Private Equity Technicals
5 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 2 companies. 3) A larger company is more industry-defensible (more resilient to downturns or more formidable competitor) 4) Provides growth (versus organic growth, which may have slowed or stalled). 5) Can be a use for excess cash.
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.
What are the uses of excess cash flow?
After paying mandatory debt amortization, either prepay debt or reinvest (should be accretive if you make good investments). It depends on how expensive your interest payments are and how much new projects/investments would add to your bottom line with regards to which one is more accretive. If you can pay yourself a dividend, do it, but most debt covenants will require a full cash sweep before paying dividends.
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.
Acid-Test Ratio
Measures a company's ability to pay off short-term liabilities with quick assets. (Current Assets - Inventories) / Current Liabilities
Return on Assets Ratio
Measures how efficiently a company is using its assets to generate profit. Net Income / Total Assets
Return on Equity Ratio
Measures how efficiently a company is using its equity to generate profit. Net Income / Shareholder's Equity
Receivables Turnover Ratio
Measures how many times a company can turn receivables into cash over a given period. Net Credit Sales / Average Accounts Receivable
Inventory Turnover Ratio
Measures how many times a company's inventory is sold and replaced over a given period. Cost of Goods Sold / Average Inventory
Dividend Yield Ratio
Measures the amount of dividends attributed to shareholders relative to the market value per share. Dividend per Share / Share Price
Earnings Per Share
Measures the amount of net income earned fro each share outstanding. Net Earnings / Total Shares Outstanding
Days' Sales in Inventory Ratio
Measures the average number of days that a company holds onto its inventory before selling it to customers 365 days / Inventory Turnover Ratio
What are the different ways to find the valuation of a company?
(1) Precedent Transactions (2) Public Comps (3) DCF (4) LBO (5) NAV (6) SOTP
What makes a good LBO investment candidate?
(S) Stable Cash Flows (A) Assets (M) Margins (C) Low CapEx (L) Low - Risk (U) Undervalued (B) Badass Management (M) Mature Industry
Assume that your company bought an asset for $10M, of which $7M was financed through debt. Walk me through the impact of this transaction on the financial statements.
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Assume that your company sold an asset for a loss of $10M (it had originally been bought for $20M). Walk me through the impact of this transaction on the financial statements.
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Company A has depreciation that is overstated by $10M. Walk me through the impact of this overstatement on the financial statements.
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How do you calculate free cash flow to equity?
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How do you calculate free cash flow to the firm?
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How do you model in PIK notes?
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How would you decide what amount of leverage to use in building a company's capital structure?
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Tax depreciation is $20M over 10 years, while financial statement depreciation for the asset is $10M over 10 years. Walk me through the impact of these differences on the financial statements, assuming a tax rate of 40%.
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Walk me through the difference between gross revenue and net revenue.
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What 3 questions would you ask a CEO of a company you were looking to invest in?
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What are the 4 main drivers of the change in IRR for an LBO scenario?
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What is an LBO?
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What makes for a good management team?
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You have two companies with different EV/EBITDA multiples in different industries. What are some reasons why their EBITDA multiples might be different?
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You sold an asset where you received $500M in cash. How does this affect your three financial statements?
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Your company sells a yearly subscription for $120. Walk me through the impact that this sale has on the financial statements.
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Company A has a potential IRR of 23% and Company B has a potential IRR of 30%. What 2 questions would you ask before you decide which to invest in?
1) How much investment? 2) Timing? 3) What industry do they operate in?
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.
Debt Ratio
Measures the relative amount of a company's assets that are provided from debt. Total Liabilities / Total Assets
Walk me through the mechanics of an LBO
1. Assumptions 2. Sources & Uses 3. Adjust Balance Sheet - Debt and Equity - Goodwill 4. Project 3 Statements 5. Project FCF 6. Debt and Interest Schedule 7. Exit Calc (MOIC and IRR) 8. Sensitivity Tables
Ways PE firms add value?
