Module 6: Course 3 Capstone: Complete LBO & Debt Model for Precision Valve & Actuator

Worked teaching capstone. The graded student packet withholds the complete solution.

Learning objectives and prerequisites

By the end of this lesson, you should be able to audit an entire leveraged acquisition. Prerequisite knowledge: All preceding modules. Work from assumptions to equations, explain the acquisition consequence, and record the evidence needed to rely on the answer.

The acquisition committee's question

Precision Valve & Actuator services and distributes industrial flow-control equipment. Its seller offers the operating business for $5 million, including normal operating working capital and excluding cash, financial debt, and real estate. Your investment committee wants a complete answer to a deceptively simple question: can the company finance that purchase, withstand disappointing sales, and deliver an acceptable return without relying on ineligible terms?

The assignment requires a sources-and-uses schedule, a monthly senior debt model, a seller-note schedule, operating cash generation, coverage tests, retained-cash roll-forwards, and an exit equity waterfall. The model should support a decision, not simply produce an attractive IRR. A finding that the price is reasonable does not establish that every proposed financing term is executable.

All amounts are actual US dollars. Precision is fictional, and this packet controls the capstone. The prospective model uses simplified taxes, a constant-rate base case, and specified operating assumptions. Current program references are dated November 5, 2026. The policy analysis follows the current SOP identified in Module 2; a real lender must verify eligibility, documentation, and applicable effective-date provisions.

Historical earnings and the purchase perimeter

Assume accepted normalized historical EBITDA of $1.3 million, $1.35 million, and $1.4 million over the last three fiscal years. Latest annual revenue is $8 million. The supplied latest-year operating structure has variable costs equal to 55% of sales and fixed recurring operating expense of $2.2 million, producing $1.4 million EBITDA.

The fixed-cost base includes replacement management, market rent, ordinary repairs, and required insurance premiums. There are no additional personal truck, travel, or owner compensation claims to add back. The accepted earnings are already normalized; adding those categories again would invent a second benefit. Financial diligence and lender review remain approval conditions, not tasks the textbook can certify for an actual borrower.

Normal NWC is included in the purchase price. The seller delivers the agreed amount with no closing true-up in the base case. Any historical seller debt is settled by the seller outside this buyer funding schedule. No target cash is acquired, and no real estate value or rental income supports the debt model.

Assume an independent valuation supports the $5 million operating price, subject to the lender accepting its scope and supporting information. Because this is a $5 million Initial Acquisition, the current appendix's valuation and QoE requirements cannot be avoided by dividing the consideration into cash and a seller note.

Reconstruct the funding plan

Professional legal and accounting transaction costs are $100,000. Financial diligence and valuation cost $50,000. The case's calculated upfront SBA guaranty fee is $110,000, and other itemized, lender-reviewed closing costs are $40,000. Initial unrestricted cash is $200,000. A separate $100,000 incremental NWC investment is made at closing above the normal delivered balance.

Uses	Amount	Sources	Amount
Seller operating consideration	$5,000,000	Senior acquisition debt	$4,000,000
Legal and accounting transaction work	$100,000	Seller full-standby note	$400,000
QoE, valuation, and diligence	$50,000	Sponsor cash equity	$1,200,000
Upfront guaranty fee	$110,000
Other reviewed closing costs	$40,000
Opening unrestricted cash	$200,000
Incremental closing NWC	$100,000
Total	$5,600,000	Total	$5,600,000

Seller cash proceeds are $4.6 million, plus the $400,000 note. Cash sources of $5.2 million match seller cash of $4.6 million and other uses of $600,000. Your workbook must pass both economic funding and cash-only checks. The note is deferred consideration, not cash received by the company.

Assume the lender accepts the stated $5.6 million project-cost denominator. Minimum Initial Acquisition injection at 10% is $560,000. Sponsor cash of $1.2 million meets it without claiming seller-note injection credit. The note remains economic debt, and no rollover ownership or earnout is part of the base structure.

Financing terms and policy gates

The senior loan is $4 million with 120 monthly payments, a ten-year maturity, and no balloon. Opening rate is an illustrative Prime 7.25% plus 2.75%, totaling 10%. Base Prime remains unchanged over the modeled hold. Do not describe this as a guaranteed fixed-rate commitment: the loan is variable and the flat path is an explicit scenario.

Assume a standard 75% guaranty, no relevant fee exception, and the FY 2027 approval period. The guaranteed balance is $3 million, giving a $110,000 upfront fee under the applicable brackets. The lender's annual service fee is not passed through as another borrower cash expense. The FY 2027 notice supplies the fee context.

The $400,000 seller note is non-interest-bearing, subordinated, and on full standby while the senior obligation remains outstanding under the agreed terms. There are no current seller payments and no accrued PIK. At the stipulated Year 5 sale, senior debt is extinguished first; seller repayment follows only through the documented permitted release and closing mechanics.

