IB Intermediate Technicals
What is beta?
Beta is a measure of the volatility 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 less than 1. A beta of 1.2 means that an investment theoretically will be 20% more volatile than the market. If the market goes up 10%, that investment should go up 12%.
If the stock market falls, what would you expect to happen to bond prices and yields
When the stock market falls, investors flee to safer securities, like bonds. This increases the demand for those securities and therefore raises their price. Since prices and yields move inversely, if bond prices rise, their yields will fall. In that case, the government may lower interest rates in an attempt to stimulate the economy.
What is correlation?
Correlation is the way that two investments move in relation to one another. If two investments have a strong positive correlation, they will have a correlation near 1 and when one goes up or down, the other will do the same. When you have two with a strong negative correlation, they will have a correlation near -1 and when one investment moves up in value, the other should move down
What are some ways to determine the extent to which a company poses a credit risk?
Determining the credit risk of a company takes an incredible amount of work and research. However, some quick checks can include credit ratings from Moody's and Standard and Poor's, the current ratio, quick ratio, interest coverage ratio, leverage ratio, and debt to equity ratio, compared to those of similar companies in the same industry
Where do you think the stock market will be in 3/6/12 months
I think the steady increase in the federal funds rate is going to slowly drive the stock market down into a recession. The recession won't be as devastating to the economy, hopefully, as the 2008 financial crisis, but it will be prolonged as inflation & the markets take time to react.
If a company with a highly levered capital structure were attempting to execute a large dividend recap (which may or may not create a negative shareholders equity balance), what might a debt holder do to enforce any protections he/she has as a debt investor
If a company has a highly levered capital structure, the legal documents governing the debt financing will generally limit the amount of total leverage (or indebtedness) that could be incurred by the company. These limits are called negative covenants, and will also be so specific as to clarify how much debt could be incurred that is senior to the existing debt in the capital structure and how much could be junior debt in the capital structure.
In what scenario could a company have negative shareholders equity?
If a company has had negative net income for a long time, it would have a negative retained earnings balance, which would lead to negative shareholders equity. A leveraged buy-out could have the same effect, and so would a large dividend payment to the owners of the business.
If a company's cash flow fluctuates greatly from year to year, which financing source is most appropriate for it?
"Anything that lacks maintenance covenants" is the best answer here. But, more specifically, it depends on how much the company's cash flow fluctuates. If the fluctuations are moderate, and the company never moves into crazy territory with its credit stats and ratios (e.g., nothing like 15x Debt / EBITDA), then it may be able to issue Senior Notes or Subordinated Notes, which have higher interest rates than Term Loans but which lack maintenance covenants. But if the company's cash flows are so unstable that it can't maintain reasonable leverage or coverage ratios, then it will have to use more Equity and possibly skip Debt altogether.
What is amortization?
Amortization is a feature that may be built into a loan requiring the borrowing company to pay off the loan over its term rather than paying the entire face value at maturity. Each payment period, the company pays its lenders the interest payment and a portion of the loan's face value. Since the pay down of face value reduces the amount outstanding, interest payments will grow successively smaller
Why pay in stock versus cash?
If a company pays in cash, those receiving it will have to pay taxes on it. Additionally, if the owners of the company being acquired want to be a part of the new company, they may prefer stock if they believe the new company will perform well and the stock will increase in value. Current market performance may also affect the stock/cash decision. However, if the market is performing poorly, or is highly volatile, the company being acquired may prefer cash for the stability it provides.
How would you calculate the discount rate for an all-equity firm
If a firm is all equity, then you would use CAPM to calculate the cost of equity, and that would be the discount rate
What will happen to the price of a bond if the fed raises interest rates?
If interest rates rise, newly issued bonds offer higher yields to keep pace. This makes existing bonds with lower coupon payments less attractive, and their price must fall to raise the yield enough to compete with the new bonds
How are convertible bonds accounted for in calculating enterprise value?
If the convertible bonds are "in the money" meaning the conversion price is below the current market price, then you account for the bonds as additional dilution to the Equity Value. However, if the bonds are out of the money, then you would account for them as debt at their face value.
