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280 Cards in this Set
- Front
- Back
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Walk me through the 3 financial statements. |
The three major financial statements are the IS, BS, and CFS The IS gives the company's revenues and expenses and goes down to the net income The BS shows the company's assets (its resources) as well as its liabilities and shareholder's equity The CFS begins with net income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end you see the company's net change in cash |
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Can you give examples of major line items on each of the financial statements? |
IS: revenue, COGS, SG&A, Operating income, Interest expense, Pretax income, Taxes, Net Income BS: Cash, AR, Inventory, Prepaid exp, PP&E, AP, Accrued Expenses, Debt, Retained earnings, contributed capital CFS: Net income, D&A, Changes in operating current assets and current liabilities; Capex; Issuance/Repurchase Debt/Equity, Dividends |
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How do the three statements link together? |
Net Income from IS flows into RE in SE on the BS and is the top line on the cash flow statements Depreciation, Amortization, and Interest expense are calculated based on corresponding balance on BS; Beg. year cash on CFS comes from BS and flow through three ending year cash on CFS is ending year cash on BS Changes in operating WC on BS appear as WC changes on cash flow changes in PP&E, Debt and shareholders equity on BS show up in investment and financing activities on CFS |
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If I were stranded on a desert island, only had 1 statement and I wanted to reviewthe overall health of a company – which statement would I use and why? |
Cash flow Statement because it gives a true picture of how much cash the company is actually generating; when assessing the financial health of a company the #1 thing you care about is cash flow |
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Let’s say I could only look at 2 statements to assess a company’s prospects – which 2would I use and why? |
The IS and beginning and ending year BS; from these two you can create the cash flow statement |
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Walk me through how Depreciation going up by $10 would affect the statements. |
IS: Pretax income down $10; assuming 40% tax rate NI down $6 CFS: NI down $6, Add back $10 of dep. so total change in cash is $4 (no other changes on CFS) BS: Cash up $4, PP&E down $10; Net income flows into RE on SE Down $6 |
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If Depreciation is a non-cash expense, why does it affect the cash balance? |
Even though Depreciation is a non-cash expense it is a tax-deductible expense and lowers the amount of cash taxes a company has to pay |
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Where does Depreciation usually show up on the Income Statement? |
COGS or operating expenses |
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What happens when Accrued Compensation goes up by $10? |
IS: operating and pre-tax income down $10; assuming 40% tax rate NI down $6 CFS: NI down $6; accrued compensation is a CL and when CL increase that is a course of cash so you would increase $10 due to increase in AC; total net change in cash is $4 BS: Cash up $4, AC up $10, NI down $6 |
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What happens when Inventory goes up by $10, assuming you pay for it with cash? |
IS: No change CFS: Inventory is CA and when CA increase it is a use of cash so total change in cash is down $10 BS: Cash down $10, inventory up $10 |
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Why is the Income Statement not affected by changes in Inventory? |
Inventory expense is only recorded on the income statement when the inventory is sold and it turns into COGS (matching principle) |
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Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all3 statements affected at the start of “Year 1,” before anything else happens? |
IS: no change CFS: Investing activities down $100 due to capex; financing activities up $100 due to debt issuance; $0 total change in cash BS: PP&E up $100; Debt up $100 |
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Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so noprincipal is paid off, and assume an interest rate of 10%. Also assume the factoriesdepreciate at a rate of 10% per year. What happens? |
IS: $10 of depreciation expense and $10 of interest expense lowers pre-tax income by $20; assuming 40% tax rate net income is down $12 CFS: NI down $12; add back depreciation $10 total change in cash is down $2 BS: Cash down $2, PP&E down $10; NI into retained earnings is down $12 |
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At the start of Year 3, the factories all break down and the value of the equipmentis written down to $0. The loan must also be paid back now. Walk me through the 3statements. |
After two years, the book value of factories is at $80 IS: Impairment expense of $80 decreases pretax income by $80; assuming 40% tax rate Net income is down $48 CFS: NI down $48 add back impairment expense so total change in cash from operating activities is up $32; pay back debt so cash flow from financing down $100; total change in cash is down $68 BS: Cash down $68, PP&E down $80, Debt down $100, NI down $48 |
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Now let’s look at a different scenario and assume Apple is ordering $10 ofadditional iPod inventory, using cash on hand. They order the inventory, but theyhave not manufactured or sold anything yet – what happens to the 3 statements? |
IS: No change CFS: Inventory is up $10 so CFO decreases by $10; total change in cash is down $10 BS: Cash down $10, Inventory up $10 |
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Now let’s say they sell the iPods for revenue of $20, at a cost of $10. Walk methrough the 3 statements under this scenario. |
Assuming that one ipod is sold IS: Operating income is up $10; assuming 40% tax rate Net income is up $6 CFS: NI up $6, Inventory down $10 so total change in cash is up $16 BS: Cash up $16, Inventory down $10, Net income up $6 |
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Could you ever end up with negative shareholders’ equity? What does it mean? |
Yes, company has consistent history of negative net income which creates a large negative RE balance; Dividend recap is another example |
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What is working capital? How is it used? |
the capital of a business that is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities; used as a financial metric to determine if company is financially sound or not; Bankers care more about changes in operating working capital because it tells you how much cash a company is generating |
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What does negative Working Capital mean? Is that a bad sign? |
Not necessarily, it depends on the type of company 1. Some companies with subscription business model will have negative WC due to high Deferred Revenue Balances 2. Retail and restaurant companies customers pay upfront and could have negative WC; use cash to pay down AP sign of business efficiency 3. In other cases, negative WC could point to financial trouble or possible bankruptcy |
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Recently, banks have been writing down their assets and taking huge quarterlylosses. Walk me through what happens on the 3 statements when there’s a writedownof $100. |
IS: Write down lowers pre-tax income by $100; assuming 40% tax rate NI down $60 CFS: NI down $60; add back impairment; change in cash is up $40 BS: Cash up $40, PP&E down $100, RE in SE is down $60 |
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Walk me through a $100 “bailout” of a company and how it affects the 3statements. |
IS: No Change CFS: Cash flow from financing up $100 BS: Cash up $100, Debt or Equity up $100 |
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Walk me through a $100 write-down of debt – as in OWED debt, a liability – on acompany’s balance sheet and how it affects the 3 statements. |
IS: non-cash gain of $100; assuming 40% tax rate NI up $60 CFS: NI up $60, subtract out $100; total change in cash is down $40 BS: Cash down $40, Debt down $100, NI up $60 |
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When would a company collect cash from a customer and not record it as revenue? |
1. SaaS Software 2. Cell phone contract 3. Magazine subscription |
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If cash collected is not recorded as revenue, what happens to it? |
Turns into Deferred Revenue |
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What’s the difference between accounts receivable and deferred revenue? |
AR - earned revenue but not yet received cash Deferred revenue - received cash but have not earned revenue |
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How long does it usually take for a company to collect its accounts receivablebalance? |
varies on a company by company basis; rule of thumb would be lower-priced transactions it would be lower than for higher-end items |
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What’s the difference between cash-based and accrual accounting? |
Cash based accounting- record revenue when cash is received and incur expenses when cash is paid out Accrual - record revenue when earned and is reasonably assured you will receive payment; recognize expenses when incurred regardless of when you pay cash |
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Let’s say a customer pays for a TV with a credit card. What would this look likeunder cash-based vs. accrual accounting? |
Cash basis - revenue would not show up until company gets cash from customer's credit card company Accrual - show up as revenue right away but instead of being in cash balance on BS it would be in the AR first then once cash is received it would go to cash |
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How do you decide when to capitalize rather than expense a purchase? |
If the purchase corresponds to an Asset with a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years. |
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Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings? |
Some argue that IS under GAAP do not reflect how profitable companies truly are because many companies have non-cash charges such as Amortization, Stock-Based compensation expense; by excluding these expenses they say this better reflects a company's true profitability |
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A company has had positive EBITDA for the past 10 years, but it recently wentbankrupt. How could this happen? |
