IB Questions

Walk me through a DCF

"A DCF, or discounted cash flow analysis, aims to value a business by projecting a company's cash flows and estimating a terminal value. First the company's unlevered free cash flows are projected out a certain number of years, let's say five, for example. Unlevered free cash flows can be defined by a company's EBIT plus depreciation amortization, deferred taxes, and other non-cash items and adjusted further by changes in working capital, capital expenditures, and taxes. These cash flows are discounted back to present value using some discount rate, typically the weighted average cost of capital. Then a terminal value is calculated to establish an expected value of the business after the final projected year (Year 5 in this example). A terminal value can be calculated in two ways: (1) taking a multiple of the final year's EBITDA or (2) using the perpetuity formula on the final year's unlevered free cash flow. This terminal value is then discounted back to present value and added to the sum of the present value of the first five years' cash flow to get a total value of the business."

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."

How do the 3 statements link together?

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

What is the weighted average cost of capital formula?

(Debt / (Debt Debt + Equity)) ∗ COD ∗ (1 − tax%) + (Equity / (Debt + Equity)) ∗ COE

What are a few examples of acquisitions?

1. Acquisition of assets 2. Leveraged buyout 3. Management buyout

Name the three methods of acquiring a business

1. Asset acquisition 2. Stock acquisition 3. 338(h)10 election

Name four sources of funds in a leveraged buyout from least to most risky.

1. Bank debt (term loan, notes) 2. High-yield debt 3. Mezzanine funding (convertible securities) 4. Equity

Name three core components that contribute to the success of a leveraged buyout.

1. Cash availability, interest, and debt pay-down 2. Operation (EBITDA) improvements 3. Multiple expansion

What are the key variables impacting EPS in a debt and equity raise, respectively?

1. Interest rate on debt 2. Price per share on equity

Name several strategies to maximize returns in an LBO

1. Minimize equity invested (this can be done by increasing the debt used). 2. Reduce the purchase price. 3. Increase the sale price (exit). 4. Increase EBITDA (cutting costs or boosting revenue). 5. Maximize cash flow.

Name the four major transaction adjustments in an accretion/dilution analysis.

1. Post-merger cost savings (synergies) 2. Amortization of identifiable intangible assets 3. New interest on raised debt 4. New shares and dividends on raised equity

Name the core uses of funds categories.

1. Purchase price 2. Net debt 3. Transaction fees

What are the major variables to an LBO analysis? Name at least four

1. Purchase price 2. Sources of cash 3. Interest rate 4. Time frame 5. Operations performance (EBITDA projections) 6. Cash flow (UFCF projections) 7. Exit multiple

What are examples of other restructurings?

1. Share buyback 2. Workforce reduction 3. Debt reconsolidation

What are some characteristics of a company that make a good LBO candidate?

1. Steady cash flows 2. Opportunities for earnings growth or cost reductions 3. A high asset base—collateral to raise more debt

Name four exit strategies to a leveraged buyout.

1. Strategic sale 2. Sale to another financial sponsor 3. IPO 4. Dividend recapitalization

What is the market risk premium for the United States?

6% (It can range from approximately 5% to 6% depending on the source.)

What is a PIK security?

A PIK security is a paid-in-kind security. The periodic interest obligations are satisfied "in kind," meaning in something other than currency. Typically, when the interest obligation comes due, more debt is raised to meet that obligation. This results in interest-on-interest, which can get costly. On the other hand, it reserves cash for other beneficial uses.

Walk me through the circular reference in a model.

A circular reference can begin in the debt schedule with some issuance or paydown of debt. When debt is paid down, for example, the interest expense is reduced. This reduction in interest expense flows into the income statement and increases net income. The increase in net income flows into the cash flow statement and increases the cash flow before debt paydown balance. Cash flow before debt paydown flows back into the debt schedule, increasing the amount of funds that can be used to pay down debt. If we have more funds, we can pay down more debt, interest expense will reduce further, impact the income statement, increase net income, increase the cash balance further, and the cycle will continue.

How is a deferred tax asset created?

A deferred tax asset can be created if a business has a net operating loss (NOL). An asset can also be created by receiving government tax credits (investing in certain energy, for example).

What is a deferred tax liability? How is such a liability created?

A deferred tax liability is a tax balance due that has not yet been paid in cash. Deferred tax liabilities are created from timing differences between book accounting (GAAP) and tax accounting.

