Debt cannot fall below zero in a basic paper LBO. Once available cash exceeds repayable debt, cap repayment at the outstanding balance and state what happens to the remainder. Do not let a negative debt balance hide an unmodeled cash distribution.
Use a capped cash waterfall
Fictional final-year starting point: debt of $30, cash of $5 and $50 of cash generated after interest, taxes, capital expenditure and operating working-capital needs. The business must retain $10 of operating cash. Assume all debt can be repaid without a fee, there are no required distributions and all cash is available within the same entity.
| Calculation | Amount |
|---|---|
| Starting cash plus cash generated | 5 + 50 = 55 |
| Cash above the $10 operating minimum | 45 |
| Repayment: smaller of $45 and $30 debt | 30 |
| Ending debt | 0 |
| Ending cash | 55 − 30 = 25 |
| Excess cash above operating minimum | 15 |
The result is zero debt and $25 cash, including the required $10 operating balance. It is not negative $15 debt and $25 cash.
Translate enterprise value to equity carefully
Suppose exit enterprise value is $200 and the valuation convention assumes the $10 operating cash stays with the operating business. Equity value is 200 − 0 + 15 = 215, before fees or other claims. If the case instead defines enterprise value as excluding all cash, the bridge may add all $25. State the convention; do not mix them.
If entry equity was $100 and there were no earlier distributions, the first convention produces 2.15× MOIC. Over a five-year hold, that is approximately 16.5% IRR. If the $15 was distributed earlier, it cannot also remain in exit cash. Timing then matters for IRR even if aggregate proceeds are unchanged.
Identify the missing real-world constraints
Actual debt may have prepayment restrictions, minimum liquidity requirements, multiple tranches, restricted cash or limits on moving cash between entities. A paper exercise often omits those details. Mention the assumptions rather than pretending a simple minimum formula models the financing documents.
This is a cash-allocation example, not a valuation recommendation. The SEC’s cash-flow guide provides the accounting distinction between financing repayments and operating cash generation.
A quick interview check
Ask: “Where did every dollar go?” Ending cash plus repayment must equal starting cash plus generated cash, absent other uses. Then ask whether any cash is counted both as a distribution and at exit.
Use the paper LBO framework for the full build and the PE case-study preparation guide for timed practice. Next, test whether a sensitivity changes the investment recommendation, rather than simply reporting a return table.