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 -Macroeconomic conditions may cause a temporary decline in financial performance, which could ultimately lead to a breach of a financial covenant of an existing bank loan, creating an event of default -Highly punitive fixed cost structures, typically facilitated by long-term, unprofitable leases and unionized employee base
How does a company decide on the amount of capital to raise in an IPO?
-It depends on the reason why the company is going public: If it needs capital for a specific purpose, such as making an acquisition, paying down debt, or buying a factory, it will aim to raise that amount of capital. -But if the company is going public to provide existing investors with an exit and liquidity, it often raises capital such that it sells a certain percentage of the company (often between 20% and 40%). T=he company wants to offer enough new shares to make investors committed to the company, but not so many that it gives up contro
How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?
A $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT (1-T) by$10(1-T). Assuming a 40% tax rate, it drops EBIT (1-T) by $6, but you must add back the $10 depreciation in the calculation of Free Cash Flow. Therefore your FCF increases by $4 and your valuation will increase by the present value of that $4.
Why might a company issue a convertible bond rather than traditional debt or equity?
A Convertible Bond is a compromise solution that lets companies borrow more cheaply than they could with traditional debt - but with possible share dilution in the future if the bonds convert into shares. A company might issue a Convertible Bond if debt is cheaper than equity for the company, but it has trouble meeting its targeted credit stats and ratios with a normal debt issuance. Also, the company must be in an appropriate industry and at the right growth stage. High-risk, high-growth companies in industries such as technology and biotech tend to issue Convertible Bonds more often than those in other industries.
What is a eurodollar bond?
A Eurodollar bond is one issued by a foreign company (not just European companies) but in U.S. Dollars rather than the home currency.
Who is a more senior creditor, a bondholder or stockholder?
A bondholder is always senior to a stockholder. In the event of bankruptcy/liquidation, the bondholder will be repaid first. Additionally, interest payments are paid to bondholders before equity holders receive any profits in the form of dividends.
What is a callable bond?
A callable bond allows the issuer of the bond to redeem the bond prior to its maturity date, thus ending coupon payments. However, a premium is usually paid by the issuer to redeem the bond early.
When should a company issue debt instead of equity?
A company will normally prefer to issue debt because it is cheaper than issuing equity. In addition, interest payments are tax deductible and therefore provide tax shields. However, a company has to have a steady cash flow to make coupon payments, whereas that is not necessary when issuing equity. A company may also try to raise debt if it feels its stock is particularly undervalued such that an equity offering would not raise the capital needed.
Describe a company's typical capital structure
A company's capital structure is made up of debt and equity, and there may be multiple levels of each. Debt can be senior, mezzanine, or subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior debt is most secure and will be paid off first in bankruptcy, it offers the lowest interest rate. The most senior debt is bank loans; the rest is bonds, which can be issued to the general public. Equity is either preferred or common stock. Preferred stock combines some features of both debt and equity: it can appreciate in value, and also pays out a consistent dividend but it has very little or no rights in a bankruptcy. Common stock is traded on the exchanges, if the company is public. In the event of bankruptcy, common stockholders have the least claim to assets in the event of liquidation, and therefore they bear the highest level of risk and earn the highest return on investment. Common shareholders are the company's owners and are entitled to profits, which may be reinvested in the business or paid as dividends
What would cause a company's credit rating to change?
A company's credit rating might change if its credit statistics, such as Debt / EBITDA or EBITDA / Interest, improve or worsen significantly, or its qualitative risk factors change. For example, if peer companies with "BB+" credit ratings have Debt / EBITDA between 4x and 5x, and the Debt / EBITDA of the company you're analyzing suddenly jumps to 6x, rating agencies will be likely to downgrade the company. But even if a company's financial stats stay the same, its credit rating might decline if its industry experiences a downturn, a major new competitor enters, or the growth outlook falls.
What is a convertible bond?
A convertible bond can be "converted" into equity during the bond's lifetime. Therefore, the bond can be converted before maturity should the bondholder decide that equity in the company is worth more than the bond.
What are covenants?
A covenant is a requirement included in the legal documents governing a bond or loan. The company must comply with these requirements during the life of the bond or loan in order to avoid a default.
