Intermediate (Reverse) Flashcards
If the asset is expected to have a useful life beyond 1 year, it should be capitalized.
When should a purchase be capitalized rather than expensed?
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.
What is operating leverage?
What are the benefits of having high operating leverage?
Initially, PP&E would increase and cash would decrease (depending on how the equipment was paid for).
Then, as depreciation starts to occur, for the income statement operating income will decrease, taxes will decrease, and NI will decrease.
For the balance sheet, PP&E contra account will change, cash will increase, and retained earnings will decrease.
For the cash flow statement, CFO will be impacted by a lower NI but adding back the depreciation amount.
I buy a piece of equipment, walk me through the 3 financial statements. Include future impacts of depreciation.
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
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?
It signals that the company is healthy and attracts investors to buy its stock, this increasing the value of the stock.
Why would a company issue dividends to investors?
Since the private company is not publicly traded, I would derive Ke and the beta from a similar company.
How would you calculate the WACC of a private company?
EBIT would decrease $10. Thus, after tax amount would decrease $7.5 (assuming 25% tax rate). But, I would add back $10 depreciation in FCF formula. Thus, the increase in cash is $2.5. I would then discount the $2.5 back 4 years, and that would be the change.
How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?
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
When should a company issue equity instead of debt?
The market risk premium is the expexted return of the market minus the risk free rate. Essentially, it is the excess return that investors require to purchase stocks over risk-free securities.
What is the market risk premium?
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.
Explain the idea of cost of equity.
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.
Why are increases in AR a cash reduction on the cash flow statement?
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.
Describe a company’s typical capital structure.
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 FCFs for a company that has NO revenue.
How would you value a company with no revenue?
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.
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?
- Invest in itself
- Retain the cash if projecting economic downturn
- Pay dividends
- Pay down debt
- Repurchase stock
What would a company do with excess cash on its balance sheet?
