Investment Banking 400 Qs - basics only

34. What's the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

First, note that this only applies to you if you are in US as IFRS does not permit the use of LIFO. LIFO stands for "Last-in First-out" and FIFO stands for "First-in First-out". They are two different ways of recording the value of inventory and the Cost of Goods Sold. With LIFO, you use the value of the most recent inventory additions of COGS, but with FIFO you use the value of the oldest inventory additions for COGS. Here's an example: let's say your starting inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4. The difference is that in LIFO, you would use the 40 most recent inventory purchase values - $120+$150+$170+$200 - for the COGS, whereas in FIFO you would use the 40 oldest inventory values - $100+$120+$150+$170 - for COGS. As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would also have lower Pre-Tax Income and Net Income. The ending inventory value would be $100 higher under FIFO and $100 lower under FIFO. If inventory is getting more expensive to purchase, LIFO will produce higher values for COGs and lower ending inventory values and vice versa if inventory is getting cheaper to purchase.

How the balance sheet is adjusted in an LBO model?

First, the Liabilities and Equities side is adjusted - the new debt is added on and shareholders' equity is wiped out and replaced by the investors equity contributed. On the Asset side, Cash is adjusted for any cash used to finance the transaction and then Goodwill and Other intangibles are used as a plug to make the Balance Sheet balance.

21. Walk me through a $100 "bailout" of a company and how it affects the 3 statements.

First, what type of "bailout" is this? Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens. *bailout in banking is when a business, an individual, or a government provides money and/or resources (also known as a capital injection) to a failing company* https://www.investopedia.com/terms/b/bailout.asp No changes to the Income statement. On the cash flow statement, Cash Flows from Financing go up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. On the Balance Sheet, Cash is up by $100 so Assets are up by $100. On the other side, Shareholders' equity would go up by $100 to make it balance.

26. How long does it usually take for a company to collect its accounts receivable balance?

Generally the accounts receivable days are in the 30-60 day range, though it's higher for companies selling high-end products and it might be lower for smaller, lower transaction-value companies.

5. How do you calculate fully diluted shares?

Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt or convertible prefered stock. To calculate the dilutive effect of options, you use the Treasury Stock Method

33. Under what circumstances would Goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios: 1. The company gets acquired or bought out and Goodwill changes as a result, since it is an accounting "plug" for the purchase price in an acquisition. 2. The company acquires another company and pays more than what its assets are worth - this is then reflected in the Goodwill number

11. Would an LBO or DCF give a higher valuation?

Technically, it could go either way. but in most cases the LBO will give you a lower valuation. The easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you're only valuing it based on its terminal value. With DCF, by contrast, you're taking into account both the company's cash flows in between and its terminal value, so values tend to be higher. Unlike a DCF, an LBO model by itself does not vie a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company based on that.

9. What are some examples of industry-specific multiples?

Technology (internet) - EV/Unique Visitors, EV/Pageviews, EV/Unique Visitors Retail / Airlines - EV / EBITDA Energy: EV/EBITDAX(exploration expense), EV/Daily Production, EV/Proved Reserve Quantities Real Estate Investment Trusts (REITs): Price/FFO per Share, Price/AFFO per Share (funds from operations, adjusted funds from operations) Technology and Energy should be straightforward - you're looking at different traffic and energy reserves as value drivers rather than the revenue or profit. For Retail/Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense. For Energy, all value is derived from companies' reserves of oil & gas, which explains the last 2 multiples; EBITDAX exists because some companies capitalize their exploration expenses and some expense them. You add back the exploration expense to normalize the numbers. For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of porperty. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sale of properties are assumed to be non-recurring, so FFO is viewed as a normlized picture of the cash flow the REIT is generating.

8. Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

The "official" reason: Cash is subtracted because it's considered a non-operating asset and because Equity Value implicitly accounts for it. The way I think about it: In an acquisition, the buyer gets the "cash" when purchasing it. So what the buyer really pays to buy the company would be (everything - cash that the company already has). Enterprise Value tells us how much you really have to "pay" to acquire another company. It is not always accurate because technically you should only subtract excess amount of cash - cash above its minimum required cash for operation.

