Investment Banking Technical

Question 1

What is Enterprise Value Made up of

Answer 1

Equity Value or Market Cap + Debt - Cash + Minority Interest + Preferred Shares

Question 2

Can Enterprise value be negative? If so why?

Answer 2

Can be due to too much Cash.
Can show that the company is not using assets very well, should be using investing it back into the company or paying out shareholders.

Question 3

Basic vs Diluted Shares. What is the difference

Answer 3

Basic Shares are all of the currently issued shares that are outstanding at a particular date. Diluted shares is assuming the impact of all dilutive effect of any stock options, warrants, convertible debt or convertible preferred shares

Question 4

What are the three valuation methods + 1 that can be used

Answer 4

1) Asset Approach: FMV of Net Assets
2) Income Approach: Discounted Cashflow
3) Market Approach: Precedent Transactions or Public Company Comparable
4) Leveraged Buyout

Question 5

Which valuation method is the best

Answer 5

It depends on the situation.
1. If no comparable or Precedent transactions, then the market approach is bad. However Precedent transactions tend to be higher due to the control premium that companies pay for or premium they pay for various strategic reasons (horizontal or vertical expansion). DCF is only as good as your inputs, garbage in garbage out.

Question 6

What are some attributes you assess when looking at comparables.

Answer 6

Industry, product offering, geography, financial criteria (size of revenue). Start narrow and expand if your search isn’t resulting in enough hits.

Question 7

Walk me through a discounted cash flow model

Answer 7

DCF values the company based on
1. PV of the companies free cash flow
2. PV of the companies terminal vale

1) You project out the companies, revenue, expenses and working capital.
2) Then calculate free cash flow for each year.
3) Discount this back to PV based on your discount rate (WACC or CAPM are common)
4) Calculate your terminal value (using either multiples method of the Perpuitity method)
5) Add both back together to calculate your enterprise value.

Question 8

What is Free Cash Flow and how do you calculate it?

Answer 8

Free cash Flow represents the cash that a company generates after accounting for cash outflows to support operations and maintain it’s capital assets. This excludes non-cash expenses. Interest payments are generally excluded. Overall money that the company has to repay it’s creditors or pay dividends.

1. Can start from Cashflow statement
   Cash flow from operation activities
   + Interest Expense
   - Tax Shield on interest expense
   - Capital expenditures
2. Start from income statement
   EBIT x (1-tax rate)
   + Add non cash expenses (depreciation, unrealized gains, SBC)
   - Change in non cash working capital
   - Capital expenditures
   (This gets your unlevered FCF as you don’t include the impact of interest)

Question 9

How do you calculate terminal value

Answer 9

Two methods

1) Perpetuity method
Terminal Value = Final Year FCF x (1+ Perpetuity growth Rate) / (Discount Rate - Perpetuity Growth Rate)

Two main assumptions
g = growth rate

This should be the growth rate of the company. Can use risk free rate or GDP growth. Keep an eye on the growth rate, if larger than economy, then it grows quicker then global economy?

r = discount rate

*If cash flow is unlevered, then use WACC and ending output is enterprise value
* if cash flow is levered, then use cost of equity which gives you equity value

2) Exit multiples method
Terminal value = Final Year EBITDA x Exit Multiple

Can use the two concurrently to see if the growth rate is reasonable.

Question 10

What is WACC and How do you calculate it?

Answer 10

Weighted Average Cost of Capital: Represents the after tax cost of capital from all sources (debt, common stock, preferred stock, bonds and other sources of debt). So it is the average rate that company expects to pay to finance it’s business.

WACC = Cost of Equity x (MV of equity / MV of Company) + Cost of Debt x (MV of debt / MV of Company) * (1 - Tax rate) + Cost of Preferred Shares x (% of Preferred)

Can use Capital Asset Pricing Model to calculate cost of equity, rest you can look at comparable to estimate the rates.

Question 11

What is Capital Asset Pricing Model and how do you calculate it

Answer 11

There is a liner correlation between risk and the expected return.
Cost of Equity = Risk Free Rate + Beta x Equity Risk Premium

Risk Free Rate = Similar treasury bills
Beta: Riskiness compared to comparable companies, if risker then greater than 1
Risk Premium: % by which company is expected to out-perform risk less assets. (Expected return - Risk Free rate)

Question 12

What is beta, how do you calculate it

Answer 12

Beta is a measure of volatility. You assess the changes in the return of company vs changes in return of the market.

Beta coefficient(β)= Covariance(R e​,R m) / Variance(R m)

Covariance of Return of market and stock: How related the changes are
variance of the market: How fair the data points are from their average values

Question 13

Explain an leverage buyout to me

Answer 13

Private equity or a group of investors will use a combination of debt and equity to finance the purchase.

Look for a target. strong cash flow, low risk, low capital expenditures.

Calculate an DCF
1. Levered cash flow: EBITDA - Interest - Debt Repayments - capital expenditures - changes in working capital
2. Terminal value: multiples approach then - Debt - Closing cost and fees
Can calculate the IRR (where npv = 0) and see if the investment is worth doing.

Question 14

Why would an acquisition be dilutive

Answer 14

If the additional income that is generated from the acquired company doesn’t offset the additional expenses that are incurred from the acquisition. (Debt costs, transaction costs, issuing new shares, etc)

Question 15

What is the price to earnings ratio

Answer 15

Price to earnings shows if the stock price is over or under valued.

