WSP Flashcards
How do capital leases affect the three financial statements?
Leases treated as capital leases (as opposed to operating leases) create an asset and associated liability
for the thing that is being leased. For example, if a company leases a building for 30 years, the building is
recognized as an asset on the lessee’s balance sheet with a corresponding debt-like liability. The income
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statement impact is the depreciation expense associated with the building, as well as interest expense
associated with the financing.
Is negative working capital a bad thing?
Negative working capital doesn’t tell you much without some context. For example, a company could
have negative working capital (i.e. current assets < current liabilities) because it is very efficient at
collecting revenue (low accounts receivable), keeping low inventory, and taking time with paying
vendors (high A/P), while efficiently investing excess cash into higher-yielding investments. In this case,
negative working capital is a good thing.
However, the opposite could be true as well – negative working capital could be a sign of impending
liquidity problems. For instance, imagine a company that’s mismanaged its cash and now faces a high
accounts payable balance that’s coming due very soon, with a low inventory balance that desperately
needs replenishing, and low levels of accounts receivable. A company in this state will need to find
external borrowing quickly to stay afloat.
What is the impact of share repurchases on EPS?
The major impact to EPS is that the actual share count is reduced, thereby increasing EPS. However,
there is sometimes an impact on net income. That’s because assuming share repurchases are funded
with the company’s excess cash, any interest income that would have otherwise been generated on that
cash is no longer available, thereby reducing net income – and EPS – slightly. Because returns on excess
cash for most companies are low, this impact is usually very minor and doesn’t offset the positive impact
to EPS from a lower share count.
Can companies amortize goodwill?
The longer answer is that under GAAP, public companies are not allowed to amortize goodwill and must
instead test it annually for impairment. However, private companies may elect to amortize goodwill. In
addition, for tax reporting purposes, goodwill may be amortized over 15 years under some
circumstances.
Why would a company issue equity vs. debt (and vice versa)?
Perhaps the greatest advantage of equity is that it has no required payments, thus giving management
more flexibility around the repayment of capital (equity eventually gets it back in the form of dividends,
but timing and magnitude are entirely at the board and management’s discretion). Another advantage
in the case of public equity is that it gives companies access to a very large investor base. On the other
hand, equity dilutes ownership, and is generally more expensive (i.e. higher cost of capital). In addition,
public equity comes with more regulation and scrutiny.
An advantage of debt is that unlike equity, debt is tax-deductible (although recent tax reform rules limit
the deduction for highly-levered companies). In addition, debt results in no ownership dilution and
generally has a lower cost of capital. Of course, the disadvantages are that debt means the company
faces required interest and principal payments, and it introduces the risk of default. In addition, debt
covenants can restrict management from undertaking a variety of activities.
How many years would it take to double a $100,000 investment at a 9% annual return (no
calculator)?
The rule of 72 says that in order to figure out how long it would take to double an investment, divide 72
by the investment’s annual return. In this case, the rule of 72 suggests that it would take approximately
72/9 = 8 years.
Why would a company buy back (aka repurchase) shares? What would be the impact on
share price and the financial statements?
A company buys back shares primarily as a way to move cash from the company’s balance sheet to
shareholders, similar to issuing dividends. The primary difference is that instead of shareholders
receiving cash (in the case of dividends), a share repurchase removes shareholders, leaving a smaller
shareholder base.
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The impact on share price is theoretically neutral – as long as shares are priced correctly, a share
buyback should not lead to a change in share price because while the share count (denominator) is
reduced, the equity value is also reduced by the now lower company cash balances. That said, share
buybacks can impact share price movement positively or negatively if they are perceived as a new signal
about the company’s future behavior or growth prospects.
For example, cash-rich but otherwise risky companies could see artificially low share prices if investors
are discounting that cash. In this case, a buyback should lead to a higher share price, as the upward
share price impact of a lower denominator is greater than the downward share price impact of a lower
equity value numerator.
Conversely, if shareholders view the buyback as a signal that the company’s investment prospects aren’t
great (otherwise, why not pump the cash into investments?), the denominator impact will be more than
offset by a lower equity value (due to lower cash AND lower perceived growth and investment
prospects).
On the financial statements, a $100 million share buyback would be treated as follows:
• Cash is credited by $100 million
• Treasury stock is debited by $100 million
Define free cash flow yield and compare it to dividend yield and P/E ratios
Free cash flow (FCF) yield = 𝐹𝐶𝐹 (𝑐𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠−𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠)
𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
For the purposes of this calculation, FCF is usually defined as cash from operations less investing
activities. FCF yield is similar to dividend yield (𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 ) as both are a way to gauge equity
returns relative to a company’s share price. Unlike dividend yield, however, FCF yield is based on cash
generated, as opposed to cash actually distributed. As a measure of fundamental value, FCF yield is
more useful because many companies don’t issue dividends (or an arbitrary fraction of their free cash
flows). If you flip the FCF yield you get Share price//FCF, which produces a cash flow version of a P/E
ratio. This has the advantage of benchmarking price against actual cash flows as opposed to accrual
profits. It also, however, has the disadvantage that cash flows can be volatile and period specific swings
in working capital and deferred revenue can have a material impact on the multiple.
Should two identical companies but with different rates of leverage trade at different P/E
multiples?
P/E multiples can vary significantly due to leverage difference for otherwise identical companies. All else
equal, as a company borrows money (debt), the EPS (denominator) will decline due to higher interest
expense. The impact on the share price, on the other hand, is harder to predict and depends on how the
debt will be used. At the two most extreme cases, imagine the debt proceeds will go unused, generating
no return, the share price will decline to reflect the incremental cost of debt with no commensurate
growth or investment. In this scenario, the share price can be expected to decline to such a level that
the PE ratio declines. On the other hand, if the debt is used to efficiently invest and grow the business,
the P/E ratio will increase.
