LOS n: Calculate and explain free cash flow forecasts in a leveraged buyout (LBO) transaction.

Q1. The effect of capital expenditures in an LBO on cash flow and cash sweep, respectively, is:

                Cash flow                       Cash sweep

A)     Increase                           Decrease

B)     Decrease                         Increase

C)     Decrease                         Decrease

Q2. An investor gathered the following information about a leveraged buyout (LBO) for 2008:

• Net income of $13.5 million.
• Depreciation expense of $5.2 million.
• Amortization of deferred charges of $450,000.
• Reinvested depreciation of $5.2 million.
• Decrease in net working capital of $1 million.
• No new capital expenditure for the year.

The LBO’s cash flow for the year is:

A)   $1.65 million.

B)   $14.95 million.

C)   $12.95 million.

Q3. When calculating the cash flows of a leveraged buyout investment from net income, the effect on cash flows of reinvested depreciation and a decrease in net working capital (NWC), respectively, is:

           Reinvested depreciation                     Decrease in NWC

A)       Decrease                                             Increase

B)       Decrease                                            Decrease

C)      Increase                                                Decrease

Q4. A private equity investor gathered the following information about a leveraged buyout (LBO) for 2008:

• Net income of $6 million.
• Depreciation expense of $2.9 million.
• Amortization of deferred charges of $100,000.
• Reinvested depreciation of $2.9 million.
• Increase in net working capital of $1 million.
• New capital expenditures of $700,000.

The LBO’s cash flow for the year is (in millions):

A)   $4.2.

B)   $6.2.

C)   $4.4.

LOS n: Calculate and explain free cash flow forecasts in a leveraged buyout (LBO) transaction. fficeffice" />

Q1. The effect of capital expenditures in an LBO on cash flow and cash sweep, respectively, is:

                Cash flow                       Cash sweep

A)     Increase                           Decrease

B)     Decrease                         Increase

C)     Decrease                         Decrease

Correct answer is C)

Capital expenditures are funds that a company uses to buy physical assets, including new equipment and property. Capital expenditures are cash outflows and thus, reduce cash flow. Since a cash sweep is the excess cash flow to repay debt, capital expenditures reduce the amount of cash sweep as well.

Q2. An investor gathered the following information about a leveraged buyout (LBO) for 2008:

• Net income of $13.5 million.
• Depreciation expense of $5.2 million.
• Amortization of deferred charges of $450,000.
• Reinvested depreciation of $5.2 million.
• Decrease in net working capital of $1 million.
• No new capital expenditure for the year.

The LBO’s cash flow for the year is:

A)   $1.65 million.

B)   $14.95 million.

C)   $12.95 million.

Correct answer is B)

To arrive at cash flow, it is necessary to start with net income and work backwards by adding back non-cash items and adjusting for cash outlays and inflows. The LBO’s 2008 cash flow is then (in millions):

CF = $13.5 + $5.2 + $0.45 ? $5.2 + $1 = $14.95.

Note that depreciation and reinvested depreciation will always cancel each other out if total capital investment is equal to or greater than the depreciation expense. Any capital investment in excess of the depreciation expense is net (new) capital investment, which is assumed to be zero in this case. Also, a decrease in net working capital is a cash inflow and should be added to net income. An increase in net working capital would be treated exactly the opposite.

Q3. When calculating the cash flows of a leveraged buyout investment from net income, the effect on cash flows of reinvested depreciation and a decrease in net working capital (NWC), respectively, is:

           Reinvested depreciation                     Decrease in NWC

A)       Decrease                                             Increase

B)       Decrease                                            Decrease

C)      Increase                                                Decrease

Correct answer is A)

While depreciation is a non-cash item that is to be added back to net income, reinvested depreciation is a cash outlay and should be subtracted. NWC is current assets less current liabilities. A decrease in NWC is a cash inflow (think cash from the sale of inventory), while an increase in NWC is a cash outflow.

Q4. A private equity investor gathered the following information about a leveraged buyout (LBO) for 2008:

• Net income of $6 million.
• Depreciation expense of $2.9 million.
• Amortization of deferred charges of $100,000.
• Reinvested depreciation of $2.9 million.
• Increase in net working capital of $1 million.
• New capital expenditures of $700,000.

The LBO’s cash flow for the year is (in millions):

A)   $4.2.

B)   $6.2.

C)   $4.4.

Correct answer is C)

To arrive at cash flow, it is necessary to start with net income and work backwards by adding back non-cash items and adjusting for cash outlays and inflows. The LBO’s 2008 cash flow is then (in millions):

CF = $6.0 + $2.9 + $0.1 ? $2.9 ? $1 ? $0.7 = $4.4

Note that depreciation and reinvested depreciation cancel out. Also, an increase in net working capital is a cash outflow and should be subtracted from net income (think intuitively: more assets on the firm’s books without a corresponding increase in liabilities must mean cash was spent to purchase those assets). A decrease in net working capital would be treated exactly the opposite.