WSP Red Book (Qs Diff to 400) Flashcards

Question

Do companies depreciate land

Answer 1

No as land is assumed to have an indefinite useful life

Answer 2

Under GAAP: $2 million, only certain liquid financial assets can be written up to reflect FMV Under IFRS: revaluation of PP&E to fair value is permitted but not widely used.

Answer 3

Intangible assets include customer lists, copyrights, trademarks, and patents, which all have a finite life and are thus amortized over their useful life.

Answer 4

No, under GAAP, Goodwill has an indefinite life. Must be tested annually for impairment.

Answer 5

Companies are assumed to continue operating indefinitely.

Answer 6

Asset's value on the balance sheet must reflect the initial purchase price not the current market value; reduces market value.

Answer 7

Sudden drops in asset value causes domino effect. An example was the subprime mortgage crisis, in which the meltdown's catalyst is considered to be FAS-157. This mark-to market accounting rule mandated financial institutions to update their pricing of illiquid securities. Soon after, write-downs in financial derivatives, most notably credit default swaps ("CDS") and mortgage-backed securities ("MBS"), ensued from commercial banks, and it was all downhill from there.

Answer 8

Only verified, unbiased data can be used in financial filings. Companies not permitted to assign values to intangible assets unless value is observable in the market via acquisition.

Answer 9

NO change on BS: * Shareholder's Equity reflects the BV of Equity (BV of Equity = A -L) * Equity Value (market cap) represents the market value BV of Equity is normally much lower than Equity Value

Answer 10

No accounts receivable line, but gets captured indirectly in revenue.

Answer 11

* Deferred Revenue: company received payments upfront and has unfulfilled obligations to the customers, hence a liability Accounts Recieveable: A/R asset because the company has already delivered goods/services and all that remains is the collection of cash from customers

Answer 12

Captured indirectly in net income as interest expense recognised on income statement

Answer 13

IS: No change, new line below net income will state dividend per share CFS: CFF will decrease by the dividend payout BS: Cash balance will decline by the dividend amount, offsetting entry will be a decrease in retained earnings since dividends come from retained earnings

Answer 14

Use of cash and thus an outflow on CFO

Answer 15

Retention ratio: proportion of net income retained by the company, net of any dividends paid out to shareholders. The inverse of the retention ratio is the dividend payout ratio, which measures the proportion of net income paid out as dividends to investors.

Answer 16

Preferred dividends are fixed obligations that must be paid before common shareholders receive any earnings. Preferred shareholders do not share in the residual earnings Common shareholders' EPS would be overstated if preferred dividends were not deducted.

Answer 17

Filed before a shareholder meeting to solicit shareholder votes. Document discloses all relevant details.

Answer 18

8-K required when company undergoes a materially significant event and must disclose the details. Trigger events include a new acquisition, disposal of assets, bankruptcy, a tender offer, senior level resignation or disclosure of investigation by the SEC.

Answer 19

While does add back D&E, doesn't capture full cash impact of CapEx or working capital changes during the period. EBITDA doesn’t adjust for stock-based compensation but 'adjusted EBITDA' can.

Answer 20

Depends on if expense is non-recurring or not. Discretionary decision by management. e.g. pharma may say it is recurring.

Answer 21

Higher CapEx --> Higher Depreciation High growth companies spending big on growth capex, ratio between capex and depreciation will far exceed 1 Mature business, stagnating or declining, only do maintenance capex --> ratio will converge near 1.

Answer 22

cash and other short-term investments (e.g., treasury bills, marketable securities, commercial paper) and any interest-bearing debt (e.g., loans, revolver, bonds) are excluded when calculating working capital because they're non-operational and don't directly generate revenue.

Answer 23

Cash & cash equivalents are closer to investing activities since the company can earn a slight return (~0.25% to 1.5%) through interest income, whereas debt is classified as financing. Neither is operations-related, and both are thereby excluded in the calculation of NWC

Answer 24

Depends: Can result from being efficient at collecting revenue, quick inventory turnover, and delaying payments to suppliers while efficiently investing excess cash into high-yield investments. OR negative working capital could signify impending liquidity issues. Imagine a company that has mismanaged its cash and faces a high accounts payable balance coming due soon, with a low inventory balance that desperately needs replenishing and low levels of AR. This company would need to find external financing as early as possible to stay afloat.

Answer 25

Cash conversion cycle ("CCC") - Number of days to conert inventory sales. Companies with lower CCCS hold more negotiating power and have quicker sale collection cycles

Answer 26

Relate to operating expenses, often along with SG&A

Answer 27

Forecasted as part of the growth with revenue

Answer 28

Forecasted to growth with revenue. If driver unclear, it can be straight-lined.

Answer 29

Simple: D&A as a % of revenue or CapEx, with CapEx as a % of revenue. Complex: Depreciation waterfall schedule to track the PP&E and useful life of each. Utilisie management plan for capex. For amorisation also need to assume useful life.

Answer 30

EOP PP&E = BOP PP&E + CapEx - Depreciation For intangibles, use management guidance or no purchases. EOP Intangibles = BOP Intangibles + Intangibles Purchases - Amortisation

Answer 31

Both used to assess near-term liquidity

Answer 32

* The cash balance used includes the minimum cash amount required for working capital needs – meaning operations could not continue if cash were to dip below this level. * Cash balance may contain restricted cash * Short-term investments that cannot be liquidated in the markets (i.e., low liquidity, cannot sell without a substantial discount). Accounts receivable could include “bad A/R"

Answer 33

Could happen in start ups or early stage companies Also could be due to the payout of dividends and share repurchases; company has returned more capital to shareholders than taken in.

Answer 34

Could happen in start ups or early stage companies Also could be due to the payout of dividends and share repurchases; company has returned more capital to shareholders than taken in.

Answer 35

* Ineffective at collecting cash * Allows receivables to balloon * Must pay cash for all inventories and supplies * Financing unavailable Too much debt

Answer 36

Debt; In the absence of debt in the capital structure, the two metrics would be equal. But if the company were to add debt to its capital structure, its ROE would rise above its ROA due to increased cash, as total assets would rise while equity decreases.

Answer 37

Imagine a company with $100 in total assets. A 10% return on assets (ROA) would imply $10 in net income. Since the debt-to-equity mix is 50/50, the return on equity (ROE) is $10/$50 = 20%.

