All Basic Shuffled Flashcards
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How are synergies used in merger models?
Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue – this additional Revenue then flows through the rest of the combined Income Statement.
Cost Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.
What about WACC – will it be higher for a $5 billion or $500 million company?
This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies.
If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company for the same reasons as mentioned above.
If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.
Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?
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.
What is Working Capital? How is it used?
Working Capital = Current Assets – Current Liabilities.
- If it’s positive, it means a company can pay off its short-term liabilities with its shortterm assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.”
- Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt).
- The point of Operating Working Capital is to exclude items that relate to a company’s financing activities – cash and debt – from the calculation.
What’s the relationship between debt and Cost of Equity?
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.
What’s the difference between cash-based and accrual accounting?
- Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out
- Accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash
- Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.
What’s the difference between a merger and an acquisition?
- There’s always a buyer and a seller in any M&A deal – the 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.
Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?
You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).
How do you value a private company?
You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:
- • You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps.
- • You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price.
- • Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
- • A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.
Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?
If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller’s Pre-Tax Income.
And if it’s an all-stock deal you can use a shortcut to assess whether it is accretive (see question regarding this).
But if the deal involves cash, stock, and debt, there’s no quick rule-of-thumb you can use unless you’re lightning fast with mental math.
What’s the flaw with basing terminal multiples on what public company comparables are trading at?
The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you’re looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range. This method is particularly problematic with cyclical industries (e.g. semiconductors).
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?
This gets confusing because of the different units involved. First, note that these convertible bonds are in-the-money because the company’s share price is $100, but the conversion price is $50. So we count them as additional shares rather than debt. Next, we need to divide the value of the convertible bonds – $10 million – by the par value – $1,000 – to figure out how many individual bonds we get: $10 million / $1,000 = 10,000 convertible bonds. Next, we need to 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. We do not use the Treasury Stock Method with convertibles because the company is not “receiving” any cash from us.
A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?
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.
What are the complete effects of an acquisition?
- Foregone Interest on Cash – The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition.
- Additional Interest on Debt – The buyer pays additional Interest Expense if it uses debt.
- Additional Shares Outstanding – If the buyer pays with stock, it must issue additional shares.
- Combined Financial Statements – After the acquisition, the seller’s financials are added to the buyer’s.
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Creation of Goodwill & Other Intangibles – These Balance Sheet items that represent a “premium” paid to a company’s “fair value” also get created.
* Note: There’s actually more than this (see the advanced questions), but this is usually sufficient to mention in interviews.*
Should Cost of Equity be higher for a $5 billion or $500 million market cap company?
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”).
Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company.
Can you give examples of major line items on each of the financial statements?
- Income Statement: Revenue; Cost of Goods Sold; SG&A; Operating Income; Pretax Income; Net Income.
- Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment; Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.
Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.
How would you value an apple tree?
The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation). Yes, you could do a DCF for anything – even an apple tree.
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?
Take Cash Flow From Operations and subtract CapEx and mandatory debt repayments – that gets you to 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.
What happens when Accrued Compensation goes up by $10?
For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation).
- Assuming that’s the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
- On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4.
- On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.
What types of sensitivity analyses would we look at in a DCF?
Example sensitivities:
- Revenue Growth vs. Terminal Multiple
- EBITDA Margin vs. Terminal Multiple
- Terminal Multiple vs. Discount Rate
- Long-Term Growth Rate vs. Discount Rate
And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense).
How do you calculate WACC for a private company?
This is problematic because private companies don’t have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.
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 $5 each – what is its fully diluted equity value?
Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all “in-the-money” – their exercise price is less than the current share price. When these options are exercised, there will be 10 new shares created – so the share count is now 110 rather than 100. However, that doesn’t tell the whole story. In order to exercise the options, we had to “pay” the company $5 for each option (the exercise price). As a result, it now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created. So the fully diluted share count is 105, and the fully diluted equity value is $1,050.
What does negative Working Capital mean? Is that a bad sign?
Not necessarily. It depends on the type of company and the specific situation – here are a few different things it could mean:
- Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
- Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront – so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.
- In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don’t pay quickly and upfront and the company is carrying a high debt balance).
- What types of sensitivities would you look at in a merger model?
