How to Use Cash Flows in an LBO Model: Debt, Dividends, and “Dough” (11:00)
In this tutorial, you’ll learn how to treat a company’s Free Cash Flow in an LBO model, and how the different assumptions (letting its Cash balance accumulate vs. repaying Debt vs. issuing Dividends) affect the IRR.
QUESTION: “I’m completing an LBO model case study. I understand there’s a difference if the company uses its cash flow to issue Dividends to the PE firm instead of repaying Debt.
But what if it lets Cash accumulate? Is that equivalent to repaying Debt?”
SHORT ANSWER: No, they’re 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.
The difference is usually pretty small, but it’s more pronounced at higher interest rates or with higher FCF relative to the initial Debt used to fund the deal.
In general, issuing Dividends will tend to produce a higher IRR than the other two options because of the time value of money: Money is worth more today than it is tomorrow, so it’s better for the PE firm to get that cash flow in Years 1-2 rather than waiting until Year 5 to get it.
Interestingly, the MoM multiple stays about the same because it is not affected by time or the time value of money – these different options mainly impact the IRR.
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).
In your models, it’s 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’t spend any time on unnecessary details or features such as these.
It’s nice to be able to add a “switch” that changes the treatment of FCF, but it’s in the bells and whistles category more than anything else.
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.
So, keep these tricks in your back pocket… but stay focused on the core parts of the model, such as projecting the company’s revenue, expenses, and cash flow, and getting the Debt repayment and Exit calculations correct.