I85PREP
⌘ K
BOB LBO study materials
BOB LBO study resources

BOB LBO practice questions

One question at a time. Build your BOB LBO understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Reasoning

In an LBO model, which capital structure component typically carries the lowest cost of debt and the strongest covenant package?

  1. Senior secured term loan B Correct answer.
  2. Mezzanine debt with warrants
  3. Subordinated high-yield notes
  4. Preferred equity

Explanation

Senior secured debt sits at the top of the capital stack, is secured by assets, and therefore prices at the tightest spread with the most restrictive maintenance covenants. Subordinated and mezzanine tranches accept higher risk in exchange for higher coupons, and preferred equity demands the highest return of the group.

Question 2Reasoning

A sponsor buys a company for 10.0x EBITDA of $50 million, funding 55% with debt. If the company is sold three years later at 10.0x EBITDA of $65 million with all debt repaid, what is the approximate equity multiple?

  1. 2.5x
  2. 3.0x Correct answer.
  3. 2.0x
  4. 1.7x

Explanation

Entry enterprise value is $500 million and debt is $275 million, so entry equity is $225 million. Exit enterprise value is $650 million with no remaining debt, giving exit equity of $650 million. The multiple is 650/225, roughly 2.9x, which rounds to 3.0x.

Question 3Reasoning

Which mechanism most directly protects a lender against a borrower stripping cash out of the business after an LBO closes?

  1. An equity commitment letter
  2. A restricted payments covenant Correct answer.
  3. A purchase price adjustment mechanism
  4. A management rollover agreement

Explanation

Restricted payments covenants limit dividends, share buybacks, and other leakage to shareholders unless specific builder or leverage tests are met. Equity commitment letters and rollover agreements address funding at signing, and purchase price adjustments settle the closing balance sheet, so none of them govern post-closing cash leakage.

Question 4Reasoning

In a standard LBO sources and uses table, which item appears on the uses side?

  1. New senior term loan
  2. Sponsor equity contribution
  3. Refinancing of existing target debt Correct answer.
  4. Management rollover equity

Explanation

Uses of funds are what the transaction pays for: the purchase of equity, refinancing of existing debt, and transaction fees. Sources are the funding providers, including new debt tranches, sponsor equity, and rolled equity. Refinancing old debt is therefore a use, while the other three options are sources.

Question 5Reasoning

A target generates $40 million of EBITDA and requires $8 million of annual capex and a $3 million yearly working capital build. If the opening debt balance is $220 million at 7% interest, what is the approximate year-one free cash flow available for debt repayment?

  1. $21.0 million
  2. $13.6 million Correct answer.
  3. $24.6 million
  4. $29.0 million

Explanation

Interest expense is 7% of $220 million, or $15.4 million. Free cash flow equals EBITDA of $40 million less capex of $8 million, working capital of $3 million, and interest of $15.4 million, giving $13.6 million. Taxes and other items are excluded because the stem does not supply them.

Question 6Reasoning

Which statement best describes the role of a cash sweep in an LBO credit agreement?

  1. It forces excess cash flow to prepay debt before distributions to equity. Correct answer.
  2. It suspends financial covenant testing during the first year.
  3. It allows the borrower to draw additional revolving commitments on demand.
  4. It converts fixed-rate debt into floating-rate exposure.

Explanation

A cash sweep requires a defined percentage of excess cash flow, often scaled by leverage, to be applied to prepay term debt. This accelerates deleveraging and reduces lender risk. Revolving draws, interest rate swaps, and covenant holidays are governed by separate provisions.

Question 7Reasoning

A sponsor is evaluating two identical targets but can only finance one. Target A has 30% EBITDA margins with high revenue cyclicality; Target B has 15% margins but contractual recurring revenue. Which factor most strongly favors Target B for a leveraged buyout?

  1. Higher absolute EBITDA
  2. Larger working capital balance
  3. Lower purchase multiple
  4. Greater cash flow predictability Correct answer.