19. How do you select comparable companies / precedent transactions?

The 3 main ways to select companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry - that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

7. Give an example of real life LBO

buying a house with mortgage - Down Payment = investor equity in LBo - Mortgage = debt in LBO - Mortgage interest payment = debt interest payment in LBO - Mortgage repayments = debt principal repayment in an LBO = Selling the house = exit

Why might you use bank debt rather than high-yield debt in an LBO?

if the PE firm is concerend about meeting the interest payment and wants a lower cost option, it would go with bank debt. Also, if the PE firm is planning to expand the operations or cap expenditures and do not want to be restricted by the incurrence covenants, it would use bank debt

tax shield in LBO?

interest payment on debt is tax-deductable. The firm, therefore, saves money on tax which can help the cash flow and the bottom line., However, the cash flow is still smaller than what a debt-free company would have.

18. You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?

it is rare to see Equity Value / EBITDA, but large financial institutions with big cash balances have negative Enterprise Value, so they might use Equity Value / Revenue instead. You might see Equity Value / Revenue if you've listed a set of financial institutions and non-financial institutions on a slide, you're showing Revenue multiples for the mom-financial institutions, and you want to show something similar for the financial institutions. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

13. How would you value an apple tree?

the same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree's cash flows - how many apples it would make per year (intrinsic valuation).

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

you would usually look at comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

7. Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its fully diluted equity value?

$1000. In this case, the options' exercise price is above the current share price, so they have no effect when it comes to diluted equity value.

1. What are the 3 major valuation methodologies?

1. Comparable Companies 2. Precedent Transactions 3. Discounted Cash Flow Analysis.

27. What are some flaws with precedent transactions?

1. Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market sentiment all have huge effects. 2. Data on precedent transactions is generally more difficult to find than it is for public company comparable, especially for acquisitions of small private companies.

5 most important accounting concepts you need to know

1. The 3 financial statements and what each one means 2. How the 3 statements link together and how to walk through questions where one or multiple items change 3. Different methods of accounting - cash-based vs. accrual, and determining when revenue and expenses are recognized 4. When to expense something and when to capitalize it. Not all expenses are created equal 5. What individual items on the statements, like Goodwill, Other Intangibles and Shareholders' Equity, actually mean.

22. Why would a company with similar growth and profitability to its Comparable Companies be valued at premium?

1. The company has just reported earnings well-above expectations and its stock price has risen recently. 2. It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. 3. It has just won a favorable ruling in a major lawsuit. 4. It is the market leader in an industry and has greater market share than its competitors.

How to boost its return in an LBO?

1. buy a lower multiple 2. sell at a higher multiple 3. increase the leverage 4. increae the company's growth rate 5. increase margins by reducing expenses.

23. What are the flaws with public company comparable?

1. there is never a 100% comparable to another company 2. The stock market contains emotion - your multiple might be dramatically high or low due to emotions of the investors 3. Share prices for small companies with thinly-traded stocks may not reflect their full value.

5. What is an "ideal" candidate for an LBO

A company that has a stable and predictable cash flow, low risk businesses, not much Cap Ex needed in the future, and opportunities to cut down on the expenses to boost the margin. A strong management team is preferred. Most important part = cash flow

25. What's the difference between accounts receivable and deferred revenue?

Accounts receivable is cash that has not been collected from the customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue is how much the company has already collected and is waiting to perform the services to record as revenue

14. At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation. It is this $80 that we will write down in the 3 statements. First, on the Income statement, tne $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. On the Cash Flow statement, Net Income is down by $48 but the write-down is a non-cash expense, so we add $80 back and therefore the Cash Flow from Operations increases by $32. there are no changes under Cash Flow from Investing, but under Financing there is a $100 charge for the loan payback. Thus, Cash flow from investing falls by $100. Overall the Net Change in Cash falls by $68. On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80. so assets have decreased by $148 total. On the other side, debt is down by $100 since it is paid off and since Net Income was down by $48, Shareholder's equity is also down by $48. Altogether Liabilities & Shareholders' Equity are down by $148 to match the assets.

