Technicals

IS: +60, +6, -8 CF: +58, -100, -100, +200 BS: +58, +58, -100, -100

. Another year passes, and prices in this real estate market double. The company decides to sell its $100 in long-term investments for $200 at the end of Year 2. It then uses the proceeds to repay its Preferred Stock. What happens on the statements from the BEGINNING of Year 2, including the interest/investment income and Preferred Dividends, to the END of Year 2?

13x

A PE firm acquires a business for a 12x EBITDA multiple, using 5x Debt / EBITDA, and plans to sell it in 5 years. The company's initial EBITDA is $100, and it grows to $200 by Year 5. If there's no Debt repayment and no additional Cash generation, what exit multiple do we need for a 25% IRR?

2x = 100% / 7 * 75% = ~14% * 75% = Between 10% and 11% 3x = 200% / 7 * 65% = ~28% * 65% = Between 18% and 19% The multiple is approximately 2x so the firm used 600 in equity at the beginning. The multiple is 11x

A PE firm acquires a company with $100 in EBITDA, which grows to $150 by the end of 7 years, at which point the PE firm sells the company for a 10x EBITDA multiple. The PE firm uses $500 of Debt initially, and the company has $300 of Net Debt remaining upon exit. If the PE firm realizes an approximate IRR of 10% on this investment, what was the purchase multiple?

The buyer's share price would drop by 50%

A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it's only worth $50 million. What happens?

IS: Down $59 CF: Down $59, Up $80, Down $80, Up $10 BS: Down $49, Down $59, Down $80, Down $80, Down $10

A company buys a factory for $100 using $100 of debt. What happens INITIALLY on the statements? One year passes. The company pays 10% interest on its debt, and it depreciates $10 on the factory each year. It also repays $20 of the loan each year. What happens on the statements in this first year? Another year passes. Again, the company pays 10% interest on its debt based on the balance at the start of the year, and it depreciates $10 on the factory, with $20 loan principal repayment. At the very END of the year, a dragon attacks the factory, and it falls apart. The company has to write down the factory's entire value and repay the remaining loan balance. Walk me through what happens on the statements from the BEGINNING of Year 2 to the END.

You don't because interest is not included in the FCF

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

IS: CF: Up $100, Down $100 BS: Up $100, Up $100 IS: Down $2 CF: Down $2 BS: Down $2, Down $2

A company issues $100 in Preferred Stock to buy $100 in long-term investments in real estate. The Preferred Stock has a coupon rate of 8%, and the long-term investments yield 10%. What happens on the statements IMMEDIATELY after the initial purchase? What happens on the statements after a year?

Tripling our money in 3 years would be a 45% IRR, and tripling it in 5 years would be a 25% IRR. It is around 35%

A private equity firm acquires a $200 EBITDA company for an 8x EBITDA multiple using 50% Debt. It wants to sell the company in 3 years, but it's difficult to find buyers, so the firm decides to take the company public instead. If this company's EBITDA increases to $240, and it repays ALL the Debt over 3 years, and the PE firm takes it public and sells off its stake evenly in Years 3 - 5 at a 10x EBITDA multiple, what's the approximate IRR?

IS: Up $54 CF: Up $54, Up $200, Down $20 BS: Up $234, Up $54, Down $200, Down $20

A year passes, and Wal-Mart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process the orders. The company also pays 5% interest on $200 of debt and repays 10% of the principal. What happens on the statements over the course of THIS one year?

IS: Down $120 CF: Down $120, Up $200 BS: Up $80, Up $200, Down $120

Amazon.com decides to pay several key vendors on credit and make them wait for the cash. It offers $200 in credit and says it will pay them in cash in a month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash?

400 Debt, 100 Stock

An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million, Net Income of $50 million, and a Debt / EBITDA ratio of 2x. Peer companies have a median Debt / EBITDA ratio of 4x. It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller has a Net Income of $30 million, EBITDA of $50 million, and no Debt. What's the best way to fund this deal?

Stock: 150 - 500 Debt: 150 Cash: 50

An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50 million, Net Income of $25 million, and a Debt / EBITDA ratio of 3x. Similar companies in the market have Debt / EBITDA ratios of 5x. What's the BIGGEST acquisition this company might be able to complete?

