PE Technical Questions
Give examples of ways companies can manipulate earnings.
"1) Switching from LIFO to FIFO or vice versa. In a rising cost environment, switching to LIFO from FIFO will show lower earnings, higher costs and lower taxes. 2) Switching from fair value to cash flow hedges. Changes in fair value hedges are in earnings, changes in cash flow hedges are in other comprehensive income. Having negative fair value hedges and then shifting them to cash flow hedges will increase earnings. 3) Taking write-downs to inventory will decrease earnings. 4) Changing depreciation methods. 5) Having a more aggressive revenue recognition policy. Accounts receivable will increase rapidly because they're extending easier credit. 6) Capitalizing interest that shouldn't be capitalized, so you decrease interest expense on the income statement. 7) Manipulating pre-tax or after-tax gains. 8) Mark-to-market/Mark-to-model."
Which structure does the seller prefer and why? What about the buyer?
"A stock deal generally favors the seller because of the tax advantage. An asset deal for a C corporation causes the seller to be double-taxed; once at the corporate level when the assets are sold, and again at the individual level when proceeds are distributed to the shareholders/owners. In contrast, a stock deal avoids the second tax because proceeds transfer directly to the seller. In non-C corporations like LLCs and partnerships, a stock purchase can help the seller pay transaction taxes at a lower capital gains rate (there is a capital gains and ordinary income tax difference at the individual level, but not at a corporate level). Furthermore, since a stock purchase transfers the entire entity, it allows the seller to completely extract itself from the business. A buyer prefers an asset deal for similar reasons. First, it can pick and choose which assets and liabilities to assume. This also decreases the amount of due diligence needed. Second, the buyer can write up the value of the assets purchased—known as a "step-up" in basis to fair market value over the historical carrying cost, which can create an additional depreciation write-off, becoming a tax benefit. Please note there are other, lesser-known legal advantages and disadvantages to both transaction structures. "
Why do P/E and EBITDA multiples yield different valuation results?
"EBITDA multiples represent the value to all stakeholders (debt and equity) while P/E ratios only represent the value to equity holders. EBITDA multiples are often times used to value firms that have negative income (but have positive EBITDA). EBITDA multiples do not factor in the effect of interest and therefore allow for comparability across firms regardless of their capital structure. Note this is why you will never see EV/earnings or Price/EBITDA ratios; the numerator and denominator must correspond to the same set of stakeholders."
What could a company do with excess cash on the balance sheet?
"First, it can re-invest the cash into organic investments or acquisitions. Second, it can distribute the extra cash to shareholders through the use of dividends. Third, it can repurchase some of its equity from the market. Fourth, it can pay down debt and decrease leverage. "
What do you think about the paper phone book business?
"It's a maturing business, so future growth rate is likely to be negative. It is an increasingly outdated form of advertising, especially in comparison to the internet. Also, the growth rate in the U.S. is slowing down due to the aging population, which further decreases the future growth rate in comparison to the historical growth rate. The key age demographic to focus on is the elderly, who may not use other prevalent forms of advertising. The main advantage of a phone book that it appeals to a niche audience—the local city population who refers to the phone book to look for local businesses. But the industry continues to mature rapidly because this niche information is increasingly being uploaded to the internet. Paper phone books need to take advantage of the internet channel, which enjoys lower distribution costs, and focus on ways to make online advertising profitable or to have businesses pay to be included on the site. However, competition is fierce; Google already provides a similar function. A good company that has created a value-added twist on the business is Yelp, a website that posts user-generated reviews of businesses. Businesses can pay to advertise in designated spots of the site based on what the user is searching for."
Of the valuation methodologies, which ones are likely to result in higher/lower value?
"Precedents usually yield higher valuations than trading comps because a buyer must pay shareholders more than the current trading price to acquire a company. This is referred to as the control premium (use 20 percent as a benchmark). If the buyer believes it can achieve synergies with the merger, then the buyer may pay more. This is known as the synergy premium. Between LBOs and DCFs, the DCF should have a higher value because the required IRR (cost of equity) of an LBO should be higher than the public markets cost of equity in WACC for the DCF. The DCF should be discounted at a lower rate and yield a higher value than an LBO. When debating whether precedents or DCFs yield higher values, you should note that DCFs are a control methodology, meaning you select the assumptions that determine the value. Some interviewers have mentioned that you get projections from management, which tends to be optimistic and can often make the DCF the highest value. Regardless, all interviewers are looking for you to say that the DCF and precedents yield higher valuations than the other two methodologies for the reasons listed above. "
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 on the statement. The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must equal Liabilities plus Shareholders' Equity. The Cash Flow Statement begins with 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."
List the line items in the cash flow statement.
"The CFS is broken up into three sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. In cash flow from operating, the key items are net income, depreciation and amortization, equity in earnings, non-cash stock compensation, deferred taxes, changes in working capital and changes in other assets and liabilities. In cash flow from investing, the key items are capital expenditures and asset sales. In cash flow from financing, the key items are debt raised and paid down, equity raised, share repurchases and dividends."
What is LIBOR? How is it often used?
"The London Interbank Offered Rate tracks the daily interest rates at which banks borrow unsecured funds from banks in the London wholesale money market, and is roughly comparable to the Fed Funds rate. LIBOR is used as a reference rate for several financial instruments, such as interest rate swaps or forward rate agreements, and they provide the basis for some of the world's most liquid and active interest rate markets."
How do the three 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 on the Cash Flow Statement."
If a company has seasonal working capital, is that a deal killer?
"Working capital ("WC") is current assets less current liabilities. Seasonal working capital applies to firms whose business is tied to certain time periods. When current assets are higher than current liabilities, this means more cash is being tied up instead of being borrowed. For instance, UGG mostly manufactures snow boots. In the winter, demand is higher, so the firm must build up inventories to meet this demand at this time, increasing current assets. Since more cash is tied up, this can increase the liquidity risk. If UGGs suddenly go out of fashion, then the company is stuck holding the inventory. Also, if people frequently pay with credit for the company's products, the amount is listed as accounts receivable ("AR"), which represents future profits but is noncash. Therefore, if the company cannot collect this owed cash in time to pay its creditors, it runs of the risk of bankruptcy. This is an issue to note and watch, but it is not a deal killer if you have an adequate revolver and can predict the seasonal WC requirements with some clarity. In general, any recurring event is fine as long as it continues to perform as planned. The one-time massive surprise event is what can kill an investment."
Why does PE use leverage? Or how does leverage increase PE returns?
