Corporate Banking Flashcards
1
Q
What are the three main financial statements?
A
Income Statement, Balance Sheet, and Cash Flow Statement
2
Q
What does the income statement consist of?
A
Revenue/Net Sales - COGS - Expenses = Net Income (AKA has EBITDA)
3
Q
What does balance sheet consist of?
A
Assets = Liabilities + Shareholders’ Equity
4
Q
What does cash flow statement consist of?
A
Beginning Cash + CF from Operations + CF from Investing + CF from Financing = Ending Cash
5
Q
How are the three main financial statements connected?
A
There are a lot of connections but some of the main ones are:
- bottom line of the income statement is net income
- Net income flows in as the starting line item on the cash flow statement in the cash flow from operations section.
- The ending cash balance calculated on the cash flow statement (CFS) is the current period cash balance on the balance sheet.
- Net income also flows into the balance sheet’s retained earnings (the cumulative net earnings to date kept by a company instead of issuing dividends to shareholders)
- Each balance sheet item that impacts cash – i.e. working capital, financing, PP&E, etc. – are linked to the cash flow statement (CFS), as either a “source” or “use” of cash.”
6
Q
How does the cash flow statement work?
A
- Organize into cash from operations, investing, and financing
- net income is one of the first lines
- adjust for non-cash items and working capital (changes in current assets and liabilities)
- One of the final lines will be change in cash.
- Beginning cash (which comes from prior period’s Balance Sheet) plus change in cash yields ending cash balance on the current period’s Balance Sheet.
7
Q
Walk me through the major line items of an income statement
A
- revenue - COGS = gross margin
- gross margin - operating expenses = operating income aka EBIT
- EBIT - interest and other expenses like taxes to get the net income
8
Q
What are the 3 components of the Cash Flow Statement
A
- Cash from Operations: aka through normal operations, sales, etc
- Cash from Investing: Capex, investments in financial markets
- Cash from Financing: includes proceeds from debt or equity issuance or repurchase
9
Q
If you could use only one financial statement to evaluate the financial state of a company, which would you choose?
A
CF statement because they you can see how much cash the company is actually using and generating
- Income statement can be misleading due to non-cash expenses like depreciation that don’t really affect the overall business
- Balance sheet is only a snapshot in time
- evaluating how the company is spending its money and withers its generating a significant amount is shown by the CF statement
10
Q
What is the difference between the Income Statement and Statement of Cash Flows?
A
- Income Statement shows the company’s sales and expenses while the cash flow statement shows what the money they generate is being used for.
- they also treat certain line items differently - for ex: D&A is an expense in IS but is added back in CF because it is not a cash transaction
11
Q
What is the link between the Balance Sheet and the Income Statement?
A
- income after dividends from IS is added to shareholders’ equity in BS under retained earnings
- Debt on BS is used to calculate interest expense on IS
- PPE from balance sheet is used to calculate depreciation on IS
12
Q
What is the link between the Balance Sheet and the Statement of Cash Flows?
A
- Beginning cash flow on CF comes from previous period’s BS and ending cash goes on current period’s BS
- Cash from operations is calculated using changes in current assets - current liabilities from the BS
- Investments in PPE from BS are put under investing activities in CF
13
Q
What is EBITDA?
A
Earnings Before Interest, Taxes, Depreciation, and Amortization
- good high-level metric for a company’s profitability because it shows how much cash is abatable to pay interest, Capex, etc
- sometimes used as a proxy for free cash flow because of it
14
Q
How could a company have positive EBITDA and still go bankrupt?
A
If interest payment > EBITDA, you can go bankrupt
15
Q
What is Enterprise Value?
A
- value of a firm as a whole, to both debt and equity holders
- calculated via Market Value of Equity + Debt + Preferred Stock + minority interest - cash
16
Q
What is net debt?
A
Total debt minus cash from balance sheet - assumes company uses excess cash to pay off debt
17
Q
If Enterprise Value is $150mm, and Equity Value is $100mm, what is net debt?