DTL = $40 Asset Write Up = $100 Goodwill = $340

An Acquirer purchases a company for a $1 billion Equity Purchase Price, and this Target has $600 million in Common Shareholders' Equity and no Goodwill. The Acquirer plans to write up the Target's PP&E and Other Intangible Assets by $100. Walk me through the Purchase Price Allocation process, assuming a 40% tax rate.

True

An acquired business is a core business asset, true or false?

With Equity Interests, you only subtract them if the metric you're looking at does not include Net Income from Equity Interests

Are there any exceptions to the rules about subtracting Equity Interests when calculating Enterprise Value?

IS: -35 CF: -35, +50 BS: +15, -35, +50

Assuming a 30% tax rate, walk me through 3 statements with a: $100 interest expense (50% cash interest / 50% PIK interest)

1. New debt is added 2. Shareholders' equity is wiped out and replaced by sponsor equity 3. Cash is adjusted 4. Goodwill and intangibles plugged

Can you explain how the Balance Sheet is adjusted in an LBO model?

1. Project out EPS 2. Assume what % of EPS is dividends paid out 3. Project dividends over the next 5-10 years 4. Discount these values using COE 5. Find TV based on P/E and discount using COE 6. Sum both values to find NPV per share

Can you walk me through a DDM?

1. Find your company's P/E ratio 2. Project out your company's EPS 3. Apply future EPS to P/E ratio

Can you walk me through a future share price analysis?

1. Select precedent transactions and the share price acquired at 2. Go 2, 40, 60 days before the transaction date and find the share price 3. Divide the acquired share price by the previous share price 4. Apply that premium to the company's share price

Can you walk me through an M&A premium analysis?

1/10 = 10% x * (1 - 40%) = .1 x = 17%

Company A buys Company B using 100% Debt. Company B has a purchase P / E multiple of 10x and Company A has a P / E multiple of 15x. What Debt interest rate is required to make the deal dilutive?

EV/EBITDA = 7.8x P/E = 16x

Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%. Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%. Company A acquires Company B using 100% Cash and pays no premium to do so. Assume a 5% Foregone Interest Rate on Cash. What are the Combined EBITDA and P / E multiples?

Yes, if it uses 600m in Debt and 400m in equity to achieve a 2.5x multiple

Could a private equity firm earn a 20% IRR if it buys a company for a Purchase Enterprise Value of $1 billion and sells it for an Exit Enterprise Value of $1 billion after 5 years?

False

Equity investments core business assets, true or false?

Becuase the NOLs in the DTAs will be used in the future

Explain why we would write down the seller's existing Deferred Tax Asset in an M&A deal.

Revenue: With revenue synergies, you might assume that the Seller can sell its products to some of the Buyer's customer base. So if the Buyer has 100,000 customers, 1,000 of them might buy widgets from the Seller. Each widget costs $10.00, so that is $10,000 in extra revenue. Expense: If each office costs $100,000 per year to rent, there will be 2 * $100,000 = $200,000 in expense synergies, which will boost the Combined Pre-Tax Income by $200,000.

Give me an example of how you might estimate revenue and expense synergies in an M&A deal.

Dividends are a cash outflow on the cash flow statement?

How are dividends reflected on the cash flow statement?

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends

How can we calculate Cost of Equity WITHOUT using CAPM?

Look at comparable LBOs

How can you determine how much Debt a PE firm might use in an LBO and how many tranches there would be?

Reduce the taxes that you have to pay by projecting the maximum about of NOLs that you can use 1. Reduce taxable income by the max NOLs 2. Multiple by the tax rate 3. Subtract that from your old pre tax income

How do Net Operating Losses (NOLs) affect a company's 3 financial statements?

They affect the implied EV because of the discount rate

How do changes in the capital structure affect the enterprise value in the long term?

Anytime the "cash" tax expense exceeds the "book" tax expense you record this as an decrease to the Deferred Tax Liability on the Balance Sheet; if the "book" expense is higher, then you record that as an increase to the DTL.

How do you account for DTLs in forward projections in a merger model?

If the asset has a useful life of over a year you capitalize the expense

How do you decide when to capitalize rather than expense a purchase?

Public company - 20-30% premium on shares Private company - traditional valuation methods

How do you determine the Purchase Price in an M&A deal?

1. Create sources and uses section 2. Project revenue and EBITDA 3. Calculate FCF and debt payments 4. Calculate the exit proceeds

How do you do a paper lbo?

