Investment Banking Important Technical Questions

What are the most common Valuation multiples? And what do they mean?

-Enterprise Value / Revenue: How valuable is a company in relation to its overall sales. - Enterprise Value / EBITDA: How valuable is a company in relation to its approximate cash flow. -Enterprise Value / EBIT: How valuable is a company in relation to the pre-tax profit it earns from its core business operations. - Price Per Share / Earnings Per Share (P / E): How valuable is a company in relation to its after-tax profits, inclusive of interest income and expense and other non-core business activities.

Walk me through a DCF

1. Project the companies free cash flows for about 5 years. Free cash flow is EBIT times 1 minus the tax rate plus depreciation and amortization, minus capital expenditures, minus the change in networking capital. 2. Predict free cash flows beyond 5 years using either a terminal value multiple or the perpetuity method. 3. To calculate perpetuity method, establish a terminal growth rate, usually about the rate of inflation or GDP growth, a low single digit percentage. 4. Now multiply the year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus the growth rate. 5. Discount rate is the WACC, use that rate to discount all your cash flows back to year zero. The sum of the present values of all those cash flows is the estimated enterprise value of the firm according to the DCF.

What is the typical long term growth rate under the perpetuity growth method?

2.5-3.0% because that is what the historic GDP is (you can't assume it grows fast than the GDP otherwise that company will take over the world).

How much equity contribution do you usually see in LBO's?

35-40%

What are common leverage amounts? Why?

4-7x Net Debt / EBITDA. You use FCF to pay down debt over the holding period, so you want a leverage amount similar to how many years you plan on holding the company.

What is the difference between the income statement and statement of cash flows?

A company's sales and expenses are recorded on its Income Statement. The Statement of Cash Flows records what cash is actually being used during the reporting period and where it is being sent. Other items included in the Cash Flow Statement could be issuance or repurchase of debt or equity and capital expenditures or other investments. Amortization and depreciation will be reflected as expenses on the Income Statement, but they will be added back to net income on the Cash Flow Statement since they are expenses but not actually use of cash.

What is a deferred tax asset and why might one be created?

A deferred tax asset occurs when a company pays more in taxes to the government than they show as an expense on their income statement in a reporting period.

What is the difference between accounts receivable and deferred revenue?

Accounts receivable is money a company has earned from delivery of goods or services but has not collected yet. Deferred revenue is the opposite, money that has not yet been recorded as revenue because it was collected for goods or services not yet delivered.

How could a company have positive EBITDA and still go bankrupt?

Bankruptcy occurs when a company can't make its interest or debt payments. Since EBITDA is Earnings BEFORE Interest, if a required interest payment exceeds a company's EBITDA, then if they have insufficient cash on hand, they would soon default on their debt and could eventually need bankruptcy protection.

What is the difference between accounts payable and accrued expenses?

Basically they are the same thing. The main difference is usually that accounts payable is typically a one time expense with an invoice (such as the purchase of inventory) while accrued expenses are recurring (like employee expenses).

How do you determine which valuation methodology to use?

Because each method has unique ability to provide useful information, you don't choose just one. The best way to determine the value of a company is to use a combination of valuation techniques. For example, if you have a precedent transaction valuation that you feel is extremely accurate, you may give that result more weight. Or if you are extremely confident in your DCF analysis, you will place more emphasis on its outcome. Valuing a company is as much an art as it is a science

When looking at the acquisition of a company, do you look at Equity Value or Enterprise Value?

Because the acquiring company must purchase both liabilities and equity in order to take over the business, the buyer will need to assess the company's Enterprise Value, which includes both the debt and the equity.

Let's say that you have a non-cash expense (Depreciation or Amortization, for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?

Because you want to reflect that you've saved on taxes with the non-cash expense. Let's say you have a non-cash expense of $10 and a tax rate of 40%. Your Net Income decreases by $6 as a result... but then you add back the entire non-cash expense of $10 on the CFS so that your cash goes up by $4. That increase of $4 reflects the tax savings from the non-cash expense. If you just added back the after-tax expense of $6 you'd be saying, "This non-cash expense has no impact on our taxes or cash balance."

What is the link between the Balance Sheet and the Statement of Cash Flows?

