IB Techs
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.
How do I determine Cost of Equity
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What are the methods of valuing a company?
- Comparable Analysis - Precedent Transaction Analysis -DCF Analysis - LBO Analysis - SOTP Analysis
How do the 3 financial statements link together?
"To tie the statements together, Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders' Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash flowing in from the final line on the Cash Flow Statement."
How does a $50 increase in capex purchased with debt would affect Enterprise value and net income?
$50 increase in capex purchased with debt shall increase the "net debt" portion used in computation of Enterprise Value and hence shall increase it. Net Income will get affected by the incremental interest and incremental depreciation.
What is the difference between IRR and CAGR?
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Why do we adjust for taxes in WACC formula
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Differences between EBITDA and FCF?
- Free Cash Flow takes into account working capital - Line items like accounts receivable/payable and inventory reflected in FCF - No tax expense reflected in EBITDA - FCF includes CAPEX
What characteristics make for a good LBO target?
- Mature industry and/or company: Stock price of the public target company is trading at a lower multiple to free cash flow as compared to a new and high growth industry or company. - Clean balance sheet with no or low amount of outstanding debt: Need the ability to be able to use debt as part of the acquisition consideration or "leverage" as the name suggests. A company with no debt and high free cash flow may be a great candidate given the fact that you can buy the company with senior debt and use the free cash flows of the company to pay the principal and interest due. - Strong management team and potential cost-cutting measures: Management is able to run and create a more efficient company with same cash generating characteristics. PE firms might decide to get rid of the old management team and hire a new team that has a successful track record of building great businesses in the respective industry. - Low working capital requirement and steady cash flows: Looking for stable and recurring cash flows that can be used to pay down debt over the years before exit, thus increasing the equity/total assets ratio of the company. - Low future capital expenditure requirements: Same reason as low working capital requirements. - Feasible exit options: One question you might ask is if there have been any historical LBO or IPO precedents in the relative industry as your LBO target candidate. Will you be able to sell this business at the same or higher entry multiple that you originally paid for the company? - Strong competitive advantages and market position: Overall, company is in a great position to keep generating steady cash flows and keep position in its markets. - Possibility of selling some underperforming or non-core assets: Company can sell assets to raise cash to pay off outstanding debt. Note that these assets should not represent a significant contributor to company's current cash flow. The spin-off of these non-core assets may increase your market multiples because your business going-forward may be compared to a new set of public peers
Why might one company want to acquire another company?
- The Buyer views the Target as undervalued. - The Buyer's own organic growth has slowed or stalled and needs to grow in other ways (via acquiring other companies) in order to satisfy the growth expectations of Wall Street. - The Buyer expects the deal to result in significant synergies (see the next post for a discussion of synergies). - The CEO of the Buyer wants to be CEO of a larger company, either because of ego, legacy or because he/she will get paid more.
Let's say you run an LBO analysis and the private equity firm's return is too low. What drivers to the model will increase the return?
- reduce the purchase price that the PE firm has to pay for the company - increase the amount of leverage (debt) in the deal - increase the price for which the company sells when the PE firm exits its investment (i.e. increase the assumed exit multiple) - increase the company's growth rate in order to raise operating income/cash flow/EBITDA in the projections decrease the company's costs in order to raise operating income/cash flow/EBITDA in the projections
If you LBO a firm for 1000 and sell it for 1000 what are 4 ways you made money on it?
1) Equity value growth: for example, assume that the target generates cumulative free cash flow of $500 million, which is used to repay debt during the investment horizon. Debt repayment increases equity value on a dollar-for-dollar basis. Assuming the sponsor sells the target for $1,000, the value of the sponsor's equity investment increases even though there is no growth in the company's enterprise value. (Equity value increases due to increasing EBITDA and decreasing net debt) 2) Dividend Recap: take on new debt to issue a special dividend to equity shareholders (No changes to the Income Statement. On the Balance Sheet, Debt would go up and Shareholders' Equity would go down and they would cancel each other out so that everything remained in balance. On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change.) 3) Sell off assets of company 4) Tax savings on the debt
If I give you the balance sheet and income statement, how do you construct the statement of cash flows?
