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Investment Banking Interview Guide, Advanced LBO Model – Quiz Questions

Answers in bold.

Table of Contents:

• Types of Debt and Financing Methods

• Financial Statement Adjustments and Debt Schedules
• Calculating Returns

Types of Debt and Financing Methods

1. All of the following types of debt are typically “floating-rate” instruments used
to finance an LBO EXCEPT:
a. Subordinated Notes
b. Term Loan A
c. Term Loan B
d. Revolver
e. None of the above
i. Explanation: The correct answer choice is A. All of the answer
choices listed above with the exception of A are floating-rate debt
instruments, meaning that its interest rate is not fixed (e.g. 8% each
year until maturity) but rather tied to something like LIBOR (e.g.
LIBOR + 3%). Both Term Loans and Revolvers have interest rates
that fluctuate, whereas subordinated notes – also referred to as
high-yield debt – have fixed interest rates that do not change over
time.

2. Which of the answer choices below lists the tranches of LBO debt from Lowest to
Highest in terms of typical interest rates?
a. Term Loan B; Term Loan A; Revolver; Senior Notes; Subordinated Notes;
Mezzanine
b. Revolver; Senior Notes; Subordinated Notes; Term Loan A; Term Loan B;
Mezzanine

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c. Revolver; Term Loan A; Term Loan B; Senior Notes; Subordinated

Notes; Mezzanine
d. Revolver; Mezzanine; Senior Notes; Subordinated Notes; Term Loan A;
Term Loan B
i. Explanation: The correct answer choice is C. All of the answer
choices above represent the various tranches of LBO debt, but only
answer choice C listed them in the correct order of lowest interest
rate to highest interest rate. Keep in mind that both the Revolver
and Term Loans represent “bank debt” which is the most senior of
all the debt, thereby making it the least risky and therefore likely to
have the lowest interest rates. Revolvers typically have lower
interest rates than Term Loan A because the borrowing is more
temporary, and Term Loan A is typically lower than Term Loan B
because principal repayments are higher. All other forms of debt –
senior notes, subordinated notes, Mezzanine – represent the “high-
yield” type debt which is riskier than bank debt and therefore
offers a higher yield to investors. Senior Notes are senior to the
other two, so rates tend to be lower, and Mezzanine is the most
junior of everything above, so interest rates (and risk) tends to be
highest there.

3. Which of the following Debt types is MOST likely to offer a Payment-in-Kind

(PIK) option for the interest payments?
a. Revolver
b. Term Loan B
c. Senior Notes
d. Subordinated Notes
e. Mezzanine
i. Explanation: PIK options do not exist for the Revolver or for Term
Loans because PIK always adds to the risk of the Debt, and these
are the least risky (and lowest potential return) forms of Debt. PIK
is also extremely unlikely for Senior Notes because although they
are classified as “High-Yield,” they are still less risky than the
others in this list. PIK may sometimes exist for Subordinated Notes,

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but remember that these notes are still senior to Mezzanine – so PIK
is definitely the most likely for Mezzanine rather than the others
here. In practice, PIK tends to be most common in economic booms
when financing is cheap and less common when financing tightens
up and it gets harder to borrow money – because it greatly
increases the credit risk of the borrower.

4. Which of the following tranches of LBO debt below have Maintenance

Covenants rather than Incurrence Covenants?
a. Mezzanine
b. Revolver
c. Senior Notes
d. Term Loans
e. Subordinated Notes
i. Explanation: Remember that Maintenance Covenants mean that
conditions like “Total Debt / EBITDA cannot exceed 4.0x” must be
true, and that only “Bank Debt” uses Maintenance Covenants. So in
this list, only the Revolver and Term Loans qualify as Bank Debt.
All the rest (Mezzanine, Senior Notes, and Subordinated Notes) are
High-Yield Debt, which uses Incurrence Covenants rather than
Maintenance Covenants.