1. High debt load and cannot pay interest expenses 2. Company is spending too much on Capex 3. Company does not have cash to meet its working capital requirements 4. Debt all matures at one time and company is unable to refinance it |
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Normally Goodwill remains constant on the Balance Sheet – why would it beimpaired and what does Goodwill Impairment mean? |
Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets and finds they are worth significantly less than they originally thought. This is a sign that the buyer overpaid for the seller. Treated the same as depreciation expense, non-cash charge that lowers net income |
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Under what circumstances would Goodwill increase? |
Company acquired another company and pays more than the book value of its net assets written up to fair market value; goodwill acts as the plug |
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Why do we look at both Enterprise Value and Equity Value? |
Enterprise value represents value of the company available to all providers of capital; Equity value only represents portion available to shareholders (equity investors) |
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When looking at an acquisition of a company, do you pay more attention toEnterprise or Equity Value? |
Enterprise value; this amount represents how much the acquirer really pays to acquire another company |
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What’s the formula for Enterprise Value? |
EV = Market value of equity + Debt + preferred stock + minority interest - cash |
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Why do you need to add Minority Interest to Enterprise Value? |
When a company owns 50% of another company it is required to report the financial performance of the other company as a part of its own performance and reports 100% of the majority-owned subsidiary's financial performance. You must add minority interest to the enterprise value so numerator and denominator both reflect 100% of the majority-owned subsidiary |
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How do you calculate fully diluted shares? |
Take basic share count and add in dilutive effect of stock options and any another dilutive securities such as warrants, convertible debt etc. Treasury stock method |
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Let’s say a company has 100 shares outstanding, at a share price of $10 each. It alsohas 10 options outstanding at an exercise price of $5 each – what is its fully dilutedequity value? |
basic equity value is $1,000. to calculate the dilutive effects of options you look to see if they are in the money and in this case they are; there will be 10 new shares created and the firm receives proceeds of $50 that it uses to repurchase some of the shares (5) so total share count is 105 *10 = $1050 |
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Let’s say a company has 100 shares outstanding, at a share price of $10 each. It alsohas 10 options outstanding at an exercise price of $15 each – what is its fully dilutedequity value? |
$1000, options are not in the money |
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Why do you subtract cash in the formula for Enterprise Value? Is that alwaysaccurate? |
Cash is considered a non-operating asset and because equity value implicitly accounts for it. The way I think about it is in the event of an acquisition, the buyer would "get" the cash of the seller and could use the cash to pay down debt |
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Is it always accurate to add Debt to Equity Value when calculating Enterprise Value? |
Most cases yes, because terms of debt agreement usually say that debt must be refinanced in an acquisition |
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Could a company have a negative Enterprise Value? What would that mean? |
Company with extremely large cash balance (banks) company on verge of bankruptcy with low market cap |
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Could a company have a negative Equity Value? What would that mean? |
No. You cannot have negative share count and you cannot have a negative share price. |
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Why do we add Preferred Stock to get to Enterprise Value? |
Preferred Stock pays out a fixed dividend, and preferred stock holders also have ahigher claim to a company’s assets than equity investors do. As a result, it is seen asmore similar to debt than common stock. |
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How do you account for convertible bonds in the Enterprise Value formula? |
If convertible bonds are in the money, you count them as additional dilution to the equity value; if not they you use the face value as a part of a company's debt |
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A company has 1 million shares outstanding at a value of $100 per share. It alsohas $10 million of convertible bonds, with par value of $1,000 and a conversion priceof $50. How do I calculate diluted shares outstanding? |
10,000 bonds; each bond converts into 20 shares of stock; 200,000 additional stock share so total diluted shares outstanding is 1,200,000 |
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What’s the difference between Equity Value and Shareholders’ Equity? |
Equity value is market value (can never be negative) Shareholder's equity is book value |
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What are the 3 major valuation methodologies? |
1. Comparable Companies 2. Precedent Transaction 3. DCF |
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Rank the 3 valuation methodologies from highest to lowest expected value. |
In general, precedent transactions will be higher than comparable companies due to control premium built into acquisitions; DCF could go either way and it more variable than other methodologies; heavily dependent on assumptions you make |
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When would you not use a DCF in a Valuation? |
Negative, Unpredictable or unstable cash flows; FIG |
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What other Valuation methodologies are there? |
LBO analysis sum of parts M&A premiums future share price analysis replacement value liquidation value |
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When would you use a Liquidation Valuation? |
Company is on the verge of bankruptcy |
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When would you use Sum of the Parts? |
Company is a conglomerate and has completely different, unrelated divisions |
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When do you use an LBO Analysis as part of your Valuation? |
Looking at a leveraged buyout scenario; floor valuation |
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What are the most common multiples used in Valuation? |
EV/EBITDA, EBIT, Revenue, P/E P/BV |
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When you’re looking at an industry-specific multiple like EV / Scientists or EV /Subscribers, why do you use Enterprise Value rather than Equity Value? |
You use EV because you assume those scientists are "available" to all investors both debt and equity in a company. |
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Would an LBO or DCF give a higher valuation? |
Most cases an LBO would give you a lower valuation; floor valuation |
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How would you present these Valuation methodologies to a company or itsinvestors? |
Usually you use a “football field” chart where you show the valuation range implied byeach methodology. You always show a range rather than one specific number. |
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How would you value an apple tree? |
Comparable apple trees are worth; cash flows from apple tree |
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Why can’t you use Equity Value / EBITDA as a multiple rather than EnterpriseValue / EBITDA? |
EBITDA is available to all investors in the company – rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. |
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What would you use in conjunction with Free Cash Flow multiples – Equity Valueor Enterprise Value? |
LFCF - Equity Value UFCF - Enterprise Value |
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How do you select Comparable Companies / Precedent Transactions? |
1. Industry Classification 2. Financial Profile (Size, Revenue, EBITDA, etc) 3. Geography For Precedent Transactions, you often limit the set based on date and only look attransactions within the past 1-2 years. |
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What do you actually use a valuation for? |
Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation. It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that “proves” the value their client is paying or receiving is “fair” from a financial point of view. |
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Why would a company with similar growth and profitability to its ComparableCompanies be valued at a premium? |
1. Market Leader 2. Recently beat earnings 3. Positive news about company recently released 4. Competitive advantage not reflected in financials |
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What are the flaws with public company comparables? |
No company is 100% comparable to another company The stock market is subject to investment sentiment and emotions Share prices for small companies with thinly-traded stocks may not reflect theirfull value. |
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How do you take into account a company’s competitive advantage in a valuation? |
1. Look at 75th percentile or higher for multiples rather than median 2. Add in a premium to some of the multiples |
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Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions? |
There’s no “rule” that you have to do this, but in most cases you do because you want touse values from the middle range of the set. But if the company you’re valuing isdistressed, is not performing well, or is at a competitive disadvantage, you might use the25th percentile or something in the lower range instead – and vice versa if it’s doing well. |
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What are some flaws with precedent transactions? |
Past transactions are rarely 100% comparable (structure, size of company, market sentiments at time of acquisition) |
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Two companies have the exact same financial profile and are bought by the sameacquirer, but the EBITDA multiple for one transaction is twice the multiple of theother transaction – how could this happen? |
