Case 008Paper LBOsHard
Build an LBO on paper from scratch for a dairy company: five years of cash flow, debt paydown, exit equity, money multiple and IRR, with working capital and tax done properly.
1The situation
Chandrika Dairy collects milk from farmer cooperatives and sells packaged milk, curd and ghee across two states. Revenue is Rs 800 crore, growing 10% a year, at an EBITDA margin of 12.5%. Depreciation is Rs 20 crore a year and capex Rs 25 crore. Tax is 25% of profit after interest. Working capital is 10% of each year's increase in revenue, because milk is paid for on delivery while supermarkets pay in forty days.
A sponsor buys it at 7x EBITDA with 60% debt at 11%, interest on the opening balance, every rupee of free cash flow repaying debt. It exits at 7x at the end of year 5.
2Your task
Lay out sources and uses, build free cash flow and the debt balance for each of the five years, and give exit equity, MOIC and IRR. Say where the return came from.
Quick check
Before building anything: EBITDA grows about 61% over five years and the exit multiple equals entry. Roughly what MOIC should you expect?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Rs 280 crore of equity becomes Rs 913 crore after five years, 3.26x and an IRR of 26.7%. EBITDA grows from Rs 100 crore to Rs 161.1 crore, worth Rs 427 crore at 7x, and free cash flow repays Rs 206 crore of the Rs 420 crore of debt. Working capital absorbs Rs 49 crore over the hold; leaving it out would overstate exit equity by that much.
Step 1What goes on the page first?
Sources and uses, in one line each, before any year is built. EBITDA is 12.5% of Rs 800 crore, Rs 100 crore; at 7x the price is Rs 700 crore. Debt is 60% of that, Rs 420 crore, so equity is Rs 280 crore, and that Rs 280 crore is the denominator of everything that follows. Then write the five column headings and the line items in order: revenue, EBITDA, less D&A, less interest, less tax, net income, add back D&A, less capex, less working capital, free cash flow, closing debt. Think of a household budget: salary in, EMI and tax out, the new fridge, the money tied up because the tenant pays late, and whatever is left goes against the home loan.
Step 2How does one year work, so the other four are copies?
Year 1. Revenue Rs 880 crore; EBITDA Rs 110 crore; less D&A Rs 20 crore gives EBIT Rs 90 crore. Interest is 11% of Rs 420 crore, Rs 46.2 crore. Tax is 25% of 90 less 46.2, Rs 11.0 crore, so net income is Rs 32.9 crore. Add back D&A, take off capex of Rs 25 crore, a net Rs 5 crore, and take off working capital of 10% of the Rs 80 crore revenue increase, Rs 8 crore. Free cash flow is Rs 19.8 crore, and debt closes at Rs 400.1 crore. Year 2 starts with interest on that smaller balance; the rest repeats.
| Year | Revenue | EBITDA | Interest | Tax | Working capital | Free cash flow | Debt, year end |
|---|---|---|---|---|---|---|---|
| 1 | 880.0 | 110.0 | (46.2) | (11.0) | (8.0) | 19.8 | 400.1 |
| 2 | 968.0 | 121.0 | (44.0) | (14.2) | (8.8) | 28.9 | 371.2 |
| 3 | 1064.8 | 133.1 | (40.8) | (18.1) | (9.7) | 39.5 | 331.7 |
| 4 | 1171.3 | 146.4 | (36.5) | (22.5) | (10.6) | 51.8 | 279.9 |
| 5 | 1288.4 | 161.1 | (30.8) | (27.6) | (11.7) | 66.0 | 213.9 |
| Total | (48.8) | 206.1 | paid down 206.1 |
Step 3What comes back at exit, and where did it come from?
Year 5 EBITDA is Rs 161.1 crore; at 7x the business is worth Rs 1127.4 crore. Debt is Rs 213.9 crore, so equity is Rs 913.4 crore. Rs 913 over Rs 280 is 3.26x, and 3.26 to the power of one fifth is 26.7% a year. For the IRR without a calculator, know that 2x in five years is about 15% and 2.5x about 20%, then place the answer between.
| 7 x 161.1 | exit enterprise value, Rs 1127.4 crore |
| 213.9 | debt left after five years of repayment |
| 280 | equity invested at entry |
The split is the judgement. Growth at 7x contributed Rs 427 crore and paydown Rs 206 crore, so about 67% of the gain is operating growth that the next buyer can see, and none of it is multiple. A dairy that grows 10% a year at a steady margin is a plausible plan; the number to challenge is the 10% working capital, because a shift to modern retail with longer payment terms would raise it and cut every year's free cash flow. Say that limit before the interviewer does.
Where candidates lose it
The common loss is dropping working capital because the setup put it last. Rs 10 crore of each year's growth never reaches the debt line, and across five years that is about Rs 49 crore of exit equity, a tenth of the answer.
The second miss is charging tax on EBITDA or on EBIT. Tax is on profit after interest, and in a levered deal the interest shield is a quarter of the interest bill.
What the interviewer asks next
- Capex rises to Rs 40 crore a year to add a cold chain. What happens to the IRR?
- The sponsor exits at 6x instead of 7x. What MOIC is left?
- How would you redo the table in your head if the interviewer changed debt to 5x EBITDA?
Asked at Blackstone, Private Equity, New York, 2016 (Wall Street Oasis): Build an lbo model with pen and paper from scratch
Company names and figures are illustrative.