WEBVTT
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Welcome to the first lesson in the actual case studies
in this module on LBO models and LBO modeling tests.
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So I'm going to start with a few quick comments about
how to approach all this material,
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and then we'll get into the actual case study here,
a 30-minute so-called paper LBO modeling test,
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and I'll show you how to go through and make estimates
for the numbers.
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We'll cover roughly the first half
of this case study here.
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This lesson begins the segment of this module that does
not correspond one to one to the written guide.
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Each segment of lessons here covers a different case
study, ranging from 30 minutes, like this one,
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up to 2 hours, and the case studies become increasingly
complex as we move along.
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Now, if you already know LBO modeling and have some
experience with it, and you just want to test yourself,
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you can complete each case study.
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Just look at the written document and the Excel files
if applicable, do it by yourself,
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and then check your work against the answer key or the
finished file or something like that.
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And if something doesn't make sense,
you can go back to the videos and review whatever you
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missed or did not answer correctly.
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If you don't have any experience,
if you're brand new to LBO modeling,
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then we recommend using the BASES method.
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So look at the before and after Excel files,
if applicable, study the video,
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and then execute it by trying it yourself in Excel or
on pencil and paper, as in this case study,
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and then scrutinize by checking your work.
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So look at the before and after files to see what has
changed, study the video to see how we do it,
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and then execute it yourself.
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And then if something doesn't match up,
check your work by looking at your version and
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comparing it to our versions.
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Let's now talk a little bit about paper LBO modeling
tests and what to expect.
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Paper LBOs are not really modeling tests because you
cannot use Excel to complete them, and normally,
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you can't even use a calculator to complete them.
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So they're really more like extended quick LBO math
case studies, sort of like the questions that we looked
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at in the previous lesson but more complex,
because you have to write everything out on paper and
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you have to do more than just calculating EBITDA and
looking at it from beginning to end.
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You also have to figure out the debt repayment because
they don't give you that part.
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To succeed, you have to round and simplify the numbers
extensively, because you're not going to be able to use
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a calculator, and you have to start with the end in
mind in order to get to the correct answers.
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For example, if a PE firm is targeting a 25% IRR over 5
years, you know that they're going to need to get a 3x
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multiple of the initial investor equity,
assuming that it's just a simple exit after 5 years and
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there's nothing in between.
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So if you can make even a very rough estimate for the
multiple, and you can see that it's maybe 1.5x or 2x,
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and it's nowhere close to 3x,
then the deal cannot possibly work.
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You don't need a precise number.
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You just need a very rough estimate.
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Typically, you also ignore fees,
and you assume cash-free,
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debt-free deals that are based on simple EBITDA
purchase and exit multiples,
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or you can just assume that debt all gets replaced and
that the cash balance stays the same from beginning
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to end to simplify things.
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With the debt, typically,
you assume that the debt either stays the same or that
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100% of the free cash flow
is used to repay debt principal.
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Otherwise, it's just too much to keep track of if you
assume that 25% of free cash flow is used for one
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tranche and then 75% is used for the other tranche.
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Something like that is just too much for these types of
pen-and-paper or pencil-and-paper case studies.
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And then one other important note is that you should
clarify the missing information before you start
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doing any work.
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What I mean is if they don't give you an EBITDA exit
multiple, you should ask if they want you to assume
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an EBITDA exit multiple.
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Should you make it the same as the purchase multiple?
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Should you come up with your own estimate based on the
company's growth profile upon exit?
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You want to figure that out before you start spending a
lot of time and effort writing everything out on paper.
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If they don't give you the company's initial EBITDA,
then they almost always want you to calculate it based
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on other numbers, like the
COGS and SG&A, for example.
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But again, you should clarify this and ask them to make
sure you're doing what they want.
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So we'll divide this case study into two main parts and
look at the assumptions, revenue and EBITDA, here.
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We'll go through the first part of the annual free cash
flow calculations, and then in the next part,
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we will wrap that up and actually calculate the free
cash flow and the debt repayment each year and go
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through the exit calculations
and make a recommendation.
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Okay.
So now let's go into Word.
