Qs Flashcards

Question

What is the advantage and disadvantage to using LBO Analysis? And what can you say in general about the resulting valuations?

Answer 1

* 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

Answer 2

* 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.

Answer 3

* 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.

Answer 4

* 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.

Answer 5

* 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.

Answer 6

* 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

Answer 7

* 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.

Answer 8

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.

Answer 9

* 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

Answer 10

* 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.

Answer 11

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

Answer 12

* 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.

Answer 13

• 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

Answer 14

* 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.

Answer 15

• 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

Answer 16

* 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.

Answer 17

* 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.

Answer 18

* 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.

Answer 19

* 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.

Answer 20

1. Relative valuation (comparing a company's worth to similar companies) 2. Intrinsic valuation (estimating NPV of future cash flows‚ i.e. estimating how much a firm's assets are worth net of liabilities)

Answer 21

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.

Answer 22

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.

Answer 23

A technology company, because technology is viewed as a "riskier" industry than manufacturing.

Answer 24

* 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.

Answer 25

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.

Answer 26

* 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.

Answer 27

* 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.

Answer 28

* 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

Answer 29

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.

Answer 30

* 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.

Answer 31

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.

Answer 32

* 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.

Answer 33

* 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.

Answer 34

* 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).

Answer 35

* 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.

Answer 36

* 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.

Answer 37

* 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."

Answer 38

* 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.

Answer 39

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.

Answer 40

* 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.

Answer 41

* 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.

Answer 42

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.

Answer 43

* 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

Answer 44

* 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)

Answer 45

* 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.

Answer 46

Nothing is different. You still wipe it out‚ allocate the purchase price‚ and create Goodwill.

Answer 47

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.

Answer 48

* 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.

Answer 49

* 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.

Answer 50

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.

Answer 51

* 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.

Answer 52

* 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.

Answer 53

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)

Answer 54

* 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.

Answer 55

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.

Answer 56

1. Free cash flow is not a meaningful metric. 2. 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)

Answer 57

It's the same as what's described previously - a stub period in the beginning does not make a difference.

Answer 58

* 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.

Answer 59

* same way you would value a company: what are comparable apple trees worth? (relative valuation) * present value of FCF for the apple (intrinsic valuation)

Answer 60

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

Answer 61

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.

Answer 62

* 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.

Answer 63

* 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.

Answer 64

* Adv.: tells you how much a company might be worth‚ theoretically‚ 1-2 years in the future * Dis.: dependence on assumptions

Answer 65

* 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.

Answer 66

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.

Answer 67

* 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)

Answer 68

* 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.

Answer 69

1. Search online and see if you can find press releases or articles in the financial press with these numbers. 2. 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. 3. Also look at online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates for the deals.

Answer 70

* 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.

Answer 71

* 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.

Answer 72

* 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

Answer 73

* 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.

Answer 74

* 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)

Answer 75

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

Answer 76

* 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.

Answer 77

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.

Answer 78

• 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.

Answer 79

Trading comp valuations tend to be higher due to the control premium (premium the buyer pays to acquire the seller)

Answer 80

* 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.

Answer 81

1. Always combine the buyer's and seller's Balance Sheets first (remember to wipe out the seller's Shareholders' Equity) 2. Make the necessary Pro-Forma Adjustments (cash‚ debt‚ stock‚ goodwill/intangibles‚ etc.) 3. Project the combined Balance Sheet using standard assumptions for each item. 4. Combine and project the Income Statement. 5. 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.

Answer 82

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.

Answer 83

Net Income + Non-Cash Charges - changes in operating assets and liabilities - CapEx - Mandatory Debt Payments

Answer 84

* 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.

Answer 85

* 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.

Answer 86

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.

Answer 87

* 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.

Answer 88

* 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.

Answer 89

* Company A: EV/EBITDA = 100/10 = 10x; P/E = 80/4 = 20x | * Company B: EV/EBITDA = 40/8 = 5x; P/E = 40/2 = 20x

Answer 90

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)

Answer 91

* 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.

Answer 92

There are a few main takeaways from this exercise: 1. Regardless of the purchase method (cash‚ stock‚ debt‚ or some combination of those)‚ the Combined Enterprise Value for the new entity stays the same. 2. 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). 3. 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.

Answer 93

* 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.

Answer 94

* 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%.

Answer 95

* 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.

Answer 96

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.

Answer 97

* 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.

Answer 98

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.

Answer 99

* 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.

Answer 100

* 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.

Answer 101

* 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.

Answer 102

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.

Answer 103

* 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.

Answer 104

* 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.

Answer 105

* 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.

Answer 106

* 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.

Answer 107

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.

Answer 108

* 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)

Answer 109

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.

Answer 110

* 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.

Answer 111

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).

Answer 112

* 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.

Answer 113

* 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

Answer 114

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)

Answer 115

* 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.

Answer 116

* 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.

Answer 117

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.

Answer 118

It should be counted as Equity there because Preferred Dividends are NOT tax-deductible, unlike interest paid on Debt.

Answer 119

* 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.

Answer 120

* 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.

Answer 121

* 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.

Answer 122

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.

Answer 123

* 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.

Answer 124

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.

Answer 125

* 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.

Answer 126

* 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.

Answer 127

* 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.

Answer 128

* 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.

Answer 129

* 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.

Answer 130

* 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.

Answer 131

* 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.

Answer 132

* 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.

Answer 133

* 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.

Answer 134

* 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.

Answer 135

* 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.

Answer 136

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.

Answer 137

* 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).

Answer 138

* 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.

Answer 139

* 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

Answer 140

* 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

Answer 141

* 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

Answer 142

No. This is not possible b/c you cannot have a negative share count or a negative share price.

Answer 143

• 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.

Answer 144

* 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.

Answer 145

* 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.

Answer 146

* 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.

Answer 147

* 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.

Answer 148

* 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."

Answer 149

* 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.

Answer 150

* 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.

Answer 151

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.

Answer 152

* 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.

Answer 153

* 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

Answer 154

* 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.

Answer 155

Company A b/c money today is worth more than money tomorrow. All else being equal, generating higher cash flow earlier on will always boost a company's value in a DCF.

Answer 156

* I/S: It's the same: NI is up by $6 at the bottom. * SCF: NI is up by $6 and we then subtract out the $6 that's attributable to the Equity Interests. And then we add $3 ($10 * 30%) in the CFO Section to reflect the Dividends that we receive from these Equity Interests. So cash at the bottom is up by $3. * B/S: Cash is up by $3 on the Assets side‚ and the Investments in Equity Interests line item is up by $6‚ but it falls by $3 due to those Dividends‚ so the Assets side is up by $6 total. On the other side‚ NI is up by $6 so SE (RE) is up by $6 and both sides balance. * NOTE: The Investments in Equity Interests line item is like a "mini-SE" for companies that you own less than 50% of - you add however much NI you can "claim‚" and then subtract out your portion of the Dividends. * Remember that only the Dividends of the parent company itself issues show up in the CFF section - Dividends received from other companies (such as what you see in this example) do not.

Answer 157

Earnings Before Interest‚ Taxes‚ Depreciation & Amortization The idea is to remove most non-cash charges and make it more accurately reflect cash flow potential (proxy for free cash flow). You may add back other non-cash charges‚ such as stock-based compensation.

Answer 158

* In this scenario‚ Company B's Market Cap gets wiped out b/c it no longer exists as an independent entity‚ and Company A's cash balance decreases b/c it has used its cash to acquire Company B. * So the Combined Market Cap = 80. Previously‚ A had 20 more Debt than Cash‚ and B had the same amount of Cash and Debt. * To get real numbers here‚ let's just say that A had 60 of Debt and 40 of Cash. Afterward‚ the Debt remains at 60 but all the cash is gone b/c it used the Cash to acquire B. We don't need to look at B's numbers at all b/c its Cash and Debt cancel each other out. * So the combined Enterprise Value = 80 + 60 = 140. It is no coincidence‚ of course‚ that Combined Enterprise Value = Company A Enterprise Value + Company B Enterprise Value. That is how it should always work in an acquisition where there was no premium paid for the seller. * You add the EBITDA and Net Income from both companies to get the combined figures. This is not 100% accurate b/c Interest Income changes for Company A since it's using cash and b/c the tax rates may be different‚ but we're going to ignore those for now since the impact will be small: * Combined EV/EBITDA = 140 / (10 + 8) = 140/18 = 7.78x * Combined P/E = 80 / (4 + 2) = 80/6 = 13.3x

Answer 159

* Yes. It means that the company has an extremely large cash balance‚ or an extremely low market capitalization (or both). * You often see it w/ companies on the brink of bankruptcy‚ and sometimes also with companies that have enormous cash balances.

Answer 160

* It might be saving its cash for something else‚ or it might be concerned about running low on cash if business takes a turn for the worst. * The buyer's stock may also be trading at an all-time high and it might be eager to use that "currency" instead‚ for the reasons stated above: stock is less expensive to issue if the company has a high P/E multiple and therefore a high stock price.

Answer 161

* You use the same Valuation methodologies we discussed in the Valuation section. If the seller is a public company‚ you would pay more attention to the premium paid over the current share price to make sure it's "sufficient" (generally in the 15-30% range) to win shareholder approval. * For private sellers‚ more weight is placed on the traditional methodologies.

Answer 162

YES: • Cost of Cash = Foregone Interest on Cash * (1 - Buyer Tax Rate) • Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate) • Cost of Stock = Reciprocal of Buyer's P/E Multiple (i.e. E/P or NI/Equity Value) • Yield of Seller = Reciprocal of Seller's P/E Multiple (ideally calculated using Purchase Price rather than the Seller's Current Share Price) * You calculate each of the Costs‚ take the weighted average‚ and then compare that number to the Yield of the Seller (the reciprocal of the Seller's P/E multiple). * If the weighted "Cost" average is less than the Seller's Yield‚ it will be accretive since the purchase itself "costs" less than what the buyers get out of it; otherwise‚ it will be dilutive. Example: The buyer's P/E multiple is 8x and the seller's P/E multiple is 10x. The buyer's int. rate on cash is 4%‚ and int. rate on debt is 8%. The buyer is paying with 20% cash‚ 20% debt‚ and 60% stock. The buyer's tax rate is 40%: • Cost of Cash = 4% * (1 - 40%) = 2.4% • Cost of Debt = 8% * (1 - 40%) = 4.8% • Cost of Stock = 1/8 = 12.5% • Yield of Seller = 1/10 = 10% • Weighted Average Cost = 20%(2.4%) + 20%(4.8%) + 60%(12.5%) = 8.9% < 10% • Summary: Since Weighted Average Cost < Seller's Yield‚ the deal is ACCRETIVE.

Answer 163

Goodwill = Equity Purchase Price - Seller Book Value + Seller's Existing Goodwill - Asset Write-Ups - Seller's Existing DTL + Write-down of Seller's Existing DTA + Newly Created DTLs + Intercompany A/R - Intercompany A/P • Seller Book Value is just the Shareholders' Equity number (technically‚ the Common Shareholders' Equity number) • You add the Seller's Existing Goodwill b/c it is "reset" and written down to $0 in an M&A deal. • You subtract the Asset Write-Ups b/c these are additions to the Assets side of the B/S - Goodwill is also an asset‚ so effectively you need less Goodwill to "plug the hole." • Normally you assume 100% of the Seller's existing DTL is written down. • The seller's existing DTA may or may not be written down completely. • You add Intercompany A/R because they go away‚ which reduces the Assets side; the opposite applies for Intercompany A/P.

Answer 164

* If the convertible bonds are in-the-money‚ meaning that the conversion price of the bonds is below the current share price‚ then you count them as additional dilution to the Equity Value (no Treasury Stock Method required - just add all the shares that would be created as a result of the bonds). * If the Convertible Bonds are out-of-the-money‚ then you count the face value of the convertibles as part of the company's debt.

Answer 165

* You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT, or FCF (Multiples Method) or you can use the Gordon Growth Method to estimate the value based on the company's growth rate into perpetuity. * The formula for Terminal Value using the Gordon Growth method: Terminal Value = Final Year FCF * (1 + Growth Rate) / (Discount Rate - Growth Rate) * Note that with either method, you're estimating the same thing: the present value of the company's FCF from the final year into infinity, as of the final year.

Answer 166

* multiples should be based on the purchase price of the company at the time of the deal announcement (the affected share price) * you only care about what the offer price was at the initial deal announcement. You never look at the company's value prior to the deal being announced.

Answer 167

* Used for many types of companies‚ mostly useful for those where CapEx is more important to factor in (since D&A flows CapEx closely) * It's a rough approximation of how valuable a company is relative to its income from business operations

Answer 168

* An Equity Rollover would show up in the Sources column in the Sources & Uses table and it would reduce the amount of Equity and Debt the PE firm needs to use to acquire the company - b/c now the PE firm only needs to acquire 90%‚ or 95%‚ or some number less than 100%‚ rather than the entire company. * At the end‚ you would also subtract some of the proceeds and allocate them to the management team rather than the PE firm when calculating returns. * If nothing else changes‚ this reduces the PE firm's IRR - but the idea is that it also incentivizes the management team to perform well and deliver greater results‚ which helps everyone.

Answer 169

* We do it for the same reason that we calculate Enterprise Value: to more accurately determine the cost of acquiring a company. * Normally in an acquisition scenario‚ in-the-money securities (ones that will cause additional shares to be created) are 1) cashed out and paid by the buyer (raising the purchase price)‚ or 2) are converted into equivalent securities for the buyer (also raising the effective price for the buyer) * Dilution doesn't always make a big difference‚ but it can be as high as 5-10% (or more) so you definitely want to capture this effect.

Answer 170

* Company A Cost of Debt = 5%*(1 - 40%) = 3% * Company A Cost of Stock = 1/10 = 10% * Company B Yield = Higher than 10% since its P/E multiple is lower * Therefore‚ this deal will always be accretive regardless of whether Company A uses debt or stock since both "cost" less than Company B's Yield. * However‚ Company A will achieve far more accretion if it uses 100% debt b/c the Cost of Debt (3%) is much lower than the Cost of Stock (10%).

Answer 171

* Remember what happens when a company issues shares: it sells the shares to new investors and receives cash in exchange for them. Here‚ they would do the same thing and issue a small portion of the shares to 3rd party investors rather than the seller to raise the cash necessary to repay the debt. * The buyer might also wait until the deal closes before it issues additional share to pay off the debt. And it could also use cash on-hand to repay the debt‚ or refinance the debt with a new debt issuance.

Answer 172

* Normally a "liquidity discount" or "lack of control discount" is applied and so it's assumed that the stake is worth 20-30% (or more) less than the book value b/c the company you're valuing doesn't truly control this other company * Also‚ you may also take tax implications into consideration‚ since these types of investments may likely be sold off. You would apply the company's tax rate in addition to the liquidity discount and calculate the after-tax proceeds.

Answer 173

That's about as far as you can reasonably predict for most companies. Less than 5 years would be too short to be useful, and more than 10 years is too difficult to project for most companies.

Answer 174

* This case refers to an Equity Interest (AKA Associate Company) - here you do NOT consolidate the statements at all. * Instead you reflect Percentage of Other Company That You Own * Value of Other Company and show it as an Asset on the B/S (Investments in Equity Interests). For example‚ if the other company is worth $200 and you own 30% of it‚ you record $60 for the Investments in Equity Interests line item. * You also add Other Company's NI * Percentage Ownership to your own NI on the I/S‚ and then subtract it on the SCF b/c it's a non-cash addition. * Each year‚ the Investments in Equity Interests line item increases by that number‚ and it decreases by any dividends issued from that other company to you. On the other side‚ RE will also change based on the change in NI‚ so everything balances.

Answer 175

A Section 338(h)(10) election blends the benefits of a Stock Purchase and an Asset Purchase: • Legally it is a Stock Purchase‚ but accounting-wise it's treated like an Asset Purchase. • The seller is still subject to double-taxation - capital gains on any Assets that have appreciated and on the proceeds from the sale. • But the buyer receives a step-up tax basis on the new Assets it acquires‚ and it can depreciate and amortize them so it saves on taxes. Even though sellers still get taxed twice‚ buyers will often pay more in a 338(h)(10) deal b/c of the tax-savings potential. It's particularly helpful for: • Sellers w/ high NOL balances (more tax-savings for the buyer b/c this NOL balance will be written down completely - so more of the excess purchase price can be allocated to Asset Write-Ups) • Companies that have been S-Corporations for over 10 years - in this case they do not have to pay taxes on the appreciation of their Assets. • NOTE: The requirements to use 338(h)(10) are complex and it cannot always be used. For example‚ if the seller is a C-Corporation it can't be applied; also‚ if the buyer is not a C-Corporation (e.g. a private equity firm)‚ it also can't be used.

