Qs Flashcards
How can we calculate Cost of Equity WITHOUT using CAPM?
There is an alternate formula:
• Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
• This is less common than the “standard” formula but sometimes you use it when the company is guaranteed to issue Dividends (e.g. Utilities companies) and/or information on Beta is unreliable.
Why are Capitalized Financing Fees an Asset?
There are a couple ways to think about this:
• It’s just like Prepaid Expenses items on the Assets side: paid for in cash up-front and then recognized as an expense over many years. Since the company has already paid for it in cash‚ its not going to cost them anything more in future periods.
• An Asset represents potential future income or potential future savings; Capitalized Financing Fees have already been paid in cash‚ so when the expense is recognized on the Income Statement over several years it reduces the company’s taxes (similar to Prepaid Expenses).
Can Beta ever be negative? What would that mean?
- Theoretically, yes, Beta could be negative for certain assets. If Beta is -1, for example, that would mean that the asset moves in the opposite direction from the market as a whole. If the market goes up by 10%, this asset would go down by 10%.
- In practice, you rarely, if ever, see negative Betas with real companies. Even something labeled as “counter-cyclical” still follows the market as a whole; a “counter-cyclical” company might have a Beta of 0.5 or 0.7, but not -1.
Let’s say a company has 100 shares outstanding‚ at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its Diluted Equity Value?
$1000. In this case‚ the options’ exercise price is above the current share price (options are not in-the-money)‚ so they have no dilutive effect.
What about a buyout of a company where you only acquire a 30% stake?
- This scenario is not a true LBO b/c a PE firm cannot “make” a company take on Debt unless it actually controls the company.
- So in this case‚ you would model it as a simple equity investment for 30% of the company‚ assume that the company operates for several years‚ and then assume that the PE firm sells its 30% stake at the end of that period.
- You would base the company’s “ending” value on an EBITDA (or other) multiple‚ and usually you assume that it’s less than or equal to the initial multiple in the beginning to be conservative.
Are revenue or expense synergies more important?
- Revenue synergies are rarely taken seriously b/c they’re so hard to predict.
- Expense synergies are taken a bit more seriously b/c it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.
How can you tell whether or not a Goodwill Impairment will be tax-deductible?
- There’s no way to know for sure unless the company states it‚ but generally Impairment on Goodwill from acquisitions is NOT deductible for tax purposes.
- If it were‚ companies would have a massive incentive to start writing down the values of their acquisitions and saving on taxes from non-cash charges‚ which the government wouldn’t like too much.
- Goodwill arising from other sources may be tax-deductible‚ but it’s rare to see significant Impairment charges unless they’re from acquisitions.
What are the 3 main criteria to pick comparable public companies?
- Geography
- Industry
- Financial (Revenue or EBITDA above‚ below‚ or between certain numbers)
Let’s walk through a real-life example of debt modeling now. Let’s say that we have $100M of debt w/ 5% cash interest‚ 5% PIK interest and amortization of 10% per year. How do you reflect this on the financial statements?
To simplify this scenario‚ we’ll assume that interest is based on the beg. debt balance rather than the average balance over the course of the year.
• Income Statement: There’s $5M of cash interest and $5M of PIK interest‚ for a total of $10M in interest expense‚ which reduces Pre-Tax Income by $10M and Net Income by $6M assuming a 40% tax rate.
• Cash Flow Statement: Net Income is $6M lower‚ but you add back the $5M in PIK interest b/c it was a non-cash charge. CFO is down by $1M‚ Since there’s 10% amortization per year‚ you repay $10M of debt each year (and presumably the entire remaining amount at the end of the period) in the CFF section - so cash at the bottom is down by $11M.
• Balance Sheet: Cash is down by $11M on the Assets side‚ so that entire side is down by $11M. On the other side‚ Debt is up by $5M due to the PIK interest but down by $10M due to the principal repayment‚ for a net reduction of $5M. Shareholders’ Equity is down by $6M due to the reduced Net Income‚ so both sides are down by $11M and balance.
• Each year after this‚ you base the cash and PIK interest on the new debt principal number and adjust the rest of the numbers accordingly.
Do you think a DCF would work well for an oil & gas company?
If it’s an Exploration & Production (E&P)-focused company, generally a DCF will not work well b/c:
1. CapEx needs are enormous and will push FCF down to very low levels.
2. Commodity prices are cyclical and both revenue and FCF are difficult to project.
• For other types of energy companies - services-based or downstream companies that just refine and market oil and gas - a DCF might be more appropriate.
• For more on this topic and the alternative to a DCF that you use for oil & gas companies (called a Net Asset Value, NAV, analysis) see the industry-specific guides.
Can you describe a few of the additional items that might be a part of Enterprise Value‚ beyond Cash‚ Debt‚ Preferred Stock‚ and Noncontrolling Interests‚ and explain whether you add or subtract each one?
Items that may be counted as Cash-Like items and subtracted:
• Net Operating Losses (NOLs): b/c you can use these to reduce future taxes; may or may not be true depending on company and deal
• Short-Term and Long-Term Investments: b/c theoretically you can sell these off and get extra cash. May not be true if they’re illiquid.
• Equity Investments: Any investments in other companies where you own between 20-50%; this one is also partially for comparability purposes since revenue and profit from these investments show up in the company’s Net Income‚ but not in EBIT‚ EBITDA‚ and Revenue
Items that may be counted as Debt-Like items and added:
• Capital Leases: Like Debt‚ these have interest payments and may need to be repaid.
• (Some) Operating Leases: sometimes you need to convert Operating Leases to Capital Leases and add them as well‚ if they meet criteria for qualifying as Capital Leases
• Unfunded Pension Obligations: These are usually paid w/ something other than the company’s normal cash flows‚ and they may be extremely large.
• Restructuring/Environmental Liabilities: similar logic to unfunded pension obligations
“Short-Term Investments” is a Current Asset - should you count it in Working Capital?
- No. If you wanted to be technical‚ you could say that it should be included in “Working Capital‚” as define‚ but left out of “Operating Working Capital.”
- But the truth is that no one lists Short-Term Investments in this section b/c Purchases and Sales of Investments are considered investing activities‚ NOT operational activities.
- “Working Capital” is an imprecise idea and we prefer to say “Operating Assets and Liabilities” b/c that’s a more accurate way to describe the concept of operationally-related B/S items - which may sometimes be Long-Term Assets or Long-Term Liabilities (e.g. Deferred Revenue).
A company has recorded $100 in income tax expense on its Income Statement. All $100 of it is paid‚ in cash‚ in the current period. Now we change it and only $90 of it is paid in cash‚ with $10 being deferred to future periods. How do the statements change?
- I/S: Nothing changes. Both Current and Deferred Taxes are recorded simply as “Taxes” and NI remains the same. NI changes only if the total amount of taxes changes.
- SCF: NI remains the same but we add back the $10 worth of Deferred Taxes in CFO - no other changes‚ so cash at the bottom is up by $10.
- B/S: Cash is up by $10 and so the entire Assets side is up by $10. On the other side‚ the DTL is up by $10 and so both sides balance.
- Intuition: Deferred Taxes saves us cash in the current period‚ at the expense of additional cash taxes in the future.
How do you calculated diluted shares and Diluted Equity Value?
- You take the basic share count and add in the dilutive effect of stock options and any other dilutive securities‚ such as warrants‚ convertible debt‚ and convertible preferred stock.
- To calculate the dilutive effect of options and warrants‚ you use the Treasury Stock Method.
How do you factor in Convertible Preferred Stock in the Enterprise Value calculation?
The same way you would factor in normal Convertible Bonds: if it’s in-the-money‚ you assume that new shares get created‚ and if it’s not in-the-money‚ you count it as Debt.
Walk me through how you project revenue for a company.
- The simplest way to do it is to assume a percentage growth rate - for example‚ 15% in Year 1‚ 12% in Year 2‚ 10% in Year 3‚ and so on‚ usually decreasing significantly over time. To be more precise‚ you could create a “bottoms-up build” or a “tops-down build:”
- BOTTOMS-UP: Start w/ individual products/customers‚ estimate the average sale value or customer value‚ and then the growth rate in customers/transactions and customer transaction values to tie everything together.
- TOPS-DOWN: Start w/ “big-picture” metrics like overall market size‚ and then estimate the company’s market share and how that will change in coming years and multiply to get their revenue.
- Of these two methods‚ bottoms-up is more common and is taken more seriously b/c estimating the “big-picture” numbers is almost impossible.
When would you use a Sum of the Parts Valuation?
For conglomerates that have completely unrelated divisions (e.g. GE)
• Should use different comparable sets for each division‚ value each division separately‚ and then add them back together to calculate Total Value
What is the advantage and disadvantage to using M&A Premium Analysis?
Same issues as precedent transactions
• Adv.: based on what real companies have actually paid for other companies
• Dis.: Can’t use acquisitions of private companies b/c premiums only apply to public companies w/ stock prices‚ data can be spotty‚ there may not be truly comparable transactions.
What are the 4 main criteria to pick precedent transactions?
- Geography
- Industry
- Financial (Revenue or EBITDA above‚ below‚ or between certain numbers)
- Time (“transactions since …” or “transactions between Year X and Year Y”)
What are the 3 major valuation methodologies?
- Public Company comparables (public comps) - relative valuation
- Precedent Transactions (trading comps) - relative valuation
- Discounted Cash Flow analysis - intrinsic valuation
When would a company be most likely to issue stock to acquire another company?
- The buyer’s stock is trading at an all-time high‚ or at least at a very high level‚ and it’s therefore “cheaper” to issue stock than it normally would be.
- The seller is almost as large as the buyer and it’s impossible to raise enough debt or use enough cash to acquire the seller.
What is a leveraged buyout and why does it work?
- In an LBO‚ a PE firm acquires a company using a combination of debt and equity (cash)‚ operates it for several years‚ possibly makes operational improvements‚ and then sells the company at the end of the period to realize a return on investment.
- During the period of ownership‚ the PE firm uses the company’s cash flows to pay interest expense from the debt and to pay off debt principal.
- An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
- By using debt‚ the PE firm reduces the up-front cash payment for the company‚ which boosts returns.
- Using the company’s cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows.
- The PE firm sells the company in the future‚ which allows it to regain the majority of the funds spent to acquire it in the first place.
What’s the difference between cash-based and accrual accounting?
- Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after an invoice has been sent to the customer and the customer has a track record of paying on time) and recognizes expenses when they are incurred rather than when they are paid out in cash.
- All large companies use accrual accounting b/c it more accurately reflects the timing of revenue and expenses; small businesses may use cash-based accounting to simplify their financial statements (you no longer need a Cash Flow Statement if everything is cash-based).
How are Prepaid Expenses and Accounts Payable different?
It’s similar to the difference between A/R and Deferred Revenue:
- Prepaid Expenses have already been paid out in cash‚ but haven’t yet shown up on the I/S‚ whereas A/P haven’t been paid out in cash but have shown up on the I/S.
- Prepaid Expenses are for product/services that have not yet been delivered to the company‚ whereas A/P is for products/services that have already been delivered.
What is the advantage and disadvantage to using LBO Analysis? And what can you say in general about the resulting valuations?
- Adv.: sets a “floor” on valuation by determining the min. amount a PE firm could pay to achieve returns
- Dis.: gives a relatively low/”floor” number rather than a wide range of values
- Val.: tends to produce lower values‚ usually lower than DCF or relative valuation‚ but ultimately dependent on assumptions
What’s the difference between Equity Value and Shareholder’s Equity?
