400 Qs

Question 1

Describe the process of working on an IPO

Answer 1

1. Meet with client to gather basic information; financial details, industry overview, customers
2. Meet bankers and lawyers to draft the registration statement, revise until acceptable
3. Go on ‘road show’ to present company to instiutional investors

Question 1

What do bankers actually do

Answer 1

• bankers advise companies on transactions – buying and selling other companies, and raising capital. They are “agents” that connect a company with the appropriate buyer, seller, or investor.
• The day-to-day work involves creating presentations, financial analysis and marketing materials such as Executive Summaries.

Question 2

What is in a pitch book

Answer 2

Depends on type of deal:

1. Bank “credentials” (similar past deals).
2. Summary of a company’s options (“strategic alternatives”).
3. Valuation and appropriate financial models
4. Potential acquisition targets (buy-side M&A deal) or potential buyers (sell-side
   M&A deal).
5. Summary and key recommendations.

Question 3

How do companies select the bankers they work with

Answer 3

• Based on relationships
• Banks pitch for the business, best picked

Question 4

Tell me the process of a typical sell-side M&A deal

Answer 4

1. Meet with company, create initial marketing materials like the Executive
   Summary and Offering Memorandum (OM), and decide on potential buyers.
2. Send out Executive Summary to potential buyers to gauge interest.
3. Send NDAs to interested buyers along with more detailed information like OM and respond to any followup due diligence requests
4. Set a “bid deadline” and solicit written Indications of Interest (IOIs) from buyers
5. Select which buyers advance to the next round.
6. Continue responding to information requests and setting up due diligence
   meetings between the company and potential buyers.
7. Set another bid deadline and pick the “winner.”
8. Negotiate terms of the Purchase Agreement with the winner and announce the deal.

Question 5

Walk me through the process of a typical buy-side M&A deal.

Answer 5

1. Research on hundreds of potential acquisition targets, and go through multiple cycles of selection and filtering
2. Narrow down the list based on their feedback and decide which ones to
   approach.
3. Conduct meetings and gauge the receptivity of each potential seller.
4. As discussions with the most likely seller become more serious, conduct more indepth due diligence and figure out your offer price.
5. Negotiate the price and key terms of the Purchase Agreement and then announce the transaction.

Question 6

Walk me through a debt issuance deal

Answer 6

similar to the IPO process but fewer banks and no SEC approval needed:

1. Meet with the client and gather basic financial, industry, and customer
   information.
2. Work closely with DCM / Leveraged Finance to develop a debt financing or LBO model for the company and figure out what kind of leverage, coverage ratios, and covenants might be appropriate.
3. Create an investor memorandum describing all of this.
4. Go out to potential debt investors and win commitments from them to finance the deal.

Question 7

What is the difference between DCM and Leveraged Finance

Answer 7

Leveraged Finance more “modeling-intensive” and more of
the deal execution with industry and M&A groups on LBOs and debt financings.

DCM, by contrast, is more closely tied to the markets and tracks trends and relevant data.

Question 8

How are ECM and DCM different from M&A

Answer 8

ECM and DCM are both “markets-based”, most of your tasks
are related to staying on top of the market, following current trends, and making recommendations to industry and product groups for clients and pitch books.

In ECM/DCM you go more in-depth on certain parts of the deal process, but you don’t get as broad a view as you might in other groups.

Question 9

Explain what a divestiture is

Answer 9

Selling off a particular division –> messier than normal

Need to create a standalone operating model, transaction structure and valuation for the particular division

Question 10

Imagine you want to draft a 1-slide company profile for an investor. What would you put there?

Answer 10

Company Header than split slide into 4:

1. Business description, HQ and key executives
2. Stock chart, historical and projected financial metrics and multiples
3. Descriptions of products and services
4. Thesis and Market Outlook

Question 11

What questions must you always ask before giving an answer to an investing question

Answer 11

1. Always ask what the investor or business goals are.
2. Always ask if there are any constraints, limitations, time horizons, or any other limiting factors.

You should also be citing specific numbers and figures where applicable

Question 12

Lets say you had $10 million to invest, what would you do

Answer 12

What are the investors goals?

Long time horizon -a well diversified portfolio

Tax-free income - municipal bonds

Question 13

Did you do anything quantitative for this deal? It looks like it just involved
research.

Answer 13

Don’t say that you did nothing
quantitative, but also don’t make it seem like you know everything there is to know
about valuation or modeling. If you didn’t build the model yourself, just point out how
you contributed to it. Here’s how you might respond:

“A lot of what I worked on was qualitative and involved researching potential buyers to see what the best fit might be. Our team did some valuation and financial modeling work as well, but since I was an intern I supported the other Analyst and Associate by finding relevant facts and figures and then going through their models, figuring out
how they worked, and then making sure the information was correct.”

Question 14

What are the 5 most important accounting concepts

Answer 14

1. The 3 financial statements and what each one means.
2. How the 3 statements link together and how to walk through questions where one or multiple items change.
3. Different methods of accounting – cash-based vs. accrual, and determining when revenue and expenses are recognized.
4. When to expense something and when to capitalize it.
5. What individual items on the statements, like Goodwill, Other Intangibles and Shareholders’ Equity, actually mean

Question 15

Walk me through the 3 financial statements

Answer 15

• 3 major financial statements are Income Statement, Balance Sheet and Cash Flow Statement

1. Income Statement
   company’s revenue and expenses, and goes down to Net Income
2. Balance Sheet
   Assets (Cash, Inventory PP&E) and Liabilities (Debt, Accounts Payable and Shareholders’ Equity).

Assets must = Liabilities + Shareholders’ Equity

3.Cash Flow Statement
Begins with Net income, adjusts for non-cash expenses and working capital changes, then lists cash flow from investing and financing activities, then net change in cash

Question 16

Can you give examples of major line items on the Income Statement

Answer 16

Income Statement: Revenue, COGS, SG&A, Operating Income, Pretax income, Net Income

Question 17

Can you give examples of major line items on the Balance Sheet

Answer 17

Balance Sheet: Cash, Accounts Recievable/Payable, Inventory, PP&E, Accrued Expenses, Debt, Shareholders’ Equity

Question 18

Can you give examples of major line items on the Cash Flow Statement

Answer 18

Cash Flow Statement

Net Income, D&A, Stock-based Compensation, Changes in Operating Assets & Liabilities, Cash Flow from Operations, CapEX, Cash Flow from Investing, Sale/Purchase of Securities, Dividens Issued, Cash Flow from Financing.

3 main sections: operating activities, investing and finanicng activities.

Add the net cash flow from all 3 sections

Question 19

How do you calculate cash flow from operations

Answer 19

CFO = Net Income + Non-Cash Expenses + Changes in Working Capital

Non- cash expenses (e.g. D&A, Gain or Losses on Sale of Assets)

Working capital - difference between a company’s current assets and current liabilities.

Question 20

How does Working Capital impact cash flow

Answer 20

1. Increase in Current Assets (e.g., Accounts Receivable, Inventory): An increase in current assets means the company has invested cash in these assets, reducing available cash.
2. Decrease in Current Assets: A decrease implies that assets have been converted to cash, increasing available cash.
3. Increase in Current Liabilities (e.g., Accounts Payable): An increase indicates that the company has delayed cash outflows, thus retaining cash.
4. Decrease in Current Liabilities: A decrease implies that the company has paid off liabilities, reducing available cash.

Question 21

Describe examples of Current Assets

Answer 21

Cash and Cash Equivalents: Liquid assets that can be readily used for payments.

Accounts Receivable: Money owed by customers for goods or services already delivered.

Inventory: Goods available for sale or raw materials used in production.

Other Current Assets: Prepaid expenses, marketable securities, etc.

Question 22

Describe examples of Current Liabilities

Answer 22

Accounts Payable: Money owed to suppliers for goods or services received.

Short-term Debt: Loans and other borrowings due within one year.

Accrued Liabilities: Expenses incurred but not yet paid (e.g., wages, taxes).

Other Current Liabilities: Deferred revenue, etc.

Question 23

How do we calculate cash flow from investing activities

Answer 23

CFI = Proceeds from Asset Sales - CapEx + Proceeds from Investment Sales - Investment Purchases

Capital Expenditures (CapEx): Subtract cash spent on purchasing fixed assets.

Proceeds from Sale of Assets: Add cash received from selling fixed assets.

Purchases of Investments: Subtract cash spent on buying investments.

Proceeds from Sale of Investments: Add cash received from selling investments.

Question 24

How do you calculate Cash Flow from Financing

Answer 24

CFF= Cash from Debt/Equity Issuance - Debt Repayment - Dividend Payments - Stock Repurchasing

Question 25

How to calculate FCF

Answer 25

FCO - CapEx = FCF

Question 26

How to rationalise all the cash flow segments

Answer 26

Add them all together to get net change in cash flow

Question 27

Break down the main process of the income statement

Answer 27

1. **Revenue - COGS = Gross Profit **
2. Gross Profit - Operating Expenses = Operating Income

Operating Expenses = SG&A and D&A.

3. EBT = Opeating Income + (Non-Operating Income - Non-Operating Expenses)

Non-Operating Income and Expenses=
* Interest Income, Interest Expense, Gains or Losses on Sale of Assets

4. Net Income = EBT - Income Tax Expense

Question 28

How do the 3 financial statements link together

Answer 28

Net income, from the Income statement, flows onto Shareholder’s Equity on the Balance Sheet, and into the top line of the Cash Flow statement

Balance sheet changes –> working capital changes on cash flow

Investing and financing activities –> affect assets such as PP&E, Debt and Shareholder’s Equity

Question 29

How are the cash and shareholders’ equity items on the Balance Sheet a plug

Answer 29

As they are a placeholder to be adjusted according to the cash flowing in from the Cash Flow statement.