1) Prepare the operating activities section by converting net income from an accrual basis to a cash basis (using indirect method: begin with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities (or used by operating activities if the result is a cash outflow). Cash provided by operating activities represents net income on a cash basis. It tells the reader how much cash was received from the daily operations of the business.) 2) Prepare the investing activities section by presenting cash activity for noncurrent assets. (This step focuses on the effect changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step) 3) Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners' equity.(This step focuses on the effect changes in noncurrent liabilities and owners' equity have on cash. Noncurrent liabilities and owners' equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.) 4) Reconcile the change in cash
How do taxes impact the DCF in three different ways?
1. It impacts DCF when we take depreciation tax shield, since depreciation is a non-cash item but save taxes in the form of cash. 2. It is also used in adding back interest component, net of tax as Interest is a tax deductible item. 3. Taxes also impact when computing FCFF from EBITDA and we need to take NOPAT i.e. (EBITDA * (1 minus tax)
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 same of the present values of all those cash flows is the estimated enterprise value of the firm according to the DCF.
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 thecalculation of Free Cash Flow. Therefore your FCF increases by $4 and your valuation will increase bythe present value of that $4,
What factors can lead to the dilution of EPS in an acquisition?
A number of factors can cause an acquisition to be dilutive to the acquiror's earnings per share (EPS), including: (1) the target has negative net income, (2) the target's Price/Earnings ratio is greater than the acquiror's, (3) the transaction creates a significant amount of intangible assets that must be amortized going forward, (4) increased interest expense due to new debt used to finance the transaction, (5) decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction and (6) low or negative synergies.
If a company takes on additional debt, would that increase or decrease the PE ratios of a company?
Additional debt increases the riskiness and decreases the earnings for the company, hence increase the P/E ratio for a firm.
What impact would funded pension obligation and unfunded pension obligation have on a company's DCF valuation? .
An unfunded pension obligation would be a debt equivalent (the pension fund is effectively providing funding to the business and is in fact part of the capital structure; the unfunded plan deficit is not tax affected for valuation purposes). The underfunded amount is an unfunded liability of the company, and should be deducted from a company's market value of invested capital in the determination of the market value of a company's equity
In what situation(s) would enterprise value be negative besides in the case of having excess cash/low debt?
Assets generate negative cash flows Equity < Cash
Let's say a company buys a piece of equipment for $100M using 1/2 cash, 1/2 debt. Debt has interest rate of 10% and tax rate is 40%. walk me through the 3 statements at time 0 and 1 year in future?
At zero period, Equipment in Non-Current Assets shall get increase by $100M with a corresponding increase in $50M debt and decrease in $50M cash. In the next year i.e. at year 1, Interest expense would increase by ($50M * 10%) = $5M. Since Interest is a tax deductible expense, this shall save taxes by 40% of Incremental interest amount i.e. $5M. Hence, a decrease in tax expense of $2M.
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 haveinsufficient cash on hand, they would soon default on their debt and could eventually need bankruptcyprotection
What is the difference between basic shares and fully diluted shares?
Basic shares represent the number of common shares that are outstanding today (or as of the reporting date). Fully diluted shares equals basic shares plus the potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt. In calculating a company's market value of equity (MVE) we always want to use diluted shares. Implicitly the market also uses diluted shares to value a company's stock.
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 thebusiness, the buyer will need to assess the company's Enterprise Value, which includes both the debt and the equity.
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 thebusiness, the buyer will need to assess the company's Enterprise Value, which includes both the debtand the equity.
Walk me through an LBO analysis...
Calculate the total acquisition price, including acquisition of the target's equity, repayment of anyoutstanding debt, and any transaction fees (such as the fees paid to investment banks and deallawyers, accountants, consultants, etc.). Determine how that total price will be paid including: equity from the PE sponsor, roll-over equityfrom existing owners or managers, debt, seller financing, etc. Project the target's operating performance over ~5 years and determine how much of the debtprincipal used to acquire the target can be paid down using the target's FCF over that time. Project how much the target could be sold for after ~5 years in light of its projected operatingperformance; Subtract any remaining net debt from this total to determine projected returns forequity holders. Calculate the projected IRR and MoM return on equity based on the amount of equity originallyused to acquire the target and the projected equity returns upon exit.