- Leverage allows you to use less equity which means that the ultimate returns are going to be higher opposed to not using leverage - Cost of debt is lower than the cost of equity (priced to 20% IRR) - Another way to look at it is that more debt makes a deal more volatile and riskier, therefore higher returns can be seen as the fair return associated with the extra risk of higher leverage
Tell me why each of the financial statements by itself is inadequate for evaluating a company?
-Income Statement: the IS alone won't tell you whether a company generates / loses cash or whether it is solvent. You need the balance sheet to tell you whether the comapny can meet its future liabilities, and you need the cash flow statemetn to ensure it is generating enough cash to tfund its operations and gorwth. - Balance sheet : the balance sheet alone won't tell you whether the company is profitable because it is only a snapshot on a particular date. A company with few liabilities and many assets could actually be losing money every year. -Cash Flow Statement: The cash flow statement won't tell you whether a company is solvent because it could have massive long term liabilities which dwarf its cash generating capabilities. The CFS also won't tell you whether the company's ongoing operations are actually profitable because in any given period cash flows could look strong or weak due to timing rather than the underlying strength of the company's business.
Why does PE generate higher returns than public markets?
-LBOs are highly levered and therefore riskier demanding higher returns - PE investments are less liquid and demand higher returns ---> PE LPs demand higher returns and GPs only target deals 20% IRR and up
How do you determine the appropriate exit multiple on a deal?
-Public comps, precedent transactions, next financial buyer analysis - Usually just keep consistent with entry multiple or even a turn lower given where we are in the cycle
Say you have a phone book business. If you increase your price by 10 percent but lose 10 percent of your advertisers, what's your revenue change?
1 percent. If ads are $1 and you have 100 advertisers, then you raise to $1.1 but go down to 90 advertisers, which is $99 in revenue. Originally, you had $100 in revenue, so you dropped $1. Mathematically speaking, originally you had 1.0# x 1.0$ = 1.0R. Now you have .9# x 1.1$ = .99R so it went down 1 percent.
What are some ways PE firms increase portfolio company value?
1) Align incentives with management 2) Improve corporate governance i.e. hold management accountable and bring in a better team if necessary 3) Identify and finance new organic growth opportunities 4) Find, finance, and execute add on acquisitions 5) Support investment in more sophisticated infrastructure / systems such as a better ERP
What constitutes a good LBO target?
1) Attractively priced asset 2) Strong and stable FCF 3) Defensible market position 4) Strong management team 5) Viable exit strategy
Walk me through an LBO at a high level.
1) Calculate the total acquisition price, including the acquisition of the target's equity, repayment of any outstanding debt, and any transaction fees 2) Determine how the total price will be paid: equity from the PE sponsor, rollover equity, debt, seller financing, etc. 3) Project the target's operating performance over ~5 years and determine how much of the debt principal can be paid down using FCFs 4) Project how much the comapny can be sold for after ~5 years, subtract net debt from total EV to determine the equity value at exit 5) Returns analysis calculating IRR and MoM
How might you still close a deal if you and the seller disagree on the price of an asset due to projections of its future operating performance?
1) Earn out - portion of purchase price held back in an escrow account until the business' actual future performance is decided. If business performs like the seller expects they are paid the remainder of the purchase price 2) Contingent seller note
How would you gauge a company's competitive position?
1) Market share 2) Profit margins 3) Brand perception 4) Product breadth and quality 5) management team quality
How would you gauge how attractive an industry is?
1) Size / Growth rate 2) Stability 3) Profitability --> Porter's five forces - Bargaining power of suppliers - bargaining power of customers - threat new entrants / barriers to entry - threat of substitution - competitive rivalry
Name five reasons why a company would want to acquire another company
1) The target company is seen as undervalued, 2) synergies can be obtained with the merger of the two companies, 3) a larger company is more industrydefensible (more resilient to downturns or more formidable competitor), 4) provides growth (versus organic growth, which may have slowed or stalled) and 5) can be a use for excess cash.
How would you estimate roughly how much debt capacity is available for an LBO?
1) Total leverage ration (Total debt / LTM EBTIDA) 2) Interest coverage ratio (LTM EBIT / Annual interest expense) --> floor is usually 1.5x 3) Min equity ratio --> ~35% today
If you put $100 in the bank and got back $2 every year for the next 19 years and then in the 20th year, received $102, what is your IRR?
2 percent. The duration of the investment does not matter.
Why would a company repurchase its own stock? What signals (positive and negative) does this send to the market?
A company repurchases its own stock if it perceives the market is undervaluing its equity. Since the management has more information on the company than the general public, when the management perceives the company as undervalued, it sends a creditable signal to the rest of the market.
How will a decrease in financial leverage affect a company's cost of equity capital, if at all?
A decrease in financial leverage lowers the beta which lowers the cost of equity capital. With less debt, the firm has a reduced risk of defaulting. This change causes equity investors to expect a lower premium for their investments and therefore reduce the cost of equity.
What is a stock purchase and what is an asset purchase?
A stock purchase refers to the purchase of an entire company so that all the outstanding stock is transferred to the buyer. Effectively, the buyer takes the seller's place as the owner of the business and will assume all assets and liabilities. In an asset deal, the seller retains ownership of the stock while the buyer uses a new or different entity to assume ownership over specified assets.
If a company acquires another company with a higher P/E in an all stock deal, will the deal likely be accretive or dilutive?
All things being equal, if the acquirer's P/E is lower than the target, then the deal will be dilutive to the acquirer's earnings per share ("EPS"). This is because the acquirer has to pay more for each dollar of earnings than the market values for its own earnings; the acquirer will have to issue proportionally more shares in the transaction. Ignoring synergies, you can see mechanically that the pro-forma earnings, acquirer's plus target's earnings (the numerator in EPS), will increase less than the pro-forma share count (the denominator), causing EPS to decline.
Walk me through an accretion/dilution analysis.
An accretion/dilution analysis (sometimes also referred to as a quick-and-dirty merger analysis) analyzes the impact of an acquisition on the acquirer's EPS. Essentially, it is comparing the pro-forma EPS (the "new" EPS assuming the acquisition occurs) against the acquirer's stand-alone EPS (the "old" EPS of the status quo). To perform an accretion/dilution analysis, you need to project the combined company's net income (pro-forma net income) and the combined company's new share count. The pro-forma net income will be the sum of the acquirer's and target's projected net income plus/minus certain transaction adjustments. Such pro-forma net income adjustments include synergies (positive or negative), increased interest expense (if debt is used to finance the purchase), decreased interest income (if cash is used to finance the purchase) and any new intangible asset amortization resulting from the transaction. The pro-forma share count reflects the acquirer's share count plus the number of shares to be issued to finance the purchase (in a stock deal). Note that in an all-cash deal, the share count will not change. Dividing pro-forma net income by pro-forma shares gives us pro-forma EPS, which you can then compare to the acquirer's original EPS to see if the transaction results in an increase to EPS (accretion) or a decrease in EPS (dilution). Usually, this analysis looks at the EPS impact over the next two years.