A
Since Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest, if we assume
there is no minority interest or preferred stock, then Net Debt will be $150mm – $100mm, or $50mm.
18
Q
Why do you subtract cash from Enterprise Value?
A
One good reason is that cash has already been accounted for within the market value of equity. You also subtract cash because it can be used either to pay a dividend or to reduce debt, effectively reducing the purchase price of the company.
19
Q
What is the difference between Enterprise Value and Equity Value?
A
Enterprise Value = value of firm to both equity and debt holders
Equity Value - value of firm to equity holders only
20
Q
When looking at the acquisition of a company, do you look at Equity Value or Enterprise Value?
A
Enterprise value bc when taking over a company you purchase both liabilities and equity
21
Q
When calculating Enterprise Value, do you use the book value or the market value of equity?
A
Market value of equity because that represents the value investors in the open market place on the company’s equity
22
Q
Could a company have a negative book Equity Value?
A
Yes, a company could have a negative book Equity Value if the owners are taking out large cash
dividends or if the company has been operating for a long time at a net loss, both of which reduce
shareholders’ equity
23
Q
What is the difference between public Equity Value and book value of equity?
A
Public Equity Value is the market value of a company’s equity; while the book value is just an
accounting number.
A company can have a negative book value of equity if it has been taking large cash dividends, or running at a net loss; but it can never have a negative public Equity Value, because it cannot have negative shares or a negative stock price.
24
Q
What does spreading comps mean?
A
Spreading comps means calculating relevant multiples from comparable companies and summarizing them for easy analysis and comparison. It can be challenging when a company’s data and financial information must be scoured to conduct the necessary research.
25
Would you be calculating Enterprise Value or Equity Value when using a multiple based on free cash flow or EBITDA?
Enterprise Value because EBITDA and free cash flow represent cash flows that are available to repay holders of a company’s
debt and equity, so a multiple based on one of those two metrics would describe the value of the firm to all investors.
26
All else equal, should the cost of equity be higher for a company with $100 million of market cap or a company with $100 billion of market cap?
Typically, a smaller company is expected to produce greater returns than a large company, meaning the smaller company is more risky and therefore would have a higher cost of equity.
27
How do you calculate Free Cash Flow?
Free cash flow is EBIT times 1 minus the tax rate plus Depreciation and Amortization minus Capital
Expenditures minus the Change in Net Working Capital
28
What is Net Working Capital?
Net Working Capital is current assets minus current liabilities. It is a measure of a company’s ability to pay off its short term liabilities with its short-term assets. A positive number means they can cover their short term liabilities with their short-term assets. A negative number indicates that the company may have trouble paying off its creditors, which could result in bankruptcy if cash reserves are insufficient.
29
What happens to Free Cash Flow if Net Working Capital increases?
Intuitively, you can think of working capital as the net dollars tied up to run the business. As more cash is tied up (either in accounts receivable, inventory, etc.), free cash flow will be reduced.
You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa.
30
When would a company collect cash from a customer and not show it as revenue? If it isn’t revenue, what is it?
Normally this will occur when a customer pays for a good or service to be delivered in the future.
Some examples would be annual magazine subscriptions, annual contracts on cell phone service, online dating site memberships, etc.
The revenue is not recognized until the good or service is delivered to the customer.
Until it is delivered, it is recorded as deferred revenue (liability) on the Balance Sheet.
It will be recognized as revenue as it
31
What is the difference between accounts receivable and deferred revenue?
Accounts receivable is money a company has earned from delivery of goods or services but has not collected yet. Deferred revenue is the opposite, money that has not yet been recorded as revenue
because it was collected for goods or services not yet delivered.
32
What is an Initial Public Offering (IPO)?
IPO is the acronym for Initial Public Offering. It is the first time a privately-held company sells shares
of stock to the public market. Usually a company goes public to raise capital for growing the business or to allow the original owners and investors to cash out some of their investment.
33
What is a primary market and what is a secondary market?