What is the advantage of performing a dividend recap?

A dividend recap could have several advantages in maximizing returns. One common advantage is to extend the holding period of the company while still raising cash to expend for the fund's needs. If the market environment is not the best for target company exit, a dividend recap would allow the fund more time to look for the right exit opportunity

What is the difference between a horizontal and vertical transaction?

A horizontal transaction is between business entities in the same industry, where as a vertical transaction is between business entities operating at different levels within an industry's supply chain.

What is the purpose of a leveraged buyout analysis?

A leveraged buyout analysis helps determine the annualized returns (IRRs) of an investor's equity investment in a business after a specific time horizon.

What is a leveraged buyout?

A leveraged buyout is an acquisition of a company using a significant amount of debt to meet the cost of the acquisition.

What is the difference between a market multiple and a purchase multiple?

A market multiple is a multiple based on the current valuation of a company; a purchase multiple is based on the price paid for a company

What is the difference between a merger and a consolidation?

A merger is the combination of two or more business entities in which only one entity remains. A consolidation is a combination of more than one business entity; however, an entirely new entity is created.

What is the purpose of a seller note in a leveraged buyout?

A seller note is a loan to the purchased business from the seller. If a certain purchase price is negotiated in an acquisition, a certain amount is of course paid immediately, and the rest can be deferred as a seller note payable in certain terms. This can be used to prevent the seller from starting a competing business or can incentivize the seller to continue to support the business.

What is a typical WACC of a standard business?

A standard WACC can range from 9% to 12%.

Name four major components of purchase price over book value.

A. Goodwill B. New intangible assets C. Asset step-up D. Deferred tax adjustments

Balance Sheet Line Items

ASSETS Current Assets Cash & Cash Equivalents Short-term investments Inventories LONG TERM ASSETS PP&E (Plant, Property & Equipment) Total Assets LIABILITIES Current Liabilities Acc. Payable Short Term Debt LONG TERM DEBT TOTAL SHAREHOLDER EQUITY

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

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

What are some common types of debts raised in a leveraged buyout?

Although there is a vast range of possible securities utilized in funding a particular LBO transaction, they can come in several major categories: bank debt, high yield debt, and mezzanine debt. Bank debt, or a term loan, is the most fundamental type of debt. It usually carries 5 percent to 12 percent interest and can be backed by the core assets of the business. Such debt can be a revolving line of credit, a term loan, and other subordinated loans or notes. High yield debt is a more aggressive type of debt borrowed at much higher interest rates to compensate for additional risk of defaulting on such debts. Interest in such debt can be upwards of 15 percent, but it varies depending on the situation at hand. Mezzanine (or convertible) lending is a hybrid between debt and equity. The general concept of a mezzanine security is that it is initially considered debt that will convert to equity after a certain amount of time or after certain hurdles are met.

Walk me through an accretion/dilution analysis.

An accretion/dilution analysis assesses the EPS impact of the combination of two entities. First, one needs to obtain the purchase price, and then the sources and uses of funds need to be analyzed. The uses of funds are comprised of the purchase price plus potentially paying down the target company's net debt and transaction fees. The sources of funds will be some combination of equity, debt, or cash on hand. Once we know the sources and uses of funds, we can begin combining the two entities by adding together each target and acquirer line item from revenue down to net income except for items relating to the target company's net debt (if we are assuming we are paying down the target company's net debt) and the target company's shareholders' equity (because we are paying off the shareholders). So, we do not include the target company interest expense and target company shares and dividends on the income statement. In addition, we need to consider four major transaction adjustments: (1) post-merger cost savings, (2) the amortization of new intangible assets if we have been able to allocate a portion of the purchase price above book value toward new intangible assets, (3) new interest expense if we have raised debt to fund the transaction, and (4) new shares if we have raised equity to fund the transaction. We can then calculate a new EPS and compare with the original company's EPS in order to assess accretion dilution.

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

At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement (yet). On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same. On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

In a comparable company analysis why would one possibly use EV/EBITDA multiples as opposed to P/E multiples?

Because EBITDA is before interest, and enterprise value (EV) is before debt, the EV/EBITDA metric is a better measure of a company's core operations. This could result in more comparable metrics as opposed to a P/E multiple, which includes the impacts of debts, depreciation, and other income or expense items.