5. Which of the following represent typical differences between Subordinated

Notes and Mezzanine?
a. Subordinated Notes have floating interest rates, whereas Mezzanine has a
fixed interest rate
b. The PIK interest option tends to be more common for Mezzanine
c. Mezzanine often includes an option for investors to receive warrants
that allow them to share in some of the deal upside
d. Subordinated Notes are secured, whereas Mezzanine is unsecured
e. None of the above
i. Explanation: A is false because both Subordinated Notes and
Mezzanine are “High-Yield Debt” and therefore have fixed interest
rates rather than floating interest rates. B is true because while PIK

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may exist for Subordinated Notes, it is much more common for

Mezzanine. C is also true because since Mezzanine is considered
“Equity level” in terms of seniority, sometimes the option to receive
equity in the company is attached to this type of Debt. D is false
because both of these are Unsecured, as are most forms of High-
Yield Debt (with an exception for Senior Notes sometimes).

6. Which of the following statements is FALSE regarding Payment-In-Kind (PIK)

debt?
a. A PIK loan does not require cash interest payments, but instead has the
interest accrue to the loan principal
b. Certain Term Loans have a PIK option
c. Often, Mezzanine debt offers a PIK option
d. PIK debt allows the PE sponsor flexibility since cash interest is not
required to be paid
i. Explanation: The correct answer choice is B. Only answer choice B
is a false statement. PIK loans do not require cash interest payment,
but instead the interest accrues to the principal balance and is paid
off in full as a ‘bullet payment’ at maturity. The only type of debt
that offers a PIK option is Mezzanine; in general, PIK debt is riskier
than both bank debt and high-yield debt and carries a higher
interest rate. Answer choice D is true, as a PE sponsor might prefer
to use PIK debt so as to preserve cash used for interest payments
and use that payment for additional Mandatory and Optional Debt
Repayment.

7. Which of the following statements are TRUE regarding “Excess Cash” in the
Sources & Uses section of an LBO model?
a. Excess cash will always show up in the Sources column
b. It arises when the target company has excess cash that the PE sponsor
uses towards funding the transaction
c. It is a very common scenario to see Excess Cash in an LBO model
d. It allows the PE firm to pay a lower price to acquire the company – for
example, $20.00 per share rather than $25.00 per share

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i. Explanation: The correct answer choices are A and B. Excess Cash

represents the incremental cash balance above and beyond what is
needed for normal operations. When a company has Excess Cash,
the PE sponsor can use this cash toward funding the buyout of the
company. And for that reason, it shows up under the Sources
column (since it becomes a source of financing for the transaction).
It is not common to see Excess Cash in LBO models and only occurs
when the company has a large cash balance for no apparent reason.
D is false because Excess Cash doesn’t reduce the upfront per-share
price that a PE firm pays – it only reduces the effective purchase
price once they’ve already acquired all the shares of the company at
a certain per-share price.

8. Which of the following statements correctly describe how you treat

Noncontrolling Interests and Equity Interests in an LBO model?
a. If you assume nothing happens to Noncontrolling Interests, then it
shows up in both the Sources and Uses columns
b. If you assume nothing happens to Equity Interests, then it shows up in
both the Sources and Uses columns
c. The treatment depends on the percentage ownership – you may list these
items just in the Sources column, just in the Uses column, or in both
depending on that percentage.
d. If you assume that the PE sponsor purchases either one, then the
treatment is similar to refinanced Debt
i. Explanation: A, B, and D are correct. Usually with both
Noncontrolling Interests and Equity Interests, you assume nothing
happens and thus they show up in both the Sources and Uses
columns. However, if you make the assumption that the PE
sponsor acquires one or both of them, then they would only show
up in the Uses column; in other words, it is treated similarly to
refinancing Debt. C is false because the percentage ownership has
nothing to do with it – an Equity Interest representing 20%
ownership is treated the same way as one that represents a 40%
ownership stake. Also, neither of these items will ever show up

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only in the Sources column – they go under Uses only, or under

BOTH Sources and Uses.