1. EBITDA Expansion a. Revenue Growth b. Cost cutting measures c. Portfolio synergies 2. Deleveraging (using CF's to pay down debt) 3. Multiple Arbitrage
Structure of an investment memo:
1. Executive Summary (company snapshot, investment thesis, key upsides & risks, recommendation) 2. Company Overview (description, product portfolio, growth drivers, high level financials) 3. Market Overview (historical & future trends, competitive landscape, growth drivers, new entrants) 4. Operations / Supply Chain Overview 5. Benchmarking Analysis (Growth Profile & Margins vs. Peers / Comps) 6. Financial & Returns Analysis (Outputs from model) 7. Key Risks & Mitigating Factors 8. Investment Recommendation
Different Ways to Value a Firm
1. Intrinsic Valuation 2. Public Trading Comps 3. Transaction Comps 4. LBO with base required IRR
What makes a good LBO investment candidate?
1. Mature Industry/Company - Stock price of public target company is trading at a lower multiple to free cash flow as compared to a new and high growth industry/company. 2. Clean Balance Sheet with No/Low Amount of Outstanding Debt - Need the ability to use debt as part of the acquisition consideration or "leverage" as the name suggests. 3. Strong Management Team and Potential Cost-Cutting Measures - Management is able to run and create a more efficient company with same cash generating characteristics. PE firms might decide to get rid of old management team and hire a new team that has a successful track record of building great businesses in the respective industry. 4. Low Working Capital Requirements & Steady Cash Flows - Look for stable and recurring cash flows that can be used to pay down debt over the years before exit, thus increasing equity/total assets ratio of the company. 5. Low Future CapEx Requirements 6. Feasible Exit Ops - If there has been any historical LBO or IPO precedents in the relative industry as LBO target candidate. 7. Strong Competitive Advantages and Market Position - Overall, company is in a great position to keep generating steady cash flows and keep position in its markets. 8. Possibility of Selling Some Underperforming or Non-Core Assets - Company can sell assets to raise cash to pay off outstanding debt. Note that these assets should not represent a significant contributor to company's current cash flow. The spin-off of these non-core assets may increase your market multiples because your business going-forward may be compared to a new set of public peers.
Criteria for selecting LBO candidates
1. Mature industry and/or company: stock is trading at a lower multiple to FCF than new companies in high-growth industries. Enables the LBO purchaser to buy the company at a relatively low cost compared to annual cash flow it produces. This cash flow will be a key ingredient in generating an attractive return for investors. 2. Clean balance sheet with no or low amount of outstanding debt: buyers need ability to use new debt as part of the acquisition consideration. Companies with high levels of pre-existing debt limit amount of new debt that it can withstand and the new debt is crucial for LBO (existing debt will often need to be refinanced in LBO) 3. Strong management team and potential business improvement measures: Management is capable of running the company effectively, and capable of creating a more efficient company (lower costs) or expanding into new profitable markets or products. 4. Strong Competitive Advantages and Market Position: Ideal if the company is in a good position within its market space (relative to current and potential competitors) - this will help shield the company from competitive pressures that might reduce profit margins (and therefore cash flows) and will help provide possible growth opportunities for the business. 5. Steady Cash Flows - Service the large debt burden for the LBO. Cyclical or highly seasonal companies can run into trouble quickly if downturn occurs. Debt-paydown is also important in that it increases the equity/total assets ratio of the company. 6. Low future capital expenditure and working capital requirements. 7. Possible sale of underperforming/non-core assets: sell to raise cash to pay off outstanding debt used to purchase the company. 8. Feasible exit options: Once the business has been improved and some of the debt used to purchase the business has been paid off, an LBO investor would generally like to exit/sell fairly quickly (3-7 year hold). Potential exits: Strategic sale, secondary buyout, IPO.
Most important factors in a merger model?