What is a perpetual bond?
A perpetual bond is a bond that simply pays a coupon payment indefinitely (or until the company goes into default) and never returns a principal amount.
How would you value a perpetual bond that pays a $1,000 coupon per year?
A perpetual bond is one that pays coupon payments regularly for eternity, with no repayment of principal (par value). The value of the bond will be coupon payment divided by the current interest rate. If the interest rate on comparable bonds were 10%, a bond paying a $1,000 coupon would be $1,000/10% or $10,000
What is the significance of primary vs secondary shares in an IPO or follow-on?
A primary offering occurs when new shares are issued by the company in an equity offering. They dilute the company's existing investors by reducing their ownership stake, but they also allow the company to raise capital. Secondary shares are existing shares sold to new investors in the offering. They do not dilute existing investors at all, but the company also receives no cash from them
What is a put bond?
A put bond is essentially the opposite of a callable bond. A put bond gives the owner of bond the right to force the issuer to buy back the security (usually at face value) prior to maturity.
What is a stock swap
A stock swap is when a company purchases another company by issuing new stock of the combined company to the former owners of the company being acquired, rather than paying in cash.
What are swaps?
A swap is an agreement to exchange future cash flows for a set period. The best known recent "swap" has been the credit default swaps issued by banks as a kind of insurance against companies not being able to repay their debt
What is a tender offer?
A tender offer is often a hostile takeover technique. It occurs when a company or individual offers to purchase the stock of the target company for a price usually higher than the current market price in an attempt to take control of the company without management approval.
Which is riskier, a 30-year coupon bond or a 30-year zero-coupon bond?
A zero-coupon bond will yield $0 until its date of maturity, while a coupon bond will pay out some cash every year. This makes the coupon bond less risky since even if the company defaults prior to the bond's maturity date, you will have received some payments with the coupon bond
What could a company do with excess cash on its balance sheet?
Although it seems like having a lot of cash on hand might be a good thing, especially in a recession, it really isn't, because there is an opportunity cost to holding cash. A company should have enough cash to protect itself from bankruptcy in a downturn, but any excess cash should be put to work. The company could pay a dividend to its equity holders or bonuses to employees, although a growing company will tend to reinvest rather than pay out cash. It can reinvest its cash in plants, equipment, personnel, or marketing; it can pay off debt, repurchase equity, or buy out a competitor, supplier, or distributor. If nothing else, that cash can earn a little something invested in CDs until it can be put to better use.
What should an investor buy preferred stock?
An investor should buy preferred for the upside potential of equity while limiting risk and assuring stability of current income in the form of a dividend. Preferred stock's dividends are more secure than those from common stock, and owners of preferred stock enjoy a superior right to the company's assets, though inferior to those of debt holders, should the company go bankrupt.
How can a company raise its stock price?
Any positive news about the company can potentially raise the stock price. If the company repurchases stock, it lowers the shares outstanding and raises the EPS, which would raise the stock price. A repurchase is also seen as a positive signal in the market. A company could announce operational efficiencies or other cost-cuts, or a change to its organizational structure such as consolidations. It could announce an accretive merger or acquisition that would increase earnings per share. Any of these occurrences would most likely raise the company's stock price.
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?
Because it's 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.
Why are ratios such as debt/EBITDA and EBITDA/interest important even if a company's debt has no maintenance covenants?
Because lenders and rating agencies still judge a company based on these metrics, even if the company is not "required" to keep them above or below certain levels. For example, rating agencies often establish credit rating "bands" of Debt / EBITDA ratios (e.g., investment- grade companies might have Debt / EBITDA below 2x) and use them as guidelines to determine the ratings. Also, some Debt investors become unwilling to invest in a company's Debt beyond certain thresholds. For example, Term Loan investors might go up to 2x Debt / EBITDA, and Senior Note investors might go up to 3- 4x Debt / EBITDA. But if the company wants to raise Debt beyond those levels, it will have to consider sources like Subordinated Notes or Mezzanine.
What is diversification?
Diversification is creating a portfolio of different types of investments. It means investing in stocks, bonds, alternative investments, etc. It also means investing across different industries. If investors are properly diversified, they can essentially eliminate all unsystematic risk from their portfolios, meaning that they can limit the risk associated with individual stocks so that their portfolios will be affected only by factors affecting the entire market.
