OK. I agree with strikershank on this. Of course, it’d be pretty impressive if you ran the numbers during an interview, but assuming that debt paydown is not a key consideration and that the company is generating enough FCF to service its debt, I calculate Company B having the same IRR in the same way that strikershank did. And IRR is the key thing to concern yourselves with here, instead of ROE, because all you really care about is how much your equity value grows by (assuming the absolute amount of debt remains constant, i.e. no debt paydown). And based on those calculations, even though Company B requires an initial investment of an additional turn of equity (2x EBITDA) compared to company A (1x EBITDA), the positive effect of compounding of revenue/EBITDA growth outweights the cost of the additional equity for company B. Thus, I go with company B. Any thoughts? Agree/disagree? Obviously this question really depends on your whole host of assumptions, but in my case, since the question didn’t give much information, I just kept my assumptions simple. Namely, I assumed no debt paydown, that FCF’s generated by the firm would be sufficient to service debt, and that the two companies were in the same industry and that company B would have equal (if not otherwise greater) exit multiple than company A because of higher growth prospects.
This is an intellectual exercise, there’s no right answer. Kide’s right in a way by discounting the value back, but Striker’s also right in assuming that these firms won’t have the same cost of capital. There’s obviously a whole host of other factors that would come into play here, they just want to see you think it through.
kide, numi, strikershank Are you all on drugs? For the third time, the initial invetstments are 100 and 120, not 20 and 40. It really helps to read the problem.
Super I. No need to insult. you should read carefully yourself before you blast others. What you would realize is we are all referring to the initial EQUITY investment which is the premise for determining the better investment, not the EV values that you stated. Better luck next time with your insults.
Super I Wrote: ------------------------------------------------------- > kide, numi, strikershank > > > Are you all on drugs? > > For the third time, the initial invetstments are > 100 and 120, not 20 and 40. > > It really helps to read the problem. No Super I, we’re not on drugs. We are talking about the initial EQUITY investment which is what the equity sponsor cares about. Have you ever done an LBO model in your life? And by the way, not to get overly snippy here (just returning the gesture, after all), but I was the one who wrote this question and I think I know how to read my own writing.
Striker/numi I admit I haven’t doen much LBO modeling (except as a lender looking at cash flows, payback, etc.) I understand that you are looking at the initial investments, but the question asked is what gives the better return to you, as the purchaser, on the invetsment you make today. Let’s say you create a shell company, put in your purchase price (100 or 120), buy the company, consolidate it in, effectively assume the debt that already exists on the books. There has been no change in the asset base, or revenue producing power of the company as a result of this purchase. Growth will happen as given in the problem. So please explain (seriously!) what is the relevance of the equity that was there from the prior owners in the old company to determining which investment will provide a better return to you going forward? As I said in an earlier post it can be used to come up with an estimate (with assumptions) of total assets of the company for an ROA calculation, but that’s it. You are paying money out now for future cash flows, and basically want the higher NPV between the two investment choices.
When you purchase a company, in simple terms you finance via debt and equity. In an LBO example like this, you would borrow the money to finance the purchase (therefore leveraging your equity). The firm that is purchasing either company A or B has $40mln of equity available. They cannot afford to purchase a firm that is worth more than that unless they borrow. So they borrow money, $80mln, and buy either A or B with that debt plus their original equity making an equity investment of $20mln or $40mln. At the end of the day when they sell firm A or B they pay back the $80mln loan and are left with the remaining equity in the business, which has grown. The importance of measuing the investment based on equity is because at the end of the day, you only care how much you equity has grown and not the value of the firm persay. Super I - i believe you’re mistaking the total investment for equity. If you put in your $100mln or $120mln, that would all be equity. Because debt is not your money. Super I says: "Let’s say you create a shell company, put in your purchase price (100 or 120), buy the company, consolidate it in, effectively assume the debt that already exists on the books. "
agreed 100% with strikershank. he explains it in common terms better than i could. for anyone who wants to understand the basic fundamentals of a leveraged buyout, strikershank’s post is a great place to start. it’s really very interesting to see what happens when you start playing with things like different debt tranches and leverage ratios – which is exactly what this question was “testing”…so as you can see, lots of thinking and analysis involved and potentially different outcomes that could vary widely depending on your assumptions. bottom line is, the equity sponsor is principally concerned with the future value of its equity investment, provided that it is generating sufficient cash flow to meet its debt obligations. and if prepayment options are available, it is also worth observing its capacity to pay down debt because paying down your debt component will increase the value of equity in your overal capital structure with respect to your exit enterprise value.
Ahh… Striker/numi… I agree with you both 100% and understand how LBOs are financed, I just did not get that from the way the question was phrased. Where it said: Purchase price is 5x EBITDA (4x debt, 1x equity) In the past when i looked at financing some LBOs I saw something like “purchase price is 5X EBITDA with 20% equity, the balance debt”. The way the info was given I seem to have misinterpreted it to be expressing the purchase price as a function of the existing structure. I most humbly admit my error (tho I did upfront say that it was not my area of expertise)
no problem at all…no need to worry about it. we’re all here to learn from each other. both phrases have the same meaning, just different ways of expressing it
Isn’t there a simpler way to look at this question? Assuming EBITDA grows at same rate as revenue, and exit multiples stays constant A Co.'s EV will increase 5% y-o-y For the equity sponsor, their investment is leveraged 5 times, so if the exit is at y1, their IRR would be (5%*5x leverage)=25%. B Co.'s EV will increase 10% y-o-y For the equity sponsor, their investment is leveraged 3 times, so if the exit is at y1, their IRR would be (10%*3x leverage)=30%. You can expand the exit assumptions to further years, but thats irrelevant if exit multiples and growth rate remains the same, and no assumption is made on the debt terms.
Zuran, that is my initial reaction to the question as well, however, this works only if you assume the Revenue Growth rates stated here = Return on Asset.
cfa3warrior, can you elaborate a little bit more? Why would an assumption for ROA be needed?
folks, there were a string of posts at the end of last week that really captured the essence of this question. it’s not about ROA – it’s about the return on your *equity* investment, and you can use IRR to solve because you’re trying to figure out the value of equity at the time that you sell the entire company by netting debt against the total enterprise value of the company that you own
agreed, Numi, I was just commenting on Zuran’s approach, which tries to calculates ROE as: growth rate x leverage. Remembering that the ROE is actually ROA x leverage. Zuran’s approach would’ve been the quickest and most correct way if we assume the 5% and 10% growth rates are the return on assets of those investments.
ok, makes sense