You work at a private equity firm that is considering a leveraged buyout of Skechers USA. Your team has gathered the following information.

Operating assumptions

In 2021 Skechers generated sales of $6.28 billion (see row 4 of the income statement). Under the management of your private equity group, Skechers sales is expected to grow at 5% for the next 5 years. Cost of sales and all operating expenses excluding depreciation expense are expected to be 88% of sales. In addition, capital expenditures are expected to be 4% of sales and depreciation is expected to be 2.5% of sales. Working capital changes are expected to be negligible.

LBO assumptions

You expect to buy Skechers at an EBITDA multiple of 5. After five years you plan to exit the investment either through a direct sale or via IPO. You want the LBO to have a debt-tocapitalization ratio of 75%. A banking syndicate has agreed to fund the leveraged buyout and has offered two possible financing deals

Option A: A 6% interest rate with a cash sweep covenant. Under the cash sweep covenant, all free cash flow to equity (FCFE) generated by Skechers must be used to pay down the loan principal for the first five years after the buyout. Under this arrangement, equity holders may not receive any dividends or other payouts for five years. Calculate the IRR generated by the LBO if Option A is selected assuming that the exit multiple is 6 times EBITDA. Use the worksheet titled LBO_CashSweep for your work.

Option B: A 9% interest rate with a 5% mandatory principal payment. Under this agreement, the firm must make debt repayments equal to 5% of loan principal. Any remaining FCFE remaining after debt repayment may be paid out to equity holders. If FCFE is lower than 5% of loan principal, the loan repayment must be equal to FCFE (i.e., no cash payments to equity holders) Calculate the IRR generated by the LBO if Option B is selected assuming that the exit multiple is 6 times EBITDA. Use the worksheet titled LBO_NoSweep for your work.