Investment Bank

how do you do a dilution accretion model?

1. calculate PF NI 2. Calculate PF shares 3. Calculate PF EPS 1. determine the purchase price of the target company 2. make a sources and uses section and determine how the acquirer will finance the transaction 3. combine the acquirer and target's pro forma financials and make adjustments - synergies, incremental interest expense 4. calculate the PF EPS and do accretion/dilution analysis PF EPS > Acquirer's EPS ... Deal is accretive PF EPS < Acquirer's EPS ... Deal is dilutive PF EPS = Acquirer's EPS ... Deal is breakeven

2. Walk me through a basic LBO

1. making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume something about the company's operations, such as Revenue Growth or Margins, depending on how much information you have. 2. create a Sources & Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required. 3. make a debt schedule and project cash flows with any adjustments needed - determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments. 4. determine exit strategy 5. calculate IRR return analysis and determine exit valuation

1. What are the 3 financial statements?

3 statements: balance sheet, income statement, cash flow statement BS: outlines all the assets, liabilities, shareholders equity -- represent a snapshot in time IS and CF statement provide the information that happens between the snapshots of the balance sheet IS: provide the revenue and expenses of a firm during a time period CF: begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash.

i. CAPM—calculate cost of equity

estimates the compensation for amnt of systematic risk that asset adds to an investor's portfolio - says that stocks that are more exposed to systematic risk must have higher expected returns to compensate investors for the increased risk they contribute to a portfolio

3. What does it mean to expense vs capitalize something?

expense: cost is immediately recognized on IS capitalize: cost recorded as an asset on BS-- useful life of greater than 1 yr

Operating Current Liabilities

AP, Accrued expenses, Accrued tax, deferred tax liability, accrued wages, deferred revenue, Deferred rent

retained earnings and how its calculated

An amount earned by a corporation and not yet distributed to stockholders. equal to the previous period's retained earnings plus net income from this period less dividends from this period.

1. Walk me through a DCF analysis

finds the intrinsic value of a company -- based on the present value of its cash flows and terminal value 1. project company's financials 5-10 years until stable cash flow 2. calculate FCF for projected years 3. calculate discount rate WACC 4. discount FCF using WACC 5. determine residual value using exit multiples or perpetuity growth formula 6. add up all cash flows to get enterprise value

how to choose comparable companies

Business profile: products, sector, geography, customers and end markets, distribution channels Financial profile: size, profitability, growth profile, ROI, credit profile Initial stage: focus on identifying companies with similar business profiles

what are the key drives of return in an LBO?

Buy at an attractive value: multiple expansion Grow the business or operationally improve Leverage Timing of exit/receipt of CF: sooner get money out, higher our cash flows

1. What happens to combined multiples and accretion/dilution if the buy is twice as big and why?

Buyer has a greater weighting now, so multiples move closer to buyer's multiples Deal becomes less accretive bc the company that's making it accretive - the seller - now has a lower weighting

Perpetuity growth

CF t+1/(r-g)

Exit multiples

Calculates the remaining value of a company's FCF produced after the projection period based on the multiple of its terminal yr EBITDA Multiple determined through finding comparable companies or using its industry average EV/EBITDA value to find EV

When should you value a company using a revenue multiple vs EBITDA?

Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result, Revenue multiples are more insightful. The revenue multiple is also optimal in industries where revenue growth is a key driver of value, such as industries with a lot of regulation, or where suppliers have more negotiating power. The EBITDA multiple is appropriate for mature companies because it measures the ability to generate and preserve cash.

4. What are the 3 valuation methods?

Comparable companies Precedent transactions Discounted Cash flow

1. Without doing math, what ranges would you expect for combined EV/EBITDA and P/E multiples

Depends on relative sizes of Buyer and Seller - more towards Buyer if buyer is bigger But in btween buyer and seller multiples

acquisition strategies

Horizontal integration: purchase of a business that expands the acquirer's business scale, geographic reach, product lines Seek economies of scale ands cope due to ability to leverage a fixed cost base and know how for greater production efficiency Vertical integration: seek cost efficieneis and potential growth opportunities by affording control over key components of the supply chian

1. Enterprise value definition and equation

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest - Cash Also in DCF, represents the present value of all projected cash flows Represents the value of the company attributable to both equity and debt investors

Calculate EV and equity value

EV = sum of present value of all cash flows

5. What are the most common multiples used in valuation?

EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).

2. Equity value definition and equation

Equity value represents the ownership value available to shareholders # shares * Share Price

What is goodwill and how is it calculated?