What are the factors that affect option pricing?
An option conveys the right, but not obligation, to engage in a future transaction on some underlying security. There are several factors that influence an option's premium, which is intrinsic value plus time value. A change in the price of the underlying security either increases or decreases the value of an option, and the price changes have an opposite effect on calls and puts. The strike price determines whether the option has intrinsic value, and it generally increases as the option becomes further in the money. Time influences option pricing because as expiration approaches, the time value of the option decreases. A security's volatility impacts the time value of a premium, and higher volatility estimates generally result in higher option premiums for both puts and calls alike. Finally, dividends and the current risk-free interest rate have a small effect known as the "cost of carry" of shares in an underlying security.
What is a PIK?
As previously noted in the accounting chapter, PIK stands for "paid in kind," another important non-cash item, which refers to interest or dividends is paid by issuing more of the security instead of cash. It can be "toggled on" at a particular time, often times at the option of the issuer. It became popular with PE firms, who could pay more aggressive prices by assuming more debt. Flipping on PIK may be an indicator that the company is nearing default on interest payments due to lack of cash because of a deteriorating business. It is a dangerous crutch for companies; PIK can dramatically increase the debt burden on the company at a time when it is already showing signs of difficulty with the existing levels.
The CEO thinks that San Francisco is a great idea, but this new operation must break even in five years. Should Hummus Palace expand into this new market?
Ask questions about the revenue and cost structure. How much will each tub of hummus cost and how many do they expect to sell? What are the variable and fixed costs? What are the needed capital expenditures, both maintenance and growth? What are the working capital needs?
Why is bank debt maturity shorter than subordinated debt maturity?
Bank debt will usually be cheaper (lower interest rate) because of its seniority. This is because it's less risky, since its needs to be paid back before debt tranches below it. To make it less risky to the lenders, a shorter maturity helps, usually less than 10 years. Secondly, bank deposits tend to have shorter maturities, so this aligns the cash flows of the bank business. You'll often see bank debt as the line item "Term Loan A" or "Term Loan B."
What is the different between bank loan and high-yield debt covenants?
Bank loans are more strict. For looser covenants, high-yield debt is rewarded with higher interest rates. Covenants can restrict economic activities, finance activities or accounting measurements. Economic activities restricted would include the sale of assets, capex, changes in corporate structure. Finance activities restricted could include issuance of additional debt and payment of cash dividends. Covenants often track accounting measurements, such as interest coverage, current ratios, minimum EBITDA.
What are some common areas of due diligence?
Be able to describe at a high level: 1) Commercial diligence 2) Valuation diligence 3) Accounting diligence 4) Legal diligence
You misstated depreciation in your model. It should be $10 million higher. How does this affect the three financial statements?
Beginning with the IS, depreciation expense is now $10 million higher. Assuming a 40 percent tax rate, net income is $6 million lower. Depreciation is non-cash and you inherit a tax benefit; on the CFS, you add back the $10 million, which results in a $4 million (-$6 million net income + $10 million depreciation expense) increase in cash. This cash increase of $4 million flows into the BS under the assets, on the left side. Also, PP&E decreases by the depreciation of $10 million, so total assets went down by $6 million. To balance, the $6 million decrease in net income impacts your shareholders equity on the right side.
What are some reasons why a company might tap the high-yield market?
Companies with low credit ratings are unable to access investment grade investors and would have to borrow at higher rates in the high-yield markets. Other companies might have specific riskier investments that they must pay a higher cost of capital for.
Company A has assets of $100 million versus Company B which has $10 million. Both have the same dollar earnings. Which company is better?
Company B has a higher return on assets ("ROA") given that both company had the same earnings but Company B was able to generate it with fewer assets and is, thus, more efficient. Something to think more about is if Company A was entirely debt financed whereas Company B was entirely equity financed. From a return on equity or investment ("ROE" & "ROI") perspective, Company A might be a better company but it would be riskier from a bankruptcy perspective so the "better" company would be less black and white in this situation. The interviewer is probably looking for the simple answer, though; that Company B is better because it is more efficient with its assets.
What is a coverage ratio? What is a leverage ratio?
Coverage ratios are used to determine how much cash a company has to pay its existing interest payments. This formula usually comes in the form of EBITDA/interest. Leverage ratios are used to determine the leverage of a firm, or the relation of its debt to its cash flow generation. There are many forms of this ratio. A standard leverage ratio would be debt/EBITDA or net debt/EBITDA. Debt/equity is another form of a leverage ratio; it measures the relation of debt to equity that a company is using to finance its operations.
What are different types of debt covenants?
Debt covenants are contractual agreements between lenders and borrowers that give lenders certain rights to help protect their investment. Strict covenants make an investment riskier for PE investor because a default on a covenant can lead to bankruptcy and loss of equity investment even if the company remains solvent Maintenance covenants - require the borrower to maintain a certain cushions to ensure their ability to repay the debt (i.e net debt ratio and interest coverage ratio) Incurrence covenants - prevent the borrower from taking action that may hurt existing debt holders - ex. taking on more debt or paying cash dividend
If you have a company with a P/E of 10x and cost of debt of 5 percent, which is cheaper for an acquisition?
Debt. The cost of equity is approximately the inverse of P/E so 1 / 10x = 10 percent. The cost of debt at 5 percent is lower, and, therefore, cheaper.
In what way is deferred revenue different from accounts receivable?
Deferred revenue is a liability because the company has already collected money from customers for goods or services it has not yet fully delivered. Accounts receivable is an asset because the company has delivered goods or services for customers and has not yet been paid.
What do you think is the best method of valuation?
Depends on the situation. Ideally, you'd like to triangulate all three main methods: precedents, trading comps and DCF. However, sometimes there are good reasons to heavily weight one over the others. A company could be fundamentally different from its peers, with a much higher/lower growth rate or risk and projections for future cash flows is very reasonable, which makes a good case to focus on the DCF. Or you may prefer trading comps over precedents because there are few precedents available or the market has fundamentally changed since the time those precedents occurred (i.e., 2006 was an expensive year due to the availability of leverage).
