WSP Red Book (Qs Diff to 400)

Question 1

Main sections of 10K

Answer 1

Question 2

Main difference between 10-K and 10-Q

Answer 2

• 10-K: annual report, fully comprehensive of mgmt comments, risk, disclosures and 3 financials
  10-Q: Quarterly reports required to be filed with the SEC, much more condensed quaterly financials with brief sections for MD&A and supplementary disclosures. Unaudited.

Question 3

What are the British and European equivalent of 10-K and 10-Q. What are the main differences in contents?

Answer 3

UK 10-K equivalent: Annual Report and Financial Statements; 10-Q equivalent: Half-Yearly Report.
EU 10-K equivalent: Annual Financial Report; 10-Q equivalent: Interim Financial Report.
UK/EU use IFRS, U.S. uses GAAP for reporting.
U.S. reports are quarterly; UK/EU reports can be half-yearly or quarterly.
UK/EU governed by local laws and EU directives; U.S. filings follow SEC regulations.

Question 4

Why is R&D an Operating Expense?

Answer 4

R&D is essential to a company’s core business operations and growth.

Necessary to sustain competitive advantage and maintain market share.

Question 5

Common Parts of Liabilities Section?

Answer 5

“Current Liabilities” include accounts payable, accrued expenses, and short-term debt, while “Long-Term Liabilities” include items such as long-term debt, deferred revenue, and deferred income taxes.

Question 6

What does an Asset represent?

Answer 6

Assets are resources with economic value that can be sold for money or bring positive monetary benefits in the future.

e.g. cash is a store, accounts recieveable are payments due from customers, and PP&E is used to generate cash flows in the future - representing inflows of cash.

Question 7

What does a Liability represent?

Answer 7

Liabilities are unsettled obligation to another party in the future and represent external sources of capital from 3rd parties to fund assets.

Liabilities represent future cash outflows.

Question 8

What does Equity represent?

Answer 8

Capital invested in the business and represents the internal sources of capital that helped fund its assets. Accumulated net profits shown here as retained earnings?

Question 9

Define Marketable Securities

Answer 9

Question 10

Define Prepaid Expenses

Answer 10

Question 11

Define Accrued Expenses

Answer 11

Question 12

Define Deferred Revenue

Answer 12

Question 13

Defined Deferred Taxes

Answer 13

Question 14

Define Lease Obligations

Answer 14

Question 15

Which is more important, the income statement or the cash flow statement?

Answer 15

Cash flow statement as it reconciles net income, the accrual-based bottom line on the income statement, to cash.

Liquidity-related issues and investments and financing activities that don’t show up on the accrual-based income statement.

Question 16

In what scenario would you pick the income statement over the cash flow (if it was a singular choice) when analysing a company

Answer 16

When analysing an unprofitable company:
* Income statement can be used for valuing company on revenue multiple
Cash flow less useful for valuation if net income, cfo and fcf are all negative

Question 17

Why is the income statement insufficient to assess the liquidity of a company?

Answer 17

Accrual accounting relies on mgmt’s discretion –> less reliable.
e.g. won’t show struggle to collect sales on credit

Only cash flow shows real cash inflows and outflows

Question 18

What are some discretionary management decisions that could inflate earnings?

Answer 18

• Excessive useful life to reduce depreciation
• Switching from LIFO to FIFA if inventory costs rise
• Refusing to write down impaired asset
• Capitalising rather than expensing costs
• Repurchasing shares to artificially increase EPS
• Deferral of CapEx and R&D
  Aggressive revenue recognition policies

Question 19

Tell me about the revenue recognition and matching principle used in accrual accounting.

Answer 19

Revenue Recognition Principal - revenue recorded in same period g/s was delivered, regardless of collected cash

Matching Principle - Expenses associated with the g/s must be recorded in the same period as revenue recognition

Question 20

What is the difference between cost of goods sold and operating expenses?

Answer 20

COGS - direct costs of production and delivery e.g. materials and labour
OpEx - Not directly associated with production but needed e.g. SG&A, R&D, rent, advertising

Question 21

If depreciation is a non-cash expense, how does it affect net income?

Answer 21

While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has already occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase

Question 22

Do companies prefer straight-line or accelerated depreciation?