The primary market is where an investment bank sells new securities before they go to market. With an IPO or bond issuance, the majority of these buyers are institutional investors who purchase large amounts of the security.
The secondary market is the market on which a stock or bond trades after the primary offering—the New York Stock Exchange, American Stock Exchange, or Nasdaq, in the United States.
34
What is the Capital Assets Pricing Model?
The Capital Assets Pricing Model, referred to as CAPM, is used to calculate the required return on
equity or the cost of equity. The return on equity is equal to the risk free rate (usually the yield on a 10- year U.S. government bond) plus the company’s beta (a measure of the stock’s volatility in relation to the stock market) times the market risk premium.
35
Where do you find the risk-free rate?
The risk-free rate is usually the current yield on the 10-year government treasury, which can be found on the front page of The Wall Street Journal, on Yahoo! Finance, etc. This is considered “risk-free” because the U.S. government is considered to be a risk-free borrower, meaning the government is expected never to default on its debt.
36
What is Beta?
Represents relative volatility or risk of a given investment with respect to the market.
β< 1 means less volatile than market (lower risk, lower reward).
β > 1 means more volatile than market (higher risk, higher reward).
A beta of 1.2 means that an investment theoretically will be 20% more volatile than the market. If the market goes up 10%, that investment should go up 12%.
37
From the three main financial statements, if you had to choose two to analyze a company, which would you choose and why?
If I had to choose two financial statements, 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, as well as the end of period Income Statement, I would be able to generate a Cash Flow Statement.
38
How does depreciation affect the cash balance if it is a non-cash expense?
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—including depreciation—will affect the cash balance.
39
How would a $10 increase in depreciation expense affect the each of the three financial statements?
Start with the Income Statement.
o The $10 increase in depreciation is an expense, which therefore lowers operating profit by $10 and reduces taxes.
o Taxes decrease by $10 x Tax Rate and net income decreases by $10 x (1–Tax Rate).
o Assuming a 40% tax rate, the drop in net income will be $6 [$10 x (1–0.40)].
Next move to the Statement of Cash Flows.
o The $6 reduction in net income reduces cash from operations by $6.
o However, depreciation is a non-cash item, so it will increase cash from operations by $10 because you add back depreciation.
o Ending cash is therefore increased by $4.
Now to the Balance Sheet.
o Cash increases by $4.
o PP&E decreases by $10 because of depreciation.
o Overall assets fall by $6.
o This needs to balance with the other side of the Balance Sheet; therefore, retained earnings will
fall by $6 due to the drop in net income.
40
In what scenario could a company have negative shareholders equity?
If a company has had negative net income for a long time, it would have a negative retained earnings balance, which would lead to negative shareholders equity. A leveraged buy-out could have the same effect, and so would a large dividend payment to the owners of the business.
41
How would you calculate the discount rate for an all-equity firm?
If a firm is all equity, then you would use CAPM to calculate the cost of equity, and that would be the
discount rate.
42
What is the market risk premium?
The market risk premium is the excess return that investors require for choosing to purchase stocks over “risk-free” securities. It is calculated as the average return on the market (normally the S&P 500, typically around 10-12%) minus the risk free rate (current yield on a 10-year Treasury).
43
What kind of an investment would have a negative beta?
An investment with a negative beta is one that moves opposite to the stock market as a whole. In other words, if the stock market moves up, the value of the negative beta investment would decline and vice versa.
Gold is an investment that has a negative beta. When the stock market goes up, the price of gold
typically declines as people flee from the “safe haven” of gold. The opposite happens when the market goes down, indicating a negative correlation.
44
Describe a company’s typical capital structure.
A company’s capital structure is made up of debt and equity, and there may be multiple levels of each. Debt can be senior, mezzanine, or subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior debt is most secure and will be paid off first in bankruptcy, it offers the lowest interest rate. The most senior debt is bank loans; the rest is bonds, which can be issued to the general public. Equity is either preferred or common stock. Preferred stock combines some features of both debt and equity: it can appreciate in value, and also pays out a consistent dividend but it has very little or no rights in a bankruptcy. Common stock is traded on the exchanges, if the company is public. In the event of bankruptcy, common stockholders have the least claim to assets in the event of liquidation, and therefore they bear the highest level of 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.