If company A has 200M in cash and the company B has 1 Billion in debt which one is accretive and why?
Company A shall be more accretive, it has more cash. Whereas company B has $1Bn debt which would have heavy interest burden and would resist it to increase in value.
If there are two companies, company A with a PE of 15x and company B with a PE of 10x which one would be more accretive and why?
Company A shall be more accretive, since it has higher P/E multiple which means that a $1 increase in earnings shall have approximately $15 increase in market price of Company A versus $10 increase in Company B's Market price.
What are the effects on the three financial statements if deferred revenue increases?
Deferred Revenue is like an advance received from customer, but sale hasn't been taken please i.e. it's a liability. Increase in deferred revenue shall increase the liability on the balance sheet with corresponding increase in cash. Cash Flow from Operating shall get increased (due to decrease (or release of funds) from working capital. There wouldn't be any effect on Income Statement.
What are the effects on the three financial statements if deferred tax increases?
Deferred Tax can be an asset or a liability. Increase in deferred tax asset means that tax benefit has been deferred to future. Similarly, deferred tax liability means >> tax liability being deferred to some future date. Increase in deferred tax asset shall increase the asset on the balance sheet with corresponding decrease in tax expense thereby increase in profit. Cash Flow from Operating shall get reduced (if used indirect method starting from Profit after Tax) since this is a non-cash item. Tax expense shall get reduced due to increase in deferred tax asset and hence profit will be increased. Opposite will be the case for deferred tax liability.
How is deferred tax assets created?
Deferred tax assets are created as a result of timing difference between items in books of accounts and tax liability computation. When excess tax is paid today, but benefit shall be received later, it is recorded as deferred tax assets. This causes expense to decrease and hence profit is increased.
What is the purpose of the Changes in 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
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 toc ommon shareholders after all expenses are paid, so if you used this multiple, you would be calculating the value of the firm's equity.
A firm trading at P/E 20 acquires a firm trading at P/E 10. Is EPS expected to go up or down?
EPS shall be unaffected by this transaction unless there are some major expected synergies near future. When a P/E 20x firm acquires lower P/E firm, consolidated market price is expected to increase due to boot-strapping of EPS to get MPS.
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.
Why can't you use EV/Earnings or Price/EBITDA as valuation metrics?
Enterprise Value (EV) equals the value of the operations of the company attributable to all providers of capital. That is to say, because EV incorporates all of both debt and equity, it is NOT dependant on the choice of capital structure (i.e. the percentage of debt and equity). If we use EV in the numerator of our valuation metric, to be consistent (apples to apples) we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA. These such metrics are also not dependant on capital structure because they do not include interest expense. Operating metrics such as earnings do include interest and so are considered leveraged or capital structure dependant metrics. Therefore EV/Earnings is an apples to oranges comparison and is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (or equity value) is dependant on capital structure (levered) while EBITDA is unlevered. Again, apples to oranges. Price/Earnings is fine (apples to apples) because they are both levered.
What is the difference between enterprise value and equity value?
Enterprise Value represents the value of the operations of a company attributable to all providers of capital. Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders.
If depreciation is a non-cash expense, then how does it affect the cash balance?
Even though depreciation is a non-cash expense, it is still tax deductible. This means that it reduces yourpre-tax income, and therefore reduces the amount of taxes a company must pay, which increases thecompany's cash balance.
How does a PIK (Payment in kind) affect/flow through the 3 financial statements?
Example: $100mm PIK note with 10.0% interest Income Statement: · Interest expense up $10mm · Assuming 40% tax rate, tax shield of $4mm tax expense is lower by $4mm Net Income is down by $6mm Statement of Cash Flows Net Income is down by $6mm from the income statement PIK interest is then added back as it is not a cash expense (paid out in the form of additional debt) Net Cash is up by $4 Balance Sheet Assets side of the balance sheet is up by $4mm due to the cash flowing in from the statement of cash flows Liabilities side of the balance sheet is up by $10mm assuming that there is additional debt principal issued for the interest payment Shareholder's Equity is down by $6mm flowing in from net income on the income statement
What's an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?