Beginning cash on the Statement of Cash Flows comes from the previous period'sBalance Sheet. Cash from operations on the Cash Flow Statement is affected by the Balance Sheet's numbers for change in net working capital, current assets minus current liabilities. Property, plant, and equipment is another Balance Sheet item that affects the Cash Flow Statement because depreciation is based on the amount of PP&E a company has. Any change due to purchase or sale of property, plant, and equipment will affect cash from investing. Finally the Cash Flow Statement's ending cash balance becomes the beginning cash balance on the new Balance Sheet

What is Beta?

Beta is a measure of the volatility or risk of an investment compared with the market as a whole. The market has a beta of 1, while investments that are more volatile than the market have a beta greater than 1 and those that are less volatile have a beta of less than 1.

What are the three components of the statement of Cash flows and Explain them.

CASH FROM OPERATIONS: Cash generated or lost through normal operations, sales, and changes in working capital (more detail on working capital below).• CASH FROM INVESTING: Cash generated or spent on investing activities; may include, for example, capital expenditures (use of cash) or asset sales (source of cash). This section will also show any investments in the financial markets and operating subsidiaries.NOTE: This section can explain a large negative cash flow during the reporting period, which isn't necessarily a bad thing if it is due to large capital expenditure in preparation for future growth. •CASH FROM FINANCING: Cash generated or spent on financing the business; may include issuance or repurchase of debt or equity

Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc., do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings?

Capital expenditures are capitalized on the balance sheet because it expected that their benefits will be realized over a long period of time, likely a number of years. If a company purchases a truck, the Company will see the benefit of that truck over the course of its useful life, and therefore will expense the truck over the course of that life in the form of depreciation on the income statement.•This is in contrast to a salary or wage expense, which is realized immediately because the Company is seeing the benefit of the work that employee is being paid for just in that short period of time.

What are the 3 major valuation methodologies?

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis. Public Comps and Precedent Transactions are examples of relative valuation (based on market values), while the DCF is intrinsic valuation (based on cash flows).

How do you calculate Cost of Equity?

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta The Risk-Free Rate represents how much a 10-year or 20-year US Treasury (or equivalent "safe" government bond in your own country) should yield; Beta is calculated based on the "riskiness" of Comparable Companies and the Equity Risk Premium is the percentage by which stocks are expected to out-perform "risk-less" assets like US Treasuries.

What is deferred revenue and why is it a liability?

Deferred revenue is cash that has been collected in advance for something that hasn't yet been delivered. For example, if you pay for a monthly magazine subscription a year in advance, you haven't yet received your magazines, therefore the magazine company has not yet recognized the revenue since the product hasn't been delivered. At the beginning of the year, they will show the full amount of the subscription in deferred revenue, and that amount will decrease by 1/12 of the amount each month as issues are delivered.

What is the purpose of the changes in the working capital section of the cash flow statement?

Due to accrual accounting, changes in balance sheet items like accounts payable and accounts receivable are not reflected

What's an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?

EBIT * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx - Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx

Can you walk me through how to calculate EBIT and EBITDA? How are they different?

EBIT is just a company's Operating Income on its Income Statement; it includes not only COGS and Operating Expenses, but also non-cash charges such as Depreciation & Amortization and therefore reflects, at least indirectly, the company's Capital Expenditures. EBITDA is defined as EBIT plus Depreciation plus Amortization. You may sometimes add back other expenses as well (see the Advanced section). The idea of EBITDA is to move closer to a company's "cash flow," since D&A are both non-cash expenses... but there's a problem with that since you're also excluding CapEx altogether.

Would you be calculating Enterprise Value or Equity Value when using a multiple based on free cash flow or EBITDA?

EBITDA and free cash flow represent cash flows that are available to repay holders of a company's debt and equity, so a multiple based on one of those two metrics would describe the value of the firm to all investors. A multiple such as P/E ratio, based on earnings alone, represents the amount available to common shareholders after all expenses are paid, so if you used this multiple, you would be calculating the value of the firm's equity.

Why might there be multiple valuations of a single company?