- Equity Value is the market value and Shareholder’s Equity is the book value.
- Equity Value could never be negative b/c shares outstanding and share prices can never be negative‚ whereas Shareholder’s Equity can be positive‚ negative or zero.
- For healthy companies‚ Equity Value usually far exceeds Shareholder’s Equity b/c the market value of a company’s stock is worth far more than its paper value. In some industries (e.g. financial institutions)‚ Equity Value and Shareholder’s Equity tend to be very close.
How do you take into account NOLs in an M&A deal?
- You apply Section 382 to determine how much of the Seller’s NOLs are usable each year.
- Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past 3 Months’ Adj. Long-Term Rates
- So if our Equity Purchase Price were $1B and the highest adj. long-term rate were 5%‚ then we could use $1B * 5% = $50M of NOLs each year.
- If the Seller had $250M in NOLs‚ then the combined company could use $50M of them each year for 5 years to offset its taxable income.
How do you treat items like Preferred Stock‚ Noncontrolling Interests‚ Debt‚ and so on‚ and how do they affect Purchase Price Allocation?
- Normally‚ you build in the option to repay (or in the case of Noncontrolling Interests‚ purchase the remainder of) these items or assume them in the Sources & Uses schedule. If you repay them‚ additional cash/debt/stock is required to purchase the seller.
- However‚ that choice‚ does NOT affect Purchase Price Allocation.
- You always start w/ the Equity Purchase Price there‚ which excludes the treatment of all these items. Also‚ you only use the seller’s Common Shareholders’ Equity in the PPA schedule‚ which excludes Preferred Stock and Noncontrolling Interests.
What about WACC - will it be higher for a $5B or $500M company?
- This is a bit of a trick question b/c it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates, then WACC should be higher for the $500M company for the same reasons stated above.
- If the capital structure is NOT the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.
How do you value Net Operating Losses (NOLs) and take them into account in a valuation?
- You determine how much the NOLs will save the company in taxes in future years‚ and then calculate the NPV of total future tax savings.
- The 2 ways to estimate tax savings in future years: 1) assume that company can use NOLs to completely offset its taxable income until the NOLs run out‚ 2) in an acquisition scenario‚ use Section 382 and multiply the highest adjusted long-term rate of the past 3 months by the Equity Purchase Price of the seller to determine the maximum allowed NOL usage in each year - and then use that to determine how much the company can save in taxes.
- Practically speaking‚ you MAY look at NOLs in a valuation‚ but you rarely factor them in. If you did‚ they would be treated similarly to Cash and you would subtract NOLs to go from Equity Value to Enterprise Value‚ and vice versa
What’s the purpose of Purchase Price Allocation in an M&A deal? Can you explain how it works?
- The ultimate purpose is to make the combined B/S balance. This is harder than it sounds b/c many items get adjusted up or down (e.g. PPE)‚ some items disappear altogether (e.g. the Seller’s Shareholders’ Equity)‚ and some new items get created (e.g. Goodwill).
- To complete the process‚ you look at every single item on the Seller’s B/S and then assess the fair market value of all those items‚ adjusting them up or down as necessary.
- So if the buyer pays‚ say $1B for the Seller‚ you figure out how much of that $1B gets allocated to each Asset on the B/S.
- Goodwill (and Other Intangible Assets) serves as the “plug” and ensures that both sides balance after you’ve made all the adjustments. Goodwill is roughly equal to the Equity Purchase Price minus the Seller’s Shareholders’ Equity and other adjustments.
- How would you model a “waterfall return” structure where different equity investors in an LBO receive different percentages of the returns‚ depending on the overall IRR?
- For example‚ let’s say that Investor Group A receives 10% of the returns up to a 15% IRR (Investor Group B receives 90%) but then receives 15% of the returns (with Investor Group B receiving 85%) beyond a 15% IRR. How does that work?
The exact Excel formulas for doing this get tricky‚ but here is the basic idea with simple numbers to make it easier to understand:
• First‚ you do a check to see what the IRR is with the amount of net sale proceeds you’ve assumed. For example‚ let’s say you get back $500M at the end and calculate that $500M equates to an 18% IRR.
• Next‚ you determine what amount of those proceeds equals a 15% IRR. So let’s say you run the numbers and find that $450M would equal a 15% IRR.
• You allocate 10% of this $450M to Investor Group A and 90% to Investor Group B.
• Then‚ you allocate 15% of the remaining $50M ($500M minus $450M) to Investor Group A and 85% to Investor Group B.
• This scenario is common in real estate development‚ where multiple groups of equity investors are commonplace‚ but you do see it in some LBOs as well.
When is a Liquidation Valuation useful?
- Most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company’s Liabilities have been paid off with the proceeds from selling all its Assets
- Often used to advise struggling businesses whether it’s better to sell off Assets or sell 100% of company
Why would you not use a DCF for a bank or other financial institution?
- Banks use Debt differently than other companies and do not use it to finance their operations - they use it to create their “products” - loans - instead.
- Also, interest is a critical part of banks’ business models and changes in “Operating Assets and Liabilities” can be much larger than a bank’s Net Income. Finally, CapEx does NOT correspond to reinvestment in business for a bank, and is often negligible.
- For financial institutions (commercial banks and insurance firms), it’s more common to use a Dividend Discount Model or Residual Income Model instead of a DCF.
Walk me through how we might value an oil & gas company and how it’s different from a “standard” company.
Public comps and precedent transactions are similar‚ but:
• You might screen based on metrics like Proved Reserves or Daily Production
• You would also look at R/P (Proved Reserves / Last Year’s Production)‚ EBITDAX and other industry specific multiples
• You could use a standard Unlevered DCF to value an oil & gas company as well‚ but it’s more common to see a Net Asset Value (NAV) 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 PV of those cash flows to value the company.
• There are other complications: oil & gas companies are cyclical and have no control over prices they receive‚ companies use either “full-cost accounting” or “successful efforts accounting” and treat the exploration expense differently according to that
How do you know if a DCF is too dependent on future assumptions?
- Some people claim that if over 50% of a company’s value comes from the present value of the Terminal Value, the DCF is too dependent on future assumptions.
- The problem, though, is that in practice this is true in almost all DCFs. If the present value of the Terminal Value accounts for something like 80-90%+ of the company’s value, then maybe you need to re-think your assumptions.
- You’re analyzing a company’s financial statements and you need to calendarize the revenue‚ EBITDA‚ and other items.
- The company earned revenue of $1000 and EBITDA of $200 from Jan. 1 to Dec. 31‚ 2050.
- From Jan. 1 to Mar. 31‚ 2050‚ it earned revenue of $200 and EBITDA of $50.
- From Jan. 1 to Mar. 31‚ 2051‚ it earned revenue of $300 and EBITDA of $75.
- What are the company’s revenue and EBITDA for the Trailing Twelve Months as of Mar. 31‚ 2051?
• Trailing Twelve Months (TTM) = New Partial Period + Twelve-Month Period - Old Partial Period
So in this case:
• TTM Revenue = $300 + $1000 - $200 = $1100
• TTM EBITDA = $75 + $200 - $50 = $225
How does Net Income Attributable to Noncontrolling Interests factor into the Free Cash Flow calculation?
- It doesn’t - or more specifically, it has no net impact b/c you subtract it at the bottom of the I/S but then add it back on the SCF.
- Just be careful that you do BOTH of those, or that you leave it out altogether - it would be incorrect to only subtract it or to only add it back, which might happen if you’re not careful with the calculation.
How do non-recurring charges typically affect valuation multiples?
• Most of the time‚ non-recurring charges typically increase valuation multiples since they reduce metrics such as EBIT‚ EBITDA‚ and EPS. You could have non-recurring income as well (e.g. a one-time asset sale) which would have the opposite effect
Walk me through what happens when you pay $20 interest on Debt‚ with $10 in the form of cash interest and $10 in the form of Paid-In-Kind (PIK) interest.
- I/S: Both forms of interest appear‚ so Pre-Tax Income falls by $20 and NI falls by $12 at a 40% tax rate.
- SCF: NI is down by $12‚ but you add back the $10 in PIK interest since it’s non-cash‚ so CFO is down by $2. Cash at the bottom is also down by $2 as a result.
- B/S: Cash is down by $2‚ so the Assets side is down by $2. On the other side‚ Debt increases by $10 b/c PIK Interest accrues to Debt‚ but SE (RE) falls by $12 due to the reduced NI‚ so this side is also down by $2 and both sides balance.
- NOTE: PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the B/S - in this case‚ that’s the existing Debt number.
Explain what a contribution analysis is and why we might look at it in a merger model.
- A contribution analysis compares how much Revenue‚ EBITDA‚ Pre-Tax Income‚ Cash‚ and possibly other items the buyer and seller are “contributing” to estimate what the ownership of the combined company should be.
- Example: Let’s say that the buyer is set to own 50% of the new company and that the seller will own 50%. But the buyer has $100M of revenue and the seller has $50M of revenue - a contribution analysis would tell us that the buyer “should” own 66% instead b/c it’s contributing 2/3 of the combined revenue.
- It’s most common to look at this w/ merger of equals scenarios‚ and less common when the buyer is significantly larger than the seller.
Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don’t interest payments also show up there? They’re a financing activity!
- The difference is that interest payments correspond to the current period and are tax-deductible‚ so they have already appeared on the I/S. Since they are a true cash expense and already appeared on the I/S‚ showing them on the SCF would be double-counting them and would be incorrect.
- Debt repayments are a true cash-expense but they do NOT appear on the I/S‚ so we need to adjust for them on the SCF.
- If something is a true cash expense and it has already appeared on the I/S‚ it will NEVER appear on the SCF unless we are re-classifying it - b/c you have already factored in its cash impact.
Walk me through how you project expenses for a company.
- The simplest method is to make each I/S expense a percentage of revenue and hold it fairly constant‚ maybe decreasing the percentages slightly (due to economies of scale)‚ over time.
- For a more complex method‚ you could start w/ each department of a company‚ the number of employees in each‚ the average salary‚ bonuses‚ and benefits‚ and then make assumptions for those going forward.
- Usually you assume that the number of employees is tied to revenue‚ and then you assume growth rates for salary‚ bonuses‚ benefits‚ and other metrics.
- COGS should be tied directly to Revenue and each “unit” sold should incur an expense.
- Other items such as rent‚ CapEx‚ and misc. expenses are linked to the company’s internal plans for building expansion plans (if they have them)‚ or to Revenue in a simpler model.
What are the 2 fundamental ways to value a company?
- Relative valuation (comparing a company’s worth to similar companies)
- Intrinsic valuation (estimating NPV of future cash flows‚ i.e. estimating how much a firm’s assets are worth net of liabilities)
Why is the Income Statement not affected by Inventory purchases?
The expense of purchasing Inventory is ONLY recorded on the I/S when the goods associated with it have been manufactured and sold - so if it’s just sitting in a warehouse‚ it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.
Let’s say that we assume 10% revenue growth and a 10% discount rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 1% or reducing the discount rate to 9%?
In this case, the change in Revenue is likely to have a bigger impact b/c you’ve change it by 90% but you’ve only changed the Discount Rate by 10% - and that lower revenue growth will push down the present value of the Terminal Value (EBITDA and the FCF growth rate will both be lower) as well as the present value of the FCFs.