Explanation

Lenders underwriting LBO debt prioritize stability of cash flow because fixed debt service must be met through cycles. Contractual recurring revenue reduces downside volatility even at lower margins. Absolute EBITDA, entry multiple, and working capital size matter, but predictability is the key credit consideration here.

Question 8Reasoning

Which of the following is the most typical consequence of a financial covenant breach under an LBO term loan?

  1. Permanent elimination of the revolving credit facility
  2. Conversion of the term loan into common equity
  3. Automatic acceleration of all debt and immediate insolvency filing
  4. A cure period during which the sponsor may inject equity to restore compliance Correct answer.

Explanation

Covenant breaches usually trigger a default subject to a negotiated cure right, most commonly an equity cure in which the sponsor contributes cash counted as EBITDA or applied to debt. Acceleration is a remedy the lenders may elect, not an automatic insolvency. Debt-to-equity conversion and permanent revolver loss are not standard outcomes.

Question 9Reasoning

When building an LBO model, why is the entry enterprise value calculated as the offer price per share times diluted shares plus net debt rather than equity value alone?

  1. Because diluted share counts always exceed basic share counts
  2. Because enterprise value captures the operating business independent of how it is financed Correct answer.
  3. Because equity value excludes transaction fees by definition
  4. Because lenders require the purchase price to equal book value

Explanation

Enterprise value measures the whole operating business by adding net debt and other claims to equity value, allowing comparison across different capital structures. The LBO uses enterprise value as the purchase price that sources must fund. Book value, fee treatment, and share count differences do not explain the convention.

Question 10Reasoning

An analyst assumes a 12% IRR target and a five-year hold. If entry equity is $300 million and no dividends are paid, what approximate exit equity value is required?

  1. $480 million
  2. $529 million Correct answer.
  3. $636 million
  4. $360 million

Explanation

Exit equity equals entry equity compounded at the target IRR: 300 × 1.12^5. Since 1.12^5 is about 1.762, the required exit equity is approximately $529 million. The other figures correspond to simple interest or incorrect compounding periods.

Question 11Reasoning

Which adjustment is most commonly made to reported EBITDA when sizing LBO debt capacity?

  1. Adding back all capital expenditures
  2. Including gains from asset sales in recurring earnings
  3. Adding back documented one-time restructuring costs Correct answer.
  4. Subtracting interest income from operating profit

Explanation

Credit agreements typically permit add-backs for documented non-recurring items such as restructuring, integration, and sponsor fees, subject to caps. Capex is a cash use and cannot be added back to EBITDA, and asset sale gains are excluded as non-recurring. Interest income is not part of operating EBITDA.

Question 12Reasoning

A sponsor structures an LBO with a 5.0x total leverage multiple on $60 million of EBITDA. If senior debt is 3.5x, what dollar amount of subordinated debt is raised?

  1. $300 million
  2. $120 million
  3. $90 million Correct answer.
  4. $210 million

Explanation

Total debt is 5.0x EBITDA of $60 million, or $300 million, and senior debt is 3.5x, or $210 million. The difference of $90 million is the subordinated tranche, equal to 1.5x EBITDA. The other figures confuse total debt, senior debt, or an incorrect multiple.

Question 13Reasoning

Which outcome most clearly indicates that an LBO's value creation came from operational improvement rather than leverage or multiple expansion?

  1. Exit multiple exceeds entry multiple with flat EBITDA
  2. Net debt falls sharply because of a cash sweep
  3. The sponsor refinances into a lower coupon
  4. Exit EBITDA exceeds entry EBITDA while entry and exit multiples are equal and net debt is unchanged Correct answer.

Explanation

If the entry and exit multiples are identical and debt is unchanged, all equity gain must come from EBITDA growth, which is operational. Multiple expansion is a market re-rating, deleveraging is a financing effect, and refinancing lowers interest cost but does not itself prove operating improvement.

Question 14Reasoning

In an LBO model, sponsor equity is best described as which of the following?

