{"id":21878,"date":"2020-01-22T18:18:03","date_gmt":"2020-01-22T23:18:03","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?post_type=biws_kb&p=21878"},"modified":"2024-10-18T19:01:11","modified_gmt":"2024-10-19T00:01:11","slug":"cash-flow-lbo","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/cash-flow-lbo\/","title":{"rendered":"How to Use Cash Flows in an LBO Model: Debt, Dividends, and \u201cDough\u201d (11:00)"},"content":{"rendered":"

QUESTION:<\/strong> \u201cI\u2019m completing an LBO model case study. I understand there\u2019s a difference if the company uses its cash flow to issue Dividends to the PE firm instead of repaying Debt.<\/p>\n

But what if it lets Cash accumulate? Is that equivalent to repaying Debt?\u201d<\/p>\n

SHORT ANSWER:<\/strong> No, they\u2019re not equivalent. Repaying Debt will almost always produce a higher IRR because by repaying Debt, the company reduces its Interest Expense in the holding period, resulting in higher FCF and higher Cash generation by the end.<\/p>\n

The difference is usually pretty small, but it\u2019s more pronounced at higher interest rates or with higher FCF relative to the initial Debt used to fund the deal.<\/p>\n

In general, issuing Dividends will tend to produce a higher IRR than the other two options because of the time value of money<\/a>: Money is worth more today than it is tomorrow, so it\u2019s better for the PE firm to get that cash flow in Years 1-2 rather than waiting until Year 5 to get it.<\/p>\n

Interestingly, the MoM multiple stays about the same because it is not affected by time or the time value of money \u2013 these different options mainly impact the IRR.<\/p>\n

If you assume no Interest Income on Cash, in a simple model, letting Cash accumulate vs. issuing Dividends results in the same MoM multiple (though the IRR still differs).<\/p>\n

In your models, it\u2019s not worth thinking about these options in detail unless they specifically ask you to do so. In a 1-3-hour case study, you shouldn\u2019t spend any time on unnecessary details or features such as these.<\/p>\n

It\u2019s nice to be able to add a \u201cswitch\u201d that changes the treatment of FCF, but it\u2019s in the bells and whistles category more than anything else.<\/p>\n

The treatment of FCF will never make a huge impact on the IRR (e.g., doubling it from 10% to 20%), but it could change it by small percentages and make your investment recommendation look a bit better.<\/p>\n

So, keep these tricks in your back pocket\u2026 but stay focused on the core parts of the model, such as projecting the company\u2019s revenue, expenses, and cash flow, and getting the Debt repayment and Exit calculations correct.<\/p>\n