Would you rather achieve high IRR or high MOIC on a deal?
Depends, but generally so long as IRR is meeting LP expectations its better to hold a business longer for a greater MoM Reasons to prefer a higher IRR: 1) Most important single metric for fundraising 2) Usually don't get paid carry unless hit a "hurdle rate" Reasons to prefer higher MoM 1) GPs are paid carry on MoM (Assuming you exceed hurdle rate) 2) Incur transaction costs in buying and selling companies so more efficient to hold for longer
Why do PE multiples and EBITDA multiples yield you different valuation results? Why use EBITDA multiples instead of PE multiples?
EBITDA multiples represent the value to all stakeholders, while the PE multiples only represent the value to equity holders. Three reasons to use EBITDA for an LBO are: 1) it can be used for firms reporting losses, 2) it allows you to compare firms regardless of leverage, and 3) because it represents operational cash flow.
What are the three ways to create equity value?
EBITDA/earnings growth, 2) FCF generation/debt paydown, and 3) multiple expansion.
What might cause two companies with identical financial statements to be valued differently?
Financial statements show historical performance, but don't necessarily provide insight into future performance. Some important things not shown by FS: - The future growth of the company's industry - The company's competitive position including, share, relationships, patents, etc. - The reputation and capabilities of the management team - The quality of the company's future strategy
How do you think about the credit metric: (EBITDA - Capex)/interest expense?
How many times a company can cover its interest burden while still being able to reinvest into the company.
What's the difference between IRR, NPV and payback?
IRR measures the return per year on a given project and is the discount rate that makes NPV equal to zero. NPV measures whether or not a project can add additional or equal value to the firm based on its associated costs. Payback measures the amount of time it takes for a firm to recoup the initial costs of a project without taking into account the time value of money.
What are some characteristics of a company that is a good LBO candidate?
Ideally, LBO'ed companies have steady cash flows, strong management, opportunities for earnings growth or cost reductions, high asset base (for collateral to raise more debt), low business risk and low need for ongoing investment (e.g. capex and working capital). The most important characteristic is steady cash flows, because sponsors need to be able to pay off the relatively high interest expense each year.
Can you give examples of major line items on each of the financial statements?
Income Statement: Revenue, COGS, SG&A, Operating Income, Pretax income, net income Balance sheet: Cash, Accounts Receivable, Inventory, PP&E, Accounts payable, accrued expenses, debt, shareholder's equity Cash Flow Statement: Net Income, D&A, stock-based compensation, changes in working capital, capex, etc.
You own a Christmas tree business. What are your working capital needs throughout the course of the year?
Inventory would likely need to be accumulated starting in November, since many people start hanging up Christmas lights and putting up Christmas trees the weekend after Thanksgiving. The inventory buildup would continue through late December. After Christmas however, demand for Christmas trees disappears. Hopefully by then there is very little inventory left, if managed properly. Since this is a cash business, where customers are paying for the trees in cash, receivables have little effect on the working capital balance and are insignificant relative to the company's inventory requirements. Payables would likely increase in the fall as the company accumulates inventory in anticipation of the upcoming holiday season and pays for the trees with credit.
Explain put-call parity.
It demonstrates the relationship between the price of a call option and a put option with an identical strike price and expiration date. The relationship is derived using arbitrage arguments, and shows that a portfolio of call options and x amount of cash equal to the PV of the option's strike price has the same expiration value as a portfolio comprising the corresponding put option and the underlying option. The parity shows that the implied volatility of calls and puts are identical. Also, in a delta-neutral portfolio, a call and a put can be used interchangeably.
You have a company with 3x senior leverage and 5x junior leverage, what happens when you sell a business for 9x EBITDA?
It's a de-leveraging transaction because pro-forma the company will have a lower total debt to EBITDA ratio.
What is a 10-K?
It's a report similar to the annual report, except that it contains more detailed information about the company's business, finances, and management. It also includes the bylaws of the company, other legal documents and information about any lawsuits in which the company is involved. All publicly traded companies are required to file a 10-K report each year to the SEC.
Given $100 million initial equity investment, five years, IRR of 25 percent, what's exit EBITDA if sold at 15x multiple?
Knowing an IRR of 25 percent over five years is approximately 3.0x equity return (there is no mathematical way of knowing this, so if you don't know this, try asking the interviewer). The ending equity value is, therefore, $300 million = $3.0x * $100 million, so the exit EBITDA must be $300/15x = $20 million.
Which valuation will be higher or lower, all else the same? DCF or LBO?
LBO is lower, as it's discounted at a higher cost of equity.
Why should the fair market value of a company be the higher of its liquidation value and its going-concern value?
Liquidation value is the amount of money that a firm could quickly be sold for immediately, usually at a discount. The fair market value, the rightful value at which the assets should be sold, is higher. Basically a liquidation value implies the buyer of the assets has more negotiating power than the seller, while fair market value assumes a meeting of the minds. The going-concern value is the firm's value as an operating business to a potential buyer, so the excess of goingconcern value over liquidation value is booked as goodwill in acquisition accounting. If positive goodwill exists, i.e., the company has intangible benefits that allow it to earn better profits than another company with the same assets; the going-concern value should be higher than the fair market value.
You have a company with $500 million of senior debt and $500 million of junior debt. The senior debt has an interest rate of L+ 500 and, in default, would recover 70 percent; the junior debt would recover 30 percent in default. What should the interest rate be on the junior debt?
Loss on default * Probability of default = incremental interest that needs to be paid. So 70 percent loss * 5 percent probability (an assumption you have to make) = 350 basis points over the senior debt or L + 850.
Say there is City 1 and City 2. City 1 has 10,000 businesses, 50,000 people and $5,000 cost per ad. City 2 has 2,000 businesses, 4,000 people and $600 cost per ad. Which city do you want to advertise in?
Make this apples to apples. Set City 2 equal to $5,000 per ads, so multiply everything by 8.3 or approximately 8 for easier mental math. City 2 has 16,000 businesses with 32,000 people. Thus you are paying the same for more competition and fewer target consumers. City 1 is the obvious choice now.
What are the four basic ways to value a company?