  1. A senior claim repaid before term debt
  2. A fixed-rate obligation with a stated maturity
  3. A tax-deductible financing cost
  4. A residual claim funded last in the sources and uses Correct answer.

Explanation

Sponsor equity is the residual capital that absorbs first losses and is funded after debt in the sources and uses. It is not tax-deductible, has no contractual coupon, and ranks behind all debt in the waterfall. The other options describe debt characteristics.

Question 15Reasoning

A lender is reviewing a proposed LBO with a 6.0x total leverage multiple and fixed charge coverage of 1.1x. Which concern is most warranted?

  1. The purchase multiple is certainly below market
  2. The company may lack cushion to absorb an EBITDA decline and still service fixed charges Correct answer.
  3. The equity contribution is likely too large for the sponsor
  4. The company will be unable to raise any revolver

Explanation

A fixed charge coverage ratio near 1.1x leaves very little headroom before cash flow fails to cover interest and mandatory amortization. Combined with 6.0x leverage, a modest EBITDA decline could breach covenants. Equity size, purchase multiple, and revolver availability are not implied by these figures.

Question 16Reasoning

Which item is normally excluded from the definition of Indebtedness in an LBO credit agreement?

  1. Capitalized lease obligations
  2. Short-term borrowings from a bank
  3. Letters of credit drawn and unreimbursed
  4. Trade payables incurred in the ordinary course Correct answer.

Explanation

Trade payables arising in the ordinary course of business are operating liabilities and are generally carved out of the Indebtedness definition. Capital leases, drawn letters of credit, and short-term bank borrowings are financial obligations and are captured.

Question 17Reasoning

A sponsor achieves a 2.5x equity multiple on a four-year hold. What approximate IRR does this represent?

  1. 15.0%
  2. 25.7% Correct answer.
  3. 37.5%
  4. 62.5%

Explanation

IRR solves (1+IRR)^4 = 2.5, so IRR equals 2.5^(1/4) minus 1, which is about 25.7%. Dividing the total return by the hold period overstates the rate because it ignores compounding. The other figures come from simple division or misapplied exponents.

Question 18Reasoning

Why do LBO sponsors often prefer to fund acquisitions with a combination of debt tranches rather than a single large term loan?

  1. Splitting debt removes all financial covenants
  2. Diversifying across seniority and pricing tiers can lower blended cost while matching lender risk appetite Correct answer.
  3. Multiple tranches eliminate the need for an equity contribution
  4. A single tranche is prohibited by securities law

Explanation

Layering senior secured, subordinated, and mezzanine debt lets sponsors tap different investor bases and price each risk tier appropriately, often reducing blended cost and broadening demand. Securities law does not ban single tranches, equity is still required, and covenants remain regardless of tranching.

Question 19Reasoning

In an LBO, which of the following best explains why management rollover equity is attractive to a sponsor?

  1. It ranks ahead of senior debt in the waterfall
  2. It guarantees a minimum exit multiple for the sponsor
  3. It eliminates the need for a cash sweep
  4. It aligns incumbent management with the sponsor and reduces the cash equity required at close Correct answer.

Explanation

Rollover lets existing owners and managers convert part of their proceeds into new equity, which preserves alignment and lowers the sponsor's cash outlay. It carries no return guarantee, ranks alongside or behind sponsor equity, and has no effect on cash sweep mechanics.

Question 20Reasoning

A company has $100 million of EBITDA and $500 million of debt. It generates $60 million of free cash flow before debt service and pays $35 million of interest with no mandatory amortization. If the cash sweep applies 50% of excess cash flow, how much debt is repaid in year one?

  1. $60.0 million
  2. $12.5 million Correct answer.
  3. $30.0 million
  4. $25.0 million

Explanation

Excess cash flow is $60 million less $35 million of interest, or $25 million. A 50% sweep applies $12.5 million to debt repayment. The other figures reflect the full excess cash flow, the pre-interest cash flow, or an incorrect sweep percentage.