Would you expect a manufacturing company or a technology company to have a higher Beta?
A technology company, because technology is viewed as a “riskier” industry than manufacturing.
Why do most mergers and acquisitions fail?
- M&A is “easier said than done.” In practice‚ it’s very difficult to acquire and integrate a different company‚ realize synergies‚ and also turn the acquired company into a profitable division.
- Many deals are also done for the wrong reasons‚ such as the CEO’s massive ego or pressure from shareholders. Any deal done without both parties’ best interests in mind is likely to fail.
Walk me through a $100 Write-Down of Debt - as in OWED Debt‚ a Liability - on a company’s Balance Sheet and how it affects the 3 statements.
This one is counter-intuitive. When a Liability is written down‚ you record it as an addition on the I/S (with an asset write-down‚ it’s a subtraction).
• I/S: Pre-Tax Income goes up by $100‚ and assuming a 40% tax rate‚ NI is up by $60.
• SCF: NI is up by $60‚ but we need to subtract that Debt Write-Down b/c it was non-cash - CFO is down by $40‚ and Cash is down by $40 at the bottom.
• B/S: Cash is down by $40 so the Assets side is down by $40. On the other side‚ Debt is down by $100 but SE is up by $60 b/c the NI was up by $60 - so Liabilities & SE is down by $40 and both sides balance.
• Intuition: One way to think about this is that writing down Assets is “bad” for us b/c it reduces our ability to generate future cash flow‚ but writing down Liabilities is “good” b/c it reduces our future expenses (sort of). I don’t recommend presenting it like that in an interview.
What are the 3 main transaction structures you could use to acquire another company?
- The 3 main structures are the Stock Purchase‚ Asset Purchase‚ and 338(h)(10) Election.
- Note that Stock Purchases and Asset Purchases exist in some form in countries worldwide‚ but that the 338(h)(10) Election is specific to the US - however‚ there may be equivalent legal structures in other countries.
- Part of the reason that both parties favor the 338(h)(10) structure is that buyers typically agree to pay more to compensate sellers for the favorable tax treatment they receive.
- See p. 49 (of 66) of BIWS - Merger Model Guide for comparison table.
- A company acquires another company for $1000 using 50% stock and 50% cash. The other company has Assets of $1000 and Liabilities of $800.
- Using that information‚ combine the companies’ financial statements and walk me through what the Balance Sheet looks like IMMEDIATELY after the acquisition.
- The acquirer has used $500 of cash and $500 of stock to acquire the seller‚ and the seller’s Assets are worth $1000‚ with Liabilities of $800 and therefore Equity of $200.
- In an M&A deal‚ the Equity of the Seller gets wiped out completely. So you simply add the Seller’s Assets and Liabilities to the Acquirer’s - the Assets side is up by $1000 and the Liabilities side is up by $800.
- Then you subtract the cash used‚ so the Assets side is up by $500 only‚ and the other side is up by $1300 due to the $800 of Liabilities and the $500 stock issuance.
- Our B/S is out of balance‚ and that’s why we need Goodwill. Goodwill equals the Purchase Price minus the Seller’s Book Value‚ so in this case it’s equal to $1000 - $200 = $800.
- That $800 of Goodwill gets created on the Assets side‚ and so both sides are now up by $1300 and the B/S balances.
Does calendarization apply to both Public Comps and Precedent Transactions?
- Applies mostly to Public Comps b/c there’s a high chance that fiscal years will end on different dates w/ a big enough set of companies
- In effect‚ you do calendarize for Precedent Transactions as well b/c you normally look at the Trailing Twelve Months (TTM) period for each deal
What should you do if you don’t believe management’s projections in a DCF model?
You can take a few different approaches:
• You could create your own projections.
• You could “hair-cut” management’s projections (reduce them by a certain percentage) to make them more conservative.
• You could show a sensitivity table based on different growth rates and margins, and show the values using both management’s projections and a more conservative set of numbers.
Why isn’t the present value of the Terminal Value, by itself, just the company’s Enterprise Value? Don’t you get Enterprise Value if you apply a multiple to EBITDA?
- Yes, you do get Enterprise Value - but that only represents the company’s “far in the future” value. Remember that in a DCF, a company’s value is divided into “near future” and “far future.”
- If you leave out the present value of FCFs in the projection period, you’re saying “For the next 5 years, this company has no value. But then at the end of Year 5, the company is miraculously worth something again.” And that doesn’t make sense.
Cost of Equity tells us the return that an equity investor might expect for investing in a given company - but what about dividends? Shouldn’t we factor dividend yield into the formula?
Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include Dividends.
What’s the point of assuming a minimum cash balance in an LBO?
- The point is that a company CANNOT use 100% of its cash flow to repay Debt each year - it always needs to maintain a minimum amount of cash to pay employees‚ pay for general and administrative expenses‚ and so on.
- So you normally set up assumptions such that any extra cash flow beyond this minimum cash balance is used to repay debt.
Let’s say instead of issuing $100 worth of stock to investors‚ the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens?
- I/S: You need to record this as an additional expense b/c it’s now a tax-deductible and a current expense‚ Pre-Tax Income falls by $100 and NI falls by $60 (assuming a 40% tax rate).
- SCF: NI is down by $60 but you add back the SBC of $100 since it’s a non-cash charge‚ so cash at the bottom is up by $40.
- B/S: Cash is up by $40 on the Assets side. On the other side‚ Common Stock & APIC is up by $100 due to the SBC‚ but RE is down by $60 due to the reduced NI‚ so SE is up by $40 and both sides balance.
- Intuition: This is a non-cash charge‚ so like all non-cash charges it impacts the I/S and affects one B/S item in addition to Cash and RE - in this case‚ it flows into Common Stock & APIC b/c that one reflects the market value of stock at the time the stock was issued. The cash increase here simply reflects the tax savings.
Why do we adjust the value of Assets such as PP&E in an M&A deal?
- B/c often the fair market value is significantly different from the B/S value. A perfect example is real estate - usually it appreciates over time‚ but due to the rules of accounting‚ companies must depreciate it on the B/S and show a declining balance over time to reflect the allocation of costs over a long time period.
- Investments‚ Inventory‚ and other Assets may have also “drifted” from their fair market values since the B/S is recorded at historical cost for companies in most industries (exceptions‚ such as commercial banking‚ do exist).
Of the valuation multiples‚ which are the most common? Which is the “worst”?
- EV/EBITDA and EV/EBIT are the most common.
- P/E is probably the “worst” or “least accurate” since it includes non-cash charges and impacted by tax rates and capital structure. P/E more commonly used among general public than finance professionals.
How do dividends issued to the PE firm affect the IRR?
- Any dividends issued‚ either in the normal course of business or as part of a dividend recap‚ increase IRR b/c they result in the PE firm receiving more cash back.
- Usually dividends make less of an impact than the 3 key variables in an LBO: purchase price‚ exit price‚ and leverage.
- Let’s say that you use Unlevered Free Cash Flow in a DCF to calculate Enterprise Value. Then, you work backwards and use the company’s Cash, Debt, and so on to calculate its implied Equity Value.
- Then you run the analysis using Levered Free Cash Flow instead and calculate Equity Value at the end. Will the implied Equity Value from both these analyses be the same?
- No, most likely it will not be the same. In theory, you could pick equivalent assumptions and set up the analysis such that you calculate the same Equity Value at the end.
- In practice, it’s difficult to pick “equivalent” assumptions, so these two methods will rarely, if ever, produce the same value.
- Think about it like this: when you use Unlevered FCF and move from Enterprise Value to Equity value, you’re always using the same numbers for Cash, Debt, etc.
- But in a Levered FCF analysis, the terms of the Debt will impact FCF - so simply by assuming a different interest rate or repayment schedule, you’ll alter the Equity Value. That’s why it’s difficult to make “equivalent assumptions.”
Can you explain how to create a multi-stage DCF, and why it might be useful?
- You use a multi-stage DCF if the company grows at much different rates, has much different profit margins, or has a different capital structure in different periods.
- For example, maybe the company grows at 15% in the first 2 years, then 10% in Years 2-4, and then 5% in Year 5, w/ decreasing growth each year after that.
- So you might separate that into 3 stages and then make different assumptions for FCF and the Discount Rate in each one.
- Note that a Standard DCF, by itself, is actually a two-stage DCF b/c you divide it into the “near future” and “far future.”
- You can divide it into more periods if you want, and it would just be an extension of this concept.
Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.
The mechanics are the same as a DCF, but we use Dividends rather than Free Cash Flows:
1. Project the company’s earnings, down to Earnings per Share (EPS).
2. Assume a Dividend Payout Ratio - what percentage of the EPS gets paid out to shareholders in the form of Dividends - based on what the firm has done historically and how much regulatory capital it needs.
3. Use this to calculate Dividends over the next 5-10 years.
4. Do a check to make sure that the firm still meets its required Tier 1 Capital Ratio and other capital ratios - if not, reduce Dividends.
5. Discount the Dividends in each year to their present value based on Cost of Equity - not WACC - and then sum these up.
6. Calculate Terminal Value based on P/BV and Book Value in the final year, and then discount this to its present value based on the Cost of Equity.
7. Sum the present value of the Terminal Value and the present values of the Dividends to calculate the company’s net present value per share.
• The key difference compared to a DDM for normal companies is the presence of capital ratios - you can’t just blindly make Dividends per Share a percentage of EPS.
Why would a PE firm choose to do a dividend recap of one of its portfolio companies?
- Primarily to boost returns. Remember‚ all else being equal‚ more leverage means a higher return to the firm.
- With a dividend recap‚ the PE firm is “recovering” some of its equity investment in the company - and as we saw earlier‚ the lower the equity investment‚ the better‚ since it’s easier to earn a higher return on a smaller amount of capital.
Explain why we use the mid-year convention in a DCF.
- You use it to represent the fact that a company’s cash flow does not arrive 100% at the end of each year - instead, it comes in evenly throughout each year.
- In a DCF w/o the mid-year convention, we would use discount period numbers of 1 for the 1st Year, 2 for the 2nd Year, 3 for the 3rd Year and so on.
- WITH the mid-year convention, we would instead use 0.5 for the 1st Year, 1.5 for the 2nd Year, 2.5 for the 3rd Year and so on.
- The end result is that the mid-year convention produces higher values since the discount periods are lower.
When calculating FCF, you always take into account taxes. But when you calculate Terminal Value, you don’t do that - isn’t this inconsistent? How should you treat it?
Here’s how to think about this one:
• First off, if you use the Gordon Growth method to calculate Terminal Value, you are taking into account taxes b/c you’re valuing the company’s FCF into perpetuity.
• And if you’re using the Terminal Value Method, you’re implicitly taking into account taxes b/c you’re assuming that [Relevant Metric] * [Relevant Multiple] IS the company’s present value from that point onward, as of the fiscal year. You’re not assuming that the company IS actually sold, just estimating what a buyer MIGHT pay for it, fully taking into account the value that the buyer would receive from its far-in-the-future, after-tax cash flows.
Can you give me examples of major line items on each of the financial statements?
- INCOME STATEMENT: Revenue; Cost of Goods Sold (COGS); Selling‚ General & Administrative (SG&A) Expenses; Operating Income‚ Pre-Tax Income‚ Net Income.