Since cash is a part of the assets on the balance sheet, the ending cash balance on the balance sheet should match the ending cash balance from the cash flow statement. adjustments are made to shareholders’ equity, particularly through retained earnings. The net income (or loss) for the period flows into retained earnings within shareholders’ equity.

Question 30

What are retained earnings

Answer 30

Retained earnings represent the cumulative amount of net income that has been retained in the company rather than distributed as dividends.

Ending retained earnings = beginning retained earnings + net income - dividens paid.

Question 31

How does net income affect shareholder’s equity

Answer 31

Net income –> retained earnings

retained earnings is a key part of shareholder’s equity

Question 32

What is shareholder’s equity made up of

Answer 32

Represents owners claim after (total assets - total liabilities).

1. Common Stock - par value of issued shares.
2. Additional Paid in Capital (APIC) - excess amount paid for shares
3. Retained Earnings- cumulative amount of net income retained
4. Treasury Stock - represents cost of shares repurchased, reduces shareholder’s equity
5. Accumulated Other Comprehensive Income (AOCI) - other unrealised gains and losses not in net income

Question 33

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why?

Answer 33

1 thing you care about when analysing financial health

Cash Flow Statement

Gives true picture of cash generation independent of all the non-cash expenses.

Question 34

Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?

Answer 34

Income Statement and Balance Sheet as you can then create the Cash Flow statement from both

(assuming you have the before and after version of the Balance sheet that correspond to Income Statement time periods)

Question 35

Walk me through how depreciation going up by $10 would affect the statements

Answer 35

1. Income Statement- Operating income declines by $10 and assuming a 40% tax rate, Net Income goes down by $6
2. Cash Flow Statement- Net Income goes down by $6 but depreciation is a non-cash expense that gets added back so overallnet cash flow goes up by $4.
3. Balance Sheet - PP&E goes down by $10 on assets and Cash is up by $4.

Thus assets are down by $6, since net income fell by $6 as well, SHareholder’s equity on the liabilities and shareholders side fell by $6 too.

Question 36

How should you approach the questions to do with the impact of changing a line item on statements

Answer 36

Always go in the order:

1. Income Statement
2. Cash Flow Statement
3. Balance Sheet

Thus you can make sure the balance sheet balances.

Question 37

How do Asset or Liability changes affect cash flow

Answer 37

Asset going up decreases cash flow

Liability going up increases cash flow

Question 38

If Depreciation is a non-cash expense, why does it not affect the cash balance

Answer 38

• Depreciation is a non-cash expense, so it is tax-deductible as taxes are a cash expense.
• Depreciation reduces to amount of taxes you pay.

Question 39

Where does Depreciation usually show up on the Income Statement

Answer 39

Each company does it differently, could be:

1. COGS
2. Operating Expenses

End result is the same, depreciation always reduces pre-tax income

Question 40

What happens when Accrued Compensation goes up by $10

Answer 40

Confirm that accrued compensation is now being recognised as an expense (rather than just changing non-accrued to accrued compensation)

1. Income Statement: operating expenses goe up by $10, Pre-Tax Income goes up by $10 and Net Income falls by $6 (assuming a 40% tax rate)
2. Cash Flow Statement: Net Income down by $6 and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations i up by $4 and the net change in cash is up by $4.
3. Balance Sheet: Cash is up by $4, so Assets are up by $4. Accrued compenisation is a liability so liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balanced.

Question 41

What is accrued compensation

Answer 41

Wages, salaries, bonuses and other forms of compensation that employees have earned but not been paid.

Recongised as a current liability on balance sheet and an expense on the income statement.

Question 42

What is inventory

Answer 42

a current asset that a business holds for resale or production. Types of inventory:

1. Raw Materials
2. Work-in-Progress (WIP).
3. Finished Goods
4. Maintenance, Repair and Operations (MRO) Inventory

Question 43

What are common inventory valuation methods

Answer 43

First-In, First-Out (FIFO):

• Assumes that the oldest inventory items are sold first.
• In times of rising prices, FIFO results in lower cost of goods sold and higher ending inventory value.

Last-In, First-Out (LIFO):

• Assumes that the newest inventory items are sold first.
• In times of rising prices, LIFO results in higher cost of goods sold and lower ending inventory value.

Weighted Average Cost:

This method averages the cost of all inventory items available for sale during the period and uses this average cost to value ending inventory and cost of goods sold.

Specific Identification:

This method tracks the actual cost of each specific item of inventory. It is practical for businesses with unique, high-value items.

Question 44

What happens when Inventory goes up by $10, assuming you pay for it with cash?

Answer 44

1. Income Statement: no change
2. Cash Flow Statement: Decreases Cash Flow from Operations by $10, as does the Net Change in Cash at the bottom.
3. Balance Sheet: Inventory goes up by $10 but Cash Flow down by $10 so the changes cancel out

Question 45

Why is the income statement not affected by changes in Inventory

Answer 45

Working capital changes do not show up on the Income Statement

Expense only recorded when goods associared with it are sold –> goes to COGS or Operating Expenses

Question 46

Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?

Answer 46

At the start of ‘Year 1’:

1. Income Statement: no change
2. Cash Flow Statement: $100 reduction in cash flow from investing, $100 increase from debt raised. Net cash stays the same.
3. Balance Sheet: increase in $100 in PPE, increase in debt of $100. Cancel each other out.

Question 48

Let’s say Apple is buying $100 worth of new iPod factories with debt. The debt is high-yield so no principal is paid off, and assume an interest rate of 10%.

Also assume the factories depreciate at a rate of 10% per year. What happens at the start of Year 2?

Answer 48

Income Statement: Operating Income reduce by $10 by D&A and $10 in Interest. W tax, Net income would fall by $12

Cash Flow Statement: Net income down by $12, add back D&A to have CFO down by $2.

Balance Sheet:Cash down by $2 and PPE down by $2 –> ASsets down by $12.

Net Income down by $12 –> Shareholder’s Equity down by $12 and balance.

Question 49

Let’s say Apple is buying $100 worth of new iPod factories with debt.

The debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year.

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

Answer 49

Income Statement: $80 write down on pre-tax income, 40% tax–> Net income declines by $48

Cash Flow Statement: Net Income down by $48 but non-cash expense so added back, CFO increases by $32. Loan payback decreases CFI by $100 –> Net Change in Cash is a fall of $68.

Balance Sheet - Cash down by $68, PPE down by $80 –> assets down by $148.

Debt down $100 and Net Income down $48 –> Liabilites and Shareholders Eq. down by $148 so balance.

Question 50

Apple is ordering $10 of
additional iPod inventory, using cash on hand. They order the inventory, but they
have not manufactured or sold anything yet – what happens to the 3 statements?

Answer 50

Income Statement: no changes

Cash Flow Statement:
Inventory up by $10 –> CFO decreases by $10 –> overall cash reduces by $10

Balance Sheet: inventory up by $10 –> Cash down by $10 –> balance :)

Question 51

Apple is ordering $10 of
additional iPod inventory, using cash on hand. They sell the iPOds for a revenue of $20. Walk me through the 3 statements under this scenario

Answer 51

Income Statement:

Revenue up by $20 and COGS up by $10 –> Gross Profit up by $10 –> w tax, Net Income up by $6

Cash Flow Statement:

Net income up $6 and Inventory decreased by $10 –> CFO up by $16

Balance Sheet:

Cash up by $16 and Inventory down by $10 vs Net Income up by $6 –> Balance.

Question 52

Could you ever end up with negative shareholder’s equity?

Answer 52

Yes;

1. LBO’s with dividend recap: owner has taken out a large portion of equity, can turn number negative
2. Also if losing money –> declinign retained earnings –> negative shareholder’s equity

Question 53

What is working capital and how is it used.

Answer 53

Working Capital = Current Assets - Current Liabilities

+ve shows company can pay off its short-term liabilities with it’s short term assets

Operating working capital more common in models: (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt)

Question 54

What does negative working capital mean, is it a bad sign?

Answer 54

not necessarily, dependent on:

1. Companies with subscriptions –> high defferred revenues –> -ve working capital
2. Retail and Restaurants –> upfront payment –> increased cash and large accounts payable –> -ve working capital
3. Could also be financial trouble or possible bankruptcy

Question 55

Walk me through what happens on the 3 statements when there’s a writedown of $100.

Answer 55

Income Statement:

$100 write-down on pre-tax Y –> 40% tax, Net Income declines by $60

Cash Flow Statement:

Net Income down by $60, but write down is a non-cash expense so added back –> CFO and net changes increases by $40

Balance Sheet

Cash is up by $40 and assets down by $100 –> Asset’s down by $60

Net Income down by $60 –> Shareholder’s Equity down by $60

Question 56

Walk me through a $100 “bailout” of a company and how it affects the 3
statements.

Answer 56

Clarify the bailout; debt, equity, both? most common equity investment form gov.

Income Statement - No Change

Cash Flow Statement

CFF up $100 –> net change up $100

Balance Sheet

Cash up $100 –> Assets up $100
Shareholder’s Equity up $100

Question 57

Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a
company’s balance sheet and how it affects the 3 statements.

Answer 57

Income Statement

Written down liability –> pre-tax income goes up by $100 –> w tax, Net Income goes up by $60

Cash Flow Statement

Net Income up by $60 –> debt write-down of $100 –> CFO and Net Cash down by $40

Balance Sheet

Cash down $60 –> Assets down $60
Debt down $100, Net Income up $60 –> Shareholder’s Equity up by $40

Question 58

When would a company collect cash from a customer and not record it as revenue

Answer 58

Companies that agree to perform services in the future collect cash upfront:

1. Web-based subscription software
2. Cell phone carriers that sell annual contracts
3. Magazine publishers that sell subcriptions

per GAAP, only record revenue when you perform services

Question 58

What’s the difference between accounts receivable and deferred revenue?

Answer 58

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been.

Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.