1. different industries with different median multiples 2. one process was more competitive and had a lot more companies bidding on the target |
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Why does Warren Buffett prefer EBIT multiples to EBITDA multiples? |
EBITDA excludes often sizable Capex companies make and hides how much cash they are actually using to finance their operations; in some industries there is a large gap between EBIT and EBITDA |
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The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’sprofitability. What’s the difference between them, and when do you use each one? |
P/E is dependent on capital structure while EV/EBIT,EBITDA are independent of capital structure |
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If you were buying a vending machine business, would you pay a higher multiplefor a business where you owned the machines and they depreciated normally, or onein which you leased the machines? The cost of depreciation and lease are the samedollar amounts and everything else is held constant. |
Lease the machines; EV would be same for both companies but with depreciated situation the charge is not reflected in EBITDA so EBITDA is higher and multiple is lower as a result; leased situation the depreciation would show up as operating expense lowering EBITDA and increasing EBITDA multiple |
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How do you value a private company? |
You use the same methodologies as with public companies: public companycomparables, precedent transactions, and DCF. Add 10-15% liquidity discount |
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Let’s say we’re valuing a private company. Why might we discount the publiccompany comparable multiples but not the precedent transaction multiples? |
There’s no discount because with precedent transactions, you’re acquiring the entirecompany – and once it’s acquired, the shares immediately become illiquid. |
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Can you use private companies as part of your valuation? |
Only in the context of precedent transactions – it would make no sense to include themfor public company comparables or as part of the Cost of Equity / WACC calculation ina DCF because they are not public and therefore have no values for market cap or Beta. |
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Walk me through a DCF. |
1. Study the target company and determine key performance drivers that you can base projections on 2. Project company's free cash flow 5-10 years out 3. Determine company's terminal value (capture value of company outside of projection period) 4. Discount the 5 years of free cash flow and TV back to present value using the firm's WACC make necessary adjustments to get equity value |
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Walk me through how you get from Revenue to Free Cash Flow in the projections. |
Revenue - cogs - operating expenses = EBIT * (1-T) + D&A - Capex - changes in WC |
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What’s an alternate way to calculate Free Cash Flow aside from taking Net Income,adding back Depreciation, and subtracting Changes in Operating Assets / Liabilitiesand CapEx? |
Operating Cash flow - capex |
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Why do you use 5 or 10 years for DCF projections? |
That’s usually about as far as you can reasonably predict into the future. Less than 5years would be too short to be useful, and over 10 years is too difficult to predict formost companies. 5-10 sufficiently spans atleast one business/economic cycle |
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What do you usually use for the discount rate? |
WACC or Cost of Equity |
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How do you calculate WACC? |
Cost of Equity * (% Equity) + Cost of Debt * (1-T) * (% Debt) + Cost of preferred * (% Preferred) |
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How do you calculate the Cost of Equity? |
CAPM CoE = Risk-Free Rate + Beta * Market Risk Premium |
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How do you get to Beta in the Cost of Equity calculation? |
Median unlevered beta of industry peers; relever it based on target company's specific capital structure |
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Why do you have to un-lever and re-lever Beta? |
When you look up the Betas they will be levered to reflect thedebt already assumed by each company. But each company’s capital structure is different and we want to look at how “risky” acompany is regardless of what % debt or equity it has.To get that, we need to un-lever Beta each time.But at the end of the calculation, we need to re-lever it because we want the Beta used inthe Cost of Equity calculation to reflect the true risk of our company, taking intoaccount its capital structure this time. |
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Would you expect a manufacturing company or a technology company to have ahigher Beta? |
Technology Company |
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Let’s say that you use Levered Free Cash Flow rather than Unlevered Free CashFlow in your DCF – what is the effect? |
You will get equity value rather than enterprise value |
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If you use Levered Free Cash Flow, what should you use as the Discount Rate? |
Cost of Equity |
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How do you calculate the Terminal Value? |
Exit multiple method or Gordon Growth Method |
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Why would you use Gordon Growth rather than the Multiples Method to calculatethe Terminal Value? |
No good comparable companies; company is in cyclical industry and current multiples wouldnt be relevant 5-10 years down the road |
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How do you select the appropriate exit multiple when calculating Terminal Value? |
Look at comparable companies and pick median; use rage of exit multiples |
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What’s an appropriate growth rate to use when calculating the Terminal Value? |
GDP growth rate of country the company is in |
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Which method of calculating Terminal Value will give you a higher valuation? |
Hard to generalize because both are highly dependent on the assumptions you make. In general, multiples method will be more variable than gordon growth method because exit multiples tend to span a wider range than LTGR |
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What’s the flaw with basing terminal multiples on what public companycomparables are trading at? |
The median multiples may change greatly in the next 5-10 years so it may no longer beaccurate by the end of the period you’re looking at. This is why you normally look at awide range of multiples and do a sensitivity to see how the valuation changes over thatrange. |
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How do you know if your DCF is too dependent on future assumptions? |
If too much of the Enterprise value from calculated from DCF is based off of terminal value |
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Should Cost of Equity be higher for a $5 billion or $500 million market capcompany? |
$500 million market cap company - smaller companies are expected to outperform larger companies in the stock market - more risky |
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What about WACC – will it be higher for a $5 billion or $500 million company? |
Depends on capital structure of both companies; if the capital structure is the same then WACC would be higher for the $500M company. |
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What’s the relationship between debt and Cost of Equity? |
Increased leverage increases the cost of equity because it makes the company's levered beta increase |
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Cost of Equity tells us what kind of return an equity investor can expect forinvesting in a given company – but what about dividends? Shouldn’t we factordividend yield into the formula? |
Dividend yields are already factored into Beta, because Beta describesreturns in excess of the market as a whole – and those returns include dividends. |
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Two companies are exactly the same, but one has debt and one does not – whichone will have the higher WACC? |
The one without debt will have a higher WACC up to a certain point because debt is "less expensive" than equity Interest on debt is tax-deductible and debt is senior to equity on a company's capital structure ; interest rates on debt are usually lower than cost of equity numbers Once a company's debt balance is too high the interest rate on debt will rise dramatically to reflect risk company poses and risk of financial distress will outweigh the benefits of debt being cheaper than equity |
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What types of sensitivity analyses would we look at in a DCF? |
Growth Projections
Margin Projections Terminal Value Sensitivity Long term growth rate Discount rate |
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Walk me through a basic merger model. |
A merger model is used to analyze the financial profile of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer's EPS increases or decreases as a result of the acquisition 1. make assumptions about acquisition - purchase price and how it was financed (debt, equity, cash) 2. project out an income statement for buyer and seller and determine pro-forma shares outstanding of buyer and seller 3. combine income statements up to pre-tax income adjusting for interest income, interest expense, newly created intangibles, synergies and use buyers tax rate to get pro-forma net income 4. divide by new share count to determine pro-forma EPS and compare with buyer's standalone EPS |
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What’s the difference between a merger and an acquisition? |
In a merger the companies are closeto the same size, whereas in an acquisition the buyer is significantly larger. |
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Why would a company want to acquire another company? |
Synergies Horizontally or vertically integrate diversify operations increase market share achieve economies of scale buyer thinks seller is undervalued Inorganic growth opportunity |
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Why would an acquisition be dilutive? |
Additional amount of NI the seller contributes to the buyer is not enough to offset buyer's foregone interest income on cash, additional interest expense, or effects of issuing additional shares |
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Is there a rule of thumb for calculating whether an acquisition will be accretive ordilutive? |