9. Which of the following deal structures could a PE firm TYPICALLY use in a

leveraged buyout?
a. Stock Purchase
b. Asset Purchase
c. 338(h)(10) Election
d. None of the above – LBOs require different deal structures
i. Explanation: Technically, all of these deal structures are available
in a leveraged buyout because they are also available in a normal
M&A deal. However, one of the requirements for a 338(h)(10) deal
is that the buyer must be a C corporation. Most private equity firms
are structured as Partnerships and the firms usually form LLC shell
companies that complete the actual acquisition, neither of which is
a C corporation. So in practice, the 338(h)(10) structure is usually
not available in an LBO. Stock purchases and asset purchases are
still available, but stock purchases are almost always used when
buying public companies, and asset purchases are more common
for private companies.

Financial Statement Adjustments and Debt Schedules

10. All of the following could show up as adjustments to the Income Statement as a
result of a LBO analysis EXCEPT:
a. Cost savings
b. Additional amortization expense
c. Additional interest expense
d. Additional depreciation expense
e. False and misleading question – all of these could show up as
adjustments
i. Explanation: The correct answer choice is E. All of the answer
choices constitute adjustments made to the income statement
during an LBO analysis. Answer choice A would represent a

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decrease in annual COGS expense or SG&A (e.g. if the PE firm

decides to cut spending or lay off employees). Answer choice B
represents not only additional amortization from newly created
Intangible Assets, but also annual amortization for Capitalized
Financing Fees (which gets created as an asset on the balance
sheet). Answer choice C represents all the cash interest (as well as
PIK interest) that needs to be paid on all the new debt issued as
part of the LBO. Answer choice D represents the write-ups to fair
market value of PP&E and the additional incremental depreciation
associated with them.

11. How is the process of adjusting the Balance Sheet different in an LBO model,
compared to what you might see in a typical merger model?
a. In an LBO model, the Shareholders’ Equity gets wiped out and replaced
with new equity from the PE firm, but in a merger model the seller’s
Shareholders’ Equity disappears altogether
b. You’ll typically add more tranches of Debt to the Balance Sheet in an
LBO model than you will in a merger model
c. In an LBO model, you combine two companies’ Balance Sheets to reflect
the PE firm and the acquired company, but in a merger model you must
make adjustments first
d. None of the above
i. Explanation: A is definitely true and is exactly as stated:
Shareholders’ Equity gets wiped out in both deal types, but in a
merger model it stays wiped out since the seller is no longer an
independent entity, but in an LBO model it gets replaced with the
PE firm’s new equity (common equity, Preferred Stock, and
anything else that goes in that section). B is also true because while
debt is often used in a merger model (and M&A deals in general),
there are typically more tranches of debt in a leveraged buyout. C is
incorrect because you never combine the PE firm’s own “Balance
Sheet” with the target company it acquires. You “make
adjustments” in both types of models, but the difference is that in

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an LBO model, you don’t combine the Balance Sheets of two

companies because it’s a single company being bought out.

12. Which of the following statements are TRUE regarding why Capitalized
Financing Fees are considered an Asset?
a. They are similar to Prepaid Expenses
b. Because they are paid for in cash up-front and then recognized as an
Income Statement expense over the years
c. They are an Asset because, similar to other non-cash charges, they may
save the company on taxes
d. They are a “plug” in an LBO model to make the Balance Sheet balance
i. Explanation: The correct answer choices are A, B, and C.
Capitalized Financing Fees are similar to Prepaid Expenses and
also similar to how PP&E is treated on the Balance Sheet. The
expense is paid up-front in cash and then ‘capitalized’ on the
Balance Sheet as an Asset. Then each period the expense is
recognized on the Income Statement, similar to how PP&E is
depreciated over time. The other reason they are considered an
Asset is because all Assets provide future benefits or cash savings.
In this case, the annual expense associated with this Asset flows
through to the Income Statement and reduces the amount of
taxable income, but is not an actual cash expense itself – so it saves
the company on taxes, similar to Depreciation. Answer choice D is
false in that the true “plug” to make the Balance Sheet balance is
Goodwill created, not the Capitalized Financing Fees.