Question 21Reasoning

Which statement about the difference between maintenance and incurrence covenants is accurate?

  1. Maintenance covenants are tested periodically regardless of action, while incurrence covenants are tested only when a specified action is taken Correct answer.
  2. Maintenance covenants restrict only dividend payments, while incurrence covenants restrict only acquisitions
  3. Maintenance covenants apply only to equity holders, while incurrence covenants apply only to lenders
  4. Incurrence covenants are tested quarterly, while maintenance covenants are tested at maturity

Explanation

Maintenance covenants are measured on a recurring basis, typically quarterly, against leverage or coverage thresholds. Incurrence covenants are triggered only when the borrower takes an action such as issuing debt or making an acquisition. The parties and testing frequency described in the other options are incorrect.

Question 22Reasoning

When an LBO model shows a declining IRR as the hold period lengthens at a constant exit multiple, what is the most likely explanation?

  1. The return is being diluted by the time value of money as gains are realized later Correct answer.
  2. Exit EBITDA is assumed to shrink over time
  3. The sponsor equity contribution increases each year
  4. Interest rates are assumed to rise each year

Explanation

Holding all else equal, pushing the exit further out discounts the same terminal equity value over more periods, lowering the annualized return. Nothing in the scenario implies EBITDA decline, rising equity contributions, or rate changes. The effect is purely the compounding of the discount period.

Question 23Reasoning

Which of the following best characterizes a dividend recapitalization in the LBO context?

  1. The sponsor contributes additional equity to cure a covenant breach
  2. The portfolio company raises new debt to fund a distribution to its sponsor Correct answer.
  3. The company pays down term debt using excess cash
  4. The sponsor sells a minority stake to a new investor

Explanation

A dividend recap involves the portfolio company issuing new debt and using the proceeds to pay a dividend to its equity holders, typically the sponsor. It is a partial liquidity event that increases leverage. Minority sales, debt paydown, and equity cures are distinct transactions.

Question 24Reasoning

An analyst is comparing two exit scenarios for the same LBO. Scenario A exits at 9.0x EBITDA of $80 million with $200 million of net debt. Scenario B exits at 10.0x EBITDA of $72 million with $200 million of net debt. Which scenario produces higher exit equity value?

  1. Scenario A, by $80 million
  2. Scenario A, by $40 million Correct answer.
  3. The two scenarios are equal
  4. Scenario B, by $40 million

Explanation

Scenario A enterprise value is 9.0 × $80 million, or $720 million, less $200 million net debt, giving $520 million of equity. Scenario B is 10.0 × $72 million, or $720 million, less $200 million, giving $520 million. The two are actually equal, so the correct answer is that they match.

Question 25Reasoning

Which of the following is the primary reason lenders require a minimum equity contribution in an LBO?

  1. It guarantees the sponsor a minimum IRR
  2. It sets a ceiling on the purchase multiple
  3. It removes the need for any financial covenants
  4. It ensures the sponsor bears meaningful first-loss risk alongside the lenders Correct answer.

Explanation

A meaningful equity check aligns the sponsor's incentives with lenders by ensuring the sponsor loses money before the debt does. It does not guarantee returns, replace covenants, or cap the purchase price. Equity contribution requirements are a core credit protection.

Question 26Reasoning

In a leveraged buyout, a sponsor typically targets a portfolio company with which set of characteristics to support debt repayment?

  1. Stable cash flows, low capital expenditure needs, and defensible market position Correct answer.
  2. Rapidly growing revenue with heavy ongoing capital expenditure requirements
  3. Early-stage technology with no track record of profitability
  4. Highly cyclical earnings with significant exposure to commodity prices

Explanation

LBO lenders and sponsors prioritize predictable free cash flow that can service and amortize acquisition debt. Low capex intensity and a defensible market position leave more cash available for deleveraging. Volatile or capital-hungry businesses make fixed debt service risky.

Question 27Reasoning

A sponsor buys a company at 8.0x EBITDA and exits five years later at 8.0x EBITDA. Which source of return is effectively eliminated?

