FINANCE Flashcards
What’s a company’s EV over EBITDA when it has an 8 percent cost of capital, 2 percent growth rate and 50 percent free cash flow conversion?
TEV= FCF * 1-1+growth rate / cost of capital - growth rate
FCF= FCF over net income–> in this case is 1/2
I’m trying to find a way to get from net income to EBITDA, but it doesn’t seem like there’s a straightforward way from the information you just gave me, so for here, I’ll just approximate net income as EBITDA for now.
So if we divide EV over EBITDA, from the free cash flow formulawe see net income would equal to 2 times the free cash flow, and we can divide EV to net income here to get a formula where we could cross off free cash flow for both the numerator and the denominator and it leads us to is the numerator, we have 1.08 from the 1 plus G divided by 0.06 from the WAC minus growth and all divided by one-half. And this gives you 1.08 divided by 0.12, which is 9 times.
How long does it take to triple a $700 principle investment with 10 percent simple interest rate?
So here the $700 doesn’t matter. What matters is the 10 percent simple interest you earn every year. To triple it, which is 300 percent, we divide 300 by 10, which gives – which gives us 30 years.
What sort of security would you likely to invest in to have a 10 percent simple interest rate for that period of time?
I think like equity with a high dividend yield could be a potential security here. so with interest rates so low right now, I – it would be hard to find a debt instrument, a simple vanilla one that gives 10 percent simple interest. What I would assume is – this would probably be a very high-yield bond if there is one, but for 30 years, a high-yield bond seems a little bit incredible, especially with given all the markets right now.
Company A has a margin of 50 percent. If the top line growth is 8 percent a year, margin expands 200 BPS and there’s not shared buy-back or change in tax rate, how much does EPS grow?
For EPS growth rate, I could just approximate that with the bottom line growth rate as the tax rate and share doesn’t change and it’s all proportional. So in the first year, we assume that we have $100 of revenue. A 50 percent margin on that gives you $50 to – $50 to EBIT, for example. And in the second year, we are going to grow it by 8 percent, so we have $108 in revenue and a 200 BP increase in margin, which gives us a 0.52 margin. And if we multiply this, we get 56 in EBIT. So 56 over 50 is a 12 percent change, so EPS should grow by 12 percent.
When debt is used to repurchase shares, in what scenario does EPS remain the same?
EPS is defined as net income over number of shares outstanding, and when you issue debt to repurchase shares, your net income will fall by the tax effective interest on that new debt and your shares outstanding will also fall by the number of shares you purchased.
so as long as net income and shares outstanding fall by the same proportion, your EPS should not change.
Explain PIK interest in simple language.
PIK interest is just countdown interest, so instead of actually paying off the interest you are due every month with cash per se, you just add it back to the principle amount.
So for example, if I had 10 percent PIK interest notes for every year, in the first year if I had 10 percent interest or paid $10, I would actually pay it off - $10 gets added back to the principle amount, so in the second year, I would have to pay 10 percent of $110, and it just keeps multiplying.
And why do you think the company would choose to raise a PIK interest note as opposed to a cash interest note?
A PIK interest note, you’re sort of – well you’re foregoing giving any cash out, right? And if a company is in a high growth stage, such as a tech company, for example, perhaps they need to use that capital to grow themselves. And there probably is higher return on capital for not paying back that debt instrument rather than reinvesting it into its own company. Tech companies are a great example.
Why is the company with higher return on investment capital better than the other?
It’s really that one is more efficient than the other. It’s – if you were to hold their investment capital or their assets flat, that one is able to generate a higher profit than the other given that same base.
How long does it take, uh, for $700 to triple, uh, at a 10 percent interest?
The way that I would think about this is you have your 700 tripled – that becomes 2,100, less your initial base of 700, so you’re looking at 1,400 in interest. 10 percent of 700 is 7, so 1,400 divided by 7 is going to give you 20. So 20 payments.
How do you calculate free cash flow to the firm and to equity shareholders?
I think it’s important to make the distinction between what the difference to the firm is, which is – or versus to the equity holders. Um, it’s that one takes account of the interest payments and the, um, debt raised or repaid. Um, so we’re thinking about free cash flow to firm, it’s going to omit those things. Um, and so you would end up having EBIT less cash taxes adding back D&A and any other non-cash expenses, less CAPEX and less changes in working capital. And that will get your, get you to your free cash flow to firm. Then once you have that number, you would take out the, uh, cash interest and, um, any, uh, debt repaid or if you were, um, bringing on more debt, you would add that back, and that would get you to your free cash flow to equity.
Assume that, that a company has issued $200 in new shares, and then it uses the $100 from the proceeds to issue dividends to shareholders. How do equity value and enterprise value change in each step?
We need to make a number of assumptions here in order to answer this question. The first being the initial enterprise value, which let’s just say is 500. Um, let’s also assume there’s no debt on the company, um, and that shares including the additional $200 worth issued, um, is 100, right? So you start out with an enterprise value of 500 and you add 200, that means you have 700 enterprise value, which also happens to be your equity value. Um, but then you issue $100 in dividends, right? So that means your equity value and your, um, and your enterprise value are now 600, right? If we’re going to think about change to equity value, particularly the shareholders, it means that your initial $7 per share now becomes $6 per share.
