Intermediate

Question 1

Of the 3 financial statements, which two would you choose to analyze a company?

Answer 1

I would ask for current period and prior period’s balance sheet as well as the income statement, because from there I could generate a cash flow statement. Therefore, I would have all 3 statements to analyze a company.

Question 2

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

Answer 2

AR means that services have been performed and the company can record revenue on its income statement. However, cash has not been recieved. Thus, the cash flow statement offsets the NI that has that AR refelcted in it. This is to avoid double counting.

Question 3

Where do you find the risk free rate?

Answer 3

Risk free rate is typically a 10 year US T-Bond. It can be found on financial websites, wall street journal, etc

Question 4

What would a company do with excess cash on its balance sheet?

Answer 4

1. Invest in itself
2. Retain the cash if projecting economic downturn
3. Pay dividends
4. Pay down debt
5. Repurchase stock

Question 5

How would you value a company with no revenue?

Answer 5

I would start with precedent transactions analysis. I would find similar transactions and analyze those. I could also compare multiples that are industry specific and not necessary related to the financial statements.

Do not project revenue when there is no revenue.

Question 6

What are companies that have a beta lower and companies that have a beta greater than 1?

Answer 6

Lower than 1:

Consumer retail, energy

Greater than 1:

E-commerce, tech, bio-tech

Question 7

Why would a company issue dividends to investors?

Answer 7

It signals that the company is healthy and attracts investors to buy its stock, this increasing the value of the stock.

Question 8

When should a company issue equity instead of debt?

Answer 8

A company should issue equity when:

• the stock price is high
• the company is investing in projects that may not generate immediate cash flows
• the company wants to pay down debt

Question 9

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

Answer 9

The public company’s shares would be priced higher because of the liquidity premium as well as the transparency premium resulting from being a public company and having increased regulatory scrutiny.

Question 10

What is operating leverage?

What are the benefits of having high operating leverage?

Answer 10

The percentage of costs that are fixed versus variable. A company that has a large degree of fixed costs has high operating leverage.

High operating leverage can be beneficial in growth stages because more revenue will fall to the bottom line as opposed to variable expenses that increase as revenue increases.

Question 11

What are some examples of items that may need to be added back to EBITDA to get a better sense of the financial health of a company?

Answer 11

One off items such as legal fees, restructuring expenses, asset impairment losses, excessive debt payments, and other things not likely to be a recurring event

Question 12

When should a purchase be capitalized rather than expensed?

Answer 12

If the asset is expected to have a useful life beyond 1 year, it should be capitalized.

Question 13

List the order of debt/equity holders’ claims to assets in the event of a bankruptcy.

Answer 13

1. Senior debt
2. Mezzanine debt
3. Subordinate debt
4. Preferred stock
5. Common stock

Question 14

How would you calculate the WACC of a private company?

Answer 14

Since the private company is not publicly traded, I would derive Ke and the beta from a similar company.

Question 15

Describe a company’s typical capital structure.

Answer 15

A company’s capital structure is made up of debt and equity.

Debt

The 3 levels of debt are senior, mezzanine, subordinated. Senior debt would offer the lowest interest rate since it would be paid off first in the event of a bankruptcy as well as allowing for collateral and other protections for the bank. Senior debt is bank loans. Mezzanine and subordinate are bonds.

Equity

Equity is either preferred or common stock. Preferred stock combines both aspects of common stock and preferred stock, because it pays a dividend and has the ability to increase in value. Common stockholders have the least claim to assets in the event of a bankruptcy.

Question 16

Explain the idea of cost of equity.

Answer 16

Companies don’t have an explicit cost of equity, unless that company pays dividends. The Ke is the expected return of that asset. Thus, if the company does not achieve that return, investors will not hold its stock. Thus, a company must spend and invest to generate the returns necessary to match its expected return on its stock price.

Question 17

When should an investor buy preferred stock?

Answer 17

If the investor wants a fixed dividend rate as well as the opportunity for capital appreciation. also, preferred stock is senior to common stock within a company’s capital structure.