1. Synergies - enable acquiring company to realize value by enhancing revenue or reducing operating costs (typically biggest driver of value in M&A deal) - CON: synergies are very hard to estimate and can often be overly optimistic 2. Form of Consideration - Cash vs. Share can have major impact of per share metrics (EPS). To make a deal more accretive, acquirer can add more cash to the mix and issue fewer shares. 3. Purchase Price and Takeover Premium - major factors in value that's created.
Limitations of a DCF?
1. Terminal Value represents a disproportionately large amount of Enterprise Value (and assumptions used to calculate TV are very sensitive) 2. Discount rate used to calculate NPV is very sensitive to changes in assumptions of beta, risk premium, etc. 3. Entire forecast for the business is based on operating assumptions that are nearly impossible to precisely pin down.
What assumptions is an LBO model most sensitive to?
1. Total leverage the business can service (typically based on debt/EBITDA ratio) 2. Cost of Debt 3. Acquisition/Exit Multiple assumptions. 4. Operating assumptions for business play a major role as well
What are the different types of PE firms?
1. Venture Capital - pools of capital that typically invest in small, early stage and emerging businesses that are expected to have high growth potential but have limited access to other forms of capital. In point of view of small start-ups with ambitious value propositions and innovations, VC funds are an essential source to raise capital as they lack access to large amounts of debt. 2. Growth Capital - growth capital investments are made in mature companies with proven business models that are looking for capital to expand or restructure their operations, enter new markets, or finance a major acquisition. Typically, these are minority investments, and companies that take on growth capital are more mature than venture-funded companies. Such companies generate revenue and profits that may not be enough to fund big expansions, acquisitions or other investments. While growth equity may sound similar to venture capital and control buyouts, there are some key differences. 3. Mezzanine Financing - While some companies might take on growth capital to finance their expansions, mezzanine financing is an alternate way. Mezzanine financing consists of both debt and equity financing used to finance a company's expansion. With mezzanine financing, companies take on debt capital that gives the lender the right to convert to an ownership or equity interest in the company if the loan isn't repaid in a timely manner and in full. Companies that take on mezzanine financing must have an established product and reputation in the industry, a history of profitability, and a viable expansion plan. A key reason why a company may prefer mezzanine financing is that it allows it to receive the capital injection needed for business without having to give up a lot of equity ownership (as long as it's able to pay back its debt on time and in full). Another advantage of taking on mezzanine financing is that it may be easier to receive traditional bank financing since it's treated like equity on a company's balance sheet. On the flip side, there are some disadvantages to companies that take on mezzanine financing. Since mezzanine financing is not collateralized, the lender takes on greater risk. Therefore, mezzanine financing is typically conducted by unconventional lending institutions versus standard lending institutions. As a result, interest rates and terms can be much higher than traditional debt financing. 4. Buyout or Leveraged Buyout (LBO) - Contrary to VC funds, leveraged buyout funds invest in more mature businesses, usually taking a controlling interest. LBO funds use extensive amounts of leverage to enhance the rate of return. Buyout funds tend to be significantly larger in size than VC funds. 5. Real Estate - pooling together investor capital to invest in ownership of various real estate properties. Four common strategies: a) Core - investments are made in low-risk / low-return strategies with predictable cash flows. b) Core Plus: Moderate-risk / moderate-return investments in core properties that require some form of value added element. c) Value Added: A medium-to-high risk / medium-to-high-return-strategy which involves the purchasing of property to improve and sell at a gain. Value added strategies typically apply to properties that have operational or management issues, require physical improvements, or suffer from capital constraints. d) Opportunistic: A high-risk / high-return strategy, opportunistic investment in properties require massive amounts of enhancements. Examples include investments in development, raw land, and mortgage notes. 6. Special Situations (Distressed) - Special situations funds specifically target companies that need restructuring, turnaround, or are in any other unusual circumstances. Investments typically profit from a change in the company's valuation as a result of the special situation. Examples of special situations include: a large public company spinning off one of its smaller business units into its own public company, tender offers, mergers and acquisitions, and bankruptcy proceedings. Besides private equity funds, hedge funds also implement this type of investment. 7. Fund of Funds - A "fund of funds" (FoF) is an investment strategy whereby investments are made in other funds rather than directly in securities, stocks, or bonds. By investing in a fund of funds, investors are granted diversification and the ability to hedge their risk by investing in various fund strategies. Unfortunately, funds of funds may be costly because investors are subject to an additional layer of fees. In addition to the management fees and a performance fee that's charged at the underlying individual fund level, investors have to incur additional fees at the FoF level.