Each method of valuation will generate a different value because it is based on different assumptions, different multiples, or different comparable companies and/or transactions.Generally, the precedent transaction methodology and discounted cash flow method lead to higher valuations than comparable companies analysis or market valuation does. The precedent transaction result may be higher because the approach usually will include a "control premium" above the company's market value to entice shareholders to sell and will account for the "synergies" that are expected from the merger. The DCF approach normally produces higher valuations because analysts' projections and assumptions are usually somewhat optimistic.

What is Enterprise Value?

Enterprise Value is the value of a firm as a whole, to both debt and equity holders. To calculate Enterprise Value in its simplest form, you take the market value of equity (aka the company's market cap), add the debt and the value of the outstanding preferred stock, add the value of any minority interests the company owns, and then subtract the cash the company currently holds.

What is the difference between enterprise value and equity value

Equity Value is the value only to the shareholders, however, Enterprise value is the value of the firm that accrues to both the shareholders and the debt holders (combined).

What is more expensive cost of equity or cost of debt?

Equity is more expensive because when a company declares bankruptcy they get paid last. Numerically, the cost of equity takes into account the leverage ratio making equity more expensive. There is also a tax benefit associated with debt.

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

Even though depreciation is a non-cash expense, it is still tax deductible. This means that it reduce s your pre-tax income, and therefore reduces the amount of taxes a company must pay, which increases the company's cash balance

Which way of calculating terminal value is more common?

Exit multiple method.

When should an expense appear on the Income Statement?

Expenses that end on the income statement must be tax deductible and must have been incurred during the period of the income statement. Ex: Marketing expense, employee salaries.

Walk me through how you get from Revenue to Free Cash Flow in the projections.

First, confirm that they are asking for Unlevered Free Cash Flow (Free Cash Flow to Firm). If so: Subtract COGS and Operating Expenses from Revenue to get to Operating Income (EBIT) - or just use the EBIT margin you've assumed. Then, multiply by (1 - Tax Rate), add back Depreciation, Amortization, and other non-cash charges, and factor in the Change in Operating Assets and Liabilities. If Assets increase by more than Liabilities, this is a negative; otherwise it's positive. Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow. Levered Free Cash Flow (FCFE) is similar, but you must also subtract the Net Interest Expense before multiplying by (1 - Tax Rate), and you must also subtract Mandatory Debt Repayments at the end.

Can you walk me through how you use Public Comps and Precedent Transactions?

First, you select the companies and transactions based on criteria such as industry, financial metrics, and geography (see the next question). Then, you determine the appropriate metrics and multiples for each set - for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples - and you calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally, you apply those numbers to the financial metrics for the company you're analyzing to estimate the potential range for its valuation.

Why do you add back non-cash charges when calculating Free Cash Flow?

For the same reason you add them back on the Cash Flow Statement: you want to reflect the fact that they save the company on taxes, but that the company does not actually pay the expense in cash.

How do you calculate FCF?

Free cash flow is EBIT times 1 minus the tax rate plus Depreciation and Amortization minus Capital Expenditures minus the Change in Net Working Capital.

What is goodwill?

Goodwill is an asset that captures what is paid for an acquisition over fair market value.

If you could choose only one financial statement to evaluate the financial state of a company, which would you choose and why?

I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating. The Income Statement can be misleading due to any number of non-cash expenses that may not truly be affecting the overall business. And the balance Sheet alone just shows a snapshot of the Company at one point in time, without showing how operations are actually performing. But whether a company has a healthy cash balance and generates significant cash flow indicates whether it is probably financially stable, and this is what the CF Statement would show.

What is an IPO?

IPO is the acronym for Initial Public Offering. It is the first time a privately-held company sells shares of stock to the public market. Usually a company goes public to raise capital for growing the business or to allow the original owners and investors to cash out some of their investment.

From the three main financial statements, if you had to choose two to analyze a company, which would you choose and why?

If I had to choose two financial statements, I would choose the Balance Sheet and the Income Statement. As long as I had the Balance Sheets from the beginning and end of the period, as well as the end of period Income Statement, I would be able to generate a Cash Flow Statement.

How do you factor in Convertible Bonds into the Enterprise Value calculation?

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value (no Treasury Stock Method required - just add all the shares that would be created as a result of the bonds). If the Convertible Bonds are out-of-the-money, then you count the face value of the convertibles as part of the company's Debt.