Would I be able to purchase a company at its current stock price?
Due to the fact that purchasing a majority stake in a company will require paying a control premium, most of the time a buyer would not be able to simply purchase a company at its current stock price.
Why do companies offer pricing discounts in IPOs
Even if a company believes its shares are worth $100.00, it usually lets new investors in an IPO purchase them at a discount of ~15% (so, $85.00 here) because those investors assume significant risk by purchasing the shares before the company is a publicly traded entity. Anything could happen between pricing and the first few minutes of trading - the company's share price might plunge by 20%, for example. To compensate investors for that risk, companies offer this discount.
What factors influence the price of an option?
Factors affecting option prices include current stock price, exercise price, volatility of the stock, time to expiration, interest rate, and dividend rate of the stock
How might you determine the numbers for revenue growth, margins, and CapEx in downside cases of a credit model?
First, you could look at the company's historical performance in recessions and see how its growth and margins have fallen and how its CapEx spending has changed when the economy has contracted. You could also look at peer companies that have not performed well and see how much their growth and margins have declined. Finally, you also have to consider the company's industry and maturity. A mature retailer with high fixed costs and inventory could easily crash and burn if demand falls, while a professional services company could adapt more smoothly by reducing its headcount.
What is a floating interest rate?
Floating rate interest is typically seen on bank loans when a bank makes a loan to a company at a rate that will move with interest rates. The loan's rate typically is LIBOR plus a certain spread based on the default risk of the borrower.
What kind of investment would have a negative beta?
Gold is an investment that has a negative beta. When the stock market goes up, the price of gold typically declines as people flee from the "safe haven" of gold. The opposite happens when the market goes down, indicating a negative correlation
What is goodwill and how does it affect net income?
Goodwill is an intangible asset included on a company's Balance Sheet. Goodwill may include things like intellectual property rights, brand name, or customer relations. Goodwill is acquired when purchasing a firm if the acquirer pays more than the book value of its assets. When something occurs to diminish the value of the intangible assets, goodwill must be "written down" in a process much like that for depreciation. Goodwill is subtracted as a non-cash expense and therefore reduces net income
How would you value a company with no revenue?
In order to value a company with no revenue, such as a start up, you must project the company's cash flows for future years and then construct a discounted cash flow model of those cash flows using an appropriate discount rate. Alternatively, you could use other operating metrics to value the company as well. If you took a start-up website with 50,000 subscribers, but no revenue, you could look at a similar website's value per subscriber and apply that multiple to the website you are valuing
How could inflation hurt creditors?
Inflation can severely injure creditors. Creditors assign interest rates based on the risk of default as well as the expected inflation rate. Creditors lending at 7% with inflation expected at 2%, are expecting to make 5%. But if inflation actually increases to 4%, they are only making 3%.
If I buy a piece of equipment; walk me through the impact on the 3 financial statements
Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement). Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement).
What is insider trading and why is it illegal?
Insider trading is buying or selling stock based on information that is not publicly available. For example, if a CEO of a pharmaceutical company knows that one of his or her company's drugs is going to be pulled from the shelves by the FDA, that CEO cannot sell his or her stock until the information has been released to the public.
If you add a risky stock to a portfolio, what happens to the overall risk of your portfolio?
It depends on the correlation between the new investment and the rest of the portfolio. It could lower the overall risk of the portfolio if the new stock has a negative correlation compared to the rest of the portfolio.
A stock is trading at $5 and a stock is trading at $50, which has greater growth potential?
It depends. The stock with the higher growth potential is most likely the stock with the lower market cap, so if the $5 stock has 1 billion shares outstanding and the $50 stock has 10,000 shares outstanding, the $50 stock would most likely have higher growth potential.
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 decreases by $6, keeping everything in balance.
If the U.S. dollar weakens, should U.S. interest rates generally rise, fall, or stay the same?
Most times, when the U.S. dollar weakens, the price of imported goods will rise, causing higher inflation. This in turn puts pressure on The Fed to raise interest rates. So if the dollar weakens, U.S. interest rates should generally rise.
