Walk me through a basic LBO model. Which sequence correctly describes the steps?

Walk me through a basic LBO model. Which sequence correctly describes the steps?

• A. Step 1 is to project financial statements; Step 2 is sources & uses; Step 3 adjust balance sheet; Step 4 assume exit; Step 5 determine purchase assumptions
• B. Step 1 is to determine the exit; Step 2 is to project statements; Step 3 to adjust balance sheet; Step 4 to determine sources & uses; Step 5 to set assumptions
• C. Step 1 is to adjust balance sheet; Step 2 is to determine sources & uses; Step 3 to set exit assumptions; Step 4 to project statements; Step 5 to make purchase assumptions
• D. Step 1 is making assumptions about purchase price, debt/equity ratio, and other variables; Step 2 is to create a Sources & Uses section; Step 3 is to adjust the Balance Sheet; Step 4 is to project the statements; Step 5 is to make exit assumptions

Answer: (D)

In an LBO model, you start by locking in the deal terms and how it will be financed. Knowing the purchase price and the planned debt/equity mix sets the foundation for everything that follows. First, make the purchase and financing assumptions. This includes the target price, the amount of debt you plan to raise, and the equity you’ll contribute, plus any other financing terms. This step determines how much money is needed and what the capital structure will look like. Next, build a Sources & Uses section. This shows where the funds come from (debt, equity, other sources) and how they are deployed (the purchase price, refinancing any existing debt, paying fees, and financing costs). It bridges the deal terms to the actual funding and use of proceeds. Then adjust the balance sheet to reflect the new capital structure. This involves incorporating the new debt, equity, and any purchase price allocations, and aligning assets and liabilities to the levered setup you’re modeling. After that, project the financial statements under this leveraged scenario. This step traces how the business generates cash, covers interest and principal repayments, and evolves over the projection period, which is crucial for assessing debt capacity and returns. Finally, set exit assumptions. Decide when you’ll exit and at what multiple or exit value, then compute returns (like IRR and equity proceeds) based on the modeled cash flows and exit. Why this order fits best: the financing structure you choose drives debt service, interest, and cash flow constraints, so you must establish it before projecting future statements. Starting with projections or exits without a defined capital structure can lead to inconsistent or infeasible results, and adjusting the balance sheet before knowing the purchase price and financing wouldn’t reflect the actual deal terms.

In an LBO model, you start by locking in the deal terms and how it will be financed. Knowing the purchase price and the planned debt/equity mix sets the foundation for everything that follows.

First, make the purchase and financing assumptions. This includes the target price, the amount of debt you plan to raise, and the equity you’ll contribute, plus any other financing terms. This step determines how much money is needed and what the capital structure will look like.

Next, build a Sources & Uses section. This shows where the funds come from (debt, equity, other sources) and how they are deployed (the purchase price, refinancing any existing debt, paying fees, and financing costs). It bridges the deal terms to the actual funding and use of proceeds.

Then adjust the balance sheet to reflect the new capital structure. This involves incorporating the new debt, equity, and any purchase price allocations, and aligning assets and liabilities to the levered setup you’re modeling.

After that, project the financial statements under this leveraged scenario. This step traces how the business generates cash, covers interest and principal repayments, and evolves over the projection period, which is crucial for assessing debt capacity and returns.

Finally, set exit assumptions. Decide when you’ll exit and at what multiple or exit value, then compute returns (like IRR and equity proceeds) based on the modeled cash flows and exit.

Why this order fits best: the financing structure you choose drives debt service, interest, and cash flow constraints, so you must establish it before projecting future statements. Starting with projections or exits without a defined capital structure can lead to inconsistent or infeasible results, and adjusting the balance sheet before knowing the purchase price and financing wouldn’t reflect the actual deal terms.