technicals

Walk me through the beginning and end of year 1 if you make a $200 purchase of equipment with half cash, half debt, 10% interest (on the debt), 40% tax rate, depreciated over 5 years (straight line) and you sell the equipment for $90 at the end of year 1

Beginning of year: No change on Income Statement. Cash Flow Statement: Cash Flow from Investing (200), Cash Flow from Financing +100. Balance Sheet: Cash (100), Equipment +200, Debt +100 = Balance Sheet balances. End of year: Income Statement: Depreciation (40), Interest Expense (10), Loss (70). Pretax Income (120), Net Income (72). Cash Flow Statement: Net Income (72), Loss +70, Depreciation +40, Equipment Sale +90. Net Change = 128. Balance Sheet: Cash +128, Equipment (200), Retained Earnings (72) = Balance Sheet balances.

Walk me through the impact of selling a piece of equipment for $90 which was originally purchased for $200 at the beginning of the year. The equipment was purchased using 60% cash/40% debt. The interest rate on debt is 10%, the tax rate is 25% and the useful life is 5 years

IS •Dep. Exp. = $40, Int. Exp. = $8, Loss = $70. •Pre-Tax income down $118, Net Income down $88.5 SCF •OCF: Net Income + depreciation + loss on equipment •ICF: equipment sale •End Cash = $111.5 BS •Assets: cash up $111.5, PP&E down $200 •Liabilities: Net Income down $88.5

Walk me through $100 increase in dep. w/ 20% TR

IS •Pre-Tax Income down $100 •Since dep. is tax-deductible, after applying a 20% tax rate, NI down $80 SCF •NI flows to top of SCF, where we add $100 back in operating activities section because depreciation is a non-cash expense •No other adjustments made, ending cash balance up $20 BS •Cash up by $20 •Acc. dep. up by $100 •NI down $80 flows to retained earnings, and A = L + E

Let's say a company decides to accelerate its depreciation. How would that affect firm value in a DCF?

Increases firm value

What happens to a DCF valuation when the corporate tax rate increases? ***Follow-Up Question*** So if the WACC decreases, why do companies not want higher taxes?

○ WACC Decreases due to larger tax shield ○ Increase in free cash flows from less taxes offsets the increased WACC in low tax settings

Company A acquires Company B in a half cash, half debt acquisition. Company B has a PE ratio of 16x. The interest rate on cash is 5%. The interest rate on debt is 10%. Assume a tax rate of 20%. Is this deal accretive, dilutive, or neutral to EPS?

𝐶𝑜𝑠𝑡=𝑤𝑐∗𝑖𝑐∗(1−𝑡𝑟)+𝑤𝑑∗𝑖𝑑∗(1−𝑡𝑑) ○ 𝐶𝑜𝑠𝑡=50%∗5%∗(1−20%)+50%∗10%∗(1−20%) ○ 𝐶𝑜𝑠𝑡=2%+4%=6% ○ 𝑌𝑖𝑒𝑙𝑑=1/𝐶𝑜𝑚𝑝𝑎𝑛𝑦𝐵's 𝑃𝐸 ○ 𝑌𝑖𝑒𝑙𝑑=1/16=6.25% ○ 𝐶𝑜𝑠𝑡<𝑌𝑖𝑒𝑙𝑑∴Accretive

What are common leverage amounts? Why?

4-7x Net Debt / EBITDA. You use fcf to pay down debt over the holding period, so you want a leverage amount similar to how many years you plan on holding the company.

Calculate share price given the following information. ○ PE=10x ○ Shares outstanding = 100 ○ Revenue = 1,600 ○ Gross margin = 50% ○ SG&A = 200 ○ D&A=100 ○ Tax rate = 20% ○ EV/EBITDA = 20x

𝑁𝑒𝑡𝑖𝑛𝑐𝑜𝑚𝑒=(𝑅𝑒𝑣𝑒𝑛𝑢𝑒∗𝐺𝑟𝑜𝑠𝑠𝑀𝑎𝑟𝑔𝑖𝑛−𝑆𝐺&𝐴−𝐷&𝐴)∗(1−𝑇𝑎𝑥𝑟𝑎𝑡𝑒) 𝑁𝑒𝑡𝑖𝑛𝑐𝑜𝑚𝑒=(1,600∗50%−200−100)∗(1−.2) 𝑁𝑒𝑡𝑖𝑛𝑐𝑜𝑚𝑒=400 𝑃𝐸=𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒/𝑁𝑒𝑡𝑖𝑛𝑐𝑜𝑚𝑒 10=𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒/400 𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒=4,000 𝑆h𝑎𝑟𝑒𝑝𝑟𝑖𝑐𝑒=𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒/𝑆h𝑎𝑟𝑒𝑠𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆h𝑎𝑟𝑒𝑝𝑟𝑖𝑐𝑒=4,000100=$𝟒𝟎 ***EV/EBITDA is irrelevant***

Cost of Equity 25%, IRR of 20%, WACC of 18%. If this deal was an all-equity financed deal, would you take it? What if it was financed with 40% debt? What other metrics would you like to learn before accepting the deal?