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We're not really going to be using Excel here at all
until we get to the final steps in the second part
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of the case study, the second lesson here.
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This company, this PE firm, Valen Capital,
is considering a leveraged buyout
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of Ravello Refineries,
an oil and industrial chemical production company.
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This company wants to increase its CapEx significantly
over the next few years to support higher growth.
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And the PE firm plans to purchase
the company for 10x EBITDA.
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It'll use a term loan for 4x EBITDA,
senior notes for 2x EBITDA.
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So, therefore, we know that this is a 60% debt,
40% equity deal.
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We also get some information about
the terms of the debt.
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Five percent interest on the term loan,
2% of the initial principal must be repaid each year,
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and 100% of the free cash
flow is used for optional repayments.
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The senior notes have a 10% interest rate and no
principal repayments are allowed.
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Then we get some information about the company's
LTM EBITDA, and indirectly, their revenue.
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So their LTM EBITDA is $250 million.
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They spend 60% of revenue on COGS and 15% on SG&A.
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D&A is not included in these figures.
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It's a separate expense.
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Therefore, the EBITDA margin of this company is just 1
minus 60% minus 15%, or 25%.
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And then we get the growth
rates for the company's revenue.
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SG&A as a percent of revenue will increase by 1%
per year, so the EBITDA margin falls by 1% per year.
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We get some information on CapEx,
purchases of intangibles,
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and the change in working capital,
and then depreciation and amortization and the effect
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of tax rate.
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And then the PE firm thinks they can get some multiple
expansion here and sell the company for 12x EBITDA
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at the end of 5 years.
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They're targeting a 20% IRR,
and so we're supposed to look at this,
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estimate the money-on-money multiple and IRR,
and then recommend for or against this deal.
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And we cannot use Excel or
a calculator for any of this.
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So let's go through this,
and we'll start with the end goal.
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We'll then project revenue and EBITDA.
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And then we will look at the first part of calculating
annual free cash flow.
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We're not going to be able to finish it,
because it does get somewhat more complicated,
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but we'll go through those three main parts here.
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So with a paper LBO test like this,
you have to start with the end in mind.
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You should know that a 20% IRR over 5 years means a
2.5x multiple, because a 15% IRR is a 2x multiple and a
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25% IRR is a 3x multiple.
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They don't give us the company's revenue on an LTM
basis, but we do have their EBITDA.
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We know that they spend 75% of their revenue total on
COGS and SG&A.
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So the EBITDA margin is just 1 minus 60% minus 15%.
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That is 1 minus 75%, so it's 25% for the margin.
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Therefore, the company's revenue is just $250 divided
by 25%, or $1,000.
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And then we also know that they're buying the company
for a purchase enterprise value of $2,500.
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That's just the $250 times the 10x multiple.
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And we know that the investor equity is 40% of that,
so that's $1,000.
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We know the debt is 60% of that, so that is $1,500.
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Putting together everything then,
this deal needs to generate $2,500 in equity proceeds,
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that's a 2.5x multiple of this $1,000,
for it to be viable, for it to achieve a 20% IRR.
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So we can keep that in mind,
and even if we run out of time, we know that,
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so we can at least maybe give a rough answer even if we
don't have everything finished by the end
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of 30 minutes.
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Let's go to Step 2 and project the revenue and EBITDA.
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Now, in any paper LBO modeling test,
or pen-and-paper test I should say,
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you have to start with revenue and EBITDA because
they're going to drive everything else.
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Also, even if you can't get all the free cash flow
numbers, if you at least have EBITDA,
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you could do something like making free cash flow a
simple percentage of EBITDA and come up with a very
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rough estimate based on that.
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I've written out here in table form the numbers that we
have so far: $1,000 in revenue,
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we have the growth rates, we have the margins,
and we have our starting EBITDA as well.
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So to make estimates for some of these,
you can think about rounding all the
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numbers extensively,
and the goal is that you want numbers that all end in 5
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or 10, or really 5 and 0,
depending on how you think about it.
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That will make the math much, much easier.
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So for example, for Year 1,
we have 5% growth on $1,000,
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and that should be pretty easy.
