Could anyone of you explain how to calculate the annual compounded return for a theoretical LBO investment in simple words here? I am mainly looking at understanding it from a practical application perspective and not just rote formula memorization. Walking through an example would be great, if any of us can do that. Thanks in advance.
Hi Anu I think there are two different forms of this question that we might need to answer, one when we are given EBITDA at the end of the debt paydown period or when we are given the firm value at the end of the paydown period. There is a formula to do both questions but I personally find it easier to use the TVM calculator function. If you are given the firm value at the end of the payment period eg A company has a current market value of $100M and outstanding debt of $40M. An LBO firm purchases the company for $140M and agrees to paydown the debt. The transaction is financed with 50% equity and 50% debt. The paydown period will be 4 years. At the end of the 4 years the debt is paid down and the company is worth $90M. Calculate the compond annual rate of return on the LBO investment. You are told the value of the company after the debt paydown period is $90M, this is the Future value (FV) The time period of the LBO investment is 4 years (N) The payment (PMT) is zero as all free cash flow is assumed to have gone to pay down the debt. The present value (PV) is the equity investment used for the LBO investment. In this case it is $70M (140 * 0.5) So in your calculator FV 90 N 4 PMT 0 PV -70 (this is negative as it is a cash outflow) CPY I/Y =6.48% So the compound annual return on the LBO investment is 6.48% If we are given an example where we are told the end of investment EBITDA rather than firm value you need to calculate the firm value using the EBITDA Using Firm Value = EBITDA/(r-g) where r = required return and g = growth rate. eg A company has a current market value of $100M and outstanding debt of $40M. An LBO firm purchases the company for $140M and agrees to paydown the debt. The transaction is financed with 50% equity and 50% debt. The paydown period will be 4 years. At the end of the 4 years the debt is paid down and the company has an annual EBITDA of $12M. EBITDA will grow at a constant rate of 4% and the required return is 10% Calculate the compond annual rate of return on the LBO investment. Firstly to calculate the firm value at the end of the paydown period Firm value = EBITDA/(r-g) = 12/(0.1-0.04) = 200 So Future Value FV = 200 Time period (N) = 4 The equity investment in the LBO (PV) is 140*0.5 =70 PMT = 0 again In the calculator FV = 200 N = 4 PMT = 0 PV =-70 CPT I/Y = 30% So the compound annual return on the investment is 30% Hope this helps
Wow! Absolutely fantastic - You are gonna set the mps for us this year I tell you! Where are you located?
Hiya, no worries i am always pleased when i can avoid learning a formula. I’m in London and taking the exam on the 17th
Okay - I am taking it on 22nd - the only date available here when I registered. Can we catch up over mails - my id is a-n-u-p-a-m-j-a-i-n-0-0-8 AT g-m-a-i-l … Thanks again for the superbly fantastic explanation - did exactly by your method thrice and made sure that I have it down totally.
Hiya, sure I’ll send you an email. You’re very welcome, glad it helps 
I didnt bother memorizing this one. Use your intuition and calculator, Brewey is dead on.