What is the difference between book value and market value of a public company?

Book value is the shareholders' equity as listed on a company's balance sheet; market value is the market capitalization (# of shares × $/share) of a business.

What is cash flow from operations?

Cash flow from operations is defined by net income + D&A + deferred taxes + other non-cash items - changes in working capital.

What is the formula for calculating unlevered free cash flows?

EBIT - Taxes + D&A + Changes in Working Capital - Capital Expenditures

What is EBITDA?

EBITDA stands for earnings before interest taxes depreciation and amortization.

How is the enterprise value of a business calculated?

Enterprise value is calculated by adding net debt to a company's market value. Net debt is the company's total debts (plus capital leases, certain convertible securities, and non-controlling interests if any) less cash.

Is an equity raise or a debt raise typically more dilutive to EPS? What are the exceptions to the common rule?

Equity is typically more dilutive to EPS than debt. If the stock price is overvalued, raising equity can be less dilutive than raising debt. Or if the interest rate is higher than the cost of equity, raising debt can be more dilutive than raising equity.

What happens when Accrued Compensation goes up by $10?

For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation). Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate). On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

Name one way to calculate IRR

IRR can be calculated as: (Exit Equity Value/Equity Invested) ^ (1/Years) − 1

What is a dividend recapitalization?

In a dividend recap, the company re-levers (raises debt on) the balance sheet. The new money raised is often paid out as a dividend.

Walk me through a leveraged buyout analysis.

In order to determine the IRR of a particular investment after a certain number of years, one first needs to establish the purchase price of the business. After estimating purchase price, one needs to determine the entire uses of funds (purchase price, net debt, and transaction fees) and the sources used to fund the acquisition (some combination of term loans, high yield debts, mezzanine, and equity). One can then construct a simple unlevered free cash flow analysis that will provide a projected EBITDA for estimating an exit and total cash produced for paying down debt. The projected EBITDA is multiplied by a multiple to get an estimated exit value. Often the purchase multiple is used as an estimated exit multiple. In order to establish return, one needs to calculate the final debt. The original debt raised to fund the acquisition plus the total interest incurred is calculated. One can estimate total interest by taking each annual interest expense multiplied by the number of years and multiplied by 1 - tax%. The sum of the original debt raised and the total interest expense less the sum of the unlevered free cash flow is the final debt balance. The return is the exit value (from the EBITDA times the multiple) less this final debt number. One can then compare the return with the equity originally invested in the business to calculate the IRR.

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

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance. Note: With this type of question I always recommend going in the order: 1. Income Statement 2. Cash Flow Statement 3. Balance Sheet Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow.

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

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

Why do we typically discount cash flows as opposed to net income?

Investors prefer cash flow as it is seen as a "truer" measure of output. Net income may show profitability, but net income profitability does not necessarily mean cash generation. An investor would prefer to know cash output to best predict cash return. This is why we more commonly refer to a discounted cash flow analysis as opposed to a discounted net income analysis.

Where does Depreciation usually show up on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

What is one major advantage of the comparable company analysis?

It is the most current of all three analyses—it gives a market perspective. The comparable company analysis is based on the most recent stock prices and financials of the company.

What is one major advantage of the discounted cash flow analysis?

It is the most technical analysis of the three. It is based on the company's cash flows from the model projections, as opposed to the comparable company analysis, which is mainly driven by market data.

How does maintenance CAPEX differ from growth CAPEX?

Maintenance CAPEX is the funds expended to extend the useful life of existing assets, whereas expansion CAPEX is the purchase of new assets to grow the business.

How is the market value of a business calculated?

Market value is calculated by multiplying the number of shares outstanding by the current share price.

Why is Market Value/EBITDA not a good comparable multiple?

Market value is the value of a business after lenders have been paid; EBITDA (before interest) is a metric before lenders have been paid

Cash flow from Operations

Net Income + Depreciation and Amortization + Deferred Taxes + Non-cash items - Changes in Working Capital ((Inventory: (Additions) / Reductions), (Acc Rec: (Additions) / Reductions in Acc Rev), (Acc Pay: Increase / (Reductions) of payables))

What is the difference between net income and cash flow?

Net income measures profitability whose components may or may not have impacted cash. Cash flow tracks just the cash impacts generated or received from operations, investing, and financing activities.

