Ability to pay analysis
LBOAn LBO solved backwards from a required return to give the highest price a financial sponsor could justify, which is a constraint rather than a valuation.
Also written: ability to pay, ability to pay floor, affordability analysis
An ability to pay analysis fixes the return and solves for the price. You assume the debt a lender will provide, the operating performance over the hold, the exit multiple and the money multiple or internal rate of return the sponsor needs, then work backwards to the highest entry value consistent with all of them. The answer is the ceiling for that buyer, which is why it usually appears on a valuation page as the lowest band.
It is a different kind of number from the others on that page. Comparables and precedents come from observed prices and a discounted cash flow comes from forecast cash flows, while this one comes from a required return. That means it moves with the debt market rather than with the business, and it will change materially between two dates on which nothing happened to the company.
Two mistakes are common. The first is circularity: setting the exit multiple equal to the entry multiple embeds the assumption that today's price is correct, so the output reflects leverage and growth and says nothing about value. Anchoring the exit to where the peer set trades is the more defensible choice, and it is the input worth defending out loud.
The second is treating it as a floor in every case. It is a floor only where the business supports real debt. For a cyclical business with volatile earnings, or one still burning cash, lenders provide little, the sponsor's maximum collapses toward what an all equity buyer would pay, and the band sits far below anything a strategic buyer would offer. Presenting that as a floor implies support that is not there.
Worked example
A target earns 120 of EBITDA and a sponsor expects 150 in five years, exiting at the peer multiple of 8.0x, so 1,200 of exit enterprise value.
With 540 of debt raised at entry and 150 repaid over the hold, 390 remains and exit equity is 810. At a 2.5 times money hurdle the sponsor can invest 324 today, supporting 864 of enterprise value, which is 7.2 times.
Open the debt market to 780 at entry, with 100 repaid, and exit equity falls to 520 while the affordable cheque falls to 208. Enterprise value rises to 988, or 8.2 times. The same business, the same return, and 124 more of price, supplied entirely by the lenders.