The case assumes no interim sponsor distributions. All residual operating cash stays in the company, consistent with a conservative treatment of injection-related distribution restrictions and the stipulated loan documents. Required guarantees, collateral, insurance assignment, eligibility, and acceptable QoE remain explicit closing gates under the current SOP.

Build the monthly debt schedule

Use nominal monthly interest of 10% / 12. The payment formula produces $52,860.2947527 each month before display rounding. Calculate interest from opening monthly debt, principal as payment minus interest, and ending debt as opening debt minus principal. Begin the next month from that ending balance.

Month 1 interest is $33,333.33, principal is $19,526.96, and ending debt is $3,980,473.04. Month 12 ends at $3,754,632.64. At month 60, principal is $2,487,889.28. The principal schedule must continue to month 120 to verify full amortization even though the investment exits after five years.

Monthly payment = 4,000,000 × (0.10/12)
                  / [1 − (1 + 0.10/12)^(-120)]
Annual service = sum of 12 monthly payments
Cumulative principal through Month 60 = 1,512,110.72
Month 60 remaining principal = 2,487,889.28
Original principal reconciliation = 4,000,000.00

Do not estimate remaining debt as half the original balance merely because half the term elapsed. Interest consumes a larger part of early payments. An error in Year 5 debt flows directly into equity proceeds and can materially overstate returns.

Operating forecast and cash taxes

Year 1 revenue is $8 million and EBITDA $1.4 million. For Years 2–5, revenue and EBITDA grow 3% annually. For this simplified base projection, variable costs remain 55% of revenue and fixed operating costs also grow 3%, preserving the initial EBITDA margin. Existing spare capacity is assumed sufficient; the investment memo must identify the evidence needed to support that assumption.

D&A is $200,000 annually. Maintenance CapEx is $200,000 annually, with no additional growth CapEx assumed. Additional annual cash NWC investment is $50,000. This is separate from the $100,000 funded at closing. The flat annual amounts are packet assumptions rather than a claim that every growing distributor's reinvestment stays constant indefinitely.

Prospective cash taxes equal 25% of positive EBITDA minus D&A minus current senior cash interest. There are no immediate refunds for tax losses, no interest-deduction limitations, and no tax benefit assumed for closing fees. These simplifications must be reconsidered in a transaction-specific model.

Year 1 pretax income is $1.4 million − $200,000 − $388,956.17 = $811,043.83. Taxes are $202,760.96. Buyer CFADS is EBITDA less cash taxes, maintenance CapEx, and annual NWC investment, or $947,239.04. Deduct senior service of $634,323.54 to obtain retained cash of $312,915.51.

Aggregate five years without losing the monthly mechanics

The annual debt and operating summaries must link to the monthly schedule and operating inputs, not be independently typed forecasts. Declining interest increases cash taxes over time, all else equal, so growing EBITDA does not translate dollar for dollar into retained cash.

Year	Senior interest	Senior principal	Total service	Ending senior debt
1	$388,956.17	$245,367.36	$634,323.54	$3,754,632.64
2	$363,263.00	$271,060.53	$634,323.54	$3,483,572.10
3	$334,879.42	$299,444.11	$634,323.54	$3,184,127.99
4	$303,523.71	$330,799.82	$634,323.54	$2,853,328.17
5	$268,884.65	$365,438.89	$634,323.54	$2,487,889.28

Year	EBITDA	Cash taxes	CFADS	Cash retained in year	Ending cash	CFADS DSCR
1	$1,400,000.00	$202,760.96	$947,239.04	$312,915.51	$512,915.51	1.4933x
2	$1,442,000.00	$219,684.25	$972,315.75	$337,992.21	$850,907.72	1.5328x
3	$1,485,260.00	$237,595.14	$997,664.86	$363,341.32	$1,214,249.04	1.5728x
4	$1,529,817.80	$256,573.52	$1,023,244.28	$388,920.74	$1,603,169.78	1.6131x
5	$1,575,712.33	$276,706.92	$1,049,005.41	$414,681.88	$2,017,851.66	1.6537x

Ending cash equals opening cash plus retained cash because the case assumes no distributions, revolver draws, discretionary sweeps, or other cash flows. Year 1 ends with $512,915.51 and Year 5 with $2,017,851.66. The company still owes the $400,000 seller note separately.

This retained-cash policy is deliberately conservative about distribution permission but optimistic in assuming no additional unmodeled operating needs. A real business may reinvest more, face seasonal troughs, or hold restricted cash. The exit assumes all retained cash can be released because a replacement buyer funds required operating liquidity separately; if the sale terms require cash to remain, reduce distributable proceeds accordingly.

Coverage: eligibility, covenant, and survival

Use latest accepted historical EBITDA of $1.4 million against combined post-transaction current service of $634,323.54. The EBITDA-based ratio is approximately 2.2071x, above the stated 1.25x Initial Acquisition floor on the assumed accepted basis. That calculation does not substitute forecast growth for required historical evidence.

The stipulated loan additionally requires buyer-CFADS coverage of at least 1.25x. Year 1 CFADS DSCR is 1.4933x and rises through the base hold. The base therefore passes both defined tests. If a lender uses a different adjusted cash-flow definition, the final credit model needs another explicit reconciliation rather than a change of labels.