- What variables would you look at?
• The most common variables to look at are:
- Purchase Price/Exit Price
- % Stock/Cash/Debt
- Revenue/Expense Synergies.
- Sometimes you also look at different operating sensitivities, like Revenue Growth or EBITDA Margin, but it’s more common to build these into your model as different scenarios instead.
- You might look at 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).
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.
- This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60.
- On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down – so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40.
- On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it balances.
If this seems strange to you, you’re not alone – see this Forbes article for more on why writing down debt actually benefits companies accounting-wise: http://www.forbes.com/2009/07/31/fair-value-accounting-markets-equities-fasb.html
When do you use an LBO Analysis as part of your Valuation?
Obviously you use this whenever you’re looking at a Leveraged Buyout – but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a “floor” on a possible Valuation for the company you’re looking at.
Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?
These days, many companies have “non-cash” charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements.
• As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.
How do you apply the 3 valuation methodologies to actually get a value for the company you’re looking at?
Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you’re valuing.
Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4 billion.
To get the “football field” valuation graph you often see, you look at the minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology.
How do you account for convertible bonds in the Enterprise Value formula?
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.
Which has a greater impact on a company’s DCF valuation – a 10% change in revenue or a 1% change in the discount rate?
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.
What’s the difference between Equity Value and Shareholders’ Equity?
Equity Value is the market value and Shareholders’ Equity is the 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.
Why do we look at both Enterprise Value and Equity Value?
Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.
Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?
- Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought.
- It often happens in acquisitions where the buyer “overpaid” for the seller and can result in a large net loss on the Income Statement (see: Microsoft/Skype).
- It can also happen when a company discontinues part of its operations and must impair the associated goodwill.
What variables impact an LBO model the most?
- Purchase and Exit Multiples have the biggest impact on the returns of a model
- The amount of leverage (debt) used also has a significant impact
- Lastly, operational characteristics such as revenue growth and EBITDA margins
What other Valuation methodologies are there?
Other methodologies include:
- Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
- Replacement Value – Valuing a company based on the cost of replacing its assets
- LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
- Sum of the Parts – Valuing each division of a company separately and adding them together at the end
- M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth
- Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value
What’s the difference between accounts receivable and deferred revenue?
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 has already collected in cash but is waiting to record as revenue.
Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?
Dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions
To figure out the numbers, you would look at:
1. “Debt Comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently
2. The rules: for example, you would never lever a company at 50x EBITDA
A. Even during the bubble leverage rarely exceeded 5-10x EBITDA
How much debt could a company issue in a merger or acquisition?
- Generally you would look at Comparable Companies/ Precedent Transactions to determine this.
- You would use the combined company’s LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of whatever companies you’re looking at, and apply that to your own EBITDA figure to get a rough idea of how much debt you could raise.
- You would also look at “Debt Comps” for companies in the same industry and see what types of debt and how many tranches they have used.
You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?
It’s 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. You might see Equity Value / Revenue if you’ve listed a set of financial institutions and non-financial institutions on a slide, you’re showing Revenue multiples for the nonfinancial institutions, and you want to show something similar for the financial institutions. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.
How do the 3 statements link together?
- To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement.
- Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders’ Equity.
- The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow Statement.
Do you need to project all 3 statements in an LBO model? Are there any shortcuts?
Yes here are the shortcuts:
- Create some form of Income Statement
- Track how the Debt Balances change
- Show cash is available to repay debt by creating type of CFS to show how much
* 4. You do not need to create a full Balance Sheet*
A. Bankers sometimes skip this if they are in a rush.
B. Full Balance Sheet is not strictly required, because you can just make assumptions on the Net Change in Working Capital rather than looking at each item individually.
Why do Goodwill & Other Intangibles get created in an acquisition?
These represent the value over the “fair market value” of the seller that the buyer has paid.
You calculate the number by subtracting the book value of a company from its equity purchase price.
More specifically, 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.
Why are Goodwill & Other Intangibles created in an LBO?
- They represent the premium paid to the “fair market value” of the company
- They act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side
If cash collected is not recorded as revenue, what happens to it?
Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and the Deferred Revenue balance decreases.
Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?
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. Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx.
Why do we add Preferred Stock to get to Enterprise Value?
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.