If you owned a small business and a larger company came to you offering an acquisition, how would you think about the offer and whether or not to take it?
Obviously, the higher the price the better, but there are a couple other things to think about as well. Are you getting paid in cash or stock? Cash is great because it is tangible and you can spend it now, but you also pay taxes on it right away. Stock you only pay taxes on when you sell and your stock can be worth more if the acquirer increases in value. However, this can also work the opposite way if the acquirer falls in value. Also think about what the acquirer's plans are for you as an owner. Are you going to continue running the business? Do you want to? The answer to these questions all depends on your personal preferences and what stage of life you are at.
What is the capital assets pricing model?
Re = Rf + B (Rm - Rf) 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.
If an option is "in the money" what does that mean?
When an investor exercises an option that is "in the money," the difference between the exercise price and the market price will create value. A call option is in the money if the exercise price is below the market price and a put option is in the money when its exercise price when it is above the market price.
What is operating leverage?
Operating leverage is the relationship between a company's fixed and variable costs. A company with more fixed costs has a higher level of operating leverage. While a company with a high degree of operating leverage will have a higher earnings growth potential than a company with a largely variable cost structure, certain financial institutions will prefer to lend to businesses with a variable cost structure to help mitigate their downside risk - the financial institution is comforted by the fact that the company they are lending to still has the ability to cut back on some of their expenses should they see an economic downturn approaching or other signs of a decrease in financial performance. Equity investors are the investors that benefit the most from earnings growth potential, and as such will prefer to invest in companies with a higher degree of operating leverage
What is PIK interest?
PIK interest is interest that is Paid In Kind. This means that rather than making a cash interest payment, the bond or loan will increase in face value each period by the PIK interest rate. Because of compounding, the company will be required to pay more overall, but the cash outflow will be at maturity rather than annually, semi annually, or quarterly.
What is a cash offer?
Payment in cash for ownership of a corporation. The other form of consideration a buyer may use to fund a transaction is with stock of the acquiring company.
If inflation rates in the United States fall relative to Great Britain's, what happens to the exchange rate?
Relatively more pounds will be in circulation and dollars will be worth more pounds. This means that each dollar will cost more pounds than it did before inflation.
If you bought a stock X a year ago for $10, sold it today for $15, and received $5 in dividends over the year, what would your overall return be?
Return on a stock is its sale price plus dividends paid minus its purchase price, as a percentage of the purchase price. For stock X, that would be 15 plus 5 minus 10, which is 10, or 100% return on my investment
What is the difference between shares outstanding and fully diluted shares?
Shares outstanding represent the actual number of shares of common stock that have been issued as of the current date. Fully diluted shares are the number of shares that would be outstanding if all "in the money" options were exercised.
How would you calculate the WACC of a private company?
Since a private company has no market capitalization and no beta, you would most likely use the WACC for a comparable public company
How would you value a zero-coupon perpetual bond?
Since a zero-coupon bond doesn't have any interest payments, and a perpetual bond has no par value, the value of a zero-coupon perpetual bond is zero because it will pay out nothing.
All else equal, how would one company prefer to pay for another?
Since cash is the cheapest source of capital, it would be the preferred way to purchase another company if the purchaser had sufficient cash. On the other hand, a company wanting to keep a significant cash buffer would prefer other ways of financing the transaction. If a company feels its stock price is inflated, it would prefer to use that to pay for the acquisition. In short, the preferred means of payment always depends upon the circumstances of the acquisition, the company, and the market.
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.
Why are increases in accounts receivable a cash reduction on the cash flow statement?
Since the cash flow statement starts with net income, an increase in accounts receivable is an adjustment to net income to reflect the fact that the company never actually received those funds
How much would you pay for a company with $50 million in revenue and $5 million in profit?
Since you have no information about historical or projected performance, and no details about the firm's capital structure, it would be impossible to do a DCF analysis. Assuming you know the firm's industry, you could identify a group of comparable companies and do a multiples analysis using the ratios from those most relevant to the company being valued.
What are some examples of items that may need to get added back to EBITDA to get a better sense for the financial health of a company?