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.
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 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.
Days Sales Outstanding (DSO)
Average number of days that receivables remain outstanding before they are collected. Used to determine the effectiveness of a company's credit and collection efforts in allowing credit to customers. (Accounts Receivable / Annual Revenue) x # days in the year
You have a company with $100M in sales. Which makes the biggest impact? A) Volume increases by 20%. B) Price increases by 20%. C) Expenses decreases by $15M.
B) Price by 20% Think about how EBITDA is affected by all three scenarios. It's not C because EBITDA will only increase by $15M. Volume will increase revenue to $120M but variable costs will increase proportionally. By increasing price, you will capture the entire $20M impact. However think: - Consumer price elasticity with price increase? - What are the variable expenses?
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 it needs to be paid back before debt tranches below it. To make it less risky to the lenders, a shorter maturity 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".
Debt to Equity Ratio
Calculates the weight of total debt and financial liabilities against shareholders equity. Total Debt(Liabilities) / Shareholder's Equity
What are the key considerations to structuring a carve-out transaction?
Carve-outs: the divestiture or sale of a division or business unit - are complicated transactions, and thus have to clear a higher hurdle for success than typical mergers and acquisitions. Carve-out businesses often make up a small percentage of the parent company's total revenue. Align management incentives - under the carve-out, management is now held accountable for performance of their own company - weak management is let go and replaced. Compensation is also restructured to tie company's key performance indicators. Revenue enhancement: increase product quality; optimize pricing; optimize sales force.
What indicators would quickly tell you if an M&A deal is accretive or dilutive?
Compare P/E multiples. The company with a higher P/E multiple can acquire lesser valued companies on an accretive basis (assuming takeover premium is not too high) Form of consideration and mix of cash vs. share is important.
Price-Earnings Ratio
Compares a company's share price to the earnings per share. Share Price / Earnings per Share
Gross Margin Ratio
Compares the gross profit of a company to its net sales to show how much profit a company makes after paying off its cost of goods sold Gross Profit / Net Sales
Operating Margin Ratio
Compares the operating income of a company to its net sales to determine operating efficiency. Operating Income / Net Sales
Given two companies (A&B), how would you determine which one to invest in?
Comprehensive Analysis: 0. Economy - General state of the economy (what cycle: recession, growth) 1. Market Share/Size of the Market/Industry - how defensible it is, opportunities for growth 2. Business Model - how they generate money, how the company works 3. Management Team - leading people? past turnarounds? industry expert? 4. Culture - how healthy is culture? conducive to success? 5. Margins/Cost Structure - fixed vs. variable costs, operating leverage 6. Capital Requirements - sustaining vs. growth CapEx, additional funding required? Ideally low CapEx 7. Operating Efficiency - inventory turnover, working capital management, etc. 8. Risk - assess riskiness of business across as many variables as possible 9. Customer Satisfaction - understanding how customers think of the business All of these need to be assessed in three ways: (1) the PAST, (2) the NEAR-TERM FUTURE, (3) the LONG-TERM FUTURE
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.
Different Sources of Cash in an LBO?