If the deal involves just cash and debt, you can sum up the interest expense for debt andthe foregone interest on cash, then compare it against the seller’s Pre-Tax Income. |
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A company with a higher P/E acquires one with a lower P/E – is this accretive ordilutive? |
Trick question. You can’t tell unless you also know that it’s an all-stock deal. If it’s anall-cash or all-debt deal, the P/E multiples of the buyer and seller don’t matter becauseno stock is being issued. |
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What is the rule of thumb for assessing whether an M&A deal will be accretive ordilutive? |
In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if thebuyer has a lower P/E, it will be dilutive. |
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What are the complete effects of an acquisition? |
Foregone interest on cash, additional interest on debt, additonal shares outstanding, combine financial statements, goodwill and other intangibles created |
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If a company were capable of paying 100% in cash for another company, whywould it choose NOT to do so? |
Company may have a minimum cash balance that it must maintain; may want to use cash for other strategic purpose; stock is trading at all time high valuation |
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Why would a strategic acquirer typically be willing to pay more for a companythan a private equity firm would? |
Strategic buyer can realize revenue and cost synergies that a PE firm cannot. This increases the valuation that the strategic acquired can pay and the deal still makes sense |
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Why do Goodwill & Other Intangibles get created in an acquisition? |
These represent the value over the “fair market value” of the seller that the buyer haspaid. More specifically, Goodwill and Other Intangibles represent things like the value ofcustomer relationships, brand names and intellectual property. |
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What is the difference between Goodwill and Other Intangible Assets? |
Goodwill - not amortized Intangible assets - amortized |
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What are synergies, and can you provide a few examples? |
Thesis behind synergies is that two companies combined are worth more than the two companies as stand alone entities 2 types of synergies cost - consolidation, cut redundant employees, etc revenue - cross sell products to new customers; increase prices due to increased market share |
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Are revenue or cost synergies more important? |
No one in M&A takes revenue synergies seriously because they’re so hard to predict.Cost synergies are taken a bit more seriously because it’s more straightforward to seehow buildings and locations might be consolidated and how many redundantemployees might be eliminated. |
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All else being equal, which method would a company prefer to use when acquiringanother company – cash, stock, or debt? |
Cash is cheaper than debt because foregone interest income on cash is a lot less than additional interest on newly created debt Stock is most expensive Cash is less risky |
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How do you determine the Purchase Price for the target company in an acquisition? |
You use the same Valuation methodologies we already discussed. If the seller is apublic company, you would pay more attention to the premium paid over the currentshare price to make sure it’s “sufficient” (generally in the 15-30% range) to winshareholder approval |
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How much debt could a company issue in a merger or acquisition? |
Look at comparable companies and precedent transactions to see how much leverage companies in the industry use Look at target company at hand to determine how much debt it can reasonably handle |
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Let’s say a company overpays for another company – what typically happensafterwards and can you give any recent examples? |
A high amount of goodwill & other intangible assets are created; goodwill would eventually be written down as an impairment charge |
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Why do most mergers and acquisitions fail? |
Like so many things, M&A is “easier said than done.” In practice it’s very difficult toacquire and integrate a different company, actually realize synergies and also turn theacquired company into a profitable division. |
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What types of sensitivities would you look at in a merger model? What variableswould you look at? |
Purchase price, %stock/cash/debt, revenue synergies, cost synergies |
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Walk me through a basic LBO model. |
1. Assumptions on purchase price, leverage, interest rates on debt 2. Sources & Uses table which shows how you finance the transaction and what capital is used for and how much investor equity is required 3. Adjust company balance sheet for debt, equity, goodwill 4. Projected company's three financial statements and determine how much debt is paid off each year based on the company's available cash flow and required interest payments 5. Make assumptions about the exit (EBITDA multiple) and calculate return based on how much equity is returned to the firm |
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Why would you use leverage when buying a company? |
Boost your returns |
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What variables impact an LBO model the most? |
Purchase and exit multiples, then leverage then growth and margine projections |
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How do you pick purchase multiples and exit multiples in an LBO model? |
The same way you do it anywhere else: you look at what comparable companies aretrading at, and what multiples similar LBO transactions have had. As always, you alsoshow a range of purchase and exit multiples using sensitivity tables. |
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What is an “ideal” candidate for an LBO? |
1. stable and recurring cash flows 2. limited need for additional capex 3. room for operational enhancements 4. strong management team 5. relatively stable and mature industry 6. large tangible asset base to serve as collateral when obtaining debt financing |
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How do you use an LBO model to value a company, and why do we sometimes saythat it sets the “floor valuation” for the company? |
You use it to value a company by setting a targeted IRR (for example, 25%) and thenback-solving in Excel to determine what purchase price the PE firm could pay to achievethat IRR. |
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Can you explain how the Balance Sheet is adjusted in an LBO model? |
Previous SE is wiped out and replaced by however much equity PE firm contributes Debt is added to BS and old debt is taken out if refinanced Cash is adjusted for any used to finance transaction and goodwill & other intangibles are added based on how much PE firm paid over the fair market value of the company's net assets |
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Why are Goodwill & Other Intangibles created in an LBO? |
Remember, these both represent the premium paid to the “fair market value” of thecompany. In an LBO, they act as a “plug” and ensure that the changes to the Liabilities& Equity side are balanced by changes to the Assets side. |
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We saw that a strategic acquirer will usually prefer to pay for another company incash – if that’s the case, why would a PE firm want to use debt in an LBO? |
1. PE firm is not holding the company for the long-term and is more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront 2. In an LBO, the debt is “owned” by the company, so they assume much of the risk.Whereas in a strategic acquisition, the buyer “owns” the debt so it is more riskyfor them. |
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Do you need to project all 3 statements in an LBO model? Are there any“shortcuts?” |
You do need some form of Income Statement, something totrack how the Debt balances change and some type of Cash Flow Statement to showhow much cash is available to repay debt But a full-blown Balance Sheet is not strictly required, because you can just makeassumptions on the Net Change in Working Capital rather than looking at each itemindividually. |
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How would you determine how much debt can be raised in an LBO and howmany tranches there would be? |
Comparable LBOs |
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Let’s say we’re analyzing how much debt a company can take on, and what theterms of the debt should be. What are reasonable leverage and coverage ratios? |
This is completely dependent on the company, the industry, and the leverage andcoverage ratios for comparable LBO transactions. |
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What is the difference between bank debt and high-yield debt? |
High-yield debt has higher interest rates High-yield debt rates are usually fixed High-yield debt has incurrence covenants (prevent you from doing something) Bank debt is usually amortized while high-yield debt has bullet maturity |
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How could a private equity firm boost its return in an LBO? |
Lower purchase price raise exit multiple increase leverage increase growth projections increase margins |
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What is meant by the “tax shield” in an LBO? |
This means that the interest a firm pays on debt is tax-deductible – so they save moneyon taxes and therefore increase their cash flow as a result of having debt from the LBO.Note, however, |
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What is a dividend recapitalization (“dividend recap”)? |
In a dividend recap, the company takes on new debt solely to pay a special dividend outto the PE firm that bought it. |
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Why would a PE firm choose to do a dividend recap of one of its portfoliocompanies? |
Primarily to boost returns. Remember, all else being equal, more leverage means ahigher return to the firm. With a dividend recap, the PE firm is “recovering” some of its equity investment in thecompany – and as we saw earlier, the lower the equity investment, the better, since it’seasier to earn a higher return on a smaller amount of capital. |
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How would a dividend recap impact the 3 financial statements in an LBO? |
