Second Year:  Same depreciation and tax assumptions as previously.  Let’s also assume a 10% interest rate on the debt and no debt amortization.  Income Statement:  Just like the previous question:  $20 of depreciation but now we also have $10 of interest expense.  Net result is a $18 reduction to net income ($30 x (1 – 40%)).  Cash Flow Statement:  Net income down $18 and depreciation up $20.  No change to cash flow from investing or financing activities (if we assumed some debt amortization, we would have a use of cash in financing activities).  Net effect is cash up $2.  Balance Sheet:  Cash (asset) up $2 and PP&E (asset) down $20 so left side of balance sheet down $18.  Retained earnings (shareholders’ equity) down $18 and voila, we are balanced.

Second Year:  Here let’s assume straightline depreciation over 5 years and a 40% tax rate.  Income Statement:  Just like the previous question:  $20 of depreciation, which results in a $12 reduction to net income.  Cash Flow Statement:  Net income down $12 and depreciation up $20.  No change to cash flow from investing or financing activities.  Net effect is cash up $8.  Balance Sheet:  Cash (asset) up $8 and PP&E (asset) down $20 so left side of balance sheet doen $12.  Retained earnings (shareholders’ equity) down $12 and again, we are balanced.

To answer this question, take the 3 statements one at a time. My advice is to start with the income statement.  Remember to tax-affect any change in revenue or costs (usually you will be told to assume a tax rate of 40%).  Work your way down to net income.  Next, tackle the cash flow statement.  The first line of the cash flow statement is net income so start with that and work your way down to net change in cash.  Last, take the balance sheet.  The first line of the balance sheet is cash so again, start with that.  The balance sheet must balance in order for your answer to be correct, which is why I recommend doing the balance sheet last.  Remember the basic balance sheet equation:  Assets = Liabilities + Shareholders’ Equity.

Don’t get too stressed when asked a question like this.  Just take it slowly, one statement at a time.

• - reduce the purchase price that the PE firm has to pay for the company
• - increase the amount of leverage (debt) in the deal
• - increase the price for which the company sells when the PE firm exits its investment (i.e. increase the assumed exit multiple)
• - increase the company’s growth rate in order to raise operating income/cash flow/EBITDA in the projections
  decrease the company’s costs in order to raise operating income/cash flow/EBITDA in the projections

The next step is to change the existing balance sheet of the company to reflect the transaction and the new capital structure.  This is known as constructing the “proforma” balance sheet.  In addition to the changes to debt and equity, intangible assets such as goodwill and capitalized financing fees will likely be created.

The third, and typically most substantial step is to create an integrated cash flow model for the company.  In other words, to project the company’s income statement, balance sheet and cash flow statement for a period of time (say, five years).  The balance sheet must be projected based on the newly created proforma balance sheet.  Debt and interest must be projected based on the post-transaction debt.

Once the functioning model is created, we can make assumptions about the private equity firm’s exit from its investment.  For example, a typical assumption is that the company is sold after five years at the same implied EBITDA multiple at which the company was purchased.  Projecting a sale value for the company allows us to also calculate the value of the private equity firm’s equity stake which we can then use to analyze its internal rate of return (IRR).  Absent dividends or additional equity infusions, the IRR equals the average annual compounded rate at which the PE firm’s original equity investment grows (to its value at the exit).

While the private equity firm’s IRR is usually the most important piece of information that comes out of an LBO analysis, the analysis also has other uses.  By assuming the PE firm’s required IRR (amongst other things), we can back into a purchase price for the company, thus using the analysis for valuation purposes.  In addition, we can utilize the LBO model to analyze the trend of credit statistics (such as the leverage ratio and interest coverage ratio) which is especially important from a lender’s perspective.

In practice, synergies are “easier said than done.”  While cost synergies are difficult to achieve, revenue synergies are even harder.  The implication is that many mergers fail to live up to expectations and wind up destroying shareholder value rather than create it.  Of course, this last fact never finds its way into a banker’s M&A pitch.