7. If Depreciation is a non-cash expense, why does it affect the cash balance?

Although Depreciation is non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

13. Now let's go out 1 year, to the start of the Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

Apple must pay interest expense and record the depreciation. Therefore, Operating income would fall by $10 due to the depreciation and Interest expense would increase by $10. Together, it will decrease the pre-tax income by $20. Assuming the income tax rate is 40%, net income would fall by $12. (20 x 0.6) On the cash flow statement, the beginning line which is the net income would be $12 less. But depreciation is a non-cash expense so we will adjust it by adding back the $10. Therefore, the Cash Flow from operations is down by $2 and total cash flow would decrease by $2. On the balance sheet, under assets, cash is down $2 and PP&E is down by $10 due to depreciation. Overall, the asset is down by $12. On the other side, since NEt Income is down by $12, Shareholder's equity is also down by $20. Any number under debt would remain the same since we assume the none of the principle is paid off.

12. Let's say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of Year 1 before anything else happens?

At the start of Year 1, before anything else has happened, there would be no changes on Apple's Income Statement yet. On the cash flow statement, the additional investment in factories would show up under Cash Flow from Investing activities as a net reduction in cash flow - goes down by $100 - and the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash stays the same. On the balance sheet, there is an additional $100 worth of factories in the PP&E, and asset is therefore up by $100. Ont he other side, debt is up by $100 as well so both sides balance.

27. What is the difference between cash based and accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain and recognizes expenses when they are incurred rather than when they are paid out in cash.

9. What happens when Accrued Compensation goes up by $10?

Confirm that the accrued compensation is now being recognized as an expense as opposed to just changing non-accrued to accrued compensation. Assuming that is the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income goes down bu $10 and Net Income would go down by $6 (if the income tax is 40%). On the Cash Flow Statement, Net Income is down by $6, and Accrued compensation will increase cash flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. On the Balance Sheet, Cash is up by $4, so assets are up by $4. On the Liabilities and equity, accrued compensation is a liability so liabilities are up by $10 and retained earnings are down by $6 due to the Net Income.

14. Why can't you use Equity Value/ EBITDA as a multiple rather than Enterprise Value / EBITDA?

EBITDA is available to all investors in the company; however, Equity Value is only available to the equity holders. Similarly, Enterprise Value is available to all investors. So we don't want to compare two things that are different like EBITDA and Equity Value since it is like comparing an apple to an orange, we want to compare two things that are similar - Enterprise Value/EBITDA.

3. What's the formula for Enterprise Value?

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest - Cash This formula does not tell the whole story and can get more complex - see the Advanced Questions. Most of the time, you can get away with stating this formula in an interview though. "Noncontrolling Interest" was formerly known as Minority Interest and some bankers still call it that.

8. What are the most common multiples used in Valuation?

EV/Revenue (Enterprise Value / Revenue), EV/EBITDA, EV/EBIT, P/E, and P/BV (share price / book value per share)

2. When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?

Enterprise Value, because that's how much an acquirer really "pays" and includes the often mandatory debt repayment

1. Why do we look at both Enterprise Value and Equity Value?

Enterprise value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.

15. What's the difference between Equity Value and Shareholders' Equity?

Equity Value also included diluted shares outstanding from the convertible bonds and options when they are in-the-money. However, Shareholders'' Equity only includes common stocks outstanding. **Equity Value is the market value and Shareholders' Equity is the book value. For healthy companies, Equity Value usually far exceeds Shareholders' Equity**

Why would a PE firm buy a company in a risky industry, such as technology?

If if the industry is risky, there are still stable companyes with stable cash flow and mature. There are PE firms that specialize in very speicifc goal or industry such as: industry consolidation - buying competitors in a similar market and combining them to increase the efficiency and win more customers Turnarounds - taking struggling companies and making them fuction properly again. Divestitures - selling off divisions of a company or taking a division and turning it into a strong stand-alone entity.

Why would a PE firm use high yield debt?

If the PE firm intends to refinance the firm at some point or they don't believe their returns are too sensitive to interest payment, they might use high yield debt. They might also use it if they do not have plans for major expenditure or selling off their assets.

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

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated or amortized over a certain number of years. *an asset is depreciated when it is tangible and amortized when it is intangible* Purchases like factories, equipment, and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

13. How do you account for convertible bonds in the Enterprise Value formula?

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they're out-of-the-money, then you count the face value of the convertibles as part of the company's debt.