Some examples are one-time, non-recurring items like legal expenses, one-time disaster payments or events, restructuring charges, debt/equity financing expenses, etc. Any items that are not likely to continue from one year to the next may be added back to EBITDA.
What is the difference between technical analysis and fundamental analysis?
Technical analysis is the process of picking stocks based on quantitative, statistical analyses, historical trends and stock movements. Fundamental analysis is examining a company's fundamentals, financial statements, industry, etc., and then picking stocks that are "undervalued."
If a company's stock has gone up 20% in the last 12 months, is the company's stock in fact doing well?
The answer to that question depends on a number of factors including the company's beta and the market's performance. If the stock's beta is 1 (meaning it should be as volatile as the market and therefore produce market returns) and the market was up 30% over the past 12 months, then the stock is doing relatively poorly.
What happens to te YTM and current yield on a bond if the company's credit ratings fall dramatically, but prevailing interest rates and the bond's coupon rate stay the same?
The bond will start to trade at a discount to par value if the company's credit rating falls dramatically, so the bond's Current Yield will increase above the coupon rate. The bond's YTM should also increase because it's based on the assumption of full repayment upon maturity - even if that's no longer realistic. The bond's YTM should increase to a figure above the Current Yield because investors now earn interest plus an annualized gain from buying the bond at a discount and earning back its par value upon maturity.
What are the main factors influencing a bond's price?
The bond's coupon rate, prevailing interest rates on similar bonds in the market, and the company's creditworthiness make the biggest impact on the bond's market price. All of them appear in the pricing formula for a bond, but the company's creditworthiness makes a more indirect impact since it affects the "Redemption" term (lower creditworthiness means that the expected repayment percentage may be below 100%)
What is the yield to maturity on a bond? If you purchase a $100 bond at a 5% discount to par value. The bond's coupon rate is 8% and matures in 5 years. What is the bond's approximate YTM?
The bond's rate of return if held through its maturity date, based on its current price, coupon payments, face value, and maturity date. You can approximate the YTM with: (Annual Interest + (Redemption Value - Bond Price) / # Years to Maturity) / ((Redemption Value + Bond Price) / 2). The annual interest is$8, the redemption value is 100 (since full repayment is assumed with YTM), the bond price is 95, and the # years to maturity is 5, so: YTM = (8 + (100 - 95) / 5) / ((100 + 95) / 2) >> YTM = (8 + 1) / 97.5 = 9.2%.
Why would a company distribute its earnings through dividends to common stockholders?
The distribution of a dividend signals that a company is healthy and profitable, thus attracting more investors, potentially driving up the company's stock price
What are some ways the market exchange rate between two country's currencies is determined?
The exchange rate between two countries' currencies is determined by a few factors. One is the interest rates in the two countries. If the interest rate in the home country increases relative to that in the foreign country, demand for the home country's currency tends to increase because investors can get higher rates of return, and increased demand strengthens the home currency. Another factor affecting exchange rates is expectations about inflation in the two countries If one country is expected to experience relatively high inflation, the inflating currency will become less valuable in the long run, all else equal.
Why is a firm's credit rating important?
The lower a firm's credit rating, the higher its risk of bankruptcy, according to ratings agencies, and therefore the higher its cost of borrowing capital
You are building a credit model for a furniture retailer, a luxury hotel chain, and a real estate company that owns multifamily units. Which would you expect to have the most extreme downside case.
The luxury hotel chain will have the most extreme Downside case because hotel spending, especially in the luxury segment, declines far more than furniture spending or apartment rent in a downturn. There might be a modest decline in apartment rents (e.g., 3-5%) during a recession as landlords try to attract new tenants, and furniture sales might also decline modestly (e.g., 5-10%) as fewer people buy homes and redecorate. But luxury hotel spending falls off a cliff in a downturn - declines of 20-30% would not be unusual.
How do you value a company differently in an IPO than in an M&A deal?
The main difference is that you focus on the forward multiples of the Public Comps because investors pay so much attention to them when a company goes public. A company's pricing in an IPO is based on these metrics as well. So, if the median 1-year forward P / E multiple for similar public companies is 20x, you might suggest a range of 1-year forward P / E multiples around 20x for your company as well.
