vagh's guide.pdf

7/27/2019 Vagh's Guide.pdf

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Stock buybacksOften you will hear that a company has announced that it will buy back itsown stock. Such an announcement is usually followed by an increase in thestock price. Why does a company buy back its stock? And why does its

price increase after?The reason behind the price increase is fairly complex, and involves threemajor reasons. The first has to do with the influence of earnings per shareon market valuation. Many investors believe that if a company buys backshares, and the number of outstanding shares decreases, the companysearnings per share goes up. If the P/E (price to earnings-per-share ratio)stays stable, investors reason, the price should go up. Thus investors drivethe stock price up in anticipation of increased earnings per share.The second reason has to do with the signaling effect. This reason is simpleto understand, and largely explains why a company buys back stock. No oneunderstands the health of the company better than its senior managers. Noone is in a better position to judge what will happen to the future

performance of the company. So if a company decides to buy back stock(i.e., decides to invest in its own stock), these managers must believe that thestock price is undervalued and will rise (or so most observers wouldVault Guide to Finance Interviews

StocksVisit the Vault Finance Career Channel at www.vault.com/finance with

insider firm profiles, message boards, the Vault Finance Job Board and more. C A R E E R 75L I B R A R Y

believe). This is the signal company management sends to the market, andthe market pushes the stock up in anticipation.The third reason the stock price goes up after a buyback can be understoodin terms of the debt tax shield (a concept used in valuation methods). Whena company buys back stock, its net debt goes up (net debt = debt - cash).Thus the debt tax shield associated with the company goes up and thevaluation rises (see APV valuation).New stock issuesThe reverse of a stock buyback is when a company issues new stock, whichusually is followed by a drop in the companys stock price. As with stock

buybacks, there are three main reasons for this movement. First, investors

believe that issuing new shares dilutes earnings. That is, issuing new stockincreases the number of outstanding shares, which decreases earnings pershare, whichgiven a stable P/E ratiodecreases the share price. (Ofcourse, the issuing of new stock will presumably be used in a way that willincrease earnings, and thus the earnings per share figure wont necessarilydecrease, but because investors believe in earnings dilution, they often drivestock prices down) .There is also the signaling effect. In other words, investors may ask why thecompanys senior managers decided to issue equity rather than debt to meettheir financing requirements. Surely, investors may believe, managementmust believe that the valuation of their stock is high (possibly inflated) andthat by issuing stock they can take advantage of this high price.Finally, if the company believes that the project for which they need money

will definitely be successful, it would have issued debt, thus keeping all ofthe upside of the investment within the firm rather than distributing it awayin the form of additional equity. The stock price also drops because of debttax shield reasons. Because cash is flushed into the firm through the sale ofequity, the net debt decreases. As net debt decreases, so does the associateddebt tax shield.

Technical Questions


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What are betas for tech industry?Which precedent transactions did you use?For valuing manulife financial used Great West Co, MetlifeFor samual manutech used AM Castle and co

Q. What has a cheaper cost of capital, Equity or Debt?

Debt will have a cheaper cost of capital. Interest expense is tax deductable and creates a taxshield for the corporation. Debtholder also have higher priority over equity holders duringliquidation, thus having less risk, thus requiring a lower rate of return.

Q. How do I determine the Cost of Debt and Equity?The cost of equity you can find through the CAPM model. Which equals to risk free rate plusbeta times excess market earnings (market earnings minus risk free rate). This will give youthe required rate of return on equity based on the beta of the asset/company. If you dontknow the Beta, use comparable company beta.The cost of debt can be found from yield to maturity on bonds if there is any debt oustanding.If no debt outstanding then look at comparable company YTM.

Q. How do I determine the Weighted Average Cost of Capital (WACC)?

The weighted average cost of capital equals to the weighted average of the cost of debt andcost of equity based on the capital structure. The cost of levered equity (found through CAPMmodel) times equity/(debt+equity) plus the cost of debt times debt/(debt+equity) times (1-t)will give you the WACC.

Q. If my capital structure is optimized, what also should be optimized?Return on Equity. Basically you have the optimal amount of equity to produce your netincome.

Q. Define cash earnings per share.cash flow from opearting activities divided by earnings per share?Cash Earnings=NI+Depreciation and Amortization+Deferred Taxes.

Q. A company is listed as an ADR on an American exchange. The ration of shares on

the home exchange to ADR shares is 6 for 1. If the ADR earnings per share is $6what is the EPS for a share listed on the home exchange?

$1, treat as if a 6 for 1 stock split occurred, 6/6.