Answer 38

Numerator comes from the income statement, which covers a specific amount of time, while the denominator comes from the balance sheet, which is a snapshot. Thus average between beginning and end of balance sheet item, denominator, is used to adjust.

Answer 39

A company's ROA and ROE ratios are benchmarked against competitors in the same industry to assess management efficiency and track historical trends. However, the ROA and ROE ratios are most useful when compared to a peer group of companies with similar growth rates, margin profiles, and risks. This approach would be best suited for established companies operating in mature, low-growth industries with many comparable companies to accurately track the management team's profitability and efficiency.

Answer 40

Measures management efficiency, if above WACC suggests efficient capital allocation. If lr then a competitive advantage.

Answer 41

How efficiently a company uses its assets to generate sales "How many dollars does a company generate per dollar of asset" Distorted by CapEx and Asset Sales

Answer 42

Inventory Turnover ratio: how often a company has sold an replaced its inventory balance throughout a specific period DIH: average number of days it takes for a company to turn its inventory into revenue

Answer 43

Measures efficiency of collecting payments

Answer 44

How quickly a company pays its vendors. Higher A/P means company pays quicker and cash outflows faster.

Answer 45

Inventory Turnover ratio: how often a company has sold an replaced its inventory balance throughout a specific period DIH: average number of days it takes for a company to turn its inventory into revenue

Answer 46

Measures efficiency of collecting payments

Answer 47

How quickly a company pays its vendors. Higher A/P means company pays quicker and cash outflows faster.

Answer 48

Assesses if earnings can cover fixed charges; rent, utilities and interest. Higher ratio means a better creditworthiness

Answer 49

Share count increases --> EPS falls But if share issuances generate cash --> increase interest income --> increase net income and EPS However most returns on excess cash are low ---> doesn't offset negative dilutive impact on EPS and share count Could also see accretive or dilutive impacts on EPS through a stock-based acquisition

Answer 50

Share buyback --> reduced share count --> increased EPS If funded with excess cash --> less interest income --> lower net income and EPS But share buyback net positive EPS

Answer 51

Effective - represents % of taxable income corporations must pay in taxes. Marginal Tax Rate - taxation % on the last dollar of a company's taxable income. Depends on statutory rate of tax, taxable incomme and brackets

Answer 52

Effective tax rate calculated using pre-tax income from the accrual-based income statement, whereas marginal is based on real cash taxes.

Answer 53

Under GAAP, many companies follow different accounting standards and rules for tax and financial reporting. * Most companies use straight-line depreciation but the IRS requires accelerated depreciation for tax purposes * Apply NOL carry forwards to reduce the amount of taxes due in later periods. When debt or accounts receivable is determined to be uncollectible (i.e., “Bad Debt” and “Bad AR”), this can create DTAs and tax differences. The expense can be reflected on the income statement as a write-off but not be deducted in the tax returns.

Answer 54

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, NOLs that arise beginning in 2018 and through 2020 could be carried back for up to a maximum of five years. The rules for claiming tax losses were changed to assist individuals and corporations negatively impacted by the pandemic. For tax years beginning after 2020, the CARES Act would allow NOLs deduction equal to the sum of: 1. All NOL carryovers from pre-2018 tax years 2. The lesser amount between 1) all NOL carryovers from post-2017 tax years or 2) 80% of remaining taxable income after deducting NOL carryovers from pre-2018 tax years. Previously, NOLs arising in tax years ending after 2017 could not be carried back to earlier tax years and offset taxable income. NOLs arising in tax years post-2017 could only be carried forward to later years. But the key benefit was that the NOLs could be carried forward indefinitely until the loss was fully recovered (yet limited to 80% of the taxable income in a single tax period).

Answer 55

The corporate tax rate will rise from the Trump Era’s Tax Cuts and Jobs Act ("TCJA") rate of 21% to 28%; estimated to increase the government’s tax revenue from $2 trillion to $3 trillion over the next decade. The top tax rate for individuals with a taxable income of $400k+ will rise from 37% to 39.6%. A 12.4% payroll tax will be imposed on those earning $400k+ and to be split evenly between employers and employees. Minimum tax on corporations with book profits of $100+ million, which would be structured so that corporations would pay the greater amount between 1) their regular corporate income tax or 2) the 15% minimum tax with net operating loss (NOL) and foreign tax credits allowed.

Answer 56

Stock-based compensation is a non-cash expense so it reduces taxable income and is added-back on the cash flow SVC incurs an additional cost to the issuer by creating additional shares, diluting existing share holders

Answer 57

* Contra-Liability: A contra-liability is a liability account that carries a debit balance. While classified as a liability, it functions closer to an asset by providing benefits to the company. An example would be financing fees in M&A. The financing fees are amortized over the debt's maturity, which reduces the annual tax burden and results in tax savings until the end of the term. * Contra-Asset: A contra-asset is an asset that carries a credit balance. An example would be depreciation, as it reduces the fixed asset’s carrying balance while providing tax benefits to the company. There is often a line called “Accumulated Depreciation,” which is the contra-asset account reflected on the balance sheet. Contra-Equity: A contra-equity account has a debit balance and reduces the total amount of equity held by a company. An example would be treasury stock, which reduces shareholders’ equity. Since treasury stock reduces the total shareholders' equity, treasury stock is shown as a negative on the balance sheet.

Answer 58

* Under the US GAAP, estimates % of AR that is uncollectible (bad debt reserve) Contra-asset on the balance sheet

Answer 59

Write Down: Downward adjustment made to an asset that FMV has fallen below it's book value. Write Offs: Reduces asset value to 0; holds no current or future value

Answer 60

Causes a drop in net income but the write-down is a non cash item so it is added back

Answer 61

IS: Initially, there'll be no impact on the income statement since the purchase of the building is capitalized. CFS: The PP&E outflow is reflected in the cash from investing section and reduces the cash balance. BS: The cash balance will go down by the purchase price of the building, with the offsetting entry to the cash reduction being the increase in PP&E. Throughout the purchased building's useful life, depreciation is recognized on the income statement, which reduces net income each year, net of the tax expense saved (since depreciation is tax-deductible)