17. What would you use in conjunction with Free Cash Flow multiples - Equity Value or Enterprise Value?

If we are working with unlevered free cash flow, we would use enterprise value and if we are working with levered free cash flow, we would rather use equity value. It is because with unlevered free cash flow, it is free cash flow before the interest payment to the debt holders and with levered free cash flow, it is only for the equity holder.

what is a dividend recapitalization?

In a dividend recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it. It'd be like if you made your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds. it is still commonly used but it has a bad reputations.

1. Walk me through a basic LBO model

In an LBO model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ration, interest rate on debt and other variables. You might also assume something about the company's operations, such as Revenue Growth or Margins, depending on how much information you have. Step 2 is to create a Sources and Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much investor equity is required. Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also add in goodwill and other intangibles on the assets side to make everything balance. Step 4 is to project the company's income statement, Balance Sheet, and cash flow statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required interest payments. Last step 5 is to make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.

9. Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller's debt, so it is accurate to say that any debt "adds" to the purchase price. However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I've personally never seen it, but once again "never say ever" applies.

14. A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1000 and a conversion price of $50. How do I calculate diluted shares outstanding?

In-the-money --> include convertible bonds as a part of Equity value Out-of-the-money --> include convertible bonds as a part of the company's debt For this problem, $1000 (company's share price) > $50 (conversion rate), it is in-the-money. Therefore, the convertible bonds will be counted toward Equity Value as an additional dilution. $10M convertible bonds / $1000 --> 10,000 convertible bonds (divide the value of the convertible bonds by the par value to figure out how many individual bonds we get). $1000 / $50 --> 20 shares per bond (divide the par value by the conversion rate to figure out how many shares per bond) So we have 200,000 new shares created by the bonds. Total diluted shares outstanding = 1 million common shares + 200,000 shares converted from the bonds = 1.2 million shares. **We do not use the Treasury Stock Method with convertibles** because the company is not "receiving" any cash from us.

6. Walk me through how Depreciation going up by $10 would affect the statements

Income Statement Operating Income would go down by $10, and assuming the income tax is 40%, the net income would decline by $6. Cash Flow Statement now starts with the net income that is $6 lower than before. However, since depreciation $10 is non-cash expense, it would be added back; therefore, the overall net cash would be up by $4. Lastly, Balance Sheet's asset - PP&E - is down by $10 however the Cash is up by $4 due to the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6, Shareholders' Equity on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance. Always, go with Income statement -> Cash Flow Statement -> Balance Sheet **Asset going up decreases Cash Flow, whereas a Liabilities going up increases your Cash Flow**

2. Can you give examples of major line items on each of the financial statements?

Income Statement has Revenue; Cost of Goods Sold; SG&A (Selling, General, and Administrative Expenses); Operating Income; Pretax Income; Net Income Balance Sheet has Cash; Accounts Receivable; Inventory; Plants, Property, and Equipment; Account Payable; Accrued Expenses; Debt; Shareholders' Equity Cash Flow Statement has Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets and Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividend Issued; Cash Flow From Financing

16. Now let's say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Income Statement: Revenue is up by $20 and Cost of Goods Sold is also up by $10. Gross Profit and Operation Income will increase by $10 as well. Assuming income tax is 40%, the Net Income is increased by $6. Cash Flow Statement: Net Income at the top is increased by $6 and the inventory is down by $10 - since we just manufactured the real inventory to the actual product - which is a net addition to the Cash Flow so the cash flow from operations is up by $16 in total. Lastly the Balance Sheet, on Assets, cash is up by $16 and Inventory is decreased by $10. so Assets is up by $6 in total. On the other side, since Net Income is up by $6 so Shareholders' Equity is up by $6 which balances out each side.

11. Why is the Income Statement not affected by changes in Inventory

Income statement is not affected by changes in inventory because the expense is only recorded when the goods associated with it are sold - so if it is just sitting in a warehouse, it does not count as a Cost of Goods Sold or Operating Expense until the company manufactures it into a product and sells it.

10. What happens when Inventory goes up by $10, assuming you pay for it with cash?

Income statement: no changes Cash Flow Statement: new income is the same. Inventory is an asset that decreases the cash flow from operations - it goes down by $10, as does the Net Change in Cash at the bottom. Balance Sheet: Inventory goes up by $10 and the cash is also down by $10. So it balances.

20. Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write-down of $100.