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

If the purchase corresponds to an Asset with a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only "last" for the current period and therefore show up on the Income Statement as normal expenses instead.

Where would you not want to use a DCF?

If you have a company that has very unpredictable cash flows, then attempting to project those cashflows and create a DCF model would not be effective or accurate. In this situation you will most likely want to use a multiples or precedent transactions analysis.

You see a "Noncontrolling Interest" (AKA Minority Interest) line item on the Liabilities side of a company's Balance Sheet. What does this mean?

If you own over 50% but less than 100% of another company, this refers to the portion you do not own. Example: Another company is worth $100. You own 70% of it. Therefore, there will be a Noncontrolling Interest of $30 on your Balance Sheet to represent the 30% you do not own.

What do you usually use for the Discount Rate?

In a Unlevered DCF analysis, you use WACC (Weighted Average Cost of Capital), which reflects the "Cost" of Equity, Debt, and Preferred Stock. In a Levered DCF analysis, you use Cost of Equity instead.

When is a Liquidation Valuation useful?

It's most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company's Liabilities have been paid off with the proceeds from selling all its Assets. It is often used to advise struggling businesses on whether it's better to sell off Assets separately or to sell 100% of the company.

How would a $10 increase in depreciation expense affect the three financial statements?

Let's start with the Income Statement. The $10 increase in depreciation will be an expense and will reduce net income by $10 times (1-the tax rate). Assuming a 40% tax rate, this will mean a reduction in net income of 60% or $6. So $6 flows to cash from operations, where net income will be reduced by $6 but depreciation will increase by $10, resulting in an increase of ending cash by $4. Cash then flows onto the Balance Sheet where it increases by $4, PP&E decreases by $10, and retained earnings decreased by $6, keeping everything in balance.

Why is leverage important?

Leverage helps reduce the initial amount of equity needed, which helps to increase the internal rate of return.

How do I calculate leverage?

Leverage is some form debt in the numerator (total debt, net debt, total senior secured) divided by EBIT/EBITDA/EBITDAR/ect

What other Valuation methodologies are there?

Liquidation Valuation - Valuing a company's Assets, assuming they are sold off and then subtracting Liabilities to determine how much capital, if any, equity investors receive. LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range. Market Valuation/Market Capitalization-The market value of equity is only used for publicly traded companies and is calculated by multiplying the number of shares outstanding by the current stock price. Sum of the Parts - Valuing each division of a company separately and adding them together at the end.

Where do I find cost of debt?

Look at Bloomberg on the debts outstanding and look at the yield to maturities.

What about alternate ways to calculate Levered Free Cash Flow?

Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments -(EBIT - Net Interest Expense) * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments Cash Flow from Operations - CapEx - Mandatory Debt Repayments

What is net working capital?

Net Working Capital is current assets minus current liabilities. It is a measure of a company's ability to pay off its short-term liabilities with its short-term assets. A positive number means they can cover their short-term liabilities with their short-term assets. A negative number indicates that the company may have trouble paying off its creditors, which could result in bankruptcy if cash reserves are insufficient.

What is net debt?

Net debt is a company's total debt minus the cash it has on the balance sheet. Net debt assumes that a company pays off any debt it can with excess cash on the balance sheet.

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

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront, but they wait weeks or months to pay their suppliers - this is a sign of business efficiency and means that they always have healthy cash flow. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when the company owes a lot of money to suppliers and cannot pay with cash on-hand).

What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?

Nothing "happens" because you can still run the analysis as-is. The company's value will certainly decrease if one or both of these turn negative, because the present value of Free Cash Flow will decrease as a result. The analysis is not necessarily invalid even if cash flow is negative - if it turns positive after a point, it could still work. If the company never turns cash flow-positive, then you may want to skip the DCF because it will always produce negative values.

Which Valuation Methodology will result in the highest valuation?

Of the four main valuation techniques (Market Value, Market Comps, Precedent Transactions and DCF) the highest valuation will normally come from the Precedent Transactions technique, because a company will pay a premium for the projected synergies coming from the merger. A DCF analysis will typically give you the next highest valuation simply because those building the DCF model tend to be somewhat optimistic in their assumptions and projections. Market Comps and Market Value will usually produce the lowest valuations.