Q. Suppose you have a company where EBITDA has been rising for the past severalyears and that company suddenly declares bankruptcy, name some reasons for whythat could have happened?Companies declare bankruptcy because they have no cash (liquidity crunch); the best answerwould be to walk down the cash flow statement and describe how each of the sections couldcontribute to a bankruptcy filing:- Working capital crunch (receivables could be rising; could be getting pushed on payables;might be required to build significant inventory)- Capex requirements could be large (ie telecom)

- Might not be able to refinance a maturing issue of debt- Litigation (ie Philip Morris posting tobacco bond)

Q. You are looking at acquiring a company, but that company has a negative bookvalue of equity. Is this a big deal?Negative book value of equity means that liabilities are larger than assets.You would want to see why the BV of equity is negative, and there could be several reasons:- Could be from negative net income over the past several years - this might a problem froman operational perspective- Might be due to a write-down of assets - would want to understand this but might not be as


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bad a recurring negative net income- Firm might have levered up to issue a large dividend - will leverage be an issue goingforward?

Q. Which will place a higher value on the company, equity comparables or M&Acomparables and why?

M&A comparables will be higher due to a control premium that must be paid and synergiesexpected to be derived from the deal

Q. Briefly walk through a discounted cash flow analysis. (including WACC)With a discounted cash flow analysis you can either find equity value or firm value. If youdecide to find firm value then you will have to get unlevered cash flows and discount them atthe weighted average cost of capital and add the present value of terminal year. Theunlevered cash flows equals to EBIT(1-t) plus depreciation minus increase in WC, minusCAPEX. We discount the 5-10 years of forecasted unlevered cash flows at the WACC discountrate. WACC=D/(D+E)*(1-T)*Rd + E/(D+E)*Re. The WACC rate reflects both the riskiness ofequity and debt holders since the cash flows are unlevered (going to both equity holders anddebt holders). WACC is the weighted average, based on capital strucutre, of cost of equityfrom CAPM model and cost of debt. Next, you would calculate a terminal value for the firmeither using a multiple of EBITDA or a perpetuity growth rate on the firm's free cash flow.

Multiple Method - Multiply the final year's EBITDA by an appropriate EBITDA multiple for thefirm (based on comparables). Terminal year calcluation is like the present value of a growingpepetuity. Perpetuity Growth Method - multiply the final year's free cash flow by (1+growthrate) and divide that by (r-g). Adding up the PV of the cash flows and terminal year will yieldus enterpries value. From here we can get equity value by subtracting net debt which is totaldebt less cash then less preferred stock less minority interest.The same can be done for equity valuation however you would use levered cash flows (NI plusdepreciation, minus CAPEX, minus increase in WC plus new issuance of debt minus repaymentof debt). You would then need to discount these forecased levered cash flows at the cost ofequity using CAPM model. Re levered = rf+ Betalevered(Rm-Rf). The rest is similar as above.To get firm value we would have to add net debt to equity value which again is total debt lesscash.

Q. If a company is considering an all-stock acquisition, what is the easiest way to

determine (roughly) whether or not the acquisition will be accretive or dilutive?If the P/E ratio of the acquiring company is higher than the target then the merger will beaccretive, if the P/E ratio is lower then it will be dilutive. For instance, if the acquirer's P/E is20, and the target's is 10, then you are able to pay less per dollar of earnings for the target.

Q. If you are going to graph a company's cost of capital, with the cost on the Y-axisand with the company's leverage level across the X-axis (from 0% leverage to 100%leverage), what would the graph look like?It would look approximately like a wide parabula (smile); the cost of capital would initiallydecline as you add leverage, however as the firm becomes increasingly levered, the cost ofcapital would increase due to bankruptcy risk

Q. Why would two companies merge / What major factors drive M &A?Some are the synergies derived from the merger such as revenue - cross-selling; expenses -

cost cutting; exploiting economies of scale, common distribution channels, elimination of acompetitor, etc., defensive (do not want someone else to acquire them), increased marketshare

Q. Why might a firm choose debt over equity financing?Some reasons:

Does not want to dilute equityCheaper cost of capital up to a reasonable levelWants to use leverage for increased returns


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They believe that there is lots of upside potential

Q. How do you unlever at beta?Unlevered beta (also known as asset beta) will be the weighted average, based on capitalstructure, of levered beta (Equity beta) plus debt betaUnlevered beta = Beta levered times equity/(debt+equity) plus (1-t) times debt/(equity+debt)times Beta of debt.However beta of debt is usually zero since risk is usually taken upon the equity holders.OR

Levered beta = Beta unlevered [1+(1-t)debt/equity]

Q. How do you calculate the enterprise value of a firm?Enterprise value = equity value (shares outstanding under Treasury method * price) plus netdebt (which is total debt less cash) + preferred stock + minority interest