Answer 62

IS: If I sell a building for $10 million with a book value of $6 million, a $4 million gain from the sale would be recognized on the income statement, which will increase my net income by $4 million. CFS: Since the $4 million gain is non-cash, it'll be subtracted from net income in the cash from operations section. In the investing section, the full cash proceeds of $10 million are captured. BS: The $6 million book value of the building is removed from assets while cash increases by $10 million, for a net increase of $4 million to assets. On the L&E side, retained earnings will increase by $4 million from the net income increase, so the balance sheet remains balanced. However, the gain on sale will result in higher taxes, which will be recognized on the income statement. This lowers retained earnings by $1 million and be offset by a $1 million credit to cash on the asset side

Answer 63

Initial Purchase Year (Year 0) IS: There'll be no changes as neither capex nor issuing debt impact the income statement. CFS: The $50 million outflow of capex will be reflected in the cash from investing section of the cash flow statement, while the $100 million inflow from the debt issuance will be reflected in the cash from financing section. The ending cash balance will be up by $50 million. BS: On the assets side, cash will be up by $50 million and PP&E will increase $50 million from the PP&E purchase, making the assets side increase by $100 million in total. On the L&E side, debt will be up $100 million, which will offset the increase in assets and the balance sheet remains in balance. End of First Year (Year 1) IS: Since the capex amount was $50 million with a useful life assumption of five years (straight-line to a residual value of zero), the annual depreciation will be $10 million. Next, the interest expense will be equal to the $100 million in debt raised multiplied by the 5% annual interest rate, which comes out to $5 million in annual interest expense. The pre-tax income will be down by $15 million and assuming a 40% tax rate, net income will be down $9 million. CFS: Net income will be down $9 million, but the non-cash depreciation of $10 million will be added back, making the ending cash balance increase by $1 million. BS: On the assets side, cash is up by $1 million and PP&E will decrease by $10 million because of the depreciation. Since equity is also down $9 million due to net income, both sides will remain in balance.

Answer 64

1. Percentage of Completion Method: Revenue is recognized based on the percentage of work completed during the period. This method is used far more common since it's in a company's best interest to record partial revenue once earned. Two conditions must be met: the collection of payment must be reasonably assured, and the total project costs with the estimated completion date are required to be provided. 2. Completed Contract Method: The completed contract method recognizes revenue once the entire project has been completed. Rare

Answer 65

Goodwill remains unchanged unless impaired --> common means that management may be overpaying or are unable to integrate new acquisitions

Answer 66

Cash restricted for a specific purpose and unavailable to the company for use. e.g. required to maintain a % of a loan.

Answer 67

Recognised PV of all future lease payments as debt, and value provided by those future leases as an asset (PP&E) on the lessee's BS Over finance lease term, asset depreciates and lease liability accrues interests and reduced by lease payments. On the income statement, depreciated and implied interest expense reduces net income. Balance sheet initially treats the finance lease as a debt-like liability and the underlying asset as an owned asset. Over the life of the lease, the income statement impact doesn't capture the rent expense as one might intuitively assume. Instead, finance lease accounting breaks up the lease payments into two components on the income statement: interest and depreciation expenses – even though a company in actuality is paying a lease payment that commingles these two items.

Answer 68

Long-term lease: Transfers substantially all risks and rewards of ownership to the lessee. Asset recognition: Lessee records the leased asset and a corresponding liability on the balance sheet. Ownership transfer: Often includes an option to purchase the asset at the end of the lease term. Lease term: Typically covers the majority of the asset's useful life. Accounting: Lease payments are split into interest expense and principal repayment.

Answer 69

IFRS doesn't allow operating leases, only GAAP. For BS same as finance lease; recognized as a liability on the balance sheet (just like debt) with the corresponding asset as PP&E. IS: Diverges; reduced by the rent (lease) expense throughout the lease term. CFS: cash flow statement will already reflect the lease payment in each period via the net income line

Answer 70

1. **Investments in Securities**: used when a company invests in another company's equity but the ownership % is less than 20%. Investments are treated as minor, passive financial investments due to the insignificant influence. 2. **Equity Investments Method**: Owns 20-50% of another company, significant. Equity method used and investment intially measured at acquisition price and reocrded as an 'Investment in Affiliate' on assets. 3. **Consolidation Method**: Parent company has majority control over 50% ownership, target balance sheet consolidated with acquirer. To reflect less than 100% owned, new line item 'Non-Controlling Intersts' which captures the value of equity in the consolidated business held by non-controlling interests.

Answer 71

1. Trading Securities: Debt or equity investments intended to generate short-term profits. Pruchase amount recorded as initial cosst on BS and marked-to-market until lost. Unrealised gains/loss recorded on income statement until realised. 2. Avaliable For Sale Securities: debt or equity securities held for long-term but sold pre-maturity. Similar to trading with BS except on IS unrealised gains and lsoses not reflect, instead recorded as 'Accumulated Other Comprehensive Income' on the balance sheet. 3. Held-to-Maturity Securities ("HTM"): long term investments only debt securities held until the end of term. Original cost recorded on BS (amortised), valeue not adjusted from changes in FMV.

Answer 72

Mark-to-market accounting would record the asset at its current fair market value and then adjust the value to reflect what an asset would sell for today. There are a few exceptions to the cost principle rule, with one of them being marketable securities, which are highly liquid and traded on stock exchanges.

Answer 73

Trapped cash refers to the accumulation of cash overseas by multinational companies. While not illegal, companies keep this cash offshore to avoid certain repatriation taxes if brought back to the US.

Answer 74

two stages of software development in which a company can capitalize software costs: 1. The application development stage for software intended for internal use such as coding 2. The stage when the software’s “technological feasibility” has been reached and can be marketed Treated like intangible asset, capitalised and amortised

Answer 75

PIK toggle note allows issuer of the debt with the option to defer an interest payment, but the entire debt balance, including the accrued payments that must be paid by maturity. Loans can come with a fixed PIK schedule but certain instruments can come with optionality to let the issuer decide whether to pay in cash or accrue to the next period.

Answer 76

IS: interest expense up $100 --> EBT decrease by $100 --> net income $60 with 40% tax CFS: net income down $70, $100 non-cash PIK interest added back --> ending cash increases by $30 BS: A; cash up $30. L&E; debt up $100, net income down $30. Balances as net $30 increase.