FCFF can also be calculated from EBITDA as per below: FCFF = EBITDA *(1 minus Tax Rate) + (Depreciation * Tax Rate) minus Capex minus Changes in Working Capital
A company makes a $100 debt purchase of equipment on Dec. 31. How does this impact the three statements this year and next year?
First Year: Income Statement: No depreciation and no interest expense so no change. Cash Flow Statement: No change to net income so no change to cash flow from operations. Just like the previous question, we've got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities. Now, however, in our cash flows from financing section, we've got an increase in debt of $100 (source of cash). Net effect is no change to cash. Balance Sheet: No change to cash (asset), PP&E (asset) up $100 and debt (liability) up $100 so we balance. Second Year: Same depreciation and tax assumptions as previously. Let's also assume a 10% interest rate on the debt and no debt amortization. Income Statement: Just like the previous question: $20 of depreciation but now we also have $10 of interest expense. Net result is a $18 reduction to net income ($30 x (1 - 40%)). Cash Flow Statement: Net income down $18 and depreciation up $20. No change to cash flow from investing or financing activities (if we assumed some debt amortization, we would have a use of cash in financing activities). Net effect is cash up $2. Balance Sheet: Cash (asset) up $2 and PP&E (asset) down $20 so left side of balance sheet down $18. Retained earnings (shareholders' equity) down $18 and voila, we are balanced.
A company makes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year?
First Year: Let's assume that the company's fiscal year ends Dec. 31. The relevance of the purchase date is that we will assume no depreciation the first year. Income Statement: A purchase of equipment is considered a capital expenditure which does not impact earnings. Further, since we are assuming no depreciation, there is no impact to net income, thus no impact to the income statement. Cash Flow Statement: No change to net income so no change to cash flow from operations. However we've got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities. No change in cash flow from financing (since this is a cash purchase) so the net effect is a use of cash of $100. Balance Sheet: Cash (asset) down $100 and PP&E (asset) up $100 so no net change to the left side of the balance sheet and no change to the right side. We are balanced. Second Year: Here let's assume straightline depreciation over 5 years and a 40% tax rate. Income Statement: Just like the previous question: $20 of depreciation, which results in a $12 reduction to net income. Cash Flow Statement: Net income down $12 and depreciation up $20. No change to cash flow from investing or financing activities. Net effect is cash up $8. Balance Sheet: Cash (asset) up $8 and PP&E (asset) down $20 so left side of balance sheet doen $12. Retained earnings (shareholders' equity) down $12 and again, we are balanced.
Who Will Pay More for My Company - A Strategic or Financial Buyer?
From my experience, the strategic buyers will be paying more due to the assumed synergies. Financial buyers will be paying less as they are looking to increase their IRRs on the exit of the business. A Financial buyer usually doesn't gain any synergies as there isn't overlap in expenses so they aren't able to combine the acquired business into their existing P/L to create incremental long-term shareholder value. The synergies can expand outside of just things that would show up on the P/L, such as eliminating a competitor in the marketplace which would hopefully in turn increase your market share and revenue. Also, you can increase the stability of your business and potentially smooth out your revenue streams to make forecasting more predictable.
What is goodwill and how is it calculated?
Goodwill, a type of intangible asset, is created in an acquisition and reflects the value (from an accounting standpoint) of a company that is not attributed to its other assets and liabilities. Goodwill is calculated by subtracting the target's book value (written up to fair market value) from the equity purchase price paid for the company. This equation is sometimes referred to as the "excess purchase price." Accounting rules state that goodwill no longer should be amortized each period, but must be tested once per year for impairment. Absent impairment, goodwill can remain on a company's balance sheet indefinitely.
Which is easier to financially model in a merger & acquisition model - expense or revenue synergies?
I feel cost/expense synergies are easier to model, as cost savings can be estimated. But revenue synergies i.e. increase is revenue is somehow always debatable and unpredictable.
If you could use only one financial statement to evaluate the financial state of a company, which would you choose?
I would want to see the Cash Flow Statement so I could see the actual liquidity position of the businessand 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 performing. But whether a company has a healthy cash balance and generates significant cashflow indicates whether it is probably financially stable, and this is what the CF Statement would show
Company X buys 80% of company Y for 100 dollars. What changes on company X's financial statements?