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It's just going to be $1,050,
because 5% of $1,000 is $50.
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Now, for the second one, the 7.5% growth rate,
the math here is a little bit messy,
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but 10% of $1,050 is just $105.
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And so 5% of that has to be $52.5.
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We have to go somewhere halfway in between those.
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And it's a bit hard to do the math in your head
yourself, but you can just round this to $80 and say
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that $80 is about $30 higher than $52.5
and around $30 lower than $105.
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Or you could go with $75 here.
It doesn't really matter.
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I'm just going to say $80, though.
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And so, therefore, the Year 2 revenue will be $1,130.
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And you can keep going like that all the way across.
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I'm just showing you a few quick examples of this.
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If you keep going, $1,130 times 10% is $113,
but you should round that down to $110.
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So that gives you $1,240 in Year 3.
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And then 10% growth on that $1,240,
10% of that is just $124.
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That's easy.
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But to make the math easier, you can round this down,
and you can make it $120.
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You could also round it up and make it $125.
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It doesn't really matter.
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Just do whatever is easiest for the math.
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I prefer to leave the revenue numbers all ending in
zero just to make the rest of the calculations
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a bit easier.
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So you can add the $120 to the $1,240,
and that gets you to $1,360.
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And then the $1,360 times 10% is $136.
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You can round that up to $140 to make your life easier,
and $140 plus the $1,360 is just the $1,500 here
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in Year 5.
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Now, if you're wondering about the accuracy of these
estimates, in Excel, it comes out to $1,502 in Year 5.
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So we're off by about 0.2%,
but it's so close that it's effectively the same.
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You really have to use round numbers like this,
and we recommend trying to get the revenue numbers
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to all end in zero, if at all possible,
because it's going to make
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everything later on much easier.
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Now, the EBITDA figures do not necessarily all have to
end in zero like this.
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They can end in five if you want
to be a little bit more precise.
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But to make things easier, again,
you could certainly set up your rounding so that they
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do all end in zero.
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For the EBITDA, here's the math.
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In the first year, we have $1,050,
and we have a 24% margin.
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We know that 25% of $1,000 is $250.
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We know that 24% is a little bit less than 25%,
and we know that $1,050 is a little bit
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more than $1,000.
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So it would be perfectly acceptable here to say that
those two differences average out,
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and EBITDA is about $250.
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And that's actually what I do down here.
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We just estimate it as $250 based on that.
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Now, for the next year, $1,130 times 23%.
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So $1,130 times 10% is $113.
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Therefore, 20%, if you multiply by 2 there,
it comes out to about $225.
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It's $226, technically,
but we can just round it to $225.
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And then we also know that 1% of $1,130 is about $11.
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Eleven times 3 is $33.
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So we can add the $33 to the $225,
which gives us the $258,
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and we can just round that up to $260.
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And you could approach this in other ways as well.
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You could also just look at this and say,
"You know what, 7.5% growth probably has more
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of an effect than the 1% drop in the margin.
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So if we had $250 before,
now we should probably bump this up and say that
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it's $260, because the revenue growth here is going to
have more of an impact than the falling margin."
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And that would be another perfect
fine way to estimate this number.
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You can see what I do as we go down here,
but essentially, we keep looking at these numbers
00:12:57.417 --> 00:13:01.732
multiplied by 10%, and use that
to get to the 20% numbers.
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And then we add 1% or 2% or something like that,
and we round it up a bit.
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The end result is that we go from $250 to $260 to $270.
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And then there's a bit of a jump at the end where we go
to $290 and $300.
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The last one is really easy,
because $1,500 times 20% is similar to 20% times 15,
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which is just $3.
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So here, we have bigger numbers,
and it just comes out to $300.
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So the last one here is actually quite easy.
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And another perfectly valid way to estimate all this
would be to actually start with the last one and to say
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20% times $1,500 is $300.
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We know that Year 1 is $250.
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We know that Year 2 is $260.
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So maybe let's just make Year 3 $270,
make Year 4 $280 or $290.
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And you don't even have to do the math that way.
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You can just look at the ending number right here and
the starting number and just assume an even progression
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of EBITDA as you go up through Year 5.