Debt: - Bank Loan/Senior Debt: cheapest of all financing instruments (lower cost of capital as first in line in capital structure); roughly half of the transaction. Typically stipulate strict limitations on the business (covenants). Generally fully amortized over a five to ten year period. Typical pricing is LIBOR + 200 - 400 bps. Closing/financing fees. - HY or Subordinated Debt: 20-30% of capital structure. Higher financial costs than senior debt; but less restrictive covenants or limitations and interest-only payments with pay down due upon maturity of debt. HY debtholders ahead of equity holders in event of liquidation. (sometimes callable after a few years) Can also consist of various mezzanine financing: i.e.: PIK notes, convertible preferred debentures. - Sponsor Equity - 20-30% of notional value of capital structure
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).
Debt Service Coverage Ratio
Determines how easily a company can pay its debt obligations. Operating Income / Total Debt Service
Interest Coverage Ratio
Determines how easily a company can pay its interest expenses. Operating Income / Interest Expenses
Walk me through the calculation of Free Cash Flow to entire firm.
EBIT (-) Taxes (+) Depreciation / Amortization (-) CapEx (-) Change in NWC
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.
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.
How do you calculate amortization of intangible assets?
First, the company will record the cost to create the software on its balance sheet as an intangible asset. The software cost the company $10,000, in this case. Next, the company estimates that the software will have a useful life of just three years given the fast paced nature of software innovation. At the end of three years, the company reckons that their internal software will have no remaining value, so its residual value is therefore zero. The company will use the straight-line method to report the amortization of the software. Subtracting the residual value -- zero -- from the $10,000 recorded cost and then dividing by the software's three-year useful life, the company's accountants determine the annual amortization for the software to be $3,333. Each year, the net asset value for the software will reduce by that amount and the company will report $3,333 in amortization expense.
How would you spend a million dollars if it were given to you?
I would consider the investment options available to me (1) PE co-invest (2) bonds and (3) equities. I do not want to invest in something I do not understand well. Since I am 25 and won't be retiring for awhile, I want a high rate of return. (1) 10% PE coinvest - high return, BUT illiquid, investments of employer (2) 60% diversified stocks - (passive equity funds) - between domestic and international (half and half) (3) 30% bonds, low-cost, medium-maturity bonds (2-10 years)- uncorrelated with equity - buy a home in 5 years.
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.
How do you assess credit risk?
Leverage Ratios (Never exceed 4x) (Debt / Equity - under 2x) Interest-Coverage Ratios (Greater than 1 - Maintenance - Above 3x) Fixed Charge Coverage Ratio Look at the industry, growth. Credit - protection against bankruptcy. Industry and Company perspective.
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 going-concern value over liquidation value is booked as goodwill in acquisition accounting. If positive goodwill exists, the going-concern value should be higher than fair market value.
Operating Cash Flow Ratio
Measure of the number of times a company can pay off current liabilities with the cash generated in a given period. Operating Cash Flow / Current Liabilities
Asset Turnover Ratio
Measures a company's ability to generate sales from assets. Net Sales / Total Assets
Cash Ratio
Measures a company's ability to pay off short-term liabilities with cash and cash equivalents. Cash & Cash Equivalents / Current Liabilities
Current Ratio
Measures a company's ability to pay off short-term liabilities with current assets. Current Assets / Current Liabilities
Why would a private equity firm use a convertible preferred note?
Most PE firms negotiate to have their stock have preference in case of liquidation. As above poster said, you could do a PIK but I think that's probably rarer in situations where you are majority shareholder. In a situation where you a minority investor, a convertible note / preferred security with cash and pik interest provides downside protection. You can also negotiate different governance rights which could give you a majority voting stake (even if you own minority in shares) depending on how it's structured. Long story short it just provides downside protection and a minimum return if you don't convert.
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 percent.
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.
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.
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.
Of the valuation methodologies, which ones are likely to result in higher/lower value?
Precedents usually yield higher valuations than trading comps because buyer must pay shareholders more than current trading price to acquire a company (control 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.
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 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
What is 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)]
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.
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.
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.
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 NWC?
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.
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).
If a company's revenue grows by 10%, 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. Similar to previous question.
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.
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.