Answer 22

Most prefer straight line due to the lower depreciation in the earlier years. Companies that are constantly acquiring new assets, won’t see the accelerated ‘flip’ in lower costs until the company sig. scales back CapEx.

Question 23

What is the relationship between depreciation and the salvage value assumption?

Answer 23

Difference between cost of asset and salvage value (residual value) at end of useful life determines the annual depreciation.

Question 24

What is the typical assumption on the salvage value by companies

Answer 24

Salvage Value of 0 to increase depreciation expenses –> higher tax benefits

Question 25

Do companies depreciate land

Answer 25

No as land is assumed to have an indefinite useful life

Question 26

A company acquired a machine for $5 million and has since generated $3 million in accumulated depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value of that PP&E on the balance sheet?

Answer 26

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.

Question 27

Which types of intangible assets are amortized?

Answer 27

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

Question 28

Can Companies Amortise Goodwill

Answer 28

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

Question 29

What is the “going concern” assumption used in accrual accounting?

Answer 29

Companies are assumed to continue operating indefinitely.

Question 30

Why are most assets recorded at their historical cost under accrual accounting?

Answer 30

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

Question 31

What role did fair-value accounting have in the subprime mortgage crisis?

Answer 31

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.

Question 32

Why are the values of a company’s intangible assets not reflected on its balance sheet?

Answer 32

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.

Question 33

If the share price of a company increases by 10%, what is the balance sheet impact?

Answer 33

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

Question 34

Do accounts receivable get captured on the income statement?

Answer 34

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

Question 35

Why is deferred revenue classified as a liability while accounts receivable is an asset?

Answer 35

• 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

Question 36

Which section of the cash flow statement captures interest expense?

Answer 36

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

Question 37

What happens to the three financial statements if a company initiates a dividend?

Answer 37

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

Question 38

How should an increase in inventory get handled on the cash flow statement?

Answer 38

Use of cash and thus an outflow on CFO

Question 39

Implication of FIFO and LIFO with rising and decreasing inventory costs?

Answer 39

Question 40

What does the retention ratio represent and how is it related to the dividend payout ratio?

Answer 40

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.

Question 41

What are the two ways to calculate earnings per share (EPS)?

Answer 41

Question 42

Why do we always use dividends on preferred stock when calculating EPS?

Answer 42

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.

Question 43

What is a proxy statement?

Answer 43

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

Question 44

What is an 8-K and when is it required to be filed?

Answer 44

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.

Question 45

Is EBITDA a good proxy for operating cash flow?

Answer 45

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.

Question 46

When adjusting for non-recurring expenses, are litigation expenses always added back?

Answer 46

Depends on if expense is non-recurring or not. Discretionary decision by management.

e.g. pharma may say it is recurring.

Question 47

How does the relationship between depreciation and capex shift as companies mature?

Answer 47

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.

Question 48

Why are cash and debt excluded in the calculation of net working capital (NWC)

Answer 48

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.

Question 49

What are Cash & Cash Equivalents, Short-Term investmetns, debt closer to than operations?

Answer 49

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

Question 50

Is negative working capital a bad sign about a company’s health?

Answer 50

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.

Question 51

What ratios would you look at to assess working capital management efficiency

Answer 51

Question 52

Explain the formulas for DIH, DSO and DPO

Answer 52

Question 53

What is the cash conversion cycle?

Answer 53

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

Question 54

What is DIO here

Answer 54

Question 55

How do you project Accounts Receivable

Answer 55

Question 56

How do you project inventories

Answer 56

Question 57

How do you project prepaid expenses

Answer 57

Question 58

How do you project other current assets

Answer 58

Question 59

How do you project Accounts Payable

Answer 59

Question 60

How do you project Accrued Expenses

Answer 60

Relate to operating expenses, often along with SG&A

Question 61

How do you project Deferred Revenue

Answer 61

Forecasted as part of the growth with revenue

Question 62

How do you project other current liabilities

Answer 62

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

Question 63

How would you forecast CapEx and D&A when creating a financial model?

Answer 63

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.

Question 64

How would you forecast PP&E and intangible assets?

Answer 64

EOP PP&E = BOP PP&E + CapEx - Depreciation

For intangibles, use management guidance or no purchases.

EOP Intangibles = BOP Intangibles + Intangibles Purchases - Amortisation

Question 65

What is the difference between current ratio and the quick ratio

Answer 65

Both used to assess near-term liquidity

Question 66

Give me some examples of when the current ratio might be misleading?