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

No changes to the Income Statement. On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations - it goes down by $10, as does the Net Change in Cash at the bottom. On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.

Is market risk premium the average return of the market?

No. The market risk premium (MRP) is Rm - Rf. Rm is the average return of the "market."

How do the three statements link together?

Note there can be many ways to answer this question. Here is a suggested solution: Net income from the income statement flows into the top of the cash flow statement and into the shareholder's equity section of the balance sheet. Each and every line item in the cash flow statement impacts a line item in the balance sheet: an asset, liability, or shareholder's equity. Total cash and cash equivalents at the bottom of the cash flow statement impacts the cash line item at the top of the balance sheet. Depreciation created on its own schedule flows into the income statement, into the cash flow statement, and impacts PP&E on the balance sheet. Changes in each working capital line item from the working capital schedule flow into the working capital section of the cash flow statement, and subsequently impact each respective balance sheet line item. Interest expense and interest income, derived from the debt schedule, flows into the income statement. Finally, any debt issuances or paydowns depicted in the debt schedule flow into the financing activities in the cash flow statements and further into the respective debt balances on the balance sheet.

Cash Flow Statement Line Items

OPERATING ACTIVITIES Net Income Depreciation & Amortization Stock Based Comp INVESTING ACTIVITIES Purchase of Land & Equipment FINANCING ACTIVITIES Purchase of Stock

What is one way to conservatively estimate an exit multiple?

Often, one can conservatively assume the purchase multiple will be the exit multiple.

How can one determine the amount of debt raised?

One can use debt multiples as comparable metrics to other similar leveraged buyouts.

How does operating working capital differ from working capital?

Operating working capital is a company's current assets excluding cash and current liabilities excluding debts. Bankers often look at operating working capital as by eliminating cash and debts, you are left with line items most closely related to a company's core operations (e.g., accounts receivable, inventories, accounts payable).

What is one major advantage of the precedent transactions analysis?

Purchase price includes a premium. This could be advantageous if we were looking to acquire a company. It would help us determine how much of a premium we would need to consider in order to convince the owner or shareholders to hand over the company.

Why is it important to remove cash from net debt to arrive at an enterprise value of a business?

Removing cash leaves us with a value that represents the core operating assets of a business.

Income Statement Line Items

Revenue - COGS = Gross Profit - Operating Expenses (SG&A, Comp) = EBITDA - Dep & Amortization = Operating Income (EBIT) - Non-Operating Expenses (Int. Exp.) = EBT - Taxes = Net Income

What are the three main steps to conducting a leveraged buyout analysis?

Step 1: Obtaining a purchase price Step 2: Estimating sources and uses of funds Step 3: Calculating investor rate of return (IRR)

EBITDA is $500MM. Which of the following has the greatest impact to EBITDA? Assume all is equal except for the below variables. a. Costs increase by $10MM. b. Pricing increases by 10%. c. Volume increases by 10%.

The answer is b. Since revenue is a product of pricing and volume, each of b and c would impact revenue. An increase in price of 10% would certainly increase revenue by 10% or $50MM. However, increasing volume, or units produced, would increase costs as well, assuming COGS is variable and based on units produced. Therefore, that potential increase in costs would offset the revenue benefits in some way. So it's safe to say that b would have a larger impact than c. We would immediately eliminate a once we realized the impact of b is greater

Walk me through a balance sheet (more detailed).

The balance sheet is a measure of a company's assets, liabilities, and shareholder's equity at a given point in time. The company's assets, a resource with economic value that is expected to provide some future benefit, is broken up into current and non-current. Current assets are resources whose economic benefit is expected to come due within one year. Examples of current assets are cash, accounts receivable, and inventories. Examples of long-term assets are property, plant and equipment (PP&E), goodwill, intangible assets, and investments in securities. A liability is a debt or obligation and is also broken up into current and non-current sections. Current liabilities are debts or obligations the come due within one year. Examples of current liabilities are accounts payable, accrued expenses, and short-term debts. Examples of long-term liabilities are long-term debts and deferred tax liabilities. Shareholder's equity consists of retained earnings and share capital less Treasury shares. The sum of the shareholder's equity and the total liabilities must equal the total value of assets: Total Assets = Total Liabilities + Shareholder's Equity

Walk me through a cash flow statement (more detailed).