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So there are many ways to do this,
and the point is you don't need to come
00:14:01.899 --> 00:14:05.219
up with perfectly exact scientific numbers here.
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You just need to get
something that is relatively close.
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Let's go into Step 3 now and
look at the annual free cash flow.
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We're not going to be able to finish this,
but I do want to at least start it in this segment
00:14:18.319 --> 00:14:19.959
of the case study.
00:14:19.959 --> 00:14:24.259
Our formula here is that free cash flow equals EBITDA
minus interest, minus taxes,
00:14:24.259 --> 00:14:29.579
plus or minus the change in working capital,
minus CapEx, minus purchases of intangibles.
00:14:29.579 --> 00:14:34.055
If you don't understand this formula,
think about the normal definition of free cash flow:
00:14:34.055 --> 00:14:35.912
cash flow from operations minus CapEx.
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Now, cash flow from operations starts with net income.
00:14:38.495 --> 00:14:41.475
Net income equals pre-tax income minus taxes.
00:14:41.475 --> 00:14:45.635
And so, therefore, you can rewrite this and say that
pre-tax income equals EBITDA
00:14:45.635 --> 00:14:47.305
minus interest, minus D&A.
00:14:47.305 --> 00:14:54.875
And then you can say that net income equals EBITDA,
minus interest, minus D&A, minus taxes.
00:14:54.875 --> 00:14:59.585
Within the cash flow statement,
cash flow from operations equals net income
00:14:59.585 --> 00:15:02.794
plus D&A, plus the change in working capital.
00:15:02.794 --> 00:15:06.484
We're adding it here because we know that change in
working capital is a source of funds,
00:15:06.484 --> 00:15:08.494
meaning it's positive.
00:15:08.494 --> 00:15:15.064
So we can just plug in the net income formula here down
into our cash flow from operations formula.
00:15:15.064 --> 00:15:20.844
We can plug that in and say that cash flow from
operations equals EBITDA minus interest, minus D&A,
00:15:20.844 --> 00:15:24.394
minus taxes, plus D&A,
plus the change in working capital.
00:15:24.394 --> 00:15:29.314
The two D&A terms cancel each other out,
because one is positive and one is negative.
00:15:29.314 --> 00:15:33.799
So cash flow from operations equals EBITDA minus
interest, minus taxes,
00:15:33.799 --> 00:15:35.319
plus the change in working capital.
00:15:35.319 --> 00:15:39.709
And then free cash flow is the same thing,
but we subtract CapEx at the end.
00:15:39.709 --> 00:15:43.769
So free cash flow equals EBITDA minus interest,
minus taxes, plus the change
00:15:43.769 --> 00:15:47.179
in working capital, minus CapEx.
00:15:47.179 --> 00:15:51.779
Purchases of intangibles is an additional item that we
should add on to the end of this.
00:15:51.779 --> 00:15:54.619
So purchases of intangibles we can
add to the end there.
00:15:54.619 --> 00:15:57.029
It works just like CapEx.
00:15:57.029 --> 00:16:01.606
These items are purchased and
then amortized over a period.
00:16:01.606 --> 00:16:05.376
I'll just delete that for now because we get into more
of the explanation below.
00:16:05.376 --> 00:16:09.736
The main thing to remember when we get to this point is
that CapEx, purchases of intangibles,
00:16:09.736 --> 00:16:13.586
and the change in working capital are all simple
percentages of revenue.
00:16:13.586 --> 00:16:17.286
So it doesn't really make sense to calculate them
separately at all.
00:16:17.286 --> 00:16:21.656
We want to group them together,
and we want to say that the change in working capital,
00:16:21.656 --> 00:16:26.806
CapEx, and purchases of intangibles all comprise this
category Other Items.
00:16:26.806 --> 00:16:32.428
Now, CapEx is 8% of revenue,
intangible purchases are 4% of revenue,
00:16:32.428 --> 00:16:36.128
and the change in working capital is 2% of revenue.
00:16:36.128 --> 00:16:38.964
The first two are negative, so negative 12%.