P/E = Market price per share / Earnings per share

Earning per share = net income / average number of shares outstanding

If greater than 1, overvalued. Market deems it worth more then the it’s earning. Could be overvalued or there is great growth.

Question 16

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

Answer 16

If the buyer has a higher P/E then the seller, should be accretive, vice versa is truth. If you are paying for more earnings than what the market values your own earnings, then it will be dilutive.

Question 17

Equity vs Debt

Answer 17

Equity
Pro: Strong market, may receive premium on it’s equity
Cons: Expected return on equity is higher, making it more expensive than debt. Also dilutes your investor pool.
- Will do this if interest rate is higher, P/E is high (share is overvalued)

Debt
Pro: Can be cheaper, interest is tax deductible
Con: Harder to be cash flow positive due to interest, less attractive to buyers as more leveraged.
- If interest rate is low, undervalued stocks

Question 18

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s
profitability. What’s the difference between them, and when do you use each one?

Answer 18

P / E depends on the company’s capital structure whereas EV / EBIT and EV / EBITDA
are capital structure-neutral. Therefore, you use P / E for banks, financial institutions,
and other companies where interest payments / expenses are critical.
EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it –
you’re more likely to use EV / EBIT in industries where D&A is large and where capital
expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in
industries where fixed assets are less important and where D&A is comparatively
smaller (e.g. Internet companies).

Question 19

13. Walk me through how we might value an oil & gas company and how it’s
    different from a “standard” company.

Answer 19

You might screen based on metrics like Proved Reserves or Daily Production.
* You would look at the above metrics as well as R/P (Proved Reserves / Last
Year’s Production), EBITDAX, and other industry-specific ones, and use
matching multiples.
You could use a standard Unlevered DCF to value an oil & gas company as well, but it’s
also common to see a NAV (Net Asset Value) Model where you take the company’s
Proved Reserves, assume they produce revenue until depletion, assign a cost to the
production in each year, and take the present value of those to value the company.

Question 20

Walk me through a NAV model

Answer 20

The NAV model flips the traditional DCF on its head because you no longer assume perpetual growth.

Instead, you assume that the company adds nothing to its reserves and that it produces 100% of its reserves until it runs out of natural resources completely.

Here’s a rough outline of how it works:

1. Set Up Columns to Track Each Commodity, Revenue, Expenses, and Cash Flows.

You want to track the beginning and ending reserves each year, the annual production volume, and the average price for each commodity; typically you use the same low/mid/high price cases that you used in the company’s operating model.

2. Assume Production Decline Rates and Calculate Revenue Until the Reserves Run Out.

Depending on the company’s previous history, you might assume a decline rate of 5-10% per year – potentially more or less depending on how mature it is.

In each year, you assume that you produce either the production volume of that year or the remaining reserves – whichever number is lower.

Then, you’d multiply the production volume times the average price each year for all commodities to get the revenue by year.

3. Project (Some) Expenses.

You focus on Production and Development expenses here, both of which may be linked to the company’s production in the first place.

You don’t assume anything for Exploration since you’re pretending that the company finds nothing and dwindles to $0 in the future, and you leave out items like corporate overhead and SG&A because we’re valuing the company on an asset-level.

4. Calculate and Discount After-Tax Cash Flows

Simply subtract the expenses from the revenue each year and then multiply by (1 – Tax Rate) to calculate the after-tax cash flows.

Then, you add up and discount everything based on the standard 10% discount rate used in the Oil & Gas industry (no WACC or Cost of Equity here).

Question 21

How do you calculate Beta

Answer 21

you look up the Beta for each Comparable Company (usually on Bloomberg), un-lever
each one, take the median of the set and then lever it based on your company’s capital
structure. Then you use this Levered Beta in the Cost of Equity calculation

For your reference, the formulas for un-levering and re-levering Beta are below:
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 22

25. Two companies are exactly the same, but one has debt and one does not – which
    one will have the higher WACC?

Answer 22

The one without debt will generally have a higher WACC because debt is “less
expensive” than equity. Why?
* Interest on debt is tax-deductible (hence the (1 – Tax Rate) multiplication in the
WACC formula).
* Debt is senior to equity in a company’s capital structure – debt holders would be
paid first in a liquidation or bankruptcy scenario.
* Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers
you see (usually over 10%). As a result, the Cost of Debt portion of WACC will
contribute less to the total figure than the Cost of Equity portion will.
Theoretically if the company had a lot of debt, the Cost of Debt might increase and
become greater than the Cost of Equity but that is extremely rare – the company without
debt has a higher WACC in 99% of all cases.

Question 23

Difference between unlevered FCF and levered FCF

Answer 23

Unlevered doesn’t account for the impact of debt. So shows the cash flow that is available for both equity and debt holders.

Unlevered FCF: EBIT x (1 - Tax Rate) + Non-Cash expenses - Non-cash Gains +/- Changes in NWC + Capital capital expenditures.

levered FCF: EBIT x (1 - Tax Rate) - Interest Expense - Mandatory Debt repayments + Non-Cash expenses - Non-cash Gains +/- Changes in NWC + Capital capital expenditures.