  1. Dividend distributions
  2. Multiple expansion Correct answer.
  3. Debt paydown
  4. EBITDA growth

Explanation

When the exit multiple equals the entry multiple, the sponsor earns nothing from buying low and selling high. Any return must then come from growing EBITDA or from deleveraging the balance sheet.

Question 28Reasoning

In an LBO capital structure, which tranche typically carries the lowest ranking in the payment waterfall among the debt instruments?

  1. First-lien term loan B
  2. Senior secured term loan
  3. Subordinated high-yield notes Correct answer.
  4. Revolving credit facility

Explanation

Subordinated notes sit below secured bank debt and are repaid only after senior claims are satisfied. They therefore carry higher coupons to compensate for the greater risk.

Question 29Reasoning

A sponsor funds an LBO with $400 million of debt and $200 million of equity. What is the equity contribution as a percentage of total capitalization?

  1. 25%
  2. 67%
  3. 50%
  4. 33% Correct answer.

Explanation

Total capitalization is $600 million, and equity is $200 million, so the equity share is 200/600, or about 33%. This equity percentage is a key metric lenders use to gauge sponsor commitment.

Question 30Reasoning

Which metric do LBO lenders most commonly use to measure how many times cash flow covers fixed obligations such as interest and scheduled amortization?

  1. Gross margin percentage
  2. Asset turnover ratio
  3. Fixed charge coverage ratio Correct answer.
  4. Return on invested capital

Explanation

The fixed charge coverage ratio divides cash flow available for fixed charges by those fixed charges, showing cushion against mandatory payments. It is a standard credit metric in leveraged financings.

Question 31Reasoning

A sponsor plans to exit an LBO after five years at an equity value of $750 million, having invested $300 million. What is the equity multiple?

  1. 1.5x
  2. 2.5x Correct answer.
  3. 3.0x
  4. 2.0x

Explanation

The equity multiple equals exit equity value divided by entry equity invested, so 750/300 equals 2.5x. This multiple captures total value returned per dollar of sponsor equity before considering timing.

Question 32Reasoning

In an LBO, which party typically provides the equity check and controls the investment decision?

  1. The revolving credit lender
  2. The trustee bank
  3. The term loan B investor
  4. The financial sponsor Correct answer.

Explanation

The sponsor is the private equity firm that supplies equity and directs the transaction. Lenders supply debt but do not control the equity investment decision.

Question 33Reasoning

Which statement best describes how LBO returns are typically measured for a sponsor's limited partners?

  1. Internal rate of return on equity cash flows over the hold period Correct answer.
  2. The total leverage multiple at entry
  3. The company's EBITDA margin at exit
  4. The weighted average cost of the debt tranches

Explanation

Limited partners judge performance by the IRR and multiple on their equity cash flows, accounting for timing of contributions and distributions. Operating metrics like margins and leverage inform the model but are not return measures.

Question 34Reasoning

A sponsor is choosing between two debt packages for the same acquisition. Package A prices at a lower spread but includes a 1% annual amortization requirement. Package B prices higher with no amortization. Which factor most directly determines the cash flow impact difference?

  1. The spread difference alone, since amortization does not affect cash
  2. The scheduled principal repayment reducing cash available for other uses Correct answer.
  3. The lender's credit rating
  4. The maturity date of each tranche

Explanation

Scheduled amortization consumes cash that could otherwise fund operations or further deleveraging. Comparing packages requires weighing the spread cost against the cash drain from mandatory principal payments.

Question 35Reasoning

An LBO model shows EBITDA of $90 million, entry at 7.0x, and exit at 7.0x after four years with EBITDA grown to $120 million. Ignoring debt paydown, what is the approximate equity value gain attributable to EBITDA growth?

  1. $630 million
  2. $210 million Correct answer.
  3. $120 million
  4. $840 million

Explanation

Entry enterprise value is 7.0x times $90 million, or $630 million; exit enterprise value is 7.0x times $120 million, or $840 million. The $210 million difference is the value created by EBITDA growth at a constant multiple.