Q. How do you value a company that is not CF positive, has no public comps, nor anyacquisition comps?Look at distribution, production methods of other companies and see if you can find anyoperational similarities. (i.e. find value drivers and see if there are companies that could becomps)

Q. Give me an example of a coverage ratio?EBITDA/interest expense: shows ability of the firm to generate sufficient cash flow to coverfixed charges; (EBITDA-Capex)/interest expense: shows ability to cover interest expense afterspending for capex

Q. What types of companies make good LBO targets?

Has predictable, stable CF; mature, steady industry; well-established products; limitedcapex and product development expenses; undervalued; owned by a motivated seller; nothighly levered

Q. Conglomerate X has a significant amount of debt maturing next year. With debt

markets still tight, what options does the company have?It could renew the debt offering if possible as higher rates?It could sell some of its assets (but would lose cashflow from that unit)It could do a secondary offering to pay off the obligations

Q. How would you value the naming rights of a stadium?You could look at comparables (adjusting for market differences, football, concerts,demographics, TV rights, size of stadium) to get the intrinsic value; you would then thinkabout market specific details and willingness to pay of potential buyers (key points understandvaluation is based on intrinsic value and willingness to pay).

Q. What are the 3 most common used valuation techniques?The 3 most common are DCF, public comp analysis using multiples, and precedent

transactions.Discounted Cash Flow (DCF)- The value of a firm is the present value of all future cashflows. A basic DCF involves forecasting free cash flow for the firm over a specific timehorizon and discounting these cash flows back at the weighted average cost of capital(WACC). Free cash flow (FCF) is usually defined as:

Operating Income (also known as EBIT) * (1-Tax Rate)


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Plus: Depreciation and Amortization (or other Non-Cash Charges)

Less: Change in Net Working Capital and Capital ExpendituresGenerally, you would forecast a FCF number for each year over a certain time horizon(usually 5 or 10 years) and then attach a terminal value (TV) for the firm. The TVrepresents the firm as a growing perpetuity. You can estimate the TV one of two ways:

TV= Final Year FCF (1+g)/(k-g)TV= Exit Multiple based on EBIT or EBITDA

The FCFs and the TV are then discounted back at the WACC. This value is known as theEnterprise Value. By subtracting out net debt (debt outstanding-less cash), you are leftwith an equity value for the firm. The equity value divided by the number of dilutedshares outstanding is the per share value.

Trading/Public Comparables (Comps)- This method involves finding comparablecompanies in the marketplace and determining at what multiple they trade to a variety of

factors. For example, if comparable companies have firm values anywhere from 5x-10xEBIT, and the company I am valuing has $100 million in EBIT, then the company couldbe worth anywhere from $500 million to $1 billion dollars. If you are asked about this,the best way is to give a quick example like the one described above.

Acquisition Comparables (Precedent transaction comps) - Similar to Trading Comps. Ifcomparable companies have been sold for 5x-10x revenues, and my company has $100million in revenues, then my company may be worth anywhere from $500 million to $1billion dollars.

They key to comparable valuation is picking the right set of comps. Obviously pickingcompanies in the same industry is necessary, but also think about other factors such as:

capital structure (companies who use more leverage may trade differently than companieswith all equity financing), size, seasonality, and operating margins.

Other valuation methods include liquidation value and Leveraged Buy-Out.

Q. Of these 3 techniques which is most likely to give the highest value of a company

and which is most likely to give the lowest value?Highest will be from transaction comps and lowest will be from public comps. WHY?

Q. How would you calculate unlevered free cash flow?

EBIT(1-T) plus depreciation and amortization minus/plus increase/decrease in WC minusCAPEX

Q. Give me an appropriate growth rate for a company's EBIT

Don't think there was really one answer, just talked about how growth differs dependingon where the company is in its life cycle and the industry outlook


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Q. What would be an appropriate growth rate to use in the terminal year?Usually 3-5 percent, can put it as the growth rate of GDP.

Q. Give me the changes in each of the three financial statements when accrued

liabilities increases by $10 and the tax rate is 40%.

ISexpenses will increase by $10, decreases EBT, and gives a tax savings of 4 dollarsbut NI decreases by 6 causing net income to fall by 6 dollars

BSliabilities will increase by $10, the equity will be lowered by $6 due to the expensewhich reduces the net income which goes into retained earning which goes into totalequity. Assets increase by $4 due to tax saving or liabilities will decrease by 4 due to taxpayable decreasing by $4

CFnet income will decrease by 6, working capital will decrease causing cash flowsfrom operating activities to increase by $4 as seen in increase of cash.