Question 58

What’s the difference between cash-based and accrual accounting?

Answer 58

• Cash based accounting recognises revenue and expenses when cash is actually recieved
• Accrual recognises revenue when collection is resonably certain and expenses when they are incurred rather than paid out in cash

most big companies use accrual due to credit card uses

Question 58

If cash collected is not recorded as revenue, what happens to it?

Answer 58

Goes into Deferred Revenue on the Balance Sheet under Liabilities

As the services performed, Deferred Revenue balance ‘turns into’ real revenue on the Income Statement

Question 59

How long does it usually take for a company to collect its accounts receivable balance?

Answer 59

Generally the accounts receivable days are in the 40-50 day range, though it’s higher for companies selling high-end items and it might be lower for smaller, lower transactionvalue companies.

Question 59

How do you decide when to capitalize rather than expense a purchase?

Answer 59

If the asset has a useful life of over 1 year, it is capitalised.

Question 59

Let’s say a customer pays for a TV with a credit card. What would this look like
under cash-based vs. accrual accounting?

Answer 59

Cash-based accounting:

Revenue would not show up until company charges the company card and deposits the funds in the bank account.

Accrual Accounting:

Show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company’s bank account, it would “turn into” Cash.

Question 60

What is capitalising rather than expensing a purchase

Answer 60

Expensing:
* Immediate impact on income statement
* Used for items with short-term benefits or low costs

Capitalising:
* Cost is recorded on the balance sheet as an asset and then depreciation/amortised over it’s useful life
* Used for larger purchases that provide long term benefits

Question 61

Why do companies report both GAAP and non-GAAP (“pro forma”) earnings

Answer 61

Many companies have non-cash charges (A,Stock-based compensation, deferred revenue write down) in their income statements. GAAP underestimates the profitability of a company.

Question 62

A company has had positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen?

Answer 62

Possibilities:

1. Company spent too much on CapEx; these are not reflected in EBITDA
2. High interest expensure
3. Debt matures and unable to refinance, losing all the cash
4. Singificant one-time charges that bankrupt the company

As EBITDA excludes investment (and depreciation) in long-term assets, interest and one-time charges

Question 63

Normally Goodwill remains constant on the Balance Sheet – why would it be
impaired and what does Goodwill Impairment mean?

Answer 63

Happens when company is acquired and intangible assets (customers, brand, intellectual prop.) and values them much worse

Can also happen when a company discontinues part of its operations and must impair the associated goodwill

Question 64

Under what circumstances would Goodwill increase?

Answer 64

1. Company is acquired, goodwill increases as a ‘plug’ for purchase price
2. Company acquires another company for more than it’s assets worth, leading to net goodwill increase

Question 65

How is GAAP accounting different from tax accounting

Answer 65

1. GAAP accrual-based but tax is cash-based
2. GAAP normally uses straight line depreciation whereas tax accounting uses accelerated depreciation
3. GAAP more accurately tracks assets/liabilities whereas tax accounting only concerned with revenue/expenses in the current period and what income tax you owe.

Question 66

What are deferred tax assets/liabillities

Answer 66

Temporary difference between what a company can dedict with cash tax purposes vs what they can deduct for book tax purposes

Question 67

When do deferred tax assets/liabilities arise

Answer 67

Deferred Tax Liabilities: when you have a tax expense on the Income Statement but haven’t paid that tax in cash

Deferred Tax Assets: when you pay taxes in cash but haven’t expensed them on the income statement

Question 68

When do deferred tax assets/liabilities have to do M&A deals

Answer 68

most common with asset write-ups and write-downs in M&A deals

asset write-up –> produce a deferred tax liability

asset write-down –> produce a deferred tax asset

Question 69

Walk me through how you create a revenue model for a company

Answer 69

Either bottoms up (more common and reliable) or tops-down builds:

1. Bottom-Up: Start with individual products/customers estimate the average sale value, and then the growth rate in sales
2. Tops-Down: Start with overall market size and then estimate company’s market share to get revenue

Question 70

Walk me through how you create an expense model for a company

Answer 70

Bottoms up:

no. of employees by department –> avg. salary, benefits, bonuses –> assume growth rates based on revenue or other

COGS tied to revenue

CapEX and misc. epenses are related to a company’s internal plans for expansion

Question 71

Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do?

Answer 71

Use estimates:

• For revenue, assume a simple growth rate
• For expenses, assume major expenses e.g. SG&A are a % of revenue

Question 72

Walk me through the major items in Shareholders’ Equity.

Answer 72

1. Common Stock: par value of issued stock
2. Retained Earnings: net income ‘saved up’ over time
3. Additional Paid in Capital: how much stock based compensation issues and new stock exercised by employee options (contra equity)
4. Treasury Stock: dollar amount of shares the company has bought back
5. Accumulated other comprehensive income: misc. income

Question 73

Walk me through what flows into retained earnings

Answer 73

Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued

Question 74

Walk me through what flows into Additional Paid-In Capial (APIC)

Answer 74

Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued

Question 75

Formula for APIC (Additional Paid In Capital)

Answer 75

APIC = Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises

Take the balance from last year, add this year’s stock-based compensation number, and then add in the value of new stock created by employees exercising options this year

Question 76

What is the Statement of Shareholders’ Equity and why do we use it?

Answer 76

Shows the major items that comprise Shareholder’s Equity

You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations

Question 77

What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?

Answer 77

• Restructuring Charges
• Goodwill Impairment
• Asset Write-Downs
• Bad Debt Expenses
• Legal Expenses
• Disaster Expenses
• Change in Accounting Procedures

To be an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement

Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA / EBIT, but that these are not “non-recurring charges” because all companies have them every year – these are just non-cash charges.

Question 78

How do you project Balance Sheet items like Accounts Recieveable and Accrued Expenses in a 3-statement model

Answer 78

Assumption as %:

• Accounts Recieveable: % of revenue
• Deferred Revenue: % of revenue
• Accounts Payable: % of COGS
• Accrued Expenses: % of operating expenses or SG&A

carry out same % into the future or assume slight changes

Question 79

How should you project Depreciation and CapEx

Answer 79

Simple way: project each one as a % of revenye or previous PP&E balance

Complex:
* PP&E Schedule that splits out different assets by useful lives.
* Assume straight-line depreciation over useful life
* Assumes CapEx based on historical investment

Question 80

How do Net Operating Losses (NOLs) affect a company’s 3 statements (quick and dirty method)

Answer 80

‘Quick and dirty’ - reduce taxable income by the portion of NOLs useable this year –> apply same tax rate and subtract new tax from old pretax income

Question 81

Whate are NOLs (Net Operating Losses)

Answer 81

Occurs when a company’s tax-deductible expenses exceed its taxable revenues

Can use this loss to offset taxable income in other years. Can also be carried forward to future years to reduce taxes

Question 82

How do Net Operating Losses (NOLs) affect a company’s 3 statements

Answer 82

Create a book vs cash tax schedule –> calculate Taxable Income based on NOLs vs calculate taxable income without the NOLs

Then book the difference as an increase to deffered tax liability on the balance sheet.

Question 83

What’s the difference between capital leases and operating leases?

Answer 83

Operating leases: short-term leasing of equipment and property, do not involve any ownership.

Capital leases: used for longer-term and give ownership rights –> they depreciate, incure interest and are counted as debt

Question 84

What are the 4 conditions, that if any are true, a lease is a capital lease

Answer 84

1. transfer of ownership at the end of the term
2. option to purchase the asset at a bargain price at end of term
3. Term of lease is greater than 75% of the useful life of the asset
4. if PV of the lease payments is greater than 90% of the asset’s fair market value

Question 85

Why do we look at both Enterprise and Equity Value

Answer 85

Enterprise Value = value of company attributale to all investors

Equity value = portion avaliable to shareholders (equity investors)

Question 86

When looking at an acquisition of a company do you pay more attention to enterprise or equity value

Answer 86

Enterprise Value, as it’s how much an acquirer really ‘pays’ and includes the mandatory debt repayments

Question 87

What is the formula for Enterprise Value

Answer 87

EV = Equity Value + Debt + Preferred Stock + Minority Interest - Cash

(formula not entire story and gets more complex)

Question 88

Why do you need to add Minority Interest to Enterprise Value

Answer 88

Whenever a company owns over 50% of another company, it is required to report 100% of the financial performance of the other company as part of its own performance.

Hence you must add minority interest to EV to reflect the subsidiary

Question 89

How do you calculate fully diluted shares

Answer 89

Basic share county + dilutive effect of stock options + other dilutive securities (e.g. warrants, convertible debt or convertible preferred stock)

To calculate dilutive effect of options you use the Treasury Stock Method

Question 90

What is the dilutive effect of stock options

Answer 90

The dilutive effect of stock options refers to the reduction in the ownership percentage and earnings per share (EPS) for existing shareholders when new shares are issued as a result of employees or others exercising their stock options.

Question 91

What are dilutive securities

Answer 91

Financial instruments that can be converted into common stock, increasing outstanding shares and diluting ownership

Question 92

What are warrants

Answer 92

• Warrants are similar to stock options but issued directly by the company and have a longer duration.

Question 93

1.

What is convertible debt

Answer 93

Type of bond/loan that can be converted into a predefined number of shares, at discretion of bondholder

Question 94

What is convertible preferred stock

Answer 94

Type of preferred share that gives the holder the option to convert the preferred shares into a certain number of common shares (usually at a fixed ratio)

Question 95

What is a restricted stock unit (RSU)

Answer 95

RSUs are company shares given to employees as part of their conversion package, subject to vesting conditions.

Question 96

What are convertible bonds

Answer 96

Type of bond that can be converted into a predetermind number of common shares during the bond’s life, at the bondholder’s discretion

Question 97

If a company has 100 shares outstanding, at a share price of $10 each.