The cash flow statement is a measure of how much cash is generated or spent over a given period. The statement is broken up into three major sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Cash flow from operating activities is the cash generated from net income, or the net income less all non-cash items from the income statement. This consists of net income plus depreciation and amortization, deferred taxes, other non-cash items, and changes in working capital. Cash flow from investing activities is cash generated or spent from investments. This includes capital expenditures, acquisitions and divestitures, and purchases and sales of securities to name the major few. Cash flow from financing activities is cash generated or spent from debt, equity, or distributions. This consists mainly of monies raised from or used to pay debts, monies received from equity and other securities, monies spent from share buybacks, and monies spent from dividend and other equity distributions. The sum of these three cash flow components completes the cash flow statement.

If you had to choose only one of the three core statements to determine the financial viability of a company, which statement would you choose?

The cash flow statement provides a true measure of cash produced by the business as opposed to an income statement, which may or may not include non-cash items. To an investor, cash is the true measure of performance. This is partially why the discounted cash flow is a valuable valuation method.

What is the purpose of the comparable company analysis?

The comparable company analysis ("comps") compares companies that are similar in product size, product, and geography to the company we are valuing.

What is the cost of equity? Please include the formula.

The cost of equity is the expected return to equity investors relative to the investment risk. COE = Rf + Beta ∗ (Rm − Rf)

What is the purpose of the discounted cash flow analysis?

The discounted cash flow analysis values a company based on its projected unlevered free cash flows and an estimated terminal value

Walk me through an income statement (more detailed).

The income statement always starts with revenue, a company's sales, and builds down to net income. Cost of goods sold is the costs most directly associated to the revenue and is reduced from the revenue to produce gross profit (revenue - COGS = gross profit). Operating expenses are the next series of costs and consist of sales, general, and administrative expenses, and marketing and advertising expenses, to name the two most common. Gross profit less operating expenses make EBITDA. Depreciation and amortization are the costs related to the aging of tangible and intangible assets respectively. EBITDA less D&A makes EBIT. Interest expense is reduced from EBIT to get EBT. EBT is then tax affected to get net income. You can also add: After net income there are two major sections reserved for equity distributions (noncontrolling interest expenses and dividends) and non-recurring or extraordinary

If I had to choose only two statements to assess a company's performance, which two would I use?

The income statement and the balance sheet. A cash flow statement can be created from an income statement and two years of a balance sheet.

Walk me through the three financial statements

The income statement, the cash flow statement, and the balance sheet are the core financial statements. The income statement is a measure of profitability—revenue less expenses is taxed and creates net income. The cash flow statement tracks how much cash has been spent or generated from three major areas: operating activities, investing activities, and financing activities. The balance sheet is a snapshot of a company's resources (assets), its obligations (liabilities), and equity. The assets must always equal the sum of a company's equity and liabilities.

What is the advantage to using leverage when making an acquisition?

The more leverage used to fund an acquisition, the less equity needed. Less equity invested will maximize your return.

What is the purpose of the precedent transactions analysis?

The precedent transactions analysis assesses relative value by looking at multiples of historical transactions.

Of the three major valuation methods, which method typically results in the highest valuation?

The precedent transactions analysis would result in the highest valuation because these statistics include a purchase premium.

Please explain the terminal value and the two methods

The terminal value of a company estimates the value of the business after the last projected year. There are two major methods for calculating the terminal value of a company. ■ Multiple method ■ Perpetuity method

What are some major differences between a basic LBO analysis and full-scale LBO model?

There are many differences between a basic and full-scale LBO model. One major difference is that simple analysis would just contain a simple cash flow build-up, whereas a full-scale model would contain complete projections. This would include the income statement, cash flow statement, balance sheet, as well as the supporting schedules. A full-scale analysis would also include balance sheet adjustments—a more detailed look at the balance sheet post-transaction adjustments. Another major difference to highlight is the simple analysis estimates interest in one year and multiplies by the number of transaction years to estimate total interest obligations. In reality, if a company is paying down debt each year, the interest expense should also be reducing. Because a full-scale model contains a debt schedule, it will more properly associate declining interest in line with debt paydown

Of the three major valuation methods, which method typically results in the lowest valuation?

