Leveraged Buyout Model (LBO)

A Leveraged Buyout (LBO) Model is a popular financial analysis tool for private equity firms, typically built in Excel. It’s used to assess whether a company is worth acquiring primarily with debt. In an LBO, private equity firms or investors purchase a company by combining equity, or their money, with debt. The model projects the target company's financial performance, including revenue, expenses, and cash flow, post-acquisition to show how its cash flow will be used to service and pay down the large amount of debt taken on. 

The main purpose of building an LBO model is to determine the potential returns for the equity investors, like the private equity firm, by calculating metrics such as Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC) at the time of an eventual sale or exit. It also helps assess the company's ability to handle the debt burden.
 

How to Build a Basic LBO Model

First, it's essential to understand the building blocks of the model and what each step aims to achieve. So let’s have a look at the key components of an LBO model:

Step 1: Make Key Assumptions

The first step of building an LBO model is to make assumptions about important factors like the following:

• Purchase Price: The total amount of money paid to acquire the target company. The purchase price is based on a valuation metric like Enterprise Value (EV), which represents the total value of the company, including debt and equity.
• Debt/Equity Ratio: This specifies the proportion of debt versus equity used to finance the purchase. A higher ratio indicates more leverage.
• Interest Rate on Debt: The cost of borrowing the debt, expressed as a percentage.

You also estimate operational metrics such as revenue growth and margins or profitability as a percentage of revenue. These assumptions provide the foundation for evaluating the feasibility and returns of the deal.

Step 2: Create a Sources and Uses Section

The next step is to build a sources and uses table, which outlines how the acquisition will be financed and where the money will go. Sources represent the capital used to fund the purchase, including equity and debt.

Uses show how this capital is allocated. These areas include the purchase price, transaction fees, and debt repayment. This section also calculates the equity contribution, or the amount of cash investors need to provide.

Step 3: Adjust the Balance Sheet

After determining financing, you modify the company’s balance sheet to reflect the new capital structure. This involves adding the newly acquired debt and equity to the liabilities and equity side, while balancing the assets side by including items like goodwill. That is the premium paid over the company’s book value. These adjustments ensure the balance sheet remains accurate post-transaction where:

• Assets = Liabilities + Equity

Step 4: Project Financial Statements

This step is all about forecasting the company’s future performance by projecting its income statement, balance sheet, and cash flow statement. Key components include estimating cash flows, accounting for interest payments (the cost of borrowing), and modeling debt repayment over time. Strong cash flow is essential for covering debt obligations and ensuring the transaction’s success.

Step 5: Calculate Returns and Exit Assumptions

The final step is to estimate the potential returns. You make assumptions about the exit strategy, such as selling the company after a few years at a multiple of its EBITDA (earnings before interest, taxes, depreciation, and amortization). Using these assumptions, you calculate metrics like the internal rate of return (IRR), which measures the profitability of the investment for equity holders.

Another profitability metric is Multiple on Invested Capital (MOIC) which calculates how many times the initial investment is returned. For example, a 2.0x MOIC means for every $1 invested, $2 was returned.
 

Common Leveraged Buyout (LBO) Model Interview Questions 

To help you prepare, we’ve gathered some typical LBO interview questions. These examples will give you a good sense of what might come up and are a great way to practice and build confidence ahead of your interview.

1. What makes a company a good LBO candidate?

The most important criteria when checking if a target company is an ideal LBO candidate is stable cash flows. That’s because the acquiring company uses the free cash flows to pay down the debt principal and interest. 

Other factors include: 

• Having assets that can be used as debt collateral
• A low purchase price and low-risk industry
• Not have a huge need for ongoing or other investments such as CapEx
• Have opportunities to decrease costs and increase margins

2. What is the Internal Rate of Return (IRR) of the following investment?

A private equity firm acquires a company with $50 million in EBITDA at an 8x multiple, using 70% debt and 30% equity. By Year 4, the company’s EBITDA has grown to $80 million, but the exit multiple has dropped to 7x. Over the holding period, $150 million of the debt is repaid and there’s no extra cash on hand. 