45
Senior Bank Loans
*Underwritten by an investment bank and syndicated to institutional buyers.
*First priority in the event of a bankruptcy.
*Often "secured" in case of liquidation by company assets pledged as collateral.
*Many times will have a "floating" interest rate based on LIBOR + a certain rate
46
Mezzanine Debt/Bonds
*Arranged by an investment bank and sold on the bond market.
*May be secured or unsecured.
*Bonds normally will have a fixed interest rate.
*Bonds may have call or put options, may be convertible into equity, etc.
47
Subordinated/High Yield Bonds
*Similar to Mezzanine Debt/Bonds but lower in the capital structure (subordinated).
*Since they are subordinated, they will have fewer rights in the event of a bankruptcy.
*Investors will require a higher interest rate on this layer of debt.
48
Preferred Stock
*Preferred stock is like a hybrid of a bond and common equity.
*The preferred will pay a constant dividend to its shareholders, and the principal value
of the preferred can gain value as well.
*Preferred stock may also carry a conversion feature, where shareholders can convert
their preferred into common.
*Preferred will be paid prior to common shareholders having any recovery in a
bankruptcy, but it is typically subordinated to all other company debt.
49
Common Stock
*Common stock is the form of equity traded on public exchanges such as NYSE &
Nasdaq.
*Common shareholders purchase shares and are the cocmpany'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.
*Common stock is lowest in the capital structure and has the fewest rights in the event
of bankruptcy.
50
When should a company issue equity rather than debt to fund its operations?
If the company feels its stock price is inflated, it would raise a large amount of capital relative to the percentage of ownership sold.
If new projects the company plans on investing in may not produce immediate or consistent cash flows to make interest payments…
If the company wants to adjust its capital structure, or pay down debt…
If the company’s owners want the ability to sell off a portion of their ownership and monetize their
investment…
51
When should an investor buy preferred stock?
- have some of the upside of equity while limiting risk and assuring stability thru a dividend
- preferred stocks dividends are more secure than those from common stock and preferred stock have greater rights in bankruptcy than common stock (tho less than debt holders)
52
Why would a company distribute its earnings through dividends to common stockholders?
The distribution of a dividend signals that a company is healthy and profitable, thus attracting more investors, potentially driving up the company’s stock price.
53
What is operating leverage?
Operating leverage is the percentage of costs that are fixed versus variable.
A company whose costs are mostly fixed has a high level of operating leverage.
If a company has a high level of operating leverage, it means that much of any increase in revenue will
fall straight to the bottom line in the form of profit, because the incremental cost of producing another unit is so low.
54
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?
The public company most likely will be priced higher due to the liquidity premium one would pay to be able to buy and sell the shares quickly and easily in the public capital markets.
Another reason the public shares should be priced higher would be the transparency required for the firm to be listed on a public exchange. Publicly traded companies are required to file audited financial statements, allowing investors to view them.
55
What could a company do with excess cash on its Balance Sheet?
Although it seems like having a lot of cash on hand might be a good thing, especially in a recession, it
really isn’t, because there is an opportunity cost to holding cash. A company should have enough cash
to protect itself from bankruptcy in a downturn, but any excess cash should be put to work. The company could pay a dividend to its equity holders or bonuses to employees, although a growing company will tend to reinvest rather than pay out cash. It can reinvest its cash in plants, equipment, personnel, or marketing; it can pay off debt, repurchase equity, or buy out a competitor, supplier, or distributor. If nothing else, that cash can earn a little something invested in CDs until it can be put to better use
56
What is goodwill and how does it affect net income?