What is the market risk premium?
The market risk premium is the excess return that investors require for choosing to purchase stocks over "risk-free" securities. It is calculated as the average return on the market (normally the S&P 500, typically around 10-12%) minus the risk free rate (current yield on a 10-year Treasury).
How might the market interpret an IPO with 100% secondary shares?
The market would typically interpret this deal negatively since the company is not issuing any new shares, which implies that growth expectations are low. Also, if so many existing investors sell their shares in the company, they're sending a signal to the market that they don't believe in the company's long-term prospects. In most market environments, it would be difficult-to- impossible to conduct an IPO with no primary shares. Interestingly, one of the hottest public company offerings in 2018 was the IPO of music streaming service Spotify, which was a 100% secondary share offering, providing a liquidity solution to existing investors. The public equity markets received the offering well, as the price stabilized in its IPO range. This was the first successful IPO that was a 100% secondary share offering in quite a while.
How do you calculate the number of fully diluted shares?
The most common way of determining the number of fully diluted shares is the treasury stock method. This method involves finding the number of current shares outstanding, adding the number of options and warrants that are currently "in the money," and then subtracting the number of shares that could be repurchased using the proceeds from exercising the options and warrants.
If company A purchases company B, what will the combined company's balance sheet look like?
The new Balance Sheet will be simply the sum of the two companies' Balance Sheets plus the addition of "goodwill," which would be an intangible asset, to account for any premium paid on top of Company B's actual assets.
If you believe interest rates will fall, which should you buy: A 10-year coupon bond or a 10-year zero-coupon bond?
The price of a zero-coupon bond is more sensitive to fluctuations in interest rates, and the price moves in the opposite direction of interest rates. So, when interest rates fall, the price of the zero-coupon bond will rise more than the price of the coupon bond. Therefore, if you believe interest rates will fall, you should purchase the zero-coupon bond.
If you have two companies that are exactly the same in revenue, growth, risk, etc. but one is private and one is public, which company's shares would be higher priced?
The public company is likely to be priced higher for a couple of reasons. The main reason is the liquidity premium investors will pay for the ability to trade their stock quickly and easily on the public exchanges. A second reason is the sort of "transparency premium" that derives from the public company's requirement to make their audited financial documents public.
Where do you find the risk free rate
The risk-free rate is usually the current yield on the 10-year government treasury, which can be found on the front page of The Wall Street Journal, on Yahoo! Finance, etc. 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
When building a model, what is the most common way to project items like accounts receivable, accounts payable, inventory, depreciation, and capital expenditures?
The straight-line method
When should a company issue equity rather than debt to fund its operations?
There are several reasons for issuing stock rather than debt. First, if a company believes its stock price is inflated, issuing stock can raise a lot of capital relative to the ownership sold. Second, if the projects to be funded may not generate predictable cash flows in the immediate future, the company would want to avoid the obligation of consistent coupon payments required by the issuance of debt. Issuing stock is also an effective way to adjust the debt/equity ratio of a company's capital structure or to monetize the owners' investment.
What conclusions can you draw if a company's EBITDA cushion for its interest coverage ratio convenant is 10% in the downside case, but its leverage ratio covenant has a cushion of 50%?
This means the company's Debt / EBITDA ratio is acceptable if things go wrong, but its EBITDA / Interest covenant is in danger of being breached if the company underperforms. The company could solve this issue by negotiating for Debt with lower interest rates but offering other terms that are more favorable to the lender, or by raising Debt with no maintenance covenants.
Suppose you hold a put option on Microsoft stock with an exercise price of $60. The expiration date is today, and Microsoft is trading at $50. About how much is your put worth and why?
This put is worth $10. It gives you the option to sell your shares at $60, and you can buy them in the open market at $50. You therefore would buy shares of Microsoft at $50 per share and immediately sell them for $60, making a profit of $10 per share.
If you read that a certain mutual fund achieved 50% returns last year, would you invest in it?
To make an investment decision you need to research more in depth into the fund's holdings, management, fee structure, etc., because past performance—especially a single year—is not an indicator of future results. A mutual fund full of mortgage backed securities could have been up 50% a few years ago and then been down 90% the year after the market for MBSs collapsed.
