If the cash balance in an LBO is set constant by contract, and the LBO pays out all of its net income in dividends, how does a cash sweep affect equityholders’ claim on assets? Equity holders’ claim on assets: A) increases. B) remains unchanged. C) decreases.
b note. because equity does not increase when the ni is paid out as dividends.
I say C. Cash will be used to pay off debt, not dividends.
That’s what I thought. The answer is A Since the cash balance is set constant by contract, the cash sweep is used to pay down the LBO’s debt. Thus, debt falls. In the unusual scenario when the entire net income is used to pay dividends, the equity component remains unchanged. A reduced debt balance coupled with unchanged equity means that equity increases relative to debt and equity holders’ claim on assets also increases Then I asked Schweser where the hell they get the money to pay off the debt, and here is their answer which I still don’t understand It doesn’t say that all cash is paid out as dividends. Just all net income. This tells us that retained earnings do not change. The firm could(and probably would) accumulate cash that, by rule if above the set amount, must be used to repay debt. Thus, we know that debt is decreasing
Makes sense, but somewhat tricky - for these questions, you REALLY need to distinguish between net income and cash flows. Very important, and many people fail to grasp the differences between the two.
One possible explanation I think is that After tax cash flow /= NI which the cash saved from depreciation from NI is used to pay off the debt…
Fuck I’ll just remember this and move on, but I believe what they’re saying is: All NI goes to debt repayment, so debt goes down. Retained earnings do not change since they are using all their NI to pay off debt. Debt down, equity same, lower D/E ratio. Equity holders get higher share.
do not worry about dumb questions like these from schweser…no lender would allow equity holders a dividends before getting paid off itself. plus, this has been discussed before…NI does not equal cash on the balance sheet. please remember, NI is an accrual figure and a company can accumulate tons of cash from collecting receivables faster then booking them or collecting deferred revenues.
Basically, ALL corporate debt (with .000000001% exception) is amortizing, so the debt balance, all else held constant and even with negative net income, will decline year over year (assuming they don’t issue new debt mid-year). So, your equity is unchanged (per the question parameters), and you know that your debt is smaller (you don’t know the magnitude, but you do know that it MUST be smaller), so A is the only answer that makes sense.
That makes sense now. Thanks everyone
something learned. 
barthezz Wrote: ------------------------------------------------------- > something learned. Every minutes, now I am moving to your thread with EM explanation:)
kevincwang Wrote: ------------------------------------------------------- > barthezz Wrote: > -------------------------------------------------- > ----- > > something learned. > > > Every minutes, now I am moving to your thread with > EM explanation:) hope you find something valuable in there…