Case 077LBO modelling testsHard

Two-hour three-statement LBO: interest is charged on the average debt balance. Show how year 1 cash, debt and interest link, why that is circular, and prove the balance sheet balances.

KKRLondon · 2025

The situation

Pallavi Home Appliances is bought with Rs 700 crore of debt at 10%. Revenue is Rs 1,200 crore and EBITDA margin 14%, so EBITDA is Rs 168 crore. Depreciation is Rs 30 crore and capex is also Rs 30 crore; working capital does not move; tax is 25%. Every rupee of free cash flow repays debt at year end, and there is no minimum cash.

The template says interest is charged on the average of opening and closing debt. The examiner wants year 1 only, then a sentence on why the sheet shows a circular reference warning, then proof that the balance sheet still balances.

Your task

Work year 1 interest, net income, cash and closing debt, explain the circularity in one sentence, and show the balance sheet check.

Quick check

If you charge interest on opening debt instead of the average, is year 1 interest higher or lower, and by roughly how much?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Year 1 interest is Rs 67.4 crore, net income Rs 53.0 crore, free cash flow Rs 53.0 crore, and debt closes at Rs 647.0 crore. The model is circular because interest depends on closing debt and closing debt depends on cash left after interest. The balance sheet balances because assets do not move: debt falls by Rs 53.0 crore and retained earnings rise by the same Rs 53.0 crore once depreciation and capex cancel.

Step 1Where does the loop come from?

Think of a loan you prepay from each month's leftover salary, where the bank charges interest on your average balance for the year. How much is left over depends on the interest; the interest depends on how much you prepaid; and how much you prepaid depends on what was left over. In the model, interest sits on the income statement, free cash flow comes off the bottom of it, that cash reduces closing debt on the balance sheet, and closing debt feeds back into the interest line. With interest on the opening balance there is no loop, because opening debt is already known. The average pulls the unknown closing balance into the calculation and the spreadsheet refers to itself.

Year 1: why interest on the average balance makes the model circularIncome statementCash flowBalance sheetEBITDA168less depreciation(30)less interest(67.4)less tax at 25%(17.7)Net income53.0Net income53.0plus depreciation30less capex(30)Free cash flow53.0all of it repays debtOpening debt700less repaid(53.0)Closing debt647.0Equity up by NI+53.0Assets unchanged0interest = 10% x (700 + 647.0) / 2 = 67.4: closing debt feeds the line that sets itInterest needs closing debt; closing debt needs cash after interest. That is the loop.
Net income of Rs 53.0 crore flows from the income statement to the cash flow statement, free cash flow of Rs 53.0 crore repays debt on the balance sheet, and the closing debt of Rs 647.0 crore feeds back into the interest line that set net income, which is why the sheet shows a circular reference.
Step 2How do you get the year 1 numbers out of a loop?

Iterate, or solve it in one line. Start with interest on opening debt, Rs 70 crore, work the cash, find the closing debt, recompute interest on the average, and repeat; it settles in three passes at Rs 67.35 crore. EBIT is 168 less 30, Rs 138 crore. Profit before tax is 138 less 67.4, Rs 70.6 crore; tax at 25% is Rs 17.7 crore; net income Rs 53.0 crore. Add back depreciation and take off the equal capex and free cash flow is net income, Rs 53.0 crore, all of which repays debt.

The relationship
FCF=(1−t)(EBIT−r2 (D0+D0−FCF))  ⇒  FCF=(1−t)(EBIT−rD0)1−(1−t) r/2=52.99\text{FCF} = (1-t)\left(\text{EBIT} - \frac{r}{2}\,(D_0 + D_0 - \text{FCF})\right) \;\Rightarrow\; \text{FCF} = \frac{(1-t)(\text{EBIT} - r D_0)}{1 - (1-t)\,r/2} = 52.99
ttax rate, 25%
rinterest rate, 10%
D_0opening debt, Rs 700 crore
EBITEBITDA less depreciation, Rs 138 crore
What it says in wordsBecause closing debt is opening debt less free cash flow, the loop is one equation in one unknown and can be solved directly; the spreadsheet iterates to the same number.
The loop settles in three passes: interest on average debt, Rs crore67686970opening-balance shortcut: 70.0070.00start: opening debt67.45pass 167.35pass 267.35pass 3Each pass: new closing debt, new average, new interest, new cash
Starting from the opening-balance guess of Rs 70 crore, each pass recomputes closing debt and the average, and interest settles at Rs 67.35 crore within three passes; the shortcut overstates interest by about Rs 2.6 crore in year 1.
Step 3How do you prove the balance sheet balances?

Change by change, not total by total. Assets do not move: capex equals depreciation so fixed assets are flat, working capital is flat, and cash is zero at both ends because the sweep takes it. On the other side, debt falls by Rs 53.0 crore and retained earnings rise by net income of Rs 53.0 crore. Those two are equal because free cash flow equals net income when depreciation and capex cancel. Zero change in assets against a net zero change in liabilities and equity: the sheet balances, and you can say exactly why.

Year 1 movement, Rs croreAmount
Cash0 (swept)
Fixed assets+30 capex, (30) depreciation: 0
Working capital0
Change in assets0
Debt(53.0)
Retained earnings+53.0
Change in liabilities and equity0
Every movement on the asset side nets to zero, and the Rs 53.0 crore fall in debt is matched by the Rs 53.0 crore rise in retained earnings, so the balance sheet balances by construction, not by a plug.

Say the practical bit too. A live model carries a circularity switch: a cell that, when off, charges interest on the opening balance so the sheet can be rebuilt without errors spreading, and when on, lets iterative calculation run. The difference in year 1 is Rs 2.6 crore of interest, small, which is why a paper LBO uses the opening balance and a built model uses the average.

Where candidates lose it

The usual loss is hard-coding interest at Rs 70 crore to make the warning disappear, then being asked why the number on the sheet does not match the formula in the header. The examiner put the average there to see whether you understand the loop, not to see whether you can avoid it.

The second is balancing the sheet with a plug in cash. Cash is zero by the sweep; if the sheet does not balance, the error is in the link between net income and retained earnings or between free cash flow and debt.

What the interviewer asks next

  • Add a Rs 50 crore minimum cash balance. What changes in the loop and in the balance sheet check?
  • The template charges interest on the opening balance but also has a revolver drawn when cash is short. Is that still circular?
  • Why does Excel's iterative calculation sometimes converge to a wrong answer, and how do you guard against it?

Asked at KKR, Mergers and Acquisitions, London, 2025 (Wall Street Oasis): 2nd round was a 2hr timed LBO modelling round at their offices where I had to build a complete 3-statement model and LBO

Company names and figures are illustrative.