- BALANCE SHEET: Cash‚ Accounts Receivable (A/R)‚ Inventory‚ Plants‚ Property & Equipment (PP&E)‚ Accounts Payable‚ Accrued Expenses‚ Debt‚ Shareholders’ Equity (SE)
- CASH FLOW STATEMENT: Cash Flow from Operations (CFO) - Net Income‚ Depreciation & Amortization (D&A)‚ Stock-Based Compensation‚ Changes in Operating Assets & Liabilities; Cash Flow from Investing (CFI) - Capital Expenditures (CapEx)‚ Sale of PP&E‚ Sale/Purchase of Investments; Cash Flow from Financing (CFF) - Dividends Issued‚ Debt Raised/Paid Off‚ Shares Issued/Repurchased
What are some examples of industry-specific multiples?
- Technology/Internet: EV/Unique Visitors‚ EV/Page Views
- Retail/Airlines: EV/EBITDAR (EBITDA + Rental Expense)
- Oil & Gas: EV/EBITDAX (EBITDA + Exploration Expense)‚ EV/Production‚ EV/Proved Reserves
- Real Estate Investment Trusts (REITs): Price/FFO per Share‚ Price/AFFO per Share (Funds from Operations‚ Adj. Funds from Operations)
What’s the difference between Accounts Payable and Accrued Expenses?
- Mechanically‚ they are the same: they’re Liabilities on the B/S used when you’ve recorded an I/S expense for a product/service you have received‚ but have not yet paid for in cash. They both affect the statements in the same way as well.
- The difference is that A/P is mostly for one-time expenses with invoices‚ such as paying for a law firm‚ whereas Accrued Expenses is for recurring expenses without invoices‚ such as employee wages‚ rents‚ and utilities.
What if Shareholders’ Equity [of the target] is negative?
Nothing is different. You still wipe it out‚ allocate the purchase price‚ and create Goodwill.
How long does it usually take for a company to collect its Accounts Receivable balance?
Generally the Accounts Receivable Days are in the 30-60 day range‚ though it can be higher for companies selling higher-priced items and it might be lower for companies selling lower-priced items with cash payments only.
You see an “Investments in Equity Interest” (AKA Associate Companies) line item on the Assets side of a firm’s Balance Sheet. What does this mean?
- If you own over 20% but less than 50% of another company‚ this refers to the portion that you DO OWN.
- Example: Another company is worth $100‚ you own 25% of it. Therefore‚ there will be an “Investments in Equity Interests” line item of $25 on your B/S to represent the 25% that you own.
Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1‚” before anything else happens?
- I/S: At the start of “Year 1‚” there are no changes yet.
- SCF: The $100 worth of CapEx would show up under CFI as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of Debt raised would up as an addition to CFF‚ canceling out the investment activity. So the cash number stays the same‚ for now.
- B/S: There is now an additional $100 worth of factories‚ so PP&E is up by $100 and Assets is therefore up by $100. On the other side‚ Debt is up by $100‚ so the entire other side is up by $100 and both sides balance.
What happens when Accrued Expenses increases by $10
For this question‚ remember that Accrued Expenses are recognized on the I/S but haven’t been paid out in cash yet. So this could correspond to payment being set aside for an employee‚ but not actually the employee in cash yet.
• I/S: Operating Income and Pre-Tax Income fall by $10‚ and NI falls by $6 (assuming a 40% tax rate).
• SCF: NI is down by $6‚ and the increase in Accrued Expenses will increase Cash Flow by $10‚ so overall CFO is up by $4 and the Net Change in Cash at the bottom is up by $4.
• B/S: Cash is up by $4 as a result‚ so Assets is up by $4. On the Liabilities & Equity side‚ Accrued Expenses is a Liability‚ so Liabilities is up by $10 and SE (Retained Earnings) is down by $6 due to the NI decrease‚ so both sides balance.
• Intuition: We record an additional expense and save on taxes with it‚ but that expense hasn’t been paid in cash yet‚ so our cash balance is actually up.
A company you’re analyzing records a Goodwill Impairment of $100. However‚ this Goodwill Impairment is NOT deductible for cash tax purposes. Walk me through how the 3 statements change.
- I/S: You still reduce Pre-Tax Income by $100 due to the Impairment‚ so NI falls by $60 at a 40% tax rate - when it’s not tax-deductible‚ you make that adjustment via DTLs or DTAs. On the Tax I/S‚ Pre-Tax Income has not fallen at all and so NI stays the same‚ which means that Cash Taxes are $40 higher than Book Taxes.
- SCF: NI is down by $60‚ but we add back the $100 Impairment since it is non-cash. Then we also subtract $40 from Deferred Taxes b/c Cash Taxes were higher than Book Taxes by $40 - meaning that we’ll save some cash (on paper) from reduced Book Income Taxes in the future. Adding up all these changes‚ there are no net changes in Cash.
- B/S: Cash is the same‚ but Goodwill is down by $100 due to the Impairment‚ so the Assets side is down by $100. On the other side‚ the DTL is down by $40 and SE (RE) is down by $60 due to the reduced NI‚ so both sides are down by $100 and balance.
- Intuition: When a charge is not truly tax-deductible‚ a firm pays higher Cash Taxes and either “makes up for” owed future tax payments or gets to report lower Book Taxes in the future.
- Remember that DTLs get created when additional future cash taxes are owed - when additional future cash taxes are paid‚ DTLs decrease.
If the seller has existing Debt on its Balance Sheet in an M&A deal‚ how do you deal with it?
- You assume that the Debt either stays on the Balance Sheet or is refinanced (paid off) in the acquisition. The terms of most Debt issuance state that they must be repaid in a “change of control” scenario (i.e. when a buyer acquires over 50% of a company)‚ so you often assume that the Debt is paid off in a deal.
- That increases the price that the buyer needs to pay for the seller.
I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?
This varies by bank and group‚ but the 2 most common methods are:
1. You pick the report with the most detailed information.
2. You pick the report with numbers in the middle of the range.
• You DO NOT pick reports based on which bank they’re coming from (esp. if they’re from the same bank you’re at‚ appearance of lack of objectivity)
how do different types of Debt and interest options affect the IRR? For example‚ does it benefit the PE firm to use a higher percentage of Term Loans or higher percentage of Senior or Subordinated Notes? What about cash vs. PIK interest?
- It is almost always better to use Debt with lower interest rates and Debt that can be repaid early. Otherwise‚ the company’s cash flows are being “wasted” b/c it’s generating cash but the PE firm is not using this cash in any way.
- So all else being equal‚ having Term Loans rather than Senior or Subordinated Notes or Mezzanine will boost IRR; cash interest will boost IRR over PIK interest b/c the debt principal doesn’t “balloon” over time; and lower interest rates will also boost IRR.
- However‚ this doesn’t tell the whole story: sometimes a PE firm will use High-Yield Debt or debt w/ PIK interest anyway if the company is having cash flow issues or if it’s too difficult to raise the funds via Term Loans.
All else being equal‚ which method would a company prefer to use when acquiring another company - cash‚ stock‚ or debt?
Assuming the buyer had unlimited resources‚ it would almost always prefer to use cash when buying another company. Why?
• Cash is cheaper than debt b/c int. rates on cash are usually under 5% whereas debt int. rates are almost always higher than that. Thus‚ foregone interest on cash is almost always LESS than the additional interest paid on debt for the same amount of cash or debt.
• Cash is almost always cheaper than stock b/c most companies P/E multiples are in the 10-20x range‚ which equals 5-10% for “Cost of Stock”
• Cash is also less risky than debt b/c there’s no chance the buyer might fail to raise sufficient funds from investors‚ or that the buyer might default.
• Cash is also less risky than stock b/c the buyer’s share price could change dramatically once the acquisition is announced.
Why would in some industries might a DCF not be relevant in valuation?
- Free cash flow is not a meaningful metric.
- The industry is asset-centric‚ so you’re better off valuing the company’s assets and liabilities
Ex.: Commercial banks‚ insurance firms‚ (some) oil & gas companies‚ Real Estate Investment Trusts (REITs)
What if you have a stub period AND you’re using a mid-year convention - how does Terminal Value change?
It’s the same as what’s described previously - a stub period in the beginning does not make a difference.
Walk me through how Depreciation going up by $10 would affect the statements.
- I/S: Operating Income and Pre-Tax Income would decline by $10 and‚ assuming a 40% tax rate‚ NI would go down by $6.
- SCF: The NI at the top goes down by $6‚ but the $10 Deprecation is a non-cash expense that gets added back‚ so overall CFO goes up by $4. There are no changes elsewhere‚ so the overall Net Change in Cash goes up by $4.
- B/S: PP&E goes down by $10 on the Assets side b/c of the Depreciation and Cash is up by $4 from the changes on the SCF. Overall‚ Assets is down by $6‚ Since NI fell by $6 as well‚ SE on the Liabilities & Equity side is down by $6 and both sides of the B/S balance.
- Intuition: We save on taxes with any non-cash charge‚ including Depreciation.
How would you value an apple tree?
- same way you would value a company: what are comparable apple trees worth? (relative valuation)
- present value of FCF for the apple (intrinsic valuation)
Give me an example of a “real-life” LBO?
The most common example is taking out a mortgage when you buy a house. We think it’s better to think of it as “buying a house that you rent out to other people‚” b/c that situation is more similar to buying a company that generates cash flow. Here’s how the analogy works:
• Down Payment - Investor Equity in an LBO
• Mortgage - Debt in an LBO
• Mortgage Interest Payments - Debt Interest in an LBO
• Mortgage Repayments - Debt Principal Repayments in an LBO
• Rental Income from Rentals - Cash Flow to Pay Interest and Repay Debt in an LBO
Can you use private companies as part of your valuation?
Only in the context of precedent transactions: it would make no sense to include them for public company comparables or as part of the Cost of Equity or WACC calculation in a DCF b/c they are not public and therefore have no values for market cap or beta.
What are the most common valuation multiples? And what do they mean?
- EV/Revenue: how valuable a company is relative to its overall sales
- EV/EBITDA: how valuable a company is relative to its approximate cash flow
- EV/EBIT: how valuable a company is relative to the pre-tax profit it earns from its core business operations
- P/E: how valuable a company is in relation to its after-tax profits‚ inclusive of interest income and expense and other non-core business activities
- Other multiples include P/BV‚ EV/Unlevered FCF‚ Equity Value/Levered FCF
- EV/Unlevered FCF is closer to true cash flow than EV/EBITDA but takes more work to calculate‚ and Equity Value/Levered FCF is even closer‚ but is affected by company’s capital structure and takes even more time to calculate.
How does Preferred Stock fit into these different financing methods? Isn’t it a type of Debt as well?
- Preferred Stock is similar to Debt and it would match the “Mezzanine” column in the table (on p. 43) most closely.
- Just like w/ Mezzanine‚ Preferred stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt.
What is the advantage and disadvantage to using Future Share Price Analysis?
- Adv.: tells you how much a company might be worth‚ theoretically‚ 1-2 years in the future
- Dis.: dependence on assumptions
Why would you use PIK (Payment In Kind) debt rather than other types of debt‚ and how does it affect the debt schedules and the other statements?
- Unlike “normal” debt‚ a PIK loan does not require the borrower to make cash interest payments - instead‚ the interest accrues to the loan principal‚ which keeps going up over time. A PIK “toggle” allows the company to choose whether to pay the interest in cash or have it accrue to principal.
- PIK is riskier than other forms of debt and carries with it a higher interest rate than traditional Bank Debt or High-Yield Debt.
