Paper LBO Walkthrough: Step-by-Step With a Fully Worked Example

A paper LBO is a leveraged buyout done with pen, paper, and round numbers — no laptop, no calculator. Interviewers use it to test whether you understand where LBO returns come from and whether you can hold a multi-step calculation together under mild pressure. It shows up in private equity interviews constantly and in banking interviews often enough that skipping it is a gamble.

The good news: every paper LBO follows the same five steps, and the numbers are always chosen to be clean. Learn the skeleton once, practice it a handful of times, and the exercise becomes almost mechanical. Below is the skeleton, then a fully worked example you can check line by line.

The five steps of every paper LBO

Whatever the specific prompt, you are always doing the same sequence. Say the steps out loud as you go — narrating is part of what is being graded.

1. 01Entry: compute purchase enterprise value (entry multiple times EBITDA), split it into debt and sponsor equity
2. 02Forecast: project EBITDA over the hold period using the growth assumption given
3. 03Cash flow: convert each year's EBITDA into free cash flow (subtract D&A to get taxable income after interest, apply taxes, add back D&A, subtract capex and any working capital change)
4. 04Debt paydown: apply cumulative free cash flow to reduce debt, giving net debt at exit
5. 05Exit and returns: exit multiple times exit EBITDA gives exit enterprise value; subtract remaining debt for exit equity; divide by entry equity for the multiple of money, then approximate the IRR

Standard simplifying assumptions

Paper LBOs run on simplifications, and stating them explicitly earns points. If the interviewer does not specify something, propose a clean assumption and confirm it.

• Interest is often computed on the opening debt balance and held constant, ignoring the benefit of paydown — say you are doing this
• D&A is frequently set equal to capex so they offset in cash flow
• Working capital changes are often assumed to be zero
• All free cash flow sweeps to debt paydown (no dividends, no cash building on the balance sheet)
• Taxes apply at a single round rate to pre-tax income
• Entry and exit multiples are often the same unless told otherwise — no multiple expansion

Worked example: the setup

Prompt: a sponsor buys a company with 100 million dollars of EBITDA at 5.0x, funding the deal with 60 percent debt. EBITDA grows by 10 million dollars per year. D&A is 20 million per year and equals capex. Interest is 10 percent on the opening debt balance, held constant. The tax rate is 40 percent, working capital is flat, and all free cash flow pays down debt. The sponsor exits after 5 years at the same 5.0x multiple. What are the multiple of money and approximate IRR?

Entry math: purchase enterprise value is 5.0 times 100, or 500 million. Debt is 60 percent of 500, so 300 million; sponsor equity is the remaining 200 million. Annual interest is 10 percent of 300, or 30 million per year under our constant-interest simplification.

Worked example: free cash flow year by year

EBITDA starts at 100 and grows 10 per year, so years 1 through 5 are 110, 120, 130, 140, and 150. For each year: pre-tax income equals EBITDA minus D&A (20) minus interest (30); apply the 40 percent tax; then free cash flow equals net income plus D&A minus capex — and since D&A equals capex, free cash flow simply equals net income here.

Cumulative free cash flow over the five years: 36 plus 42 plus 48 plus 54 plus 60 equals 240 million.

• Year 1: EBITDA 110, pre-tax income 110 - 20 - 30 = 60, taxes 24, net income 36, free cash flow 36
• Year 2: EBITDA 120, pre-tax income 70, taxes 28, net income 42, free cash flow 42
• Year 3: EBITDA 130, pre-tax income 80, taxes 32, net income 48, free cash flow 48
• Year 4: EBITDA 140, pre-tax income 90, taxes 36, net income 54, free cash flow 54
• Year 5: EBITDA 150, pre-tax income 100, taxes 40, net income 60, free cash flow 60

Worked example: exit and returns

Debt at exit is the opening 300 million minus 240 million of cumulative paydown, leaving 60 million. Exit enterprise value is 5.0 times year-5 EBITDA of 150, or 750 million. Exit equity value is 750 minus 60, which is 690 million.

The multiple of money is 690 divided by the 200 million of entry equity: 3.45x over five years. For the IRR, use the standard five-year anchors — 3.0x is roughly 25 percent and 4.0x is roughly 32 percent — so 3.45x lands at approximately 28 percent. That is exactly the level of precision expected; nobody wants you solving for the exact root in your head.

Close by attributing the return, because strong candidates do: the sponsor put in 200 and got back 690. EBITDA growth from 100 to 150 at a constant 5.0x multiple added 250 to enterprise value, debt paydown of 240 shifted that much value from lenders to equity, and there was no multiple expansion by assumption.

Where candidates lose points

The math above is deliberately easy. The exercise is failed on process, not arithmetic difficulty.

• Forgetting to subtract D&A before taxes and then add it back after — taxes must be computed on pre-tax income, not EBITDA
• Subtracting interest twice, or not at all, in the cash flow build
• Losing the running debt balance and subtracting the wrong figure at exit
• Quoting the return on total capital instead of on the sponsor's equity
• Working silently — narrate every step so the interviewer can follow and nudge you
• Panicking over the IRR conversion instead of using the memorized multiple-to-IRR anchors

How to practice

Do this exact example from a blank page until you can finish in under ten minutes, then vary one assumption at a time: change the tax rate to 25 percent, add a turn of multiple expansion, grow EBITDA at a percentage instead of a fixed amount. Each variation forces you to re-derive rather than recall.

Pair the full walkthroughs with short daily arithmetic reps — the drills and the Daily 10 keep the component skills sharp so the full exercise stays about structure, not multiplication.

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