In an LBO, how is the target purchase price determined, and why is it called a floor valuation?

In an LBO, how is the target purchase price determined, and why is it called a floor valuation?

• A. By using a fixed EBITDA multiple derived from comps; this approach sets the floor
• B. By setting a targeted IRR and back-solving to determine the purchase price; floor valuation because PE firms want to pay the least
• C. By projecting cash flows and selecting the lowest exit multiple
• D. By aligning with a strategic acquirer’s offer

Answer: (B)

The main idea is that the purchase price in an LBO is set by the sponsor’s required return, not by a market price. You build a model of the target’s cash flows, financing with debt and equity, and an assumed exit at a chosen multiple. Then you back-solve for the entry price that makes the equity investors’ internal rate of return hit the target IRR. That entry price is called a floor valuation because it’s the minimum price at which the deal can still meet the sponsor’s hurdle return given the financing structure and the exit assumptions; paying more would push returns below the target, while paying less would push them above the target. This approach reflects how leverage and financing terms make IRR highly sensitive to the purchase price, so the floor price sets the least amount you’d effectively be willing to pay to achieve the desired return.

The main idea is that the purchase price in an LBO is set by the sponsor’s required return, not by a market price. You build a model of the target’s cash flows, financing with debt and equity, and an assumed exit at a chosen multiple. Then you back-solve for the entry price that makes the equity investors’ internal rate of return hit the target IRR. That entry price is called a floor valuation because it’s the minimum price at which the deal can still meet the sponsor’s hurdle return given the financing structure and the exit assumptions; paying more would push returns below the target, while paying less would push them above the target. This approach reflects how leverage and financing terms make IRR highly sensitive to the purchase price, so the floor price sets the least amount you’d effectively be willing to pay to achieve the desired return.