Answer 77

Original issue discount ("OID") feature of debt to make the issuance more appealing to investors as a "deal sweetener". Typically, the reduction is 1-2% of the debt issuance. For example, that if there's $100 of debt being raised, you'll issue it so that the lender only has to pay $98 or $99. An OID is modeled similarly to financing fees and amortized over the term of the debt.

Answer 78

Introduced when a cell refers to itself directly or indirectly e.g. For example, interest expense is calculated off the beginning and ending balances of a company's debt outstanding, which includes the revolver. Furthermore, the revolver drawdown/(paydown) for a given period is directly impacted by interest expense – thereby, a circular reference is created.

Answer 79

Mgmt often announce plans for issuances and buybacks. Use formula to answer. For differences between basic and diluted, differences calculated according to historical and straight lined; decent proxy.

Answer 80

PE = Share Price / EPS Therefore Forecasted EPS * PE Assumptions = Implied Share Price

Answer 81

1. Defined Contribution: employer makes specified contributions periodically, shown as part of SG&A 2. Defined Benefit: Employer estimating each period the contribution to satisfy upcoming defined benefits --> assumptions on expected payments --> recognise pension expense in SG&A --> offsetting pension asset (if cash contribution bigger than expense) or liability (if cash contribution smaller than expense) --> both lead to DTAs and DTLs due to differences between GAAP and Cash taxes

Answer 82

Assumes that the proceeds from exercising dilutive options go towards repurchasing stock at the current share price to reduce the net dilutive impact

Answer 83

Total Debt = all interest-bearing debt, non equity financial claims (preferred stock and non-controlling interest) Cash & Equivalents = non-operating assets such as cash, short-term investments and equity investments Net Debt = Total Debt – Cash & Equivalents

Answer 84

The underlying idea of net debt is that the cash on a company’s balance sheet could pay down the outstanding debt if needed. For this reason, cash and cash equivalents are netted against the company’s debt, and many leverage ratios use net debt rather than the gross amount ?

Answer 85

Theoretically none as EV is capital structure neutral --> cash and debt balance However cost of financing could negatively impact the profitability and lead to a lower valuation

Answer 86

When calculating multiples using EV, the numerator will be the consolidated metric, thus minority interest must be added to enterprise value for the multiple to be compatible

Answer 87

"In-the-money" --> TSM same as additional dilution from equity. "Out of the money" --> treated as liability (similar to debt)

Answer 88

1. Intrinsic Valuation: Business ability to generate cash flow 2. Relative Valuation: Look at comparable and derive averages

Answer 89

DCF due to reliance on assumptions and projections

Answer 90

Using various methods allows you to arrive at a more defensible approximation and sanity-check your assumptions. e.g. DCF and Trading Comps together

Answer 91

Not entirely as comps analysis has implicit assumptions itself which are inconsistent with DCF. Assuming market consensus to be accurate/closer.

Answer 92

Free cash flow ("FCF") represents a company's discretionary cash flow, meaning the cash flow remaining after accounting for the recurring expenditures to continue operating. The simplest calculation of FCF is shown below: Free Cash Flow (FCF) = Cash from Operations – Capex The cash from investing section, other than capex, and the financing section are excluded because these activities are optional and discretionary decisions up to management.

Answer 93

The calculation of free cash flow should include only inflows/(outflows) of cash from the core, recurring operations. That said, a periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring and a normal part of operations (i.e., capex is required for a business to continue operating)

Answer 94

Both DCF and Comps see to value the operations of the business, so need to set apart core to normalise figures. 1. A few examples of nonoperating income to exclude would be income from investments, dividends, or an asset sale. Each example represents income that's non-recurring and from a discretionary decision unrelated to the core operations. 2. When performing comps, the core operations of the target and its comparable are benchmarked. To make the comparison as close to “apples to apples” as possible, non-core operating income/(expenses) and any non-recurring items should be excluded.

Answer 95

* Both FCF yield and dividend yield can gauge equity returns relative to a company's share price * FCF yield more useful as a fundamental value than dividend as any companies don’t issue dividends * Inverted FCF yield benchmarks prices against actual cash flow compared to P/E. However cash flow can be volatile (shifts in working capital, and deferred revenue)

Answer 96

D/E mix that minimises the cost of capital while maximising firm value

Answer 97

Theoretically neutral impact on share price: share count reduced but equity value is also reduced by lower cash balances. Depends on perceptions; is the upward share price impact greater than the downward share price of a lower equity value

Answer 98

* Avoid double taxation * Artifical boost of EPS * Counteract dilutive impact of stock-based compensation Cutting a dividend can be very negatively interpreted

Answer 99

* Net income drops from $100 million to $90 million [($200 million new borrowing x 5%) = $10 million] * Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15.0 x $90 million) Interest tax deductible so ignored. * Net equity value increase of $50 million due to dividend. Assumptions are key; cost of debt higher or P/E ratios falling could wipe out any benefit. Debt levels will always eventually effect cost of capital and P/E.

Answer 100

Low-growth companies with fewer profit prospects. Mgmt pay dividends to signal commpany is confident in long-term profitability and appeal to long-term dividend investors.

Answer 101

IRR can handle more complex situations with the timing of the cash inflows and outflows accounted for rather than just smoothing out investment returns CAGR used for assessing historical growth, IRR used for investment decision

Answer 102

* Assume I have enough to make a down payment and investment period of 10 years Buy: Buy and pay mortgage, real estate tax and maintenance fees (some tax deductions on interest and depreciation. After 10 years, sell the property reflecting the historical real estate growth rate. Calculate IRR from monthly outlays and final inflow. Rent: Estimate rent and escalations based on comps. Invest spare cash with long-term historical returns 5-7%. Use IRR to make informed decision Comparison: not precisely apples to apples. NYC real estate riskier and less liquid than public stock.

Answer 103

Painting lacks intrinsic value, no cash flows so can't be valued traditionally. Price is a function of market willingness so analyse comparable transactions.

Answer 104

Used when valuing private companies to account for the illiquidity of the asset. Investors will pay a premium for a similar asset with higher liquidity.

Answer 105

1. Forecast UFCF, which represent free cash flows to the firm before the impact of leverage 2. Calculate Terminal Value; value of all unlevered FCF calculated through perpetuity or exit multiple 3. Discount forecast period CFs and TV according to the WACC 4. Enterprise value --> equity value. EV - Cash & Equivalents (non-operating assets such as equity investments and marketable securities) + Debt + Preferred Stock + Minority Interests (and any other financial obligations). 5. Price per Share calculation: divide the equity value by diluted shares outstanding. 6. Sensitivity Analysis: normaly adjust WACC and Exit Multiples. Also can do a football field analysis to show how different multiples affect TV.]