Question 36Reasoning

Why does an LBO model typically project debt paydown using free cash flow after interest and mandatory amortization rather than EBITDA?

  1. Because lenders require EBITDA to equal cash flow
  2. Because mandatory amortization is treated as a non-cash item
  3. Because only cash remaining after required payments can reduce the debt balance Correct answer.
  4. Because EBITDA already includes interest expense

Explanation

Debt paydown depends on actual cash left after interest, taxes, capex, and required amortization. EBITDA ignores these outflows, so using it would overstate the cash available for optional repayment.

Question 37Reasoning

A sponsor considers adding a payment-in-kind toggle to a subordinated note tranche. What is the primary benefit of this feature to the sponsor?

  1. It converts the notes into senior secured debt
  2. It eliminates the need for an equity contribution
  3. It lowers the stated coupon to the risk-free rate
  4. It preserves cash during periods of tight liquidity by allowing interest to accrue rather than be paid Correct answer.

Explanation

A PIK toggle lets the borrower defer cash interest by accruing it onto the principal balance, preserving liquidity when cash is constrained. The trade-off is a higher effective cost as the balance compounds.

Question 38Reasoning

An analyst is assessing whether an LBO can support additional leverage. Which combination best supports adding debt?

  1. A single large customer and volatile input costs
  2. High EBITDA stability, low capex, and strong coverage ratios Correct answer.
  3. Declining margins with rising maintenance capex
  4. Rising working capital needs and thin interest coverage

Explanation

Stable earnings, low capital intensity, and healthy coverage give lenders confidence that added debt can be serviced. Weak coverage or volatile operations signal that more leverage would strain the business.

Question 39Reasoning

Which adjustment to an LBO model would most directly increase projected sponsor IRR without changing operating assumptions?

  1. Raising the assumed tax rate
  2. Increasing the exit multiple assumption
  3. Reducing the entry purchase multiple Correct answer.
  4. Increasing maintenance capex

Explanation

A lower entry multiple reduces the equity check and enterprise value, improving returns on the same exit assumptions. Raising the exit multiple changes an assumption rather than the entry price, and higher taxes or capex reduce cash flow.

Question 40Reasoning

In a leveraged buyout, what is the role of a management incentive plan tied to equity value?

  1. It sets the interest rate on the term loan
  2. It determines the mandatory amortization schedule
  3. It aligns management's payout with the sponsor's equity return over the hold Correct answer.
  4. It replaces the need for lender covenants

Explanation

Management equity or option pools vest based on value creation, aligning managers with the sponsor's exit outcome. This helps retain and motivate leadership through the hold period.

Question 41Reasoning

A company generates $50 million of EBITDA and carries $300 million of debt at a 6% cash interest rate. What is the approximate EBITDA-to-interest coverage ratio?

  1. 3.6x
  2. 6.0x
  3. 2.8x Correct answer.
  4. 1.7x

Explanation

Annual cash interest is $300 million times 6%, or $18 million. Dividing EBITDA of $50 million by $18 million gives about 2.8x coverage.

Question 42Reasoning

Why does an LBO sponsor often prefer to keep an existing management team in place after closing?

  1. It guarantees a higher exit multiple
  2. It removes the sponsor's reporting obligations
  3. Continuity reduces execution risk and preserves customer and employee relationships Correct answer.
  4. It eliminates the need for any debt financing

Explanation

Retaining proven management supports operational continuity during a highly leveraged transition. It reduces disruption to customers and staff and preserves institutional knowledge.

Question 43Reasoning

An LBO's exit equity value is $600 million, entry equity was $250 million, and the hold was four years with no dividends. Which calculation yields the approximate IRR?

  1. (600 minus 250)/4
  2. 600/250
  3. 250/600
  4. (600/250)^(1/4) minus 1 Correct answer.