Also has 10 options outstanding at an exercise price of $5 each - what is it fully diluted equity value

Answer 97

Basic Equity: 100 * $10= $1000

When options exercised share count increases from 100 –> 110

Company has additional cash of $50 (10 * $5), which is used to buy back 5 of the new shares

Share count goes from 110 –> 105. Fully diluted equity value is $1,050

Question 98

Let’s say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each – what is its fully diluted equity value?

Answer 98

$1,000. In this case the options’ exercise price is above the current share price (out of the money), so they have no dilutive effect as they are not expected to be exercised.

Question 99

What is fully diluted equity

Answer 99

Total equity of a company that would exist if all potential sources of equity were exercised or converted into common stock

Question 100

Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

Answer 100

The “official” reason: Cash is subtracted because it’s considered a non-operating asset and because Equity Value implicitly accounts for it.

The way I think about it: In an acquisition, the buyer would “get” the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d really have to “pay” to acquire
another company.

It’s not always accurate because technically you should be subtracting only excess cash –
the amount of cash a company has above the minimum cash it requires to operate.

Question 101

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

Answer 101

In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller’s debt, so it is accurate to say that any debt “adds” to the purchase price.

However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I’ve personally never seen it, but once again “never say never” applies.

Question 102

Could a company have a negative Enterprise Value? What would that mean?

Answer 102

Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with:

1. Companies on the brink of bankruptcy.
2. Financial institutions, such as banks, that have large cash balances.

Question 103

Could a company have a negative Equity Value? What would that mean?

Answer 103

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

Question 104

Why do we add Preferred Stock to get to Enterprise Value?

Answer 104

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company’s assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

Question 105

How do you account for convertible bonds in the Enterprise Value formula?

Answer 105

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they’re out-of-the-money then you count the face value of the convertibles as part of the company’s Debt.

Question 106

A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?

Answer 106

convertible bonds are in-the-money because the company’s share price is $100 and conversion price is $50. So we count them as additional shares rather than debt.

divide the value of the convertible bonds – $10 million – by the par value – $1,000 – to find no. of individual bonds:

$10 million / $1,000 = 10,000 convertible bonds.

figure out how many shares this number represents. The number of
shares per bond is the par value divided by the conversion price:

$1,000 / $50 = 20 shares per bond
.
So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million diluted shares outstanding.

Question 107

Why is the Treasury Stock Method not used with convertible bond calculation with diluted shares outstanding

Answer 107

We do not use the Treasury Stock Method with convertibles because the company is not “receiving” any cash from us.

Question 108

What’s the difference between Equity Value and Shareholders’ Equity

Answer 108

Equity value = Market value

Shareholders’ Equity = Book value

Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders’ Equity could be any value. For healthy companies, Equity Value usually far exceeds Shareholders’ Equity.

Question 109

Are there any problems with the Enterprise Value formula (EV= Equity Value - Cash + Debt + Preferred Stock + Minority Interest) you just gave me?

Answer 109

Too simple, need to add:

1. Net Operating Losses - similar to cash
2. Long-Term Investments - similar to cash
3. Equity Investments - similar to cash, should be discounted
4. Capital Leases - also have interest payments so should be added in like debt
5. (Some) Operating Leases - sometimes need to convert operating leases to capital leases and add them as well
6. Unfunded Pension Obligations - counted as debt asw

Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Minority Interest – NOLs – Investments + Capital Leases + Unfunded Pension Obligations

Question 110

Should you use the book value or market value of each item when calculating Enterprise Value?

Answer 110

Technically, you should use market value for everything.

In practice, use market value only for the Equity Value portion, because it’s almost impossible to establish market values for the rest of the items in the formula.

Question 111

What percentage dilution in Equity Value is “too high?”

Answer 111

anything over 10% is odd.

If your basic Equity Value is $100 million and the diluted Equity Value is $115 million, you might want to check your calculations – it’s not necessarily wrong, but over 10% dilution is unusual for most companies.

Question 112

What are the 3 major valuation methodologies?

Answer 112

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

Question 113

Rank the 3 valuation methodologies from highest to lowest expected value.

Answer 113

There is no ranking that always holds.

In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium

a DCF could go either way and it’s best to say that it’s more variable than
other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

Question 114

When would you not use a DCF in a Valuation

Answer 114

1. If the company has unstable or unpredictable cash flows (e.g. start ups)
2. When working capital and debt serve a fundamentally different role

(e.g. banks and financial institutions do not re-invest debt and working capital is a huge part of their balance sheet)

Question 115

What other Valuation methodologies are there? Give 6

Answer 115

1. Liquidation Valuation: Selling company’s assets at fair market value - liabilities = determine capital that equity investors recieve
2. Replacement Value – Valuing a company based on the cost of replacing its assets
3. LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
4. Sum of the Parts – Valuing each division of a company separately and adding them together at the end
5. M&A Premiums Analysis – Find the acquisition premium to establish what your company is worth
6. Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of comps, then discounting it back to its PV

Question 116

When would you use a liquidation valuation

Answer 116

Used to see wether equity shareholders will recieve any capital after debts have been paid off.

Advise struggling business on wether to sell off assets or entire company

Question 117

When would you use Sum of the Parts

Answer 117

Used in conglomerates with unrelated divisions as can’t use same comps and precedents for diff divisions.

Question 118

When do you use an LBO Analysis as part of your valuation

Answer 118

Used to establish purchase price a PE firm could pay, which is usually lower than what companies will pay

Often used as a ‘floor’ on a possible valuation

Question 119

What are the most common multiples used in Valuation

Answer 119

EV/Revenue, EV/EBITDA, EV/EBIT, P/E , and P/BV (Share Price / Book Value per Share)

Question 120

What are some examples of industry-specific multiples?

Answer 120

Technology (Internet): EV / Unique Visitors, EV / Pageviews

Retail / Airlines: EV / EBITDAR

Energy: EV / EBITDAX, EV / Daily Production, EV / Proved Reserve Quantities

Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations)

For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring,
so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating.

Question 121

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?

Answer 121

You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company.

The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to.

Question 122

Would an LBO or DCF give a higher valuation?

Answer 122

Could go either way, but mostly LBO will give a lower valuation

This is as an LBO valuation only looks at the terminal value, while the DCF looks at both a company’s cash flows throughout and it’s terminal value.

(NOte: LBO gives a price for a given IRR rather than a valuation)

Question 123

How would you present these Valuation methodlogies to a company or its investors?

Answer 123

Usually use a ‘football field’ chart where you show the valuation range

Question 124

How would you value an apple tree?

Answer 124

The same way you would value a company:

1. looking at what comparable apple trees are worth (relative valuation)
2. the value of the apple tree’s cash flows (intrinsic valuation).

Question 125

Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise
Value / EBITDA?

Answer 125

EBITDA is avaliable to all investors, like Enterprise Value

Equity Value/ EBITDA is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure - only the part avaliable to equity investors

Question 126

When would a Liquidation Valuation produce the highest value?

Answer 126

highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason

As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

Question 127

Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

Answer 127

You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.

You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet.

This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!

Question 128

What would you use in conjunction with Free Cash Flow multiples – Equity Value
or Enterprise Value?

Answer 128

Unlevered FCF-Enterprise Value

Levered FCF-Equity Value

Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered already includes Interest and the money is therefore only available to equity investors.

Debt investors have already “been paid” with the interest payments they received

Question 129

You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?

Answer 129

very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead.

MIght be used when using revenue multiples for non-financial institutions

Question 130

How do you select Comparable Companies / Precedent Transactions?

Answer 130

3 main ways:

1. Industry
2. Financial Criteria (Revenue, EBITDA, etc.)
3. Geography

For precedent, often only look at past 1-2 years.

Question 131

What do you actually use a valuation for?

Answer 131

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.

Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

Question 132

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

Answer 132

1. Beaten earnings expectation and stock price rose
2. Some type of competitive advantage not reflected in financials (e.g. key patent or intellectual property)
3. Won a favourable ruling in a major lawsuit
4. Market leader in industry and greater market share

Question 133

What are the flaws with public company comparables

Answer 133

• Never 100% comparable
• Stock market ‘emotional’
• Share prices for small companies with low vol. trading, may not reflect their full value

Question 134

How do you take into account a company’s competitive advantage in a valuation?

Answer 134

1. Look at the 75th percentile or higher for the multiples rather than the Medians.
2. Add in a premium to some of the multiples.
3. Use more aggressive projections for the company.

In practice you rarely do all of the above – these are just possibilities

Question 135

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions

Answer 135

Not necessarily, if:

Distressed company: use 25th percentile

Competitive adv. company: 75th percentile

Question 136

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case?

Answer 136

When big mismatch between M&A and public market

e.g. no public companies has been acquired recently but there have been a lot of small private companies acquired at very low valuations.

Question 137

What are some flaws with precedent transactions?

Answer 137

• Rarely 100% comparable - transaction structure, coompany size and market sentiment all have huge effects.
• Data on precedents is more difficult to find, especially for private small acquisitions

Question 138

Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction – how could this happen?

Answer 138

1. One process more competitive
2. One company had recent bad news or depressed stock price
3. In different industries with different median multiples

Question 139

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Answer 139

Warren Buffett once famously said, “Does management think the tooth fairy pays for capital expenditures?”

He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations.

In some industries there is also a large gap between EBIT and EBITDA –anything that is very capital-intensive, for example, will show a big disparity

Question 140

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s
profitability. What’s the difference between them, and when do you use each one?

Answer 140

P/E depends on capital structure, whereas EV/EBIT and EV/EBITDA are capital-structure netural.

This ise P/E for banks, financial insts. and other companies where interest payments are critical.

EV/EBIT includes D&A whereas EV/EBITDA excludes it –> use EV/EBIT where D&A is large, EV/EBITDA when fixed assets are less important.