Answer 176

Sure - b/c the PE firm uses a certain percentage of Debt to buy this company in the beginning. So if they raise $500M of Debt and only pay w/ $500M in cash‚ and then the company pays off that $500M of Debt over 5 years and the firm receives back $1B in cash at the end‚ that's a 15% IRR.

Answer 177

* It hides the amount of debt principal and interest that a company is paying each year‚ which can be very large and make company cash flows negative‚ also hides CapEx spending * EBITDA also ignores working capital requirements (e.g. A/R‚ Inv.‚ A/P)‚ which can be large for some companies * in a lot of cases EBITDA may not even be close to true cash flow‚ it's widely used for convenience and comparability (better for comparing cash generated by a company's core business operations than other metrics)

Answer 178

* In short‚ no. The complex methods give you similar numbers most of the time - you're not using them to get "better" numbers‚ but rather to get better support for those numbers. * If you just say‚ "Revenue grows by 10% per year‚" there isn't much evidence to back up that claim. But if you create a bottoms-up revenue model by segment‚ then you can say‚ "The 10% growth is driven by a 5% price increase in this segment‚ a 10% increase in units sold here‚ 15% growth in units sold in this geography" and so on.

Answer 179

* To tie the 3 statements together‚ NI from the I/S becomes the top line of the SCF. * Then you add back any non-cash charges such as D&A to this NI number. * Next‚ changes to operational B/S items appear and either reduce or increase cash flow depending on whether they are Assets or Liabilities and whether they go up or down. That gets you to CFO. * Now you take into account investing and financing activities and changes to items like PP&E and Debt on the B/S; those will increase or decrease cash flow‚ and at the bottom you get net change in cash. * On the B/S for the end of this period‚ Cash at the top equals the beginning Cash number (from the start of this period)‚ plus the net change in cash from the SCF. * On the other side‚ NI flows into SE to make the B/S balance. * At the end‚ Assets must always equal Liabilities plus SE.

Answer 180

When Prepaid Expenses "decrease‚" it means that expenses are now recognized on the I/S. For example‚ we've previously paid for an insurance policy in cash and have now recognized that same expense on the I/S. • I/S: Pre-Tax Income is down by $10 and NI is down by $6. • SCF: NI is down by $6 but since Prepaid Expense is an Asset‚ a decrease of $10 results in an increase of $10 in cash. At the bottom of the SCF‚ cash is up by $4 as a result. • B/S: On the Assets side‚ Cash is up by $4 and Prepaid Expense is down by $10‚ so the Assets side is down by $6 overall. On the other side‚ SE is down by $6 b/c of the reduced NI‚ so both sides balance. • Intuition: Here‚ we're losing NI and paying additional taxes‚ but we've already paid out these expenses in cash previously. So our Cash balance goes up rather than down‚ despite the additional I/S expenses.

