IB Quick & Dirty

Question 1

Walk me through the three major financial statements.

Answer 1

The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement.

The Cash Flow statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company’s net change in cash.

The Balance Sheet shows the company’s Assets (it’s resources, such as Cash, PP&E), Liabilities (such as Debt and Accounts Payable), and Shareholder’s Equity. Assets must equal liabilities plus Shareholder’s Equity.

Question 2

How do the 3 statements link together?

Answer 2

To tie the statements together, Net Income from the Income Statement flows into the top line of the Cash Flow Statement and into Shareholder’s Equity on the Balance Sheet, and changes to the Balance Sheet items appear as working capital changes on the Cash Flow Statement, and and investing and financing activities affect Balance Sheet items such as PP&E, Debt, and Shareholder’s 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.

Question 3

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

Answer 3

You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that’s the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.

Question 4

What is deferred tax?

Answer 4

Deferred tax represents a company’s liability for taxes owed that is postponed to future periods. Deferred tax is primarily the result of tax law that allows firms to write off expenses faster than they are recognized and thus create a deferred tax liability.

Question 5

A company makes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year?

Answer 5

First Year: Let’s assume that the company’s fiscal year ends Dec. 31. The relevance
of the purchase date is that we will assume no depreciation the first year. Income
Statement: A purchase of equipment is considered a capital expenditure which does
not impact earnings. Further, since we are assuming no depreciation, there is no
impact to net income, thus no impact to the income statement. Cash Flow Statement:
No change to net income so no change to cash flow from operations. However we’ve
got a $100 increase in CapEx so there is a $100 use of cash in cash flow from
investing activities. No change in cash flow from financing (since this is a cash
purchase) so the net effect is a use of cash of $100. Balance Sheet: Cash (asset)
down $100 and PP&E (asset) up $100 so no net change to the left side of the balance
sheet and no change to the right side. We are balanced.

Second Year: Here let’s assume straight-line depreciation over 5 years and a 40%
tax rate. Income Statement: Just like the previous question: $20 of depreciation,
which results in a $12 reduction to net income. Cash Flow Statement: Net income
down $12 and depreciation up $20. No change to cash flow from investing or
financing activities. Net effect is cash up $8. Balance Sheet: Cash (asset) up $8 and
PP&E (asset) down $20 so left side of balance sheet down $12. Retained earnings
(shareholders’ equity) down $12 and again, we are balanced.

Question 6

What is the difference between enterprise value and equity value?

Answer 6

Enterprise Value represents the value of the operations of a company attributable to all providers of capital. Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders.

Question 7

What is the formula for Enterprise Value?

Answer 7

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

Question 8

What is the difference between basic shares and fully diluted shares?

Answer 8

Basic shares represent the number of common shares that are outstanding today (or as of the reporting date). Fully diluted shares equal basic shares plus the potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt. In calculating a company’s market value of equity (MVE) we always want diluted shares.

Question 9

What are the three main valuation methodologies?

Answer 9

The three main valuation methodologies are (1) Comparable Company analysis (2) Precedent Transaction analysis and (3) Discounted Cash Flow (DCF) analysis

Question 10

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

Answer 10

There is no ranking that always holds, but in general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

Question 11

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

Answer 11

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.

Question 12

How do you select Comparable Companies / Precedent Transactions?

Answer 12

The 3 main ways to select companies and transactions:
1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography

For Precedent Transactions, you often limit the set based on date and only look at transactions within a limited amount of years. The most important factor is industry - that is always used to screen for companies/transactions.

Question 13

Walk me through a DCF.

Answer 13

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate - usually the Weighted Average Cost of Capital. Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC. Finally, you add the two together to determine the company’s Enterprise Value.

Question 14

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Answer 14

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1-Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital. This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT.

The formula can be summarized as:
FCF = NOPAT + D&A - CapEx - Δ Net Working Capital

Or more explicitly:
FCF = [Revenue - COGS - Operating Expenses] * (1 - Tax Rate) + D&A - CapEx - Δ Net Working Capital

Question 15

How do you calculate WACC?