Answer 106

* Represents the expected return on an investment based on its risk profile Discount rate is the minimum return threshold of an investment based on comps.

Answer 107

* FCFF: cash flow from core operations. EBIT (unlevered measure of profit) --> tax --> add back non-cash --> working capital adjustments --> subtract CapEx --> FCFF FCFF = EBIT × (1 – Tax Rate) + D&A – Changes in NWC – Capex FCFE: Cash flows after lender payments, residual for equity owners. Net Income --> add back non-cash --> working capital adjustments --> subtract CapEx --> add cash inflows/outflows from new borrowings, net of debt paydowns

Answer 108

* Unlevered DCF arrives directly at enterprise value, discount with WACC * Levered DCF arrives directly at equity value, discount with equity value, to get to EV add back net debt. In theory end up at same Enterprise and Equity but in practice v difficult to get precisely the same

Answer 109

Opportunity cost of an investment based on comparable investments with similar risk profiles.

Answer 110

Capital asset pricing model ("CAPM"), which links the expected return on a security to its sensitivity to the overall market

Answer 111

There has been much debate around normalized risk-free rates. Aswath Damodaran has argued against the usage of normalized rates and has written that “you should be using today’s risk-free rates and risk premiums, rather than normalized values when valuing companies or making investment assessments.

Answer 112

ERP measures incremental risk of investing in equities over risk-free securities. ERP ranged from 4-6% based on historical spreads between the S&P 500 returns over the yield on risk-free bonds. Equity Risk Premium (ERP) = Expected Market Return − Risk Free Rate

Answer 113

Beta measures the systematic (i.e., non-diversifiable) risk of a security compared to the broader market. Said another way, beta equals the covariance between expected returns on the asset and the market, divided by the variance of expected returns on the market.

Answer 114

Systemic Risk: undiversiable market risk inherent within the entire equity market. Unavoidable risk that cannot be mitigated through diversification. Unsystemic Risk: company-specific or industry risk reducable through diversification

Answer 115

Higher beta --> more risk and volatility --> higher discount rate --> lower valuation

Answer 116

Average of unlevered betas of comparable businesses and relevers at the target capital structure of the valued company. Implied assumption is that company's business risk will converge with peers over LR.

Answer 117

Company specific noise is eliminated which could include distorting events that cause the correlation to be less accurate. Very useful for private companies lacking readily observable betas.

Answer 118

Company specific noise is eliminated which could include distorting events that cause the correlation to be less accurate. Very useful for private companies lacking readily observable betas.

Answer 119

1. Backward Looking: Estimate beta through regression model that compares historical and company returns. Past performance not an accurate indicator. 2. Large Standard Error: assumption sensitive e.g. index used as proxy for market return, company specific events unrelated to the true market correlation 3. Assuming constant capital structure: Beta reflects the averages past D/E ratios instead of the current leverage in the company's capital structure. Leverage amount directly related to maturity so expected to change.

Answer 120

Levered beta = risk from leverage + unlevered beta more leverage used in a capital structure, the higher the beta given the increased volatility from debt

Answer 121

Mature companies, low betas --> non-cyclical risk, cheaper financing, strong CFs --> higher % of leverage used High beta --> harder terms, cyclical risk --> lower % of leverage

Answer 122

Yes, Gold. Inverse rs w market.

Answer 123

Observable in the market as the yield on debt with equivalent risk. If the company being valued doesn't have publicly traded debt, the cost of debt can be estimated using a so called “synthetic rating” and default spread based upon its credit rating and interest coverage ratio.

Answer 124

Cost of Equity higher as: * Interest is tax-deductible --> tax shield Equity investors bottom of capital structure, and no fixed payments

Answer 125

Internal Rate of Return: The IRR is the rate of return on a project’s expenditures. Given a beginning value and ending value, the IRR is the implied interest rate at which the initial capital investment would have to grow to reach the ending value. Alternatively, it's defined as the discount rate on a stream of cash flows leading to a net present value (NPV) of 0. Weighted Average Cost of Capital: The WACC (or cost of capital) is the average minimum required internal rate of return for both debt and equity providers of capital. Thus, an IRR that exceeds the WACC is an often-used criterion for deciding whether a project should be pursued.

Answer 126

The discount rate and the sales growth rate will be sensitized in a proper DCF model, but the discount rate's impact would far exceed that of operational assumptions such as the sales growth rate.

Answer 127

exit multiples approach was used to calculate the terminal value, it's important to cross-check the amount by backing out into an implied growth rate to confirm it's reasonable

Answer 128

In theory, a DCF is an intrinsic, cash-flow based valuation method independent of the market. By using the exit multiple approach, relative valuation is being brought into the valuation. However, the exit multiple approach is widely used in practice due to being easier to discuss and defend in terms of justifying the assumptions used.

Answer 129

Inaccurate for companies with strong seasonal demand e.g. Canada Goose focus on winter clothing.

Answer 130

Unlevered DCF should stay the same but a substantial rise in debt would impact the implied valuation due to a higher cost of debt increase.

Answer 131

If one company has significantly more cash on its balance sheet, it'll most likely be better positioned from a risk perspective. When assessing leverage risk, a company's excess cash should be considered since this cash could help paydown debt. Hence, many consider cash to be “negative debt” (i.e., the implied assumption of net debt). Therefore, one of the main leverage ratios looked at in addition to Total Debt/EBITDA is Net Debt/EBITDA. All else being equal, the company with a higher excess cash balance and lower Net Debt/EBITDA would be at lower risk of bankruptcy (and lower cost of debt).

Answer 132

* Forecast period may not be long enough * In final year in the explicit stage, company should have reach normalised, stable growth TV assumptions may be too aggressive and not reflect stable growth

Answer 133

Vested: only vested (exercisable) options in the money are assumed to be exercised Outstanding: consider unvested ITM options, as any unvested will soon vest.

