Technical IB

How do you value a company?

Intrinsic value (discounted cash flow valuation), and Relative valuation (comparables/multiples valuation).

What is typically higher- the cost of debt or the cost of equity?

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax-deductible, creating a tax shield. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation.

Why is the Discount Rate higher for stock-market investments than it is for Debt investments, such as money lent to others?

The stock market offers higher potential returns, but also greater risk, and annual returns tend to fluctuate far more than returns on Debt; interest rates on Debt are usually fixed or vary only within a specific range.

Which of the following factors AFFECT the IRR of an investment?

the expected future cash flow and cash flow growth rate. The upfront "asking price." The expected selling price. ince the IRR is based on the amount you pay upfront, the cash flows the investment generates afterward, and the selling price at the end, these three factors all affect it.

What is WACC?

weighted average cost of capital (WACC)

What is goodwill? How does it affect net income?

"Goodwill" on a company's balance sheet represents value that the company gained when it acquired another business but that it can't assign to any particular asset of that business. Goodwill doesn't always affect a company's net income, but if that goodwill becomes "impaired," the effect can be substantial. Goodwill impairment occurs when a company decides to pay more than book value for the acquisition of an asset, and then the value of that asset declines. The difference between the amount that the company paid for the asset and the book value of the asset is known as goodwill

Walk me through the three major financial statements

"The three financial statements are the income statement, balance sheet, and statement of cash flows. The income statement is a statement that illustrates the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year. Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity. Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating. Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year."

A company will generate $300 of cash flow next year, and its cash flow is expected to grow at 5% per year for the long term. You could earn 12% per year by investing in other, similar companies. How much would you pay for this company?

$4,286. Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), so this one becomes: $300 / (12% - 5%) = $4,286. Remember that a higher Discount Rate makes a company less valuable, and a higher cash flow growth rate makes a company more valuable. The third answer is incorrect because 12% here *is* your targeted yield since you could earn that percentage by investing in other, similar companies.

Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk. Company A is trading at a 15 P/E multiple, while the other trades at 10 P/E. which would you prefer as an investment?

10 P/E: A rational investor would rather pay less per unit of ownership.

If you had to evaluate a business based on just 2 of the company's financial statements, which two would you choose?

Balance sheet and income statement. If you have both the year beginning and year-end account balance values, along with the income statement, you can reproduce the cash flow statement.

Why are Losses on Asset Sales considered non-cash expenses that you add back on the Cash Flow Statement?

Because as long as you've *sold something* in the current period, then you have not lost money *in the current period*. Because a "Loss" just means that you've sold the Asset for less than the purchase price in a prior period. Because non-cash adjustments are based on what happens *in the current period* only.

Deferred Revenue reflects Cash that we've already collected upfront for a product/service we haven't delivered yet. Why is it a Liability? That's great for us!

Because unlike with Assets, Deferred Revenue will *not* generate future cash flow, and the burden is on us to deliver the product or service (and pay for it).

Why is money today worth more than it is next year?

Because you could invest it today and earn more by next year.Money is worth more today than it is tomorrow or next year because you could invest it today and earn more by that future date. Inflation does not always exist - sometimes there is deflation - and it's not the MAIN reason for the time value of money. Interest rates are not necessarily "very low" all the time, and low interest rates mean that money is *not* worth quite as much more today (since you will earn less by investing it).

our friend has a brilliant new investment idea: He wants to acquire local laundromats. He claims that laundromats are low-risk, low-capital businesses, and that you can easily earn 15% per year on your investment. How can you decide whether or not to make an investment?

Compare this 15% estimated annual return to what you could earn elsewhere - with similar risk levels.o evaluate an investment, you have to compare the projected returns to what you could earn on other, similar investments with similar risk levels. For example, if you could earn 20% elsewhere with the same amount of risk, then this opportunity doesn't make sense. But if you could earn only 7% elsewhere with the same risk level, this opportunity makes more sense. It *is* possible to earn more than the long-term average stock-market return, so the third answer choice is false.

Which of the following statements are CORRECT advantages and disadvantages of using Equity vs. Debt to fund a business?

Debt is generally cheaper than Equity because after-tax interest rates on Debt tend to be lower than equity investors' returns expectations, but most Debt also comes with covenants that restrict a company's debt levels and financial ratios. Issuing Equity dilutes existing shareholders, making the company less valuable to them, but Debt does not affect them at all. The third answer is wrong because additional Equity will increase the company's Shares Outstanding and the EPS figure on its Income Statement.

How can you tell whether or not an item should appear on the Cash Flow Statement?