If Company X buys 80% i.e. Controlling Stake in Company Y for $100, this $100 shall be recorded as an investment in Company X standalone balance sheet. In consolidated balance sheet, Company X will record 100% of Company Y assets and liabilities with a corresponding balancing amount of non-controlling interest equivalent to 20% stake not owned by Company X.
Would you rather be a firm that has a P/E ratio of 20 or a interest rate of 6%?
If I am a risk-averse investor, I would choose 6% interest rate. But if I am a risk-taker, I would rather choose stock with a P/E of 20x.
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.
If a company raise $100 debt to repurchase 10 shares. The annual interest rate on debt is 10%. The marginal tax rate is 40%, and the effective tax rate is 30%. what happens to EPS after year 1?
If company raise $100 debt @ 10% interest with 30% effective tax rate; its incremental interest expense, net of tax shall be ($100*10%*(1-30%)) = $7 << Therefore, net income shall get increase by this amount. Whereas, no. of shares outstanding shall get reduced by 10 shares leading to higher EPS proportionately.
Depreciation was overstated by X amount; walk me through how this affects each of the three financial statements.
If depreciated was overstated by a particular amount, balance sheet will show lower PP&E asset balance due to higher accumulated depreciation. Income Statement shall show higher depreciation expense due to which profitability would get lowered. Since depreciation is a non-cash expense, it shall be added back to net profit to get Cash Flow from Operating Activities (if indirect method is used).
Can Terminal value be Negative?
If for some reason, WACC is less than the growth rate, then Terminal Value can be negative. High growth companies may get negative terminal values only due to misuse of this formula. Please note that no company can growth at a high pace for an infinite time period. The growth rate that is used here is to a steady growth rate that the company can generate over a long period of time.
Consider an inflationary environment, how would the 3 statements be impacted if a company switched from LIFO to FIFO based accounting? How would Net Income/CFO change?
In case of inflationary environment i.e. prices are increasing>>> switching from LIFO (Last in First Out) to FIFO (First In First Out) shall result in lower cost of goods sold and higher inventory balance. As LIFO in inflationary conditions means, higher priced purchases would be put to use first and hence will be expenses as COGS (Cost of goods sold). Now converting them to FIFO shall make it opposite i.e. lower COGS. Cash flow from operations shall be changed increased by saved cost of goods sold less tax effect on that saved cost of goods sold.
How does net income differ in a debt transaction vs. an all cash transaction?
In debt transactions, net income shall get reduced by the amount of interest, net of tax. While all cash transaction have greater net income, net of tax.
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.
Explain the concept of synergies and provide some examples.
In simple terms, synergy occurs when 2 + 2 = 5. That is, when the sum of the value of the Buyer and the Target as a combined company is greater than the two companies valued apart. Most mergers and large acquisitions are justified by the amount of projected synergies. There are two categories of synergies: cost synergies and revenue synergies. Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations. For example, closing one corporate headquarters, laying off one set of management, shutting redundant stores, etc. Revenue synergies refer to the ability to sell more products/services or raise prices due to the merger. For example, increasing sales due to cross-marketing, co-branding, etc. The concept of economies of scale can apply to both cost and revenue synergies.
If I bought $100 worth of property, plant, and equipment with cash, how would it effect the balance sheet, the income statement and the statement of cash flows.
In this case, PP&E balance shall get increased by $100 and on the other hand Cash shall get reduced by $100. Hence overall total assets will not be affected by this transaction. Since this is a capital item transaction, revenue items i.e. Income Statement shall not be affected by this. In Cash Flow Statement, investing activity shall get reduced by $100 with a purchase of this PP&E asset as it will be an outflow of cash.
What impact would selling an asset at loss have on the three financial statements?
Income statement shall show a decline in Net Income by loss on asset sold. Balance Sheet's assets would get reduced by the book value of assets sold. Cash Flow would add cash from investing activities with sale amount.
What impact would buying an asset with debt have on the three financial statements?
Income statement shall show a decline in Net Income with the incremental interest expense, net of tax. Balance Sheet's assets would get increased and debt would come under liability side with the same amount. Cash Flow would have no flow, since there has been no cash transaction.
How does an increase in accrued expenses impact the cash flow statement?
Increase in accrued expense shall increase the working capital and hence shall result in increase in cash from operating activities.