If they're ITM you add them back to find EV

How do you factor in Convertible Preferred Stock in the Enterprise Value calculation?

You add RSUs and performance shares because they are live convertibles

How do you factor in Restricted Stock Units (RSUs) and Performance Shares when calculating Diluted Equity Value?

If there is a gain or loss you record the sale price

How do you know if you record the sale price or the book value on the cash flow statement?

Project each one as a % of revenue or previous PP&E balance

How do you project Depreciation & Capital Expenditures?

1. Revenue - based on units sold and average selling price or market size and share. 2. COGS and Operating Expenses - Percentages of revenue 3. Net Interest Expense - Based on debt 4. Taxes and Net Income - Buyer's tax rate 5. Major Cash Flow Items - Depreciation & Amortization, WC

How do you project out financial statements?

Find the maximum amount of allowable NOLs each year by using this formula: Allowable NOLs = Equity Purchase Price * Highest of Past 3 Months' Adjusted Long Term Rates

How do you take into account NOLs in an M&A deal?

It makes the DCF higher because an increase in current liabilities decreases nwc and means less is subtracted

How does a increase in current liabilities affect DCF

A 2.5x multiple over 5 years is a 20% IRR, while a 2.5x multiple over 3 years is a ~35% IRR, so we'd expect an IRR in between those. But it will be closer to 35% since 2.7x is above 2.5x. We could approximate this IRR as 30%; in real life, it is exactly 30%.

How does the IRR change if, after going public, the company's share price drops by approximately 10% per year in Years 4 and 5?

IS: CF: +100, -100 BS: +100, -100

How would a $100 dividend recap impact the 3 financial statements in an LBO?

It would affect the WACC but not the FCF because the FCF does not include interest

How would raising $100M debt in Year 3 affect the DCF valuation of a company?

1. Cost synergies 2. New depreciation and amortization expense 3. Interest expense 4. Sponsor management fees

How would you adjust the Income Statement in an LBO model?

IS: +12 CF: +12, -20 BS: -8, +12

I don't believe you. Walk me through what happens if an Acquirer purchases a Target for an Equity Purchase Price $80, in 100% Cash, and the Target has $200 in Assets, $100 in Liabilities, and $100 in Common Shareholders' Equity.

1000

If 100 convertible bonds are at a price of $10 and par value of $100, how many shares are created if they are exercised?

10x, 6,5x

Let's say this same Acquirer (Equity Value of $500 million and Enterprise Value of $600 million) has Net Income of $50 million and EBITDA of $100 million. The Target (Purchase Equity Value of $100 million and Purchase Enterprise Value of $150 million) has Net Income of $10 million and EBITDA of $15 million. What are the Combined P / E and EV / EBITDA multiples in a 100% Stock deal? Assume the same tax rates for the Acquirer and Target

2225/200 = 11.1x

Now assume the company repays 75% of the initial Debt balance over 5 years. What exit multiple do we need for a 25% 5-year IRR?

EV/EBITDA = 7.8x P/E = 20x

Now let's say that Company A instead uses 100% Debt with a 10% interest rate to acquire Company B. Again, Company A pays no premium for Company B. What are the combined multiples?

Yes, because the WACA is 6% while the seller's yield is 6.7%

The seller's yield is 6.7%, and the company uses debt with an interest rate of 10% to acquire the seller. Is the deal still accretive?

IS: CF: Down $100 BS: Down $100, Down $100

This same company now realizes that it has too much cash, so it wants to issue dividends or repurchase shares. How do they impact the 3 statements differently? Assume $100 in dividends vs. $100 in shares repurchases.

If you are only increasing the pricing of previous products

Under what circumstances would $100M in revenue synergies be a straight addition to the pro forma company's EBITDA?

UFCF is available to all investors and WACC represents all investors

WACC reflects the company's capital structure, so why do you pair it with Unlevered FCF? It's not capital structure-neutral!

IS: CF: Down $100 BS: Down $100, Up $100 IS: Up $60 CF: Up $60, Up $500 BS: Up $560, Up $60, Down $500

Wal-Mart buys $500 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600.

IS: Up $60 CF: Up $60, Down $100 BS: Down $40, Up $60, Up $100 IS: CF: Up $100 BS: Up $100, Down $100

Walk me through what happens on the statements when a customer orders a product for $100 but doesn't pay for it in cash, and then what happens when the cash is finally collected.