Question 141

Why is P/E influenced by capital structure, but EV/EBIT(DA) isn’t

Answer 141

EPS in P/E is derived from net income which is effected by capital structure.

A higher debt causes the P/E to fall due to higher interest payments depressing net income and EPS

EV/EBITDA: EV incl. both equity and debt (balancing both), while EBITDA excludes interest expeneses.

Question 142

If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same
dollar amounts and everything else is held constant.

Answer 142

You would pay more for the one where you lease the machines.

Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not
reflected in EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher

Question 143

How do you value a private company?

Answer 143

Same methodlogy; public comps, precdents and DCF. Differences:

• Apply a 10-15% discount to public comp as private company not as liquid
  Valuation shows Enterprise Value rather than the implied per-share price as with public companies
• DCF estimate WACC based on public comps

Question 144

Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?

Answer 144

no discount because with precedent transactions, you’re acquiring the entire
company – and once it’s acquired, the shares immediately become illiquid.

Question 145

Can you use private companies as part of your valuation?

Answer 145

Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

Question 146

How do you value banks and financial institutions differently from other
companies?

Answer 146

Utilise diff. multiples for public comps and precdents:

• Screen based on assets or desposits
• ROE, ROA, BV and TBV rather than EBITDA
• Use multiples such as P/E, P/BV, and P/TBV rather than EV/EBITDA

Rather than a traditional DCF, use different methodologies for intrinsic valuation:

• Dividend Discount Model (DDM): sum up the PV of a bank’s dividends for the future and then addd it to terminal PV, based on a P/BV
• Residual Income Model: take current BV and add the PV of the excess returns to that BV to value it. “Excess return” each year is (ROE * Book Value) - (Cost of Equity * Book Value)

Question 147

Walk me through an IPO valuation for a company that’s about to go public

Answer 147

We only care about relevant multiples with public company comparables to estimate the enterprise value.

Work to Equity Value from Enterprise Value and also subtract IPO proceeds to get ‘new’ cash

Divide by total number of shares to egt new share price

If you were using P / E or any other “Equity Value-based multiple” for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there.

Question 148

I’m looking at financial data for a public company comparable, and it’s April (Q2)
right now. Walk me through how you would “calendarise” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.

Answer 148

The “formula” to calendarize financial statements is as follows:

TTM = Most Recent Fiscal Year + New Partial Period – Old Partial Period

e.g. take company’s Q1 numbers, add the most recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year.

Question 149

Walk me through an M&A premiums analysis

Answer 149

Looking at similar transactions and seeing the premiums:

1. Screen precedents (industry, date and size)
2. Get the Seller’s share price before announced transaction
3. Calculate the day premiums
4. Get medians for each set and apply to companys current share price

Question 150

Walk me through a future share price analysis

Answer 150

Projectin companies share price and then discounting back to PV:

1. Get the median historical P/E of public comps
2. Apply multiple to company’s 1/2yr forward to projected EPS to get its implied future share price.
3. DIcount back to PV using a discount rate in line with Cost of Equity

Norm do a sensitivity anlysis with a range of PE and discount rates

Question 151

Both M&A premiums analysis and precedent transactions involve looking at previous M&A transactions. What’s the difference in how we select them?

Answer 151

• All sellers in the M&A premiums must be public
• Use a broader set of transactions for M&A premiums; +10 and less stringent.

Question 153

Walk me through a Sum-of-the-Parts analysis

Answer 153

Value each division of a company using separate comps and transactions, then add up each division’s value to get the total for the company.

Question 154

How do you value Net Operating Losses and take them into account in a valuation

Answer 154

NOLs based on how much they’ll save the company in taxes in future years and then the PV of the sum of tax savings.

1. Assume a company can use NOLs to completely offset taxable income until the NOLs run out
2. Im Acquisition scenario, use SEction 382, and multiply the adjusted long-term, published by the IRS, rate by the equity purchase price of the seller to determine the maximum allowed NOL useage in each year.

You might look at NOLs in a valuation but you rarely add them in – if you did, they would be similar to cash and you would subtract NOLs to go from Equity Value to Enterprise Value, and vice versa

Question 155

I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?

Answer 155

This varies by bank and group, but two common methods:

1. You pick the report with the most detailed information.
2. You pick the report with numbers in the middle of the range

Question 156

I have a set of precedent transactions but I’m missing information like EBITDA
for a lot of the companies – how can I find it if it’s not available via public sources?

Answer 156

1. Search online and see if you can find press releases or articles in the financial
   press with these numbers.
2. Failing that, look in equity research for the buyer around the time of the
   transaction and see if any of the analysts estimate the seller’s numbers.
3. Also look on online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates

Question 157

How far back and forward do we usually go for public company comparable and
precedent transaction multiples?

Answer 157

Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years.

Public Comps: More likely to look backward and foward more.

Precedent transactions: odd to go forward more than 1 year because your information is more limited

Question 158

I have one company with a 40% EBITDA margin trading at 8x EBITDA, and
another company with a 10% EBITDA margin trading at 16x EBITDA. What’s the problem with comparing these two valuations directly?

Answer 158

Misleading to compare companies with v diff margins. One with higher margin will usually have a lower multiple.

Consider screening based on margins.

Question 159

Walk me through how we might value an oil & gas company and how it’s
different from a “standard” company

Answer 159

Public comps and precedents similar but:

• Might screen on metrics like Proved Reserves or Daily Production –> R/P (Proved Reserves/ Last Years Production), EBITDAX

Could also use unlevered DCf or NAV (Net Asset Value) Model.

ALso different accounting models may effect valuation.

Question 160

Walk me through how we would value a REIT (Real Estate Investment Trust) and
how it differs from a “normal” company.

Answer 160

REITs asset intensive and dep. on cash generation of assets:

• Price/FFO per Share (Funds from Operations) and Price/AFFO (Adjusted FFO), which adds back Depreciation and substact gains on property sales
• Value properties through NOI/cap rate
• Replacement Valuation is more common because can estimate the cost of buying new land and building new properties

Question 161

Walk me through a DCF

Answer 161

DCF values a company based on PV of its cash flows and PV of it’s terminal value

FIrst project company’s financials using assumptions for re. growth, expenses, working capital; then get down to free cash flow for each year, sum and discount to NPV based on WACC

Determine the company’s Termial Value using Multiples or Gordon Growth, discount back to NPV using WACC

Add NPV of Terminal Value + NPV of Projected FCF

Question 162

Walk me through how you get from revenue to free cash flow

Answer 162

Revenue - COGS - Operating Expenses = Operating Income (EBIT)

EBIT * (1-Tax Rate) = NOPAT (Net Operating Profit After Taxes)

NOPAT + Depreciation + non-cash charges + Net Working Capital -CapEx = Unlevered Free Cash Flow

Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You should confirm that this is what the interviewer is asking for.

Question 163

WHy do you minus CapEx to get FCF

Answer 163

CapEx is a cash outflow necessary to both sustain and grow operations.

Hence for FCF to be truly ‘free’ it must have no CapEx charge

Question 164

What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Answer 164

Cash Flow from Operations - CapEx = Levered Cash Flow

To get to Unlevered Cash Flow, you then need to add back the tax-adjusted
Interest Expense and subtract the tax-adjusted Interest Income.

Question 165

What is Net Working Capital and how does it affect Free Cash Flow

Answer 165

NWC = Current Assets - Current Liabiliites

Increase in working capital indicates more cash is tied up in operating the business

Decrease in working capital means company is freeing up cash from operations.

Question 166

Why do you use 5 or 10 years for DCF projection

Answer 166

That’s usually about as far as you can reasonably predict into the future.

Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

Question 167

What do you usually use for the discount rate?

Answer 167

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you’ve set up the DCF (e.g. LFCF)

Question 168

How do you calculate WACC

Answer 168

Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) +
Cost of Preferred * (% Preferred)

Cost of Equity derived from the CAPM, others look at comparable companies

Question 169

1.

When calculating the WACC why is the (Cost of debt * (Debt %)) multipled by (1-tax rate)

Answer 169

Interest is Tax-Deductible, creating a tax shield and an after-tax cost of debt.

After Tax Cost of Debt = Cost of Debt * (1- tax rate)

Ensure the WACC appropiately reflects after tax costs of all forms of capital

Question 170

How do you calculate the Cost of Equity?

Answer 170

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

Pull equity risk premium from Ibbotson’s

Can also include a size, industry and country premium to account for performance

Question 171

How do you get to Beta in the Cost of Equity calculation?

Answer 171

1. Look up the Beta for each Comparable Company (usually on Bloomberg)
2. un-lever each one, take the median of the set and then lever it based on your company’s capital structure.
3. Then you use this Levered Beta in the Cost of Equity calculation

Question 172

What is the formula for un-levering and levering Beta

Answer 172

Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 173

1.

Why do you have to un-lever and re-lever Beta

Answer 173

‘Apples-to-Apples’ theme

Betas levered to reflect debt/equity mix of that company –> need to unlever and relever to reflect our company

Question 174

Would you expect a manufacturing company or a technology company to have a higher Beta?

Answer 174

A technology company, because technology is viewed as a “riskier” industry than manufacturing.

Question 175

Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash
Flow in your DCF – what is the effect?

Answer 175

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been “paid” with the interest payments).

Question 179

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Answer 179

use the Cost of Equity rather than WACC since we’re not concerned with Debt or Preferred Stock in this case – we’re calculating Equity Value, not Enterprise
Value.

Question 180

How do you calculate the Terminal Value?

Answer 180

1. Apply exit multiple to Y5 EBITDA, EBIT or FCF
2. Gordon’s Growth
   Terminal Value = Y5 FCF * (1+Growth Rate)/(Discount Rate - Growth Rate)

Question 180

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

Answer 180

Normally always use comps

Use Gordon Growth if no good comps or have reason to believe multiples will change sig.

If v. cyclical might use long-term growth rates rather than exit multiples.