No changes on IS BS Debt goes up and SE goes down On CFS there would be changes under financing |
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Let’s say I have a new, unknown item that belongs on the Balance Sheet.How can I tell whether it should be an Asset or a Liability? |
An Asset will result in additional cash or potential cash in the future A Liability will result in less cash or potential cash in the future |
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Let’s say that you have a non-cash expense (Depreciation or Amortization,for example) on the Income Statement. Why do you add back the entireexpense on the Cash Flow Statement? |
Because you want to reflect that you’ve saved on cash taxes with the non-cashexpense |
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How can you tell whether or not an expense should appear on the Income Statement? |
1. It must correspond to the current period 2. It must be tax-deductible |
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Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don’t interest payments also show up there? They’re a financing activity! |
The difference is that interest payments correspond to the current period and are tax-deductible, so they have already appeared on the Income Statement. Since they are a true cash expense and already appeared on the IS, showing them on the CFS would be double-counting them and would be incorrect. |
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Wait a minute… Deferred Revenue reflects cash that we’ve already collected upfront for a product/service we haven’t delivered yet. Why is it a Liability? That’s great for us! |
Think about how Deferred Revenue works: not only is the burden on us to deliver the product/service in question, but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as real revenue. Deferred revenue implies future expenses |
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How are Prepaid Expenses (PE) and Accounts Payable (AP) different? |
Prepaid Expenses - You have paid for in cash but have yet to recognize expense on IS AP - You have incurred expense on IS but have not yet paid the cash |
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You see a “Noncontrolling Interest” (AKA Minority Interest) line item on the Liabilities side of a company’s Balance Sheet. What does this mean? |
If you own over 50% but less than 100% of another company, this refers to the portion you do not own. |
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“Short-Term Investments” is a Current Asset – should you count it in Working Capital? |
Considered an investing activity and not an operating activity vital to the business' core functions |
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What happens when Accrued Expenses decreases by $10 (i.e. it’s now paid out in the form of cash)? Do not take into account cumulative changes from previous increases in Accrued Expenses. |
IS - No Change
BS - Cash down $10, Accrued Expenses down $10 |
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Accounts Receivable increases by $10. Walk me through the 3 statements. |
IS - Revenue up $10, Pre-tax Income up $10, assuming 40% TR NI up $6 CFS - NI up $6, AR up $10 so net change in cash is down $4 BS - Cash down $4, AR up $10, NI in RE in SE up $6 |
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Prepaid Expenses decreases by $10. Walk me through the statements. Do not take into account cumulative changes from previous increases in Prepaid Expenses. |
IS - Expense of $10 lowers pre-tax income by $10, assuming 40% tax rate NI down $6 CFS - NI down $6, PE down $10 so net change in cash is up $4 BS - Cash up $4, PE down $10, NI down $6 |
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A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change. |
IS - Gain of $20 increases pre-tax income by 20, assuming 40% tax rate NI up $12
BS - Cash up $112, PPE down $100, NI up $12 |
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Explain what happens on the 3 statements when a company issues $100 worth of shares to investors. |
IS - No Change CFS - Cash flow from financing up $100 BS - Cash up $100, SE up $100 |
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A company decides to issue $100 in Dividends – how do the 3 statements change? |
IS - No Change CFS - Cash flow from financing down $100 BS - Cash down $100, Se down $100 |
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A company has recorded $100 in income tax expense on its Income Statement. All $100 of it is paid, in cash, in the current period. Now we change it and only $90 of it is paid in cash, with $10 being deferred to future periods. How do the statements change? |
IS - No Change CFS - Deferred Tax Liability up $10 so net change in cash is $10 BS - Cash up $10 DTL up $10 |
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What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ? |
2 different ways to record the value of inventory LIFO - most recent inventory additions are the first ones counted toward COGS when sold FIFO - oldest inventory additions are the first ones counted toward COGS when sold |
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A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase. |
IS - No Changes CFS - CFI down $100, CF from Financing up $100; no net change in cash
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Now walk me through what happens at the end of Year 1, after the company has earned interest, paid interest, and paid back some of the debt principal. $100 Debt 5% interest 10% yearly principal repayment $100 ST securities 10% interest |
IS - Interest Income is $10 and interest expense is $5 so pretax income up $5, assuming 40% tax rate NI up $3
BS - Cash down $7; Debt down $10, NI up $3 |
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Now let’s say that at the end of year 1, the company sells the $100 of Short-Term Securities but gets a price of $110 for them instead. It also uses the proceeds to repay the $90 worth of remaining Debt. |
IS - Gain from sale of $10, assuming 40% tax rate NI up $6 CFS - NI up $6, Subtract out gain of $10 so net change in cash from CFO down $4, Sale of securities at $110 increases CFI $110; CFF down $90 from repayment of debt; so total change in cash is up $16 BS - Cash up $16 STI down $100; debt is down $90 NI up $6 |
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Let’s say we have the same scenario, but now instead of issuing $100 worth of stock to investors, the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens? |
IS - Pre-tax income down $100, assuming 40% tax rate Ni down $60 CFS - NI down $60, Add back $100 SBC total change in cash is up $40 BS - Cash up $40, Common stock/APIC up $100 and RE down $60 |
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Can you walk me through how you use Public Comps and Precedent Transactions? |
Select companies and transactions based on criteria such as industry, financial metrics, and geography Then, you determine the appropriate metrics and multiples for each set Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally, you apply those numbers to the financial metrics for the company you’re analyzing to estimate the potential range for its valuation. |
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When is a DCF useful? When is it not so useful? |
A DCF is best when the company is large, mature, and has stable and predictable cash flows (think: Fortune 500 companies in “boring” industries). Your far-in-the-future assumptions will generally be more accurate there. A DCF is not as useful if the company has unstable or unpredictable cash flows (tech start-up) or when Debt and Operating Assets and Liabilities serve fundamentally different roles |
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How are the key operating metrics and valuation multiples correlated? In other words, what might explain a higher or lower EV / EBITDA multiple? |
Usually, there is a correlation between growth and valuation multiples. So if one company is growing revenue or EBITDA more quickly, its multiples for both of those may be higher as well. |
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What are some problems with EBITDA and EBITDA multiple? And if there are so many problems, why do we still use it? |
1. Hides the amount of debt principal and interest that a company is paying each year -> could be very large and make the company cash flow negative 2. hides capex spending 3. EBITDA ignores WC requirements Another argument for EBITDA is that although it’s not close to cash flow, it’s better for comparing the cash generated by a company’s core business operations than other metrics – so you could say that EBITDA is more about comparability than cash flow approximation |
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Why are Public Comps and Precedent Transactions sometimes viewed as being “more reliable” than a DCF? |
It’s because they’re based on actual market data, as opposed to assumptions far into the future. |
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What are the flaws with Public Company Comparables? |
No company is 100% comparable to another company Stock market is emotional share prices for thinly-traded companies might not reflect full value |
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what are the three main financial statements? Walk me through each. |
IS: Revenue - COGS - Operating expenses = EBIT - nonoperating expenses = EBT - taxes = net income BS: Assets = Liabilities + Equity SCF: Beg. Cash + CF from Ops. + CF from Inv. + CF from Fin. = Ending Cash |
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How are the three main financial statements connected? |
1) NI from IS flows into RE on SE 2) NI is first line item on cash flow from ops adjust for non-cash expenses on IS; 3) Dep, Int. and Amor, expense calculated based on PP&E, dEbt and amortizable intangibles on BS Beg cash on cFS is beg cash on BS -> flow through three and add change in cash to beg year cash gives ending year cash which is ending year cash on BS 5) Changes in NWC on cfs from Ops comes from BS 6) investing activities -> capex from PP&E on BS 7) Financing Activities -> Issuance/repurchase Debt/Equity; Dividends |
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Walk me through the major line items of an Income Statement. |
Revenue - COGS = GM - operating expenses = EBIT - interest expense = EBT - taxes = net income |
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When should an expense appear on the income statement? |
1) Must be tax deductible 2) incurred during time period of IS |
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What are the three components of the Statement of Cash Flows? |
CFO - Cash generated through normal business operations, or changes in WC