Answer 66

• 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”

Question 67

Is it bad if a company has negative retained earnings?

Answer 67

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.

Question 68

Is it bad if a company has negative retained earnings?

Answer 68

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.

Question 69

How can a profitable firm go bankrupt?

Answer 69

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

Question 70

What does return on assets (ROA) and return on equity (ROE) each measure?

Answer 70

Question 71

What is the relationship between return on assets (ROA) and return on equity (ROE)?

Answer 71

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.

Question 72

If a company has a ROA of 10% and a 50/50 debt-to-equity ratio, what is its ROE?

Answer 72

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%.

Question 73

When using metrics such as ROA and ROE, why do we use averages for the denominator?

Answer 73

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.

Question 74

What are some shortcomings of the ROA and ROE metrics for comparison purposes?

Answer 74

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.

Question 75

What is the return on invested capital (ROIC) metric used to measure?

Answer 75

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

Question 76

What does the asset turnover ratio measure?

Answer 76

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

Question 77

What does inventory turnover measure and how does it differ from days inventory held (DIH)?

Answer 77

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

Question 78

What are accounts receivables turnover measure

Answer 78

Measures efficiency of collecting payments

Question 79

What does accounts payables turnover measure and is a higher or lower number preferable?

Answer 79

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

Question 80

What does inventory turnover measure and how does it differ from days inventory held (DIH)?

Answer 80

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

Question 81

What are accounts receivables turnover measure

Answer 81

Measures efficiency of collecting payments

Question 82

What does accounts payables turnover measure and is a higher or lower number preferable?

Answer 82

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

Question 83

What are some ratios you would look at to perform credit analysis?

Answer 83

Question 84

What are the 2 types of credit ratios to assess a company’s default risk?

Answer 84

Question 85

How do you calculate the debt service coverage ratio (DSCR) and what does it measure?

Answer 85

Question 86

How do you calculate the fixed charge coverage ratio (FCCR) and what does it mean?

Answer 86

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

Question 87

How would raising capital through share issuances affect earnings per share (EPS)?

Answer 87

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

Question 88

How would a share repurchase impact EPS

Answer 88

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

Question 89

What is the difference between effective and marginal tax rates?

Answer 89

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

Question 90

Why is the effective and marginal tax rate often different?

Answer 90

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

Question 91

Could you give specific examples of why the effective and marginal tax rates might differ?

Answer 91

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.

Question 92

What impact did the COVID-19 Tax Relief have on NOLs?

Answer 92

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).

Question 93

What are the notable takeaways from Joe Biden’s proposed tax plans?

Answer 93

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.

Question 94

Does a company truly not incur any costs by paying employees through stock-based compensation rather than cash?

Answer 94

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

Question 95

Could you define contra-liability, contra-asset, and contra-equity with examples of each?

Answer 95

• 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.

Question 96

What is an allowance for doubtful accounts on the balance sheet?

Answer 96

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

Question 97

Difference between a write-down and a write-off?

Answer 97

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

Question 98

Why do asset write downs net benefit cash

Answer 98

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

Question 99

How does buying a building impact the 3 FS?

Answer 99

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)

Question 100

How does selling a building with a book value of $6 million for $10 million impact the three financial statements?

Answer 100

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

Question 101

If a company issues $100 million in debt and uses $50 million to purchase new PP&E, walk me through how the three statements are impacted in the initial year of the purchase and at the end of year 1. Assume a 5% annual interest rate on the debt, no principal paydown, straight-line depreciation with a useful life of five years and no residual value, and a 40% tax rate

Answer 101

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.

Question 102

For long-term projects, what are the two methods for revenue recognition?

Answer 102

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

Question 103

If a company has continuously incurred goodwill impairment charges, what do you take away from seeing this in their financials?

Answer 103

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

Question 104

What is restricted cash and could you give me an example?

Answer 104

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

Question 105

What is the accounting treatment for finance leases?

Answer 105

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.

Question 106

What is a finance lease

Answer 106

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.

Question 107

What is the accounting treatment for operating leases?

Answer 107

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

Question 108

What are the three different types of intercompany investments?

Answer 108

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.

Question 109

What are the three sub-classifications of investment securities?

Answer 109

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.

Question 110

Could you name an example of an asset that’s exempt from the cost principle rule?

