Walk me through an LBO model.

In an LBO or M&A deal, the acquiror is often allowed to write up the PP&E and / or intangible assets to fair market value. Fair market value represents what the assets would be worth if they were sold in the open market, and this value is often greater than the book value of the PP&E or intangible assets. That’s because the book value doesn’t account for factors like rising property prices or an increase in the value of the company’s brand or other intangible assets.

When the assets are written up, this also increases the depreciation and amortization, which lowers pre-tax income and lower taxes on the income statement.

However, the government will not recognize this asset write-up as they naturally do not want to incentivize asset write-ups to decrease taxes. A deferred tax liability is created on the balance sheet representing the total tax savings over the lifetime of the asset, and this deferred tax liability amortizes over the lifetime of the asset write-up. Meanwhile, the change in deferred tax liability reduces operating cash flows and represents the additional tax paid to the government.

In the end, an asset write-up has no impact on cash flows or IRR, but increases the value of the assets on the balance sheet which can be useful for improving borrowing terms as lenders will use the asset values as a basis for their collateral.