CFI - Cash generated or invested on Capex, sale of assets, etc. CFF - Cash generated or spent on issuance/repurchase debt/equity, dividends, etc. |
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If you could use only one financial statement to evaluate the financial state of a company, which wouldyou choose? |
Statement of Cash flows; as a financial analyst the most important thing you care about in a company is how much cash flow it generates; this is a positive sign of financial stability |
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What is the difference between the Income Statement and Statement of Cash Flows? |
A company’s sales and expenses are recorded on its Income Statement. The Statement of Cash Flowsrecords what cash is actually being used during the reporting period and where it is being spent. |
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What is the link between the Balance Sheet and the Income Statement? |
NI less dividends flows into RE on SE Interest expense calculated based on Debt Depreciation calculated based on PP&E Amortization calculated based on Amor. Intangibles |
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What is the link between the Balance Sheet and the Statement of Cash Flows? |
Beg cash on BS is beg cash on CFS; flow through three ending year cash balance on CFS is ending year cash on BS Changes in NWC is based on Changes in operating working capital line items on BS Changes in LTA is in investing activities Issuance/repurchase of debt/equity/change in Dividends from BS show up on CFF |
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Say I have an unknown item that belongs on the Balance Sheet. How would I be able to tell if it should be anasset or a liability? |
Will it bring future cash inflow or outflow? |
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What is goodwill? |
An intangible asset that is created in the event when one company acquires another company for more than their net asset value written up to fair market value |
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What is the purpose of the Changes in Working Capital section of the cash flow statement? |
Due to accrual accounting, changes in balance sheet items like accounts payable and accounts receivableare not reflected |
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What is the difference between Accounts Payable and Accrued Expenses? |
Basically they are the same thing. The main difference is usually that accounts payable is typically a onetime expense with an invoice (such as the purchase of inventory) while accrued expenses are recurring(like employee expenses). |
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What is deferred revenue and why is it a liability? |
Deferred revenue is cash that has been collected in advance for something that hasn’t yet been delivered. Doesnt reflect future expenses that will be incurred that are matched with the revenue that will be generated |
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What is the difference between Accounts Receivable and Deferred Revenue? |
AR - Recognized revenue but havent received cash Deferred revenue - received cash but not earned revenue |
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What is the difference between Accounts Payable and Prepaid Expenses? |
Accounts Payable - Recognize expense on income statement but have not yet paid liability Prepaid expenses - payments paid for product or service to be received in future. As products or services are received they will be recognized as expenses on the income statement |
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If depreciation is a non-cash expense, then how does it affect the cash balance? |
Even though depreciation is a non-cash expense, it is a tax deductible expense which ultimately decreases the amount of cash taxes that a company must pay, which increases a company's cash balance |
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What is a deferred tax liability and why might one be created? |
Deferred tax liability is a tax expense amount reported on a company’s income statement not actuallypaid in that time period, but expected to be paid in the future. This occurs when a company pays less intaxes to the government than they show as an expense on their income statement. |
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What is a deferred tax asset and why might one be created? |
A deferred tax asset occurs when a company pays more in taxes to the government than they show as anexpense on their income statement in a reporting period. |
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What is EBITDA? |
Earnings before interest, taxes, depreciation, & amortization Financial performance metric independent of capital structure or financing decisions; great independent comparison metric Used as proxy for profitability independent of financing decisions and investment decisions |
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How could a company have positive EBITDA and still go bankrupt? |
1) High debt burden and cannot make interest payments 2) debt all matures at one time 3) company is spending too much on capex 4) ignores working capital requirements; company could be short on cash and not be able to obtain financing |
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What is Enterprise Value? |
Value of firm available to all providers of capital EV = Market value of equity + net debt + minority interest + preferred equtity |
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What is net debt? |
Debt - cash |
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Why do you subtract cash from Enterprise Value? |
Cash is accounted for within market value of equity; Cash in company could be used to repay debt that it has on its balance sheet |
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When looking at the acquisition of a company, do you look at Equity Value or Enterprise Value? |
Enterprise value; When you acquire accompany you are assuming both assets and liabilities so you must take into account debt
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When calculating Enterprise Value, do you use the book value or the market value of equity? |
Market value - true value of company's equity in open marketplace |
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Could a company have a negative book Equity Value? |
Yes, continuous history of negative profitability would result in retained losses |
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What is the difference between public Equity Value and book value of equity? |
Equity value - market value book value - historical cost of equity (accounting number) |
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What is valuation and what is it used for? |
Valuation is the process of determining the worth of an asset, company, security, etc. Investment bankings use valuation to advise their clients on what they could in reality sell or acquire a business or subsidiary for
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What are some ways you can value a company? |
Comps, Precedent transaction, DCF, LBO Valuation |
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Other valuation techniques? |
liquidation, replacement, sum of parts, M&A premium, future share price analysis |
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How do you value a private company? |
Same techniques that you would use for a public company; in comps and DCF you would at a liquidity discount |
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What does spreading comps mean? |
Collecting a group of peer companies and calculating their relevant multiples to determine a median multiple from the set from which you can value the target company |
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Would you be calculating Enterprise Value or Equity Value when using a multiple based on free cash flow orEBITDA? |
Enterprise value; EBITDA and UFCF both represent cash flows available to all providers of capital |
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Walk me through a Discounted Cash Flow model. |
1) study the target and determine key performance drivers from which you can base your projections on 2) project free cash flows of company for specified period (usually 5-10 years; economic/business cycle) 3) determine value of company beyond projection horizon (terminal value) 4) Discount 5-10 years of free cash flow and TV back to present value using firms WACC 5) make necessary adjustments to find firms implied equity value |
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How do you calculate a firm’s terminal value? |
1) Gordon growth method
2) exit multiple method The first is the terminal multiple method. To use thismethod, you choose an operation metric (most commonly EBITDA) and apply a comparable company’smultiple to that number from the final year of projections. ** both cases discount back to present value like you did with 5 years of FCF |
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What is WACC and how do you calculate it? |
Used as a discount rate in DCF valuation; reflects the weighted average blend of a company's cost of raising new capital -> represents riskiness of company. Investors demand to earn a certain return based on risk they are taking represents the blended cost to both debt and equity holders WACC = Cost of Equity * (% equity in capital structure) + Cost of Debt * (1-T) * (% of debt in capital structure) + Cost of PE * (% PE in capital structure) |
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All else equal, should the WACC be higher for a company with $100 million of market cap or a company with$100 billion of market cap? |
Depends on capital structure of two companies |
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All else equal, should the cost of equity be higher for a company with $100 million of market cap or a companywith $100 billion of market cap? |
$100 million; expected to produce greater returns |
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How do you calculate Free Cash Flow? |
EBIT * (1-T) +D&A - capex - Change in WC
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Why do you project out free cash flows for the DCF model? |
Firm is worth the present value of the free cash flows that it generates that could be theoretically returned to providers of capital |
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When would you not want to use a DCF? |
Company has none or unstable/unpredictable cash flow generation |
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What is Net Working Capital? |
Capital used in daily business operations by company CA - CL; metric to determine financial stability of company IBD care about changes in WC because it signifies whether cash is being tied up or being generated by changes in WC on a year to year bases |