•No, IRR < CoE •Yes, IRR > WACC •Test your strength at evaluating important import investment criteria - trading multiples, growth profile, cyclicality competitor performance

Calculate what junior debt is trading at given the following information. ○ EBITDA = 90 ○ EV/EBITDA = 10x ○ Senior debt = 800 ○ Junior debt = 400

E𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒𝑉𝑎𝑙𝑢𝑒=𝐸𝐵𝐼𝑇𝐷𝐴∗(𝐸𝑉/𝐸𝐵𝐼𝑇𝐷𝐴) 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒𝑉𝑎𝑙𝑢𝑒=90∗10=900 𝐽𝑢𝑛𝑖𝑜𝑟𝐷𝑒𝑏𝑡𝑉𝑎𝑙𝑢𝑒=(𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒𝑉𝑎𝑙𝑢𝑒−𝑆𝑒𝑛𝑖𝑜𝑟𝐷𝑒𝑏𝑡)/𝐽𝑢𝑛𝑖𝑜𝑟𝐷𝑒𝑏𝑡 𝐽𝑢𝑛𝑖𝑜𝑟𝐷𝑒𝑏𝑡𝑉𝑎𝑙𝑢𝑒=(900−800)/400=$𝟎.𝟐𝟓

Would you use fully diluted or standard shares outstanding when calculating share price for a DCF?

Fully Diluted

What likely effect will Joe Biden's election have on the valuation of companies in a DCF analysis?

Higher corporate tax rate

Walk me through the impact of a $200mm PIK note with 5% interest, a $500mm note with 1% interest and interest income of $3mm on the 3 financial statements (assume 20% tax rate)

IS •Pre-Tax Interest Expense net down $12mm, NI down by $9.6mm SCF •NI flows to top of SCF, where we add $10mm back in operating activities section because PIK interest is a non-cash expense •No other adjustments made, ending cash balance up $0.4mm BS •Cash up by $0.4mm •Debt Principal up by $10mm •NI down $9.6mm flows to retained earnings, and A = L + E

Walk me through $10 of PIK interest on the three financial statements. Assume a 20% tax rate.

IS: Interest expense -10, Taxes +2, Net income -8 CFS:Net income -8, Interest expense +10, ΔCash +2 BS: Cash +2, Debt +10, Retained earnings -8

Would a company rather have $100 in accounts receivable or $100 in inventory?

Inventory because it can generally be sold at a higher price (excluding liquidation scenarios) than cost whereas a company can only collect accounts receivable at face value

Even though junior debt has higher interest rates, why would a financial sponsor choose to use it as opposed to senior debt in an LBO?

Less covenants and concerned about having cash flows needed to make debt payments (bullet payment at maturity and PIK interest)

How does an increase in $5 million of CAPEX affect your EBITDA?

No effect

How would I value a money tree that produces $100 every year for eternity?

Perpetuity : CF / discount rate Discount rate: risk-free rate Assuming the risk-free rate equals 1%, tree = $10,000

Company A acquires Company B in a 35% cash, 25% debt and 40% stock acquisition. Company A's P/E multiple is 8x. Company B's P/E ratio is 16x. The foregone interest rate on cash is 2% and the interest rate on debt is 5%. Is this deal accretive, dilutive, or neutral to EPS? (assuming 20% tax rate)

•Weighted CoE = (1 / 8) * 40% = 5% •Weighted CoD = 5% * 25% * (1-Tax) = 1% •Weighted CoC = 2% * 35% * (1-Tax) = 0.56% •WACC = 6.56% •Seller's Yield = (1/16) = 6.25%. Since Cost > Yield, Dilutive

Sibley & Co. sells red and white striped button-up shirts. The company recently purchased a new loom for $500 and fabric for $500 using $1,000 of debt. The cost of debt is 10% with no amortization. The company uses the straight-line method of depreciation. The machine's estimated useful life is 10 years. Walk me through what happens on the three financial statements after you purchase the equipment and fabric and then what happens after one year. Assume a 20% tax rate.

Purchasing the equipment and fabric IS:No change CFS:CAPEX -500, Inventory -500, Cash from financing +1000, ΔCash 0 BS:Machinery +500, Inventory +500, Debt +1,000 One year later IS:Depreciation -50, Interest -100, Taxes +30, Net income -120 CFS:Net income -120, Depreciation +50, ΔCash -70 BS:Cash -70, Machinery -50, Retained earnings -120

Say you need to value a mining company. This company generates revenue and cash flow solely through the mining of diamonds. You have projected free cash flow and need to calculate a terminal value. Assume you are only allowed to use one formula to find this terminal value. Would you use the exit multiple method or the perpetuity growth method?