Market comparisons/trading comps/comparable companies: Metrics, such as multiples of revenue, earnings and EBITDA like P/E and EV/EBITDA can be compared among companies operating in the same sector with similar business risks. Usually a discount of 10 percent to 40 percent is applied to private companies due to the lack of liquidity of their shares. Precedents/acquisition comps: At what metrics (same as above) were similar companies acquired? Discounted cash flow ("DCF"): Based on the concept that value of the company equals the cash flows the company can produce in the future. An appropriate discount rate is used to calculate a net present value of projected cash flows. Leveraged Buyout ("LBO"): Assuming an IRR (usually 20 percent to 30 percent), what would a financial buyer be willing to pay? Usually provides a floor valuation.
Would you make an offer to buy a company at its current stock price?
No, you would not offer to buy a company at its current stock price because the current shareholders require a premium to be convinced to tender their shares. Premiums usually range from 10 percent to 30 percen
Is goodwill depreciated?
Not anymore. Accounting rules now state that goodwill must be tested once per year for impairment. Otherwise, it remains on the BS at its historical value. Note that goodwill is an intangible asset that is created in an acquisition, which represents the value between price paid and value of the company acquired.
Same example as above, what happens when you sell the asset for 8x EBITDA?
On a firm basis, it has a neutral impact, but it is de-leveraging on a senior debt basis.
A pen costs $10 dollars to buy. It has a life of ten years. How would you put it on the balance sheet?
On the left side, $10 as an asset. Assuming a straight-line depreciation for book and no salvage value at the end of its useful life, it would be worth $9 at the end of the first year, $8 the second year, and so on. Net income will be lowered every year by the tax-affected depreciation, so shareholders' equity will be reduced by 60 cents, assuming a 40 percent tax rate.
Why would you use options outstanding over options exercisable to calculate transaction price in an M&A transaction?
Options outstanding represent the total amount of options issued. Options exercisable are options that have vested and can actually be exercised at the strike price. During a potential M&A transaction however, all of the target's outstanding options will vest immediately and thus the acquirer must buy out all option holders.
If a company issues a PIK security, what impact will it have on the three statements?
PIK stands for "paid in kind," another important non-cash item that refers to interest or dividends paid by issuing more of the security instead of cash. This can mean compounding profits for the lenders and flexibility for the borrower. For instance, a mezzanine bond of $100 million and 10 percent PIK interest will be added to the BS as $100 million as debt on the right side, and cash on the left side. On the CFS, cash flow from financing will list an increase of $100 million as debt raised. When the PIK is triggered and all else is equal, interest on the IS will be increased by $10 million, which will reduce net income by $6 million (assuming a 40 percent tax rate). This carries over onto the CFS where net income decreases by $6 million and the $10 million of PIK interest is added back (since it is non-cash), resulting in a net cash flow of $4 million. On the BS, cash increases by $4 million, debt increases by $10 million (the PIK interest accretes on the balance sheet as debt) and shareholders equity decreases by $6 million.
What are the ways in which a company can spend available cash/FCF?
Pay down debt, issue dividends, buy back stock, invest in the business (capital expenditures), and engage in acquisitions.
Given that there is no multiple expansion and flat EBITDA, how can you still generate a return?
Reduce interest expense, improve tax rate, depreciation tax shield, the simple act of leverage, pay down debt, pay a dividend, reduce capex, reduce working capital requirements and reduce change in other.
If you merge two companies, what does the pro-forma income statement look like? Discuss whether you can just add each line item for the proforma company. Please start from the top.
Revenues and operational expenses can be added together, plus any synergies. Fixed costs tend to have more potential synergies than variable costs. Selling, general and administrative ("SG&A") expense is another source of synergy, as you only need one management to lead the two merged companies. D&A will increase more than the sum due to financing fees and assets being written up. This brings you to operating income. Any changes in cash will affect your interest income. Interest expense will change based on the new capital structure. New or refinanced debt will change pro-forma interest expense. For rolled over debt, since your cash flows will change, your debt paydown may alter, which also affects interest. Based on all the changes previously, this will obviously cause taxes to differ so you cannot just add the two old tax amounts. Also, if any NOLs are gained, those may offset the new combined taxable income. To summarize, nothing can be simply added together. If you have done EPS accretion/dilution analysis, you can mentally work your way through that to formulate your answer.
What are the potential investment exit strategies for an LBO fund?
Sale (to strategic or another financial buyer), IPO or recapitalization (releveraging by replacing equity with more debt in order to extract cash from the company).
After debating the merits of each, the interviewer says that the CEO wants to pursue a geographic expansion strategy. Which market should she expand into?
San Francisco could be an interesting market because of its similarity to New York. San Francisco has a young urban population that would likely enjoy ethnic foods and be open to trying new cuisines. The city also would have a large number of high-end grocery stores and specialty food retailers to sell to.
What is Sarbanes-Oxley and what are the implications?
Sarbanes-Oxley was a bill passed by Congress in 2002 in response to a number of accounting scandals. To reduce the likelihood of accounting scandals, the law established new or enhanced standards for publicly held companies. Those in favor of this law believe it will restore investor confidence by increasing corporate accounting controls. Those opposed to this law believe it will hinder organizations that do not have a surplus of funds to spend on adhering to the new accounting policies.
In an LBO, if cost of debt is 10 percent, what is the minimum return required to break even?
Since interest is tax deductible, the break-even return is the after-tax cost of debt. Assuming tax rate of 40 percent, the break-even return is 6 percent.
In another scenario, at the end of the second year, the pen runs out of ink and you have to throw it away. How much is it on the balance sheet?
Since the pen is worthless, you'll need to write down the value of this equipment to $0. Due to the write down, net income declines by $4.8 based on a 40 percent tax rate, which flows to shareholders' equity. The $8 write-down is noncash; on the CFS, it is added to the $4.8 decline in net income, resulting in a net cash flow of $3.2. Combined with the write-down of $8 for PP&E, net change in assets is a decrease of $4.8, which balances the $4.8 decrease in shareholder's equity
Let's say you run an LBO analysis and the resulting return is below the required return threshold of your PE firm. What drivers to the model will increase the return?
Some of the things that will boost return are: 1) increase leverage (debt), 2) reduce purchase price, which decreases the amount that the firm has to pay, 3) increase exit/sale price or multiple, which increases the return on the investment, 4) increase the growth rate, which raises operating income/cash flow/EBITDA in the projections, and 5) decrease costs, to also raise operating income/cash flow/EBITDA in the projections.
Walk me through S&U?