Why is debt cheaper than equity?
Interest expense is tax-deductible, hence the (1-tax rate) in the WACC formula Debt is senior to equity in the cap structure, so in a bankruptcy liquidation debtholders would get paid off first Intuitively, the cost of debt (interest rates) is lower than the cost of equity (which is often around 10%+), so debt will lower WACC
How does accounts payable & inventory affect Free Cash Flow?
Inventory & Accounts payable forms part of Working Capital items. Any increase in inventory shall increase Working Capital and hence shall reduce the Free Cash Flow. On the other hand, any decrease in accounts payable shall increase the working capital and hence shall increase the Free Cash Flow.
What are the effects on the three financial statements if inventory decreases?
Inventory decrease shall result in decrease in Current Assets and hence will decrease the Total Assets as a whole. But if we consider the corresponding effect of this decrease, mostly through Cost of Sales, that shall increase the Cash Balance>> hence will make no effect on current & total assets). It shall result in decrease in cash flows due to increase in working capital by spending cash over it. Hence shall reduce the cash (in Cash Flow Statement) No effect on Income Statement.
Explain why the WACC curve (U-shaped) is shaped that way.
It is mainly because of crystallization of debt, which means that until a cost of debt is cheaper than cost of equity WACC curve shall go downwards. The moment we take more and more deb, riskiness in the business increases and hence cost of debt also increase. This increase in cost of debt leads to increase in WACC curve making it U-Shaped.
What are the effects on the three financial statements if there is a gain on sale of assets?
It shall have no direct impact on Balance Sheet, but indirectly it shall increase the cash received (more than the book value of assets) on sale of assets. This would be added back while computing Cash Flow from operating activities. Indirectly, this gain would be present under "Proceeds from sale of Assets" under investing activity. This shall increase Income for the period it is related to.
How does non-controlling interest affect the three financial statements?
Non-Controlling interest (i.e. the stake not owned by the parent company) gets increased whenever subsidiary earns profits and gets reduced when it distributes dividends. In Consolidated Income Statement, profits attributable to Non-Controlling Shareholders get reduced from the total net profit. In Balance sheet, profits earned by non-controlling stakeholders results in increasing the balance of non-controlling interest. Similarly dividend distributed to non-controlling stakeholders reduces this balance in the balance sheet. Cash Flow statement gets reduced by dividends paid (from financing activities) with the amount given as dividends to non-controlling stakeholders.
A company makes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year?Continuing with the last question, on Jan. 1 of Year 3 the equipment breaks and is deemed worthless. The bank calls in the loan. What happens in Year 3?
Now the company must writedown the value of the equipment down to $0. At the beginning of Year 3, the equipment is on the books at $80 after one year's depreciation. Further, the company must pay back the entire loan. Income statement: The $80 writedown causes net income to decline $48. There is no further depreciation expense and no interest expense. Cash Flow Statement: Net income down $48 but the writedown is non-cash so add $80. Cash flow from financing decreases $100 when we pay back the loan. Net cash is down $68. Balance Sheet: Cash (asset) down $68, PP&E (asset) down $80, Debt (liability) down $100 and Retained Earnings (shareholders' equity) down $48. Left side of the balance sheet is down $148 and right side is down $148 and we're good!
Which one would companies prefer and why? Cutting costs by one dollar or adding one dollar to revenue?
Obviously the company with adding one dollar to revenue, since cutting the costs has never been a sustainable initiative. Increasing the revenue organically increase the profit margins and better turnover ratios.
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.
You have two companies with different EV/EBITDA multiples in different industries. What are some reasons why their EBITDA multiples might be different?
One of the firms experienced an unsystematic event that resulted in a pop/selloff in its stock price (earnings beat vs revelations over mgmt scandal, etc) One of the firms may have multiple companies bidding to acquire it, adding a lift to the share price Both firms may be situated in entirely different geographies, meaning different accounting standards thus slight variation in what is/isnt included in ebitda
How would you calculate the free cash flow of a company, if given only the revenue?
Only way is to use Free Cash Flow to Sales multiple (of similar companies) to get the Free Cash Flow from revenue.
If a company with a low P/E acquires a company with a high P/E in an all stock deal, will the deal likely be accretive or dilutive?