If it has already appeared on the Income Statement and affected Net Income, but it is *non-cash*. If it has *not* appeared on the Income Statement, but it *does* affect the company's cash flow and Cash balance. Examples of items in the first category are Depreciation & Amortization; items in the second category include CapEx, Dividends, and Equity and Debt issuances

A company begins offering 12-month installment plans so that customers can pay evenly over each month in a year rather than 100% upfront. How will its cash flow change?

In the short term, the company's cash flow will decrease because some customers will take more time to submit cash payments. In the long term, the impact depends on how much the company's sales grow vs. the percentage of customers that take advantage of these plans. In the near term, the company's cash flow will decrease because fewer customers will pay upfront in cash, which boosts the company's Accounts Receivable and reduces its cash flow. It is unlikely that sales will grow enough in the short term to offset this change. In the long term, however, the company's cash flow might improve if the company's revenue and operating income increase substantially - in that case, Net Income would increase (cash flow increase), more than offsetting the increase in Accounts Receivable (cash flow decrease). But the impact depends on which change is bigger, so you can't say that cash flow will increase or decrease.

How might you project Inventory differently in a quarterly financial model rather than a standard annual model?

Inventory can still be a percentage of COGS, but you must link it to the company's LTM or annualized COGS in each period. Balance Sheet line items in a quarterly model must be linked to *annualized* or LTM Income Statement figures because they are influenced by more than just the company's performance in one quarter. The second answer isn't correct because it doesn't make sense to use "annual" COGS, as in COGS in the last fiscal year, for Inventory this quarter. You should use an annualized or LTM figure to reflect the company's recent performance. The last answer is incorrect because you can use Days Inventory Outstanding in either type of model.

Which of the following conditions must be true for an expense to appear on the Income Statement?

It must correspond to the current period. It must be tax-deductible (for book purposes). define Income Statement expenses: Expenses on the IS must correspond to the CURRENT period, and they must affect the company's taxes. These rules explain why Debt principal repayment, for example, does NOT appear on the Income Statement - it is related to the current period, but it is NOT tax-deductible. But with Interest Expense, both of those conditions are true, so Interest Expense DOES appear on the Income Statement. The first answer is false because Depreciation is a non-cash expense that always appears on the Income Statement. The last answer is false because Gains and Losses appear on the Income Statement, but they are not operational in nature.

Your company plans to shift a portion of employee compensation from salaries to stock, options, and restricted stock units (RSUs). How will this Stock-Based Compensation affect the company's financial statements?

It will boost the company's Cash Flow from Operations, but also make the company less valuable to existing equity investors. The first answer choice is correct: Stock-Based Compensation appears on the Income Statement as a tax-deductible expense, but you add it back on the Cash Flow Statement since it is non- cash. Therefore, it boosts the company's Cash Flow from Operations, just like Depreciation does. HOWEVER, unlike other non-cash expenses such as D&A, SBC increases the company's share count, diluting existing investors and making the company less valuable to them. The other answers here are wrong (SBC doesn't affect CFF immediately after it is issued) or incomplete.

How can you tell whether an item should be an Asset, a Liability, or an Equity line item on the Balance Sheet?

Items that will generate future cash flow for the company, directly or indirectly, should be Assets. Items that will reduce the company's future cash flow and which cannot be sold should be Liabilities. Items that represent funding sources for the company *without* explicit future cash costs (in most cases) should be listed within Equity. An Asset is something that will generate future cash flow, or that can be sold for Cash; a Liability is the opposite. Equity items are similar to Liabilities because they act as funding sources, but they do not incur future cash costs (with some exceptions, such as Preferred Stock with a fixed coupon rate or a company with required Dividend payments). This distinction is not about revenue or expense collection because plenty of expense-related items are Assets (e.g., Prepaid Expenses) and plenty of revenue-related items are Liabilities (e.g., Deferred Revenue).

Which of the following steps are part of the process when you link the financial statements?

Make Net Income from the bottom of the Income Statement the top line of the Cash Flow Statement. Adjust Net Income for non-cash items such as Depreciation & Amortization. Reflect changes in operational Balance Sheet items, such as Accounts Receivable and Inventory. Factor in the company's investing and financing activities and sum up Cash Flow from Operations, Investing, and Financing to get the Net Change in Cash at the bottom of the Cash Flow Statement. Make Cash on the Balance Sheet the ending Cash number on the CFS. Make Retained Earnings on the Balance Sheet equal to Old Retained Earnings + Net Income - Dividends (if the company issues Dividends).