Answer 134

Some finance professionals completely ignore restricted stock from the diluted share count because they're unvested. However, increasingly, unvested restricted stock is included in the diluted share count under the logic that eventually they'll vest, and it's thus more conservative to count them

Answer 135

When assuming the preferred stock is converted for calculating the diluted share count, eliminate it from enterprise and equity value calculations

Answer 136

If conversion into common stock is assumed to calculate the share count, the convertible bonds should be eliminated from the balance sheet when calculating net debt to be consistent (and avoid double-counting).

Answer 137

capitalized because leases usually burden the tenant with obligations and penalties that are far more similar to debt obligations than to a simple expense when operating leases are significant for a business (retailers and capital-intensive businesses), the rent expense should be ignored from the free cash flow build-up, and instead, the present value of the lease obligation should be reflected as part of net debt.

Answer 138

This forecast will be used for perpetuity, utilising effective rate will create DTLs and DTAs and make them an recurring line item forever which is inaccurate Should look at historical periods and base your near-term tax rate assumptions on the effective tax rate, for 2nd stage of DCF, tax rate should be normalised and within the close range of the marginal tax rate.

Answer 139

* Higher FCF from higher net income * Higher cost of debt due to a higher after tax cost of debt and a higher re-levered beta Higher beta --> cost of equity and WACC increases

Answer 140

DDM; value of a company is a function of the future dividends, whereas DCF is future cash flows DDM forecasts future DPS and growth rate assumptions which are then discounted according to the cost of equity. TV calc is done with an equity based multiple (P/E).

Answer 141

General sensitivity to assumptions in forward looking models: * DDM can't be used on high-growth companies as growth rate would be higher than the expected return * Most companies don't pay dividends * Ignores buybacks Poor companies issue large dividends

Answer 142

If the numerator is enterprise value, metrics such as EBIT, EBITDA, unlevered free cash flow (FCFF), and revenue multiples can be used since these are all unlevered (i.e., pre-debt) measures of profitability. In contrast, if the numerator is equity value, metrics such as net income, levered free cash flow (FCFE), and earning per share (EPS) would be used because these are all levered (i.e., post-debt) measures.

Answer 143

Ask if for trading or transaction comps Determine peers --> collect relevant information --> input financials and scrub + calendarise for differences --> Calculate multiples listing different percentiles and removing outliers ---> Apply multiple

Answer 144

Often excluded due to skewing towards current valuation. But if impetus is that market may misprice indv. Stocks but is correct on a whole, then should include the target

Answer 145

ADV: Public information, less data needed, current valuation DISADV: peer can be subjective, apples to oranges peers, market can be emotional, low trade volume may effect

Answer 146

When collecting the data to perform transaction comps, you would use deal announcement press releases, proxy filings, and the merger agreement to learn about the deal terms. You would also use the target company's filings (annual and quarterly reports) for historical financial data, research reports, and financial data vendors such as Bloomberg, Capital IQ, or FactSet for historical share price data and estimated earnings forecasts.

Answer 147

Competition, Strong synergies, asset scarcity, undervalued target, mismanagement

Answer 148

Strong constraint on the amount of deals with only looking at very recent transactions Must look into the context. May not even be announced

Answer 149

What was the transaction rationale from both the buyer and seller's perspective? Was the acquirer a strategic or a financial buyer? How competitive was the sale process? Was the transaction an auction process or negotiated sale? What were the economic conditions at the time of the deal? Was the transaction hostile or friendly? What was the purchase consideration? If the industry is cyclical (or seasonal), did the transaction close at a high or low point in the cycle?

Answer 150

* LTM results are actual * LTM can be distorted by non-recurring items --> should be excluded * Forward multiples take into account future potential

Answer 151

* ROIC is critical component * Different industries or geograhies * Mispricing or inconsistent EPS

Answer 152

You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a company’s value and profits independent of its capital structure. Technically, they won't be exactly equal because enterprise value depends on the cost of capital, so there'll be some variation

Answer 153

Leverage --> higher interest --> lower EPS Share price hard to predict as it's dependent on view on capital allocation

Answer 154

Enterprise Value/EBITDA multiples are the most common, followed by EV/EBIT and P/E. P/B ratios are used to value financial institutions EV/Revenue multiples are used to value unprofitable companies (EV – Capex)/EBITDA multiples can be used for capital-intensive industries such as manufacturing or cable companies.

Answer 155

Enterprise Value Multiples: EV/Revenue, EV/EBIT, EV/EBITDA Equity Value Multiples: Price/Earnings (P/E), Price/Book (P/B), Price/Levered Cash Flows

Answer 156

The company's P/E ratio would be higher. The company's four year-back P/E ratio was 5.0x and its current P/E ratio is 10.0x. Therefore, its P/E doubled after its EPS declined by $1.00. One potential interpretation is that the company is now overvalued and shouldn't be trading at a 10.0x multiple given the deteriorated EPS. Realistically, the market would view a decrease in EPS negatively, resulting in a lower share price and valuation. But since the share price didn't change, there are a few possible explanations: 1. The company could have issued more shares to raise capital that had a dilutive impact on EPS. 2. The company might have made a dilutive acquisition with stock as the main purchase consideration. In both cases, the cause of the lower EPS is the increase in the denominator. The share price remaining constant suggests the market reaction to how the company plans to use the newly raised capital or the M&A deal was positive, otherwise, the share price would've dropped. Similar to how EPS can be artificially boosted from share buybacks, it can decrease without there being an actual drop in performance. The issuance of additional shares typically results in the per-share value decreasing from the dilution, but the $10 share price is the post-dilution share price (meaning, the price was upheld despite the dilution).

Answer 157

Standardising P/E with long-term growth (g) undervalued if below 1, 1 is ok, overvalue if above 1 There are two approaches for the growth rate used: 1. Trailing PEG: growth rate based on a company's historical growth. 2. Forward PEG: more commonly; growth rate from a 1-3 year projection

Answer 158

e P/B ratio can be used when the company's book value captures a substantial part of its real value. An example would be commercial banks, as most of their assets and liabilities are frequently re-valued and similar to their actual market values

Answer 159

Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result, multiples based on revenue are the only available option to gain some level of insight.

Answer 160

An internet company with no revenue or negative profitability could be valued using user engagement metrics such as the subscriber count, monthly active users, daily active users, and website hits. For example, prerevenue internet startups are often valued using multiples such as EV/DAU or EV/MAU.