Question 180

What’s an appropriate growth rate to use when calculating the Terminal Value?

Answer 180

Normally you use the country’s long-term GDP growth rate, the rate of inflation, or something similarly conservative.

Question 181

How do you select the appropriate exit multiple when calculating Terminal Value?

Answer 181

Look at comps and pick median

Show a range of exit multiples and Terminal Values over that range

Question 182

Which method of calculating Terminal Value will give you a higher valuation?

Answer 182

Hard to generalise as dep. on assumptions

Multiples more variable than the Gordon Growth method, as multiples span a wider range than possible long-term growth rates.

Question 183

What’s the flaw with basing terminal multiples on what public company
comparables are trading at?

Answer 183

median multiples may change greatly in the next 5-10 years

normally look at a wide range of multiples and do a sensitivity

Multiples is particularly problematic with cyclical industries (e.g. semiconductors).

Question 184

How do you know if your DCF is too dependent on future assumptions?

Answer 184

The “standard” answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions

In reality, almost all DCFs are “too dependent on future assumptions” – it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.

But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…

Question 185

Should Cost of Equity be higher for a $5 billion or $500 million market cap
company?

Answer 185

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be “more risky”).

Question 186

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 186

trick question because it depends on whether the capital structure
is the same for both companies.

If the capital structure is the same:

WACC should be higher for the $500
million company

If capital structure is not the same:

Could go either way depending on how much debt/preffered stock each one has and what the interest rates are.

Question 187

How do you calculate the Cost of Debt

Answer 187

Weighted Average Interest Rate = Pre-Tax cost of debt

After Tax-Cost of Debt = Pre-Tax cost of debt * (1-Tax Rate)

Question 188

What’s the relationship between debt and Cost of Equity?

Answer 188

More debt means that the company is more risky, so the company’s Levered Beta will be higher – all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity

Question 189

Cost of Equity tells us what kind of return an equity investor can expect for
investing in a given company – but what about dividends? Shouldn’t we factor
dividend yield into the formula?

Answer 189

Trick Question.

Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include dividends

Question 190

How can we calculate Cost of Equity WITHOUT using CAPM

Answer 190

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends

Use when dividends are v important or lack info on beta or other variables in CAPM

Question 191

Cost of Equity tells us what kind of return an equity investor can expect for
investing in a given company – but what about dividends? Shouldn’t we factor
dividend yield into the formula?

Answer 191

One without debt will have a higher WACC up to a certain point then it increases

First Phase debt is ‘cheaper’ as:
* Interest on debt is tax-deductible
* Debt is senior to equity in capital structure, so get paid first.
* Interest rates on debt are lower than Cost of Equity, so Cost of Debt portion of WACC will contribute less than the Cost of Equity portion

Once debt is high enough, IR rises dramatically –> Cost of Debt increases to higher than Cost of Equity and additional debt increases WACC

Creates U-Shape graph.

Question 192

Which has a greater impact on a company’s DCF valuation – a 10% change in revenue or a 1% change in the discount rate?

Answer 192

You should start by saying, “it depends” but most of the time the 10% difference in revenue will have more of an impact.

That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Question 193

What about a 1% change in revenue vs. a 1% change in the discount rate?

Answer 193

The discount rate is likely to have a bigger impact on the valuation, though
the correct answer should start with, “It could go either way, but most of the time…”

Question 194

How do you calculate WACC for a private company?

Answer 194

estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

Question 195

What should you do if you don’t believe management’s projections for a DCF
model?

Answer 195

• Create your own projections.
• Modify management’s projections to make them more conservative.
• sensitivity table based on management and more conservative growth rates and margins

Question 196

Why would you not use a DCF for a bank or other financial institution?

Answer 196

Banks use debt differently and do not re-invest it in the business; use it to create loans

Interest is a critical part of banks’ business models and changes in working capital can be much larger than a bank’s net income – so traditional measures of cash flow don’t tell you much.

For financial institutions, it’s more common to use a Dividend Discount Model or Residual Income Model instead of a DCF

Question 197

What types of sensitivity analyses would we look at in a DCF?

Answer 197

Example sensitivities:

• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

Question 198

1.

A company has a high debt load and is paying off a significant portion of its
principal each year. How do you account for this in a DCF?

Answer 198

Trick question.

You don’t account for this at all in a DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement – but we only go down to Cash Flow from Operations and then subtract Capital Expenditures to get to Free Cash Flow.

If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off – but we still wouldn’t count the principal repayments themselves anywhere.

Question 199

What is the mid-year convention

Answer 199

Adjustment to DCF that assumes cash flows are recieved evenly throughout the year –> thus can be treated as if recieved in the middle of the year

Question 200

Explain why we would use the mid-year convention in a DCF.

Answer 200

You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year – instead, it comes in evenly throughout each year.

In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on.

With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second
year, 2.5 for the third year, and so on

Question 201

What is the stub period in the DCF

Answer 201

Stub period refers to a partial period at the start or end of the forecast timeline shorter than a full year.

Question 202

What discount period numbers would I use for the mid-year convention if I have a stub period – e.g. Q4 of Year 1 – in my DCF?

Answer 202

Question 203

How does the terminal value calculation change when we use the mid-year
convention?

Answer 203

1. Multiples Method

add 0.5 to the final year discoutn number, to reflect the fact the company gets sold at the end of the year.

2. Gordon Growth Method

no adjustment as assuming cash flows grow into prepetuity and recieved throughout the year

Question 204

If im working with a public company in a DCF, how do i calculate its per-share value

Answer 204

Enterprise Value –> + Cash, - Debt,- Preferred Stock, - Minority interests (and other debt like items) = Equity Value

Use circular calculation that takes into account basic shares outstanding, options, warrants, convertibles, and other dilutive securities.

It’s circular because the dilution from these depends on the per-share price – but the per-share price depends on number of shares outstanding, which depends on the per-share price.

Question 207

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

Answer 207

Mechanically same as DCF but dividends rather than FCF:

1. Project out the company’s earnings, down to EPS
2. Assume a dividend payout ratio of EPS based on historicals and how much regulatory capital it needs.
3. Use this to calculate dividends over the next 5-10 years.
4. Check to make sure that the firm still meets its target Tier 1 Capital and
   other capital ratios – if not, reduce dividends.
5. Discount the dividend in each year to its present value based on Cost of Equity and then sum these up.
6. Calculate terminal value based on P / BV and BV in the final year, and
   then discount this to its PV based on Cost of Equity.
7. Sum the PV of the terminal value and the PV of the dividends to get the company’s net present per-share value.

Question 208

What is convertible debt

Answer 208

a loan that a company receives, which gives the bondholder the option to convert the debt into a specified number of shares of the company’s common stock at a predetermined conversion price and under certain conditions.

Question 209

When you’re calculating WACC, let’s say that the company has convertible debt.

Do you count this as debt when calculating Levered Beta for the company?

Answer 209

Trick question.

If the convertible debt is

in-the-money then you do not count it as debt but instead assume that it contributes to dilution, so the company’s Equity Value is higher.

out-of-the-money then you count it as debt and use the interest rate on the convertible for Cost of Debt.

Question 210

We’re creating a DCF for a company that is planning to buy a factory for $100 in
cash in Year 4. Currently the PV of its Enterprise Value according to the DCF is $200.

How would we change the DCF to
account for the factory purchase, and what would our new Enterprise Value be?

Answer 210

add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow.

The actual math here is messy but you would calculate the present value by dividing $100 by ((1 + Discount Rate)^4) – the “4” just represents year 4 here. Then you would subtract this amount from the Enterprise Value.

Question 212

What do you need to know mainly about Meger Models

Answer 212

You don’t need to understand merger models as well as an M&A banker does, but you do need to more than just the basics, especially if you’ve had a finance internship or fulltime job before.

It’s important to know the effects of an acquisition, and understand concepts such as synergies and why Goodwill & Other Intangibles actually get created.

One thing that’s not important? Walking through how all 3 statements apre affected by an acquisition. In 99% of cases, you only care about the Income Statement in a merger model (despite rumors to the contrary).

Question 213

Walk me through a basic merger model

Answer 213

Analyses: financial profiles of 2 companies, purchase price, how purchase is made, determines wether buyer EPS increases or decreases

1. Make assumption about the acquisition - price, cash or debt combination, valuations and shares of buyer and seller, project out an Income Statement for each one
2. Combine income statements, adjust for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer’s Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the
   combined EPS

Question 214

What’s the difference between a merger and an acquisition?

Answer 214

difference between “merger”
and “acquisition” is more semantic than anything. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

Question 215

Why would a company want to acquire another company?

Answer 215

Possible reasons:
* Gain market share
* Grow quicker
* Seller undervalued or has critical tech/IP e.g. medical patents
* Significant synergies

Question 216

Why would an acquisition be dilutive?

Answer 216

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares.

Acquisition effects – such as amortization of intangibles – can also make an acquisition
dilutive.

Question 217

What is foregone interest on Cash, Interest paid on Debt , and why is it adjusted in the merger model when combining income statements?

Answer 217

Foregone interest on cash - interest income that a company loses when it uses its cash reserves to finance an acquisition instead of leaving that cash invested in interest-bearing accounts or securities.

Interest Paid on Debt: If the acquisition is financed with debt, the combined company’s income statement must reflect the new interest expenses.

Question 218

What are acquisition effects

Answer 218

Financial consequences from an acquisition:

changes in operating expenses, new costs related to integration, changes in capital structure, and the amortization of intangible assets, among others.

Question 219

What effect does the amortisation of intangibles on the dilutive effect of acquisitions

Answer 219

Amortization of intangibles is the process of gradually expensing the value of intangible assets over their useful lives.

During an acquisition, it often pays more than the fair market value of the tangible assets. The excess amount paid is allocated to various intangible assets or goodwill.