Answer 181

``` Common Sensitivities: • Revenue Growth vs. Terminal Multiple • EBITDA Margin vs. Terminal Multiple • Terminal Multiple vs. Discount Rate • Terminal Growth Rate vs. Discount Rate ```

Answer 182

1. Reduce the Purchase Price. 2. Increase the Exit Multiple and Exit Price. 3. Increase the Leverage (debt) used. 4. Increase the company's growth rate (organically or via acquisitions) 5. Increase margins by reducing expenses (cutting employees‚ consolidating buildings‚ etc.) • These are all "theoretical" and refer to the model rather than reality - in practice it's hard to actually implement these changes.

Answer 183

* Nothing "happens" b/c you still run the analysis as-is. The company's value will certainly decrease if one or both of these turn negative, b/c the present value of FCF will decrease as a result. * The analysis is not necessarily invalid even if cash flow is negative - if it turns positive after a point, it could still work. * If the company never turns cash flow-positive, then you may want to skip the DCF b/c it will always produce negative values.

Answer 184

* Most likely the firm with the strong brand will get the higher valuation * Remember that valuation is not a science‚ it's an art‚ and the market can behave irrationally. Values are not based strictly on financial criteria‚ and other factors such as brand name or "trendiness" can all make an impact.

Answer 185

The median multiples may change greatly in the next 5-10 years, so they may no longer be accurate by the end of the period you're looking at. This is why you look at a wide range of multiples and run sensitivity analyses to see how these variables impact the valuation.

Answer 186

* No changes to the Income Statement. On the Balance Sheet‚ Debt goes up and Shareholders' Equity goes down‚ canceling each other out‚ so that everything remains in balance. * On the Cash Flow Statement‚ there would be no changes to Cash Flow from Operations or Investing‚ but under Cash Flow from Financing‚ the additional Debt raised would cancel out the Dividend paid out to investors‚ so there would be no net change in cash.

Answer 187

* First‚ the Liabilities & Equity side is adjusted - the new debt is added‚ and the Shareholders' Equity is "wiped out" and replaced by however much Investor Equity the PE firm is contributing (i.e. how much cash it's paying for the company). * On the Assets side‚ Cash is adjusted for any cash used to finance the transaction and for transaction fees‚ and then Goodwill & Other Intangibles are used as a "plug" to make the B/S balance. * There will also be all the usual effects that you see in transactions: Asset Write-Ups and Write-Downs‚ DTLs‚ DTAs‚ Capitalized Financing Fees‚ and so on.

Answer 188

* The most common method here is to calculate Terminal Value using one method, and then to see what the implied long-term growth rate or implied multiple via the other method would be. * Example: You calculate Terminal Value with a long-term growth rate assumption of 4%. Terminal Value is $10,000. You divide that Terminal Value by the final year EBITDA and get an implied EBITDA multiple of 15x - but the Public Comps are only trading at a median of 8x EBITDA. In this case, your assumption is almost certainly too aggressive and you should reduce that long-term growth rate.

Answer 189

* past transactions are rarely 100% comparable - the transaction structure‚ size of the company‚ and market sentiment all make a huge impact * data on precedent transactions is generally more difficult to find than it is for public company comparables‚ esp. for acquisitions of small private companies

Answer 190

Here‚ nothing has been consolidated b/c we own less than 50% of the other company. So nothing on the statements yet reflects this other company. • I/S: We create an item "NI from Equity Interests" (or something similar) below our normal NI at the bottom‚ which results in our REAL NI (NI Attributable to Parent) increasing by $6 ($20 * 30%). • SCF: NI is up by $6‚ but we subtract this $6 of additional NI b/c we haven't really received it in cash when we own less than 50% - it's not as if we control the other company and can just "take it." Cash remains unchanged. • B/S: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this NI‚ so the Assets side is up by $6. On the other side‚ SE (RE) is up by $6 to reflect this increased NI‚ so both sides balance.

Answer 191

* I/S: Operating Income decreases by $10 due to the 10% Depreciation charge each year‚ and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense). Assuming a tax rate of 40%‚ NI falls by $12. * SCF: NI at the top is down by $12. Depreciation is a non-cash expense‚ so you add it back and the end result is that CFO is down by $2. That's the only change on the SCF‚ so overall cash is down by $2. * B/S: On the Assets side‚ Cash is down by $2 and PP&E is down by $10 due to the Depreciation‚ so overall the Assets side is down by $12. On the other side‚ NI was down by $12‚ SE is also down by $12 and both sides balance. * Remember that the Debt number itself does not change since we've assumed that nothing is paid back.

Answer 192

* I/S: No changes. * SCF: Inventory is an Asset so that reduces CFO - it goes down by $10‚ as does the Net Change in Cash at the bottom. * B/S: On the Assets side‚ Inventory is up by $10 but Cash is down by $10‚ so the changes cancel out and Assets still equals Liabilities & Equity. * Intuition: We've spent cash to buy Inventory‚ but haven't manufactured or sold anything yet.

Answer 193

* The exact treatment depends on the terms of the Purchase Agreement - the buyer might assume them or it might allow the seller to "cash them out" if the per-share purchase price is above the exercise prices of these dilutive securities. * If you assume that they're exercised‚ then you calculate dilution to the Equity Purchase Price in the same way you normally would - the Treasury Stock Method for options‚ and the "if converted" method for convertibles.

Answer 194

* First‚ note that interest expense NEVER shows up in the CFF section b/c it is tax-deductible and it always appears on the I/S. So showing anything in that section for interest expense would be double-counting. * You show PIK interest in the CFO section b/c it is a non-cash expense - we're adding it back b/c it's just like D&A. It reduces taxes but is not actually paid out in cash.

Answer 195

* Terminal Value = Final Year FCF * (1 + Growth Rate) / (Discount Rate - Growth Rate) * Here's the intuition behind it: Let's say that we know for certain that we'll receive $100 every year indefinitely, and we have a required return of 10%. * That means we can "afford" to pay $1000 now ($100/10%) to receive $100 in Year 1 and $100 in every year after that forever. * But now let's say that the stream of $100 were actually growing each year - if that's the case, then we could afford to invest more than the initial $1000. * Let's say that we expect the $100 to grow by 5% every year - how much can we afford to pay now to capture all those future payments, if our required return is 10%? * Well that growth increases our effective return, so now we can pay more and still get the same 10% return. We can estimate the $100 by (10% - 5%). 10% is our required return and 5% is the growth rate. So in this case, $100 / (10% - 5%) = $2000. * This corresponds to the formula above: $100 represents Final Year FCF * (1 + Growth Rate), 10% is the Discount Rate, and 5% is the Growth Rate. * The higher the expected growth, the more we can afford to pay upfront. And if the expected growth is the same as the required return, theoretically, we can pay an infinite amount (you get a divide by zero error in the equation) to achieve that return.

Answer 196

* You expense transaction and miscellaneous fees (such as legal and accounting services) upfront and capitalize the financing fees and amortize them over the term of the debt. * Expensed transaction fees come out of Retained Earnings when you adjust the B/S (and Cash on the other side)‚ while Capitalized Financing Fees appear as a new Asset on the Balance Sheet (and reduce Cash immediately) and are amortized each year according to the tenor of the debt. * In reality‚ you pay for all of these fees upfront in cash. However‚ since financing fees correspond to a long-term item rather than a one-time transaction‚ they're amortized over time on the Balance Sheet. It's similar to how new CapEx spending is depreciated over time. * NONE of this affects Purchase Price Allocation. These fees simply increase the "Funds Required" number discussed above‚ but they make absolutely NO impact on the Equity Purchase Price or on the amount of Goodwill created.

Answer 197

* You generally calendarize to company you're valuing‚ so in this case‚ Jun 30 * For the Mar 31: take the current FY‚ add the Mar 31 - Jun 30 period‚ subtract the Mar 31 - Jun 30 period from the previous FY * For the Dec 31‚ take the current FY‚ add the Jan 1 - Jun 30 period‚ subtract the Jan 1 - Jun 30 period from the previous FY

Answer 198

Generally‚ precedent transactions will produce higher numbers because a buyer must pay a premium to acquire another company

Answer 199

1. Highlight the 75th percentile or higher for the multiples rather than the median 2. Add in a premium to some of the multiples 3. Use more aggressive projections for the company

Answer 200

* This means that the interest a firm pays on debt is tax-deductible - so they save money on taxes and therefore increase their cash flow as a result of the debt from the LBO. * Note‚ however‚ that the firm's cash flow is still lower than it would have been w/o the debt - saving on taxes helps‚ but the added interest expense still reduces Net Income by more than the reduced taxes helps the firm. * A lot of people get confused about this point and think that this "tax shield" is a really big deal in an LBO‚ but it makes marginal difference compared to all the other variables.

Answer 201

* Company has just reported earnings well above expectations and its stock price has risen in response * has some type of competitive advantage not reflected in financials‚ such as a key patent or other intellectual property * just won a favorable ruling in a major lawsuit * is the market leader in an industry and has greater market share than its competitors

Answer 202

* In this case‚ you would start recording a lower CapEx charge on the combined SCF‚ and then reflect a reduced Depreciation charge on the I/S from that new CapEx spending each year. * You would not start seeing the results until Year 2 b/c reduced Depreciation only comes after reduced CapEx spending. This scenario would be much easier to model w/ a full PP&E schedule where you can adjust the spending and the resulting Depreciation each year.

Answer 203

TRICK QUESTION • You should always take these charges from the SCF if possible‚ sometimes the charges are partially embedded within other line items on the I/S. If they don't appear on the SCF‚ look them up in the Notes to the Financial Statements. • You only add them back to EBITDA if they're truly non-recurring charges. If a company claims to be "restructuring" for the past 5 years‚ that's not exactly a non-recurring expense...

Answer 204

1. Select the precedent transactions based on industry‚ date and size. 2. For each transaction‚ get the seller's share price 1 day‚ 20 days‚ 60 days before the transaction was announced‚ i.e. the unaffected share price (you can also look at 90-day intervals‚ or 30 days‚ 45 days‚ etc.) 3. Calculate the 1-day premium‚ 20-day premium‚ etc. by dividing the per-share purchase price by the appropriate share price on each day. 4. Get the medians for each set‚ and then apply them to your company's share price‚ share price 20 days ago‚ and so on to estimate how much of a premium a buyer might pay for it. • You only use this when valuing a public company b/c private companies don't have share prices. Sometimes the set of companies here is exactly the same as your set of precedent transactions‚ but typically is broader.

Answer 205

* WB dislikes EBITDA b/c it hides the CapEx companies make and disguises how much cash they require to finance their operations * Any industry that is capital intensive and asset-heavy will have a huge disparity between EBIT and EBITDA * Note: EBIT itself does NOT include CapEx but it includes depreciation (which is directly linked to CapEx). If a company has high depreciation‚ chances are it has high CapEx spending

Answer 206

* If the company has existing debt and the PE firm refinances it (pays it off)‚ it's a non-factor b/c it goes away. If the PE firm assumes the debt instead‚ you need to factor in interest and principal repayments on that debt over future years. * Normally you do this by assuming that existing debt interest is paid off first after you've calculated Cash Flow from Operations minus CapEx. Then‚ you can use any remaining cash flow after that to pay off debt principal for new debt raised in the LBO.

Answer 207

* Usually there is a correlation between growth and valuation multiples * Math also plays a role‚ sometimes companies w/ extremely high EBITDA margins may have lower EBITDA multiples because EBITDA itself is much higher to begin with (and its in the denominator)

Answer 208

* A seller almost always prefers a Stock Purchase to avoid double taxation and to dispose of all its Liabilities. * A buyer almost always prefers an Asset Purchase so it can be more careful about what it acquires and to get the tax benefit from being able to deduct D&A on Asset Write-Ups for tax purposes. * However‚ it's not always possible to "pick" one or the other - for example‚ if the seller is a large public company only a Stock Purchase is possible in 99% of cases.

Answer 209

* Break it down and think of the individual components of WACC: Cost of Equity, Cost of Debt, Cost of Preferred, and the percentages for each one. Then, think about the individual components of Cost of Equity: the Risk-Free Rate, the Equity Risk Premium & Beta. * The Risk-Free Rate would decrease b/c governments worldwide would drop interest rates to encourage spending; but then Equity Risk Premium would also increase by a good amount as investors demand higher returns before investing in stocks; Beta would also increase due to all the volatility; so overall, we can guess that the Cost of Equity would increase b/c the latter two increases would likely more than make up for the decrease in the risk-free rate. * Now for WACC, the Cost of Debt and Cost of Preferred Stock would both increase as it would become more difficult for companies to borrow money; the Debt to Equity ratio would likely increase because companies' share prices would fall, meaning that Equity Value decreased for most companies while Debt stayed the same; so proportionally, yes, Debt and Preferred would likely make up a higher percentage of a company's capital structure; but remember: the Cost of Debt and Cost of Preferred both increase, so that shift doesn't matter too much; as a result, WACC almost certainly increases b/c almost all these variables push it up - the only that pushes it down is the reduced risk-free rate. * There's a simpler way to think about it as well: all else being equal, did companies become more valuable or less valuable during the financial crisis? Less valuable - because the market discounted their future cash flows at a higher rates, so WACC must have increased.

Answer 210

A high amount of Goodwill & Other Intangibles would be created if the purchase price is far above the Shareholders' Equity of the target. In the years following the acquisition‚ the buyer may record a large Goodwill Impairment Charge if it reassess the value of the seller and finds that it truly overpaid.

Answer 211

For the same reason you add them back on the SCF: you want to reflect the fact that they save the company on taxes, but that the company does not actually pay the expense in cash.

Answer 212

* Liquidation Valuation: valuing a company's assets‚ assuming they are sold off and then subtracting Liabilities to determine how much capital‚ if any‚ equity investors receive * LBO Analysis: determining how much a PE firm could pay for a company to hit a target IRR‚ usually in the 20-25% range * Sum of the Parts: Valuing each division of a company separately and adding them together at the end * M&A Premiums Analysis: analyzing M&A deals and figuring out the premium that each buyer paid‚ and using this to establish what your company is worth * Future Share Price Analysis: projecting a company's share price based on the P/E multiples of the public company comparables and then discounting it back to its present value

Answer 213

Although Depreciation is a non-cash expense‚ it is tax-deductible. Therefore‚ an increase in Depreciation will reduce the amount of taxes you pay‚ which boosts your cash balance. The opposite happens if Depreciation decreases.

Answer 214

1. You could use the Comparable Companies and the Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews (internet start-ups) rather than EV/Revenue or EV/EBITDA 2. You could use a "far-in-the-future" DCF and project a company's financials out until it actually earns revenue and profit (e.g. biotech and pharmaceutical firms)

Answer 215

* Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and Noncontrolling Interests (and any other debt-like items) to get to Equity Value. * Then you divide by the company's share count (factoring in all dilutive securities) to determine the implied per-share price.

Answer 216

* Income Statement: We record a Gain of $500‚ since we sold Balance Sheet Assets of $500 for $1000. That boosts Pre-Tax Income by $500 and Net Income by $300 assuming a 40% tax rate. * Cash Flow Statement: Net Income is up by $300‚ but we subtract the Gain of $500 in the CFO section‚ so cash flow is down by $200 so far. We add the full amount of sale proceeds ($1000) in the CFI section‚ so cash at the bottom is up by $800. * Balance Sheet: Cash on the Assets side is up by $800‚ but we've lost $500 in Assets‚ so the Assets side is up by $300. On the other side‚ Shareholders' Equity is also up by $300 due to the increased Net Income. * In this scenario‚ you'd also have to go back and remove revenue and expenses from this sold-off division and label them "Discontinued Operations" on the financial statements prior to the close of the sale.

Answer 217

* Goodwill typically stays the same over many years and is not amortized. It changes only if there's Goodwill Impairment (or another acquisition). * Other Intangible Assets‚ by contrast‚ are amortized over several years and affect the Income Statement by reducing Pre-Tax Income. * Technically‚ Other Intangible Assets might represent items that "expire" over time‚ such as copyrights or patents‚ but you do not get into that level of detail as a banker - it's something that accountants and auditors would determine post-acquisition.

Answer 218

* Company A Cost of Stock = 1/15 = 6.67% * Company B Yield = 1/10 = 10% * Therefore‚ the after-tax Cost of Debt must be above 10% for the acquisition cost to exceed Company B's Yield. * 10% / (1 - 40%) = 16.67%‚ so we can say "above approximately 17%" for the answer. That is an exceptionally high interest rate‚ so a 100% debt deal here would almost certainly be accretive instead.

Answer 219

* Adv.: ignores "noise" in the market and determines value based on assets & liabilities * Dis.: not useful for most healthy companies b/c it tends to produce extremely low values * Val.: 99% of the time will produce the lowest number b/c most companies are worth more than what their book value (balance sheets) suggest

Answer 220

* It depends on the economy and fundraising climate for PE firms‚ but an IRR in the 20-25% range‚ or higher‚ would be "good." It far exceeds the average annual return of the stock market‚ and is significantly above the yields on corporate and municipal bonds. * Sometimes PE firms will go lower and accept a 15-20% IRR‚ but usually they target at least 20%. Remember that PE is a riskier and less liquid asset class than equities or bonds‚ so the investors in the PE fund need to be compensated for that in the form of higher returns.

Answer 221

* Usually‚ you look at the TTM period for both sets and then you look forward 1 or 2 years. * You're more likely to look backward more than 1 year and go forward more than 2 years for public company comparables‚ for precedent transactions it's odd to go forward more than 1 year b/c the information is more limited.

Answer 222

* Adv.: not as subject to market fluctuations‚ theoretically sound since it's based on ability to generate cash flows * Dis.: subject to far-in-the-future assumptions‚ less useful for fast-growing‚ unpredictable companies * Val.: tends to be the most variable b/c of dependence on assumptions

Answer 223

1. Business Profile (sector‚ products and services‚ customers and end markets‚ distribution channels‚ geography) 2. Financial Profile (size‚ profitability‚ growth profile‚ return on investment‚ credit profile)

Answer 224

* Typically this happens when the customer pays upfront‚ in cash‚ for months or years of a product/service‚ but the company hasn't delivered it yet. You see this in web-based subscription software‚ cell phone carriers that sell annual contracts‚ and magazine publishers that sell subscriptions. * You only record revenue when you actually deliver the products/services - so the company does not record cash collected as revenue right away.