Goodwill is an intangible asset included on a company’s Balance Sheet. Goodwill may include things like intellectual property rights, brand name, or customer relations. Goodwill is acquired when
purchasing a firm if the acquirer pays more than the book value of its assets. When something occurs to diminish the value of the intangible assets, goodwill must be “written down” in a process much like that for depreciation. Goodwill is subtracted as a non-cash expense and therefore reduces net income.
57
What are some examples of items that may need to get added back to EBITDA to get a better sense for the financial health of a company?
Some examples are one-time, non-recurring items like legal expenses, one-time disaster payments or
events, restructuring charges, debt/equity financing expenses, etc. Any items that are not likely to continue from one year to the next may be added back to EBITDA
58
What is the current interest rate?
Could change but ~4%
59
What is the S&P 500 currently trading at?
~$6,000
60
What is the default premium?
The default premium is the difference between the yield on a corporate bond and the yield on a
government bond with the same time to maturity to compensate the investor for the default risk of the
corporation, compared with the “risk-free” comparable government security.
61
What is the default risk?
The default risk is the risk of a given company not being able to make its interest payments or pay back
the principal amount of their debt. All else equal, the higher a company’s default risk, the higher the
interest rate a lender will require it to pay.
62
What is “face value”?
Face value or par value of a bond is the amount the bond issuer must pay back at the time of maturity.
Bonds are usually issued with a $1,000 face value.
63
What is the coupon payment?
The coupon payment on a bond or loan is the interest payment a company will pay to holders of the
bond/loan.
This coupon payment is the stated interest rate times the face amount of the bond or loan. Bonds
typically make coupon payments annually or semi-annually while loans typically make interest
payments once per quarter.
o If a company issues 10% 7-year annual bonds with a face value of $1,000 each, annual coupon payments will be $100 each: . The chart below shows the
hypothetical cash flows with a $1,000 purchase in year zero, then a $100 coupon payment each year from years one through seven and the repayment of principal in year seven in addition the
final coupon payment.
"The coupon payment is the amount a company pays its loan and bondholders, usually on an annual,
semi-annual or quarterly basis. It is the coupon rate, or interest rate times the face value of the bond. For example, the coupon payment on an annual 10% bond with a $1,000 face value would be $100."
64
What is the difference between an investment grade bond and a “junk bond”?
An investment grade bond is one that has a good credit rating (AAA to BBB, Aaa to Baa) and a low risk
of default and therefore pays a low interest rate. These are usually low-risk, fundamentally sound
companies, which produce steady, reliable cash flows significantly greater than their interest
requirements.
A “junk bond” is a bond that has a poor credit rating (BB to D, Ba to C) and a relatively high risk of
bankruptcy and is therefore required to pay investors a higher interest rate. These companies usually are
characterized as having less consistent cash flows, or they may be in relatively more volatile industries.
"An investment grade bond is a bond issued by a company that has a relatively low risk of bankruptcy
and therefore has a low interest payment. A “junk bond” is one issued by a company that has a high risk
of bankruptcy but is paying high interest payments."
65
What is the difference between a corporate bond and a consumer loan?
"The main difference between a corporate bond and a consumer loan is the market that it is traded on. A
bond issuance is usually for a larger amount of capital, is sold in the public market and can be traded. A
loan is issued by a bank, and is not traded on a public market."
66
How do you price a bond?
"The price of a bond is the net present value of all future cash flows (coupon payments and par value)
expected from the bond using the current interest rate."
For the example below, assume the current interest rate is 7% on comparable bonds. The bond you are
looking to invest in has a $100 face value and pays 10% annual interest. Since the bond you are investing in pays a higher coupon than bonds of comparable companies, you will be required to pay a
premium for that higher interest rate, hence the $112.30 price, which brings the yield on the bond down
to levels in line with comparables.
67
If the price of a bond goes up, what happens to the yield?
The price and yield of a bond move inversely to one another. Therefore, when the price of a bond goes
up the yield goes down.
The bond's yield is determined by dividing its annual interest payment by its current price.