Intangible assets are a non-cash expense with a finite life are then amortized over time, reducing the combined company’s earnings. This can be significant in the context of a merger, especially if the acquired company has substantial intangible assets. The reduction in net income due to amortization can make an acquisition appear dilutive.

Question 220

Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

Answer 220

Just cash and debt:
sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller’s Pre-Tax Income.

All-stock: If acquirer PE higher than target –> accretive as acquirere is paying less for the earning of the targen than its own earnings are valued.

Cash, stock, and debt: there’s no quick rule-of-thumb

Question 221

A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?

Answer 221

Trick question. You can’t tell unless you also know that it’s an all-stock deal. If it’s an all-cash or all-debt deal, the P/E multiples of the buyer and seller don’t matter because no stock is being issued.

Sure, generally getting more earnings for less is good and is more likely to be accretive but there’s no hard-and-fast rule unless it’s an all-stock deal.

Question 222

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

Answer 222

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.

On an intuitive level if you’re paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you’repaying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.

Question 223

What are the complete effects of an acquisition

Answer 223

1. Foregone Interest on Cash - buyer loses interest on cash it would’ve earned w/o acquisition
2. Additional Interest on Debt
3. Additional Shares Outstanding -
4. Combined financial statements
5. Creation of Goodwill & other intangibles - Balane Sheet items that represent a ‘premium’ paid to a company’s ‘fair value’ also get created

more than this

Question 224

If a company were capable of paying 100% in cash for another company, why
would it choose NOT to do so?

Answer 224

Saving its cash for something else

Stock may be at an all time high

using debt allows for higher IRR

Question 225

Why would a strategic acquirer typically be willing to pay more for a company
than a private equity firm would?

Answer 225

Because the strategic acquirer can realize revenue and cost synergies that the privateequity firm cannot unless it combines the company with a complementary portfolio
company.

Those synergies boost the effective valuation for the target company.

Question 226

Why do Goodwill & Other Intangibles get created in an acquisition?

Answer 226

represent the value over the “fair market value” of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price.

Goodwill and Other Intangibles represent things like the value of
customer relationships, brand names and intellectual property – valuable, but not true financial Assets that show up on the Balance Sheet

Question 227

What is the difference between Goodwill and Other Intangible Assets?

Answer 227

Goodwill typically stays the same over many years and is not amortized. It changes only if there’s goodwill impairment

Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line.

Question 228

Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?

Answer 228

Yes, could also have:

Purchased In-Process R&D Write-off

any Research & Development projects that were purchased in the
acquisition but which have not been completed yet.

**Deferred Revenue Write-off. **

seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-down the value of the Deferred Revenue to avoid “double-counting” revenue

Question 229

What are synergies, and can you provide a few examples?

Answer 229

when a buyer gets more value than out of an acquisition than what the financials would predict. 2 types:

Revenue Synergies: The combined company can cross-sell or up-sell products to customers. Access new markets.

Cost Synergies: Combined company can consolidate buidling and admibistrative staff –> lay off redunancies

Question 230

How are synergies used in merger models?

Answer 230

Revenue Synergies

Normally add these to the Revenue figures for the combined company and then assume a certain margin on the Revenue

Cost Synergies

Normally you reduce COGS or OpEx

Question 231

Are revenue or cost synergies more important?

Answer 231

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 see how buildings and locations might be consolidated and how many redundant employees might be eliminated

That said, the chances of any synergies actually being realized are almost 0 so few take them seriously at all

Question 232

All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?

Answer 232

Always prefers to use cash:

• Cash is “cheaper” than debt because interest rates on cash are usually under 5%
• Cash is also less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds from investors.
• General stock most expensive way to finance a transaction and risky due to price volatility

Question 233

How much debt could a company issue in a merger or acquisition?

Answer 233

Find Company LTM EBITDA

Find median comps of Debt/EBITDA

Apply to find debt

Answer 234

You use the same Valuation methodologies we already discussed. If the seller is a public company, you would pay more attention to the premium paid over the current share price to make sure it’s “sufficient” (generally in the 15-30% range) to win
shareholder approval.

For private sellers, more weight is placed on the traditional methodologies.

Question 235

Let’s say a company overpays for another company – what typically happens afterwards and can you give any recent examples?

Answer 235

High amount of Goodwill & Other Intangibles created

Large goodwill impairment later if company decides it overpaid

Question 236

A buyer pays $100 million for the seller in an all-stock deal, but a day later the
market decides it’s only worth $50 million. What happens?

Answer 236

The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would not necessarily be cut in half.

Depending on how the deal was structured, the seller would effectively only be receiving half of what it had originally negotiated.

This illustrates one of the major risks of all-stock deals: sudden changes in share price could dramatically impact valuation.

Question 237

Why do most mergers and acquisitions fail?

Answer 237

it’s very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division.

Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders. Any deal done without both parties’ best interests in mind is likely to fail.

Question 238

What role does a merger model play in deal negotiations?

Answer 238

Model is a sanity check, just an indication

It might say, “Ok, the model tells us this deal could work and be moderately accretive – it’s worth exploring more.”

It would never say, “Aha! This model predicts 21% accretion – we should definitely acquire them now!”

Emotions, ego and personalities play a far bigger role in M&A (and any type of
negotiation) than numbers do

Question 239

What types of sensitivities would you look at in a merger model? What variables would you look at?

Answer 239

most common variables:
* Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies.

Could also look at different operating sensitivities:
* Revenue Growth or EBITDA Margin

Sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Price vs. Cost Synergies, Purchase Price vs. Revenue Synergies,
or Purchase Price vs. % Cash (and so on).

Question 240

What’s the difference between Purchase Accounting and Pooling Accounting in an M&A deal?

Answer 240

Purchase Accounting:

seller’s shareholders’ equity number is wiped out and the premium paid over that value is recorded as Goodwill on the combined balance sheet post-acquisition.

Pooling Accounting:

Combine the 2 shareholders’ equity
numbers rather than worrying about Goodwill and the related items that get created.

specific requirements for using pooling accounting, so in 99% of M&A deals you will use purchase accounting

Question 241

Walk me through a concrete example of how to calculate revenue synergies.

Answer 241

“Let’s say that Microsoft is going to acquire Yahoo. Yahoo makes money from search advertising online, and they make a certain amount of revenue per search (RPS). Let’s say this RPS is $0.10 right now. If Microsoft acquired it, we might assume that they could boost this RPS by $0.01 or $0.02 because of their superior monetization. So to calculate the additional revenue from this synergy, we would multiply this $0.01 or
$0.02 by Yahoo’s total # of searches, get the total additional revenue, and then select a margin on it to determine how much flows through to the combined company’s Operating Income.”

Question 243

Walk me through an example of how to calculate expense synergies.

Answer 243

“Let’s say that Microsoft still wants to acquire Yahoo!. Microsoft has 5,000 SG&A-related employees, whereas Yahoo has around 1,000. Microsoft calculates that post-transaction, it will only need about 200 of Yahoo’s SG&A employees, and its existing employees can take over the rest of the work. To calculate the Operating Expenses the combined company would save, we would multiply these 800 employees Microsoft is going to fire post-transaction by their average salary.”

Question 244

How do you take into account NOLs in an M&A deal?

Answer 244

Apply Section 382 to determine how much of the seller’s NOLs are usable each year.

Allowable NOLs = Equity Purchase Price * Highest of Past 3 Months’ Adjusted Long Term Rates

Question 245

Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in M&A deals?

Answer 245

Created when you write up and down assets in a transaction: asset write-up creates a deferred tax liability, and an asset write-down creates a deferred tax asset.

An asset write-up creates a deferred tax liability because you’ll have a higher
depreciation expense on the new asset, which means you save on taxes in the short-term – but eventually you’ll have to pay them back, hence the liability. The opposite applies for an asset write-down and a deferred tax asset.

Question 246

Why do you eventually have to pay back the taxes saved in the short-term on a DTL from an asset write up

Answer 246

Paying Back Taxes:

During the period when book depreciation is higher, the company pays less tax than it otherwise would have if tax depreciation were also higher. This creates a deferred tax liability.

As the temporary difference reverses (e.g., book depreciation falls to the same level as tax depreciation or lower), the company loses the earlier tax savings it gained. Now, since there’s no longer a discrepancy (or the discrepancy is smaller), the taxes paid reflect the full taxable income without the earlier benefit from higher book depreciation.

The company doesn’t pay “extra” tax per se; rather, it pays the tax it had deferred. The DTL is essentially a recognition that the tax savings taken in earlier periods will lead to higher taxes in future periods compared to what would have been paid if there had been no write-up.

Final Reconciliation:

When the temporary difference is fully reversed (e.g., when the asset is fully depreciated or sold), the deferred tax liability is fully paid off. This reconciliation ensures that over the life of the asset, the total tax paid is consistent with what it would have been without the timing differences, but the timing of when those taxes are paid is different.

Question 247

How do DTLs and DTAs affect the Balance Sheet Adjustment in an M&A deal?

Answer 247

Take them into account with everything else when calculating the amount of
Goodwill & Other Intangibles to create on your pro-forma balance sheet.

Deferred Tax Asset = Asset Write-Down * Tax Rate
Deferred Tax Liability = Asset Write-Up * Tax Rate

Question 248

let’s say

• buying a company for $1 billion with half-cash and half-debt, and you had a $100 million asset write-up and a tax rate of 40%.
• In addition, the seller has
  total assets of $200 million,total liabilities of $150 million, and shareholders’ equity of $50 million.

What would happen to the combined company’s balance sheet (ignoring transaction/financing fees)

Answer 248

First, you simply add the seller’s Assets and Liabilities (but NOT Shareholders’
Equity – it is wiped out) to the buyer’s to get your “initial” balance sheet.