Cash survival is a third question. Minimum unrestricted operating cash is $200,000 in this case. Annual retention exceeds that starting reserve, but monthly collections and payments must still be examined. A business can finish the year with growing cash after having breached its minimum during a large inventory purchase.

Revenue stress and exact covenant breakpoints

Stress Year 1 revenue by −10%, −20%, and −30%. Variable costs remain 55% of revenue, fixed costs stay $2.2 million, and D&A, senior service, maintenance CapEx, and $50,000 NWC investment remain unchanged. Taxes retain their zero floor. This isolates operating leverage and financing burden; it is not a complete recession forecast.

Revenue decline	EBITDA	CFADS	CFADS DSCR	Cash after service
0%	$1,400,000.00	$947,239.04	1.4933x	$312,915.51
10%	$1,040,000.00	$677,239.04	1.0677x	$42,915.51
20%	$680,000.00	$407,239.04	0.6420x	$-227,084.49
30%	$320,000.00	$70,000.00	0.1104x	$-564,323.54

At −10%, annual cash after service stays positive but the 1.25x CFADS covenant fails. At −20%, annual operations consume $227,084.49 after service, exceeding the $200,000 opening reserve by $27,084.49 before any minimum-cash requirement. To preserve the full required $200,000 reserve, additional funding or changes of $227,084.49 would be necessary under this isolated annual case.

CFADS equals 1.25x service at revenue of approximately $7,542,712.23, a 5.7161% decline. It equals 1.15x at 8.0654% decline and 1.0x at 11.5895% decline. The EBITDA-based ratio reaches 1.25x only at 16.8638% decline. Show both, because confusing those calculations would misidentify the failed contractual or program-style test.

A higher rate and collection delay can worsen these results together. Resetting to 12% after the first twelve payments raises annualized remaining-term service to approximately $684,134.58. Recalculate actual interest and taxes for that reset scenario; do not merely change the denominator while pretending the interest shield remains identical.

Assume a sale at the end of Year 5 for 4.0x Year 5 EBITDA. EBITDA is $1,575,712.334, so EV is $6,302,849.34. Exit transaction costs equal 3% of EV, or $189,085.48. Normal NWC is delivered as part of EV and is not added again. Distributable cash is the retained balance stipulated above.

Exit waterfall	Amount
Enterprise sale value	$6,302,849.34
Exit transaction costs	($189,085.48)
Remaining senior principal	($2,487,889.28)
Seller-note payoff after senior extinguishment	($400,000.00)
Retained cash released under sale assumptions	+$2,017,851.66
Equity proceeds	$5,243,726.23

Sponsor equity invested is $1.2 million at time zero. There are no interim contributions or distributions in the base case. MOIC is $5,243,726.23 / $1.2 million = 4.3698x. Five-year annual IRR is 4.3698^(1/5) − 1, approximately 34.3049%. Actual dated flows should use XIRR rather than assuming exact annual intervals.

Entry EV/EBITDA is $5 million / $1.4 million, or approximately 3.5714x. Selling at 4.0x therefore assumes multiple expansion. Holding the exit multiple at the entry level produces equity proceeds around $4,588,680.11 and IRR 30.7679%. At 3.0x exit, proceeds fall to $3,715,285.27 and IRR 25.3609%, with all other case assumptions unchanged.

These sensitivities do not validate the base return. They reveal how operating cash retention, deleveraging, EBITDA growth, and pricing assumptions contribute. A distressed business can lose customers and value simultaneously, so an exit-multiple change alone is not a complete downside case.

Lender Red Flags & SOP Violations: adding retained cash after already distributing it.

Cash appears either as an interim receipt or as a balance retained for later use. Counting both overstates returns. Likewise, repay the seller note once and verify that senior payoff precedes release of its standby restrictions.

Submission and investment judgment

Submit a linked workbook, a policy-and-evidence register, and a four-page financing memorandum. The workbook must contain the full 120-month amortization, five-year operating and cash summaries, sources and uses, seller-note balance, both coverage measures, exact stress thresholds, and the exit waterfall.

The memorandum should recommend proceed conditionally, revise price or financing, or decline. Identify the thin revenue tolerance under the cash covenant, the evidence supporting fixed costs and spare capacity, restrictions on distributions and seller payments, required QoE and valuation, guarantees, insurance, and rate-reset risk. A high IRR alone is not an approval rationale.

Score funding accuracy at 15 points, debt and tax mechanics at 25, cash and coverage at 25, returns at 15, and evidence and decision quality at 20. Pass at 80/100 with no funding imbalance, hidden balloon, duplicated note or NWC payment, ineligible earnout, or undisclosed covenant breach. The course rewards an auditable decision even when the appropriate conclusion is not to buy.

Self-Study Problem Set

Problem 1: reconcile Year 1 cash from net income

Calculate net income, OCF, and cash after investment and principal using the packet's Year 1 values.