Assume that a company goes from 20 percent debt to cap to 30 percent debt to cap. How does cost of equity, cost of debt and WAC change?
Your cost of equity and your cost of debt shouldn’t change, but cost of debt is less expensive than cost of equity, so given that the percentage of debt relative to the total capital has increased, your weighted average cost of capital should go down.
What are the limitations of a discounted cash flow model?
I look at the limitations as really two things – one are the cash flow projections. The farther into the future you’re projecting the cash flow, the less likely it is to be accurate. And then two are the assumptions around the discount rate, um, and the growth rate which are both highly theoretical, and I think it’s difficult to make an argument that our company is going to grow in perpetuity or at the very least that it’s going to grow above anything greater than, you know, GDP.
How do you calculate free cash flow to the firm? To equity?
To the firm (unlevered free cash flow): EBITDA less taxes less capital expenditures less increase in net working capital. To equity (levered free cash flow): Same as firm FCF and then less interest and any required debt amortization.
What are the four basic ways to value a company?
Market comparisons/trading comps/comparable companies: Metrics, such as multiples of revenue, earnings and EBITDA like P/E and EV/EBITDA can be compared among companies operating in the same sector with similar business risks. Usually a discount of 10 percent to 40 percent is applied to private companies due to the lack of liquidity of their shares. Precedents/acquisition comps: At what metrics (same as above) were similar companies acquired? Discounted cash flow (“DCF”): Based on the concept that value of the company equals the cash flows the company can produce in the future. An appropriate discount rate is used to calculate a net present value of projected cash flows. Leveraged Buyout (“LBO”): Assuming an IRR (usually 20 percent to 30 percent), what would a financial buyer be willing to pay? Usually provides a floor valuation.
Of the valuation methodologies, which ones are likely to result in higher/lower value?
Precedents usually yield higher valuations than trading comps because a buyer must pay shareholders more than the current trading price to acquire a company. This is referred to as the control premium (use 20 percent as a benchmark). If the buyer believes it can achieve synergies with the merger, then the buyer may pay more. This is known as the synergy premium. Between LBOs and DCFs, the DCF should have a higher value because the required IRR (cost of equity) of an LBO should be higher than the public markets cost of equity in WACC for the DCF. The DCF should be discounted at a lower rate and yield a higher value than an LBO. When debating whether precedents or DCFs yield higher values, you should note that DCFs are a control methodology, meaning you select the assumptions that determine the value. Some interviewers have mentioned that you get projections from management, which tends to be optimistic and can often make the DCF the highest value. Regardless, all interviewers are looking for you to say that the DCF and precedents yield higher valuations than the other two methodologies for the reasons listed above.
What do you think is the best method of valuation?
Depends on the situation. Ideally, you’d like to triangulate all three main methods: precedents, trading comps and DCF. However, sometimes there are good reasons to heavily weight one over the others. A company could be fundamentally different from its peers, with a much higher/lower growth rate or risk and projections for future cash flows is very reasonable, which makes a good case to focus on the DCF. Or you may prefer trading comps over precedents because there are few precedents available or the market has fundamentally changed since the time those precedents occurred (i.e., 2006 was an expensive year due to the availability of leverage).
What is a WACC?
The “WACC,” weighted average cost of capital, is the discount rate used in a DCF analysis to determine the present value of the projected free cash flows and terminal value. Conceptually, the WACC represents the blended opportunity cost to lenders and investors of a company. The WACC reflects the cost of each type of capital: debt and equity, weighted by the respective percentage of each type of capital assumed for the company’s capital structure. Specifically the WACC is defined as: WACC = [(% Equity) * (Cost of Equity)] + [(% Debt) * (Cost of Debt)(1-tax rate)]
Name five reasons why a company would want to acquire another company.
1) The target company is seen as undervalued, 2) synergies can be obtained with the merger of the two companies, 3) a larger company is more industry-defensible (more resilient to downturns or more formidable competitor), 4) provides growth (versus organic growth, which may have slowed or stalled) and 5) can be a use for excess cash.
Would you make an offer to buy a company at its current stock price?
No, you would not offer to buy a company at its current stock price because the current shareholders require a premium to be convinced to tender their shares. Premiums usually range from 10 percent to 30 percent.
If a company acquires another company with a higher P/E in an all stock deal, will the deal likely be accretive or dilutive?
All things being equal, if the acquirer’s P/E is lower than the target, then the deal will be dilutive to the acquirer’s earnings per share (“EPS”). This is because the acquirer has to pay more for each dollar of earnings than the market values for its own earnings; the acquirer will have to issue proportionally more shares in the transaction. Ignoring synergies, you can see mechanically that the pro-forma earnings, acquirer’s plus target’s earnings (the numerator in EPS), will increase less than the pro-forma share count (the denominator), causing EPS to decline.