Answer 110

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.

Question 111

What is trapped cash and what benefit does it provide to companies?

Answer 111

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.

Question 112

When can a company capitalize software development costs under accrual accounting?

Answer 112

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

Question 113

What is a PIK toggle note?

Answer 113

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.

Question 114

If a company has incurred $100 in PIK interest, how would the three-statements be impacted?

Answer 114

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.

Question 115

What is the purpose of the original issue discount feature of debt?

Answer 115

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.

Question 116

Why are circularities created in financial models?

Answer 116

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.

Question 117

How would you forecast a company’s basic and diluted share count?

Answer 117

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.

Question 118

How can you forecast a company’s implied share price using its EPS?

Answer 118

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

Question 118

What are the two types of pension plans and how does the accounting differ for each?

Answer 118

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

Question 119

What does the TSM (treasury stock method) assume

Answer 119

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

Question 120

Which line items are included in the calculation of net debt?

Answer 120

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

Question 121

When calculating enterprise value, why do we add net debt?

Answer 121

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 ?

Question 122

If a company raises $250 million in additional debt, how would its enterprise value change?

Answer 122

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

Question 123

Why do we add minority interest to equity value in the calculation of enterprise value?

Answer 123

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

Question 124

How are convertible bonds and preferred equity with a convertible feature accounted for when calculating enterprise value?

Answer 124

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

Question 125

Two main approaches to valuation?

Answer 125

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

Question 126

Which of the valuation methodologies is the most variable in terms of output?

Answer 126

DCF due to reliance on assumptions and projections

Question 127

Contrast the discounted cash flow (DCF) approach to the trading comps approach.

Answer 127

Question 128

How can you determine which valuation method to use?

Answer 128

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

Question 129

Would you agree with the statement that relative valuation relies less on the discretionary assumptions of individuals?

Answer 129

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

Question 130

What does free cash flow (FCF) represent?

Answer 130

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.

Question 131

Why are periodic acquisitions excluded from the calculation of FCF?

Answer 131

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)

Question 132

Explain the importance of excluding non-operating income/(expenses) for valuations.

Answer 132

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.

Question 133

Define FCF yield and compare it to dividend yield and P/E ratios

Answer 133

• 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)

Question 134

Optimal Capital Structure?

Answer 134

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

Question 135

Why would a company issue equity vs debt?

Answer 135

Question 136

What would the impact of company share buybacks on the share price and financial statements be?

Answer 136

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

Question 137

Why might a company prefer to repurchase shares over the issuance of a dividend?

Answer 137

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

Question 138

A company with $100 million in net income and a P/E multiple of 15x is considering raising $200 million in debt to pay out a one-time cash dividend. How would you decide if this is a good idea? The P/E multiple stays the same and there is a cost to debt of 5%

Answer 138

• 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.

Question 139

When would it be most appropriate for a company to distribute dividends?

Answer 139

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.

Question 140

What is CAGR and how do you calculate it?

Answer 140

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

Question 141

How would you evaluate the buy vs. rent decision in London?

Answer 141

• 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.

Question 142

How would you value a painting?

Answer 142

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

Question 143

What is an illiquidity discount?

Answer 143

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.

Question 144

Walk me through a DCF

Answer 144

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.]

Question 145

Conceptually, what does the discount rate represent?

Answer 145

• 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.

Question 146

What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)? How do you calculate each

Answer 146

• 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

Question 147

What is the difference between the unlevered DCF and the levered DCF?

Answer 147

• 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

Question 148

What is WACC conceptually?

Answer 148

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

Question 149

What cost of debt is used in the WACC?

Answer 149

Question 150

How does the CAPM model work

Answer 150

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

Question 151

Should you use normalised rates with valuations?

Answer 151

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.

Question 152

Define the equity risk premium used in the CAPM formula.

Answer 152

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

Question 153

Explain the concept of beta (β).

Answer 153

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.

Question 154

What is the difference between systematic risk and unsystematic risk?

Answer 154

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

Question 155

Effect of higher beta on valuation?

Answer 155

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

Question 156

What is the industry beta approach

Answer 156

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.

Question 157

Benefits of an industry beta approach?

Answer 157

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.

Question 158

Benefits of an industry beta approach?

Answer 158

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.

Question 159

What are the flaws of regression betas?

Answer 159

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.