Goodwill is an intangible asset and reflects the value of a company that is not attributed to its other assets and liabilities. Goodwill =Equity purchase price paid for company - Target's book value (i.e. excess purchase price). This can remain on a company's balance sheet indefinitely barring impairment.

9. If I were stranded on a desert island and I only had 1 statement and wanted to review a company's overall health - which statement would I use and why?

I would use the Cash Flow Statement because while the balance sheet provides a snapshot of a company's financial position and the income statement highlights its profitability, the cash flow statement gives a true picture of how much cash the company is actually generating. When evaluating the health of a company, while it is not the sole determining factor, the amount of cash available is very important as cash is used to pay bills, invest and make transactions as well as pay off debts.

2. Major items on each financial statement

IS: Revenue, COGS, operating expense, operating income, tax expense, interest expense, NI BS: cash, assets and liabilities - assets: AR, AP, Accrued Revenue, PPE, inventory - liabilities: AP, Accrued expense, deferred revenue, short term debt, long term debt - shareholder's equity: common stock, retained earnings, additional PIC, treasury stock CF statement: operating, investing (capex), financing activities

4. Walk me through how depreciation going up by $10 would affect the statements assuming tax rate is 40%

IS: decrease operating income by $10. since depreciation is tax deductible, add back $4. So NI decrease by $6 CF: NI decrease by $6, add back depreciation effects of $10 since it's a non cash expense. CF up by $4 BS: assets: PPE decr by $10, cash up $14. Liabilities: RE down by $6.

5. What happens when inventory goes up by $10?

IS: not affected CF: operating activities decr cash by $10 BS: inventory up $10, cash down $10

How do EV and Equity Value change with different purchase methods?

In M&A scenarios, change in purchase method won't affect EV/EBITDA, but will affect P/E EV rep all investors in co so cash, debt, stock wont affect EV combined But will affect combined equity value bc Equity value depends on amnt of stock issue, and combined NI is affected by cash and debt used

3. What's the difference between a merger and an acquisition?

In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly large

a. Project FCF

NOP - change in NFA - change in NOWC

NFA

Net Fixed Assets: total purchase price of all a company's fixed assets with total depreciation subtracted capex = timing of purchase of PPE change in NFA = PPE(t) - PPE(t-1) = Capex - depreciation

equity multiples

P/E ratio Price/book ratio

why do you need to assume the purchase price in an LBO?

Purchase price must be assumed to determine the supporting financing structure

How are synergies used in merger models?

Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue - this additional Revenue then flows through the rest of the combined Income Statement. Cost Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.

1. Sell-side M&A walkthrough

Sale of a company, division, business, or collection of assets 1. organization and prep: identify seller objectives, perform sell-side advisor due diligence, select buyer universe, prepare marketing materials and confidentiality agreement 2. first and second presentations and bidding 3. negotiations 4. closing role of IB: provide strategic advice, guid client through each stage of transaction, facilitate successful closing and maximize value of company's sale

3. What is the ideal candidate for an LBO?

Strong cash flow generation: need a business that demonstrates the ability to support periodic interest payments Lending and defensible market positions: brand name recognition, superior products, scale advantages, etc Growth opportunities: more likely to drive EBITDA multiple expansion Efficiency enhancement opportunities: cost savings Low capex requirements: enhance CF generation capabilities Strong asset base: pledged as collateral against a loan- increases the likelihood of principal recovery in bankruptcy Proven management team

explain what synergies are

Synergies: expected cost savings, growth opportunities, other financial benefits - Basically, the buyer gets more value than out of an acquisition than what the financials would predict. Cost synergies: headcount reduction, consolidation of overlapping headquarters and facilities, and the ability to buy key inputs at lower prices due to increased purchasing power Economies of scales Revenue synergies: to the enhanced sales growth opportunities presented by the combination of businesses

how are the 3 financial statements linked?

The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement. IS and BS: net income flows into stockholder's equity via retained earnings. IS and CF: net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. CF and BS: Any BS items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period.

Operating Current Assets

The current assets used to support operations, such as AR, Inventory, Prepaid Expense, (all current assets besides cash)

4. Why would a company want to acquire another company?

The decision to buy another company (or assets of another company) is driven by numerous factors, including the desire to grow, improve, and/or expand an existing business platform Several possible reasons: - The buyer wants to gain market share by buying a competitor. - The buyer needs to grow more quickly and sees an acquisition as a way to do that. - The buyer believes the seller is undervalued. - The buyer wants to acquire the seller's customers so it can up-sell and cross-sell to them. - The buyer thinks the seller has a critical technology, intellectual property or some other "secret sauce" it can use to significantly enhance its business. - The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

4. Give an example of a "real life" LBO

The most common example is taking out a mortgage when you buy a house. Here's how the analogy works: - Down Payment: Investor Equity in an LBO - Mortgage: Debt in an LBO - Mortgage Interest Payments: Debt Interest in an LBO - Mortgage Repayments: Debt Principal Repayments in an LBO - Selling the House: Selling the Company / Taking It Public in an LBO

What is the treasury stock method?