Other things being equal, if the Price to Earnings ratio (P/E) of the acquiring company is lower than the P/E of the target, then the deal will be dilutive to the acquiror's Earnings Per Share (EPS). This is because the acquiror has to pay more for each dollar of earnings than the market values its own earnings. Hence, the acquiror will have to issue proportionally more shares in the transaction. Mechanically, proforma earnings, which equals the acquiror's earnings plus the target's earnings (the numerator in EPS) will increase less than the proforma share count (the denominator), causing EPS to decline.
How does a PIK (Payment in kind) affect the 3 financial statements.
Payment in kind is an expense for a business and hence shall result in lowering the profitability. Outflow of resources from the business decrease the assets of the business. Non-cash expense adjustments shall lead to add back of these expenses in Cash Flow Statement and will increase the Cash from Operating Activity.
Which of the valuation methodologies will result in the highest valuation?
Precedent->DCF->Comps 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.
What are the effects on the three financial statements if prepaid expenses increase?
Prepaid Expense increase shall result in increase of Current Assets and hence will increase the Total Assets as a whole. (But if we consider the corresponding effect of this increase, mostly through Cash payment, that shall decrease the Cash Balance>> hence will make no effect on current & total assets). It shall result in decrease in cash flows due to increase in working capital by spending cash over it. Hence shall reduce the cash (in Cash Flow Statement) No effect on Income Statement.
Why might P/E ratios differ for two companies with the same revenues?
Revenue only shows the top line where as the Earnings in the P/E ratio is Net Income. A company that operates more efficiently (with less expenses) would have a smaller P/E ratio.
What happens when you shorten the depreciation life of an asset?
Shortening the depreciable life of an asset increases the depreciation amount per year, which shall reduce an asset book value faster than otherwise.
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.
You said that you typically forecast a DCF out for 5-10 years; how many years out would you forecast a large-cap company versus a high-growth startup?
Since a large-cap company is closer to a steady-state, you would forecast it for a shorter period; in this case for 5 years. The startup is farther from a steady state so you would forecast that out for a longer period.
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 WACCfor a comparable public company.
Why is the cash flow statement more useful than the balance sheet in valuing a company?
Since it shows the actual cash generated and used by the business in a year. While valuing or buying any business, its cash flows are more important that its assets & liabilities balances in the balance sheet.
If common equity investors are below preferred equity investors in the capital structure, and therefore preferred shareholders have a higher claim on assets, why are preferred dividend rates higher than common dividend rates?
The basic reason that preferred dividend rates are higher than common stock dividend rate is because preferred stockholders have only dividend into their hands. But Common Stockholders have common dividends, voting power along with capital appreciation in stock prices.
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.
If you have two companies that are exactly the same in revenue, growth, risk, etc. but one is private and one ispublic, 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 liquiditypremium 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'srequirement to make their audited financial documents public.
Walk me through an accretion/dilution analysis...
The purpose of an accretion/dilution analysis (sometimes also referred to as a quick-and-dirty merger analysis) is to project the impact of an acquisition to the acquiror's Earnings Per Share (EPS) and compare how the new EPS ("proforma EPS") compares to what the company's EPS would have been had it not executed the transaction. In order to do the accretion/dilution analysis, we need to project the combined company's net income ("proforma net income") and the combined company's new share count. The proforma net income will be the sum of the buyer's and target's projected net income plus/minus certain transaction adjustments. Such adjustments to proforma net income (on a post-tax basis) include synergies (positive or negative), increased interest expense (if debt is used to finance the purchase), decreased interest income (if cash is used to finance the purchase) and any new intangible asset amortization resulting from the transaction. The proforma share count reflects the acquiror's share count plus the number of shares to be created and used to finance the purchase (in a stock deal). Dividing proforma net income by proforma shares gives us proforma EPS which we can then compare to the acquiror's original EPS to see if the transaction results in an increase to EPS (accretion) or a decline in EPS (dilution). Note also that we typically will perform this analysis using 1-year and 2-year projected net income and also sometimes last twelve months (LTM) proforma net income.
What are the accounting adjustments made in an M&A situation?