A mining company based in North America wants to expand into Turkmenistan by acquiring a promising mineral deposit there. The company's overall WACC is 12%, but its WACC in Central Asia is 30%. It believes the IRR from this new project will be 25%. Should it expand into Turkmenistan?

No. The IRR is below the region-specific WACC. You must compare IRR to WACC on a project or region-specific basis. The WACC for the company as a whole doesn't matter because the risk is greater in a country like Turkmenistan than it is in the U.S., Canada, or even Mexico.

A company's Change in Working Capital as a percentage of the Change in Revenue has been positive 5-10% over the past 3 years. Over the next 5 years, it is projected to increase to 20%. Is this assumption incorrect?

Not necessarily - the company's business model might change over time.If something changes in the company's business model, such as more upfront cash collection, it might make sense for the Change in Working Capital to become more positive over time. The other answers are all incorrect because they are generalizations that are not necessarily true in all scenarios. For example, if a company's business model requires significant upfront investment in Inventory, its Change in WC might become more negative as the company grows.

How are Prepaid Expenses, Accounts Payable, and Accrued Expenses different?

Prepaid Expenses have already been paid in Cash, but have not been incurred as expenses. Accounts Payable have not yet been paid in Cash, but have been incurred as expenses. Accounts Payable and Accrued Expenses work similarly on the financial statements, but Accounts Payable tends to be for specific items with invoices rather than monthly, recurring expenses

What does the internal rate of return (IRR) mean?

The IRR is the Discount Rate at which the Net Present Value (NPV) of an investment is 0. The IRR is the "the effective compounded interest rate on an investment." If you invest $1,000 today and end up with $2,000 after five years, the IRR represents the interest rate you'd have to earn on that $1,000 each year (compounded) to end up with $2,000 in 5 years.

You are analyzing an airline company in the U.S. and comparing it to peer companies in the U.K. and Germany. How are the financial statements of each company MOST likely to be different?

The companies in the U.K. and Germany most likely begin their Cash Flow Statements with something *other* than Net Income. There may be minor naming differences, such as "Statement of Financial Position" instead of "Balance Sheet." ompanies outside the U.S. tend to use the *Direct Method* - recording Cash Received and Cash Paid - for their Cash Flow Statements, or they tend to start their Cash Flow Statements with Operating Income, Pre-Tax Income, or something other than Net Income. There are also minor naming differences, but the Income Statement and Balance Sheet tend to be similar in all regions. The last answer is false because Interest is tax- deductible and Dividends are not tax-deductible in most regions of the world, including the ones described here.

A company mentions that it will start to collect cash payments from customers for a monthly subscription service a year in advance. What will be the cash flow impact of this practice?

The company's cash flow will increase because this practice will boost its Deferred Revenue. collecting cash payments before a product or service has been delivered corresponds to Deferred Revenue, and an increase in Deferred Revenue means that a company's cash flow also increases. This change has nothing to do with Accounts Receivable (AR is the opposite situation, where the customers do *not* pay upfront) or expenses, so the other answer choices are wrong.

Which of the following is the MOST LIKELY sign that your expense and margin assumptions in a 3-statement projection model are incorrect?

The company's variable expenses stay about the same, but its fixed expenses keep growing as its revenue increases.ariable expenses are linked to the company's revenue, so they should increase as revenue increases. Fixed expenses often increase as well, but they don't necessarily trend exactly with revenue. The first answer is not necessarily wrong because changes in a company's business model might explain this margin increase.

How do you calculate the cost of equity?

The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model (CAPM).here are several competing models for estimating the cost of equity, however, the capital asset pricing model (CAPM) is predominantly used on the street. The CAPM links the expected return of a security to its sensitivity the overall market basket (often proxied using the S&P 500). The formula is: Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf )

What's the advantage of projecting Accounts Receivable based on Days Sales Outstanding (DSO) in an annual model instead of making it a percentage of Revenue?

There's no numerical advantage, but other people often understand DSO more intuitively than AR / Revenue.Projecting AR based on Days Sales Outstanding produces the same numerical results, and the trend lines should also be the same since the underlying drivers (AR and Annual Revenue) are the same. However, it's often easier to explain DSOsince it represents the average number of days required to collect receivables from customers. The third answer is wrong because seasonality doesn't factor into an annual model.

How do you leverage a company's cash flow?

To find a company's cash flow leverage, divide operating cash flow by total debt. For example, if operating cash flow is $500,000 and total debt is $1,000,000, the company has a cash flow leverage ratio of 0.5. The higher the ratio is, the better position the company is in to meet its financial obligations

Can you walk me through a DCF model?