This answer can depend on several items. Remember it's not only about giving the correct answer; it's how that answer is supported. How you answer the question is important. The comparable company analysis is based on market multiples, so if the market is highly valued, this analysis could produce results higher than the DCF. However, the DCF is based on a financial model. If the model has been constructed based on aggressive metrics, the DCF analysis could produce higher results than the comparable company analysis. I typically build conservative models that, coupled with the fact that cash flows are discounted back to present value, usually result in the DCF being lower than the comparable company analysis. As long as you are comfortable with the drivers of each, you can properly defend your answer.

Why is the Income Statement not affected by changes in Inventory?

This is a common interview mistake - incorrectly stating that Working Capital changes show up on the Income Statement. In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

Why would an investor care about cash flow versus net income?

This question is quite similar to the previous, but it's important that one grasps these concepts because questions around them could be asked several different ways. An investor is more apt to base his investment using the cash flow statement as it tracks the "true" measure of how much cash has been generated or spent over a period. Net income may report profitability, but how much of that profitability had actually been converted into cash? If none, for example, the investor would be less likely to see his investment returned. "Cash is king" holds true in this context. And this is why we more commonly look at cash flow in a discounted cash flow analysis as opposed to net income

What is the formula to properly discount a cash flow?

UFCF / (1 + Discount Rate)^period

What is the formula for the perpetuity method?

UFCF ∗ (1 + g) / (r − g)

What is working capital used for?

Working capital is a measure of a company's current assets less its current liabilities. Working capital is often looked at as a measure of a company's near-term liquidity or operating efficiency as current assets (resources that will be converted into cash within a year) less liabilities (debt or obligations due within one year) can help determine if there will be enough cash in the short term to cover a company's upcoming liabilities or obligations.

What cost of equity discount rate would you use to value a target company in a leveraged buyout using a discounted cash flow analysis?

You would often use a rate that reflects the expected equity return of the fund. If the fund is expecting a 25% return, this could be the rate to use.

Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?

You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).

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 multiple. At exit, the sale price is dependent on the EBITDA times the exit multiple. So, 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.

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

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

What are three major ways to facilitate an acquisition?

a. Acquisition of assets b. Acquisition of equity c. 338(h)10 election

What are the three major methods of valuation?

a. Comparable company analysis b. Precedent transactions analysis c. Discounted cash flow analysis

What are the major disadvantages of the precedent transactions analysis?

a. Historical analysis. Precedent transactions by definition are historical transactions. The analysis may be irrelevant if we are in a completely different economic environment. b. Difficult to find relevant transactions. Especially in an environment where there are not many acquisitions, it may not be possible to find acquisitions similar to the one we are analyzing. c. Difficult to get data. Even if we do find relevant transactions, it is not always easy to find the data to create the multiples.

What are the major disadvantages of the comparable company analysis?

a. It may be difficult to find companies to compare. If the company has a unique business model, is in a very "niche" industry, or is not the size of a public company, it may be difficult to find the right comparables. b. The markets may be under- or overvalued. We could be in a market environment where the entire industry in overvalued or undervalued. If so, our analysis will be flawed.

What are the most common variables in an LBO analysis?

a. Purchase price. The higher the purchase price, the more costly the investment may be to the investor, and therefore the lower the IRR. b. Sources of cash. The amount of debt that can be raised to make such an investment will also affect the IRR. The more debt we can raise, the less equity we have to put in, and so the higher our expected returns will be. c. Interest rate. A lower interest rate would lower our costs, which would increase our cash, which would allow us to pay down debt faster and increase the IRR. d. Time frame. Typically, a shorter time frame would produce a higher IRR. e. Operations performance (EBITDA projections). The more we can improve EBITDA, the higher our potential sale value, which would increase IRR. Also, a higher EBITDA would improve our cash flow. f. Cash flow (UFCF projections). Improved cash flow performance will allow us to pay down debt faster and will improve our IRR. g. Exit multiple. The higher our exit multiple (exit value), the higher our return.

What are a few major disadvantages of the discounted cash flow analysis?

a. Terminal value. Although the first projected years are based on modeled cash flows, the terminal value accounts for a very significant portion of the overall valuation. That terminal value is based on a multiple or a perpetuity. b. Model projections. The model projections could be inaccurate; they could be overstated or understated depending on what is driving the projections. c. Discount rate. The discount rate may be difficult to estimate. We will go through standard techniques, but these standards do not apply in all situations.

What are some advantages of LBO financing?

a. The more debt used to make the purchase, the less equity needed, which can maximize potential returns. b. Interest payments on debt are tax deductible.