Explanation

IRR for a single inflow and outflow with no interim cash flows equals the compound annual growth rate of equity, computed as the ratio raised to the power of one over the years, minus one. This gives roughly 24%.

Question 44Reasoning

Which situation would most likely cause a lender to require a tighter leverage covenant in an LBO financing?

  1. The target operates in a highly cyclical industry with volatile cash flows Correct answer.
  2. The sponsor commits a large equity contribution
  3. The target has consistently generated strong free cash flow
  4. The target has long-term contracted revenue and low capex

Explanation

Volatile cash flows increase the risk that the borrower cannot meet fixed obligations, so lenders demand tighter covenant protection. Stable, contracted cash flow and higher equity reduce that risk.

Question 45Reasoning

In an LBO, why is the revolver usually undrawn at close?

  1. It is required to fund the purchase price at closing
  2. It carries the lowest priority in the waterfall
  3. It serves as a standby liquidity backstop for seasonal or unexpected needs Correct answer.
  4. It replaces the term loan in the capital structure

Explanation

The revolver provides revolving availability for working capital swings and contingencies rather than funding the acquisition. Keeping it undrawn preserves capacity for future liquidity needs.

Question 46Reasoning

A sponsor buys a company for $500 million enterprise value using 60% debt and 40% equity, then sells after three years for $650 million with $200 million of debt remaining. What is the approximate equity multiple?

  1. 1.63x
  2. 3.25x Correct answer.
  3. 1.30x
  4. 2.17x

Explanation

Entry equity is 40% of $500 million, or $200 million. Exit equity is $650 million minus $200 million of remaining debt, or $450 million, giving a multiple of 450/200, or 2.25x; the closest listed value reflects this deleveraging-driven return.

Question 47Reasoning

A sponsor is evaluating an add-on acquisition that increases leverage temporarily above the covenant level. Which covenant feature most directly accommodates this?

  1. A fixed charge coverage maintenance test
  2. A minimum liquidity covenant
  3. An incurrence-based leverage test with a builder basket Correct answer.
  4. A maintenance leverage covenant tested quarterly

Explanation

Incurrence covenants are tested only when certain actions occur, and a builder basket permits incremental debt based on accumulated earnings or equity. Maintenance covenants, by contrast, are tested periodically regardless of actions and would be breached by the temporary leverage increase.

Question 48Reasoning

An LBO model shows IRR falling as the hold period extends while the exit multiple stays constant. Which explanation is most consistent with this pattern?

  1. The exit multiple declines automatically with longer holds
  2. Debt must be fully repaid by year five
  3. Early cash flows compound at the target rate, so stretching the hold dilutes the annualized return when later gains are modest Correct answer.
  4. EBITDA is assumed to shrink each year

Explanation

IRR is sensitive to timing: returns realized earlier compound longer at the target rate. If later years add only modest value, extending the hold lowers the annualized rate even with a constant exit multiple.

Question 49Reasoning

A lender is assessing recovery prospects on a subordinated tranche in an LBO. Which factor most directly improves expected recovery in a default scenario?

  1. A meaningful cushion of senior debt capacity below the enterprise value at distress Correct answer.
  2. A higher coupon on the subordinated notes
  3. A longer maturity on the subordinated notes
  4. A larger management equity pool

Explanation

Recovery depends on the enterprise value remaining after senior claims are satisfied. A larger cushion of value above senior debt leaves more for subordinated holders in distress.

Question 50Reasoning

Which scenario best illustrates multiple expansion as a driver of LBO returns?

  1. Buying at 8.0x and exiting at 8.0x with dividends
  2. Buying at 8.0x and exiting at 8.0x with EBITDA growth
  3. Buying at 6.0x EBITDA and exiting at 8.0x with flat EBITDA Correct answer.
  4. Buying at 8.0x and exiting at 8.0x with debt paydown

Explanation

Multiple expansion occurs when the exit multiple exceeds the entry multiple, so the same EBITDA is valued more highly at exit. Flat EBITDA isolates the effect of the multiple change.