Why is valuing a bond more difficult than it appears?
When a company initially issues a bond to investors to raise capital, it is straightforward to model. But in the secondary markets - where investors buy and sell bonds from other investors - it gets more complicated. First off, the bond's market price can change over time. The timing also gets tricky because bonds pay interest at different intervals, and a new investor may have to pay for "Accrued Interest" if he/she purchases the bond in between interest payments. Also, bonds often have embedded call, put, and conversion options, all of which complicate the analysis. Finally, some bonds also have warrants or equity options attached, which make it trickier to calculate the yields.
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
What kinds of companies can typically sustain and adequately service the debt burden incurred in an LBO transaction structure?
Typically, candidates for an LBO are profitable business with a strong track record of generating cash flow sufficient to sustain moderate debt levels over multiple economic cycles. This will allow the company to build equity value as the company services the debt incurred at the initial transaction. Other business characteristics for creditworthy borrowers in a levered capital structure include high margin businesses with defendable market positions and a long-term, recurring customer base.
What is the difference between adjusted present value and WACC
WACC incorporates the effect of interest tax shields into the discount rate. Typically calculated from actual data from Balance Sheets and used for a company with a consistent capital structure over the period of the valuation APV adds present value of financing effects to Net Present Value assuming all Equity Value. Useful where costs of financing are complex and if capital structure is changing. Used for Leveraged Buyouts
What is the difference between a corporate bond and a corporate loan?
While both loans and bonds are forms of debt, there are several differences between them. One difference is that a loan will be syndicated by a bank who leads the deal and then sells pieces of the loan to other investors such as loan funds and CLOs. A bond will be underwritten by a bank that will go on a road show to sell the issue to other financial institutions like mutual funds. Another difference is that a bank loan is a private security in which investors may have access to private, more detailed information about the company's operations, which then prohibits them from investing in public bonds or stocks. Bondholders have access only to public information and are therefore not restricted. Yet another difference is that bank loans are usually secured by all assets of the company, while bonds may or may not be secured. Bonds are also lower in the capital structure and will be repaid in bankruptcy after loans are, so all else equal, bonds will have a higher interest rate.
Would lenders ever pay attention to scenarios other than the downside cases in a credit model?
Yes, potentially. Lenders focus on the Downside cases because their upside is limited to the interest rate on the Debt, while their downside consists of losing everything. However, some forms of Debt, such as Mezzanine, may offer warrants or equity co-investment options, which could affect the numbers significantly. For example, if the Downside case numbers look bad (e.g., a decent chance of recovering only 80% of a loan's principal), the lender might do the deal anyway if the equity options make the IRR high enough in the Base or Upside cases
What is the difference between yield to maturity and yield to worst?
Yield to maturity assumes the debt holder will maintain the investment through its maturity date, collecting all interest payments and being repaid in full when it matures. Yield to worst is the lowest potential yield an investor can earn on a debt investment short of default by the issuer. This means that if a bond is callable, or has other provisions, an investor could earn less than yield to maturity should the company exercise a prepayment option to get out of the bond early.
How do you build an IPO model for a company?
You start by assuming a range of forward multiples (often P / E multiples) and then applying them to the company's projected financial metrics. If you're using P / E multiples, that gets you the company's implied post-money Equity Value when it starts trading. But companies almost always offer new investors a pricing discount in IPOs, so you have to apply that discount (10-15%) to determine the post-money Equity Value at pricing. Then, you can determine the Offering Price per Share by taking the post-money Equity Value at pricing, subtracting the offering size, and dividing by the company's pre-IPO share count. Based on that, you can calculate the Primary Shares issued in the offering. For example, a post-money Equity Value of $10 billion / $50.00 Offering Price = 200 million shares, and if the company currently has 150 million shares, it must issue 50 million new ones. You can then determine the Secondary Shares and Overallotment Shares based on separate assumptions for those. Finally, you calculate the % of the company sold in the IPO and its valuation multiples at pricing and trading, reflecting the Net IPO Proceeds in its Equity Value and Enterprise Value.
