Key Rule 3

Question 1

Key rule 3:
- how to project the statements and pay off debt

Answer 1

Ideally, you can reuse the existing financial statements that you’ve already built for the company.
- You have to projected income statements could then calculate the free cash flow, and as well as the interest payments as well, a circular references.

Question 2

How to project income statement

Answer 2

• revenue growth - want to decline over time
• EBIT/ EBITDA margins - should stay same range each year
• BS items many of these can be percentages of revenue cost of goods sold or operating expenses
• D&A and other non-cash charges: historical averages, and percentages of revenue
• capEx: make it a percentage of revenue, then use the historical average, or assume a fixed dollar amount growth each year

Question 3

Once you have the key financial statement line items for the period you’re projecting, you can use the numbers to

Answer 3

Calculate how much that the company pays of each year

Question 4

What does free cash flow mean in the context of an LBO model?

Answer 4

It means cash flow from operations minus capital expenditures

Here it basically means how much cash do we have available to repay debt principle each year after we’ve already paid for our normal expenses and for the interest expense on the debt

Question 5

Once free, cash flow is calculated the logic to repay debt is:

Answer 5

1. Make any mandatory repayments first.
2. When with the remaining cash flow available make optional repayments

Question 6

Why is repaying debt, a little bit trickier than on the face of it?

Answer 6

• Most companies have a minimum cash balance that needs to be maintained at all times, so you can’t assume that 100% of its cash flow goes into repaying debt
• Not all types of that can be repayed early. It’s allowed with bank debt, but not with high yield debt
• Company may not have enough cash flow for his minimum mandatory debt repayments, in which case it might need to borrow more via a revolver

Question 7

The interest expense on the income statement in an LBO model depends on how much debt is paid off over the

Answer 7

Course of a year because the company pays interest each quarter of the month, so normally in models you average the beginning and ending debt balances to determine the annual interest expense

Question 8

How can a circular reference be created?

Answer 8

The ending debt balance depends on how much cash for you had after paying for interest, but the interest itself depends on the ending debt balance

That’s the purpose of ‘allow circular references’ field
- yes: average beginning an ending debt balances each year to calculate interest
- no: use beginning balances instead.