- Adding it to the debt schedules is similar to adding High-Yield Debt w/ a bullet maturity - except instead of assuming cash interest payments‚ you assume that the interest accrues to the principal.
- You include this interest on the Income Statement‚ but you need to add back any PIK interest on the Cash Flow Statement‚ b/c it’s a non-cash expense.
Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?
B/c the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies make it easier for the strategic acquirer to pay a higher price and still realize a solid return on investment.
Why do we look at both Enterprise Value and Equity Value?
- Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors)
- You look at both b/c Equity Value is the number the public-at-large sees (“the sticker price”) while Enterprise Value represents its true value (what it would really cost to acquire)
In an LBO model‚ is it possible for debt investors to earn a higher return than the PE firm? What does it tell us about the company we’re modeling?
- Yes‚ and it happens more often than you’d think. Remember‚ High-Yield Debt investors often get interest rates of 10-15% or more - which effectively guarantees an IRR in that range for them.
- So no matter what happens to the company or the market‚ that debt gets repaid and the debt investors receive their interest payments.
- But let’s say that the median EBITDA multiples contract‚ or that the company fails to grow or actually shrinks - in these cases the PE firm could easily get an IRR lower than what the debt investors get.
I have a set of precedent transactions but I’m missing information like EBITDA for a lot of the companies‚ since they were private. How can I find it if it’s not available via public sources?
- Search online and see if you can find press releases or articles in the financial press with these numbers.
- Failing that‚ look in equity research for the buyer around the time of the transaction and see if any of the analysts estimate the seller’s numbers.
- Also look at online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates for the deals.
What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ?
- First‚ note that this question does not apply to you if you’re outside the US b/c IFRS does not permit the use of LIFO.
- LIFO stands for “Last-In‚ First-Out” and FIFO stands for “First-In‚ First-Out” - they are 2 different ways of recording the value of Inventory and the Cost of Goods Sold (COGS).
- With LIFO‚ you use the value of the most recent Inventory additions for COGS‚ but w/ FIFO‚ you use the value of the oldest Inventory additions for COGS.
- Here’s an example: let’s say your starting Inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1 ($120 total)‚ $15 each in Q2 ($150 total)‚ $17 each in Q3 ($170 total)‚ and $20 each in Q4 ($200 total).
- You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO‚ you record 40 * $30 = $1200 for the annual revenue.
- The difference is that in LIFO‚ you would use the 40 most recent Inventory purchase values ($120 + $150 + $170 + $200) for the COGS‚ whereas in FIFO you would use the 40 oldest Inventory values ($100 + $120 + $150 + $170) for COGS.
- As a result‚ the LIFO COGS would be $640 and FIFO COGS would be $540‚ so LIFO would also have a lower Pre-Tax Income and NI. The ending Inventory value would be $100 higher under FIFO and $100 lower under LIFO.
- If Inventory is getting more expensive to purchase‚ LIFO will produce higher value for COGS and lower ending Inventory values and vice versa if Inventory is getting cheaper to purchase.
Why do Goodwill & Other Intangibles get created in an acquisition?
- These represent the amount that the buyer has paid over the book value (Shareholders’ Equity) of the seller. You calculate the number by subtracting the seller’s Shareholders’ Equity (technically the Common Shareholders’ Equity) from the Equity Purchase Price.
- Goodwill and Other Intangibles represent the value of customer relationships‚ employee skills‚ competitive advantages‚ brand names‚ intellectual property‚ and so on - valuable‚ but not physical Assets in the same way factories are.
How do you use Equity Value and Enterprise Value differently?
- Equity Value gives you a general idea of how much a company is worth; Enterprise Value tells you more specifically how much it would cost to acquire.
- You use them differently depending on the valuation multiple you’re calculating. If the denominator of the multiple includes interest income and expense (e.g. Net Income) you use Equity Value; otherwise if it does not (e.g. EBITDA) you use Enterprise Value
I have one company with a 40% EBITDA margin trading at 8x EBITDA‚ and another company with a 10% EBITDA margin trading at 16x EBITDA. What’s the problem with comparing these two valuations directly?
- It can be misleading to compare companies w/ drastically different margins. Due to basic math‚ the 40% margin company will usually have a lower multiple (whether or not its actual value is lower)
- In this situation‚ might want to consider screening based on margins and remove the outliers - you would not try to “normalize” the EBITDA multiples based on margins.
When is a DCF useful? When is it not useful?
- DCF is best when the company is large‚ mature‚ and has stable and predictable cash flows (the far-in-the-future assumptions will be more accurate)
- DCF is not as useful if the company has unstable or unpredictable cash flows (start-up) or when Debt and Operating Assets & Liabilities serve fundamentally different roles (financial institutions)
I’m looking at financial data for a public company comparable‚ and it’s April (Q2) right now. Walk me through how you would calendarize this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.
TTM = Most Recent Fiscal Year + New Partial Period - Old Partial Period
• TTM = (Jan 1 - Dec 31) of most recent FY + Q1 of this FY (Jan 1 - Mar 31) - Q1 of previous FY (Jan 1 - Mar 31)
• For US-based companies‚ can find quarterly numbers in the 10-Q
You see a “Noncontrolling Interest” (AKA Minority Interest) line item on the Liabilities side of a company’s Balance Sheet. What does this mean?
- If you own over 50% but less than 100% of another company‚ this refers to the portion you DO NOT OWN.
- Example: Another company is worth $100. You own 70% of it. Therefore‚ there will be a Noncontrolling Interest of $30 on your B/S to represent the 30% you do not own.
Let’s say that a buyer doesn’t have enough cash available to acquire the seller. How could it decide between raising debt‚ issuing stock‚ or some combination of those?
There’s no simple rule to decide - key factors include:
• The relative “cost” of both debt and stock: For example‚ if the company is trading at a higher P/E multiple it may be cheaper to issue stock (e.g. P/E of 20x = 5% cost‚ but debt at 10% interest = 10%*(1 - 40%) = 6% cost.
• Existing Debt: If the company already has a high debt balance‚ it likely can’t raise as much new debt.
• Shareholder dilution: Shareholders do not like the dilution that comes w/ issuing new stock‚ so companies try to minimize this.
• Expansion Plans: If the buyer expands‚ begins a huge R&D effort‚ or buys a factory in the future‚ it’s less likely to use cash and/or debt and more likely to issue stock so that it has enough funds available.
Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?
• A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future - in other words‚ you’ve underpaid on taxes and need to make up for it in the future.
• A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future - you’ve paid too much before‚ and now you get to save on taxes in the future.
• Both DTLs and DTAs arise b/c of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes. You see them most often in 3 scenarios:
1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes)
2. When Assets get written up for book‚ but not tax purposes‚ in M&A deals.
3. When pension contributions get recognized differently for book vs. tax purposes.
What can you say in general about valuations using Public Comps vs. Trading Comps?
Trading comp valuations tend to be higher due to the control premium (premium the buyer pays to acquire the seller)
How does a DCF change if you’re valuing a company in an emerging market?
- The main difference is that you’ll use a much higher Discount Rate, and you may not even necessarily link it to WACC or Cost of Equity, because there may not even be a good set of Public Comps in the country.
- You might also add in a premium for political risk and uncertainty, and you might severely reduce management’s growth or profit expectations, especially if they have a reputation for being overly optimistic.
Normally in an accretion/dilution model you care most about combining both companies’ Income Statements and Balance Sheets. But let’s say I want to combine all 3 financial statements - how would I do this?
- Always combine the buyer’s and seller’s Balance Sheets first (remember to wipe out the seller’s Shareholders’ Equity)
- Make the necessary Pro-Forma Adjustments (cash‚ debt‚ stock‚ goodwill/intangibles‚ etc.)
- Project the combined Balance Sheet using standard assumptions for each item.
- Combine and project the Income Statement.
- Then‚ project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model. You can usually just add items together here‚ but you may eliminate some of the seller’s investing or financing activities depending on what the buyer wants to do.
• You never combine the I/S or SCF BEFORE the acquisition closes. You only look at the combined statements immediately AFTER the acquisition and into future years.
If you were buying a vending machine business‚ would you pay a higher EBITDA multiple for a business that owned the machines and where they depreciated normally‚ or one in which the machines were leased? The depreciation expense and the lease expense are the same dollar amounts and everything else is held constant.
Higher multiple for the one w/ leased machines‚ all else being equal.
• Purchase Enterprise Value would be the same for both acquisitions‚ but depreciation is excluded from EBITDA‚ so EBITDA is higher (dep. exp. added back)
• For the company w/ the lease‚ the lease expense would show up in operating expenses‚ making EBITDA lower and the EV/EBITDA multiple higher to get to the same EV.
How do you get levered free cash flows (free cash flow to equity)?
Net Income + Non-Cash Charges - changes in operating assets and liabilities - CapEx - Mandatory Debt Payments
What if you own less than 20% of another company?
- This is where it gets inconsistent. Some companies may still apply the Equity Interest treatment in this case‚ especially if they exert “significant influence” over the other company.
- But sometimes they may also classify it as a simple Investment or Security on the B/S‚ acting as if they have simply bought a stock or bond and ignoring the other company’s financials.
What are synergies‚ and can you provide a few examples?
- Synergies refer to cases where 2 + 2 = 5 (or 6‚ or 7…) in an acquisition. The buyer gets more value out of an acquisition than what the financials would otherwise suggest.
- There are 2 types: Revenue Synergies and Cost (or Expense) Synergies.
- Revenue Synergies: The combined company can cross-sell products to new customers or up-sell additional products to customers. It might also be able to expand into new geographies as a result of the deal.
- Expense Synergies: The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.
What happens when Accrued Expenses decreases by $10 (i.e. it’s now paid out in the form of cash)? Do NOT take into account cumulative changes from previous increases in Accrued Expenses.
Assuming that you are not taking into account any previous increases (confirm this):
• I/S: There are no changes.
• SCF: The change in Accrued Expenses in the CFO section is negative $10 b/c you pay it out in cash‚ and so the cash at the bottom decreases by $10.
• B/S: Cash is down by $10 on the Assets side and Accrued Expenses is down by $10 on the other side‚ so it balances.
• Intuition: This is a simple cash payout of previously recorded expenses.
How doe Net Operating Losses (NOLs) affect a company’s 3 statements?
- The “quick and dirty” way: reduce the Taxable Income by the portion of the NOLs that you can use each year‚ apply the same tax rate‚ and then subtract that new Tax number from your old Pre-Tax Income number (which should stay the same). Then you can deduct whatever you used up from the NOL balance (which should be a part of the DTA line item).
- A more complex way to do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs‚ and then look at what you would pay in taxes without the NOLs. Then you record the difference as an increase to the DTL on the B/S.
- This method reflects the fact that you’re saving on cash flow - since the DTL‚ a Liability‚ is rising - but correctly separates the NOL impact into book vs. cash taxes.
What is the P/E multiple used for? What does it mean?
- Used for many types of companies‚ most relevant for banks and financial institutions‚ distorted by non-cash charges‚ capital structure and tax rates
- It’s a rough measure of how valuable a company is in proportion to its after-tax earnings.
This is a multi-part question. Let’s look at another M&A scenario:
• Company A: Enterprise Value of 100‚ Market Cap of 80‚ EBITDA of 10‚ Net Income of 4.
• Company B: Enterprise Value of 40‚ Market Cap of 40‚ EBITDA of 8‚ Net Income of 2.