The direct costs of producing goods sold by a company?

What are COGS?

- Double Your Money in 3 Years = ~25% IRR - Double Your Money in 5 Years = ~15% IRR - Triple Your Money in 3 Years = ~45% IRR - Triple Your Money in 5 Years = ~25% IRR

What are IRR rules of thumb?

Expenses that a business incurs through normal operations of the company

What are operating expenses?

1. TV is more than 50% of final value 2. Terminal multiples or growth rates too high 3. Double-counting items

What are some signs that you might be using the incorrect assumptions in a DCF?

1. Stock purchase: - Seller is taxed at a capital gains tax rate - The buyer receives no step-up tax basis - A DTL is created as a result - Most common for large public companies 2. Asset Purchase - Buyer acquires only certain assets and liabilities - Seller is taxed on the amount the assets have appreciated and capital gains taxes - Buyer receives a step-up tax basis - Most common for distressed public companies 3. Section 338(h)(10) - Buyer acquires all assets and liabilities - Seller is taxed on the amount assets have appreciated and pays a capital gains tax rate - The buyer receives a step up tax basis - Most common for distressed public companies - Buyer usually pays more because it sucks for the seller

What are the main 3 transaction structures you could use to acquire another company?

• Purchase Price: Stated as a per-share amount for public companies. • Form of Consideration: Cash, Stock, Debt... • Transaction Structure: Stock, Asset, or 338(h)(10) • Treatment of Options: Assumed by the buyer? Cashed out? Ignored? • Employee Retention: Do employees have to sign non-solicit or non-compete agreements? What about management? • Reps & Warranties: What must the buyer and seller claim is true about their respective businesses? • No-Shop / Go-Shop: Can the seller "shop" this offer around and try to get a better deal, or must it stay exclusive to this buyer? Hide Answer

What are the most imporrtant points of negotiation in an M&A deal?

1. Lower Purchase Price 2. Multiples Expansion 3. Increasing leverage 4. Dividend recapitalization 5. Exiting the investment earlier 6. Accelerating the company's growth 7. Improving margins 8. Realizing synergies with other portfolio companies

What are the ways to increase returns in an LBO?

It means that COGS take up 30% of the revenue

What does a 70% gross margin mean?

It means that its net income is increasing due to non-cash charges

What does it mean if a company's FCF is growing, but its Change in Working Capital is more and more negative each year?

Positive: company can pay off short term liabilities with short term assets Negative:

What does it mean if working capital is positive? Negative?

No because some companies may just have a large deferred revenue balance

What does negative Working Capital mean? Is that a bad sign?

COD and COE always increase with an increase in debt while WACC will decrease at first because debt is weighted more but increase over time as the risk of bankruptcy increases

What happens to COD, COE, and WACC when debt increases?

Equity value decreases because retained earnings decreases

What happens to equity value when dividends are issued?

Expensed transaction fees come out of Retained Earnings when you adjust the Balance Sheet, while capitalized financing fees appear as a new Asset on the Balance Sheet and are amortized each year according to the tenor of the debt.

What happens to transaction fees and financing fees in an M&A deal?

Total Debt/EBITDA cannot exceed 3.0x

What is an example of a maintenance covenant?

You would tie the number of new shares to the buyer's own shares - so the seller might receive 1.5 shares of the buyer's shares for each of its shares

What is an exchange ratio in M&A?

1. Pick public company comparables to use 2. Work back enterprise value to equity value and find share price 3. Divide by total number of shares to say what the company IPOs at

What is the IPO valuation process for a company that is about to go public?

It has to be part of the company's core operations and be recurring

What is the criteria for an item to be included in FCF?

Extend the explicit forecast period

What is the easiest way to fix your DCF?

Deferred Tax Asset = Asset Write-Down * Tax Rate Deferred Tax Liability = Asset Write-Up * Tax Rate

What is the formula for DTLs and DTAs?

WACA = Cash/Total * COC + Debt/Total * COD + Equity/Total * COE COC = Forgone Interest * (1 - tax) COD = Interest * (1- tax) COE = E/P of buyer

What is the formula for WACA?

Old WC - New WC

What is the formula for the change in NWC?

EBITDA growth rates

What operational metric has the strongest correlation with EV/EBITDA?