The treasury stock method is a way of calculating a hypothetical number of shares outstanding based on current options and warrants that are currently "in the money." shareprice - strike price)/share price

8. Revenue model for a company

There are 2 ways you could do this: a bottoms-up build and a tops-down build. Bottoms-Up: Start with individual products/customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together. Tops-Down: Start with "big-picture" metrics like overall market size, then estimate the company's market share and how that will change in coming years, and multiply to get to their revenue. Of these two methods, bottoms-up is more common and is taken more seriously because estimating "big-picture" numbers is almost impossible.

6. Walk through Comparable Companies analysis

To conduct CCA, analysts select a set of comparable public companies, operating in the similar industry or sector and location to the valuation company, then compare the valuation company with those companies to estimate its value which can be fairly traded in the market. 1. Identify businesses that are similar to the target. 2. Extract specific financial information from the comparable businesses' financial statements (e.g., EBITDA, market capitalization, net debt, etc.) 3. Compute the comparable companies' valuation multiples such as P/E ratio or EV/EBITDA ratio 4. Calculate the average valuation multiple of the comparable companies, such as the average P/E 5. Multiply the target's financial information (net income, EBITDA, etc.) with the calculated average valuation multiple to determine the value of the target, which would typically be market capitalization or enterprise value.

expense model for a company

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward. Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics. Cost of Goods Sold should be tied directly to Revenue and each "unit" produced should incur an expense. Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company's internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

5. How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

difference between EBIT and EBITDA

While EBIT represents the organization's operating income, EBITDA shows the cash flow its operations generate because it excludes non-cash operating expenses, like depreciation and amortization. Although equipment may lose its value over time, the business doesn't lose tangible money until it pays to replace that equipment.

7. LIFO vs FIFO

With LIFO, you use the value of the most recent inventory additions for COGS, but with FIFO you use the value of the oldest inventory additions for COGS. COGS: starting inventory + purchases - ending inventory Here's an example: let's say your starting inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4. You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you record 40 * $30 or $1,200 for the annual revenue. The difference is that in LIFO, you would use the 40 most recent inventory purchase values - $120 + $150 + $170 + $200 - for the Cost of Goods Sold, whereas in FIFO you would use the 40 oldest inventory values - $100 + $120 + $150 + $170 - for COGS. As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would also have lower Pre-Tax Income and Net Income. The ending inventory value would be $100 higher under FIFO and $100 lower under FIFO. In general if inventory is getting more expensive to purchase, LIFO will produce higher values for COGS and lower ending inventory values and vice versa if inventory is getting cheaper to purchase.

1. Why do we need both Equity and Enterprise value

You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.

what are the acquisition effects?

a. Foregone intr on cash: - The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition - so that reduces its PreTax Income, Net Income, and EPS b. Add intr on debt: The buyer pays additional Interest Expense if it uses debt, which reduces its Pre-Tax Income, Net Income, and EPS. c. Add shares outstanding: If the buyer pays with stock, it must issue additional shares, which will reduce its EPS d. Combined financials e. Creation of goodwill: These Balance Sheet items represent the premium that the buyer paid over the seller's Shareholder's Equity, and are required to ensure that the Balance Sheet balances

1. What is an LBO?

acquisition of a company, division, business, or collection of assets using debt to finance a large portion of the purchase price Goal = realize an accceptable return on its equity investment upon exit

Why is EBITDA important

can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Many businesses tend to use this value because it reflects an accurate calculation of a company's performance and profitability, without including factors like taxes and interest that cannot always be controlled. It is important to note that the EBITDA measures profitability and not necessarily cash flow.

forms of financing in M&A

cash, debt, equity

7. What are the different methods to acquiring the company? Which is preferred?

cash, stock, or debt Assuming the buyer had unlimited resources, prefer to use cash when buying another company. - Cash is "cheaper" than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than that. - Thus, foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt. - Cash is also less "risky" than debt because there's no chance the buyer might fail to raise sufficient funds from investors. - It's hard to compare the "cost" directly to stock, but in general stock is the most "expensive" way to finance a transaction - remember how the Cost of Equity is almost always higher than the Cost of Debt? That same principle applies here. - Cash is also less risky than stock because the buyer's share price could change dramatically once the acquisition is announced.