First‚ Calculate the EV/EBITDA and P/E multiples for each one.
- Company A: EV/EBITDA = 100/10 = 10x; P/E = 80/4 = 20x
* Company B: EV/EBITDA = 40/8 = 5x; P/E = 40/2 = 20x
A company’s current stock price is $20/share and its P/E multiple is 20x‚ so its EPS is $1. It has 10M shares outstanding. Now it does a 2-for-1 stock split - how do its P/E multiple and valuation change?
They don’t
• Company has 20M shares outstanding‚ but equity value has stayed the same‚ so share price will fall to $10‚ EPS falls to $0.50‚ and P/E multiple remains at 20x
• Splitting stock into fewer units or additional units does not‚ by itself‚ make a company worth more or less (in practice‚ a stock split is viewed favorably by the market and a company’s value may go up and it’s share price‚ in this case‚ might not necessarily be cut in half)
What about the treatment of other securities, like Mezzanine and other Debt variations?
- If interest is tax-deductible, you count them as Debt in the Levered Beta calculation; otherwise, they count as Equity, just like Preferred Stock.
- For WACC itself, you normally look at each type of Debt separately and assume that the “Cost” is the weighted average effective interest rate on that Debt.
This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x
What was the point of this multi-step scenario and these questions? What does it tell you about valuation multiples and M&A activity?
There are a few main takeaways from this exercise:
- Regardless of the purchase method (cash‚ stock‚ debt‚ or some combination of those)‚ the Combined Enterprise Value for the new entity stays the same.
- Company B’s Market Cap (and the book version of it - Shareholders’ Equity) always gets wiped out when it is acquired (technically‚ whenever the acquisition is for over 50% of Company B).
- Regardless of the purchase method‚ the Combined EV/EBITDA multiple does not change b/c Combined Enterprise Value always stays the same and b/c the Combined EBITDA is not affected by changes in interest or additional shares outstanding.
Should you ever factor in off-Balance Sheet Assets and Liabilities in a DCF?
- Potentially, yes, especially if they have a big impact on Enterprise Value and Equity Value (i.e. if they’re something that the acquirer would have to repay).
- But it’s not terribly common to see them, partially b/c when off-B/S items are more important (for commercial banks w/ derivative books, for example), you don’t even use DCF.
What if the equity contributed (investor equity) in the beginning is the same as the net proceeds to the PE firm at the end‚ when it sells the company?
- In this case‚ it’s much tougher to earn a high IRR b/c the major cash inflow at the end is the same as the major cash outflow at the beginning.
- If nothing else happens‚ the IRR would be 0% in this case. If the company issues dividends to the firm or the PE firm does a dividend recap‚ then the IRR will be higher than 0%.
Let’s say we create a brand new operating metric for a company that approximates its cash flow. Should we use Enterprise Value or Equity Value in the numerator when creating a valuation multiple based on this metric?
- It depends on whether or not this new metric includes the impact of interest income and interest expense.
- If it does‚ you use Equity Value. If it doesn’t‚ you use Enterprise Value.
What’s the relationship between Debt and Cost of Equity?
More Debt means that the company is riskier, so the company’s Leveraged Beta will be higher - so all else being equal, Cost of Equity would increase. Less Debt would decrease Cost of Equity.
How do you calculate WACC?
- WACC = Cost of Equity * (% Equity) + Cost of Debt * (1 - Tax Rate) * (% Debt) + Cost of Preferred Stock * (% Preferred)
- In all cases, the percentages refer to how much each component comprises of the company’s capital structure.
- For Cost of Equity, you can use CAPM and for the others you usually look at comparable companies and comparable debt issuances and the interest rates and yields issued by similar companies to get estimates.
T/F: Does a valuation tell you how much a company is worth?
False. A valuation only gives you a range of possible values for a company. Valuation is all about the potential range for a company’s value.
If cash collected is not recorded as revenue‚ what happens to it?
- It goes into the Deferred Revenue balance on the B/S under Liabilities.
- Over time‚ as the services or products are delivered‚ the Deferred Revenue balance turns into real revenue on the I/S and the Deferred Revenue balance decreases.
You’re reviewing a company’s Balance Sheet and you see an “Income Taxes Payable” line item on the Liabilities side. What is this?
- Income Taxes Payable refers to normal income taxes that accrue and are then paid out in cash‚ similar to Accrued Expenses‚ but for taxes instead.
- Example: A company pays corporate income taxes in cash once every 3 months. But they also have monthly I/S where they record income taxes‚ even if they haven’t been paid out in cash yet.
- Those taxes increase the Income Taxes Payable account until they are paid out in cash‚ at which point Income Taxes Payable decreases.
Are there are any exceptions to the rules about subtracting Equity Interests and adding Noncontrolling Interests when calculating Enterprise Value?
- You pretty much always add Noncontrolling Interests b/c the financial statements are always consolidated when you own over 50% of another company.
- But with Equity Interests‚ you ONLY subtract them if the metric you’re looking at does NOT include Net Income from Equity Interests (which only appears toward the bottom of the I/S)
- For example: Revenue‚ EBIT‚ and EBITDA all exclude revenue and profit from Equity Interests‚ so you subtract Equity Interests.
- But with Levered FCF (FCF to Equity)‚ typically you’re starting w/ Net Income Attributable to Parent Company‚ which already includes Net Income from Equity Interests.
- Normally you subtract that out in the CFO section of the SCF so you would still subtract Equity Interests if you calculate FCF by going through all the items in that section.
- But if you have not subtracted out Net Income from Equity Interests (if you’ve used some other formula to calculate FCF)‚ you should NOT subtract it in the Enterprise Value calculation - you WANT to show its impact in that case.
- This is a very subtle point‚ most bankers would probably not understand the explanation above.
Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example‚ what happens when you have Existing Debt‚ a Revolver‚ Term Loans‚ and Senior Notes?
First off‚ note that you MUST make all mandatory debt repayments on each tranche of debt before anything else. So there is no real “order” there - you simply have to repay what is required. The “order” applies only when you have extra cash flow beyond what is needed to meet these mandatory repayments:
• REVOLVER: You borrow additional funds here and add them to the balance if you don’t have enough cash flow to meet the mandatory debt repayments each year; you use any extra cash flow each year to repay this Revolver first‚ before any other debt.
• EXISTING DEBT: This comes first‚ before the new debt raised in the LBO‚ when setting aside extra cash flow to make optional repayments.
• TERM LOANS: Payments on these come after paying off the Revolver and any existing debt.
• SENIOR NOTES: These come last in the hierarchy and typically optional repayment is limited or not allowed at all.
• To track this in an LBO model‚ you need to separate out the Revolver from the mandatory repayments from the optional repayments‚ and keep track of the cash flow that’s available after each stage of the process.
Let’s say we do this [move from Enterprise Value to Implied per Share Value for a public company] and find that the Implied per Share Value is $10. The company’s current share price is $5. What does this mean?
- By itself, this does not mean much - you have to look at a range of outputs from a DCF rather than just a single number. So you would see what the Implied per Share Value is under different assumptions for the Discount Rate, revenue growth, margins, and so on.
- If you consistently find that it’s greater than the company’s current share price, then the analysis might tell you that the company is undervalued; it might be overvalued if it’s consistently less than the current share price across all ranges.
Explain how a Revolver is used in an LBO model.
- You use a Revolver when the cash required for Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
- REVOLVER BORROWING = MAX(0‚ Total Mandatory Debt Repayment - Cash Flow Available to Repay Debt)
- The Revolver starts off “undrawn‚” meaning that you don’t borrow money and don’t accrue a balance unless you need it - similar to how credit cards work.
- You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments.
- Within the debt repayments themselves‚ you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans.
- You’re analyzing a company with $100 in Short-Term Investments on its Balance Sheet. These Investments are classified as Available-for-Sale (AFS) Securities.
- The market value for these securities increases to $110.
- Walk me through what happens on the 3 statements.
- I/S: Since these are AFS Securities‚ you do NOT report unrealized Gains and Losses on the I/S. There are no changes.
- SCF: There are no changes b/c no cash accounts change.
- B/S: The Short-Term Investments line item increases by $10 on the Assets side and Accumulated Other Comprehensive Income (AOCI) increases by $10 on the other side under SE‚ so the B/S balances.
Why do you subtract Cash in the formula for Enterprise Value? Is that always accurate?
- In an acquisition‚ the buyer would “get” the cash of the seller‚ so it effectively pays less for the company based on how large its cash balance is. Remember‚ Enterprise Value tells us how much you’d effectively have to “pay” to acquire another company.
- It’s not always accurate b/c technically you should subtract only excess cash (the amount of cash a company has above the minimum cash required to operate)
- In practice‚ the minimum cash required by a company is difficult to determine; also‚ you want the Enterprise Value calculation to be relatively standardized among different companies‚ so you normally just subtract the entire cash balance.
Walk me through the most important terms of a Purchase Agreement in an M&A deal.
There are dozens‚ but here are the most important points:
• Purchase Price: Stated as a per-share amount for public companies; just a number (the Equity Purchase Price) for private companies.
• Form of Consideration: Cash‚ Stock‚ Debt…
• Transaction Structure: Stock‚ Asset‚ or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed Out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-compete agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about their respective businesses?
• No-Shop/Go-Shop: Can the seller “shop” this offer around and try to get a better deal‚ or must it stay exclusive to this buyer.
What would you use with Free Cash Flow multiples - Equity Value or Enterprise Value?
- For Unlevered FCF‚ you use enterprise value (cash flow available to all investors)
- For levered FCF‚ you use equity value (cash flow available to equity investors)
How can you estimate the IRR in an LBO? Are there are any rules of thumb?
Yes‚ you can use these rules of thumb to come up with a quick estimate:
• If a PE firm doubles its money in 5 years‚ that’s a 15% IRR
• If a PE firm triples its money in 5 years‚ that’s a 25% IRR
• If a PE firm doubles its money in 3 years‚ that’s a 26% IRR
• If a PE firm triples its money in 3 years‚ that’s a 44% IRR
Remember that “money” here refers to Investor Equity (i.e. the amount of cash the PE firm invests and receives back)‚ NOT to the total purchase price or exit price.
You’re analyzing a set of transactions where the buyers have acquired everything from 20% to 80% to 100% of other companies. Should you use all of them as part of your valuation?
- Ideally no. It’s best to limit the set to just 100% acquisitions‚ or at least >50 acquisitions‚ b/c the dynamics are very different when you acquire an entire company or majority stake vs. a minority stake.
- You may not always be able to do this due to lack of data or lack of transactions‚ but generally transactions get less and less comparable as the percentage acquired varies by more and more.
Why can’t you use Equity Value / EBITDA as a multiple rather than EV/EBITDA?
Equity Value/EBITDA is comparing apples to oranges because equity value does not reflect the company’s entire capital structure (only what is available to common shareholders).
Why might a PE firm allot some of a company’s new equity in an LBO to a management option pool‚ and how would this affect the model?
- This is done for the same reason that buyers use Earnouts in M&A deals: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment.
- The difference is that there’s no technical limit on how much management might receive from such an option pool: their proceeds will be a percentage of the company’s final sale value.
- In your LBO model‚ you would need to calculate a per-share purchase price when the PE firm exits the investment‚ and then calculate how much of the proceeds go to the management team based on the Treasury Stock Method.