Sellers prefer a stock purchase so they're not double taxed and so they can get rid of their liabilities. Buyers prefer an asset purchase so they can be more careful about what they require and receive the tax benefit of depreciation

What type of purchase agreement do buyers and sellers prefer>

You'd think, based on "3x in 3 years = ~45% IRR" that the IRR would be around 35% here. But the Dividends arrived in Year 2 instead of Year 3, so it's higher than that. We would approximate it as "Between 35% and 40%" - in real life, it is 39%.

What's the approximate IRR if a PE firm acquires a company using $500 of Investor Equity, sells it for $1,000 in Equity Proceeds in Year 3, and receives a Dividend of $250 in Year 2?

In purchase accounting the seller's shareholders' equity number is wiped out and the premium paid over that value is recorded as Goodwill on the combined balance sheet post-acquisition. In pooling accounting, you simply combine the 2 shareholders' equity numbers rather than worrying about Goodwill and the related items that get created.

What's the difference between Purchase Accounting and Pooling Accounting in an M&A deal?

Operating leases: short term leases that show up as operating expenses Capital leases: long term leases that depreciate and are counted as debt

What's the difference between capital leases and operating leases?

Both EV and Equity value are affected by operational changes but EV is affected exclusively by them so usually EV changes more

When there's an operational change, how can you determine whether Equity Value or Enterprise Value will change by more?

If their hard assets were severely undervalued

When would a Liquidation Valuation produce the highest value?

The healthcare company because it is a less asset intensive industry

Which should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company? Why?

Because EV is the core business available to all investors

Why are only changes in core operating assets associated with changes in EV?

Because it corresponds with equity value

Why do you use net income to common?

Because first debt and cash increase which balance out, but then the cash decreases because it is used to buy a core operating asset

Why does enterprise value go up with you raise $200m in Debt, use cash to buy a new piece of equipment?

Because it increases equity value but decreases enterprise value because of the cash increase

Why does issuing $200m in Equity for an IPO not affect enterprise value?

Because the other non-cash expenses are not recurring

Why is D&A added back but other non cash expenses are not?

Because they are an operational liability

Why might someone argue that you should NOT add capital leases when moving from Equity Value to Enterprise Value?

Because unfunded pensions require additional funding while accounts payable are usually paid off with a company's cash flow

Why might you add back Unfunded Pension Obligations but not something like Accounts Payable? Don't they both need to be repaid?

No. because the company is exposed to commodity risk which is antithetical to the steady cash flows that financial sponsors look for

Would a mining company be a good candidate for an LBO?

A retailer because it is less dependent on assets to generate revenue

Would you expect a retailer or an airline company to have a higher Asset Turnover Ratio?

A 2x multiple in 5 years is a 15% IRR, while a 3x multiple is a 25% IRR, so a 20% IRR should be right in between: A 2.5x multiple. Initially, we buy the business for an Enterprise Value of $1,000, using $500 of Investor Equity and $500 of Debt. We need to earn back $1,250 in proceeds at the end, since 2.5 * $500 = $1,250. The company repays $250 in Debt, which means that $250 in Debt remains at the end. Therefore, we need to sell the company for an Exit Enterprise Value of $1,250 + $250 = $1,500. Since the Exit Multiple stays the same at 10x, EBITDA must grow to $150 over 5 years

You buy a $100 EBITDA business for a 10x EBITDA multiple, and you believe you can sell it in 5 years for a 10x multiple. You use 5x Debt / EBITDA to fund the deal, and the company repays 50% of that Debt over 5 years. By how much does EBITDA need to grow over 5 years for you to realize a 20% IRR?

20%

You have a company with an EV/Revenue of 2x and an EV/EBITDA of 10x. What is the EBITDA margin?

BS: +50, +200, +250

Your company decides to acquire another company for $1,000, using cash. The other company has $400 in Cash, $600 in PP&E, $250 in Accounts Payable, and $750 in Equity. What happens to your company's BALANCE SHEET immediately after this acquisition takes place? Assume that your company has identified $50 in Other Intangible Assets with a useful life of 10 years.

IS: Down $12 CF: Down $12, Up $20 BS: Up $8, Down $12, Down $20

Your company just acquired another one for $1,000 in cash. The other company's Shareholders' Equity was $500, and you identified $100 in Other Intangible Assets with a useful life of 5 years. What happens on the 3 statements from just AFTER the acquisition closes to the end of the first year following the acquisition? Only factor in Goodwill and Other Intangible Assets.