Answer 225

* A DCF values a company based on the present value of its Cash Flows and the present value of its Terminal Value. * First, you project a company's financials using assumptions for revenue growth, margins, and the Change in Operating Assets and Liabilities; then you calculate FCF for each year, which you discount and sum up to get to the NPV. The Discount Rate is usually the WACC. * Once you have the present value of the FCFs, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then you discount that back to its NPV using the Discount Rate. * Finally, you add the two together to determine the company's Enterprise Value.

Answer 226

* They use leverage to increase their returns. * Any debt raised for an LBO is not "your money"‚ so if you're paying $5B for a company‚ it's easier to earn a high return on $2B of your own money and $3B borrowed from other people than it is on $5B of your own money. * A secondary benefit is that the firm also has more capital available to purchase other companies b/c they've used debt rather than their own funds.

Answer 227

• REVOLVER: Lowest Int. Rate‚ Floating Cash Int.‚ 3-5 year tenor‚ not amortized‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ No Call Protection‚ Maintenance Covenant • TERM LOAN A: Low Int. Rate‚ Floating Cash Int.‚ 4-6 year tenor‚ straight-line amortized‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ Sometimes Call Protection‚ Maintenance Covenant • TERM LOAN B: Higher Int. Rate‚ Floating Cash Int.‚ 4-8 year tenor‚ minimal amortization‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ Sometimes Call Protection‚ Maintenance Covenant • SENIOR NOTES: Higher Int. Rate‚ Fixed Cash Int.‚ 7-10 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Senior Unsecured‚ Sometimes Secured‚ Yes Call Protection‚ Incurrence Covenant • SUBORDINATED NOTES: Higher Int. Rate‚ Fixed Cash Int.‚ 8-10 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Senior Subordinated‚ Not Secured‚ Yes Call Protection‚ Incurrence Covenant • MEZZANINE: Highest Int. Rate‚ Fixed Cash (or PIK) Int.‚ 8-12 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Equity‚ Not Secured‚ Yes Call Protection‚ Incurrence Covenant NOTES: • Each type of debt is arranged in order of rising interest rates - so Revolver has the lower interest rates‚ Term Loan A is slightly higher‚ B is slightly higher‚ Senior Notes are higher than Term Loan B and so on. • "Seniority" refers to the order of claims on a company's assets in a bankruptcy - the Senior Secured holders are first in line‚ followed by Senior Unsecured‚ Senior Subordinated‚ and then Equity Investors. • "Floating" or "Fixed" Interest Rates: A "floating" interest rate is tied to LIBOR. For example‚ L + 100 means that the int. rate of the loan is whatever LIBOR is at currently‚ plus 100 basis point (1.00%). A fixed int. rate‚ on the other hand‚ would be 11%. It doesn't "float" w/ LIBOR or any other rate. • Amortization: "Straight Line" means the company pays off the principal in equal installments each year‚ while "bullet" means that the entire principal is due at the end of the loan's lifecycle. "Minimal" just means a low percentage of the principal each year‚ usually in the 1-5% range. • Call Protection: Is the company prohibited from "calling back" - paying off or redeeming - the security for a given period? This is beneficial for investors b/c they are guaranteed a certain number of interest payments.

Answer 228

Depends on how it's performing relative to the index and relative to companies in its own industry (outperforming can lead to $25-30M‚ performing on par would be $20M‚ or underperforming would be

Answer 229

* The same way you do it anywhere else: you look at what comparable companies are trading at‚ and at what multiples similar LBO transactions have been completed at. As always‚ you show a range of purchase and exit multiples using sensitivity tables. * Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but this is just for valuation purposes if you're using an LBO model to value the company.

Answer 230

It should be higher for the $500M company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and are therefore "riskier").

Answer 231

* Remember the definitions of Assets and Liabilities: an Asset results in more future cash and a Liability results in less future cash. * Think about how Deferred Revenue works: not only is the burden on us to deliver the product/service in question‚ but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as real revenue. * It's counter-intuitive‚ but that is why Deferred Revenue is a liability: it implies additional future expenses.

Answer 232

1. Select the universe of comparable companies based on key criteria (e.g. industry‚ financial metrics‚ geography) 2. Locate the necessary financial information 3. Spread key statistics‚ ratios‚ and trading multiples (e.g. revenue‚ revenue growth‚ EBITDA‚ EBITDA margins‚ revenue and EBITDA multiples) 4. Benchmark the comparable companies (min.‚ 25%ile‚ median‚ 75%ile‚ max) 5. Apply multiples & determine valuation

Answer 233

* P/E is dependent on company's capital structure‚ EV/EBIT and EV/EBITDA are capital structure-neutral. So you use P/E for financial institutions where interest is critical and capital structures are similar. * EV/EBIT includes D&A‚ where EV/EBITDA excludes it‚ more likely to use EV/EBIT in industries where D&A is large and where CapEx and fixed assets is important (manufacturing) and EV/EBIT where fixed assets are less important and where D&A is comparatively smaller (e.g. internet companies)

Answer 234

* There are a couple options here; you could attempt to "roll-forward" the financial statements to this date in between quarterly end dates. For example‚ you might create an Aug. 17 Balance Sheet by looking at the B/S as of Jun. 30 and the B/S as of Sep. 30 and averaging them (since Aug. 17 is roughly in the middle). * For the I/S and SCF‚ you could just take the Jul. 1 - Sep. 30 quarterly numbers and multiply by (43/90) since 43 days of the quarter will pass in the "combined" period between Aug. 17 and Sep. 30. * The main problem is that this method creates a lot of extra work‚ b/c now you have to roll forward all the statements to this random date‚ figure out the numbers from that date to the end of the quarter‚ and then add additional quarters until the end of the buyer's fiscal year. * So in practice‚ you usually assume a cleaner close date in merger models unless you need 100% precision for some reason.

Answer 235

* The most common variables to analyze are Purchase Price‚ %Stock/Cash/Debt‚ Revenue Synergies‚ and Expense Synergies. Sometimes you also look at different operating sensitivities‚ like Revenue Growth or EBITDA Margin‚ but it's more common to build these into your model as different scenarios instead. * You might look at sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Price vs. Cost Synergies‚ Purchase Price vs. Revenue Synergies‚ or Purchase Price vs % Cash (and so on).

Answer 236

* I/S: You record a Gain of $10 ($110 - $100)‚ so Pre-Tax Income is up by $10 and NI is up by $6 with a 40% tax rate. * SCF: NI is up by $6 but you subtract the Gain of $10‚ so CFO is down by $4. Under CFI‚ you record the $110 as an addition to cash flow‚ so cash is up by $106 so far. Then under‚ CFF‚ you pay off $90 worth of Debt‚ which reduces cash by $90. Overall‚ Cash at the bottom is up by $16. * B/S: Cash on the Assets side is up by $16 but Short-Term Securities is down by $100‚ so the Assets side is down by $84. On the other side‚ Debt is down by $90 but SE (RE) is up by $6 due to the NI increase‚ so that side is also down by $84 and both sides balance.

Answer 237

If A/R increases by $10‚ it means that we've recorded revenue of $10 but haven't received it in cash yet. For example‚ a customer has ordered a $10 product from us and we've delivered it‚ but we are still waiting on cash payment. • I/S: Revenue is up by $10 and so is Pre-Tax Income‚ which means that Net Income is up by $6 assuming a 40% tax rate. • SCF: NI is up by $6 but the A/R increase is a reduction in cash (since we don't have the cash yet)‚ so we need to subtract $10‚ which results in cash at the bottom being down by $4. • B/S: On the Assets side‚ Cash is down by $4 and A/R is up by $10‚ so the Assets side is up by $6. On the other side‚ SE is up by $6 b/c NI has increased by $6. Both sides balance. • Intuition: When A/R increases‚ it means that we've paid taxes on additional revenue but haven't received any of that revenue in cash yet‚ so our cash balance decreases by the additional amount in taxes we've paid.

Answer 238

highly unusual‚ but could happen if company has substantial hard assets but market was severely undervaluing it for a specific reason (missed earnings or cyclicality)

Answer 239

* No‚ by definition EBITDA must be greater than or equal to EBIT‚ b/c EBITDA = EBIT + D&A (neither of which can be negative‚ can be $0 theoretically) * Since EBITDA is always greater than or equal to EBIT‚ EV/EBITDA must always be less than or equal to EV/EBIT for a single company

Answer 240

* You would use the SCF b/c it gives a true picture of how much cash the company is actually generating - the I/S is misleading b/c it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures. * And that's the #1 thing you care about when analyzing the financial health of any business - its true cash flow.

Answer 241

* Equity Value / Book Value‚ Price per Share / Book Value per Share * BV multiples have become less relevant over time b/c most firm's equity value (market value) is vastly different from its book value (Shareholder's Equity on the B/S). * This is b/c firms have become more service-oriented and intellectual property-oriented.

Answer 242

* Many companies have non-cash charges such as Amortization and Intangibles‚ Stock-Based Compensation‚ and Write-Downs on their Income Statements‚ all of which negatively impact their Net Income. * Companies therefore report alternative "Pro Forma" metrics that exclude these expenses and paint a more favorable picture of their earnings‚ under the argument that these metrics better represent "true cash earnings."

Answer 243

It's impossible to say b/c it could go either way depending on the assumptions. There's no general rule that always applies, or that even applies most of the time.

Answer 244

* Normally you use the country's long-term GDP growth rate, the rate of inflation, or something similarly conservative. * For companies in developed countries, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

Answer 245

* no company is 100% comparable to another company * stock market is "emotional"‚ multiples might be dramatically higher or lower on certain dates depending on market movements * share prices for small companies w/ thinly traded stocks may not reflect full value

Answer 246

No‚ you almost always show a range. You may make the median the center of the range‚ but you don't have to (you could focus on 75%ile‚ 25%ile or anything else‚ depending on if the company is outperforming‚ underperforming‚ etc.)

Answer 247

* Increased leverage‚ past a certain point could easily reduce IRR: * If interest payments and principal repayments exceed the company's cash flow‚ the IRR will drop. * If there's declining growth or margins‚ you could also get a scenario where increasing debt past a certain point results in a lower IRR. * Most of the time increasing the Debt balance increases the IRR - but not always. The trick with an LBO is to find the "sweet spot" that maximizes the IRR for the PE firm but which also doesn't make it difficult for the company to repay debt.

Answer 248

* Calendarization is used b/c different companies have different fiscal years. * This creates a problem b/c you can't directly compare all these periods. You always need to look at the same calendar period when you create a set of public comps. * So you adjust all the fiscal years by adding and subtracting "partial" periods. You almost always adjust other companies' fiscal years to match the company you're valuing. * Ex.: If you fiscal year July 1 - Jun 30 and need to calendarize to end on Dec 31‚ you would 1) start with a Jul 1 - Jun 30 statement‚ 2) add the Jul 1 - Dec 31 financials from THIS year‚ 3) subtract the Jul 1 - Dec 31 financials from LAST year

Answer 249

* The mechanics are the same‚ but the transaction structure is more likely to be an Asset Purchase or 338(h)(10) Election; private sellers also don't have Earnings per Share so you would only project down to Net Income on the seller's Income Statement. * Note that accretion/dilution makes no sense if you have a private buyer because private companies do not have Earnings per Share.

Answer 250

* The rule is that you divide the stub discount period by 2, and then you simply subtract 0.5 from the "normal" discount periods of the future years. (See p. 53 for example of a Q4 stub). * See (p. 53-54) another example for a Q2-Q4 stub (e.g. we're valuing the company on Mar. 31 and its Fiscal Year ends on Dec. 31) * What is the logic here? Think about it like this: let's take the example of the normal discount period for Year 1 being 1.75, representing 3 quarters and then a full year. * Now ask yourself when you receive that cash flow in Year 1. You're still receiving it midway through that 1st Year, in other words, you still use 0.5 of that period. * However, you also need to take into account the 3/4 of this partial year b/c 3 quarters pass between now and the start of Year 1. So you still have 0.75 there, and the mid-year discount period with the stub period is 0.75 + 0.5, or 1.25. * That is why it's not 1.75/2 like you might expect: it's about when you receive that cash flow in a given Year, from the perspective of the start of Year 1 - and then you add the total amount of time that passes between now and the start of Year 1. There's no mid-year discount applied there b/c we don't receive any Year 1 cash in this 1st partial year.

Answer 251

You would use Cost of Equity rather than WACC since we're ignoring Debt and Preferred Stock and only care about the Equity Value for Levered FCF.

Answer 252

* This is like asking‚ "If declaring bankruptcy helps you relieve your obligations‚ why not do it whenever you rack up debt?" * And the answer is similar: b/c it may help in the short-term‚ but in the long-term it hurts the company's credibility and ability to borrow in the future. If a company continually writes down its Liabilities‚ investors will stop trusting it - and the inability to borrow again will hurt it far more than a reduced NI would.

Answer 253

Earnings Before Interest & Taxes: This is the firm's operating income from the I/S (Revenue - COGS - Operating Expenses). This includes impact of depreciation‚ amortization and other non-cash charges

Answer 254

* This one's subtle‚ but you frequently see both of these items on the statements b/c a company can owe AND save on future taxes - for different reasons. * For example‚ they might have Net Operating Losses (NOLs) b/c they were unprofitable in early years‚ and those NOLs could be counted as DTAs. * But they might also record accelerated Depreciation for tax purposes‚ but straight-line it for book purposes‚ which would result in a DTL in early years.

Answer 255

* I/S: Revenue is up by $20 and COGS is up by $10‚ so Gross Profit‚ Operating Income‚ and Pre-Tax Income are all up by $10. Assuming a 40% tax rate‚ NI is up by $6. * SCF: NI at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the Inventory into real iPads)‚ which is a net addition to cash flow - so CFO is up by $16 overall. These are the only changes on the CFS‚ so cash at the bottom is up by $16. * B/S: Cash is up by $16 and Inventory is down by $10‚ so the Assets side is up by $6 overall. On the other side‚ NI was up by $6‚ so SE is up by $6 and both sides balance. * Intuition: This simply reflects the sale of products at a certain cost‚ and the after-tax profit from that. The only tricky part is how Cash increases by $16‚ not $6 - that just reflects the "release" in net working capital you get from selling off the Inventory.

Answer 256

* Usually this happens when a company buys another one and the acquirer reassess what it really got out of the deal - customer relationships‚ brand name‚ and intellectual property - and finds that those "Assets" are worth significantly less than they originally thought. * It often happens in acquisitions where the buyer "overpaid" for the seller and it can result in extremely negative Net Income on the I/S. * It can also happen when a company discontinues part of its operations and must impair the associated Goodwill.

Answer 257

* First‚ note that you ONLY look at optional repayments for Revolvers and Term Loans - High-Yield Debt doesn't have a prepayment option‚ so effectively it's always $0. * You start by checking how much cash flow is available based on your Beg. Cash Balance‚ Min. Cash Balance‚ Cash Flow Available for Debt Repayment from the Cash Flow Statement‚ and how much you've spent on Mandatory Debt Repayments so far. * Then‚ if you've used your Revolver at all‚ you pay off the maximum amount that you can with the cash flow you have available. * Next‚ for Term Loan A you assume that you pay off the maximum possible amount‚ taking into account the fact that you have less cash flow from having paid down the Revolver. You also need to take into account the fact that you might have paid off some of Term Loan A's principal as part of the Mandatory Repayments. * Finally‚ you do the same thing for Term Loan B‚ subtracting from the "cash flow available for debt repayment" what you've already used for the Revolver and Term Loan A. * Just like with Term Loan A‚ you need to take into account any Mandatory Repayments you've made so that you don't pay off more than the entire Term Loan B balance. * The formulas here get very messy and depend on how your model is set up‚ but this is the basic idea for optional debt repayments.

Answer 258

* They are different concepts (yes, the names get very confusing here). You always use Levered Beta with Cost of Equity b/c Debt makes the company's stock riskier for everyone involved. * And you always use that same Cost of Equity number for both Levered FCF, where Cost of Equity itself is the Discount Rate, and also for Unlevered FCF, where Cost of Equity is a component of the Discount Rate (WACC).

Answer 259

* This represents the scenario where the company itself uses its excess cash (i.e. if it only requires $10M in cash but has $50M on its B/S‚ $40M is the excess cash) to fund the transaction. This always shows up in the Sources column. * It's just like how you subtract Cash when calculating Enterprise Value: an acquirer would "receive" that Cash upon buying the company. * You do not always see this item - it's more common when the company has a huge amount of excess cash and has no real reason for having it.

Answer 260

The "Net Asset" or "Liquidation" model‚ where you value the firm's assets and liabilities‚ then subtract the modified Total Liability Value from the modified Total Asset Value. This method is more common in balance sheet-centric industries such as insurance.

Answer 261

* It's best to split out the historical data by quarters and then to analyze the Year-over-Year (YoY) Growth for each quarter. For example‚ in Q1 of Year 2 you would look at how much the company has grown revenue by in Q1 of previous years. * It wouldn't make much sense to use Quarter-over-Quarter growth (i.e. Q1 over Q4 in the previous year) b/c many companies are seasonal. * The same applies for expenses as well: always make sure you take into account seasonality w/ quarterly projections.

Answer 262

A percentage that's less than 10%, for two reasons: 1. Remember that we discount all those FCFs - so even if they increase by 10%, the present value change is less than 10%. 2. There's still the Terminal Value and the present value of that. That has NOT increased by 10%, so neither has the company's total value. • You can't give an exact number for the increase without knowing the rest of the numbers (Discount Rate, Terminal Value, etc.) in the analysis.

Answer 263

* Normally you look at the Public Comps and pick the median of the set, or something close to it. * You always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. * So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples ranging from 6x to 10x.

Answer 264

1. Value each division of a company using Comparable Companies and Precedent Transactions. 2. Get to separate multiples for each division and apply to company's division's metrics for division valuation. 3. Add up each division's value to get total value for company • picking a range of multiples for each division is crucial

Answer 265

* Tax Benefits simply record what the company has saved in taxes as a result of issuing Stock-Based Compensation (e.g. they issue $100 in SBC and have a 40% tax rate so they save $40 in taxes). * Excess Tax Benefits are a portion of these normal Tax Benefits and represent the amount of taxes they've saved due to share price increases (i.e. the Stock-Based Compensation is worth more due to a share price increase since they announced plans to issue it). * Neither one is a separate item on the I/S. * On the SCF‚ Excess Tax Benefits are subtracted out of CFO and added to CFF‚ effectively "re-classifying" them. Basically you're saying‚ "We've gotten some extra cash flow from our share price increasing‚ so let's call it what it is: a financing activity." * Also on the SCF‚ you add back the Tax Benefits in CFO. You do that b/c you want them to accrue to APIC on the B/S. You're saying‚ "In addition to the additional value we created w/t his stock/option issuance‚ we've also gotten some value from the tax savings‚ so let's reflect that value along with the SBC itself under APIC."