- An option pool by itself would reduce the PE firm’s return‚ but this is offset by the fact that the company should perform better with this incentive in place.
What is the Equity Value / Levered FCF multiple used for? What does it mean?
- Not very common b/c it requires more work to calculate and may produce wildly different numbers depending on capital structure
- It’s the most accurate measure of a company’s true “cash flow” and how valuable it is relative to that cash flow
When you’re looking at an industry specific multiple like EV/Proved Reserves or EV/Subscribers (for telecom companies‚ for example)‚ why do you use Enterprise Value rather than Equity Value?
Enterprise Value is used b/c those proved reserves or subscribers are “available” to all the investors (both debt and equity) in a company. This is almost always the case unless the metric already includes interest income and expense (FFO & AFFO)
What is an exchange ratio and when would companies use it in an M&A deal?
- An exchange ratio is an alternate way of restructuring a 100% stock M&A deal‚ or any M&A deal with a portion of stock involved.
- Let’s say you were going to buy a company for $100M in a 100% stock deal. Normally you would determine the number of shares to issue by dividing the $100M by the buyer’s stock price.
- With an exchange ratio by contrast‚ you would tie the number of new shares to the buyer’s own shares - so the seller might receive 1.5 shares of the buyer’s shares for each of its shares‚ rather than shares worth a specific dollar amount.
- Buyers might prefer to do this if they believe their stock price is going to decline post-transaction. Sellers‚ on the other hand‚ would prefer a fixed dollar amount in stock unless they believe the buyer’s share price will rise after the transaction.
How does a DCF for private company differ?
- The mechanics are the same, but calculating Cost of Equity and WACC is problematic b/c you can’t find the market value of Equity or Beta for private companies.
- So you might estimate WACC based on the median WACC of its Public Comps, and do the same for Cost of Equity if you’re using that as the Discount Rate.
Let’s say Apple is buying $100 worth of new iPad factories with debt. At the end of Year 2‚ the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements change ONLY from the start of Year 2 to the end of Year 2.
After 2 years‚ the value of the factories is now $80 if we go with the 10% Depreciation per year assumption. It is this $80 that we will write down on the 3 statements. Also‚ don’t forget about the Interest Expense - it still needs to be paid in Year 2.
• I/S: We have $10 worth of Depreciation and then the $80 Write-Down. We also have $10 of additional Interest Expense‚ so Pre-Tax Income is down by $100. NI is down by $60 at a 40% tax rate.
• SCF: NI is down by $60 but the Write-Down and Depreciation are both non-cash expenses‚ so we add them back and cash flow is up by $30 so far. There are no changes under CFI‚ but under CFF there is a $100 charge for the loan payback - so CFF falls by $100. Overall cash at the bottom decreases by $70.
• B/S: Cash is now down by $70‚ and PP&E has decreased by $90‚ so the Assets side is down by $160. On the other side‚ Debt is down by $100 since it was paid off‚ and since NI was down by $60‚ SE is down by $60. Both sides are down by $160 and balance.
How do you treat Preferred Stock in the formulas above for Beta?
It should be counted as Equity there because Preferred Dividends are NOT tax-deductible, unlike interest paid on Debt.
How do you factor in Restricted Stock Units (RSUs) and Performance Shares when calculating Diluted Equity Value?
- RSUs should be added to the common share count‚ b/c they ARE just common shares. The only difference is that the employees who own them have to hold onto them for a number of years before selling them.
- Performance Shares are similar to Convertible Bonds‚ but if they’re not in-the-money (the share price is below the performance share price target)‚ you do not count them as Debt - you ignore them altogether. If they are in-the-money‚ you assume that they are normal common share and add them to the share count.
How do you think about synergies if the combined company can consolidate buildings?
- If the buildings are leased‚ you assume that both lease expenses go away and are replaced w/ a new‚ larger lease expense for the new or expanded building. So in that case‚ it is a simple matter of New Lease Expense - Old‚ Separate Lease Expense to determine the synergies.
- If the buildings are owned‚ it gets more complicated b/c one or both of them will be sold‚ or perhaps leased out to someone else. Then you would have to look at Depreciation and Interest savings‚ as well as additional potential income if the building is rented out.
How much debt could a company issue in a merger or acquisition?
- You would look at Comparable Companies and Precedent Transactions to determine this. You would use the combined company’s EBITDA figure‚ find the median Debt/EBITDA ratio of the companies or deals you’re looking at‚ and apply that to the company’s own EBITDA figure to get a rough idea of how much debt it could raise.
- You could also look at “Debt Comps” for similar‚ recent deals and see what types of debt and how many tranches they have used.
How should you project Depreciation and Capital Expenditures?
You could use several different approaches here:
• Simplest: Make each one a % of revenue.
• Alternative: Make Depreciation a % of revenue‚ but for CapEx average several years of CapEx‚ or make it an absolute dollar change (e.g. it increases by $100 each year) or percentage change (it increases by 2% each year).
• Complex: Create a PP&E schedule‚ where you estimate the CapEx increase each year based on management’s plans‚ and then Depreciate existing PP&E using each asset’s useful life and the straight-line method; also Depreciate new CapEx right after it’s added‚ using the same approach.
A company decides to issue $100 in Dividends - how do the 3 statements change?
- I/S: No changes. Dividends count as a financing activity and are not tax-deductible‚ so they never appear on the I/S.
- SCF: CFF is down by $100 due to the Dividends‚ so cash at the bottom is down by $100.
- B/S: Cash is down by $100 on the Assets side‚ and SE (RE) is down by $100 on the other side‚ so both sides balance.
- Intuition: This is another non-operational CFS/BS item‚ so it is a simple use of cash and nothing else changes.
What is the difference between Bank Debt and High-Yield Debt?
This is a simplification‚ but broadly speaking there are 2 “types” of Debt: “Bank Debt” and “High-Yield Debt.” Usually in a sizable LBO‚ the PE firm uses both types of debt. There are many differences‚ but here are a few of the most important ones:
• High-Yield Debt tends to have higher interest rates than Bank Debt (hence the name “high-yield”) since it’s riskier for investors.
• High-Yield Debt interest rates are usually fixed‚ whereas Bank Debt interest rates are floating (they change based on LIBOR or the prevailing interest rates in the economy).
• High-Yield Debt has incurrence covenants‚ while Bank Debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset‚ buying a factory‚ etc.) while maintenance covenants require you to maintain minimum financial performance (for example‚ the Total Debt / EBITDA ratio must be below 5x at all times).
• Bank Debt is usually amortized - the principal must be paid off over time - whereas High-Yield Debt‚ the entire principal is due at the end (bullet maturity) and early principal repayments are not allowed.
Both M&A premiums and precedent transactions involve analyzing previous M&A transactions. What’s the difference in how we select them?
- All the sellers in the M&A Premiums Analysis must be public
- Usually we use a broader set of transactions for M&A premiums (we might use fewer than 10 precedent transactions but we might have dozens of M&A premiums. The industry and financial screens are usually less stringent.
- Aside from those‚ screening criteria are similar‚ financial metrics‚ industry‚ geography‚ and date.
Is always accurate to add Debt to Equity Value when calculating Enterprise Value?
- In most cases‚ yes‚ b/c the terms of a Debt issuance usually state that Debt must be repaid in an acquisition. And a buyer usually pays off a seller’s Debt‚ so it is accurate to say that Debt “adds” to the purchase price.
- Adding Debt is also partially a matter of standardizing the Enterprise Value calculation among different companies: if you added it for some and didn’t add it for others‚ EV would no longer mean the same thing and valuation multiples would be off.
What are the different classifications for Securities that a company can use on its Balance Sheet? How do they differ?
- TRADING: These securities are very short-term and you count all Gains and Losses on the I/S‚ even if they’re unrealized (i.e. you haven’t sold the Securities yet).
- AVAILABLE FOR SALE (AFS): These Securities are longer-term and you don’t report Gains and Losses on the I/S - they appear under Accumulated Other Comprehensive Income (AOCI). The B/S values of these Securities also change over time b/c you mark them to market.
- HELD-TO-MATURITY (HTM): These Securities are even longer-term‚ and you don’t report unrealized Gains or Losses anywhere. Gains and Losses are only reported when they’re actually sold.
- A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements‚ it records Depreciation of $15 in Year 1‚ $10 in Year 2‚ and $5 in Year 3.
- Walk me through what happens on the BOOK financial statements in Year 3.
- I/S: On the Book I/S‚ you use the Book Depreciation number so Pre-Tax Income falls by $10 and NI falls by $6 with a 40% tax rate. On the Tax I/S‚ Depreciation was $5 so NI fell by $3 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes‚ Pre-Tax Income was $100 and Taxes were $40. Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $95. Book Taxes were $36 and Cash Taxes were $38‚ so Book Taxes fell by $4 and Cash Taxes fell by $2).
- SCF: On the Book SCF‚ NI is down by $6‚ but you add back the Depreciation of $10 and you subtract out $2 worth of additional Cash Taxes - that represents the fact that Cash Taxes were higher than Book Taxes in Year 1 (meaning that you’re now paying extra to make “catch-up payments.” At the bottom‚ Cash is up by $2.
- B/S: Cash is up by $2‚ but PP&E is down by $10 due to the Depreciation‚ so the Assets side is down by $8. On the other side‚ the DTL decreases by $2 due to the Book/Cash Tax difference and SE (RE) is down by $6 due to the reduced NI‚ so both sides are down by $8 and balance.
Explain what happens on the 3 statements when a company issues $100 worth of shares to investors.
- I/S: No changes (since this doesn’t affect taxes and since the shares will be around for years to come).
- SCF: CFF is up by $100 due to this share issuance‚ so cash at the bottom is up by $100.
- B/S: Cash is up by $100 on the Asset’s side and SE (Common Stock & APIC) is up by $100 on the other side to balance it.
- Intuition: This one does not affect taxes and does not correspond to the current period‚ so it doesn’t show up on the I/S - just like similar items‚ all that changes is Cash and then something else on the B/S.
- A company has Net Operating Losses (NOLs) of $100 included in the Deferred Tax Asset (DTA) line item on its Balance Sheet because it has been unprofitable up until this point.
- Now the company finally turns a profit and has Pre-Tax Income of $200 this year.
- Walk me through the 3 statements and assume that the NOLs can be used as a direct tax deduction on the financial statements.
- I/S: The company can apply the entire NOL balance to offset its Pre-Tax Income‚ so Pre-Tax Income falls by $100 and NI falls by $60 at a 40% tax rate.
- SCF: NI is down by $60 but the company hasn’t truly lost anything - it has just saved on taxes. So you add back this use of NOLs and label it “deferred taxes” - it should be a positive $100‚ which means that Cash at the bottom is up $40.
- B/S: Cash is up by $40 and the DTA is down by $100‚ so the Assets side is down by $60. On the other side‚ SE (RE) is down by $60 due to the reduced NI‚ so both sides balance.
Why are Goodwill & Other Intangibles created in an LBO?
- These both represent the premium paid to Shareholders’ Equity of the company. In an LBO‚ they act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Asset side.
- So if the company’s Shareholders’ Equity was originally worth $1B and the PE firm pays $1.5B to acquire the company‚ roughly $500M in goodwill & Other Intangibles will be created.
Wait a second‚ why might you add back Unfunded Pension Obligations but not something like Accounts Payable? Don’t they both need to be repaid?
- The distinctions are magnitude and source of funds. 99% of the time‚ A/P is paid back via the company’s cash flow from it’s normal business operations and it tends to be very small.