Let’s break it down step by step:

1. Purchase Price

EBITDA × Entry Multiple = $50 million × 8 = $400 million

2. Capital Structure at Entry

• Debt (70%) = $280 million
• Equity (30%) = $120 million 

3. Exit Value

EBITDA × Exit Multiple = $80 million × 7 = $560 million

4. Equity Value at Exit

Remaining Debt = $280 million – $150 million = $130 million

Equity Value = Exit Value – Remaining Debt = $560 million – $130 million = $430 million

5. IRR Calculation

We use the standard IRR formula:

Plug in the numbers:

👉 In finance interviews, it’s not just about knowing the formulas – you should also be able to run quick calculations in your head with confidence. Check out our Mental Math Tool and sharpen your calculation skills!

3. What’s the logic behind the use of debt or leverage in an LBO, and why does it increase potential returns?

The logic behind using debt or leverage in an LBO is to increase equity returns. Financing a significant portion of the acquisition with borrowed money means the private equity firm invests less of its own capital upfront. 

As the acquired company generates cash flow, it repays the debt. This debt repayment increases the equity value without requiring additional equity investment. Since the cost of debt is typically lower than the expected return on equity, and interest payments are often tax-deductible, which is good for the returns for equity investors.

4. What variables affect a leveraged buyout the most?

The variables with a huge impact on a leveraged buyout are purchase and exit multiples. These affect the purchase and exit prices, and hence profitability of the deal. PE firms target a lower purchase price and a higher exit price to maximize returns. 

The amount of leverage used is also impactful. More debt often results in higher returns if the company is able to repay the debt from the cash flows. 

5. Can you use an LBO model to value a company? 

Yes, you can use an LBO model to value a company, but it provides a "floor" or minimum valuation. You’ll need to set a target IRR and then back-solve to find out what purchase price the acquiring firm might pay to achieve that IRR. 

An LBO determines the maximum purchase price a private equity firm could pay while still achieving its target Internal Rate of Return (IRR) or Multiple on Invested Capital (MOIC). While other valuation methods focus on intrinsic or market value, an LBO model values the company from the perspective of a financial buyer and their required returns.

6. Both an LBO valuation and a DCF valuation uses cash flows to value a company. What makes them different? 

A DCF (Discounted Cash Flow) valuation aims to determine the intrinsic value of a company by discounting its unlevered free cash flows, that’s cash flow before debt payments, back to the present. It represents what the company is worth, regardless of its capital structure.

However, an LBO valuation seeks to answer the question of how much a PE firm should pay for a target company if they want to achieve a certain IRR within a given period. So, it constrains the value of a company based on expected returns.

👉 Want more sample questions about valuation methods like DCF and LBO to master your finance interview? Then check out these question sets we’ve prepared for you in our Case Library! 

Key Takeaways

The LBO model is one of the most practical and return-focused valuation tools used in private equity. It allows investors to analyze how a company can be acquired largely with debt, how that debt can be repaid over time using operational cash flows, and how much return can ultimately be generated for equity holders. The goal is not just to assess the feasibility of the deal but to understand the full financial picture, from acquisition to exit.

Building an LBO model follows a structured process: you begin with key assumptions around purchase price and financing, then outline how the deal is funded, adjust the balance sheet, project financials, and calculate returns. Each step helps determine whether the transaction can generate the desired outcome for investors.

LBO models are frequently tested in finance interviews, as they assess both your technical know-how and your grasp of financial strategy. Typical questions focus on return drivers, capital structure, and how an LBO compares to methods like DCF.

Understanding the logic behind leverage, the impact of entry and exit multiples, and when to use LBO modeling for valuation gives you a real edge. Whether you're preparing for interviews or building models in Excel, mastering this framework is a must-have skill in private equity and financial analysis.