OE - EV and Deal Walkthrough Flashcards
Who are the stakeholders of a corporation? What are their differing objectives?
Equity Holders - growth and increase in equity value and dividends
Debt Holders - steady cash flows that pay the debt burden consistently with limited risk
Management / employees - compensation and stability of employment
Define sources and uses of capital.
For the day to day operations, sources of capital relate to the origin of the capital used in the firm - this includes both debt and equity investments as well as internal financing (asset sales, income from operations, etc.)
Uses of capital relate to how the capital is employed, which can include purchasing assets (CAPEX), funding operations (working capital), paying down debt, etc.
[Advanced: Sources and Uses will also come up in reference to an M&A transaction, where sources represent how the deal is paid for (new equity issued, debt raised, cash) and uses represent how that capital is used (buying out the existing equity holders, refinancing target company debt, paying transaction fees, etc.)]
Explain how to use the Treasury Stock Method to calculate fully diluted shares.
You start with common shares outstanding, and add net new shares created. Net new shares created equals in the money options, warrants, and restricted stock less the number of common shares that can be purchased in the market with related proceeds. Related proceeds is equal to the strike price of the options times the number of options.
[Example: A company has 100 shares outstanding with 10 options outstanding that have a strike price of $5. The company’s stock price is $10. Since the strike price is below the stock price the 10 options are ‘in the money’ and will convert to stock. There are now 100+10 = 110 shares outstanding. The company will get proceeds from the conversion of these options based on number of options times the strike price of $50 (10 options x $5). The company can use these proceeds to buy back 5 shares of its own stock from the market ($50/10 = 5). So fully diluted shares outstanding using the Treasury Stock method is 105 shares (110-5).]
Can a company have negative market cap? Can it have negative enterprise value?
No, a company cannot have negative market cap, since the share price cannot be less than zero. Yes, a company could have negative enterprise value, for instance, if it had an abundance of cash and cash equivalents on its books. (Why would a negative enterprise value not last?)
Suppose you have a firm with the following information: EV/EBITDA: 10x P/E: 20x Interest Expense: 20 Interest Rate: 5% D&A: 20 Market Cap: 200 Calculate the tax rate for this firm.
Debt: 400 (Interest Expense (20)/ Interest Rate (.05))
Enterprise Value: 600 (Market Cap (200) + Debt (400))
EBITDA: 60 (EV/EBITDA) Given above
EBIT: 40 (EBITDA - D&A)
EBT: 20 (EBIT - Interest Expense)
Net Income: 10 (Market Cap (200) / Price to Earnings Ratio (20))
Therefore since you go from 20 EBT to 10 in Net Income the tax rate is 50%.
What is the difference between equity value and shareholder’s equity?
Equity value is a market valuation metric (market value), whereas Shareholder’s Equity is an accounting metric (book value).
Why would a corporation not want to have large amounts of cash on its balance sheet? What would you advise such a company to do?
Sitting on excess cash has an opportunity cost - the difference between the interest earned on holding cash and price paid for having the cash as measured by the company’s cost of capital or WACC (weighted average cost of capital). If a company can get 20% return on equity investing in a new project or by expanding the business, it is a costly mistake to keep the cash in the bank. If the project’s return is less than the company’s cost of capital, the cash should be returned to shareholders through dividends or share repurchases.
Prioritize the following items in terms of risk and reward: Convertible debt, equity, senior debt, and subordinated
Low risk / reward to high risk / reward: (1) Senior debt; (2) Subordinated debt (3) Convertible debt (4) Equity.
Rank in order of the cost of capital: Treasury Bill, mezzanine, convertible, and equity.
From lowest to highest: Treasury Bill, convertible, mezzanine, (with warrants attached), equity.
Why add debt to your capital structure?
- To increase your firm’s return on equity.
- To finance a deal / project without diluting shareholder value.
- To add value to the firm due to the tax shield of interest.
What are some considerations when adding leverage to a company?
- Ability to service the debt
- How it affects the firm’s risk of default / credit rating
- How it affects the firm’s cost of debt
- How it affects the firm’s return on equity
- The loss of financial flexibility restricts alternatives of management and the firm
- Costs of financial distress (lost sales, suppliers reluctant to supply, legal fees, inability of the firm to take advantage of opportunities.)
- Existing debt covenants
A company has $400mm in cash and no other assets. They have no debt, and their market capitalization is $200mm. What is happening here?
Assuming that no debt means that there are no liabilities whatsoever on the balance sheet, there are a couple of explanations for this.
The firm could have off-balance sheet obligations (e.g. operating leases, R&D, and joint ventures). The company could also potentially be going through a costly lawsuit.
This would otherwise not last, as an investor could purchase the equity for $200mm and have $400mm in cash, thus the price of the equity should be at least very close to $400mm.
You have a company with $60,000 in equity, $40,000 in debt, you issue another $10,000 in debt. What is the TEV (total enterprise value) of the company?
TEV is $100,000. Without taxes, the market value of debt increased by $10,000, but cash also increased by $10,000, which would reduce TEV. The net impact of the debt issuance on TEV is $0. With taxes, the equity value would grow to $60,000 + (tax rate * 10,000), and thus TEV would increase by the tax shield of debt.
The same company from the previous question now uses the $10,000 in cash that they raised through debt to invest in new equipment. What is the new TEV of the company (ignore taxes)?
Taking the cash and investing it in core assets for the company will raise EV. Formulaically EV should now increase by $10,000 since cash decreases by $10,000 while debt and equity remained the same. But in reality it is more complicated. If the rate of return on the investment in new equipment is greater than the company’s WACC then EV should increase by more than $10,000. If the rate of return is less than the company’s WACC then EV would likely increase, but by less than the $10,000 spent on the equipment (it was a poor investment). If WACC equals the rate of return on the investment then the EV should increase by exactly $10,000.
Which would you expect to have higher leverage, a tech company or a chain of retail stores?
Expect a chain of retail stores to have higher leverage because:
They have more consistent cash flows v. tech startups
They need continued capital to expand their footprint