Answer 266

* Under cash-based accounting‚ the revenue would not show up until the company charges the customer's credit card‚ receives authorization‚ and deposits the funds in its bank account - at which point it would add to Revenue on the I/S (and Pre-Tax Income‚ Net Income‚ etc.) and Cash on the B/S. * Under accrual accounting‚ it would show up as Revenue right away but instead of appearing in Cash on the B/S‚ it would go into A/R at first. Then‚ once the cash is actually deposited in the company's bank account‚ it would move into the Cash line item and A/R would go down.

Answer 267

* Adv.: based on what real companies have actually paid for other companies * Dis.: data can be spotty (esp. for private acquisitions)‚ there may not be truly comparable transactions

Answer 268

* This gets confusing b/c there are contradictory definitions. The simplest one is that Pro-Forma numbers exclude certain non-cash acquisition effects (e.g. Amortization of Newly Created Intangibles‚ Depreciation of PP&E Write-Up‚ Deferred Revenue Write-Down‚ Amortization of Financing Fees) * Some people include all of these‚ other people include only some of these‚ and companies themselves report numbers in different ways. Excluding Amortization of Intangibles is the most common adjustment here. * While a lot of companies report numbers this way‚ the concept itself is flawed and inconsistent b/c companies themselves already include existing non-cash charges like D&A and stock-based compensation. To make things even more confusing‚ some people will also add back some or all of those items as well.

Answer 269

* Trick question. If the Convertible Bonds are in-the-money then you do not count them as Debt, but instead assume that they contribute to dilution, so the company's Equity Value is higher. * If they're out-of-the-money, then you count them as Debt and use the interest rate on the Convertible Bonds for the Cost of Debt (and include them in Debt in the formula for Levered Beta).

Answer 270

You pay for all of these fees upfront in cash (legal‚ advisory‚ and financing fees paid on the debt)‚ but the accounting treatment is different: • Legal & Advisory Fees: these come out of Cash and Retained Earnings immediately as the transaction closes. • Financing Fees: These are amortized over time (for as long as the Debt remains outstanding)‚ very similar to how CapEx and PP&E work: you pay for them upfront in cash‚ create a new Asset on the Balance Sheet‚ and then reduce that Asset over time as the fees are recognized on the Income Statement.

Answer 271

* Once again‚ Company B's Market Cap gets wiped out since it no longer exists as an independent entity. So Combined Market Cap = 80. * The combined company has 40 of additional Debt‚ so if we continue with the assumption that A has 60 of Debt and 40 of Cash‚ the Enterprise Value is 80 + 60 + 40 - 40 = 140‚ the same as in the previous example (IMPORTANT: Regardless of the purchase method‚ the combined Enterprise Value stays the same). * The Combined EBITDA is still 18‚ so EV/EBITDA = 140/18 = 7.78x * But the combined Net Income has changed. Normally‚ Company A Net Income + Company B Net Income = 6‚ but now we have 40 of debt at 10% interest‚ which is 4‚ and when multiplied by (1 - 25%)‚ equals 3. * So Net Income falls to 6 - 3 = 3‚ and Combined P/E = 80/3 = 26.7x

Answer 272

Call Protection refers to paying off the ENTIRE debt balance‚ whereas "Prepayment" refers to repaying PART of the principal early‚ before the official maturity date.

Answer 273

* Restructuring Charges‚ Goodwill Impairment‚ Asset Write-Downs‚ Bad Debt Expenses‚ One-Time Legal Expenses‚ Disaster Expenses‚ Changes in Accounting Policies * Note that to qualify as an "add-back" or "non-recurring" charge for EBITDA / EBIT purposes‚ it needs to affect Operating Income on the Income Statement. So if one of these charges is "below the line‚" then you do not add it back for the EBITDA / EBIT calculation. * Also note that you DO add back D&A and sometimes SBC when calculating EBITDA‚ but that these are not "non-recurring charges" b/c all companies have them every year - they're just non-cash charges.

Answer 274

* You record this 30% as an "Investment in Equity Interest" or "Associate Company" on the Assets side of the B/S‚ and you reduce Cash to reflect the purchase (assuming that Cash was used). You use this treatment for all ownership percentages between 20% and 50%. * You can still use an accretion/dilution analysis; just make sure that the new Net Income reflects the 30% of the other company's Net Income that you are entitled to.

Answer 275

* "Calendarizing" means "Rather than using a company's normal fiscal year figures‚ let's use another year-long period during the year and calculate their revenue‚ expenses‚ and other key metrics for that period. * For example‚ a company's fiscal year might end on Dec. 31 - if you calendarized it‚ you might look at the period from Jun. 30 in the previous year to Jun. 30 of this year rather than the traditional Jan. 1 - Dec. 31 period. * You do this most frequently w/ public comps b/c companies often have "misaligned" fiscal years. If one company's year ends Dec. 31‚ another's ends Jun. 30‚ and another's ends Sep. 30‚ you need to adjust and use the same time period for all of them - otherwise‚ you're comparing apples to oranges b/c the financial figures are all from different time periods.

Answer 276

* First‚ note that these convertible bonds are in-the-money b/c the company's share price is $100‚ but the conversion price is $50. So we count them as additional shares rather than debt. * Next‚ we need to divide the value of the convertible bonds $10M by the par value $1000 to figure out how many individual bonds there are ($10M / $1000 = 10‚000 convertible bonds). * Next‚ we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price: $1000 / $50 = 20 shares per bond * So we have 200‚000 new shares (20 * 10‚000) created by the convertibles‚ giving us 1.2M diluted shares outstanding. * We do not use the Treasury Stock Method with convertibles b/c we do not pay the company anything to "convert" the convertibles - it just becomes an option automatically once the share price exceeds the conversion price.

Answer 277

* Retail‚ Restaurant‚ and Airlines (EV/EBITDAR): used for comparability by adding back rental expense b/c some companies rent while others own * Oil & Gas Companies (EV/EBITDAX): used for comparability by adding back exploration expense b/c some companies capitalize (portions of) their expense while others expense directly to I/S. EV/Proved Reserves and EV/Daily Production are also important for energy. * Real Estate (P/FFO or P/AFFO): P = Price‚ FFO = Funds from Operations‚ AFFO = Adj. FFO‚ more accurate the P/E for REITs since they add back depreciation (large non-cash charge) and gains/losses * Internet Companies (EV/Unique Visitors or EV/Registered Users): used if company is not yet profitable or generating revenues

Answer 278

* I/S: On the Book I/S you list 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 $15 so NI fell by $9 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 $4. Book Pre-Tax income afterward was therefore $90 and Tax Pre-Tax Income was $85. Book Taxes were $36 and Cash Taxes were $34‚ so Book Taxes fell by $4 and Cash Taxes fell by $6). * SCF: On the Book Cash Flow Statement‚ NI is down by $6‚ but you add back the Depreciation of $10 and you add back $2 worth of Deferred Taxes - that represents the fact that Cash Taxes were lower than Book Taxes in Year 1. At the bottom‚ Cash is up by $6. * B/S: Cash is up by $6 but PP&E is down by $10 due to the Depreciation‚ so the Assets side is down by $4. On the other side‚ the DTL increases by $2 due to the Book/Cash Tax difference‚ but SE (RE) is down by $6 due to the lower NI‚ so both sides are down by $4 and balance.

Answer 279

* Either one works. You could assume that the buyer leverages the seller's products or services and sells them to its own customer base - but typically you assume an uplift to the seller's average selling price‚ or something else that the buyer can do w/ the seller's existing customers. * You approach it that way b/c the buyer‚ as a larger company‚ can make more of an immediate impact on the seller than the seller can make on the buyer.

Answer 280

* The same way you project the financial statements anywhere else: assume a revenue growth rate‚ make key expenses a percentage of revenue‚ and then tie Balance Sheet and Cash Flow Statement items to revenue and expenses on the Income Statement - and to historical trends. * To project the cash flow available to repay debt each year‚ you take Cash Flow from Operations and subtract CapEx. * Just as in the DCF Analysis‚ you assume that other items in the Investing and Financing sections are non-recurring and therefore do not impact future cash flows. * Note that this calculation only determines how much in debt principal the company could potentially repay - interest expense has already been factored in on the Income Statement‚ and its impact is already reflected in the Cash Flow from Operations number.

Answer 281

* This scenario refers to a Noncontrolling Interest (AKA Minority Interest): you consolidate all the financial statements and add 100% of the other company's statements to your own. * It's similar to a 100% acquisition where you do the same thing‚ but you also create a new item on the Liabilities & Equity side called a Noncontrolling Interest to reflect the portion of the other company that you don't own (e.g. if it's worth $100 and you own 70%‚ you would list $30 here). * Just like with normal acquisitions‚ you also wipe out the other company's SE when you combine its statement with yours‚ and you still allocate the purchase price. * You also subtract NI Attributable to Noncontrolling Interests on the I/S - in other words‚ the other company's Net Income * Percentage You Do Not Own. But then you add it back on the SCF in the CFO section. That is just an accounting rule and has no cash impact. * On the B/S‚ the Noncontrolling Interest line item increases by that number (NI Attributable to Noncontrolling Interests) each year. RE decreases by that same number each year b/c it reduces NI‚ so the B/S remains in balance.

Answer 282

* If the purchase corresponds to an Asset with a useful life of over 1 year‚ it is capitalized (put on the B/S rather than shown as an expense on the I/S). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years. * Purchases like factories‚ equipment and land all last longer than a year and therefore show up on the B/S. Employee salaries and the cost of manufacturing products (COGS) only "last" for the current period and therefore show up on the I/S as normal expenses instead. * Note that even if you're paying for something like a multi-year lease for a building‚ you would NOT capitalize it unless you own the building and pay for the entire building in advance.

Answer 283

* A merger model is used to analyze the financial profiles of 2 companies‚ the purchase price and how the purchase is made‚ and it determines whether the buyer's EPS increases or decreases afterward. * Step 1 is making assumptions about the acquisition - the price and whether it was done using cash‚ stock‚ debt‚ or some combination of those. Next‚ you determine the valuations and shares outstanding of the buyer and seller and project the Income Statements for each one. * Finally‚ you combine the Income Statements‚ adding up line items such as Revenue and Operating Expenses‚ and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate and get the Combined Net Income‚ and then divide by the new share count to determine the combined EPS. * You could also add in the part about Goodwill and combining the Balance Sheets‚ but it's best to start with answers that are as simple as possible at first.

Answer 284

* In theory, yes. If you know that a company's capital structure is definitely changing in a certain, predictable way in the future, sure, go ahead and use that. * In practice, you rarely know this information in advance, so it's not terribly practical to make this kind of assumption.

Answer 285

* NO‚ there are a number of assumptions here that rarely hold up in the real world: the seller and buyer have the same tax rates‚ there are no other acquisition effects such as new D&A‚ there are no transaction fees‚ no synergies‚ etc. * And most importantly‚ the rule truly breaks down if you use the seller's current share price rather than the price the buyer is paying to purchase it. * It's a great way to quickly assess a deal‚ but it is NOT a hard-and-fast rule.

Answer 286

* In this case‚ you have to project the financial statements for this "stub period‚" which is easier than it sounds b/c it is usually a matter of multiplying the full-year statements by 1/4‚ 1/2‚ 3/4‚ and so on. If you have quarterly projections‚ you could use those and avoid the need for extra math. * Example: If the PE firm buys the company on Mar. 31‚ you would multiply the line items on the full-year I/S and SCF by 3/4 to determine the numbers from Apr. 1 to Dec. 31‚ which is three-quarters of the year. You would also have to project the B/S to the Mar. 31 close date and use those numbers when adjusting the B/S and allocating the purchase price. * The IRR calculation will also be different in this case. * This concept is not difficult‚ but it creates extra work w/o a huge benefit so most LBO models are built based on full calendar years instead.

Answer 287

* You need to make sure that the buyer and the seller use the same fiscal years post-transaction. Normally you change the seller's financial statements to match the buyer's. * If the buyer's fiscal year ends on December 31 and the seller's ends on June 30‚ for example‚ you would have to take Q3 (Jan - Mar) and Q4 (Apr - Jun) from the seller's most recent fiscal year and then add Q1 (Jul - Sep) and Q2 (Oct - Dec) from the seller's current fiscal year to match the buyer's current fiscal year. * The 2nd point here is that you may also need to create a stub period from the date when the deal closes to the end of the buyer's current fiscal year. * For example‚ if the deal closes on September 30 but the fiscal year ends on December 31‚ the buyer and seller are still one combined company for that 3-month period and you need to account for that‚ normally via a separate "stub period" right before the start of the first full fiscal year as a combined entity.

Answer 288

* The idea is that you're replicating the SCF but only including recurring, predictable items. And in the case of Unlevered FCF, you also exclude the impact of Debt entirely. * That's why everything in CFI except for CapEx is excluded, and why the entire CFF is excluded (the only exception being Mandatory Debt Repayments for Levered FCF).

Answer 289

It could be a separate line item‚ or it could be embedded in COGS or Operating Expenses - each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduced Pre-Tax Income.

Answer 290

* Purchase and exit multiples (and therefore purchase and exit prices) have the greatest impact‚ followed by the amount of leverage (debt) used. * A lower purchase price equals a higher return‚ whereas a higher exit price results in a higher return; generally‚ more leverage also results in higher returns (as long as the company can still meet its debt obligations). * Revenue growth‚ EBITDA margins‚ interest rate and principal repayment on Debt all make an impact as well‚ but they are less significant than those first 3 variables.

Answer 291

* You calculate the IRR by making the amount of Investor Equity (Cash) that a PE firm contributes in the beginning a negative‚ and then making cash flows or dividends to the PE firm‚ as well as the net sale proceeds (basically the Equity Value) at the end‚ positives. * And then you can apply the IRR function in Excel to all the numbers‚ making sure that you've entered "0" for any periods where there's no cash received or spent. You can calculate IRR manually‚ but it's very time-consuming. * Technically‚ the IRR is defined as "the discount rate at which the net present value of cash flows from the investment equals 0." * It's easier to think of it as the effective interest rate: If you've invested that cash in the beginning and earned an interest rate of X% on it‚ compounded each year‚ you would earn the positive cash flows shown in the model.

Answer 292

* Mechanically‚ it's similar b/c you still allocate purchase price‚ combine and adjust the Balance Sheets‚ and combine the Income Statements‚ including acquisition effects. * The difference is that accretion/dilution is not meaningful if it's a private company b/c it doesn't have an EPS number; so you would place more weight on a contribution analysis‚ or even on something like the IRR of the acquisition.

Answer 293

* I/S: No changes. * SCF: You add back the $100 in Tax Benefits from SBC in CFO and subtract out the $40 in Excess Tax Benefits‚ so CFO is up by $60. Then under CFF‚ you add back the $40 in Excess Tax Benefits‚ so Cash at the bottom is up by $100. * B/S: Cash is up by $100‚ so the Assets side is up by $100. On the other side‚ Common Stock & APIC is up by $100 b/c Tax Benefits from SBC flow directly into there. * The Rationale: Essentially we're "reclassifying" the Tax Benefits OUT of CFO and saying that they should accrue to a company's SE. And we are also saying that Excess Tax Benefits (which arise due to share price increases) should be counted as a Financing activity but should NOT impact cash‚ since they're already a part of the normal Tax Benefits.

Answer 294

First‚ confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an Equity (Preferred Stock) investment from the government‚ so here's what happens: • I/S: No changes. • SCF: CFF goes up by $100 to reflect this new investment‚ so the Net Change in Cash is up by $100. • B/S: Cash is up by $100 so the Assets side is up by $100; on the other side‚ SE goes up by $100 to make it balance (Common Stock & APIC for a normal equity investment or Preferred Stock for preferred). • Intuition: It's the same as a normal stock issuance: no I/S changes b/c nothing affects the company's taxes.

Answer 295

When you're discounting the Terminal Value back to its present value, you use different numbers for the discount period depending on whether you're using the Multiples Method or Gordon Growth Method: • Multiples Method: You add 0.5 to the final year discount number to reflect that you're assuming the company gets sold at the end of the year. • Gordon Growth Method: You use the final year discount number as is, b/c you're assuming the FCFs grow into perpetuity and that they are still received throughout the year rather than just at the end.

Answer 296

The Discount Rate change will almost certainly have a bigger impact b/c that affects everything from the present value of FCFs to the present value of Terminal Value - and even a 10% change makes a huge impact.

Answer 297

Technically you should use Market Value for everything. In practice‚ however‚ you usually use market value only for the Equity Value portion b/c it's difficult to determine market values for the rest of the items in the formula - so you take the numbers from the company's Balance Sheet.

Answer 298

* Unlevered FCF = EBIT*(1 - Tax Rate) + Non-cash expenses - Change in Operating Assets & Liabilities - CapEx * Levered FCF = Net Income + Non-Cash expenses - Change in Operating Assets & Liabilities - CapEx - Mandatory Debt Repayments

Answer 299

* obviously for LBOs * used to "set a floor/lower bound" on company valuation‚ min. amount that PE firm would be willing to pay to achieve targeted returns * often see it used when both strategics (normal companies) and financial sponsors are competing to buy the same company and you want to determine the potential price if a PE firm were to acquire the company.

Answer 300

1. Equity Value = $500M/80% = $625M 2. Enterprise Value = Equity Value - Cash + Debt = $625M - $50M + $100M = $675M 3. Revenue Multiple = $675M / $300M = 2.25x 4. EBITDA Multiple = $675M / $100M = 6.75x

Answer 301

* You use a stub period when you're valuing a company before or after the end of its fiscal year and there are 1 or more quarters in between the current date and the end of the fiscal year. * For example, it's currently Sep. 30 and the company's fiscal year ends on Dec. 31. * In this case, it wouldn't be correct to assume that FCF only starts on Jan. 1 of the next year - there are still 3 months between now and the end of the year, the company still generates FCF in those 3 months, and you need to account for it somewhere in your model. * So you would calculate FCF in that 3-month period, use 0.25 for the discount period, and then use 1.25 for the discount period for the first full year of the model, 2.25 for the next year, and so on.

Answer 302

* I/S: Interest Income is $10 ($100 * 10%) and Interest Expense is $5 ($100 * 5%)‚ so Pre-Tax Income increases by $5‚ and NI increases by $3 assuming a 40% tax rate. * SCF: NI is up by $3. In CFF‚ we repay $10 worth of debt ($100 * 10%)‚ so cash at the bottom is down by $7. * B/S: Cash on the Assets side is down by $7‚ so the Assets side is down by $7. On the other side‚ Debt is down by $10 due to the repayment and SE (RE) is up by $3 due to the NI‚ so this side is also down by $7 and the B/S balances.