00:16:38.964 --> 00:16:45.088
The change in working capital is positive,
so positive 2%, meaning that this entire Other Items
00:16:45.088 --> 00:16:49.388
right here is negative 10% of revenue.
00:16:49.388 --> 00:16:53.548
So once again, to calculate this,
we can just round all the numbers once again.
00:16:53.548 --> 00:16:55.868
We have our revenue right here at the top.
00:16:55.868 --> 00:17:02.111
And all we have to do is take 10% of this revenue each
year, and that's what all these other items will be.
00:17:02.111 --> 00:17:05.667
So 10% of $1,050 is easy.
It's just $105.
00:17:05.667 --> 00:17:11.217
Ten percent of $1,130 is $113,
but we're just rounding it to $115.
00:17:11.217 --> 00:17:13.197
Same for the $1,240.
00:17:13.197 --> 00:17:18.067
Yes, technically, it's $124,
but we're just rounding it to $125
00:17:18.067 --> 00:17:19.477
to make the numbers easier.
00:17:19.477 --> 00:17:21.289
Same with the $1,360.
00:17:21.289 --> 00:17:25.547
Let's just round it to $125 rather than $136.
00:17:25.547 --> 00:17:28.277
And then for the $1,500, that's easy.
00:17:28.277 --> 00:17:29.717
It's just $150.
00:17:29.717 --> 00:17:34.024
So we have our Other Items,
and we have part of the free cash flow calculation.
00:17:34.024 --> 00:17:39.384
But to finish this, we need the taxes and the interest.
00:17:39.384 --> 00:17:45.094
We also need the depreciation and amortization in order
to calculate the taxable income and taxes.
00:17:45.094 --> 00:17:48.774
Now, the D&A here is easy
because it's 5% of revenue.
00:17:48.774 --> 00:17:53.504
So all we do is take these other items here and take
half of them.
00:17:53.504 --> 00:17:56.474
And we can round the numbers again
to save some time and effort.
00:17:56.474 --> 00:17:59.354
So half of $105, we can say, is roughly $50.
00:17:59.354 --> 00:18:01.703
Half of $115 is roughly $55.
00:18:01.703 --> 00:18:04.477
Half of $125 is roughly $60.
00:18:04.477 --> 00:18:09.168
Half of $135, we can round down to $130,
and that comes out to $65.
00:18:09.168 --> 00:18:11.759
And then half of $150 is $75.
00:18:11.759 --> 00:18:19.006
So the D&A part here is easy, but the interest,
taxable income, and taxes are trickier because we have
00:18:19.006 --> 00:18:23.339
debt repayment going on,
and so we cannot actually calculate these all at once.
00:18:23.339 --> 00:18:29.808
We could calculate all these items in advance above,
but the interest, taxable income, and taxes,
00:18:29.808 --> 00:18:32.408
and the debt repayment are all
going to depend on each other.
00:18:32.408 --> 00:18:33.888
I have the dependencies down here.
00:18:33.888 --> 00:18:38.438
The interest will depend on the debt balance,
but the debt balance depends on free cash flow.
00:18:38.438 --> 00:18:41.058
The free cash flow, though,
depends on interest and taxes.
00:18:41.058 --> 00:18:43.338
And then the taxes depend on interest.
00:18:43.338 --> 00:18:46.478
So we have to do this part iteratively,
and we have to start in Year 1,
00:18:46.478 --> 00:18:53.060
calculate the interest there, get all these numbers,
and then keep going throughout Years 2, 3, 4, and 5.
00:18:53.060 --> 00:18:55.488
We'll save that for the next lesson here.
00:18:55.488 --> 00:18:58.698
I'm not going to do a recap and summary because there's
nothing to really summarize.
00:18:58.698 --> 00:19:00.706
You have everything in the written document here.
00:19:00.706 --> 00:19:04.406
But so far, we have calculated
everything that we could in advance.
00:19:04.406 --> 00:19:07.016
And then coming up next,
we'll go through the iterative process,
00:19:07.016 --> 00:19:09.056
which gets a little bit more involved.
00:19:09.056 --> 00:19:12.306
And then we'll go through
the exit calculations after that.