68
If you believe interests rates will fall, and are looking to make money due to the capital appreciation on bonds,
should you buy them or short sell them?
If you believe interest rates are going to fall bond prices should rise. If you are looking to make money
on the capital appreciation of the bonds, you should be looking to buy the bonds.
Since price moves inversely to interest rates, if you believe interests rates will fall, bond prices will rise,
and therefore you should buy bonds.
69
What is the current yield on the 10-year Treasury note?
~4.2%
70
If the price of the 10-year Treasury note rises, what happens to the note’s yield?
The price and yield are inversely related, so when the price goes up, the yield goes down.
71
What would cause the price of a Treasury note to rise?
If the stock market is extremely volatile, and investors are fearful of losing money, they will desire risk
free securities, which are government bonds. The increase in demand for these securities will drive the
price up, and therefore the yield will fall.
72
If you believe interest rates will fall, should you buy bonds or sell bonds?
If interest rates fall, bonds prices will rise, so you should buy bonds.
73
What is the order of creditor preference in the event of company bankruptcy?
The first creditors to get paid in the event of liquidation are the senior debt holders—usually banks and
senior bondholders. They likely have some of the firm’s assets as collateral. Next come those holding
subordinated debt, followed by preferred stockholders. Common stockholders have the last claim on
assets in the event of liquidation or bankruptcy.
74
What is the difference between senior secured debt or “bank debt” and bonds?
1. Bank debt is secured by the assets of the company and bonds many times are
not, so the interest rate on bank debt is typically lower.
2. Bank debt tends to have floating interest rates based on LIBOR plus a spread, whereas bonds normally pay at a fixed rate.
3. Bank debt may carry financial maintenance covenants that require the company to maintain certain leverage levels, interest coverage levels, etc., while bonds do not.
4. Bank debt is normally amortized at a certain percentage per year.
5. Bank debt tends to be pre-payable at any time, whereas bonds tend to have call protection for some years after issuance, ensuring that bonds remain
outstanding.
75
Why would a company use bank debt rather than high-yield bonds?
Bank debt is secured by the assets of the company and therefore normally commands lower interest
rates. The trade off is that it will typically amortize and may have maintenance covenants.
76
Why might two bonds with the same maturity and same coupon, from the same issuer, be trading at different
prices?
There are a couple of explanations for the observed price difference. A bond that is putable or convertible would demand a premium, and a callable bond would trade at a discount.
* Putable = allows the bondholder (investor) to sell the bond back to the issuer before maturity at a predetermined price
* Convertible = gives the bondholder the right to convert the bond into a set number of company shares
* Callable = allows the issuer (company) to redeem the bond early before maturity at a set price. This is bad for investors because if interest rates drop, the issuer might call the bond early and refinance at a lower rate, cutting potential returns.
77
What are bond ratings?
A bond rating is a grade given to a bond according to its risk of defaulting.
The three best known and most trusted ratings agencies are Standard & Poor’s, Moody’s, and Fitch.
Recently, ratings agencies have faced some skepticism about their ratings techniques because so many
of the mortgage backed securities that were given very high ratings ended up defaulting.
The lower the grade, the more speculative the stock, and all else equal, the higher the yield.
"A bond rating is a grade given to a bond based on its risk of defaulting. This rating is issued by an independent firm and updated over the life of the bond. The most trusted rating agencies are S&P, Moody, and Fitch, and their ratings range from AAA to C or even D. The top rating of AAA goes to highly rated “investment grade” bonds with a low default risk; the C rated bond is “non-investment grade” or “junk,” and a rating of D means the bond is already in default and not making payments."
78
How would you evaluate the creditworthiness of a company?
Look at the company’s Character (track record of repaying debt), Capacity (stats like Debt / EBITDA and EBITDA / Interest), Capital (contribution from the company’s assets), Collateral (what the lender can claim if the loan is not repaid), and Conditions (purpose of the loan).
79
What are maintenance and incurrence covenants?