Income statement: the $100 wirte-down shows up in the Pre-Tax Income line. Assuming that the tax rate is %40, Net Income declines by $60. On Cash Flow Statement: Net Income is down by $60. But, write down is not a cash expense, so it will be added back. Therefore, Cash Flow from Operations increases by $40. Overall, Net Change in Cash is increased by $40. On Balance Statement, Cash is up by $40 and an asset that is not specified on the question is down by $100. Shareholders' equity is down by $60.

8. Where does Depreciation usually show up on the Income Statement?

It could be a separate line, or it could be embedded in COGS or Operating Expenses. Every company does it differently. The end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

LBO Model Questions & Answers

It is important to understand how different variables affect the output and how and why a PE firm would structure a deal in a certain way.

4. If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

It would be the Cash Flow Statement. It's because the Cash Flow Statement shows the overall and a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that is the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.

5. 2 statements to access a company's prospects - which 2 would I use and why?

It would be the Income statement and Balance Sheet. Because you can create the cash flow statement using those two statements (with an assumption that you have "before" and "after" versions of the Balance sheet that correspond to the same period the Income Statement is tracking).

6. Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each - what is its fully diluted equity value?

Its basic equity value = $1000 ($10 x 100). To calculate the dilutive effect of the options, first you note that the options are all "in-the-money" - their exercise price is less than the current share price. When these options are exercised, there will be 10 new shares created - so the share count is now 110 rather than 100. However, that doesn't tell the whole story. In order to exercise the options, we had to "pay" the company $5 for each option (the exercise price). As a result, it now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created. So the fully diluted share count is 105, and the fully diluted equity value is $1050. ($10 x 100 shares + $5 x 10 shares)

Enterprise / Equity Value Basic

Make sure you know all the relevant formulas and understands concepts like the Treasury Stock Method for calculating diluted shares.

15. Now let's look at different scenario and assume Apple is ordering $10 of additional Ipad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet, what happens to the 3 statement?

No change to Income statement since nothing has been sold from the newly bought inventory. On the cash flow statement, net income does not change. But the cash flow from operations decreases by $10 due to inventory being up by $10. On the balance sheet, inventory is up by $10 and cash is down by $10 so no change in assets and therefore nothing to balance out with liability and shareholders' equity.

11. Could a company have a negative Equity Value? What would that mean?

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

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

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue Balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy. For instance, when customers don't pay quickly and upfront and the company is carrying a high debt balance.

7. When do you use an LBO Analysis as part of your Valuation?

Obviously you use this whenever you're looking at a Leveraged Buyout - but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay It is often used to set a "floor" on a possible Valuation for the company you're looking at.

4. What other Valuation methodologies are there?

Other methodologies include: - Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive. - Replacement Value - Valuing a company based on the cost of replacing its assets - LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range -Sum of the Parts - Valuing each division of a company separately and adding them together at the end - M&A Premiums Analysis - Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth - Future Share Price Analysis - Projecting a company's share price based on the P/E multiples of the public company comparables, then discounting it back to its present value

28. Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?

Possible Reasons: - one process was more competitive and had a lot more companies bidding on the target - One company had recent bad news or a depressed stock price so it was acquired at a discount - They were in industries with different median multiples.

12. Why do we add Preferred Stock to get to Enterprise Value?

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company's assets than equity investors (common stocks holders) do. As a result, it is seen as more similar to debt than common stock.

3. What variables impact an LBO model the most?

Purchase and exit multiple have the biggest impact on the returns of a model. After that, the amount of leverage used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margin. - at what multiple you would buy and sell the company for. - how much debt you have to take - how much revenue and EBITDA does it generate that you can use to pay off the debt before exiting.

31. A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Several possibilties: 1. The company is spending too much on CapExp - these are not reflected at all in EBITDA, but it could still be cash-flow negative. 2. The company has high interest expense and is no longer able to afford its debt. 3. The company's debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash completely when paying back the debt. 4. It has significant one-time charges (from litigation, for instance) and those are high enough to bankrupt the company. Remember, EBITDA excludes investment in long-term assets, interest and one-time charges - and all of these could end up bankrupting the company.

26. When will it be false that Precedent Transactions usually produce a higher value than comparable companies?

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations. For the most part, this generalization is true but there are exceptions to almost every "rule" in finance.