Question 160

What is the impact of leverage on the beta of a company?

Answer 160

Levered beta = risk from leverage + unlevered beta

more leverage used in a capital structure, the higher the beta given the increased volatility from debt

Question 161

What is the typical relationship between beta and the amount of leverage used?

Answer 161

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

Question 162

What are the formulas used to unlever and relever beta?

Answer 162

Question 163

Is it possible for an asset to have a negative beta?

Answer 163

Yes, Gold. Inverse rs w market.

Question 164

How do you estimate the cost of debt?

Answer 164

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.

Question 165

Which is typically higher, the cost of debt or the cost of equity?

Answer 165

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

Question 166

Difference between WACC and IRR?

Answer 166

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.

Question 167

Which would have more of an impact on a DCF, the discount rate or sales growth rate?

Answer 167

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.

Question 168

How can the TV be sanity-checked with exit multiples

Answer 168

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

Question 169

What is the argument against using the exit multiple approach in a DCF?

Answer 169

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.

Question 170

Could you give me an example of when the mid-year convention might be inappropriate?

Answer 170

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

Question 171

How would raising additional debt impact a DCF analysis?

Answer 171

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.

Question 172

Imagine that two companies have the same total leverage ratio with identical free cash flows and profit margins. Do both companies have the same amount of default risk?

Answer 172

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).

Question 173

If 80% of a DCF valuation comes from the terminal value, what should be done?

Answer 173

• 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

Question 174

Difference between vested and outstanding in the money options?

Answer 174

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

Question 175

How would you handle restricted stock in the share count?

Answer 175

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

Question 176

What should you watch out for with preferred stock when conversion into common stock is assumed to calculate the share count in a valuation?

Answer 176

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

Question 177

Consequence of assuming common stock is used to calculate the share count?

Answer 177

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).

Question 178

How should operating leases be treated in a DCF valuation?

Answer 178

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.

Question 179

For forecasting purposes, do you use the effective or marginal tax rate?

Answer 179

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.

Question 180

How does a lower tax rate impact DCF valuation:

Answer 180

• 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

Question 181

How does a dividend discount model (DDM) differ from a DCF?

Answer 181

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).

Question 182

What are the major drawbacks of the dividend discount model (DDM)?

Answer 182

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

Question 183

What are common equity value multiples

Answer 183

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.

Question 184

Walk me through the process of “spreading comps.”

Answer 184

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

Question 185

Should the target company being valued be included in its peer group?

Answer 185

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

Question 186

What are the primary advantages and disadv. of the trading comps approach?

Answer 186

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

Question 187

To perform transaction comps, how would you compile the data?

Answer 187

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.

Question 188

Besides incentivizing existing shareholders to sell, what other factors lead to higher control premiums being paid?

Answer 188

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

Question 189

Why is transaction comps analysis often more challenging than trading comps?

Answer 189

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

Question 191

When putting together a peer group for transaction comps, what questions would you ask?

Answer 191

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?

Question 192

When valuing a company using multiples, what are the trade-offs of using LTM vs. forward
multiples?

Answer 192

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

Question 193

Why might two companies with identical growth and cost of capital trade at different P/E multiples?

Answer 193

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

Question 194

Should two identical companies with different leverage ratios trade at different EV/EBITDA
multiples?

Answer 194

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

Question 195

Should two identical companies with different leverage ratios trade at different P/E multiples?

Answer 195

Leverage –> higher interest –> lower EPS

Share price hard to predict as it’s dependent on view on capital allocation

Question 196

Which multiples are the most popular in valuation?

Answer 196

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.

Question 197

What are some common enterprise and equity value multiples?

Answer 197

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

Question 198

A company has an EPS of $2.00 that has declined to $1.00 four years later. Assume its share price
has remained the same at $10. Is its current P/E ratio higher or lower than its four year-back P/E
ratio, and how would you interpret this situation?

Answer 198

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).

Question 199

When would the use of the PEG ratio be appropriate?

Answer 199

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

Question 200

When would you value a business using the P/B ratio?

Answer 200

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

Question 201

When should you value a company using a revenue multiple vs. EBITDA?

Answer 201

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.

Question 202

How would you value a pre-revenue early stage internet company?

Answer 202

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.

Question 203

Why is calendarization a required step when performing comps analysis?