Answer 161

Calendarization aligning the fiscal year ending dates of a group of comparable companies to allow for an accurate comparison. The general convention is to adjust the financials so that all the fiscal years end in December. The reason calendarization is necessary is that cyclicality and seasonality can skew results and create discrepancies when making comparisons

Answer 162

Market can misprice indv. companies Inevstors can be emotional and overreact

Answer 163

Medians remove the distortive impact of outliers on the peer group multiple. Preferable for large peer groups. The mean preferable for smaller peer groups with fewer than five comparable companies and no outliers

Answer 164

1. Revenue Synergies: Cross-selling, upselling, product bundling, new distribution channels, geographic expansion, access to new end markets, reduced competition leads to more pricing power 2. Cost Synergies: Eliminate overlapping workforces (reduce headcount), closure or consolidation of redundant facilities, streamlined processes, purchasing power over suppliers, tax savings (NOLs)

Answer 165

Strategic buyers can often benefit from synergies, which enables them to offer a higher price

Answer 166

Premiums paid analysis is a type of analysis prepared by investment bankers when advising a public target, in which the average premium paid in comparable transactions serves as a reference point for an active deal.

Answer 167

1. Broad Auction: sell-side bank will reach out to as many prospective buyers as possible to maximize the number of interested buyers and finding the highest possible offer 2. Targeted Auction: In a targeted auction, the sell-side bank (usually under the client's direction) will have a shortlist of buyers contacted.

Answer 168

A negotiated sale involves only a handful of potential buyers and is most appropriate when there's a specific buyer the seller has in mind. Speed of close and confidentiality are two distinct benefits. These deals are negotiated “behind-closed-doors” and generally on friendlier terms based on the best interests of the client.

Answer 169

Overpaying/Overestimating Synergies: Inadequate Due Diligence Lack of Strategic Plan Poor Execution/Integration

Answer 170

M&A is often a defensive response to structural sector disruption that presents a threat to an existing business model

Answer 171

1 - 2 page marketing document done by sell-side client. Just enough information to understand proposal and protect client. Intent is to generate enough interest to gain confidential information memorandum

Answer 172

Post NDA doc that provides potential buyers with an in-depth overview n range from being a 20 to 50-page document with the specific contents being a detailed company profile, market overview, industry trends, investment highlights, business segments, product or service offerings, past summary financials, performance projections (called the “Management Case”), management biographies, and the transaction details/timing.

Answer 173

n LOI is a letter stating the proposed initial terms, including the purchase price, the form of consideration, and planned financing sources. non-binding, represents what a definitive agreement could look like, but still room for negotiation and revisions to be made in submitted LOIs (i.e., this is not a final document).

Answer 174

sell-side prevented from looking for higher bids and leveraging the buyer’s current bid with other buyers. Violating triggers a significant breakup fee by the seller and an investigation would be made into the sell-side bank to see if they were contacting potential buyers when legally restricted from doing so. a seller can protect themselves using reverse termination fees ("RTFs"), which allow the seller to collect a fee if the buyer were to walk away from the deal

Answer 175

Material adverse change ("MAC") is a highly negotiated, legal mechanism intended to reduce the risk of buying and selling parties from the merger agreement date to the deal closure date. MACs are legal clauses included in virtually all merger agreements that list out the conditions that allow the buyer the right to walk away from a deal without facing legal repercussions or significant fines

Answer 176

1. **Tender Offer**: In a tender offer, the acquirer will publicly announce an offer. The intent is to acquire enough voting shares to have a controlling stake in the target's equity that enables them to push the deal through. 2. **Proxy Fight**: attempting to persuade existing shareholders to vote out the existing management team to take over the company.

Answer 177

tender offers are announced publicly to gain control over a company without its management team and board of directors' approval. In contrast, a traditional merger would involve two companies jointly negotiating on an agreement to combine.

Answer 178

Poison Pill Defense: existing shareholders the option to purchase additional shares at a discounted price, which dilutes the acquirer's ownership and makes it more difficult for the acquirer to own a majority stake ] Golden Parachute Defense: key employees' compensation packages are adjusted to provide more benefits if they were to be laid. Disincetivise the acquirer from purchase due to increased costs. Dead Hand Defense: additional shares are automatically issued to every existing shareholder (excluding the acquirer). Crown Jewel Defense: agreement where the company’s crown jewels could be sold if the company is taken over. In effect, this would immediately make the target less valuable and less desirable to the acquirer

Answer 179

White Knight Defense: when a friendly acquirer interrupts the takeover by purchasing the target. White Squire Defense: an outside acquirer will step in to buy a stake in the company to prevent the takeover. target company will not have to give up majority control over the business Acquisition Strategy Defense: target company can resort to is to make an acquisition. end result is the balance sheet is less attractive post-deal from the lower cash balance Pac-Man Defense: target attempts to acquire the hostile acquirer. employed as a last-resort Greenmail Defense: Greenmail is when the acquirer gains a substantial voting stake in the target company and threatens a hostile takeover unless the target repurchases its shares at a significant premium. Thus, in a greenmail defense, the target will be forced to resist the takeover by repurchasing its shares at a premium. However, anti-greenmail regulations have made this nearly impossible nowadays.

Answer 180

each board member is intentionally classified into distinct classes regarding their term length, gaining additional board seats becomes a more complicated and lengthy process for hostile acquirers (and deters takeover attempts).

Answer 181

sale of a business segment Due to: * cut costs and shift their focus to their core business * Restructuring * Regulatory pressure * Activist investors

Answer 182

Selling a portion of equity interest in a subsidiary to public investors In most cases, parent retains a controlling stake After carve-out, subsidiary is a new legal entity with a separate mgmt team and board.

Answer 183

separate a particular division to create an independent entity with new shares (ownership claims). existing shareholders will receive new shares in proportion to their original proportion of ownership in the company (i.e., pro-rata).

Answer 184

Subsidiary: A subsidiary is when the parent company remains the majority shareholder (50%+). Affiliate Company: An affiliate company is when the parent company has only taken a minority stake.

Answer 185

when a privately held company undergoes a merger with another company that's already publicly traded in the markets. benefit of reverse mergers is that the public entity can now issue shares without incurring the costs associated with IPOs

Answer 186

An S-4 is a required form that must be filed with the SEC prior to a merger and acquisition activity taking place. Contained in the S-4 will be material information related to the transaction, such as the deal rationale, negotiated terms, risk factors, pro forma financials, and other related material.