13. Which of the following statements are TRUE regarding the use of the Revolver
and when you draw on it?
a. The Revolver is drawn when the cash required for Mandatory Debt
Repayment exceeds the cash flows available for debt repayment (i.e.
FCF in an LBO model)
b. The Revolver starts off undrawn – similar to a personal credit card with
a fixed credit line

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c. A drawn Revolver is the first debt tranche to be repaid with excess cash
in subsequent periods before any repayment of Term Loans
d. Revolvers are the first debt tranche to be repaid with excess cash because
they are the most expensive form of LBO financing
i. Explanation: The correct answer choices are A, B, and C. All of the
above statements with the exception of D are true statements. The
purpose of the Revolver is to draw it down in emergency situations
in which there is not enough cash from FCFs to cover Mandatory
Debt Repayments. The Revolver starts off undrawn and is identical
in concept to a personal credit card. Furthermore, excess cash is
always used to repay the drawn Revolver first, before any
payments are made on the Term Loans. Answer choice D is false
because while it is true that Revolvers are typically the first to be
repaid with excess cash, they are actually the LEAST expensive
form of LBO financing.

14. You have just repaid the Revolver using the remaining cash left over after
mandatory repayments. Which 2 types of debt do you repay next?
a. Term Loan A
b. Senior Notes
c. Subordinated Notes
d. Term Loan B
i. Explanation: The correct answer choices are A and D. Usually after
making Mandatory Debt Repayments, if there is excess cash flow
you can also make Optional Debt Repayments. Usually the first
priority here is to pay off any drawn Revolver in full. After that has
been repaid, you make principal repayments on Term Loan A.
Term Loan B follows Term Loan A, usually because the allowed
optional repayments are smaller for Term Loan B. Senior Notes and
Subordinated Notes are both forms of high-yield debt, which
typically prohibit prepayments altogether.

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15. You’ve made mandatory repayments on Term Loans A and B and the Senior
Notes. There is also a Revolver. How much do you repay optionally on Term
Loan B?
a. Set it equal to the cash flow available for debt repayment (prior to
Revolver borrowing) minus Total Mandatory Repayments minus Optional
Repayments on the Revolver and Term Loan A
b. Do what the answer choice above suggests, but also add in a check to
make sure that you don’t repay MORE than the total amount of debt
remaining
c. You can’t generalize the approach here – it depends on the specific type of
LBO and the company involved and the formula is always different
d. None of the above is exactly correct
i. Explanation: The answer is D – answer choices A and B are close to
the correct answer, but neither one is exactly correct. C is incorrect
because there is a general purpose formula that works regardless of
the number of debt tranches. That general purpose formula is:
=MAX(MIN(Prior Year Term Loan B – Mandatory Term Loan B
Repayment, Subtotal Before Revolver – Total Mandatory
Repayments and Optional Repayments on Revolver and Term
Loan A),0). A and B correspond to the inner part of that formula –
everything that’s inside the MIN function. But what’s with that
MAX formula on the outside? That handles the case where
additional revolver borrowing is required. If additional borrowing
is required, Subtotal Before Revolver – Total Mandatory
Repayments and Optional Repayments on Revolver and Term
Loan A will be a negative number, which makes no sense to use as
the repayment figure. If we need to draw on the Revolver to meet
the minimum required mandatory repayments, then it means that
we CANNOT repay anything optionally, so that’s why we set the
optional Term Loan B repayment to 0 in that case. We go over this
formula in more detail in the financial modeling courses and case
studies / bonus webinars provided on the site.