Answer 303

* In this case you have to use the XIRR function in Excel rather than the IRR function‚ and you enter the dates of all the cash flows in addition to the amounts. * The impact on IRR depends on the length of the holding period. If this "stub period" results in a longer holding period (5.5 years or 5.75 years rather than 5 years)‚ IRR will decrease because a longer time period means a lower effective interest rate. * If this "stub period" results in a shorter holding period (4.5 years or 4.75 years rather than 5 years)‚ IRR will increase b/c a shorter time period = a higher effective interest rate.

Answer 304

* To do this‚ you would get the EPS accretion/dilution to $0.00 and then back-solve in Excel to get the required synergies to make the deal neutral to EPS. * It's important b/c you want an idea of whether or not a deal "works" mathematically‚ and a high number for the break-even synergies tells you that you're going to need A LOT of cost savings or revenue synergies to make it work.

Answer 305

Two conditions must be true for an expense to appear on the I/S: 1. It must correspond to something in the current period 2. It must be tax-deductible. • Employee compensation and marketing spending‚ for example‚ satisfy both conditions. • Depreciation and Interest Expense also meet both conditions - Depreciation only represents the "loss in value" of PP&E (or to be more technically precise‚ the allocation of the investment in PP&E) in the current period you're in. • Repaying debt principal does NOT satisfy both of these conditions b/c it is not tax-deductible. • ADV. NOTE: Technically‚ "tax-deductible" here means "deductible for BOOK tax purposes" (i.e. only the tax number that appears on the company's I/S).

Answer 306

* b/c they're based on actual market data vs. assumptions about the future * note you still need to make future assumptions (Forward Year 1‚ Forward Year 2) * also‚ sometimes you may not have good or truly comparable data‚ in which case a DCF might produce better results

Answer 307

* If the buyer assumes the Debt‚ it appears in BOTH the Sources and Uses columns and has no effect on the Funds Required. * If the buyer pays off the Debt‚ it appears only in the Uses column and increases the Funds Required.

Answer 308

* Present range of valuations from different methodologies on a "football field" * to do this‚ calculate min.‚ 25%ile‚ median‚ 75%ile‚ max values for each set (2-3 years of comps and the transactions‚ for each different multiple used) and then multiply by the relevant metrics for the company you're analyzing) * For public companies‚ you will also work backwards to calculate Equity Value and implied per Share Price based on this.

Answer 309

* NI + Non-Cash Charges - Changes in Operating Assets & Liabilities - CapEx - Mandatory Debt Repayments * (EBIT - Net Interest Expense) * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets & Liabilities - CapEx - Mandatory Debt Repayments * CFO - CapEx - Mandatory Debt Repayments

Answer 310

DCF analysis works best for stable‚ mature companies with predictable growth rates and profit margins. It doesn't work as well for high-growth start-ups‚ companies on the brink of bankruptcy‚ and other situations where growth and margins are artificially high‚ low or unpredictable.

Answer 311

1. Unlike normal valuations‚ in an IPO valuation‚ we only care about public company comparables (we select them as we normally would). 2. Then‚ we decide on the most relevant multiple(s) to use and then estimate our company's Enterprise Value based on that (or Equity Value depending on the multiple). 3. Once we have the Enterprise Value‚ we work backwards to calculate Equity Value. We also have to account for the IPO proceeds in here (by adding them since we're working backwards‚ these proceeds are what the company receives in cash from the IPO) 4. Then we divide by the total number of shares (old and newly created) to get its per-share price. When people say "An IPO priced at..." this is what they're referring to.

Answer 312

* These get created when you write-up assets - both tangible and intangible - and when you write down assets in a transaction. An Asset Write-up creates a DTL and an Asset Write-Down creates a DTA. * You write down and write up assets b/c their book values (what's on the B/S) often differ substantially from their "fair market values." * An asset write-up creates a DTL b/c you'll have a higher Deprecation Expense on the new asset‚ which means you save on taxes in the short-term‚ but eventually you'll have to pay them back‚ so you get a liability. The opposite applies for an asset write-down and a DTA.

Answer 313

Technically‚ could go either way‚ but in most cases LBO gives lower valuation. • With LBO‚ you do not get any value form the cash flows of a company in between Year 1 and the final year‚ you only get "value" out of its final year • With DCF‚ you're taking into account both the company's cash flows in the period itself as well as the terminal value‚ so values tend to be higher • Note: unlike DCF‚ the LBO model itself does not give you a valuation‚ you start with a target IRR and then back-solve the implied valuation of the company (how much sponsor could pay)

Answer 314

* This is completely dependent on the company‚ the industry‚ and the leverage and coverage ratios for comparable LBO transactions. * To figure out the numbers‚ you would look at "Debt Comps" showing the types‚ tranches‚ and terms of debt that similarly sized companies in the industry have used recently. * There are some general rules: for example‚ you would never lever a company at 50x EBITDA‚ and even during bubbles‚ leverage rarely exceeds 10x EBITDA. * For interest coverage ratios (e.g. EBITDA/Interest)‚ you want a number where the company can pay for its interest w/o much trouble‚ but also not so high that the company could clearly afford to take on more debt. * For example a 20x coverage ratio would be far too high b/c the company could easily pay 2-3x more in interest. But a 2x coverage ratio would be too low‚ b/c a small decrease in EBITDA might result in a disaster at that level.

Answer 315

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital b/c of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon‚ Wal-Mart‚ and McDonald's often have negative Working Capital‚ b/c customers pay upfront‚ but they wait weeks or months to pay their suppliers - this is a sign of business efficiency and means that they have a healthy cash flow. 3. In other cases‚ negative Working Capital could point to financial trouble or possible bankruptcy (for example‚ when the company owes a lot of money to suppliers and cannot pay with cash on-hand).

Answer 316

* You use the same methodologies as with public companies: public comps‚ trading comps‚ and DCF‚ but there are some differences: * You might apply a 10-15% (or more) liquidity discount to the public company comparable multiples b/c shares/ownership in the private company is not as liquid * You can't use a M&A Premiums Analysis or Future Share Price Analysis b/c a private company doesn't have a share price. * Your valuations show Enterprise Value for the company as opposed to the Implied-per-Share Price as with public companies. You can still calculate Equity Value‚ but a "per-share-price" is meaningless for a private company. * A DCF gets tricky b/c a private company doesn't have a market capitalization or beta - you would probably estimate WACC based on the public comps' WACC rather than trying to calculate it yourself.

Answer 317

* This is a trick question because you need more information to answer it. * If the purchase price were the same as the exit price here‚ the IRR would be 0%. But the question only says that the purchase multiple is the same as the exit multiple. * Most companies grow over a 5-year period‚ so EBITDA in the exit year will almost always be higher than EBITDA when the company was initially purchased. * Unless you know what the EBITDA was in both years‚ it's impossible to say what the IRR was. If EBITDA was initially $100M but only grew to $110M‚ that's a very low IRR‚ but if it grew to $200M or $300M‚ the exit price was 2-3x the purchase price and that implies a much higher IRR.

Answer 318

* SOURCES: Debt and Preferred Stock (All Types)‚ Investor Equity (PE firm's cash)‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Management Rollover * USES: Equity Value of Company‚ Advisory and Legal Fees‚ Capitalized Financing Fees‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Debt Refinanced‚ Noncontrolling Interests Purchased. * Debt and Debt-like items such as existing Preferred Stock and Noncontrolling Interests can always be either assumed (remain on the B/S) or refinanced/purchased (paid off and disappear). * The "management rollover" refers to the option to let the management team reinvest their shares and options into the deal. For example‚ if the team currently owns 5% of the company‚ the PE firm might say‚ "We'll acquire 95% of the shares‚ and then let you keep the 5% you own to incentivize you to perform well over these next few years and reap the rewards."

Answer 319

* I/S: There are no changes b/c Dividends never show up on the I/S. * SCF: There's an additional Dividend of $5 under CFF on the SCF‚ so cash is down by $5. * B/S: The Assets side is down by $5 as a result and SE (RE) is also down by $5. * NOTE: Remember that the other company's financial statements are consolidated w/ your own when you own over 50% - you only split out NI separately. So there's no need to multiply by ownership percentages or anything when factoring in the impact of Dividends‚ or really any item other than NI.

Answer 320

* Options Exercisable vs. Options Outstanding: normally companies put in place restrictions on when employees can actually exercise options - so even there are 1M options outstanding right now‚ only 500K may actually be exercisable EVEN IF they're all in-the-money. * There's no correct answer for which one to use here. Some people argue that you should use Options Outstanding b/c typically‚ all non-exercisable Options become exercisable in an acquisition‚ so that's the more accurate way to view it. * Others argue that Options Exercisable is better b/c you don't know whether or not the non-exercisable ones will become exercisable until the acquisition happens. * However you treat it‚ you need to be consistent with all the companies you analyze.

Answer 321

You ignore them b/c the company uses its own cash flow to pay interest and pay off debt principal. Since the PE firm itself is not paying for these‚ neither one affects its IRR.

Answer 322

There are several possibilities: 1. The company is spending too much CapEx - these are not reflected in EBITDA but represent true cash expenses‚ so CapEx alone could make the company cash flow-negative. 2. The company has high Interest Expense and is no longer able to afford its Debt. 3. The company's Debt all matures on one date and it is unable to refinance due to a "credit crunch" - and it runs out of cash when paying back the Debt. 4. It has significant one-time charges (from litigation‚ for example) that have been excluded from EBITDA and those are high enough to bankrupt the company. • Remember‚ EBITDA excludes investments in (and Depreciation of) Long-Term Assets‚ Interest‚ and Non-Recurring Charges - and any one of those could represent massive cash expenses.

Answer 323

The most common adjustments: • Cost Savings - Often you assume the PE firm cuts costs by laying off employees‚ which could affect COGS‚ Operating Expenses‚ or both. • New Depreciation Expense - This comes from any PP&E Write-Ups in the transaction. • New Amortization Expense - This includes both the amortization from written-up intangibles and from capitalized financing fees. • Interest Expense on LBO Debt - You need to include both Cash and PIK interest here. • Sponsor Management Fees - Sometimes PE firms charge a "management fee" to a company to account for the time they spend managing it. NOTES: • Cost Savings and new D&A hit the Operating Income line; Int. Expense and Sponsor Management Fees affect Pre-Tax Income. • Common and Preferred Stock Dividends (e.g. from a Dividend Recap‚ or just a normal preferred stock issuance) are not on this list b/c theoretically‚ Dividends should always be listed on the SCF. • In many cases‚ however‚ they will actually be shown on the I/S in an LBO and will impact the Net Income line item only (no tax impact - they get subtracted after you've calculated Pre-Tax Income * (1 - Tax Rate)). Just be aware of this b/c you will see it from time to time‚ and remember that neither one is tax-deductible.

Answer 324

* Normally, you use the effective tax rate b/c you want to capture what the company is actually paying out in taxes, not what it "should" be paying out according to standard federal and state rates. * Sometimes you may adjust the tax rate if it's an unusual situation (e.g. the company is a sole proprietorship LLC and therefore income is taxed at the owner's personal income tax rate, but a large corporation is considering acquiring the company).

Answer 325

* All it means is that if Assets are increasing by more than Liabilities, the company is spending cash and therefore reducing its cash flow, whereas if Liabilities are increasing by more than Assets, the company is increasing its cash flow. * For example, if it places a huge order of Inventory, sells products, and records revenue, but hasn't received the cash from customers yet, Inventory and A/R both go up and represent uses of cash. * Maybe some of its Liabilities, such as A/P and Deferred Revenue also increase, but think about what happens: if the Assets increase by, say, $100, and the Liabilities only increase by $50, it's a net cash flow reduction of $50. * So that is what this section is for - we need to take into account the cash changes from these operationally-linked B/S items.

Answer 326

* TRICK QUESTION: You can't tell unless you also know that it's an all stock deal. If it's an all-cash or all-debt deal‚ the P/E multiple of the buyer doesn't matter b/c no stock is being issued. * If it is an all-stock deal‚ then the deal will be accretive since the buyer "gets" more in earnings for each $1.00 used to acquire the other company that it does from its own operations. The opposite applies if the buyer's P/E multiple is lower than the seller's.

Answer 327

* Normally you leave these alone and assume that nothing happens - so they show up in BOTH the Sources AND Uses columns when you make assumptions in the beginning. * You could assume that the PE firm acquires one or both of these‚ in which case they would ONLY show up in the Uses column - similar to refinancing existing Debt.

Answer 328

* The model is used as a sanity check and as a way to test various assumptions. A company would NEVER decide to do a deal b/c of the output of a model. * It might say‚ "OK‚ the model tells us this deal could work and would be moderately accretive - it's worth exploring in more detail." * It would never say‚ "Aha! This model predicts 21% accretion - we should have acquired this company yesterday!" * Emotions‚ ego and personalities play a far bigger role in M&A than numbers do.

Answer 329

* The one w/o Debt is not "at a disadvantage" - but it won't be valued as highly b/c of the way the WACC formula works. * Keep in mind that companies do not make big decisions based on financial formulas. If a company has no reason to take on Debt (e.g. it is very profitable and does not need funds to expand its business), then it won't take on Debt.

Answer 330

In an LBO Model: • Step 1: is making assumptions about the Purchase Price‚ Debt/Equity ratio‚ Interest Rate on Debt‚ and other variables; you might also assume something about the company's operations‚ such as Revenue Growth or Margins‚ depending on how much information you have. • Step 2: is to create a Sources & Uses section‚ which shows how the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required. • Step 3: is to adjust the company's Balance Sheet for the new Debt and Equity figures‚ allocate the purchase price‚ and add in Goodwill & Other Intangibles on the Assets side to make everything balance. • Step 4: you project out the company's Income Statement‚ Balance Sheet‚ and Cash Flow Statement‚ and determine how much debt is paid off each year‚ based on the available Cash Flow and the required Interest Payments. • Step 5: you make assumptions about the exit after several years‚ usually assuming an EBITDA Exit Multiple and calculate the return based on how much equity is returned to the firm.

Answer 331

You might sometimes do this if it's a cyclical industry, such as chemicals, b/c it may be important to show the entire cycle from low to high.

Answer 332

• PPE and Fixed Asset Write-Ups: You may write up the values of these Assets in an acquisition‚ under the assumption that the market values exceed the book values. • Deferred Tax Liabilities and Deferred Tax Assets: You may adjust these up or down depending on the asset write-ups and deal type. • Transaction and Financing Fees: You also need to factor in these fees into the model somewhere. • Inter-Company A/R & A/P: Two companies "owing" each other cash no longer makes sense after they've become the same company. • Deferred Revenue Write-Down: Accounting rules state that you can only recognize the "profit portion" of the seller's Deferred Revenue post-acquisition. So you often write down the "expense portion" of the seller's Deferred Revenue over several years in a merger model. * You do NOT need to know all the details for entry-level interviews‚ but you should be aware that there are more advanced adjustments in M&A deals.

Answer 333

* If you're running an Unlevered DCF and you're counting Unfunded Pension Obligations as Debt, you should exclude pension-related expenses from Unfunded Obligations on the I/S and SCF, for the same reason you exclude interest payments on Debt. * For a Levered FCF, you would do the opposite and leave in these expenses b/c they're a form of "interest expense."

Answer 334

* No. All this business w/ management ownership has nothing to do with the exact percentage of Debt and Equity used. * All that changes is that if the management team owns more‚ the PE firm can use less Debt and Equity (cash) overall to acquire the company. * Using 80% Debt vs. 60% Debt (or any other percentage) has no impact on the management ownership percentage‚ which is a separate issue entirely.

Answer 335

* Income Statement: No changes. * Cash Flow Statement: We record $1000 for "Acquisitions" in the CFI section‚ so cash at the bottom is down by $1000. * Balance Sheet: Cash is down by $1000 on the Assets side‚ but we add in the subsidiary's Assets of $500‚ so this side is down by $500 so far. We also create $800 worth of Goodwill b/c we bought this subsidiary for $1000‚ but (Assets minus Liabilities) was only $200. So the Assets side is up by $300. The other side is up by $300 b/c of the assumed Liabilities‚ so both sides balance.

Answer 336

Incurrence Covenants: • Company cannot take on more than $2B of total debt. • Proceeds from any asset sales must be earmarked to repay debt. • Company cannot make acquisitions of over $200M in size. • Company cannot spend more than $100M on CapEx each year. Maintenance Covenants: • Total Debt / EBITDA cannot exceed 3.0x; Senior Debt / EBITDA cannot exceeds 2.0x • (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0x • EBITDA / Interest Expense cannot fall below 5.0x • EBITDA / Cash Interest Expense cannot fall below 3.0x • (EBITDA - CapEx) / Interest Expense cannot fall below 2.0x

Answer 337

* The 3 major financial statements are the Income Statement (I/S)‚ Balance Sheet (B/S) and the Cash Flow Statement (SCF). * The I/S shows the company's revenue and expenses over a period of time‚ and goes down to Net Income (NI)‚ the final line on the statement. * The B/S shows the company's Assets (its resources - such as Cash‚ Inventory‚ and PP&E) as well as its Liabilities (such as Debt and Accounts Payable) and Shareholders' Equity (SE) at a specific point in time. Assets must equal Liabilities plus SE. * The SCF begins with NI‚ adjusts for non-cash expenses and changes in operating assets and liabilities (working capital)‚ and then shows how the company has spent or received cash from Investing or Financing activities; at the end‚ you see the company's net change in cash.

Answer 338

Simple Formula: • Enterprise Value = Equity Value + Debt + Preferred Stock + Non-controlling Interests - Cash Advanced Formula: • Enterprise Value = Equity Value + Debt + Preferred Stock + Non-controlling Interests + Capital Leases + Unfunded Pension Obligations and Other Liabilities - Cash - NOLs - Investments - Equity Investments

Answer 339

* Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta * The Risk-Free Rate represents how much a 10-year or 20-year US Treasury (or equivalent "safe" government bond in your own country) should yield; Beta is calculated on the "riskiness" of Comparable Companies and the Equity Risk Premium is the percentage by which stocks are expected to out-perform "risk-less" assets like US Treasuries. * Normally, you pull the Equity Risk Premium from a publication called Ibbotson's * NOTE: Depending on your bank and group, you might also add in a "size premium" and "industry premium" to account for additional risk and expected returns from either of those. * Small-cap stocks are expected to out-perform large-cap stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.