iii. Calculate cost of debt

construct financial ratios for different debt levels (interest coverage ratio, debt/equity), find firms with similar ratios and obtain their debt rating (usually assigned by credit rating agencies), find the current rD for such a debt rating by identifying interest rates associated with those ratings

enterprise value multiples

eliminate effects of debt financing EV/rev EV/EBITDA EV/EBIT

7. Walk through a precedent transactions analysis

historical valuation method where you will be comparing past transactions in order to gauge current valuation of your company 1. locating universe of transactions 2. finding necessary financials of comparables: EV, EPS, net debt, EBITDA, Revenue 3. calculate key trading multiples: EV/sales, EV/EBITDA, Equity value/NI, P/E 4. average the multiples of the comparable transactions 5. value your company using the comparable transactions multiples

what adjustments do you make to NI in merger model?

i. Synergies, D&A, foregone intr on cash, intr paid on new debt, shares

What does IRR mean?

internal rate of return - total return on a sponsor's equity investment and factors in time value of money

ii. Calculate Beta

measures exposure of an individual stock to market-wide risk - Measures extent to which stock i's returns r(i) co-move with the market returns r(M)

5. Dilution vs accretion

measures the effects of a transaction on a potential acquirer's earnings, assuming a given financing structure. It centers on comparing the acquirer's earnings per share (EPS) pro forma for the transaction versus on a standalone basis. Accretive: when the combined (pro forma) EPS is greater than the standalone EPS Dilutive: the pro forma EPS would be lower than the standalone EPS

NOP calculation

net operating profit Revenue - COGS - operating expenses - depreciation = EBIT EBIT - tax on EBIT = NOP

3. Why do you need to unlever/relever beta?

neutralize the effects of different capital structures (remove the influence of leverage) - the banker must unlever the beta for each company in the peer group to achieve the asset beta (unlevered)

what is PPA - purchase price allocation?

newly acquired assets are re-evaluated and adjusted to their fair value Acquirer allocates the purchase price into assets and liabilities of target company acquired in transaction Components Net identifiable assets: total value of assets - liabilities Write up: adjusting increase to the book value of an asset if asset's carrying value < fair market value Goodwill: excess amt paid over the target company's net value

change in NOWC

operating current assets - operating current liabilities

why do PE firms like to use leverage? 1. What are the benefits of using leverage?

provides additional benefit of tax savings realized due to tax deductibility of interest expense Beneficial to use debt in the beginning because there's a lower upfront cost, and since money today is worth more than money 5 years from now, it's much easier to get a higher return relative to the portion invested

similarities and differences between comps and precedent transactions

similarities: rely on the valuation multiples of other companies to price the targets. differences: The first one utilizes current market prices, while the second analysis looks for historical deals. Therefore, the precedent transaction will have greater difficulty finding comparables. Equity value: precedents analysis based on the announced offer price per share as opposed to closing price on a given day The comparable company analysis often results in lower valuations compared to the precedent transaction analysis because there are control premiums that push the valuation higher.

2. Buy-side M&A walkthrough

the purchase, sale, spin-off, and combination of companies, their subsidiaries and assets. Role of IB: The core analytical work centers on the construction of a detailed financial model that is used to assess valuation, financing structure, and financial impact to the acquirer. banker also advises on key process tactics and strategy, and plays the lead role in interfacing with the seller and its advisors - Understand investment criteria and target industries - Identify potential acquisition targets - Conduct due diligence on shortlisted companies, including financials and synergies - Perform valuation analysis using various methodologies - Structure the deal, negotiate purchase price and terms - Assist in drafting and negotiating definitive agreement - Coordinate closing activities, including regulatory approvals and financing - Provide strategic guidance throughout the acquisition process

walk me through a basic merger model

used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer's EPS increases or decreases. 1. determine purchase price and method 2. projections of financials 3. combine financials + calculate Goodwill (PPA) 4. adjustments to NI 5. calculate accretion/dilution analysis first step is to make assumptions of the purchase price and method Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one. Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line you apply the buyer's Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS.

b. Determine WACC

weighted avg cost of capital discount rate for FCF - expected return you can earn by investing in a different project with similar risk

6. What is NWC? NOWC?

working capital: current assets less liabilities Op working capital: current operating assets less current operating liabilities negative OWC: positive funds to the rest of the business (OWL > OWA)