20. How do you apply the 3 valuation methodologies to actually get a value for the company you're looking at?

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you're valuing. To get the "football field" valuation graph you often see, you look at the minimum maximum, 25th and 75th percentile in each set as well and create a range of values based on each methodology.

1. Walk me through the 3 financial statements.

The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. The Income statement gives the company's revenue and expenses, and goes down to Net Income, the final line of the statement. The Balance Sheet shows the company's assets - its resources - such as Cash, Inventory, PP&E, as well as Liabilities such as Debt and Accounts Payable, and Shareholder's Equity. Assets must equal Liabilities plus Shareholders' Equity. Lastly, Cash Flow Statement begins with its Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities, at the end, you see the company's net change in cash.

strategic acquirer will usually prefer to pay for the firm in cash, if that is the case why would a PE firm want to use debt in an LBO?

The PE firm does not hold the company for too long. it will usually sell in a few years. So it is not concerned about the expense of cash or debt. It is focused on the amount of leverge they are taking to boost the return once exit. In an LBO, debt is owned by the company, so they assume much less risk along with the debt; however, when a firm is acquired, the buyer owes the debt. so there are much more risk following with it.

4. How do you pick purchase multiples and exit multiples in an LBO model?

The same way you do it anywhere else: - look at comparable companies and see where they are trading at. - look at similar LBO transactions and what their multiples were. - make sure to show a range of multiples using sensitivity analysis Sometimes you might use a specific IRR target that you are trying to achieve to set the multiples. But this is only for valuation purpose.

25. Do you always use the median multiples of a set of public company comparable or precedent transactions?

There's no "rule" that you have to do this, but in most cases, you do because you want to use values from the middle range of the set. But if the company you're valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead - and vice versa if it's doing well.

30. Why do companies report both GAAP and non-GAAP (or Pro Forma) Earnings?

These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-Down in their Income Statements. As a result, some argue that Income statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.

Why are Goodwill & other intangibles created in LBO?

These goodwill and other intangibles are used to represent the premium paid to the fair market value. In an LBO they are used as a plug to ensure that the changes to the Liabilites and equites are balanced to the Assets side

When analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratio?

This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions. To figure out the numbers, you would look at debt comps showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently. There are some general rules: you would never lever a company at 50x EBITDA, and even during the bubble leverage rarely exceed 5-10x EBITDA.

15. When would a Liquidation Valuation produce the highest value?

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality).

6. When would you use Sum of the Parts?

This is most often used when a company has completely different, unrelated divisions - a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division, and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

5. When would you use a Liquidation Valuation?

This is the most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company's debts have been paid off. It is often used to advise struggling businesses on whether it's better to sell of assets separately or to try and sell the entire company

23. When would a company collect cash from a customer and not record it as revenue?

Three examples of businesses that might do the above: 1. Web-based subscription software 2. Cell phone carriers that sell annual contracts 3. Magazine publishers that sell subscriptions Companies that agree to services in the future often collect cash upfront to ensure stable revenue - this makes investors happy as well since they can better predict the company's future performance. Per the rules of accounting, you only record revenue when you actually perform the services - so the company would not record everything as revenue right away.

2. Why would you use leverage when buying a company?

To increase return. To leverage out their position. They can buy other firms at the same time with their captial.

3. How do the 3 statements link together

To tie the statements together, Net Income from the Income statement flows into Shareholders' Equity on the balance sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt, and Shareholders' Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs", with Cash flowing in from the final line of the cash flow statement.

2. Rank the 3 valuation methodologies from highest to lowest expected value.

Trick question - there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. Beyond that, a DCF could go either way and it's the best to say that it's more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

28. Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Under the cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - at which point it would show up as revenue on the Income Statement and Cash on the Balance Sheet. Under the accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on Balance Sheet, it will appear as Account Receivable. Then, once the cash is actually deposited in the company's bank account, it will turn into Cash.

24. if cash collected is not recorded as revenue, what happens to it?

Usually it goes into Deferred Revenue on the Balance Sheet under the Liabilities. As the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and Deferred Revenue balance decreases.

32. normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

12. How would you present these Valuation methodologies to a company or its investors?

Usually you use a "football field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.