Sources contain the variable tranches of capital structure. Some examples from senior to junior are bank debt, junior subordinated notes, convertible preferred, hybrids and sponsor equity. Cash belonging to the target can also be used as a source. Finally, proceeds from options exercised at the target are a source. You need to determine how these sources are used; the main component is the purchase of the company, either of the assets or shares. Then is purchase of the target's options, refinancing debt and transaction costs (banker and lawyer fees).
Say you had a bullet proof vest manufacturer. Given only this information, what are weaknesses you can envision for this company?
Starting with weaknesses, the first major one is the uncompromising need for quality. Lives are on the line if the product fails! Expenses need to accommodate the high cost of testing. Raw materials need to be carefully monitored to be of the appropriate quality, so its supplier chains need to be reliable and/or flexible. The threat of potential liabilities is enormous here; an insurance company will charge a higher premium if it elects to represent this company at all. To some extent, this item is a commodity, but there will definitely be brand differentiation for the players who show consistent quality. R&D will need to be expended to maintain a technological edge for the best vest: maximum usage, lightest, thinnest and weather-resistant. A large portion of the buyers will comprise a few government contracts. This is good, in that contracts are usually long-term, which gives certainty to future revenues and inventory needs. However, governments pick a supplier based on bidding auctions, so there is significant pressure to present the lowest price.
At the end of the second year, you discover the pen is a rare collector's item. How much is it on the balance sheet?
Still $8. You continue to depreciate it. Assets are recorded at historical values. Some traded financial instruments qualify for "mark to market accounting," so those assets are valued at market, but this accounting practice has been severely criticized in recent times.
A company has $10 million of cash and $1 million of shares, nothing else. What's its stock price?
Stock price is value/shares so $10 million/1 million, which is a stock at $10 per share
What is a WACC?
The "WACC," weighted average cost of capital, is the discount rate used in a DCF analysis to determine the present value of the projected free cash flows and terminal value. Conceptually, the WACC represents the blended opportunity cost to lenders and investors of a company. The WACC reflects the cost of each type of capital: debt and equity, weighted by the respective percentage of each type of capital assumed for the company's capital structure. Specifically the WACC is defined as: WACC = [(% Equity) * (Cost of Equity)] + [(% Debt) * (Cost of Debt)(1-tax rate)]
If you could have only one of the three main financial statements, which would it be?
The IS is definitely inappropriate to pick. Income statements are full of non-cash items, which work fine for theoretical purposes, like matching revenue to expenses in appropriate time periods, but if none of it could be liquidated then company is worth nothing. Most pick CFS, because cash is king in determining a company's health. One interviewer selected BS because you can back out the main components of the cash flow statement (capex via PP&E and depreciation, net income via retained earnings, etc.). The BS is also helpful in distressed situations to determine the company's liquidation value.
You have a company with $100 million in sales. Which makes the biggest impact? A) Volume increases by 20 percent B) price increases by 20 percent C) expenses decrease by $15 million.
The answer is B) price by 20 percent. Think about how EBITDA is affected by all three scenarios. It's not C because EBITDA will only increase by $15 million. Volume will increase the revenue to $120 million but variable costs will increase proportionally. By increasing price, you will capture the entire $20 million impact.
What if the company wins $10 million in the lotto?
The company doubled its cash and thus its value. Now it's up to $20 per share.
What if this was an LBO scenario and you had a sponsor putting in 500 million of equity?
The company would be less risky because it has more liquidity now.
What is the treasury method? Walk through calculation.
The treasury stock method assumes that acquirers will use option proceeds to buy back exercised options at the offered share price. New shares = common shares + in the money options - (options x strike/offered price).
Which corporate bond would have a higher coupon, a AAA or a BBB? What are the annual payments received by the owner of a five year zero coupon bond?
The corporate bond with a rating of BBB will have a higher coupon because it is perceived to have a higher risk of defaulting. To compensate investors for this higher perceived risk, lower rated bonds offer higher yields. The owner of a fiveyear zero coupon bond receives no annual payments. Instead, the owner will pay a discount upfront and then receive the face value at the time of maturity.
A company runs two operating subsidiaries. One sells coffee and one sells doughnuts. You own 100 percent of the coffee subsidiary. You own 80 percent of the doughnut subsidiary. The coffee subsidiary generates $100 million of EBITDA. The doughnut subsidiary generates $200 million of EBITDA. Doughnut companies are worth 5.0x EBITDA. The parent share price is $10 and there are 100 million shares. The company has cash of debt of $500 million and cash of $200 million. What's the enterprise value to EBITDA multiple for this company?
The enterprise value is market capitalization plus net debt plus minority interest. Market cap is easily to calculate, shares * share price, so $10*100 million = $1,000 million. Net debt is debt less cash so $500 million - $200 million = $300 million. The question has given you the approximate market value of the minority interest in the doughnut company which is 5.0x EBITDA, so $200 * 5.0x * (1 - 80%) = $200 million. As a side note, when calculating enterprise value for comps, you might take the minority value from the balance sheet. This fine to do in such cases. However, a finance professional always chooses market value over book value, so this question gives you enough information to calculate the market value of the minority interest. Back to the answer: you total this all up for EV, which comes to $1,500 million = $1,000 million + $300 million + $200 million. The total EBITDA is $300 million = $100 million + $200 million. Therefore, the EV/EBITDA multiple is $1,500/$300 = 5.0x.
You sold an asset where you received $500 million in cash. How does this affect your three financial statements?
The key to this question is inquiring about the book value of the asset when sold. Ask the interviewer for this. For instance, if it is $400 million, then a $100 gain on sale of asset is recorded. Assuming a 40 percent tax rate, net income increases by $60 million. On the CFS, remember that assets are recorded at book value when sold. Therefore, you have a $400 million "sale of asset" under cash from investing activities. Your net cash flow is $460 million. On the BS, cash increases by $460 million and PP&E decreases by $400 million. The $60 million increase on the left side of the BS is offsest by the $60 million increase in shareholder's equity on the right side.
What is the link between the balance sheet and income statement?
The main link between the two is profits from the IS are added to the BS as retained earnings. Next, the interest expense on the IS is charged on the debt that is recorded on the BS. D&A is a capitalized expense from the IS that will reduce the PP&E on the asset side of the BS.
A product's life cycle is now mature. What happens to the net working capital?
The net working capital needs should decrease as the business matures, which increases cash flows. As the business develops, it becomes more efficient; investment requirements are lower.
A company has $100 million of EBITDA. It grows to $120 million in five years. Each year you paid down $25 million of debt. Let's say you bought the company for 5.0x and sold it for 5.5x. How much equity value did you create? How much is attributed to each strategy of creating equity value?