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What happens to Free Cash Flow if Net Working Capital increases? |
Decreases; cash tied up in some current asset or Current liability paid down |
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When would a company collect cash from a customer and not show it as revenue? If it isn’t revenue, what is it? |
Customer pays for product or service in advance Subscriptions -> magazines, cell phone contracts, SaaS software; deferred revenue Cannot recognize revenue until service or product is delivered |
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What is the difference between accounts receivable and deferred revenue? |
AR - revenue earned but cash not yet received Deferred revenue - received cash but revenue not earned |
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Why might there be multiple valuations of a single company? |
Each valuation methodology will give a different value because each is based on different assumptions and methodologies |
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Why might two companies with similar growth and profitability have different valuations? |
One company could be market leader; maybe it has a competitive advantage that isn't represented in financial statements |
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How do you determine which valuation methodology to use? |
Because each method has unique ability to provide useful information, you don’t choose just one. Thebest way to determine the value of a company is to use a combination of valuation techniques. |
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What is an Initial Public Offering (IPO)? |
An IPO is the first public sale of stock in a previously private company Companies go public for a number of reasons—raising capital, cashing out for the original owners, andinvestor and employee compensation. |
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What is a primary market and what is a secondary market? |
The primary market is where an investment bank sells new securities before they go to market. With anIPO or bond issuance, the majority of these buyers are institutional investors who purchase largeamounts of the security. The secondary market is the market on which a stock or bond trades after the primary offering—theNew York Stock Exchange, American Stock Exchange, or Nasdaq, in the United States. |
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What is the Capital Assets Pricing Model? |
Equation used to calculate cost of equity for a firm Ce = Rf + B * (Rm - Rf) |
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Where do you find the risk-free rate? |
10-yr treasury; WSJ |
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What is Beta? |
Represents volatility or risk of a given investment with respect to the market <1 = less risky >1 = more risky |
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From the three main financial statements, if you had to choose two to analyze a company, which would youchoose and why? |
Ending year and beginning year BS and IS |
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When should a purchase be capitalized rather than expensed? |
If the useful life of the asset being acquired is over 1 year |
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How would a $10 increase in depreciation expense affect the each of the three financial statements? |
IS - Pre-tax income down $10, assuming 40% tax rate NI down $6 CFS - NI down $6, add back $10 of CFS net change in cash is up $4 BS - Cash up $4, PP&E down $10; NI flows to RE in SE and is down $6 so both sides balance |
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Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc.,do not create any asset, and instead instantly create an expense on the income statement that reduces equity viaretained earnings? |
Useful life of asset; Capex has useful life over a year and expenses are systematically allocated over useful life time period; Other expenses are realized immediately and are therefore expensed as incurred |
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How is it possible for a company to show positive net income but go bankrupt? |
Negative free cash flow (capex, debt matures) Deteriorating working capital |
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I buy a piece of equipment; walk me through the impact on the 3 financial statements. |
IS - No change immediately CFS - Cash flow from investing down $100 from Capex so net change in cash is $100 BS - Cash down $100, PP&E up $100 OVer the life of the asset - PP&E decreases, depreciation expense lower NI and RE on BS, and CFS from Ops goes up |
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Why are increases in accounts receivable a cash reduction on the cash flow statement? |
On the cash flow from operations section of the CFS, when you account for changes in WC and a current asset rises, this is a use of cash because cash is tied up in a CA such as AR; AR signifies you have earned the revenue but have yet to receive the cash |
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In what scenario could a company have negative shareholders equity? |
If a company has continuous negative earnings for an extended period of time; dividend recap in leveraged buyout scenario |
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How would you calculate the discount rate for an all-equity firm? |
You would use the CAPM to calculate cost of equity |
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What is the market risk premium? |
The excess return investors require for investing in riskier assets like stocks rather than a risk-free treasury Average return on market - risk free rate |
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What kind of an investment would have a negative beta? |
Gold - moves opposite to the market as a whole (safe haven asset) |
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How much would you pay for a company with $50 million in revenue and $5 million in profit? |
I would look at industry comps to see what peer competitors are trading at; I would then determine a relevant multiple to price the company based on its standing in the industry (industry leader/laggard) |
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How would you value a company with no revenue? |
Find another relevant metric to value the company; construct DCF to discount future cash flows the company will generate |
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How would you calculate the WACC of a private company? |
Use WACC of a comparable company because the firm has no beta or market capitalization |
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Describe a company’s typical capital structure. |
A company may finance itself using multiple layers of debt & equity. Each will have a different cost and preference in the event of bankruptcy. Debt Senior term loan debt - highest on CS; institutional investors (floating rate) Mezzanine debt - sold on bond market by IB (fixed rate) Subordinated debt/high yield bonds - highest interest rate on debt - few rights in bankruptcy Equity Preferred stock - mix of debt & equity (capital appreciation and fixed and recurring dividend payments - higher than common equity in capital structure Common stock - lowest in capital structure - highest cost in most cases - capital appreciation & dividends depending on firm |
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When should a company issue equity rather than debt to fund its operations? |
1) high stock price with high valuation - issue less shares to receive capital 2) if investment will not yield cash flow immediately 3) Adjust capital structure 4) liquidation event |
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When should an investor buy preferred stock? |
If he or she wants a security that has debt & equity components 1) fixed dividend (interest payment 2) capital appreciation |
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Why would a company distribute its earnings through dividends to common stockholders? |
A distribution of a dividend signals to investors that the company is in a healthy financial position and has excess capital to return to shareholders |
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How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company? |
An increase in $10 on depreciation statement would lower EBIT by $10, assuming 40% tax rate EBIT tax-affected would be down $6, add back $10 = increase in $4 of free cash flow Discount the $4 back to present value |
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If you have two companies that are exactly the same in revenue, growth, risk, etc. but one is private and one ispublic, which company’s shares would be higher priced? |
the public company would likely be priced higher due to it having a liquidity premium -> easy to buy and sell shares in it |
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What could a company do with excess cash on its Balance Sheet? |
1) make a strategic acquisition 2) pay dividend 3) repurchase debt 4) repurchase shares 5) reinvest capital back into business by making investments in firm 6) invest in short term investments |
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What is goodwill and how does it affect net income? |
Goodwill is an intangible asset on a company's BS (brand name, customer relations, intellectual property rights) that is created in the event when one company acquires another for more than the net asset value written up to fair market value of a company; Does not affect net income initially, but buyer must assess goodwill for impairment annually and if impairment exists this would be a non-cash expense that would decrease NI |
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What are some examples of items that may need to get added back to EBITDA to get a better sense for thefinancial health of a company? |
one-time charges - legal expenses, restructuring charges etc |
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When building a model, what is the most common way to project items like accounts receivable, accountspayable, inventory, depreciation, and capital expenditures? |
AR - % of sales, DSO Inventory - % of cogs, Days in Inventory AP - % of COgs or Days Payable outstanding Depreciation - create a depreciation schedule or % of PP&E or sales Capex - % of revenues or company guidance |
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How/why do you lever/unlever Beta? |
By unlevering the beta, you remove the financial effects of debt in the capital structure. This unleveredbeta shows you the risk of a firm’s equity compared to the market. Comparing unlevered betas allowsinvestors to see how much risk they will be taking by investing in a company’s equity (i.e. buying stockin the public market). |