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16. A company has $200 million of debt with a 7% cash interest rate, 4% PIK interest
rate, and amortization of 12% per year. Interest is based on the beginning debt
balance. What happens in Year 1?
a. $14M cash interest and $8M PIK interest for a total of $22M interest
expense on the Income Statement
b. Add back $8M to CFO (from PIK interest) and subtract out $24M from
CFF (from 12% amortization) on the Cash Flow Statement
c. Debt is up by $8M due to PIK interest but also down by $24M due to
principal repayment so Debt is down by $16M overall
i. Explanation: All of the above answer choices are correct. This
question tests your knowledge of how the various debt structures
affect the financial statements. On the income statement, there
would be a total of $22M in interest expense – $14M in cash and
$8M from PIK. Since the PIK interest is a non-cash expense, we
would add back the $8M in the CFO section. Under Cash flow from
Financing, we repaid $24M of debt principal due to the 12%
amortization, so CFF would decrease. On the Balance Sheet, debt
would initially increase by the $8M in PIK interest. However, we
repaid $24M in principal, so the Debt on the Balance Sheet would
be reduced by $16M. Note that we do not need the tax rate for any
of this because the question doesn’t ask us for the COMPLETE set
of effects in Year 1 – it’s only asking which changes here actually
happen in Year 1.

Calculating Returns

17. How would a “stub period” of 6 months in an LBO model affect the PE firm’s
IRR?
a. It would increase IRR if it extends the holding period
b. It would decrease IRR if it extends the holding period
c. It would be neutral to IRR regardless of the holding period
d. It would increase IRR if it reduces the holding period
e. It would decrease IRR if it reduces the holding period

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i. Explanation: B and D are the correct answer choices. A “stub

period” refers to a case where, for example, the PE firm closes the
buyout of a company on June 30th but the company’s fiscal year
ends on December 31st. So you have to project those 6 months in
between and include them in in the model, and that’s what the
“stub period” refers to. The impact on IRR depends on whether the
stub period increases or decreases the holding period. For example,
if the PE firm planned to hold the company for 5 years but now, as
a result of the stub period, it holds it for 5.5 years, that will push
down IRR because additional time will reduce returns, all else
being equal. However, if this stub period results in the PE firm only
holding the company for 4.5 years instead, that will push up IRR
because the reduced time will increase IRR, all else being equal –
you can sell a company for a lower price in a 4.5-year period and
get the same IRR as if you sold the company for a higher price at
the end of a 5-year period.

18. Which of the following reasons explain why debt investors could earn a higher
IRR than the private equity firm itself in an LBO?
a. Exit EBITDA multiples severely contract
b. The PE sponsor overpaid significantly for the company
c. EBIT margins and growth rates deteriorate due to excessive expenses
d. Net proceeds to the PE sponsor at exit equal initial equity contributed
i. Explanation: All of the answer choices above are true. While it is
rare for the debt investors to earn a higher IRR than the equity
investors, it can happen. Answer choices A and B both reflect key
items that affect IRR the most – namely, exit price and purchase
price. Answer choice C would result in a lower exit value as well.
Answer choice D is a rare example in which the exit proceeds
received equal the initial PE sponsor equity investment. In that case
if all else stays constant, the IRR achieved would be 0%. In that
case, it would be impossible for the debt investors to get a lower
return unless the company goes bankrupt. A key point to keep in
mind is that high-yield debt investors typically receive interest

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rates in the 10-15% range or higher (depending on the economy

and prevailing interest rates), making the IRR hurdle for equity
investors (i.e. the PE sponsor) more difficult to achieve.