Answer 15

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1-Tax Rate) + Cost of Preferred * (% Preferred). In all cases, the percentages refer to how much of the company’s capital structure is taken up by each component. For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.

Question 16

How do you calculate the Cost of Equity?

Answer 16

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

• The Risk-Free Rate represents how much a 10-year or 20-year US Treasury should yield
• Beta is calculated based on the “riskiness” of Comparable Companies and the Equity
• Risk Premium is the % by which stocks are expected to out-perform “risk-less” assets.

Question 17

How do you calculate Terminal Value?

Answer 17

You can either apply an exit multiple to the company’s Year “n” EBITDA (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 “n” Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).

Question 18

What is an “ideal” candidate for an LBO?

Answer 18

“Ideal” candidates have stable and predictable cash flows, low risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an opportunity for expense reductions to booth their margins. A strong management team also helps, as does a base of assets to use as collateral for debt. The most important part is stable cash flow.

Question 19

How could a private equity firm boost its return in an LBO?

Answer 19

• Lower the Purchase Price in the model.
• Raise the Exit Multiple / Exit Price.
• Increase the Leverage (debt) used.
• Increase the company’s growth rate (organically or via acquisitions).
• Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.)

Question 20

Why would an acquisition be dilutive?

Answer 20

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, or the effects of issuing additional shares. Acquisition effects - such as amortization of intangibles - can also make an acquisition dilutive.

Question 21

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

Answer 21

In an all stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive. On an intuitive level, if you’re paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you’re paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.

Alternative explanation:

1. Buyer has higher P/E: The market values the buyer’s earnings more highly. By buying a company with a lower P/E, they’re essentially getting earnings at a “discount” compared to their own. This tends to boost their overall EPS.
2. Buyer has lower P/E: The market values the buyer’s earnings less. By buying a company with a higher P/E, they’re paying a “premium” for earnings compared to their own. This tends to reduce their overall EPS.

Question 22

What criteria would you use to help a client make an acquisition?

Answer 22

Financial Criteria: EPS accretion/dilution; Does it create shareholder value (NPV > 0)?; source of cash for the acquisition

Strategic Criteria: Growth in market share; industry consolidation/economies of scale; Vertical integration; Technological or intellectual property acquisition; regulatory & political change

Question 23

What is the difference between Goodwill and Other Intangible Assets?

Answer 23

Goodwill typically stays the same over many years and is not amortized. it changes only if there’s goodwill impairment (or another acquisition). Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitting the Pre Tax Income line.

Question 24

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

Answer 24

Synergies refer to cases where 2+2=5 (or 6, 7, etc) in an acquisition. Basically, the buyer gets more value out of an acquisition than what the financials would predict.

Question 25

What are Revenue Synergies?

Answer 25

The combined company can cross sell products to new customers or up sell new products to existing customers. It might also be able to expand into new geographies as a result of the deal (Access to new markets, geographies and customers; Ability to cross-sell products; Vertical Integration; Network effects)

Question 26

What are Cost Synergies?

Answer 26

The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations (Economies of scale; Economies of Scope; Cost efficiencies across value chain).

Question 27

What are the advantages and disadvantages to raising equity?

Answer 27

Pro: In a strong market, a company may be able to receive a premium on its equity.

Con: The expected return on equity is higher (at least 12%-15%) making it more expensive than debt

Question 28

What are the advantages and disadvantages to raising debt?

Answer 28

Pro: interest on debt is tax deductible, reducing its cost

Con: The Company’s debt is less marketable if it’s already highly leveraged. Additionally, the interest payment on debt makes it more difficult for cash flow to be positive.

Question 29

If a company wants to raise $100 million, what are the different ways to do it?

Answer 29

Equity Capital Markets: IPO, Follow On…

Debt Capital Markets: Loans, bonds…

Mergers and Acquisitions: Sell division…

Operations: Re-align internal funds (not likely)

Question 30

Why would a company choose to raise capital through ECM?

Answer 30

Interest rates are high: issuing equity avoids taking on expensive debt.

Stock is overvalued: can raise more capital by selling shares at a high price.

Company is over-leveraged: issuing equity improves debt-to-equity ratio

Markets are receptive to new equity issuances.