Give an example of a “real-life” LBO.
The most common example is taking out a mortgage when you buy a house. Here’s how the analogy works:
1. Down Payment: Investor Equity in an LBO
2. Mortgage: Debt in an LBO
3. Mortgage Interest Payments: Debt Interest in an LBO
4. Mortgage Repayments: Debt Principal Repayments in an LBO
5. Selling the House: Selling the Company / Taking It Public in an LBO
Could a company have a negative Enterprise Value? What would that mean?
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 – but Enterprise Value is not even used for commercial banks in the first place so this doesn’t matter much.
How do you calculate the Terminal Value?
You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.
The formula for Terminal Value using Gordon Growth is:
Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).
Why would you not use a DCF for a bank or other financial institution?
Banks use debt differently than other companies and do not re-invest it in the business – they use it to create their “products” – loans – instead.
Also, 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.
Are revenue or cost synergies more important?
No one in M&A takes revenue synergies seriously because they’re so hard to predict.
Cost synergies are taken a bit more seriously because it’s more straightforward to 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.
When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?
You use 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.
Walk me through how Depreciation going up by $10 would affect the statements.
- Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6.
- Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4.
- Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Shareholders’ Equity side is down by $6 and both sides of the Balance Sheet balance.
Note: With this type of question I always recommend going in the order: 1. Income Statement 2. Cash Flow Statement 3. Balance Sheet This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow.
Walk me through a basic merger model.
A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases.
- Step 1 is making assumptions about the acquisition – the price and whether it was cash, stock or debt or some combination of those.
- Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one.
- Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting 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.
Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?
Yes. You could also have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off.
The first refers to any Research & Development projects that were purchased in the acquisition but which have not been completed yet. The logic is that unfinished R&D projects require significant resources to complete, and as such, the “expense” must be recognized as part of the acquisition.
The second refers to cases where the 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.
Why do most mergers and acquisitions fail?
- Like so many things, M&A is “easier said than done.”
- In practice 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.
What should you do if you don’t believe management’s projections for a DCF model?
You can take a few different approaches:
- You can create your own projections.
- You can modify management’s projections downward to make them more conservative.
- You can show a sensitivity table based on different growth rates and margins and show the values assuming managements’ projections and assuming a more conservative set of numbers.
In reality, you’d probably do all of these if you had unrealistic projections.
If you use Levered Free Cash Flow, what should you use as the Discount Rate?
You would 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.
1. Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?
2. Go out 1 year, to the start of Year 2. Assume 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?
3. 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.
1.
- At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet).
- On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same.
- On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.
2. After a year has passed, Apple must pay interest expense and must record the depreciation.
- Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income would fall by $12.
- On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
- On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance.
Remember, the debt number under Liabilities does not change since we’ve assumed none of the debt is actually paid back.
3.
- After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48.
- On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100. Overall, the Net Change in Cash falls by $68.
- On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148 and both sides balance.
What is the difference between bank debt and high-yield debt?
This is a simplification, but broadly speaking there are 2 “types” of debt: “bank debt” and “high-yield debt.”
There are many differences, but here are a few of the most important ones:
1. High-yield debt tends to have higher interest rates than bank debt
A. Hence the name “high-yield”
2. High-yield debt interest rates are usually fixed
A. Whereas bank debt interest rates are “floating” – they change based on LIBOR or the Fed interest rate
3. High-yield debt has incurrence covenants
A. While bank debt has maintenance covenants
B. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.), while maintenance covenants require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times)
4. Bank debt is usually amortized – the principal must be paid off over time
A. Whereas with high-yield debt, the entire principal is due at the end (bullet maturity)
B. Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt.
Again, there are many different types of debt – this is a simplification, but it’s enough for entry-level interviews
How would you present these Valuation methodologies to a company or its investors?
Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. As an example, see page 10 of this document (a Valuation done by Credit Suisse for the Leveraged Buyout of Sungard Data Systems in 2005): http://edgar.sec.gov/Archives/edgar/data/789388/000119312505074184/dex99c2.htm
How do you determine the Purchase Price for the target company in an acquisition?
- You use the same Valuation methodologies we already discussed.
- If the seller is 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.
What are some flaws with precedent transactions?
- Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all have huge effects.
- Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies.