19. Investor Group A receives 7% of the returns up to a 15% IRR (Investor Group B
receives 93%), but then receives 15% of the return (with Investor Group B
receiving 85%) beyond a 15% IRR. Net sales proceeds upon exit are $750M,
which corresponds to a 20% IRR; net proceeds of $350M would have
corresponded to a 15% IRR. How much would Investor Groups A and B receive?
a. Investor Group A would receive $24.5M on first 15% of returns
b. Investor Group B would receive $325.5M on first 15% of returns
c. Investor Group A would receive $60M on returns beyond first 15%
i. Explanation: All of the above are correct. The first step is to
determine what dollar amount of net sales proceeds corresponds to
a 15% IRR, which the questions states as $350M. So investor group
A would receive 7% of this amount on the first 15% of IRR
achieved, which corresponds to $24.5M. Investor group B would
receive 93% of the $350M, for $325.5M. Then investor group A will
receive 15% of proceeds beyond the first 15% return achieved. So
we take the total proceeds of $750M and subtract out the $350M,
which is equal to $400M. $400M * 15% = $60M, which is what
Investor Group A receives. The remaining $340M goes to Investor
Group B.

20. Which of the following examples reflect situations where INCREASING leverage
in an LBO might REDUCE the IRR achieved?
a. Interest payments alone far exceed the company’s cash flows
b. The economy enters a recession and the company’s EBIT margin
deteriorates significantly
c. The current leverage ratio (Total Debt / EBITDA) is at 2.0x
d. The interest coverage ratio (EBITDA / Interest Expense) is 20.0x
i. Explanation: The correct answer choices are A and B. In general,
more debt enhances the IRR achieved… but only up to a certain
point. Once that point is exceeded, additional debt reduces the IRR

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achieved and increases the risk of bankruptcy for the company in

question. Both answer choices A and B represent unique situations
in which additional debt will hurt the portfolio company and thus
reduce the IRR achieved. If the company is no longer able to use its
free cash flow to repay debt principal and the interest payments
become extremely large, its cash balance will decrease while its
debt stays the same – resulting in reduced net proceeds to the PE
firm upon exit. However, answer choices C and D represent
situations in which the portfolio company has lots of unused
additional debt capacity, in which case additional debt could be
raised to enhance the final IRR achieved.

21. An LBO could be financed with 100% Term Loan A, 100% Senior Notes, OR
100% PIK Mezzanine. All else being equal, which one produces the highest IRR?
a. 100% PIK Mezzanine
b. 100% Senior Notes
c. 100% Term Loan A
i. Explanation: The correct answer choice is C. The most tempting
answer might be 100% PIK Mezzanine since there would be no
actual cash interest to be paid. Since it is PIK debt, the interest
would accrue to the principal balance, so cash flow available for
debt service would be the highest since there would be no
mandatory or optional debt repayments. However, we need to
keep in mind that Mezzanine debt is the highest risk form of high-
yield debt, and thus carries the highest interest expense associated
with it, even if it is not actually paid out in cash. Bank debt is the
least risky form of LBO financing and thus commands the lowest
interest rates. Also, only bank debt allows for prepayments, so even
more debt could be retired earlier during the investment-holding
period, thus resulting in the highest IRR achieved from the options
above. In short: the equity contributed by the PE firm in the
beginning would be the same with any of these options. But with
Term Loan A, the net proceeds to the PE firm at the end would be

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highest, resulting in the highest IRR. The net proceeds would be

lower with Senior Notes and lower still with PIK Mezzanine.

22. How would a management option pool affect the IRR achieved by the PE
sponsor in an LBO?
a. It will increase the IRR
b. It will decrease the IRR
c. It could go either way
i. Explanation: The correct answer choice is C. From a strictly
mathematical perspective, a management option pool would take
away equity from the PE investor and share it with company
management, and thus it would decrease the IRR. However, this
option pool is created so as to ‘align incentives’ between principals
(i.e. PE sponsor) and agents (i.e. operating executives). Therefore,
despite the fact that this lowers PE sponsor’s IRR from a
mathematical perspective, it could be more than offset by the
benefits of management working very hard to improve operations,
which would benefit both parties and result in a higher exit value
and thus a higher IRR as well.

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