You would use the exit multiple method because there is not an infinite amount of diamonds in the ground. At some point, you will run out of diamonds for which to dig. The perpetuity growth method assumes the company can grow forever, but that cannot happen because it will run out of this natural resource in the future.

A company has $50 EBITDA, $100 in Senior Debt, $250 Junior debt and is trading at 8x EBITDA. What is the market value of their equity? How about if they are trading at 6X EBITDA? If the implied equity value is 0, but there is no liquidity crisis and the shares are trading on the market, is there any value behind them? What would the break-even trading multiple be for equity holders?

•Equity Value at 8x EBITDA = 8 * $50 - $100 - $250 = $50 •Equity Value at 6x EBITDA = 6 * $50 - $100 - $250 = ~ $0 •Although the implied equity value at 6x EBITDA is ~ $0, the stock price will hover slightly above $0 so long as the firm has recovery value •Break Even Trading Multiple = $350/$50 = 7x

•P/E = 20x •EV/EBITDA = 10x •Interest Expense = 20mm •Interest Rate = 5% •D&A = $20mm •Market Capitalization = $200mm Find Tax Rate

•Interest Expense / Interest Rate = $400mm (debt principle) •Market Capitalization + Debt Principle = EV = $600mm •EBITDA = $60mm •EBIT = $40mm •EBT = $20mm •P/E 🡪 Market Cap / Net Income, Net Income = $10mm •Tax Rate = 50%

Find EV: 100 shares outstanding, $15 per share, 15 Options, $10 strike price, 500 debt, 300 cash, 50 minority interest. Treasury stock method

•New Shares = $15 * 10 = $150 •Share Repurchases = $150 / $15 = 10 •Net New Shares = 15 - 10 + 100 = 105 •Equity Value = $15 * 105 = $1575 •Enterprise Value = $1575 + $500 - $300 + $50 = $1825

All else being equal, what happens to WACC when the tax rate increases? What happens to our overall valuation?

•When the tax rate increases, our cost of debt decreases •Cost of Debt = Pre-Tax Cost of Debt * (1-Tax Rate) •While our WACC has decreased which means we are discounting our cash flows by a slightly lower amount than prior - the tax rate will have a much greater effect on the unlevered free cash flows •Unlevered Free Cash Flows = EBIT * (1-Tax Rate) + Depreciation - Capital Expenditures -Change in NWC •Overall, our valuation will decrease as a result of the increase in the tax rate

•Year 0: 10x EV/EBITDA; 5x Leverage Ratio; $200mm EBITDA •Year 5: 10x EV/EBITDA; $280mm; $200mm cash after paydown

•Year 0: 10 * $200mm = $2000mm EV; 5 * $100mm = $500mm debt; $2000mm - $1000mm = $1000mm equity value •Year 5: 10 * $280mm = $2250mm EV; $2800mm + $200mm = $3000mm equity value •$2450mm/$1500mm = 2x MoM •Short-hand: 15% IRR

Rank these three assets from low to high in terms of beta: software company, utilities company, and a slot machine that generates $50 per year every year.

○ Answer: Slot machine (beta=0), utilities company, software company

DCF: How does a large Capex expense in the third year change the terminal value using perpetuity growth? Exit Multiple Method?

○ PGM: Increases it due to more depreciation, resulting in a larger tax shield ○ EMM: Stays the same due to EBITDA remaining unchanged

Given the following information, what is enterprise value? ○ Levered free cash flow yield = 10% ○ EBITDA = 100 ○ D&A = 25 ○ Interest expense= 10 ○ CAPEX = 30 ○ ΔNWC = -10 ○ Taxes = 5 ○ Debt = 300 ○ Cash =50

𝐿𝐹𝐶𝐹=𝐸𝐵𝐼𝑇𝐷𝐴−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝐸𝑥𝑝.−𝑇𝑎𝑥𝑒𝑠−𝐶𝐴𝑃𝐸𝑋−𝛥𝑁𝑊𝐶𝐿𝐹𝐶𝐹=100−10−5−30−(−1 0)=65 ***D&A does not matter because it cancels out*** 𝐿𝐹𝐶𝐹𝑌𝑖𝑒𝑙𝑑=𝐿𝐹𝐶𝐹/𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒 10%=65/𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒𝑉𝑎𝑙𝑢𝑒=𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒+𝐷𝑒𝑏𝑡−𝐶𝑎𝑠h𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒𝑉𝑎𝑙𝑢𝑒=650+300−50=𝟗𝟎𝟎