Walk me through a DCF Step 1 - Build a forecast The first step in the DCF model process is to build a forecast of the three financial statements, based on assumptions about how the business will perform in the future. On average, this forecast typically goes out about five years. Of course, there are exceptions and it may be longer or shorter than this. Walk me through a DCF Step 2 - Calculate the Terminal Value We continue walking through the DCF model by calculating the terminal value. There are two approaches to calculating a terminal value: perpetual growth rate and exit multiple. Walk me through a DCF Step 3 - Discount the cash flows to get the present value In step 3 of this DCF walk-through, it's time to discount the forecast period (from step 1) and the terminal value (from step 2) back to the present value using a discount rate. The discount rate is almost always equal to the company's weighted average cost of capital (WACC). At this point, we've arrived at the enterprise value for the business, since we used unlevered free cash flow. It's possible to derive equity value by subtracting any debt and adding any cash on the balance sheet to the enterprise value. an investment banking analystwill typically perform extensive sensitivity and scenario analysis to determine a reasonable range of values for the business, as opposed to arriving at a singular value for the company.

Why do we need the three financial statements in the first place? Why can't we just track a company's revenue and expenses?

We need the three financial statements primarily to track the company's real cash flow and to determine how its Cash, Debt, and Working Capital change over time. The first answer choice corresponds to Accounts Receivable, the second one corresponds to Accrued Expenses and Accounts Payable, and the third choice corresponds to CapEx and Equity and Debt issuances and repayments.

When does it make sense to invest in a company or asset?

When its asking price is below its intrinsic value and when the potential returns exceed your opportunity cost. You invest when the company's current "asking price" or market value is below its "intrinsic value," as determined by the Present Value of its future cash flows (e.g., a stock trades at $10, but its intrinsic value is $15). The second answer choice refers to an investment where the IRR exceeds the Discount Rate, which implies the same state: The asking price is below the intrinsic value.

What are the three valuation methods?

When valuing a company as a going concern, there are three main valuation methods used by industry practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent transactions

In a 3-statement projection model, Depreciation is 3% of Revenue each year, and CapEx is 6% of Revenue. How can you tell whether or not these assumptions are reasonable?

You can check these percentages against the company's historical performance, other peoples' forecasts, and other metrics from the company. For example, there should be some relationship between CapEx growth and Revenue growth - companies invest in capital assets to grow their sales over time.

What's the point of projecting a company's financial statements?

You project a company's financial statements to assess potential Debt or Equity investments in the company and to value the company on a standalone basis. There are other reasons to create projections as well, but those are some of the most common ones.

How do you "value" yourself? Here "value" means in financial terms

https://www.schwabmoneywise.com/public/moneywise/essentials/personal_net_worth

In which of the following scenarios is it MOST appropriate to project a company's revenue based on Market Share * Market Size rather than Units Sold * Average Unit Price?

if the company operates in a huge market with 2-3 major competitors, where each company owns 20-30% of the market. Market Size is best when several companies dominate a market, and it's easy to find information on the total market size and the share of each company in it. It's less appropriate for the third case because market share means little in a highly-fragmented market, and it would be tough to find the information. The first answer is wrong because it's feasible to use Units Sold * Average Unit Price even for 3-4 product lines rather than 1-2; it would be less feasible if the company had 20-30 different product lines.

How much would you pay for a company that generates $100 of cash flow every single year into eternity?

it depends on your Discount Rate, or "targeted yield." if your targeted yield is 10%, you would pay $100 / 10%, or $1,000, for this company. But if your targeted yield is 20%, you would pay only $100 / 20%, or $500, for this company. The second answer is wrong because the question stated that there is no growth. While the statement in the fourth answer is correct, it's not the best answer because the MAIN POINT of the question is that a company's value *to you* depends heavily on your other investment options.

Which of the following factors would make the IRR of an investment INCREASE?

its future cash flows are expected to grow at a faster rate and he investment's expected future selling price increases. ince IRR is based on the price you pay today, the cash flows you earn afterward, and the selling price of the investment, higher cash flow growth and a higher selling price would both increase the IRR.

Explain gamma to me as you would explain it to your grandmother.

the rate of change in an option's delta per 1-point move in the underlying asset's price. Gamma is an important measure of the convexity of a derivative's value, in relation to the underlying. A delta hedge strategy seeks to reduce gamma in order to maintain a hedge over a wider price range. A consequence of reducing gamma, however, is that alpha will also be reduced.