The purchase price is $500 million = $100 million * 5.0x. It exits at $660 million = $120 million * 5.5x. This is a profit of $160 million, plus you paid down debt of $125 million = $25 * 5, so your total equity value increased by $285 million = $160 million + $125 million. Obviously the $125 million of the total equity value is due to debt paydown. $100 million comes from the EBITDA growth, ($120 million - $100 million) * 5. Finally, the rest of its equity value increase is attributed to multiple expansion, (5.5x - 5.0x) * $120 million = $60 million. Totaling these up, $125 million + $100 million + $60 million is the $285 million of equity value increase that matches what we calculated earlier.
If you were to advise a company to raise money for an upcoming project, what form would you raise it with (debt versus equity)?
The right answer is "it depends." First and foremost, companies should seek to raise money from the cheapest source possible. However, there might exist certain conditions, limitations or implications of raising money in one form or another. For example, although the cheapest form of debt is typically the most senior (corporate loans), the loan market might not have any demand. Or the company might not have the cash flow available to make interest payments on new debt. Or the equity markets might better receive a new offering from this company than the debt markets. Or the cost of raising an incremental portion of debt might exceed that of raising equity. All of this should be considered when answering this question. Be prepared to ask more clarifying questions—your interviewer will most likely be glad you did.
What if the company uses the lotto money to repurchase shares at $25/share? What's the share price today if the repurchase is in one month?
The stock should be worth $20/share today. With $10 million buying $25/share, you can repurchase 0.4 million shares. You have 1 million - 0.4 million= 0.6 million shares left. The 0.4 shares are worth $25/share because that was what was paid for them. The remaining 0.6 shares are worth the remaining value/remaining shares, which is $10 million/0.6 million = $16.67/share. If you weight the two shares, $16.67 * 60% + $25 * 40%, then your total share price is $20.
If I increase AR by $10mm, what effect does that have on cash? Explain what AR is in layman terms.
There is no immediate effect on cash. AR is account receivable, which means the company received an IOU from customers. They should pay for the product or service at a later point in time. There will be an increase in cash of $10 million when the company collects on the account receivable.
What is the relationship between a bond's price and its yield?
They are inversely related. That is, if a bond's price rises, its yield falls and vice versa. Simply put, current yield = interest paid annually/market price * 100 percent.
How much pizza is sold in New York City every year?
This is a strict consulting case question; you'll encounter fewer of these in your interviews. HF/PE consulting questions focus more on business scenarios, but you can get asked this type of question as a brainteaser. These "guestimations" can be solved either "top down" or "bottom up." Top down approach: Assume that 10 million people live in New York City and that 80 percent of them, or eight million people, eat pizza. Let's say that the average New Yorker eats pizza twice a month, and will eat two slices each time. If a slice of pizza costs $2, then that's $4 spent at each sitting and $8 spent each month. That equates to $96 (round to $100 for simplicity) every year. Multiply that by eight million pizza eaters, and the market size for pizza in New York is approximately $800 million. Bottom-up approach: A slice of pizza in New York costs approximately $2 per slice. If the average person has two slices with his meal, then the average ticket (not including drinks) is $4. If the average person eats pizza twice a month, then that's $8 a month or $96 a year (round to $100 for simplicity). Let's assume that 80 percent of the 10 million people in New York City eat pizza. That means that the eight million pizza eaters in New York spend approximately $100 each every year on pizza, for a total of $800 million.
You are giving the following opportunity. A company wants to sell trees in water. In the 1950s, a smelting plant redirected water flow, which flooded a forest used for timberland. A logger, who is also a scuba driver, has discovered this and wants to sell the wood. How would you look at this investment?
This was a real opportunity that this company looked at. It's easy for interviewers to ask questions about actual investments they've looked at because they know all the answers. Ask if the product is actually saleable. It is—being 40 feet under water means the wood is not oxizable and, thus, doesn't rot. Ask if there is already an industry that does this. There is, and it is profitable. Ask about all the regular factors that comprise a good investment, including the experience of management. The interviewing firm passed on this opportunity because the scuba driver had no industry experience. Management is incredibly important because finance guys need to rely on current management to turn around the company (relying on equity incentives) or else hire industry experts.
Hummus Palace sells gourmet hummus throughout New York City. It distributes its tubs of hummus primarily through two channels: high-end grocery stores and specialty food retailers. Over the past few years, the company has been experiencing a slowdown in its sales. What are three potential growth strategies the company could pursue?
To find out why there's been a slowdown in sales, start with asking questions about the industry—what is the market size, what are some of the key trends and what does the competitive landscape look like? Then inquire about the company—what is its growth profile and value proposition? Is it a scalable business, and does management have the knowledge and experience to turn the company into a market leader? These questions should provide you with some context to help you come up with growth strategies for the company. Hummus Palace could grow through acquisition or organically. It could expand into new product lines (gourmet falafel), new channels (hummuspalace.com), or new markets (San Francisco).
Assume the following scenario: EBITDA of $10 million and FCF of $15 million. Entry and exit multiple are 5x. Leverage is 3x. At time of exit, 50 percent of debt is paid down. You generate a 3x return. 20 percent of options are given to management. At what price must you sell the business?
To make a 3x return based on the financial parameters, you must sell the business at $90 million. You know the EV is EBITDA times entry multiple: $10 million * 5x = $50 million. Debt is equal to EBITDA times leverage: $10 million * 3x = $30 million. EV minus debt equals equity: $50 million - $30 million = $20 million. Debt needs to be paid down by half or $30 million * 50% = $15 million. To make a 3x return, sponsor equity needs to grow to $20 million * 3x = $60 million. Since management receives 20 percent of the equity in options, the total equity needs to grow to $60 million/(1 - 20%) = $75 million. Since your ending debt is $15 million and ending equity is $75 million, the EV at exit is $90 million.
How do you calculate free cash flow to the firm? To equity?
To the firm (unlevered free cash flow): EBITDA less taxes less capital expenditures less increase in net working capital. To equity (levered free cash flow): Same as firm FCF and then less interest and any required debt amortization.
What determined your split between bonds and bank in the deal? If there is a higher growth capex proportion of total capex, would you still want to use same split?