Question 31

When would a company opt for DCM financing?

Answer 31

Interest rates are low: can lock in cheap long-term debt financing

Stock is undervalued: avoid diluting shareholders at a low share price (raising equity while share prices are lower means they have to issue more shares which is dilutive)

Company is under-leveraged: has capacity to take on more debt

Debt markets are liquid and open to new issuances

Question 32

When would a company pursue mergers and acquisitions when looking to raise capital?

Answer 32

Need to realign business strategy quickly

In a desperate situation and need to combine with a stronger company

Strong demand/valuations making selling attractive

Can achieve synergies or economies of scale through combination

Question 33

When would a company attempt operational changes as a way to raise capital?

Answer 33

Need to realign strategy but M&A not feasible

Want to improve efficiency and profitability organically

External financing or M&A options are limited

Question 34

Company A has a PE of 20 and Company B has a PE of 15. Company A acquires Company B with all cash, using a 10% loan. Is the deal accretive or dilutive?

Answer 34

With a P/E of 15, it is like saying that you are paying $15 now to earn $1 every year.

The Earnings Yield is the inverse of the P/E ratio expressed as a percentage, so 1/(P/E ratio)*100. For Company B, the Earnings Yield is 6.67%.

Because the interest rate on the loan is 10% (greater than the Earnings Yield of Company B), the acquisition is dilutive.

The cost of borrowing would exceed the earnings yield and reduce Company A’s EPS.

Question 35

What is the difference between investment grade and non-investment grade bonds?

Answer 35

Investment Grade: lower risk of default, issued by financially stable companies or governments, lower yields due to lower risk, preferred by conservative investors and many institutional investors.

Non-Investment Grade: higher risk of default, issued by companies with weaker financial positions, higher yields to compensate for increased risk, often referred to as “junk bonds” or “high-yield bonds”.

Question 36

Define what a company credit rating is and the factors that contribute to a high or low credit rating?

Answer 36

A company’s credit rating is determined by various factors that indicate its financial health and ability to repay debt.

High Credit Rating Factors: strong financial performance and profitability, stable cash flows, low debt levels relative to assets and earnings, diverse revenue streams, strong market position, effective management.

Low Credit Rating Factors: Weak or inconsistent financial performance, high debt levels, limited cash flow or liquidity issues, concentrated revenue sources, weak competition position, industry volatility or decline.

Question 37

Explain what it means for a company to be overleveraged or underleveraged.

Answer 37

These terms refer to a company’s capital structure and use of debt.

Over-Levered Companies: have taken on too much debt relative to their equity and cash flow, higher risk of financial distress or bankruptcy

Question 38

Define term loans.

Answer 38

Term loans are a form of debt financing where a company borrows a specific amount of money for a predetermined period, typically ranging from 1 to 30 years.

• fixed repayment schedule with regular installments
• can have fixed or variable interest rates
• often secured by company assets
• may include covenants that restrict certain company actions

Question 39

Define notes.

Answer 39

Notes are debt securities that typically have a maturity between 2 to 10 years, falling between commercial paper (short-term) and bonds (long-term) in the debt spectrum.

• Fixed interest rate payments
• Principal repaid at maturity
• Can be secured or unsecured
• Often more flexible terms than term loans

Question 40

Define equity-linked instruments.

Answer 40

Equity-linked instruments are hybrid securities that combine characteristics of both debt and equity.

Convertible Bonds: Can be converted into a predetermined number of common shares, generally offer lower interest rates than straight debt, provide potential upside if the stock price increases.

Preferred Stock: pays fixed dividends, has priority over common stock in dividend payments and liquidation, may be convertible to common stock.

Question 41

Compare term loans, notes, and equity-linked instruments.

Answer 41

When companies use term loans: financing large capital expenditures or acquisitions, expanding operations or entering new markets, refinancing existing debt.

When companies use notes: General corporate purposes, refinancing short-term debt, funding ongoing operations or moderate expansion.

When companies use equity-linked instruments: attracting investors who want potential equity upside with some downside protection, lowering immediate interest expenses compared to straight debt, delaying dilution of existing shareholders.