Why do you subtract cash from Enterprise Value?

One good reason is that cash has already been accounted for within the market value of equity. You also subtract cash because it can be used either to pay a dividend or to reduce debt, effectively reducing the purchase price of the company.

What is the difference between accounts payable and prepaid expenses?

Prepaid expenses are payments that have been made for products or services that will be delivered in the future. As the products or services are received they will be recognized as expenses on the income statement. Accounts payable is a liability for a good or service that has been received and recognized as an expense, but has not yet been paid for in cash.

What is the difference between public equity value and book value of equity?

Public Equity Value is the market value of a company's equity; while the book value is just an accounting number. A company can have a negative book value of equity if it has been taking large cash dividends, or running at a net loss; but it can never have a negative public Equity Value, because it cannot have negative shares or a negative stock price.

If Enterprise Value is $150mm, and Equity Value is $100mm, what is net debt?

Since Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest, if we assume there is no minority interest or preferred stock, then Net Debt will be $150mm - $100mm, or $50mm.

Should you use Enterprise Value or Equity Value with Net Income when calculating valuation multiples?

Since Net Income includes the impact of interest income and interest expense, you always use Equity Value.

How does depreciation affect the cash balance if it is a non-cash expense?

Since depreciation is an expense, it will reduce the amount of taxes a company will pay. Since taxes are a cash expense, anything that affects them—including depreciation—will affect the cash balance.

What does spreading comps mean?

Spreading comps is the process of calculating relevant multiples from a number of different comparable companies and summarizing them for easy analysis/comparison.

Why do you use 5 or 10 years for the "near future" DCF projections?

That's about as far as you can reasonably predict for most companies. Less than 5 years would be too short to be useful, and more than 10 years is too difficult to project for most companies.

How do you select Comparable Companies or Precedent Transactions?

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

What is the Capital Assets Pricing Model?

The Capital Assets Pricing Model, referred to as CAPM, is used to calculate the required return on equity or the cost of equity. The return on equity is equal to the risk free rate (usually the yield on a 10-year U.S. government bond) plus the company's beta (a measure of the stock's volatility in relation to the stock market) times the market risk premium.

What's the basic concept behind a Discounted Cash Flow analysis?

The concept is that you value a company based on the present value of its Free Cash Flows far into the future. You divide the future into a "near future" period of 5-10 years and then calculate, project, discount, and add up those Free Cash Flows; and then there's also a "far future" period for everything beyond that, which you can't estimate as precisely, but which you can approximate using different approaches.

Why might two companies with similar growth and profitability have different valuations?

The difference in valuation could reflect some sort of a competitive advantage that isn't represented on the financial statements. Perhaps the more valuable company is a market leader in a key region or owns uniquely valuable intellectual property or enjoys a significantly stronger management track record

Why is the Income Statement not affected by Inventory purchases?

The expense of purchasing Inventory is only recorded on the Income Statement when the goods associated with it have been manufactured and sold - so if it's just sitting in a warehouse, it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.

Walk me through the major lines of an Income Statement?

The first line of the Income Statement represents revenues or sales. From that, you subtract the cost of goods sold, which leaves a gross profit. Subtracting operating expenses, depreciation and amortization from gross profit gives you operating income. From operating income, you subtract interest expense and any other expenses (or add other income) to get pre-tax income. Then subtract Income Tax and what's left is net income.

What is the primary market and what is a secondary market?

The primary market is the market where a new stock or bond is sold the first time it comes to market. The secondary market is where the security will trade after its initial public offering or bond issuance.

Why do you project out Free cash flows for the DCF model?

The reason you project FCF for the DCF is because FCF is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company.

Where do you find the risk free rate?

The risk-free rate is usually the current yield on the 10-year government treasury, This is considered "risk-free"because the U.S. government is considered to be a risk-free borrower, meaning the government is expected never to default on its debt.

What are the three main Financial Statements?

The three main financial statements are the Income Statement, the Balance Sheet, and the Statement of Cash Flows. The Income Statement shows a company's revenues, costs, and expenses, which together yield net income. The Balance Sheet shows a company's assets, liabilities, and equity. The Cash Flow Statement starts with net income from the Income Statement; then it shows adjustments for non-cash expenses, non-expense purchases such as capital expenditures, changes in working capital, or debt repayment and issuance to calculate the company's ending cash balance.