There are various adjustment made while recording M&A transactions: 1. Contra items elimination (like debtor or creditor) 2. Goodwill & fair value adjustments (excess of book value paid for net assets) 3. Profit elimination on stock lying in the books
Let's say I'm a private equity firm and i invest $10MM in a company. In 2 years I have sold the business and achieved a 20% IRR. How much did I sell the business for?
This can be computed as: Invested Amount * (1 + IRR)^n $10MM * (1+20%)^2 = $14.4MM
How do you calculate fully diluted shares?
To calculate fully diluted shares, we need to add the basic number of shares (found on the cover of a company's most recent 10Q or 10K) and the dilutive effect of employee stock options. To calculate the dilutive effect of options we typically use the Treasury Stock Method. The options information can be found in the company's latest 10K. Note that if the company has other potentially dilutive securities (e.g. convertible preferred stock or convertible debt) we may need to account for those as well in our fully diluted share count.
How do we use the Treasury Stock Method to calculate diluted shares?
To use the Treasury Stock Method, we first need a tally of the company's issued stock options and weighted average exercise prices. We get this information from the company's most recent 10K. If our calculation will be used for a control based valuation methodology (i.e. precedent transactions) or M&A analysis, we will use all of the options outstanding. If our calculation is for a minority interest based valuation methodology (i.e. comparable companies) we will use only options exercisable. Note that options exercisable are options that have vested while options outstanding takes into account both options that have vested and that have not yet vested. Once we have this option information, we subtract the exercise price of the options from the current share price (or per share purchase price for an M&A analysis), divide by the share price (or purchase price) and multiply by the number of options outstanding. We repeat this calculation for each subset of options reported in the 10K (usually companies will report several line items of options categorized by exercise price). Aggregating the calculations gives us the amount of diluted shares. If the exercise price of an option is greater than the share price (or purchase price) then the options are out-of-the-money and have no dilutive effect.
All else equal, should the cost of equity 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.
Is it possible for an M&A deal to be dilutive if the acquirer and target have the same P/E ratio? If so, under what circumstances?
Yes there can be a situation when M&A deal can be dilutive, when the incremental cost (i.e. interest on funds used to buy target) is greater than the synergies.
What happens when you buy $100 of inventory with $50 in debt and $50 in cash?
When $100 inventory is bought with $50 in debt and $50 in cash>> it would result in increasing $100 in current assets with $50 decline in cash (as outflow of cash), with a corresponding $50 increase in debt (liability).
What is Minority Interest and why do we add it in the Enterprise Value formula?
When a company owns more than 50% of another company, U.S. accounting rules state that the parent company has to consolidate its books. In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the "sub") on its own financial statements. But since the parent company does not 100% of the sub, the parent company will have a line item called minority interest on its income statement reflecting the portion of the sub's net income that the parent is not entitled to (the percentage that it does not own). The parent company's balance sheet will also contain a line item called minority interest which reflects the percentage of the sub's book value of equity that the parent does NOT own. It is the balance sheet minority interest figure that we add in the Enterprise Value formula. Now, keep in mind that the main use for Enterprise Value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take, say, sales or EBITDA from the parent company's financial statements, these figures due to the accounting consolidation, will contain 100% of the sub's sales or EBITDA, even though the parent does not own 100%. In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest). By doing this, both the numerator and denominator of our valuation metric account for 100% of the sub, and we have a consistent (apples to apples) metric.
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 thatrepresents the true supply-demand value of the company's equity in the open market.
Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a writedown of $100
Whenever write-down happens, Income Statement is charged with such write-down amount, lowering down the profits for that period. This shall also cause to decrease the amount of asset by $100 i.e. the writedown amount. Since this is a non-cash expense, cash flow statement would not be affected by it directly.
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?
Without knowing more information about the companies, it is impossible to say. If the capital structures are the same, then the larger company should be less risky and therefore have a lower WACC. However, if the larger company has a lot of high-interest debt, it could have a higher WACC.
How does net working capital (increase/decrease of net working capital) affect free cash flow?
Working Capital is an amount that is required for successful operation of business. This means that any increase in working capital shall require additional cash and will leave lesser free cash flow and vice-versa.
How do you value a private company answer?
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.
If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements?
depreciation is an expense so operating income (EBIT) declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. Finally, the balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder's equity decreased $6.
