Accounting, Finance and Valuations (Intermediate)

Question 1

What is beta?

Answer 1

represents volatility or risk of a given instrument with respect to the market
< 1 less volatile than market
> 1 more volatile than market

Question 2

What does a beta of 1.2 mean?

Answer 2

that an investment is 20% more volatile than the market, if the market goes up by 10% that investment should go up 12%

Question 3

From the three main financial statements, if you had to choose two to analyse a company which would you choose and why?

Answer 3

I would choose the balance sheet and the income statement, as long as I had the balance sheets from the beginning and end of the period, and the end period Income Statement, I can generate a Cash Flow statement

Question 4

How does depreciation affect the cash balance if its a non cash expense?

Answer 4

Since depreciation is an expense, it will reduce the amount of taxes a company will pay. Since taxes are a cash expense, anything that affects them, will affect the cash balance

Question 5

How would a $10 increase in depreciation expense affect the income statement?

Answer 5

$10 increase in depreciation is an expense so it would decrease operating profit by $10 and reduce taxes by $10 (tax rate). Net income would be reduced by $10 (1-tax rate), assuming 40% tax rate, net income would be reduced by $6

Question 6

How would a $10 increase in depreciation expense affect the cash flow statement?

Answer 6

$10 decrease in depreciation, is a non cash expense so it would be added back to cash from operations because you add back depreciation. But because net income is reduced by $6 retained earnings is reduced by $6. So cash balance increases by $4

Question 7

How would a $10 increase in depreciation expense affect the balance sheet statement?

Answer 7

cash asset increases by $4 since cash balance in the cash flow statement increased by $4, PP&E would decrease by $10 because of depreciation. So assets would be reduced by $6

Question 8

Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc, do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings?

Answer 8

• PP&E are capital expenditures that are capitalalized on the balance sheet because it is expected that their benefits will be realised over a long period of time, years. While expenditures such as paying salary, taxes, the benefits are realised in the short term. Paying salary, the employees work is realised in the short term, because the company is seeing the benefit of the work of that employee is being paid for just in that short period of time. But purchasing a truck the benefit will be seen over its useful life and therefore the truck will be expensed accordingly in the income statement in the form of depreciation

Question 9

How is it possible for a company to show positive net income and go bankrupt?

Answer 9

net income does not mean free cash flow, a company can go bankrupt if

1. they have high capital expenditure for replacement or repair of PP&E
2. debt maturities that the company cannot afford to repay or refinance
3. swings in working capital

Question 10

I buy a piece of equipment walk me through the impact on the 3 financial statements

Answer 10

if you buy a truck, you won’t see any change initially in the income statement. in the cash flow statement, buying a truck is an outflow of cash, so the cash balance will decrease. In the balance sheet the cash asset will decrease but the PP&E will increase. Through the lifetime of the truck, it will be depreciated. Depreciation since its an expense will reduce net income by depreciation amount(1-tax rate), since net income is reduced, retained earnings in the balance sheet will decrease and PP&E will also decrease. Depreciation is a non cash expense so it needs to be added to cash from operations in the cash flow statement

Question 11

Why are increases in accounts receivable a cash reduction on the cash flow statement?

Answer 11

increase in accounts receivable means company has earned but has not yet collected cash for its service or product. So it needs to be readjusted, must be subtracted in the cash flow statement because no cash has been collected

Question 12

In what scenario could a company have a negative shareholders equity?

Answer 12

If a company has a negative net income for a long time, then retained earnings would be negative, which would lead to a negative shareholders equity. A leverage buyout could have the same effect, and a large dividend payment to owners of the business

Question 13

How would you calculate the discount rate for an all equity firm?

Answer 13

If the firm has no debt, then we would calculate the CAPM to calculate the cost of equity and use that as the discount rate

Question 14

What is the market premium?

Answer 14

The rate of return that stockholders require for choosing to purchase a stock over risk free securities.
calculated as the average return on the market (S&P 500) minus the risk free rate (yield on a 10 year treasury government bond)
Market premium = Rm - Rf

Question 15

What kind of investment would have a negative beta?

Answer 15

an investment that moves opposite to the market, gold for instance, as the stock market moves up price of gold declines as people move away from the safe haven of gold

Question 16

How much would you pay for a company with $50 million in revenue, and $5 million in profit?