What is the link between the balance sheet and the income statement?

There are many links between the Balance Sheet and the Income Statement. The major link is that any net income from the Income Statement, after the payment of any dividends, is added to retained earnings. In addition, debt on the Balance Sheet is used to calculate the interest expense on theIncome Statement, and property plant and equipment will be used to calculate any depreciation expense.

How do you calculate a firms terminal value?

There are two ways to calculate terminal value. The first is the terminal multiple method. To use this method, you choose an operation metric (most commonly EBITDA) and apply a comparable company's multiple to that number from the final year of projections. The second method is the perpetuity growth method where you choose a modest growth rate, usually just a bit higher than the inflation rate or GDP growth rate, and assume that the company can grow at this rate infinitely. You then multiply the FCF from the final year by 1 plus the growth rate, and divide that number by the discount rate(WACC) minus the assumed growth rate.

Why do you use Enterprise Value for Unlevered Free Cash Flow multiples, but Equity Value for Levered Free Cash Flow multiples? Don't they both just measure cash flow?

They both measure cash flow, but Unlevered Free Cash Flow (Free Cash Flow to Firm) excludes interest income and interest expense (and mandatory debt repayments), whereas Levered Free Cash Flow includes interest income and interest expense (and mandatory debt repayments), meaning that only Equity Investors are entitled to that cash flow

For Public Comps, you calculate Equity Value and Enterprise Value for use in multiples based on companies' share prices and share counts... but what about for Precedent Transactions? How do you calculate multiples there?

They should be based on the purchase price of the company at the time of the deal announcement. For example, a seller's current share price is $40.00 and it has 10 million shares outstanding. The buyer announces that it will pay $50.00 per share for the seller. The seller's Equity Value in this case, in the context of the transaction, would be $50.00 * 10 million shares, or $500 million. And then you would calculate its Enterprise Value the normal way: subtract cash, add debt, and so on.

Say I have an unknown item that belongs on the balance sheet. How would I be able to tell if it should be an asset or a liability?

Think of it this way. Will the line item result in the company receiving cash in the future, or will it result in the company needing to spend cash in the future? If it will result in an increase in cash in the future, then it is an asset. If it will result in a decrease in cash in the future, then it is a liability.

When would a company collect cash from a customer and not show it as revenue? if it isn't revenue, what is it?

This typically occurs when a company is paid in advance for future delivery of a good or service, such as a magazine subscription. If a customer pays for delivery of 12 months of magazines in advance, cash from that purchase goes onto the Balance Sheet as cash, but also increases deferred revenue, a liability. As each issue is delivered to the customer over the course of the year, the deferred revenue line item will go down, reducing the company's liability, while a portion of the subscription payment will be recorded as revenue.

Sum of the Parts

This valuation technique should be used if the company has multiple divisions with different margins, growth rates, etc. For example, one methodology you could use for a company like Apple would be to value each of their different businesses (iPhone, iPod, iPad, desktop, laptop, software, accessories, etc) on its own and then combine the values of all those divisions.

Cost of Equity tells us the return that an equity investor might expect for investing in a given company - but what about dividends? Shouldn't we factor dividend yield into the formula?

Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include Dividends.

When should a purchase be capitalized rather than expensed?

Typically any purchase that will be used for a long period of time (more than a year) will be categorized as a capital expenditure and will be capitalized on the balance sheet.

All else equal, should the WACC be higher for a company with $100 million of market cap or a company with $100 Billion of market cap?

Typically, a smaller company is expected to produce greater returns than a large company, meaning the smaller company is more risky and therefore would have a higher cost of equity.

How can I increase IRR?

Using more debt and less equity, increase FCF, paying a lower multiple, selling at a higher multiple, finding synergies between a platform and add-in/tuck-on, the industry is more appealing at end of holding period than the beginning, hiring very experienced management, moving the headquarters to a more tax-friendly environment.

What is valuation and what is it used for?

Valuation is the procedure of calculating the worth of an asset, security, company, etc. -This is one of the primary tasks that investment bankers do for their clients. Investment bankers are hired to value a company, often in the context of purchasing another company, selling itself or divesting a division. -Investment bankers use valuation in pitch books and other presentations to guide clients toward what they should expect.