Answer 203

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

Question 204

If the market matters most when valuing public companies, do we even need a comps analysis? Why not just use the market cap directly to value the company?

Answer 204

Market can misprice indv. companies

Inevstors can be emotional and overreact

Question 205

When applying a peer group derived EV/EBITDA multiple onto your target company, what is an argument for using the group’s median multiple instead of the mean?

Answer 205

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

Question 206

Describe a recent M&A deal

Answer 206

Question 207

What are typical revenue and cost synergies

Answer 207

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)

Question 208

Why should companies acquired by strategic acquirers expect to fetch higher premiums than those
selling to private equity buyers?

Answer 208

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

Question 209

1.

How do you perform premiums paid analysis in M&A?

Answer 209

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.

Question 210

1.

Tell me about the two main types of auction structures in M&A.

Answer 210

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.

Question 211

What is a negotiated sale?

Answer 211

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.

Question 212

What are some of the most common reasons that M&A deals fail to create value?

Answer 212

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

Question 213

Studies have repeatedly shown a high percentage of deals destroy shareholder value. If that’s the
case, why do companies still engage in M&A?

Answer 213

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

Question 214

What is the purpose of a teaser?

Answer 214

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

Question 215

What does a confidential information memorandum (CIM) consist of?

Answer 215

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.

Question 216

What are the typical components found in a letter of intent (LOI)?

Answer 216

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).

Question 217

What are “no-shop” provisions in M&A deals?

Answer 217

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

Question 218

What is a material adverse change (MAC), and could you provide some examples?

Answer 218

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

Question 219

Contrast asset sales vs. 338(h)(10) election vs. stock sales.

Answer 219

Question 220

What are the two most common ways that hostile takeovers are pursued?

Answer 220

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.

Question 221

How does a tender offer differ from a merger?

Answer 221

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.

Question 222

What are some preventive measures used to block a hostile takeover attempt?

Answer 222

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

Question 223

What are some active defense measures to block a hostile takeover attempt?

Answer 223

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.

Question 224

What is a staggered board and how does it fend off hostile takeover attempts?

Answer 224

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).

Question 225

What is a divestiture and why would one be completed?

Answer 225

sale of a business segment

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

Question 226

How does an equity carve-out differ from a divestiture

Answer 226

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.

Question 227

What is a spin-off and why are they completed?

Answer 227

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).

Question 228

What is the difference between a subsidiary and an affiliate company?

Answer 228

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.

Question 229

What is a reverse merger and what benefits does it provide?

Answer 229

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

Question 230

What is an S-4 filing and when does it have to be filed?

Answer 230

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.

Question 231

What is the difference between the Schedule 13-D and 13-G filing?

Answer 231

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.

Question 232

Can you explain what the “winner’s curse” is in M&A?

Answer 232

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.

Question 233

What is a holdback in M&A?

Answer 233

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

Question 234

What type of material is found in an M&A pitchbook?

Answer 234

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)

Question 235

Walk me through a simple M&A model.

Answer 235

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?”

Question 236

What are two ways to determine the accretive/dilutive impact to EPS?

Answer 236

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.

Question 237

What does accretion/dilution analysis tell you about the attractiveness of a transaction?

Answer 237

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

Question 238

What does it mean when a transaction is done on a “cash-free, debt-free” basis?

Answer 238

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.

Question 239

Is it better to finance a deal via debt or stock?

Answer 239

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.

Question 240

What does purchase consideration refer to in M&A?

Answer 240

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

Question 241

What is an exchange ratio and what are the two main types?

Answer 241

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

Question 242

When might an acquirer prefer to pay for a target company using stock over cash?

Answer 242

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.

Question 243

Would you expect an all-cash or all-stock deal to result in a higher valuation?

Answer 243

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.

Question 244

In all-stock deals, how can you determine whether an acquisition will be accretive or dilutive?

Answer 244

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.

Question 246

Assume that a company is trading at a forward P/E of 20x and acquires a company trading at a
forward P/E of 13x. If the deal is 100% stock-for-stock and a 20% premium was paid, will the deal
be accretive in year 1?

Answer 246

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.

Question 247

How do you calculate the offer value in an M&A deal?

Answer 247

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

Question 248

Why is a “normalised” share price used when calculating the offer value?

Answer 248

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

Question 249

How do you calculate the control premium in an M&A model?

Answer 249

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.