Maintenance covenants relate to financial metrics that the company must maintain after it raises debt – for example, it must maintain Debt / EBITDA of less than 5x and EBITDA / Interest of at least 2x to avoid penalty fees. These are most common on “bank debt” issuances such as Revolvers and Term Loans.
Incurrence covenants relate to specific actions that a company must take or not take. For example, if the company sells assets, it must use 50% of the proceeds to repay the lenders. These are more common on high-yield bonds.
80
What’s the difference between Revolvers and Term Loans?
They’re both forms of Senior Secured Debt with floating interest rates and maintenance covenants, but Revolvers are more like “overdraft accounts” for companies.
If a company needs to borrow beyond its current capacity, it can do so by drawing on its Revolver, which is usually undrawn at first. The company then pays interest on the drawn portion until it can repay that amount (there are commitment/undrawn fees as well).
By contrast, Term Loans are drawn initially and amortize over time – anywhere from 20% per year over five years (fully amortizing) to 1% per year until maturity (closer to “bullet maturity”). The company pays interest on the full principal remaining in each period.
81
Walk me through a Discounted Cash Flow model.
irst, project the company’s free cash flows for about 5 years using the standard formula.( Free cash
flow is EBIT times 1 minus the tax rate, plus Depreciation and Amortization, minus Capital
Expenditures, minus the Change in Net Working Capital.) Next, predict free cash flows beyond 5 years
using either a terminal value multiple or the perpetuity method. To calculate the perpetuity, establish a
terminal growth rate, usually about the rate of inflation or GDP growth, a low single-digit percentage.
Now multiply the Year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus
the growth rate. Your discount rate is the Weighted Average Cost of Capital, or WACC. Use that rate to
discount all your cash flows back to year zero. The sum of the present values of all those cash flows is
the estimated present Enterprise Value of the firm according to a discounted cash flow model.
82
How do you calculate a firm’s terminal value?
Terminal multiple method
- Find a comparable’s company multiple EV/EBITDA (usually) and multiply the last projected years’ FCF by that to get the terminal value
Perpetuity growth method
- choose a modest growth rate, usually just a bit higher than the inflation rate or GDP growth rate, and assume that the company can grow at this rate infinitely. You then multiply the FCF from the final year by 1 plus the growth rate, and divide that number by the discount rate (WACC) minus the assumed growth rate.
83
What is WACC and how do you calculate it?
WACC is the acronym for Weighted Average Cost of Capital. It reflects the overall cost of a company’s raising new capital, which is also a representation of
the riskiness of investing in the company.
Mathematically, WACC is the percentage of equity in the capital structure times the cost of equity (calculated by the Capital Assets Pricing Model) plus
percentage of debt in the capital structure times one minus the corporate tax rate times the cost of
debt plus percentage of preferred stock in the capital structure times the cost of preferred stock if there is any preferred stock outstanding.
84
All else equal, should the WACC be higher for a company with $100 million of market cap or a company with $100 billion of market cap?
Without knowing more information about the companies, it is impossible to say. If the capital structures
are the same, then the larger company should be less risky and therefore have a lower WACC. However,
if the larger company has a lot of high-interest debt, it could have a higher WACC.
85
All else equal, should the cost of equity be higher for a company with $100 million of market cap or a company
with $100 billion of market cap?
Typically, a smaller company is expected to produce greater returns than a large company, meaning the
smaller company is more risky and therefore would have a higher cost of equity.
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How do you calculate Free Cash Flow?
Free cash flow is EBIT times 1 minus the tax rate plus Depreciation and Amortization minus Capital
Expenditures minus the Change in Net Working Capital
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Why do you project out free cash flows for the DCF model?
The reason you project FCF for the DCF is because FCF is the amount of actual cash that could
hypothetically be paid out to debt holders and equity holders from the earnings of a company.
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What is a positive covenant? What is a negative covenant? What is a financial covenant?
A positive covenant is where the borrower or obligor is required to continue to do something or actively do something (such as a pipeline purchasing insurance for spills). A negative covenant restricts them from carrying out a certain action. A financial covenant is a maintenance level that the company must not breach (for instance, debt to EBITDA of 3 times).