What is WACC and how do you calculate it?

WACC is the acronym for Weighted Average Cost of Capital. It is used as the discount rate in a discounted cash flow analysis to calculate the present value of a company's cash flows and terminal value. It reflects the overall cost of a company's raising new capital, which is also a representation of the riskiness of investing in the company. Mathematically, WACC is the percentage of equity in the capital structure times the cost of equity (calculated by the Capital Assets Pricing Model) plus percentage of debt in the capital structure times one minus the corporate tax rate times the cost of debt—current yield on outstanding debt—plus percentage of preferred stock in the capital structure times the cost of preferred stock if there is any preferred stock outstanding.

When calculating enterprise value, do you use the book value or the market value of equity?

When calculating a company's Enterprise Value, you use the market value of the equity because that represents the true supply-demand value of the company's equity in the open market

Could a company have a negative book Equity Value?

Yes, a company could have a negative book Equity Value if the owners are taking out large cash dividends or if the company has been operating for a long time at a net loss, both of which reduce shareholders' equity.

Evaluate this example of Goodwill: Company A Buys company B for $100 million in cash. Company B has one asset, which is a factory with a book value of $75 million, debt of $25 million, and equity of $50 million which equals the book value (Assets-Liabilities).

•Company A's cash balance declines of $100 million to finance acquisition (cost of the acquisition) •Company A's PP&E increases by $75 million (book value of Company B's factory) •Company A's debt increases by $25 million (Company B's acquired debt) •Company A's goodwill increases $50 million (purchase price of Company B minus book value of equity in Company B

What is a deferred tax liability and why might one be created?

•Deferred tax liability is a tax expense amount reported on a company's income statement not actually paid in that time period, but expected to be paid in the future. This occurs when a company pays less in taxes to the government than they show as an expense on their income statement. •This can be caused due to differences in depreciation expense between book reporting (GAAP) and tax reporting. This will lead to differences in tax expense reported in the financial statements and taxes payable to the government.

How is it possible for a company to show positive net income but go bankrupt?

•High capital expenditure requirements for replacement or repair of existing property, plant and equipment •Debt maturities that the company cannot afford to repay or refinance •Seasonal swings in working capital

What's the point of that "Changes in Operating Assets and Liabilities" section? What does it mean?

All it means is that if Assets are increasing by more than Liabilities, the company is spending cash and therefore reducing its cash flow, whereas if Liabilities are increasing by more than Assets, the company is increasing its cash flow.

What is IRR?

Internal rate of return; what discount rate is required to make the net present value of all cash uses/sources equal to 0.

Where does Depreciation usually appear 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 - each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

If cash collected is not recorded as revenue, what happens to it?

It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services or products are delivered, the Deferred Revenue balance turns into real revenue on the Income Statement and the Deferred Revenue balance decreases.

How do you value a private company?

You can value a private company with the same techniques you would use for a public company but with a few differences that make it more difficult. Financial information will likely be harder to find and potentially less complete and less reliable. Second, you can't use a straight market valuation for a company that isn't publicly traded. In addition, a DCF can be problematic because a private company won't have an equity beta to use in the WACC calculation. Finally, if you're doing a comps analysis using publicly traded companies, a 10-15% discount may be required as a 10-15% premium is paid for the public company's relative liquidity.

Is there a valid reason why we might sometimes project 10 years or more anyway?

You might sometimes do this if it's a cyclical industry, such as chemicals, because it may be important to show the entire cycle from low to high.

What happens to Free cash flow if net working capital increases?

You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa.

How are the three main financial statements connected

a) Always start with the Income Statement. We work our way from Revenue all the way down to Net Income. b) Net Income, fortunately, is the first line item on the SCF in the CFO section. From here we can work our way through CFO, adjusting for any items as necessary (determined by the income statement and balance sheet), and ultimately determine the change in cash over the period. c) Now that we have the change in cash, we can use this to determine the new cash balance on the balance sheet. We need to make the other required adjustments (such as depreciation and PP&E or asset sales) throughout the balance sheet. d) To make the balance sheet balance, we need to remember to add our Net Income into the Retained Earnings account. This will make the balance sheet balance.