Answer 340

• Purpose is to project company's share price 1 or 2 years from now and then discount back to present value. 1. Get the median historical (usually Trailing Twelve Months‚ TTM) P/E multiple of the public company comparables 2. Apply this P/E multiple to your company's 1-year forward or 2-year forward projected EPS to get its implied future share price 3. Discount this share price back to its present value by using a discount rate in line with the company's cost of equity • Normally look at range of P/E multiples and discount rates (sensitivity table)

Answer 341

This is a good point, but in practice you will still multiply by (1 - Tax Rate) anyway. What matters is not whether the Debt is currently reducing the company's taxes, but whether there's potential for that to happen in the future.

Answer 342

* The setup is similar: you still project revenue and expenses over a 5-10 year period, and you still calculate Terminal Value. * The difference is that you do NOT calculate FCF - instead, you stop at NI and assume that Dividends Issued are a percentage of NI, and then you discount those Dividends back to their present value using the Cost of Equity. * Then, you add those up and add them to the present value of the Terminal Value, which you might base on a P/E multiple instead. * Finally, a Dividend Discount Model gets you the company's Equity Value rather than its Enterprise Value since you're using metrics that include interest income and expense.

Answer 343

* Used when CapEx or changes in operational assets and liabilities such as Deferred Revenue have a big impact‚ also critical in DCFs * It's similar to levered FCF‚ but it's capital structural-neutral‚ so it's better for comparing different companies

Answer 344

There are 2 main differences: 1. A/R has NOT yet been collected in cash from customers‚ whereas Deferred Revenue has been. 2. A/R is for a product/service that the company has ALREADY delivered but hasn't been paid for yet‚ whereas Deferred Revenue is for a product/service the company has NOT yet delivered. • A/R is an Asset b/c it implies additional future cash whereas Deferred Revenue is a Liability b/c it implies the opposite.

Answer 345

* Yes‚ you can use something called a collar‚ which guarantees a certain price based on the range of the buyer's stock price to the seller's stock price. Here's an example: * Suppose that we had a 100% stock deal w/ a 1.5x exchange ratio (i.e. the seller receives 1.5 of the buyer's shares for each 1 of its own shares). The buyer's share price is $20 and the seller has 1000 shares outstanding. Right now‚ it's worth $30‚000 (1000 * 1.5 * $20) to the seller. Here's how we could set up a collar: * If the buyer's share price falls below $20/share‚ the seller still receives the equivalent of $20 per buyer share in value. So if the buyer's share price falls to $15‚ now the seller would receive 2000 shares instead. * If the buyer's share price is between $20 and $40 per share‚ the normal 1.5x exchange ratio is used. So the value could be anything from $30‚000 to $60‚000. * If the buyer's share price goes above $40 per share‚ the seller can only receive the equivalent of $40 per buyer share in value. So if the buyer's share price rises to $80‚ the seller would receive only 750 shares instead. * Collar structures are not terribly common in M&A deals‚ but they are useful for reducing risk on both sides when stock is involved.

Answer 346

A company would acquire another company if it believes it will earn a good return on its investment - either in the form of a literal ROI‚ or in terms of a higher EPS number‚ which appeals to shareholders. There are several reasons why a buyer might believe this to be the case: • The buyer wants to gain market share by buying a competitor. • The buyer needs to grow quickly and sees an acquisition as a way to do that. • The buyer believes the seller is undervalued. • The buyer wants to acquire the seller's customers so it can up-sell and cross-sell products and services to them. • The buyer thinks the seller has a critical technology‚ intellectual property‚ or other "secret sauce" it can use to significantly enhance its business. • The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

Answer 347

* Trick question. You don't account for this at all in an Unlevered DCF b/c you ignore interest expense and debt principal repayments. * In a Levered DCF, you factor it in by reducing the interest expense each year as the Debt goes down and also by reducing FCF by the mandatory repayments each year. * The exact impact - i.e. whether the implied Equity Value goes up or down - depends on the interest rate and the principal repayment percentage each year; however, in most cases the principal repayments far exceed the net interest expense, so the Equity Value will most likely decrease b/c Levered FCF will be lower each year.

Answer 348

Trick question - there is no one ranking that will always hold up. • In general‚ precedent transactions will be higher than comparable public companies due to the control premium built into acquisitions (buyer must pay premium to acquire seller) • DCF could go either way‚ best to say it's just more variable than other methodologies. Often produces highest value‚ but can produce lowest value as well depending on assumptions.

Answer 349

* The Basic Equity Value is $1000 (100 * $10 = $1000). To calculate the dilutive effect of the options‚ first you note that the options are all "in-the-money" - their exercise price is less than the current share price. * When these options are exercised‚ 10 new shares get created - the share count is now 110 rather than 100. * However‚ in order to exercise the options‚ we had to "pay" the company $5 for each option (the exercise price). As a result‚ it now has $50 in additional cash‚ which it uses to buy back 5 of the new shares created. * So the fully diluted share count is 105 and the Diluted Equity Value is $1‚050.

Answer 350

Normally you assume that these are percentages of revenue or expenses‚ under the assumption that they're all linked to the I/S: • A/R (% of Revenue)‚ Prepaid Expense (% of Operating Expense)‚ Inventory (% of COGS)‚ Deferred Revenue (% of Revenue)‚ A/P (% of Operating Expenses)‚ Accrued Expenses (% of Operating Expenses) • Then you either carry the same percentages across in future years or assume slight increases or decreases depending on the company. • You can also project these metrics using "days‚" e.g. Accounts Receivable Days = Accounts Receivable / Revenue * 365‚ assume that the days required to collect A/R stays relatively the same each year‚ and calculate the A/R number from that.

Answer 351

* If the PE firm intends to refinance the debt at some point or they don't believe their returns are too sensitive to interest payments‚ they might use High-Yield Debt. * They might also use High-Yield Debt if they don't have plans for a major expansion effort or acquisitions‚ or if they don't plan to sell off the company's assets.

Answer 352

* First, confirm that they are asking for Unlevered FCF (FCF to Firm). If so: * Subtract COGS and Operating Expenses from Revenue to get to Operating Income (EBIT) - or just use the EBIT margin you've assumed. * Then, multiply by (1 - Tax Rate), add back D&A and other non-cash charges, and factor in the Change in Operating Assets and Liabilities. If Assets increase by more than Liabilities, this is negative; otherwise, it's positive. * Finally, subtract CapEx to calculate Unlevered FCF. * Levered FCF is similar, but you must also subtract the Net Interest Expense before multiplying by the (1 - Tax Rate), and you must also subtract Mandatory Debt Repayments at the end.

Answer 353

* The difference is that in DCF you're saying‚ "What could this company be worth‚ based on the present value of its near-future and far-future cash flows? * But in an LBO‚ you're saying‚ "What CAN we pay for this company if we want to achieve an IRR of say‚ 25%‚ in 5 years?" * So both methodologies are similar‚ but w/ the LBO valuation‚ you're constraining the values based on the returns you're targeting.

Answer 354

• this can occur when there is substantial mismatch between M&A markets and public markets. For example‚ no public companies have been acquired recently but lots of small private companies have been acquired at low valuations

Answer 355

* Whenever a company owns over 50% of another company‚ it is required to report 100% of the financial performance of the other company as part of its own performance. Even if it doesn't own 100%‚ it reports 100% of the majority-owned subsidiary's financial performance. * You must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

Answer 356

* In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate involves more guesswork. * However, you might use Gordon Growth if you have no good Comparable Companies or if you believe that multiples will change significantly in the industry several years down the road. For example, if an industry is cyclical (e.g. chemicals or semiconductors) you might be better off using long-term growth rate rather than exit multiples.

Answer 357

* First off‚ you would reverse any new write-ups to Assets to handle this scenario the easy way‚ if possible. So if we had Asset Write-Ups of $300‚ then it would be easy to simply reverse those and make it so the Assets were worth only $1700‚ which would result in positive Goodwill instead. * If it is not possible to do that (e.g. there were no Asset Write-Ups or they cannot be reversed for some reason) then we need to record a gain on the Income Statement for this "Negative Goodwill." * In this case the company's Shareholders' Equity is $1200 but we paid $1000 for it‚ so we do the following: * Income Statement: Record a Gain of $200‚ boosting Pre-Tax Income by $200 and Net Income by $120 at a 40% tax rate. * Cash Flow Statement: Net Income is up by $120‚ but we subtract the Gain of $200‚ so Cash is down by $80 so far. Under CFI‚ we record the $1000 acquisition‚ so Cash at the bottom is down by $1080. * Balance Sheet: Cash is down by $1080‚ but we have $2000 of New Assets‚ so the Assets side is up by $920. On the other side‚ Liabilities is up by $800 and Shareholders' Equity is up by $120 due to the increased Net Income‚ so both sides are up by $920 and balance.

Answer 358

* There's no strict rule here‚ but most bankers would say that anything over 10% is odd. * If the basic Equity Value is $100M and the diluted Equity Value is $115M‚ you might want to check your calculations - it's not necessarily wrong‚ but over 10% dilution is unusual for most companies. And something like 50% dilution would be highly unusual.

Answer 359

Levered FCF gives you Equity Value rather than Enterprise Value, since the cash flow is only available to Equity Investors (Debt Investors have already been "paid" with the interest payments and principal repayments).

Answer 360

Working Capital = Current Assets - Current Liabilities • If it's positive‚ it means a company can pay off its short-term Liabilities with its short-term Assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound." • You use Operating Working Capital more commonly in finance‚ and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities Excluding Debt) • The point of Operating Working Capital is to exclude items that relate to a company's financing and investment activities - Cash‚ Investments‚ and Debt - from the calculation. • "Changes in Working Capital" more commonly called "Changes in Operating Assets and Liabilities) also appears on the SCF in CFO and tells you how these operationally-related B/S items change over time.

Answer 361

With Trading Securities‚ you DO show Unrealized Gains and Losses on the I/S. • I/S: Both Operating Income and Pre-Tax Income increase by $10‚ and so NI increases by $6 at a 40% tax rate. • SCF: NI is up by $6‚ but you subtract the Unrealized Gain of $10 b/c it's non-cash‚ so Cash at the bottom is down by $4. • B/S: Cash is down by $4 on the Assets side and Short-Term Investments is up by $10‚ so the Assets side is up by $6 overall. On the other side‚ SE (RE) is up by $6 due to the increased NI. • Intuition: We've paid taxes on a non-cash source of income‚ so cash is down. However‚ the paper value of our Assets has increased.

Answer 362

* You would need to create quarterly financial statements for both the buyer and the seller for the Sep 30 - Dec 31 period‚ and you would show that as the first "combined" period in the merger model. * So you would combine the Income Statements‚ Balance Sheets‚ and Cash Flow Statements for that 3-month period‚ and then keep them combined for the rest of the time after that (adjusting the seller's financial statements to match the fiscal year of the buyer‚ as in the example above). * Normally you do not care much about accretion/dilution for stub periods like this‚ so you would just calculate it for the first full fiscal year after the transaction close.

Answer 363

* There's no discount b/c with precedent transactions‚ you're acquiring the entire company - and once it's acquired‚ the shares immediately become illiquid. * But shares (the ability to buy individual "pieces" of a company rather than the whole thing) can be either liquid (if it's public) or illiquid (if it's private) * Since shares of public companies are always more liquid‚ you would discount public company comparable multiples to account for this.

Answer 364

* Usually you look at recent‚ similar LBOs and assess the debt terms and tranches that were used in each transaction. * You could also look at companies in a similar size range and industry‚ see how much debt outstanding they have‚ and base your own numbers on those.

Answer 365

* It's always better to pay the bare minimum. Think about the math for a second: interest rates on Debt rarely go above 10-15%. Let's just assume that they're 10% and that the Company has $1000 in debt. * Initially, it pays $100 in Interest Expense, and after taxes that's only $60 [$100 * (1 - 40%)]. So Levered FCF is reduced by $60 each year assuming no principal repayment. * What happens if the company decides to repay $200 of that Debt each year? Levered FCF is down by at least $200 each year, and the company still pays interest, albeit lower interest, until the end of the period. * So the company is always better off, valuation-wise, waiting as long as possible to repay Debt.

Answer 366

This one's easy b/c now Book and Tax Depreciation are the same. • I/S: Pre-Tax Income is down by $10‚ so NI falls by $6. • SCF: NI is down by $6 and you add back the $10 of Depreciation on the SCF‚ but there are no changes to Deferred Taxes b/c Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4. • B/S: Cash is up by $4 but PP&E is down by $10‚ so the Assets side is down by $6. The other side is also down by $6 b/c SE (RE) is lower due the reduced NI.

Answer 367

For relative valuation‚ the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different • The financial criteria consists of Assets‚ Loans‚ or Deposits rather than revenue or EBITDA • You look at metrics like ROE‚ ROA‚ and Book Value and Tangible Book Value rather than Revenue‚ EBITDA‚ etc. • You use multiples such as P/E‚ P/BV‚ P/TBV rather than EV/EBITDA Rather than a traditional DCF‚ you use 2 different methodologies for intrinsic valuation: • Dividend Discount Model (DDM): you sum up the PV of a bank's dividends in future years and then add it to the PV of the bank's terminal value‚ using based on a P/BV or P/TBV multiple • Residual Income Model (Excess Returns Model): you take the bank's current BV and add the PV of the excess returns to that BV to value it. The "excess return" each yea is (ROE*BV) - (Cost of Equity*BV)‚ basically how much the returns exceeded your expectations. • These methodologies and multiples are required b/c Interest is a critical component of a bank's revenue and because Debt is a "raw material" rather than just a financing source‚ also‚ banks' Book Values are usually very close to their market caps

Answer 368

* If the PE firm assumes debt when acquiring a company‚ that debt remains on the Balance Sheet and must be paid off (both interest and principal) over time. And it has no net effect on the funds required to acquire the company. In this case‚ the existing debt shows up in both the Sources and Uses columns. * If the PE firm refinances the debt‚ it pays it off‚ usually replacing it w/ new debt that it raises to acquire the company. Refinancing debt means that additional funds are required‚ so the effective purchase price goes up. In this case‚ the existing debt shows up only in the Uses column.

Answer 369

* You take them into account w/ everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma B/S. The formulas are as follows: * DTA = Asset Write-Down * Tax Rate; DTL = Asset Write-Up * Tax Rate * So let's say you were buying a company for $1B w/ 50% cash and 50% debt‚ and you had a $100M asset write-up and a tax rate of 40%. In addition‚ the seller has total Assets of $200M‚ total Liabilities of $150M‚ and Shareholders' Equity of $50M. Here's what would happen on the combined company's balance sheet (ignoring transaction and financing fees): * First‚ you simply add the seller's Assets and Liabilities (but NOT Shareholders' Equity - it is wiped out) to the buyer's to get your "initial" B/S. Assets are up by $200M an Liabilities are up by $150M. * Then Cash on the Assets side goes down by $500M. * You have an Asset Write-Up of $100M‚ so Assets go up by $100M; Debt on the Liabilities & Equity side goes up by $500M. * You get a new DTL of $40M ($100M * 40%) on the Liabilities & Equity Side. * Assets are down by $200M total and Liabilities & Shareholders' Equity are up by $690M ($500 + $40 + $150) * So you need Goodwill & Intangibles of $890M on the Assets side to make both sides balance.

Answer 370

Ideal candidates should: • Have stable and predictable cash flows so they can repay debt (the most important) • Be undervalued relative to peers in the industry (lower purchase price) • Be a low-risk business (debt repayments) • Not have much need for ongoing investments such as CapEx • Have an opportunity to cut costs and increase margins • Have a strong management team • Have a solid base of assets to use as collateral for debt

Answer 371

* In theory‚ yes‚ b/c when you own less than 20%‚ the other company should be recorded as a Security or Short-Term Investment and you would only factor in the Dividends received but not the NI from the Other Company. * In practice‚ however‚ treatment varies and some companies may actually record this scenario the same way‚ especially if they exert "significant influence" over the 10% owned company.

Answer 372

* An acquisition is dilutive if the additional Net Income the seller contributes is not enough to offset the buyer's foregone interest on cash‚ additional interest paid on debt‚ and the effects of issuing additional shares. * Acquisition effects - such as the amortization of Other Intangible Assets - can also make an acquisition dilutive.

Answer 373

* First off‚ this metric of Cash Flow from Operations - CapEx is not exactly Levered FCF: normally w/ Levered FCF you subtract mandatory debt repayments as well. * Assuming that CapEx (or any other big expenses) can be reduced post-LBO is dangerous b/c CapEx‚ in theory‚ drives revenue growth. * So if you reduce CapEx and claim that it's not truly necessary‚ can you still make the same assumptions about the company's revenue growth?

Answer 374

The company "pays" for Equity in two ways: 1. It may issue Dividends to its common shareholders, which is a cash expense. 2. It gives up stock appreciation rights to other investors, so in effect it's losing some of that upside - a non-cash but very real "cost." • It is tricky to estimate the impact of both of those, which is why we usually use the Risk-Free Rate + Equity Risk Premium * Beta formula to estimate the company's expected return instead.

Answer 375

* They are similar but not the exact same idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the CURRENT YEAR. * For example‚ if a company owes $300 in taxes at the end of each quarter during the year‚ on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months‚ at which point Income Taxes Payable would decrease once again. * By contrast‚ DTAs and DTLs tend to be longer-term and arise b/c of events that do NOT occur in the normal course of business.

Answer 376

Since Net Income includes the impact of interest income and interest expense‚ you always use Equity Value.

Answer 377

Yes‚ it is common in 2 scenarios: 1. Leveraged Buyouts w/ dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash)‚ which can sometimes turn the number negative. 2. It can also happen if the company has been losing money consistently and therefore has declining Retained Earnings balance‚ which is a portion of SE. • It doesn't "mean" anything in particular‚ but it might demonstrate that the company is struggling. • NOTE: The Equity Value (AKA Market Cap) is different from SE and that Equity Value can NEVER be negative.

Answer 378

