier on is always worth more than
money received later on. So A and B are correct, and C is incorrect
since a Dividend Recap will boost the IRR in an LBO.

Calculating Returns

18. Which of the following explanations of the Internal Rate of Return (IRR) is FALSE?
a. IRR is the interest rate that, when compounded annually, gives you the net
proceeds at the end, assuming the initial amount you put down in the
beginning
b. If we invested this initial amount of money and got this specific interest rate,
compounded each year, we’d end up with the total amount of money shown
in the final year
c. It’s the discount rate which makes the Net Present Value of the cash flows
from the investment equal to zero
d. It’s the “effective interest rate” on the investment
e. All of the above (i.e. these are all false explanations)
f. None of the above (i.e. these are all accurate explanations)
i. Explanation: None of the alternative definitions for IRR provided
above are false; rather, all the alternative definitions above are true.
Answer choice C is the academic and theoretical definition of IRR.
However, answer choices A, B, and D all conceptually do a better job
of explaining what the IRR actually means. One thing to note is that
sometimes the IRR is alternatively referred to as the ‘dollar weighted
return’ but it refers to the same thing.

19. Which of the statements below are TRUE regarding estimating IRR in an LBO?
a. A 15% IRR is when PE fund doubles its money in 5 years

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b. A 44% IRR is when PE fund triples its money in 3 years

c. A 25% IRR is when PE fund triples its money in 5 years
d. A 26% IRR is when PE fund doubles its money in 5 years
i. Explanation: The correct answer choices are A, B, and C. They are all
covered in the interview guide as quick “rules of thumb” you can use
to estimate IRR in different situations. Here, the term “money” refers
to the investor’s equity stake only, and NOT the total purchase price or
exit price.

20. A PE fund buys a company (with no existing debt or cash) for $500 million, at a
purchase EBITDA multiple of 10.0x. They use 75% debt and 25% equity. At the end
of the 3-year period, they sell the company at an exit EBITDA multiple of 12.0x.
However, EBITDA has not changed at all. Finally, the PE fund has paid off $150
million worth of debt. What is the approximate IRR on this deal?
a. Approximately a 44% IRR
b. Approximately a 15% IRR
c. Approximately a 25% IRR
d. Approximately a 26% IRR
i. Explanation: The correct answer choice is A. We can refer to the rules
of thumb provided in the LBO Guide to approximate the IRR returns.
In this case, the PE sponsor tripled their money in 3 years, which
corresponds to a 44% IRR. Here is how we do the calculation: the PE
sponsor used $125M in cash to acquire the company and borrowed the
remaining $375M. 3 years later the company is sold and the exit
multiple expanded to 12.0x. However, EBITDA remained the same.
Since the company was initially purchased at 10.0x EBITDA for $500M,
that implies an EBITDA of $50M per year. So we take this $50M
EBITDA and multiply it by the exit multiple of 12.0x, which results in
an exit price of $600M. The net proceeds to the PE sponsor is $375M
(i.e. exit price less remaining debt outstanding), resulting in 3.0x the
initial investment (i.e. $375M net proceeds / $125M initial investment =
3.0x).

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21. It is NOT possible to earn an IRR above 15% if a PE firm sells its portfolio company
at the same price that it initially purchased the company for.
a. True
b. False
i. Explanation: The correct answer choice is B. Even if a PE fund exits the
portfolio company at the same price that it initially purchased it at, it
can still earn a high IRR. The thing to keep in mind is that the PE fund
used minimal amounts of cash to gain control of the company itself.
For instance, if the PE fund had an equity stake of 20% and used
borrowed fund to finance the remaining 80% of purchase price, it
could use the cash flows from the company to aggressively pay down
the debt outstanding. For example, if the PE fund paid down 20% of
the total debt outstanding, then its initial equity stake of 20% would
grow to 40% and then even if they sell the company for only the
original purchase price, the PE fund could still achieve a satisfactory
IRR return on the transaction. And you can get even better numbers if,
for example, the PE firm borrowed for 80% of the price, repaid 100% of
the debt, and therefore has even higher net proceeds at the end.

22. All of the following items boost the IRR achieved by PE funds in LBOs EXCEPT:
a. Lower equity contributed by PE firm
b. Lower “purchase” EBITDA multiple
c. Lower “exit” EBITDA multiple
d. Higher EBITDA margins
e. Higher revenue growth rates
i. Explanation: The correct answer choice is C. All of the above answer
choices (with the exception of answer choice C) would result in a
higher IRR being achieved by the PE fund. Answer choice A represents
a lower “cash down payment” and more debt, which enhances returns.
Answer choice B results in a lower purchase price for the company
being taken private, which also saves the PE firm money initially and
boosts returns. Answer choice D results in higher exit value since the
final selling price is a function of EBITDA, and a higher EBITDA
generally means a higher price. Answer choice E would result in

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higher revenues, which would result in a higher EBITDA even if

margins remain constant, and therefore a higher exit price when the PE
firm sells the company.