Answer 187

disclose publicly when an investor has taken a significant stake in a company in terms of ownership and voting power: **Schedule 13-D**: filed when an investor acquires a minimum of 5% of a public company's total common equity, and over 2% was acquired in the last twelve months. direct statement in the filing, answering whether they intend to acquire more of the company’s shares to gain further influence. **Schedule 13-G**: can be filed in lieu of the 13-D as long as the investor doesn't intend to take control of the company. This alternative, short-form version is filed when an investor acquires 5%+ of the total equity but less than 2% in the last twelve months. reporting requirements are shorter, less detailed, and depend on the investor's classification (e.g., institutional investor, passive investor). If the investor's intent is amended, the 13-D must be filed within ten days of the change.

Answer 188

Winner’s curse in M&A is the tendency for the winning bidder to have paid far beyond the target's fair value. especially if the acquisition doesn't pan out as expected, which can lead to write-downs of the acquired assets.

Answer 189

mitigate transaction risks, a holdback mechanism can require a portion of the purchase price of an acquisition to be placed in escrow to protect the interests of the buyer post-closing until the terms of the agreement have been satisfied. ensure the seller follows through on all agreed upon conditions outlined in the deal agreement

Answer 190

1. Introduction of the Investment Bank and Dedicated Team Members 2. Situational Overview of the Deal and Client Company 3. Prevailing Market and Industry Trends 4. Implied Valuation Range and Combined M&A Model 5. Proposed Deal Strategy Outline and Key Considerations 6. Credentials and Tombstones of Relevant Industry Experience 7. Appendix (DCF Model, Trading Comps, Transaction Comps)

Answer 191

An M&A model takes two companies and combines them into one entity. 1. assume purchase price, sources & uses 2. acquirer’s balance sheet is consolidated with targets. Certain line items such as working capital can be added together, while others require further analysis. major adjustment is calculating the incremental goodwill, which involves making assumptions regarding asset write-ups and deferred taxes created (or eliminated). 3. Next, deal-related borrowing and paydown, cash used in the transaction, and the elimination of target equity all need to be reflected. 4. Lastly, the income statements are combined to determine the combined, pro forma accretion/dilution in EPS – which is ultimately the question being answered: "Will this deal be accretive or dilutive?"

Answer 192

1. Bottom-Up Analysis: starting from the buyer ’s and seller’s standalone EPS and adjusting to reflect the incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write-ups. 2. Top-Down Analysis: two income statements are combined, starting with revenue and then moving down to expenses while making the deal-related adjustments.

Answer 193

significant accretion or dilution is often a sign of potential investor reaction from the transaction. Many buyers fear dilutive deals because they can lead to a decline in share price post-announcement. These concerns are not relevant to whether a deal actually creates long-term value for the acquiring company’s shareholders. Accretion: When Pro Forma EPS > Acquirer’s EPS Dilution: When Pro Forma EPS < Acquirer’s EPS Breakeven: No Impact on Acquirer’s EPS

Answer 194

Nearly all M&A deals are negotiated on a “cash-free, debt-free” basis. implicitly assumes the seller will pay off all the debt outstanding and extract all the excess cash before the new buyer completes the transaction. Excess cash in this context is defined as the cash remaining after the debt has been paid down and above its minimum cash balance. Since the acquirer doesn't have to assume the debt on the seller’s balance sheet or get to use its cash, the acquirer is just paying the seller for the company's enterprise value.

Answer 195

Buyer’s Perspective: Higher Buyer P/E --> use stock to be accretive debt; cost, access and impact will be evaluated Seller’s Perspective: Most sellers will prefer cash over a stock sale unless tax deferment is a priority for the seller. A stock sale is usually most palatable to the seller in a transaction that more closely resembles a merger of equals and when the buyer is a public company.

Answer 196

Purchase consideration represents the acquirer's proposed payment method Tax consequences represent decisive factors that shareholders consider when assessing an offer: * all-cash has an immediate tax consequence * all-equity, this would not trigger any taxes. Shareholders’ perception of the post-M&A company can also impact their decision to have shares or not

Answer 197

stock deals; purchase offer can be either a fixed or floating exchange ratio 1. **Fixed Exchange Ratio**:he number of shares to be required by the target’s shareholders is constant, as well as their ownership percentage in the new entity, regardless of the share price movement 2. **Floating Exchange Ratio: ** sets a specific amount per share the acquirer has agreed to pay for each share of the target’s stock in the form of the acquirer’s shares. target's shareholders have downside protection

Answer 198

For the acquirer, main benefit of paying with stock is that it preserves cash and avoid using debt. For the seller, a stock deal makes it possible to share in the future growth of the business and enables the seller to defer the payment of tax on gain associated with the sale.

Answer 199

an all-stock deal comes with the possibility of higher returns if the combined entity performs well and the market has a favorable view of the acquisition, leading to share price appreciation.

Answer 200

if the acquirer is being valued at a lower P/E than the target in an all-stock deal, the acquisition will be dilutive. The reason being more shares must be issued, which increases the dilutive impact. But if the acquirer is being valued at a higher P/E than the target, the acquisition will be accretive.

Answer 201

Yes, stock-for-stock deals where the acquirer’s P/E ratio is higher than the target’s P/E are always accretive. Don't get tricked. A 20% premium just brings the target’s P/E to 13 + (13 x 20%) = 15.6 P/E, which is still below the acquirer ’s P/E.

Answer 202

The offer price per share refers to the purchase price to acquire the seller's equity on a per-share basis. Thus, the calculation of offer value involves multiplying the fully diluted shares outstanding (including options and convertible securities) times the offer price per share. Offer Value = Fully Diluted Shares Outstanding × Offer Price Per Share

Answer 203

Oftentimes, news of the deal or even rumors can leak and cause the price of the companies involved in the deal to rise (or decrease). Therefore, the latest share price may already reflect investors’ opinions on the deal and not be an accurate depiction of the real standalone valuation of the target company

Answer 204

It is important to use the normalized share price in the calculation, as rumors of the deal could have reached the public before an official announcement. To accurately calculate the control premium, the denominator (i.e., pre-deal share price) must be “unaffected” by the news of the transaction.

WSP Red Book (Qs Diff to 400) Flashcards

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