• Assets are up by $200 million and Liabilities are down by $150 million.
• Then, Cash on the Assets side goes down by $500 million.
• You have an asset write-up of $100 million, so Assets go up by $100 million.
• Debt on the Liabilities & Equity side goes up by $500 million.
• You get a new Deferred Tax Liability of $40 million ($100 million * 40%) on the
  Liabilities & Equity side.
• Assets are down by $200 million total and Liabilities & Shareholders’ Equity are up by $690 million ($500 + $40 + $150).
• So you need Goodwill & Intangibles of $890 million on the Assets side to make
  both sides balance.

Question 250

Could you get DTLs or DTAs in an asset purchase?

Answer 250

No, because in an asset purchase the book basis of assets always matches the tax basis. They get created in a stock purchase because the book values of assets are written up or written down, but the tax values are not.

Question 251

How do you account for DTLs in forward projections in a merger model?

Answer 251

create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pretax Income on its books, and then you determine what it actually pays in cash taxes based on its NOLs and newly created amortization and depreciation expenses

Anytime“cash” tax expense > “book” tax expense, you record this as an decrease to the DTL on the Balance Sheet; if the “book” expense is higher, then you record that as an increase to the DTL

Question 252

Explain the complete formula for how to calculate Goodwill in an M&A deal

Answer 252

Goodwill = Equity Purchase Price - Seller Book Value + Seller’s Existing Goodwill - Asset Write-Ups - Seller’s Existing DTL + Write-Down of Seller’s Existing DTA + New DTL

Question 253

What are some notes to the Goodwill formula in an M&A deal:

Goodwill = Equity Purchase Price - Seller Book Value + Seller’s Existing Goodwill - Asset Write-Ups - Seller’s Existing DTL + Write-Down of Seller’s Existing DTA + New DTL

Answer 253

• Seller Book Value is just the Shareholders’ Equity number.
• You add the Seller’s Existing Goodwill because it gets written down to $0 in an
  M&A deal.
• You subtract the Asset Write-Ups because these are additions to the Assets side of the Balance Sheet.
• Normally you assume 100% of the Seller’s existing DTL is written down.
• The seller’s existing DTA may or may not be written down completely (see the
  next question).

Question 254

Explain why we would write down the seller’s existing Deferred Tax Asset in an M&A deal

Answer 254

Write it down to reflect that DTA include NOLs, and you might use these NOLs post-transaction to offset the combined entity’s taxable income.

In asset or 338(h)(10) purchase, assume that the entire NOL balance goes to $0 in the transaction, and then you write down the existing Deferred Tax Asset by this NOL write-down

Question 255

Explain the formula for a DTA Write Down

Answer 255

DTA Write-Down = Buyer Tax Rate * MAX(0, NOL Balance – Allowed Annual NOL Usage * Expiration Period in Years)

This formula is saying, “If we’re going to use up all these NOLs post transaction, let’s not write anything down. Otherwise, let’s write down the portion that we cannot actually use post-transaction, i.e. whatever our existing NOL balance is minus the amount we can use per year times the number of years.”

Question 256

What’s a Section 338(h)(10) election

Answer 256

Why might a company want to use a Section 338(h)(10) in an M&A deal?A Section 338(h)(10) election blends the benefits of a stock purchase and an asset purchase:

• Legally it is a stock purchase, but accounting-wise it’s treated like an asset purchase.
• The seller is still subject to double-taxation – on its assets that have appreciated and on the proceeds from the sale.
• But the buyer receives a step-up tax basis on the new assets it acquires, and it can depreciate/amortize them so it saves on taxes.

Question 257

Why might a company want to use a Section 338(h)(10) in an M&A deal?

Answer 257

Even though the seller still gets taxed twice, buyers will often pay more in a 338(h)(10) deal because of the tax-savings potential. It’s particularly helpful for:

• Sellers with high NOL balances (more tax-savings for the buyer because this NOL balance will be written down completely – and so more of the excess purchase price can be allocated to asset write-ups).
• If the company has been an S-corporation for over 10 years – in this case it doesn’t have to pay a tax on the appreciation of its assets. The requirements to use 338(h)(10) are complex and bankers don’t deal with this – that is the role of lawyers and tax accountants.

Question 258

What is an exchange ratio and when would companies use it in an M&A deal?

Answer 258

An exchange ratio is an alternate way of structuring a 100% stock M&A deal, or any M&A deal with a portion of stock involved

Exchange ratios tie the number of new shares to the buyers own shares rather than a specific dollar amount. Buyer prefer this is f their stock price is believed to decline post-transaction - sellers prefer a fixed dollar amount unless stock rises.

Question 259

Walk me through the most important terms of a purchase agreement in an M&A Deal.

Answer 259

Most important ones:

• Purchase Price: Stated as a per-share amount for public companies.
• Form of Consideration: Cash, Stock, Debt…
• Transaction Structure: Stock, Asset, or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-compete agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about their respective businesses?
  No-Shop / Go-Shop: Can the seller “shop” this offer around and try to get a better deal, or must it stay exclusive to this buyer?

Question 260

What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?

Answer 260

An Earnout is a form of “deferred payment” in an M&A deal – it’s most common with private companies and start-ups, and is highly unusual with public sellers.

It is usually contingent on financial performance or other goals – for example, the buyer might say, “We’ll give you an additional $10 million in 3 years if you can hit $100 million in revenue by then.”

Buyers use it to incentivize sellers to continue to perform well and to discourage management teams from taking the money and running off to an island in the South Pacific once the deal is done.

Question 261

How would an accretion / dilution model be different for a private seller?

Answer 261

The mechanics are the same, but the transaction structure is more likely to be an asset purchase or 338(h)(10) election; private sellers also don’t have Earnings Per Share so you would only project down to Net Income on the seller’s Income Statement.

Note that accretion / dilution makes no sense if you have a private buyer because private companies do not have Earnings Per Share.

Question 262

How would I calculate “break-even synergies” in an M&A deal and what does the number mean?

Answer 262

To do this, you would set the EPS accretion / dilution to $0.00 and then back-solve in Excel to get the required synergies to make the deal neutral to EPS.

It’s important because you want an idea of whether or not a deal “works” mathematically, and a high number for the break-even synergies tells you that you’re going to need a lot of cost savings or revenue synergies to make it work.

Question 263

Normally in an accretion / dilution model you care most about combining both companies’ Income Statements. But let’s say I want to combine all 3 financial statements – how would I do this?

Answer 263

1. Combine the buyer’s and seller’s balance sheets (except for the seller’s Shareholders’ Equity number).
2. Make the necessary Pro-Forma Adjustments (cash, debt, goodwill/intangibles, etc.).
3. Project the combined Balance Sheet using standard assumptions for each item (see the Accounting section).
4. Then project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model.

Question 264

How do you handle options, convertible debt, and other dilutive securities in a merger model?

Answer 264

The exact treatment depends on the terms of the Purchase Agreement – the buyer might assume them or it might allow the seller to “cash them out” assuming that the per-share purchase price is above the exercise prices of these dilutive securities.

If you assume they’re exercised, then you calculate dilution to the equity purchase price in the same way you normally would – Treasury Stock Method for options, and assume that convertibles convert into normal shares using the conversion price.

Question 265

What are the main 3 transaction structures you could use to acquire another company?

Answer 265

Stock Purchase, Asset Purchase, and 338(h)(10) Election.

Question 266

What are the basic differences in a stock purchase?

Answer 266

• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
• The seller is taxed at the capital gains tax rate.
• The buyer receives no step-up tax basis for the newly acquired assets, and it can’t depreciate/amortize them for tax purposes.
• A Deferred Tax Liability gets created as a result of the above.
• Most common for public companies and larger private companies.

Question 267

What are the basic differences in Asset Purchase?

Answer 267

• Buyer acquires only certain assets and assumes only certain liabilities of the seller and gets nothing else.
• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public companies.

Question 268

What are the basic differences in Section 338(h)(10) Election?

Answer 268

• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above
• Most common for private companies, divestitures, and distressed public companies.
• To compensate for the buyer’s favourable tax treatment, the buyer usually agrees to pay more than it would in an Asset Purchase.

Question 269

What is a step-up tax basis for the buyer in the Asset Purchase and Section 338(h)(10) Election?

Answer 269

Buyer receives a “stepped-up” tax basis in the acquired assets, meaning the tax basis of the assets is reset to their fair market value (FMV) as of the acquisition date.

This step-up allows the buyer to claim higher depreciation and amortization, reducing taxable income, which provides a tax benefit over time.

Question 270

Would a seller prefer a stock purchase or an asset purchase? What about the buyer?

Answer 270

A seller almost always prefers a stock purchase to avoid double taxation and to get rid of all its liabilities.

The buyer almost always prefers an asset deal so it can be more careful about what it acquires and to get the tax benefit from being able to deduct depreciation and amortization of asset write-ups for tax purposes.

Question 271

Explain what a contribution analysis is and why we might look at it in a merger model.

Answer 271

A contribution analysis compares how much revenue, EBITDA, Pre-Tax Income, cash, and possibly other items the buyer and seller are “contributing” to estimate what the ownership of the combined company should be.

For example, let’s say that the buyer is set to own 50% of the new company and the seller is set to own 50%. But the buyer has $100 million of revenue and the seller has $50 million of revenue – a contribution analysis would tell us that the buyer “should” own 66% instead because it’s contributing 2/3 of the combined revenue. It’s most common to look at this with merger of equals scenarios, and less common when the buyer is significantly larger than the seller.

Question 272

How do you account for transaction costs, financing fees, and miscellaneous expenses in a merger model?

Answer 272

expense transaction and miscellaneous fees upfront, but capitalize the financing fees and amortize them over the life of the debt.

Expensed transaction fees come out of Retained Earnings when you adjust the Balance Sheet, while capitalized financing fees appear as a new Asset on the Balance Sheet and are amortized each year according to the tenor of the debt.