Typically, you'd like as much bank debt as possible because it's cheaper than regular bonds. However, this mostly depends on how much a bank is willing to loan. Next, the sponsor and debt holders have to negotiate the agreements/covenants that they can live with. The more senior the debt, like the bank debt, the more restrictive it tends to be. Bank debt also usually requires collateral to be pledged. Finally, the timeline of debt payback needs to evaluated; bank debt usually has a shorter maturity, so the bank needs to ensure that the company will be able to face its liabilities when due or else face bankruptcy. Growth capex is more favorable than maintenance capex. It's flexible; maintenance capex needs to be paid every year just to keep the company running, whereas growth capex can be stalled in times of downturn. Also, growth capex implies investments, which yield higher cash flows in the future, that can be used to support more debt.
If a company's revenue grows by 10 percent, would its EBITDA grow by more than, less than or the same percent?
Unless there are no fixed costs, EBITDA will grow more. This is because fixed costs will stay the same, so total costs will not increase as much as revenue. Note this is similar to the previous question, but now looking at it in terms of percentage.
Why do private equity firms use leverage when buying a company?
Using more debt to finance the purchase of a company allows the PE firm to use less of their money (equity) to pay for the deal. If the investment is successful, the higher the leverage, the higher the return when exiting the investment (e.g. selling the company five years later).
Let's say that I have a bond with a 5 percent coupon. What happens to the market price when the prevailing interest rates rise to 8 percent? How are the coupons affected?
When the prevailing interest rates rise to 8 percent, the market price of the coupon bond decreases. This happens because the investor can obtain a higher interest rate on the market than what the bond is currently yielding. To make the bond appealing to potential investors, the market price decreases. This causes the bond's return to increase at maturity as a means of compensating for the decreased value of coupon payments. The coupons themselves remain constant; the new market price instead balances the yield to keep it neutral with the current market.
What is a PIPE?
With the cost of credit rising, private investments in public equity, ("PIPEs"), have become more popular. This is an alternative way for companies to raise capital; PIPEs are made by qualified investors (HF, PE, mutual funds, etc.) who purchase stock in a company at a discount to the current market value. The financing structure became prevalent due to the relative cheapness and efficiency in time versus a traditional secondary offering. There are less regulatory requirements as there is no need for an expensive roadshow. The most visible PIPE transaction of 2008: Bank of America's $2 billion investment in convertible preferreds of mortgage lender Countrywide Financial.
Say you have a normal bond that you buy at par and you get the face amount at maturity. Is that most similar to buying a put, selling a put, buying a call or selling a call?
You can liken it to selling a put because if the stock decreases in value, you lose money, like a bond defaulting. But if its neutral, you're neutral in both cases.
What are some of the due diligence questions that you would ask?
You might start off with industry questions to determine if it is an industry that the sponsor would want to be in, and then determine how well positioned the company is within that industry. Ask about market rivalry, whether the industry is growing, what the company's and its competitors respective market shares are, what the primary strategy for product competition (brand, quality, price?) is. Ask whether there are barriers to entry or economies of scale, supplier and buyer power, threat of substitutes, etc. Then move onto questions about the company's own operating performance. Zero in on growth, what is projected, how much is attributed to growth of the industry versus market share gains. What is the resilience of this company to downturns? What demographics is the revenue focused in, and how will these demographics change? What is the cost structure, how efficient are the supply and distribution chains? What's the proportion of fixed to variable costs? How well do you utilize assets? Ask about capital expenditures, growth versus maintenance. Also ask about how working capital is managed. How well do you collect on account receivables or manage accounts payable? Next, move to financials: How much cash is available right now? What are the projected financials? Then you want to ask about opportunities: Are there non-core or unprofitable assets or business lines? Is there opportunity for improvement or rationalization? You also care significantly about the quality of management. How long have they been in their positions, what are their backgrounds? Is the sponsor able to replace them, if needed? What are the legal and regulatory risks? Are there any HR issues, like union or labor problems? What's your exit strategy here? Is the industry consolidating so that a sale might be made easier?
Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?
You would rather have the extra dollar of EBITDA because of the multiplier effect. At exit, the EV is dependent on the EBITDA times the exit multiple. An extra dollar of debt paydown increases your equity value by only one dollar; an extra dollar of EBITDA is multiplied by the exit multiple, which results in a greater value creation.
If I handed you an offering memorandum, what are some of the things you'd think about?
You would think about how you would value the company; whether it was a good LBO candidate. You'd try to understand the business as much as possible, especially in operational points like capex, working capital needs, margins, customers, etc. You'd examine at the industry, look for growth opportunities and question whether the sponsor and/or management could capitalize on those opportunities. You would wonder what would be appropriate capital structure, and whether it is achievable in the current markets. Most importantly, you'd think about all the potential risks.
Your initial investment is $1.5 million and $100,000 of capex/year over the next five years. Each tub of hummus costs $2.75 to produce and will be sold for $4.75. You think you can sell 200,000 plates per year.
Your total fixed costs are $2.0 million ($1.5 million + $100 thousand * 5). The gross margin is $2 which times the volume sold of 200 thousand is $400 thousand of profit per year. $2 million/$400 thousand neatly breaks even in five years, so yes, you can expand in this market.
Advantages of LBO financing?
a) As the debt ratio increases, equity portion shrinks to a level where one can acquire a company by only putting up 20 to 40 percent of the total purchase price. b) Interest payments on debt are tax deductible. c) By having management investing, the firm guarantees the management team's incentives will be aligned with their own.
You have two investment opportunities: Company A and Company B. Company A: Revenue: $100 million EBITDA: $20 million Projected annual revenue growth: 5 percent for the next five years Purchase price: 5x EBITDA/4x Debt and 1x Equity Company B: Revenue: $100 million EBITDA: $20 million Projected annual revenue growth: 10 percent for the next five years Purchase price: 6x EBITDA/4x Debt & 2x Equity. Which is the better investment opportunity based on this information? Assume the exit multiple is the same as the entrance multiple.
ssuming constant EBITDA margins and ignoring compound growth for simplicity, EBITDA for Company A in year 5 will be about $25 million = $20 million * [1 + (5% *5 )], and Company B will be $30 million = $20 million * [1 + (10% *5 )]. You purchased Company A for $100 million = 20 * 5x and Company B for $120 million = 20 * 6x. You sold Company A for about $125 million = 25 * 5x and Company B for about $180 million = 30 * 6x. This creates a profit of $25 million and $60 million, respectively. You invested $20 million of equity into Company A, so your return is 1.25x = $25 million/$20 million, while Company B has a higher return of 1.5x = $60 million/$40 million. Thus you already know Company B is the better investment; also, the higher EBITDA will increase the amount of debt being paid down, which increases the equity return more.