What do you actually use a valuation for?

Usually you use it in pitch books and in client presentations when you're providing updates and telling them what they should expect for their own valuation. It's also used right before a deal closes in a Fairness Opinion, a document a bank creates that proves the value their client is paying or receiving is fair from a financial point of view. Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

22. Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a company's balance sheet and how it affects the 3 statements.

When a liability is written down, it is a gain on the Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% income tax, Net Income is increased by $60. On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down ($100) - so Cash From Operations is down by $40, and Net Change in Cash is down by $40. On the Balance Sheet, Cash is down by $40. So Assets is down by $40. Liabilities is also down by $100 due to the debt write-down. However, Shareholders' Equity is up by $60 due to the increase in Net Income. In total, Liabilities and Shareholders' equity is down by $40 which matches the Assets.

4. Why do you need to add the Noncontrolling Interest to Enterprise Value?

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial performance. In keeping with the "apples-to-apples" theme, you must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

What is Working Capital? How is it used?

Working Capital = current assets - current liabilities. If it is positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound". *sound means reliable and sensible* Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current assets - Cash & Cash Equivalents) - (Current Liabilities - Debt). The point of Operating Working Capital is to exclude items that relate to a company's financing activities - cash and debt - from the calculation.

Do you need to project all three statements in an LBO model? Are there any short cuts?

Yes, you don't necessarily need to project all 3 statements. for example, you do not need to create a full Balance Sheet - bankers sometimes skip this if they are in a rush. You do need to have some form of Income statement, something to track how the Debt balances change and some type of cash flow statement to show how much cash is available to repay debt. but full-blown balance sheet is not strictly requires, because you can just make assumptions on the net changes in working capital rather than looking at each item individually.

17. Could you ever end up with negative shareholders' equity? What does it mean?

Yes. It is common in these 2 scenarios. 1. Leveraged Buyouts with dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative. 2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is portion of Shareholders' equity. It doesn't mean anything in particular, but it can be a cause for concern and possibly demonstrates that the company is struggling especially for the second scenario. Even for LBO, Shareholders' equity never turns negative immediately after an LBO, it would only happen following a dividend recap or continued net losses.

10. Could a company have a negative Enterprise Value? What would that mean?

Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see this with: - Companies on the brink of bankruptcy. - Financial institutions, such as banks, that have large cash balances - but Enterprise Value is not even used for commercial banks in the first place so this doesn't matter much

3. When would you not use a DCF in a valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startups) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you wouldn't use a DCF for such companies.

Valuation Questions & Answers - Basics

You need to understand how and why each valuation method is used, which ones produce the highest or lowest values and also keep in mind exceptions to each "rule".

10. When you're lookin at an indsutry-specific multiple like EV/Scientists or EV/Subscribers, why do you use Enterprise Value rather than Equity Value?

You use Enterprise Value because those scientists or subscribers are "availbale" to all the investors (both debt and equity) in a company. The same logic doesn't apply to everything, though - you need to think through the multiple and see which investors the particular metrix is "available" to.

6. How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor valuation" for the company?

You use the model to value a company by setting a targeted IRR and then back solve in Excel to determine what purchase price the PE firm could pay to achieve the IRR. Sometimes it is called floor valuation because PE firms usually want to pay the least amount to buy a firm and it is usually less than what any strategic acquirer would pay.

16. Let's go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

You would use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/ Revenue or EV/EBITDA. You would not use a "far in the future DCF" because you can't reasonably predict cash flows for a company that is not even making money yet. This is very common wrong answer given by interviewees. When you can't predict CF, use other metrics - don't try to predict CF anyway

Bank Debt vs. High Yield Debt

a few of the important differences are: - high yield debt tends to have a higher interest rates - High yield debt interest rates are usually fixed, whereas bank debt interest rates are "floating" - they change based on LIBOR or the FED interest rate. High-yield debt has incurrence covenants while bank debt has maintenance covenants. Incurrence covenants prevent you from doing something such as selling your asset while maintenance covenants require you to maintain a minimum financial performance such as a specific debt to equity ratio or EBITDA - Bank debt is usually amortized - the principal must be paid off over time - whereas with high yield debt, the entire principal is due at the end, aka bubble payment or bullet maturity PE firm would usually use both in a sizeable LBO