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What are some events of default?
Failure to pay interest after a grace period (cure period) in excess of allowed cushion.
Failure to pay principal.
Breach of aforementioned covenants without cure.
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What is debt capacity?
Assuming a given EBITDA, the debt capacity is the amount of debt the company can take on without exceeding the terms of a maintainane convenant (if applicable). For example, if a company has $100 of EBITDA with a leverage covenant of 3.0x the debt capacity is $300.
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What is the debt cushion?
The debt cushion is the debt capacity minus how much debt the company has now.
Starbucks has EBITDA of 10 Billion and Debt of 30 Billion. The pre-tax cost of debt is 5% (definitely not the case in today’s market).
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What is a bridge loan?
A bridge loan is a short-term loan used until a person or company secures permanent financing or pays an existing obligation. It allows the borrower to meet current obligations by providing immediate cash flow. Bridge loans have relatively high interest rates and are usually backed by some form of collateral, such as real estate or the inventory of a business.
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Current Ratio
Current Assets/Current Liabilities - (aka working capital ratio) measures the capability of a business to meet its short-term obligations that are due within a year
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Quick Ratio
Indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities ==> Quick Assets (Cash + Cash Equivalents + Marketable Securities + Net Account Receivables)/ Current Liabilities
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What are some ways you can value a company?
- simplest is market valuation which is just public equity value of company --> can then get enterprise value from that
- others include comparable company analysis, precedent transactions, DCF and LBO valuation
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Comparable Companies Valuation
1. Take the average multiple from comparable companies (based on size, industry, etc.) for a certain metric (such as EV/EBITDA) and multiply it by the metric of the company you are valuing (in this case EBITDA).
*Most common multiple is Enterprise Value/EBITDA, but also used are P/E, EV/EBIT, Price/Book, EV/Sales.
2. When you multiply that product will be the Enterprise or Equity Value (in this case Enterprise)
Ex: Comparable Company A is trading at an EV/EBITDA multiple of 6.0x, and the
company you are valuing has EBITDA of $100 million; your company’s EV would be valued at
$600 million based on this valuation technique
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Market Valuation
*The market value of equity is only for publicly traded companies and is the easiest
valuation technique.
*Market value is calculated simply by multiplying the number of shares outstanding by
the current stock price.
*This is also known as Market Cap, and gives the Equity Value of the firm
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Precedent Transaction (Valuation method)
*First, find historical transactions similar to the transaction in question, including size of the company, industry, economic contexts, etc.
*Then look at the valuation process and what metrics were used (EBIT< EBITDA, etc) and create a valutation based on the sales price (sold at 3x EBITDA for example)
*Apply the multiple to the appropriate metric for the current company.
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LBO Valuation
*Essentially an LBO (leveraged buyout) is when a firm uses a higher than normal amount of debt to finance the purchase of a company, then uses the coompany's cash flows to pay off the debt over time.
*The acquired company's assets may be used as collateral for the loan.
*Ideally, the debt has been partially or fully retired when LBO buyers are ready to sell the company, and—as sole equity owners of the company—they can collect most of the profits from the sale.
* Since a smaller equity check was needed up front due to the higher level of debt used to purchase the company, this can result in higher returns to the original investors than if they had paid for the company entirely with their own equity
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Highest to lower valuation
Precedent Transaction because a company will pay a premium for anticipated synergies from merger. DCF is next bc of optimistic projections while Market comps and market value are the lowest because it's based on the market (no synergies)
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What is the current risk free rate?
~4.3%
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Difference between Total Debt and Net Debt
Total Debt = total of all debt obligation on the balance sheet
Net Debt = total debt - cash aka total debt after all cash is used to pay debt
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What is the S&P, DOW, and NASDAQ trading at right now?
As of 3/9:
- Dow ~43,000
- S&P ~5,800
- NASDAQ ~18,200
