MS Prep Flashcards
How do you determine cost of debt?
Interest rate on the debt, if its offered in tranches you can for a weighted average cost of debt.
What do you use for the discount rate?
WACC
How do you calculate WACC?
%equity (cost of equity) + % debt (cost of debt)(1-tax rate) + (% preferred)(cost of preferred)
What is an LBO?
The floor value of a company, the lowest value the existing owner would accept for their company
Two large publicly traded companies are looking to merge. What might they consider prior to agreeing to merge?
Strategic fit, recognize synergies, optimism in shareholders, boost the equity value of the company
Would you prefer to use perpetuity model or multiples method for terminal value?
Perpetual growth method assumes that a business will generate cash flows at a constant rate forever. Using the perpetuity growth model generally renders a higher value
What are the 4 types of valuations and rank them?
Precedent transaction, comparable companies, DCF, LBO
What is the difference between comparable and precedents?
Comps focus on current market values of specific public companies; precedents use historical transaction data from past deals. Precedents often result in higher valuations due to the inclusion of premiums
Describe what synergies are?
Cost & Revenue synergies are savings. Cost synergies are more concrete, removing redundant roles, economies of scale with combined companies. Revenue synergies can be access to patents or other intellectual property, cross-selling or cross marketing products to an existing customer base.
Why do we use EBITDA? Why not gross margin?
EBITDA provides a clear view of a company’s operating performance on its core business operations without the influence of capital structure. Gross margin only measures profitability after cost of goods sold, and its does not include other operating expenses like overhead, salaries.
Is EV/Net Income a good multiple? Then what is a good pair for Net Income?
EV / Income is not good because EV represents both debt and equity holders when net income represents only equity holders. A better pair for net income is the P/E ratio
What is WACC? How do we calculate cost of equity?
WACC is the weighted average cost of capital, represents the company’s average cost of financing its operations and is used as a discount rate in a DCF.
Cost of Equity - CAPM, Risk free rate + Beta * Equity risk premium
If you are an investor looking at a company, cost of debt 8% while cost of equity 9.5%, what do you think?
A lower cost of debt suggests the company may have room to leverage more debt however it is important to analyze the company’s cash flow stability and market conditions
What are some of the frequently used valuation methodologies and how would you present them?
Comps analysis, Precedent Transaction Analysis, DCF, LBO, Sum of the parts, they are displayed in a football field chart, to show the range of expected values.
What’s your intuition about why a sponsor would do an LBO?
They believe they can maximize their returns through leverage, can make operational improvements, stable cash flows, easy exit, assets they can sell or use as collateral, company is undervalued.
What does Beta represent and how do you calculate it
Beta is a measure of a stock’s volatility or risk compared to the overall market. It indicates how sensitive a stock’s price is to movements in the broader market.
Use publically available betas, unlever them and relever using your capital structure
Beta = Covariance of stock and market returns / variance of market returns
why do you lever and unlever Beta
Betas used from comparable companies is levered to that companies capital structure, we need to remove that capital structure and lever it to our capital structure
Why would we want to know the implied enterprise value of a company?
Implied Enterprise value is an estimate of a company’s value based on an individual’s opinion of the company. Current enterprise value is based on the market’s view of the company, the market can be wrong.
Where does SBC show up in the financial statements?
Income Statement: typically included as an operating expense
Cash Flow Statement: SBC is added back to net income in the operating activities because it is a non cash expense
Balance Sheet: SBC impacts equity under additional paid in capital
Where do dividends show up in the financial statements
Balance Sheet - reduces retained earnings under shareholders equity
Cash Flow Statement - Appears as a cash outflow under financing activities
Income Statement - Not reported
Why would one company have a WACC of 7% vs another company with a WACC of 15%
This is because of the risk profile, capital structure, creditworthiness, industry, tax rate
What is beta?
Beta is a measure of a stock’s volatility or systematic risk relative to overall market risk
How do you go from Net income to EBITDA
Start with Net Income, add back interest, add back taxes, add back depreciation, add back amortization
Explain LBOs high level
Buy a residential investment property with a tenant, you use cash for a down payment and finance the rest. The rental income pays off the mortgage and carry for the property, you use some of the income to fix up the house, sell the house pay off the remainder of the mortgage and keep the profit.
How do you calculate dilutive shares?
Treasury Stock method
How do you calculate the cost of debt for a company with numerous tranches of debt
Weighted average cost of Debt | Proportion of tranche = principal / total principal | Proportion of a tranche * Interest rate of Tranche, sum this up and multiply by 1-Tax Rate
Where do you get the cost of debt for floating rate loans
Cost of Debt = risk free rate of return + credit spread * 1-Tax Rate
What is a good LBO candidate
Stable and predictable CFs, area to increase margins, cut costs, good management team, good assets to use as collateral, does not require capital expenditures, industry that is easy to exit.
If you were to do an LBO which industry would you choose
I would want an industry with stable predictable cash flows, low volatility, and strong market prediction. Also would want good assets to use as collateral for secured debt. Personally speaking, there was a lot of room for automation for the steel company I worked for. I would pitch buy Olympic steel and sell it to Clevland cliffs.
What would happen to my EV if my WACC increased?
An increase in WACC reduces the present value of future cash flows, thereby reducing the enterprise value
If I was to buy a company and had cash vs equity, which would I want to use, why? What about debt?
Cash is the best option when you have sufficient liquidity and want to avoid ownership dilution
Equity - is useful when preserving cash is important, and when the stock is highly valued
Debt - is ideal when you want to preserve ownership and leverage is appropriate, but only if the company can comfortably service the debt with stable cash flows
When do you amortize goodwill?
You do not amortize goodwill, you can amortize intangibles
What is a DCF and why would we want to use it?
A DCF is the most intrinsic valuation of a company based on the PV of its expected future cash flows.
You would use a DCF when you have reasonable visibility into future cash flows, that are stable and predictable, you want a company’s intrinsic value
How do you calculate the present value of cash flow in a given year?
PV = CF / (1+r)^n
R = discount rate, WACC
What gets used mostly unlevered fcf or levered fcf?
Unlevered Free Cash flow is mostly used.
If a women, a leader in the company, buys a yacht for personal use and it costs 60m, how to 3 statements change
No impact for personal use
If a women, a leader in the company, buys a yacht for business use and it costs 60m which is borrowed, how to 3 statements change
Income Statement : -NC-
Cash flow statement: -NC- Cash inflow from financing, cash outflow for investing activities
Balance Sheet: PP&E and debt both increase by $60 million
Company buys $10M of land using full debt. What happens to the three statements on Day 1
Income Statement : -NC-
Cash Flow Statement: Increase in cash from Financing Activities / Decrease from investing activities / No net change
Assets: Increase by $10 million / Debt: $10 million
The company has a good credit rating. What rate of interest would it be charged for the debt?
5.525% but could probably get better rate by going to private credit
Walk me through the statements if the company pays interest on that debt
Income Statement: decrease in pretax income, * (1-tax rate) decrease in net income
Cash flow statement: cash is down
Balance sheet: cash and retained earnings are down
Revenue to Free Cash Flow
Revenue
-COGS
-Operating Expense
EBIT * (1-Tax Rate)
+ Depreciation
-Capital Expenditures
change in working capital
Unlevered free cash flow
What are the key levers that impact an LBO
Purchase price, debt to equity ratio, interest rate, exit multiple
How would you choose a multiple for exiting an LBO?
You look at recent transactions of comparable companies
What would be a company’s discounted value from its 5th year?
PV = CF 5th year / (1+WACC)^5