Answer 16

If that is the only information I’m given then I wouldn’t be able to do a DCF analysis because I wouldn’t have any information on the company’s historical or projected performance, and no detail’s on the company’s capital structure. But assuming that I know the industry, I could do a comparable companies analysis by using ratios from relevant companies being valued

Question 17

How would you value a company with no revenue?

Answer 17

For instance, a startup with no revenue. I would project the company’s cash flows for future years and then construct a DCF model using an appropriate discount rate. I could also look at a comparable startup. For instance, if the company I’m looking at is a website with 10,000 subscribers, I could look at another website and see their value per subscriber and apply that multiple to the startup I’m looking at

Question 18

Why is there tax shield in WACC?

Answer 18

because there are tax deductions on interest paid, which are for the companies’ benefit. So the net cost of a company’s debt is the amount of interest it is paying, minus the amount it has saved in taxes because of its tax-deductible interest payments.

Question 19

What is Adjusted Present Value (APV)?

Answer 19

net present value of a company if financed only equity plus the present value of any financing benefits, which would include it being financed by debt.
- the value of a project financed with debt may be higher than that of an all equity financed one since the cost of capital normally decreases with leverage, turning some negative NPV projects into positive ones

Question 20

What is the difference between adjusted present value and WACC?

Answer 20

WACC: incorporates the effect of interest tax shields into the discount rate, typically calculated from actual data from the balance sheet and used for a company with a consistent capital structure over the period of the valuation
APV: adds present value of financing effects to Net Present Value assuming an all equity value, useful where costs of financing are complex and if capital structure is changing, used for leverage buyouts

Question 21

APV equation

Answer 21

APV = unlettered firm value + net effect of debt

Question 22

How would you calculate the WACC of a private company?

Answer 22

since a private company would have no beta and market cap which are used to calculate WACC, you would most likely get the WACC of a comparable company

Question 23

Describe a company’s typical capital structure

Answer 23

A company’s typical capital structure is normally compromised of debt and equity, and there may be various levels to each
Debt can be senior, mezzanine or subordinate. In the event of bankruptcy, senior debt would be paid off first, then mezzanine and then subordinate. The most senior debt is bank loans, and since it is the most secure it offers the lowest interest rates. Mezzanine and subordinate are bonds which can be issued to the public
Equity is either preferred or common stock. Preferred stock has features of both debt and equity: it can appreciate in value, and also pays out a consistent dividend but it has little or no rights to bankruptcy. Common stock is traded on the exchanges, if the company is public. In the event of bankruptcy, common shareholders are the last to be paid, because they have the least claim to the assets in the event of a liquidation. So its high risk and earn the highest return on investment. Common shareholders are the company’s owners and are entitled to profits, which may be reinvested in the business or paid as dividends

Question 24

Preferred stock

Answer 24

• mix of debt and equity
• receive a constant dividend and its value can be appreciated
• will be paid prior to common stockholders in the event of liquidation, but after claims to debt holders

Question 25

Common stock

Answer 25

• equity traded on public exchange such as NYSE and Nasdaq
• common shareholders purchase shares and are the company’s owners, with voting rights that can be exercised in corporate decisions
• stock is underwritten by a bank hired to run the highly complex IPO process, the new shares issued are then sold mainly to institutional buyers in the primary market
• common stock is lowest in the capital structure and has the fewest rights in the event of bankruptcy

Question 26

What is operating leverage?

Answer 26

operating leverage is the percentage of costs that are fixed to costs that are variable

• a company whose costs are mostly fixed will have a high operating leverage, which is better
  ex: equinox has high operating leverage because most of its costs are fixed, like same number of staff, same size gym, same locker rooms, same maintenance expense, equinox could go from 500 to 510 members and have little or no costs

Question 27

How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?

Answer 27

A $10 increase in depreciation would decrease EBIT by $10, so decreasing FCF by $10(1-tax rate) so $6 assuming 40% tax rate, but since depreciation must be added back when calculated FCF, FCF would increase by $4 and your valuation would increase by the present value of that $4
$4/ (1+ WACC)^4

Question 28

If you have two companies that are exactly the same in revenue, growth, risk, etc but one is private and one is public, which company’s shares would be higher priced?

Answer 28

Public company priced higher because

1. liquidity premium investors will pay for the ability to trade the stock quickly and easily on the public exchange
2. transparency premium that comes from the public company’s requirement to make their audited financial documents public