23. A mega-cap private equity fund such as KKR or Blackstone is considering buying a
$4 billion public company using 50% debt and 50% equity. It has run the numbers
and found that it could realize a 20% IRR in 5 years at those levels. Furthermore, the
fund also has more than enough cash on hand to do the deal at those levels. During
deal negotiations, however, the PE firm pushes to contribute only $1.5 billion in
equity rather than $2 billion. Why would it do this?
a. All else being equal, less equity contributed will still boost its IRR
b. A 20% IRR is too low and will not please the firm’s Limited Partners
c. Because the firm needs more “dry powder” on hand and wants to save cash
in case it decides to make more investments in the near future
d. None of the above
i. Explanation: A 20% IRR is a good outcome, so B is not the best answer
choice here. It really comes down to the two answers outlined in A and
C: a PE firm almost always earns more by contributing less equity, so
it’s in their interest to negotiate it down even lower, if possible,
assuming that the company can support that level of debt. C is also a
major motivation, and sometimes PE firms are actually prohibited
from investing over a certain amount or percentage of equity in a
single deal. Fund-raising is expensive and time-consuming, so it is in
their interest to reduce the amount of cash contributed as much as
possible before doing the deal.

24. It is INCORRECT to assume an Exit Multiple that’s higher than the Purchase
Multiple, because multiples always decline over time.
a. True
b. False
i. Explanation: The correct answer choice is B. It is certainly true that in
majority of cases, the conservative assumption to make in an LBO
model is that the exit EBITDA multiple is lower than or equal to the
purchase EBITDA multiple. However, it certainly is possible (and does

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sometimes happen) that the exit EBITDA multiple is higher than the
‘entry’ EBITDA multiple (which is known as “multiple expansion”).
For example, if the PE firm purchased the company in a cyclical
industry such as chemicals or semiconductors and bought it at the
bottom of the cycle, it could easily realize a higher multiple when it
sells the company. More generally, the PE firm might have bought the
company at the bottom of a recession, and might be selling the
company when the economy has improved. So it’s not necessarily
incorrect to assume this, but generally you want to be more
conservative and assume the same multiple, or a lower multiple.

25. Since a recession reduces most companies’ cash flows, the returns achieved by PE
funds raised (and investments made) in the midst of economic recessions are always
lower.
a. True
b. False
i. Explanation: The correct answer choice is B; this statement is false. It is
true that during recessions the cash flow and profits earned by
hypothetical portfolio company would be reduced. However, going
back to the 3 main drivers of PE returns, a lower purchase price almost
always results in a higher IRR return later on. When the economy is in
the midst of a recession, PE firms can more easily buy companies
cheaply, which makes it much easier to sell the portfolio company later
on (say, after the recession ends) at a healthy price and attractive IRR.
Of course, the PE firms’ portfolio companies could also suffer during
the recession and become less valuable as a result – so it works both
ways.

26. Which of the following scenarios will produce the HIGHEST IRR for a PE firm in an
LBO scenario?
a. The PE firm invests $100 million in a company and earns back $200 million at
the end when it sells the company, representing a 2.0x return.
b. The PE firm invests $50 million in a company and earns back $150 million at
the end when it sells the company, representing a 3.0x return.

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c. The PE firm invests $150 million in a company and earns back $375 million at
the end when it sells the company, representing a 2.5x return – but it also
receives a dividend of $100 million from the company in Year 3, boosting the
return to 3.2x.
d. You cannot determine the answer without knowing the time periods for
each of these scenarios (i.e. how many years in between purchase and exit).
i. Explanation: This is a trick question – remember that it’s not just the
cash-on-cash return that matters, but also the time period involved.
Scenario B here, for example, might seem much better than Scenario
A… but that is not necessarily true. For example, in Scenario A, the PE
firm will earn a 26% IRR if the investment takes 3 years to exit. But if
Scenario B takes 7 years to exit, that’s only a 17% IRR (check the
numbers yourself in Excel). The same applies to Scenario C – yes, a
3.2x return is great, but not if it takes 10 years to realize that. So it all
depends on the time as well as the cash-on-cash return, which is why
D is the correct answer.

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