- Items like Unfunded Pension Obligations‚ by contrast‚ usually require additional funding (e.g. the company raises Debt) to be repaid. These types of liabilities also tend to be much bigger than Working Capital / Operational Asset and Liability items.
Do you use Equity Value or Enterprise Value for the Purchase Price in a merger model?
- This is a trick question because neither one is entirely accurate. The PPA schedule is based on the Equity Purchase Price‚ but the actual amount of cash/stock/debt used is based on that Equity Purchase Price plus the additional funds needed to repay debt‚ pay for transaction-related fees‚ and so on.
- That number is not exactly “Enterprise Value” - it’s something in between Equity Value and Enterprise Value‚ and it’s normally labeled “Funds Required” in a model.
Do you need to project all 3 statements in an LBO model? Are there are any shortcuts?
- Yes there are shortcuts and you don’t necessarily need to project all 3 statements.
- For example‚ you do not need to create a full B/S - bankers sometimes skip this if they are in a rush. You do need some form of I/S‚ something to track how the Debt balance changes and some type of SCF to show how much cash is available to repay debt.
- But a full-blown B/S is not strictly required b/c you can make an assumption for the overall Change in Operating Assets and Liabilities rather than projecting each one separately.
Could there be cases where cash is actually more expensive than debt or stock in an acquisition?
- With debt this is impossible‚ b/c it makes no logical/financial sense: why would a bank ever pay more on cash you’ve deposited than it would charge to customers who need to borrow money?
- With stock it is almost impossible‚ but sometimes if the buyer has an extremely high P/E multiple (e.g. 100x)‚ the reciprocal of that (1%) might be lower than the after-tax cost of cash. This is rare‚ extremely rare.
Walk me through how you would value a REIT and how it differs from a “normal” company.
Similar to energy‚ real estate is asset-intensive and a company’s value depends on how much cash flow specific properties generate.
• You look at Price / FFO per Share (Funds from Operations) and Price / AFFO per Share (Adj. FFO)‚ which add back depreciation and undo gains/losses on property sales.
• A Net Asset Value (NAV) model is the most common intrinsic valuation methodology‚ you assign a cap rate to the company’s projected NOI and multiply to get the value of its real estate‚ adjust and add its other assets‚ subtract liabilities and divide by its share count to get NAV per Share‚ and then compare that to its current share price.
• You value properties by dividing Net Operating Income (NOI = Property’s Gross Income - Property Operating Expenses & Taxes) by the capitalization rate (based on market data)
• Replacement Valuation is more common b/c you can actually estimate the cost of buying new land and building new properties
• A DCF is still a DCF‚ but it flows from specific properties instead and it tends to be far less common than the NAV model.
A buyer pays $100M for the seller in an all-stock deal‚ but a day later the market decides that it’s only worth $50M. What happens
- The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50M loss in value. It would NOT necessarily be cut in half.
- Depending on the deal structure‚ the seller would effectively only receive half of what it had originally negotiated.
- This illustrates one of the major risks of all-stock deals: sudden changes in share price could dramatically impact the valuation (there are ways to hedge against that risk).
How would an LBO of a private company be different?
- The mechanics are the same. The only difference is that you think of the purchase price as a lump sum number rather than as a premium to the company’s share price times the number of shares outstanding.
- Evaluating LBOs of private companies can also be trickier b/c information is limited.
What is the Enterprise Value / EBITDA multiple used for? What does it mean?
- Used for many types of companies‚ most useful for those where CapEx and D&A are not as important since it excludes both.
- It’s a rough approximation of how valuable a company is relative to its operational cash flow
What is the advantage and disadvantage to using Sum of the Parts Analysis? And what can you say in general about the resulting valuations?
- Adv.: more accurately values diversified conglomerate-type companies
- Dis.: appropriate data for each division is often lacking
- Val.: if a company really is “worth more in parts” this will produce higher values than relative valuations
What is the advantage and disadvantage to using public comps?
- Adv.: based on real data as opposed to future assumptions
* Dis.: there may not be true comparables‚ less accurate for thinly traded stocks or volatile companies
Could a company have a negative Equity Value? What would that mean?
No. This is not possible b/c you cannot have a negative share count or a negative share price.
Walk me through how you adjust the Balance Sheet in an LBO model.
• This is very similar to what you see in a merger model - you calculate Goodwill‚ Other Intangible Assets‚ and the rest of the Write-Ups in the same way‚ and then the B/S adjustments (e.g. subtracting Cash‚ adding in Capitalized Financing Fees‚ writing up Assets‚ wiping out Goodwill‚ adjusting the DTAs/DTLs‚ adding in new debt‚ etc.) are almost all the same.
• The key differences are:
1) In an LBO model you assume that the existing Shareholders’ Equity is wiped out and replaced by the value of the cash the PE firm contributes to buy the company; you may also add in Preferred Stock‚ Management Rollover‚ or Rollover from Option Holders to this number as well depending on your assumptions.
2) In an LBO model you’ll usually add more tranches of debt compared to what you would see in a merger model.
3) In an LBO model‚ you’re not combining two companies’ Balance Sheets.
How do you factor in one-time events such as raising Debt, completing acquisitions, and so on in a DCF?
- Normally, you ignore these types of events b/c the whole point of calculating FCF is to determine the company’s cash flow on a recurring, predictable basis.
- If you know for a fact that something is going to occur in the near future, then you could factor that in - issuing Debt or Equity would change Cost of Equity and WACC (and the company’s FCF in a levered DCF); completing an acquisition or buying an asset would reduce cash flow initially but perhaps boost it later on.
Normally we care about the IRR for the equity investors in an LBO - the PE firm that buys the company - but how do we calculate the IRR for the debt investors?
- For the debt investors‚ you need to calculate the interest and principal payments that they receive from the company each year.
- Then you simply use the IRR function in Excel and start with the negative amount of the original debt for “Year 0‚” assume that the interest and principal payments each year are your “cash flows” and then assume that the remaining debt balance in the final year is your “exit value.”
- Most of the time‚ returns for debt investors will be lower than returns for the equity investors - but if the deal goes poorly or the PE firm can’t sell the company for a good price‚ the reverse could easily be true.
As an approximation, do you think it’s OK to use (EBITDA - Changes in Operating Assets & Liabilities - CapEx) to approximate Unlevered Free Cash Flow?
- This is inaccurate b/c it excludes taxes completely. It would be better to use EBITDA - Taxes - Changes in Operating Assets & Liabilities - CapEx.
- If you need a very quick approximation, yes, this formula can work and it will get you closer than EBITDA by itself. But taxes are significant and should not be overlooked.
A company sells some of its PP&E for $120. On the Balance Sheet‚ the PP&E is worth $100. Walk me through how the 3 statements change.
- I/S: You record a Gain of $20 ($120 - $100)‚ which boosts Pre-Tax Income by $20. At a 40% tax rate‚ Net Income is up by $12.
- SCF: Net Income is up by $12‚ but you need to subtract out that Gain of $20‚ so CFO is down by $8. Then‚ in CFI‚ you record the entire amount of proceeds from the sale‚ $120‚ so that section is up by $120. At the bottom of the SCF‚ cash is therefore up by $112.
- B/S: Cash is up by $112‚ but PP&E is down by $100 since we’ve sold it‚ so the Assets side is up by $12. The other side is up by $12 as well‚ since SE is up by $12 due to the NI increase.
- Intuition: Gains and Losses are not non-cash‚ but they are re-classified on the SCF. The cash increase here simply reflects the after-tax profit from the Gain - if we had sold the PP&E at its Balance Sheet value‚ there would be no change on the I/S.
Let’s say that you have a non-cash expense (Depreciation or Amortization for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?
- Because you want to reflect that you’ve saved on taxes with the non-cash expense.
- Let’s say you have a non-cash expense of $10 and a tax rate of 40%. Your NI decreases by $6 as a result… but then you add back the entire non-cash expense of $10 on the SCF so that your cash goes up by $4.
- That increase of $4 reflects the tax savings from the non-cash expense. If you just added back the after-tax expense of $6 you’d be saying‚ “This non-cash expense has no impact on your taxes or cash balance.”
- A company raises $100 worth of Debt‚ at 5% interest and 10% yearly principal repayment‚ to purchase $100 worth of Short-Term Securities with 10% interest attached.
- Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase.
- I/S: No changes yet.
- SCF: The $100 Purchase of Short-Term Securities shows up as a reduction of cash flow under CFI‚ and the $100 Debt raised shows up as a $100 increase under CFF. Cash at the bottom is unchanged.
- B/S: Short-Term Securities on the Assets side is up by $100‚ and Debt on the Liabilities side is up by $100 so both sides balance.
Apple is ordering $10 of additional iPad inventory‚ using cash on hand. They order the inventory‚ but they have not manufactured or sold anything yet - what happens to the 3 statements?
- I/S: No changes.
- SCF: Inventory is up by $10‚ so CFO decreases by $10. There are no further changes‚ so overall Cash is down by $10.
- B/S: Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the B/S remains in balance.
What’s an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?
There are many “alternate” methods - here are few common ones:
• EBIT * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets & Liabilities - CapEx
• CFO + Tax-Adjusted Net Interest Expense - CapEx
• NI + Tax-Adjusted Net Interest Expense + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx
• NOTE: The difference with these is that the tax numbers will be slightly different as a result of when you exclude the interest.
Why do you use Enterprise Value for Unlevered Free Cash Flow multiples but Equity Value for Levered Free Cash Flow multiples? Don’t they both just measure cash flow?
- They both measure cash flow‚ but Unlevered FCF (FCF to firm) excludes interest income and interest expense (and mandatory debt repayments)‚ whereas Levered FCF includes interest income and interest expense (and mandatory debt repayments)‚ meaning that only Equity Investors are entitled to that cash flow.
- Therefore‚ you use Equity Value for Levered FCF and Enterprise Value for Unlevered FCF.
How would you present these Valuation methodologies to a company or its investors? And what do you use it for?
- usually you use a “football field” chart where valuation ranges are implied by each methodology. You ALWAYS show a range rather than one specific number
- you could use a valuation for: 1) pitch books and client presentations‚ 2) parts of other models (defense analyses‚ merger models‚ LBO models‚ DCFs‚ almost everything in finance will incorporate a valuation in some way‚ 3) fairness opinions
What happens when you acquire a 70% stake in a company?
- For all acquisitions where over 50% (but less than 100%) of another company gets acquired‚ you still go through the purchase price allocation process and create Goodwill‚ but you record a Noncontrolling interest on the Liabilities side for the portion you do NOT own. You also consolidate 100% of the other company’s statements with your own‚ even if you only own 70% of it.
- Example: You acquire 70% of another company using Cash. The company is worth $100‚ and has Assets of $180‚ Liabilities of $100‚ and Equity of $80.
- You add all of its Assets and Liabilities to your own‚ but you wipe out its Equity since its no longer considered an independent entity. The Assets side is up by $180 and the Liabilities side is up by $100. You also used $70 of Cash‚ so the Assets side is now only up by $110.
- We allocate the purchase price here‚ and since 100% of the company was worth $100 but its Equity was only $80‚ we create $20 of Goodwill - so the Assets side is up by $130.
- On the Liabilities side‚ we create a Noncontrolling Interest of $30 to represent the 30% of the company that we do NOT own. Both sides are up by $130 and balance.