* You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pre-Tax Income on its books‚ and then you determine what it actually pays in cash taxes based on its NOLs and its new D&A expenses (from any Asset Write-Ups) * Anytime the "cash" tax expense exceeds the "book" tax expense you record this as a decrease to the Deferred Tax Liability on the B/S; if the "book" expense is higher‚ then you record that as an increase to the DTL.

Answer 379

* EBIT is just a company's operating income on its I/S‚ it includes not only COGS and operating expenses‚ but also non-cash expenses such as D&A and therefore reflects‚ at least indirectly‚ the company's CapEx * EBITDA is defined as EBIT plus D&A. You may sometimes add back other expenses * The idea of EBITDA is to move closer to a company's "cash flow‚" since D&A are non-cash expenses‚ but the problem is that you exclude CapEx altogether

Answer 380

* The "optimal capital structure" is the combination of Debt, Equity, and Preferred Stock that minimizes WACC. * There is no real way to determine this formulaically b/c you'll always find that Debt should be 100% of a company's capital structure since it's always cheaper than Equity and Preferred Stock, but that can't happen b/c all companies need some amount of Equity as well. * Plus, taking on additional Debt will impact the Cost of Equity and the Cost of Preferred, so effectively it is a multivariable equation with no solution. * You may be able to approximate the optimal structure by looking at a few different scenarios and seeing how WACC changes - but there's no mathematical solution.

Answer 381

* Let's say that Company A wants to acquire Company B. Company A has 5000 SG&A related employees‚ whereas Company B has around 1000. * Company A calculates that post-transaction‚ it will only need about 800 of Company B's SG&A employees‚ and its existing employees can take over the rest of the work. * To calculate the Operating Expenses the combined company would save‚ we would multiply these 200 employees that Company A is going to fire post-transaction by their average salary‚ benefits‚ and other compensation expenses.

Answer 382

1. Foregone Interest on Cash - The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition. 2. Additional Interest on Debt - The buyer pays additional Interest Expense if it uses debt. 3. Additional Shares Outstanding - If the buyer pays with stock‚ it must issue additional shares. 4. Combined Financial Statements - After the acquisition‚ the seller's financial statements are added to the buyer's. 5. Creation of Goodwill & Other Intangibles - These Balance Sheet items that represent the premium paid to a seller's Shareholders' Equity also get created.

Answer 383

Although technology is "riskier" than other markets‚ remember that there are mature‚ cash flow-stable companies in almost every industry. There are PE firms that specialize in very specific goals‚ such as: • Industry Consolidation: Buying competitors in a market and combining them to increase efficiency and win more customers. • Turnarounds: Taking struggling companies and improving their operations • Divestitures: Selling off divisions of a company or turning a division into a strong stand-alone entity. * So even if a company isn't doing well or even if it seems risky‚ the PE firm might buy it if it falls into one of the categories that the firm focuses on. * This whole issue of "risk" is more applicable in industries where companies truly have unstable cash flows - anything based on commodities‚ such as oil‚ gas‚ and mining‚ for example.

Answer 384

EBIT*(1 - tax rate) + Non-cash charges - changes in operating assets and liabilities - CapEx

Answer 385

* EPS is important mostly b/c institutional investors value it and base many decisions on EPS and P/E multiples - not the best approach‚ but it is how they think. * A merger model has many purposes besides just calculating EPS accretion/dilution - for example‚ you could calculate the IRR of an acquisition if you assume that the acquired company is resold in the future‚ or even that it generates cash flows indefinitely into the future. * An equally important part of a merger model is assessing what the combined financial statements look like and how key items change. * So it's not that EPS accretion/dilution is the ONLY important point in a merger model - but is what's most likely to come up in interviews.

Answer 386

* First‚ let's tackle the options outstanding: since they are in-the-money‚ we assume that they get exercised and that 100 new shares get created. * The company receives 100 * $10 = $1000 in proceeds. Its share price is $20 so it can repurchase 50 shares with these proceeds. Overall‚ there are 50 additional shares outstanding now (100 new shares - 50 repurchased). * The 50 RSUs get added as if they were common shares‚ so now there's a total of 100 additional shares outstanding. * For the convertible bonds‚ the conversion price of $10 is below the company's current share price of $20‚ so conversion is allowed. * We divide the par value by the conversion price to see how many new shares per bond get created: $100 / $10 = 10 new shares per bond * Since there are 100 convertible bonds outstanding‚ we therefore get 1‚000 new shares (100 convertible bonds * 10 new shares per bond) * In total‚ there are 1‚100 additional shares outstanding. The diluted share count is therefore 11‚100. * The Diluted Equity Value is 11‚100 & $20 = $222‚000

Answer 387

* There's always a buyer and a seller in any M&A deal - the difference is that in a merger‚ the companies are similarly-sized‚ whereas in an acquisition the buyer is significantly larger (often by a factor of 2-3x or more). * Also‚ 100% stock (or majority stock) deals are more common in mergers because similarly sized companies rarely have enough cash to buy each other‚ and cannot raise enough debt to do so either.

Answer 388

* Enterprise Value = Diluted Equity Value - Cash + Debt + Noncontrolling Interest * Enterprise Value = $222K - $10K + $30K + $15K = $257K

Answer 389

It's a different scenario because: 1. The PE firm does not hold the company for the long-term - it sells it after a few years‚ so it is less concerned with the higher "expense" of debt over cash and is more concerned about using leverage to boost its returns by reducing the capital it contributes upfront. 2. In an LBO‚ the company is responsible for repaying the debt‚ so the company assumes much of the risk. Whereas in a strategic acquisition‚ the buyer "owns" the debt‚ so it is more risky for them.

Answer 390

* Preferred Stock pays out a fixed dividend‚ and Preferred Shareholders also have a higher claim to a company's assets than equity investors do. As a result‚ it is more similar to Debt than common stock. * Also‚ just like Debt‚ typically Preferred Stock must be repaid in an acquisition scenario.

Answer 391

Again, this should have no net impact on FCF b/c you add it at the bottom of the I/S and then subtract it out in the SCF.

Answer 392

* I/S: You show a line item for "NI Attributable to Noncontrolling Interests" near the bottom. You subtract $3 (Other Company Net Income of $10 * 30% You Don't Own) to reflect the 30% of the other company's NI that does not "belong" to you. At the bottom of the I/S‚ the "NI Attributable to Parent" line item is down by $3. * SCF: NI is down by $3 as a result‚ but you add back this same charge b/c you do‚ in fact‚ receive this NI in cash when you own over 50% of the other company. So cash at the bottom of the SCF is unchanged. * B/S: There are no changes on the Assets side. On the other side‚ the Noncontrolling Interests line item (included in SE) is up by $3 due to this NI‚ but RE is down by $3 b/c of the reduced NI at the bottom of the I/S‚ so this side doesn't change and the B/S remains in balance.

Answer 393

You would pick the I/S and B/S because you can create the SCF from both of those (assuming that you have the "Beginning" and "Ending" Balance Sheets that correspond to the same period the I/S is tracking.

Answer 394

• Operating Leases are used for short-term leasing of equipment and property‚ and do not involve ownership of anything. Operating lease expenses show up as Operating Expenses on the I/S and impact Operating Income‚ Pre-Tax Income‚ and NI. • Capital Leases are used for longer-term items and give the lessee ownership rights; they Depreciate‚ incur Interest Expense‚ and are counted as Debt. • A lease is a Capital Lease is any one of the following 4 conditions is true: 1. If there's a transfer of ownership at the end of the term. 2. If there's an option to purchase the asset at a "bargain price" at the end of the term. 3. If the term of the lease is greater than 75% of the useful life of the asset. 4. If the present value of the lease payments is greater than 90% of the asset's fair market value.

Answer 395

* I/S: The $100 Write-Down reduces Pre-Tax Income by $100. With a 40% tax rate‚ NI declines by $60. * SCF: NI is down by $60‚ but the Write-Down is a non-cash expense‚ so we add it back - and therefore CFO increases by $40. Cash at the bottom is up by $40. * B/S: Cash is now up by $40 and an Asset is down by $100 (it's not clear which Asset since the question never stated it). Overall‚ the Assets side is down by $60. On the other side‚ since NI was down by $60‚ SE is also down by $60 - and both sides balance. * Intuition: The same as any other non-cash charge: we save on taxes‚ so our Cash goes up‚ and something on the B/S changes in response.

Answer 396

* Most of the time, yes, because all items other than CapEx are generally non-recurring, or at least do not recur in a predictable way. * If you have advance knowledge that a company is going to sell or buy a certain amount of securities, issue a certain amount of stock, or repurchase a certain number of shares every year, then sure, you can factor those in. But it's extremely rare to do that.

Answer 397

* You use it to value a company by setting a targeted IRR (for example‚ 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR. * This is sometimes called a "floor valuation" b/c PE firms almost always pay less for a company than strategic acquirers (no synergies to be realized).

Answer 398

* An Asset will result in additional cash or potential cash in the future - think about how Investments or A/R will result in a direct cash increase‚ and how Goodwill or PP&E may result in an indirect cash increase in the future. * A Liability will result in less cash or potential cash in the future - think about how Debt or A/P will result in a direct cash decrease‚ and how something like Deferred Revenue will result in an indirect cash decrease as you recognize additional taxes in the future from recognizing revenue. * Ask what direction cash will move in as a result of this new item and that tells you whether it's an Asset or Liability.

Answer 399

* First off, note that you don't have to calculate anything - you could just take the company's Historical Beta, based on its stock performance vs. the relevant index. * Normally, however, you come up with a new estimate of Beta based on the set of Public Comps you're using to value the company elsewhere in the Valuation, under the assumption that your estimate will be more accurate. * You look up the Beta for each Comparable Company (usually on Bloomberg) un-lever each one, take the median of the set and then lever that median based on the company's capital structure. Then you use this Levered Beta in the Cost of Equity calculation. * The formulas for un-levering and re-levering Beta are as follows: * Unlevered Beta = Levered Beta / (1 + [(1 - Tax Rate) x (Total Debt/Equity)]) * Levered Beta = Unlevered Beta * (1 + [(1 - Tax Rate) x (Total Debt/Equity)])

Answer 400

* Sure‚ let's say that Company A sells 10‚000 widgets/year in N. America at an average price of $15 and Company B sells 5000 widgets/year in Europe at an average price of $10. Company A believes that it can sell its own widgets to 20% of Company B's customers‚ so after it acquires Company B it will earn an extra 20% * 5000 * $15 in revenue or $15‚000. * It will also have expenses associated w/ those extra sales‚ so you need to reflect those as well (if it has a 50% margin‚ for example‚ it would reflect an additional $7‚500 rather than $15‚000 to Operating Income and Pre-Tax Income on the combined Income Statement. * This last point about expenses associated w/ revenue synergies is important and one that a lot of people forget - there's no such thing as "free" revenue with no associated costs.

Answer 401

This isn't the right way to think about it - remember that investors need to be compensated for the risk they take. And now think about what happens if early repayment is allowed: • Initially‚ the investors might earn $100M in interest on $1B worth of debt‚ at a 10% interest rate. • Without early repayment‚ the investors keep getting that $100M in interest each year paid directly to them. • With early repayment‚ this interest payment drops each year and the investors receive increasingly less each year - and that drops their effective return. All else being equal‚ debt investors want companies to keep debt on their Balance Sheets as long as possible.

Answer 402

In most cases‚ no - b/c one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most PE firms are organized as LLCs or Limited Partnerships‚ and when they acquire companies in an LBO‚ they create an LLC shell company that "acquires" the company on paper.

Answer 403

No‚ b/c in an Assets Purchase‚ the book basis of assets always matches the tax basis. DTLs and DTAs get created in Stock Purchases b/c the book values of Assets are written up or written down‚ but the tax values do not.

Answer 404

False. The DCF can produce higher numbers‚ but not necessarily. The DCF is more dependent on assumptions than relative valuation. You could make extremely conservative assumptions‚ while market is currently hot/overvalued.

Answer 405

* If the PE firm is concerned about the company meeting interest payments and wants a lower-cost option‚ they might want to use Bank Debt. * They might also use Bank Debt if they are planning on a major expansion or Capital Expenditures and don't want to be restricted by incurrence covenants.

Answer 406

The one without Debt will generally have a higher WACC b/c Debt is "less expensive" than Equity. Why? • Interest on Debt is tax-deductible - hence the (1 - Tax Rate) multiplication in the WACC formula. • Debt is senior to Equity in a company's capital structure - debt investors would be paid first in a liquidation or bankruptcy scenario. • Intuitively, interest rates on Debt are usually lower than Cost of Equity numbers (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion.

Answer 407

* In this case‚ you need a 9-month stub period rather than a 3-month stub period in the previous case. * So you would need to find or create quarterly financial statements for Q4 of the seller's fiscal year ending June 30‚ and then Q1 and Q2 for the next year. * You would also take the last 3 quarters of the buyer's fiscal year and combine the statements from that period w/ the seller's‚ taking into account all the normal acquisition effects for that period.

Answer 408

* In this scenario, you would include additional CapEx spending of $100 in Year 4 of the DCF, which would reduce FCF for that year by $100. The Enterprise Value, in turn, would decrease by the present value of $100 in Year 4. * The math gets messy, but you would calculate the difference by dividing $100 by (1 + Discount Rate)^4. Then you would subtract this amount from the Enterprise Value.

Answer 409

* Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue (all additional Revenue costs something) - additional Revenue then flows through the rest of the combined Income Statement‚ and you reflect the additional expenses as well. * Expense Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount‚ which in turn boosts the combined Pre-Tax Income and Net Income‚ increasing the EPS and making the deal more accretive.

Answer 410

1. They take more time to calculate and you have to go through financial statements in more detail. 2. They may not be standardized since companies include very different items in the CFO section of the SCF. Summary: EBIT & EBITDA multiples are more common due to convenience and comparability.

Answer 411

* When you look up the Betas on Bloomberg (or whatever source you're using) they will already be levered b/c a company's previous stock price movements reflect the Debt they've taken on. * But each company's capital structure is different and we want to look at how "risky" a company is regardless of what % debt or equity it has. * To do that, we need to un-lever Beta each time. We want to find the inherent business risk that each company has, separate from the risk created by Debt. * But at the end of the calculation, we need to re-lever the median Unlevered Beta of that set b/c we want the Beta used in the Cost of Equity calculation to reflect the total risk of our company, taking into account its capital structure this time as well.

Answer 412

* In an Unlevered DCF analysis, you use WACC, which reflects the "Cost" of Equity, Debt, and Preferred Stock. * In a Levered DCF analysis, you use Cost of Equity instead.

Answer 413

* In a dividend recap‚ the company takes on new debt solely to pay a special dividend out to the PE firm that bought it. * It would be like if you made your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds. * Dividend recaps boost the IRR in a LBO b/c they help the PE firm to recover some of its initial investment early. They have developed a bad reputation among some lenders b/c the debt in this case does not actually benefit the company itself.

Answer 414

* The basic idea is that you normally write down most of the seller's existing DTLs and DTAs to "reset" its tax basis‚ since it's now part of another entity. * And then you may create new DTLs or DTAs if there are Asset Write-Ups or Write-Downs and the book and tax D&A numbers differ. * If there are write-ups‚ a DTL will be created in most deals since the Depreciation on the write-ups is not tax-deductible‚ which means that the company will pay more in cash taxes; the opposite applies for write-downs and there‚ a DTA would be created.

Answer 415

* Normally you assume that existing debt on the Balance Sheet gets repaid first. * After that‚ it depends on the seniority of the debt and also whether or not the debt can even be repaid early. For example‚ typically you are not allowed to repay High-Yield Debt before its maturity date. * So if you have a Revolver (sort of like a "credit card" for a company) and then multiple Term Loans (Bank Debt)‚ normally you'll repay the Revolver first‚ followed by the most senior Term Loan‚ and then the more junior Term Loans. * In theory‚ you should want to repay the most expensive form of Debt first - but unlike w/ student loans‚ car loans‚ or mortgages‚ it's not always allowed.

Answer 416

When there is a lot of good market data and the companies are truly comparable. It doesn't work as well when data is spotty or when company under analysis is unique or can't easily be compared to others.

Answer 417

1. M&A Premium Analysis - still based on precedent transactions‚ but instead of calculating valuation multiples‚ you calculate premiums that buyers have paid. 2. Future Share Price Analysis - project a company's future share price based on P/E (or other) multiples of comparable companies‚ then discount back to present value 3. Sum of the Parts - split a company into different segments‚ pick different sets of public comps and precedent transactions for each‚ assign multiples‚ value each division separately‚ then add up all the values at the end to determine company's total value.

Answer 418

* One process was more competitive and had a lot more companies bidding on the target * One company had recent bad news or a depressed stock price so it was acquired at a discount * They were in industries w/ different median multiples * The two companies have different accounting standards and have added back different items when calculating EBITDA‚ so the multiples are not truly comparable

Answer 419

* If Depreciation is higher on the tax schedule in the first few years‚ the DTL will increase b/c you're paying less in cash taxes initially and need to make up for it later. * Then‚ as tax Depreciation switches and becomes lower in the later years‚ the DTL will decrease as you pay more in cash taxes and "make up for" the early tax savings.

Answer 420

* An earnout is a form of "deferred payment" in an M&A deal (it's most common w/ private companies and start-ups) and is highly unusual for public sellers. * It is usually contingent on financial performance or other goals - for example‚ the buyer might say "We'll pay you an additional $10M in 3 years if you can hit $100M in revenue by then." * Buyers use it to incentivize sellers to continue to perform well and to discourage management teams from taking the money and running off to an island in the South Pacific once the deal is done.

Answer 421

* The concept is that you value a company based on the present value of its Free Cash Flows far into the future. * You divide the future into a "near future" period of 5-10 years and then calculate, project, discount, and add up those Free Cash Flows; and then there's also a "far future" period for everything beyond that, which you can't estimate as precisely, but which you can approximate using different approaches. * You need to discount everything back to its present value b/c money today is worth more than money tomorrow.