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How would you calculate an equity beta? |
Regression of the returns of that company against the S&P 500; slope is beta |
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What would be the effect of using levered free cash flow rather than unlevered free cash flow in your DCFmodel? |
Would yield implied equity valuation - cash flows represent cash to shareholders after debt holders have been paid |
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What’s the difference between cash-based accounting and accrual accounting? |
Cash-based accounting - recognize revenue and incur expenses when cash is actually received or paid out Accrual accounting - recognize revenue when it is earned and payment is reasonable assured; recognize expenses when incurred regardless of when actually paid out |
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What is the difference between LIFO and FIFO? |
Both are ways to value inventory and COGS LIFO - most recently added inventory is recognized as COGS in the sale of inventory FIFO - oldest goods purchased is recognized as COGS in sale of inventory |
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How do you go from the Enterprise Value you would calculate using a DCF to a per share price for a publiccompany? |
Subtract net debt, minority interest, preferred stock; divide implied equity value by diluted # of shares outstanding |
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What did the S&P 500/Dow Jones Industrial Average/Nasdaq close at yesterday? Why did the market move up or down the previous day? |
S&P 500 - 1921 DJIA - 16,102 NASDAQ - 4,638 |
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Company XYZ released increased quarterly earnings yesterday, but their stock price still dropped. Why? |
1) management guidance was not as high as analysts expected 2) broad market selloff 3) earnings not as high as analysts expected |
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What do bankers do during an Initial Public Offering (IPO)? |
The purpose of an IPO is to issue the least number of shares possible for the highest price per share,therefore raising the most money for the lowest possible ownership percentage of the company. 1) meet with clients to gather information on financials, industry, company overview etc and then draft an S-1 2) road show - present company to institutional investors |
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Can you tell me about a recent IPO you have followed? |
Fitbit? |
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How can a company raise its stock price? |
repurchase stock or make an accretive acquisition announce cost cutting increase dividend or announce dividend |
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When should a company buy back stock? |
Believes its stock is undervalued and wants to boost share price; if it has extra cash and wants to return value to shareholders |
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Why do some stocks rise so much on the first day of trading after their IPO and others don’t? How is that“money left on the table”? |
Money left on the table means the company could have completed the offering at a higher price, and thatdifference in valuation goes to the initial investors in the stock, rather than to the company raising themoney. This means the company could have sold the same stock in its IPO at a higher price than itactually did. |
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When should a company issue debt instead of equity? |
1) tax-shield on interest expense 2) cheaper than cost of equity 3) if company feels stock is undervalued |
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What are some reasons that two companies would want to merge? |
Synergies Horizontally or vertically integrate diversify operations consolidate operations achieve economies of scale move into new markets tax jurisdiction reasons Gain patents, PP&E, |
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What are synergies? |
Synergies are the improvements that result from the combination of two companies; The idea is that two companies combines are worth more than they are separately and that they can generate a higher EPS than on a standalone basis Cost synergies - cut redundant operations; economics of scale revenue synergies - raise prices due to less competition; cross sell products to combined customers |
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What is the difference between a strategic buyer and a financial buyer? |
Strategic buyer - looking to acquire another company for strategic business reasons such as to gain synergies, growth, etc. Financial buyer - Group looking to acquire a company solely from an investment perspective |
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Which will normally pay a higher price for a company, a strategic buyer or a financial buyer? |
Strategic buyer - willingness to pay a premium to acquire company because they are more likely to benefit from synergies |
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Can you name two companies that you think should merge? |
Think of two!!! |
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What is a stock swap? |
An acquired company agrees to be acquired by the buyer with the buyer's stock used as the proceeds; they believe in the success of the merger and want to share in the upside |
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What is the difference between shares outstanding and fully diluted shares? |
Shares outstanding - include only common shares fully diluted - takes into account dilutive effects of securities such as: options, warrants, convertible debt |
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How do you calculate the number of fully diluted shares? |
TSM 2 assumptions 1) all dilutive securities in the money will convert to common 2) all proceeds received from conversion will be used to repurchase shares This method involves finding the number of current shares outstanding, adding the number of optionsand warrants that are currently “in the money,” and then subtracting the number of shares that could berepurchased using the proceeds from exercising the options and warrants. |
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Why pay in stock versus cash? |
If market is performing well and buyer has attractive stock price they can issue less equity than if market was performing poorer; acquired company's shareholders want to take part in potential upside of acquisition; shareholders would have to pay taxes on cash received |
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All else equal, how would one company prefer to pay for another? |
Cash, debt, equity |
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Describe a recent M&A transaction you have read about. |
Look one up!!! |
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If Company A purchases Company B, what will the combined company’s Balance Sheet look like? |
combine balance sheet with the addition of goodwill |
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What is the difference between an accretive merger and a dilutive merger, and how would you go about figuringout whether a merger is accretive or dilutive? |
Accretive -> EPS increases Dilutive -> EPS decreases |
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Company A is considering acquiring Company B. Company A’s P/E ratio is 50 times earnings, whereasCompany B’s P/E ratio is 20 times earnings. After Company A acquires Company B, will Company A’searnings per share rise, fall, or stay the same? |
Rise |
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Walk me through the basics of a merger model? (AKA an accretion dilution model) |
Purchase of a merger model is to assess the financial performance of two companies and see if as a result of a acquisition the buyer's EPS increases or decreases 1) make assumptions about purchase price and how the deal will be financed (%stock, debt, cash) 2) project out buyer's and seller's income statements and determine shares outstanding 3) combine income statements up to pre-tax income line adjusting for synergies, foregone interest income on cash, new interest expense, newly created intangibles new depreciation from written up assets 4) use buyers tax rate to get to pro-forma net income and divide by pro-forma shares outstanding (buyers shares + new shares created) |
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What is a leveraged buyout? |
A firm acquired a company with a substantial portion of the proceeds being debt therefore the new company is highly levered; firm uses cash flows of company to pay down debt over investment horizon -> capital structure mix changes |
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How could a firm increase the returns on an LBO acquisition? |
1) decrease purchase price 2) increase exit multiple 3) increases leverage in capital structure 4) project more operational improvements in investment horizon |
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How do you pick purchase multiples and exit multiples for an LBO? |
These multiples are determined as in any other M&A transaction. The analysts working on thetransaction will look at M&A comparable transactions and public company comparables. |
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What makes a company an attractive target for a leveraged buyout? |
1) Stable and recurring cash flows 2) large tangible asset base to obtain attractive debt financing terms 3) relatively stable & mature industry 4) limited need for additional capex 5) room for operational improvements |
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What are deferred tax assets (DTA’s) and deferred tax liabilities (DTL’s), and how are they created in an M&Atransaction? |
DTAs and DTLs are created in an M&A transaction through the write-up or write-down of assets. |
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In a leveraged buyout, what would be the ideal amount of leverage to put on a company? |
Fine line between maximizing leverage on a deal to juice returns and putting the company at risk for financial distress; Look at similar deals in the past for companies in same or similar industries with financial characteristics; assess particular company and determine realistically how much debt it can sustain based on cash flow generation characteristics |
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What are the three types of mergers and what are the benefits of each? |
Vertical - acquire supplier or distributor
Conglomerate - diversify operations |
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What is a merger model? |
A merger model is a way to look at the financials of two companies, the purchase price, and how thepurchase is made to determine whether it is accretive or dilutive to the buyer. |