Q. If a private company wishing to sell the company approached you, how would

you go about advising the company?

a. Would value the company with comparables or precedent transactionsi. Acquisition-look at DCF analysis for valuationii. Merger-synergies look at market comps, precedent transactions

Q. Where do you think interest rates will be 2 year from now?In 2008 we have seen huge rate cuts so if economy starts stabilizing by 2009 then wemight see some increase in the previous months. In 2010 we will probably see a more

stabilized level of rates maybe even a bit of increase if economy starts growing at a rapidrate

Q. What is EBITDA?Earnings Before Interest Taxes Depreciation Amortization, used as a proxy for cash flow

Q. Walk me through a typical cash flow statement, balance sheet, or income

statement.CFCash flow from operating activities, investing activities, financing activities.Operating activities consists of net income plus depreciation & amortization and anyother non cash expenses, less increase in WC.Investing activities consists of any CAPEX made throughout the yearFinancing activities consists of dividend payments, issuance of new debt, repayment ofdebt

BSconsists of assets, liabilities and equityAssets includes short and long term assetsLiabilities includes short and long term liabilities such as debt


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Equity includes shareholders equity and retained earnings and other comprehensiveincomeISconsists of revenues, expenses and net income. Expenses can be recurring or onetime such as extraordinary and unusual losses.

Q. Company X's net income is ___; how do I compute their cash flow?Net income + depreciation and any non cash expenses, less increase in WC

Q. What is goodwill? How does it affect net income?Goodwill is generated only when acquiring another company, the excess paid over thevalue of assets. Measure of synergies when purchasing another company. It is notamortized, however if believed to be impaired you can do a loss on goodwill which willaffect net income.

Q. What is working capital?Current assets minus current liabilities. Measure of a companys efficiency and short

term financial health.

Q. What are deferred taxes? Where do they come from?Deferred taxes are the difference between the tax payable arising from depreciation at thecompanies own rates (financial accounting) and the depreciation rates used for taxpurposes (capital cost allowance for tax accounting).

Q. What is beta, what are limitations of beta?

Beta measures the sensitivity of security compared to the market, a measure ofmarket/systematic risk.Beta gives no information about the trend of an asset with respect to the trend of theindex. In fact, calculation of beta explicitly removes the trend, so has no dependency onit.

Q. What is CAPM, what are limitations of CAPM?Capital asset pricing model. Required return = risk free plus beta times excess marketearnings.Limitations - sensitive to historical period used, beta may change, markets are inefficient

Q. What is duration, convexity?

a. Duration is weighted average of present value of cash flowsb. Measures DP/DR, price sensitivity to rate changesc. Convexity is second derivative, how sensitive is DP to large changes in DR

Q. Define Sharpe RatioThe optimal portfolio that is tangent to the efficient frontierMeasure of the excess return (or Risk Premium) per unit of risk (slope of the securitymarket line)


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Q. If a company has bank loans, secured credit lines and high yield bonds, which

would de-value first if the company were to move insolvent.

Q. What assumptions would you make in valuing a business in a highly cyclical

business?Would have to make some kind of assumption about the cash flows and the timing of thecash flows.

Q. What is the difference between a leveraged buyout and a merger?

A merger involves the mutual decision of two companies to combine and become oneentity; it can be seen as a decision made by two "equals". The combined business,through structural and operational advantages secured by the merger, can cut costs andincrease profits, boosting shareholder values for both groups of shareholders. A typicalmerger, in other words, involves two relatively equal companies, which combine to

become one legal entity with the goal of producing a company that is worth more than thesum of its parts.

Takeover is the combination of unequals. A larger company buying a smaller one. Thiscombination of "unequals" can produce the same benefits as a merger, but it does notnecessarily have to be a mutual decision. A larger company can initiate a hostile takeoverof a smaller firm, which essentially amounts to buying the company in the face ofresistance from the smaller company's management.

Q. What are common multiples used to gauge equity performance?

Some common equity multiples are price to earnings (P/E), price to book value, price tofree cash flow to equity

Q. How are the multiples computed (numerator, denominator)?

There are usually equity multiples and firm value (EV) multiples. Numerator for equitymultiples is price per share or market cap and denominator can be earnings per share,book value per share, net income, free cash flow to equity. For EV multiples thenumerator is usually enterprise value and denominator would be things such as operatingincome (EBIT), EBITDA or book value of capital.

Firm value multiples are easier to work with than equity multiples when comparingcompanies with different debt ratios.

Q. What multiples are generally used in a merger/acquisition?

Most commonly used multiple in M&A is the P/E multiple. Add more, and talk aboutwhy.


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Q. What are common ratios used to assess the debt of a company?

Two main ones are Debt/equity ratio, EBIT/interest expense (interest coverage ratio)

Q. Why use EBIT in the DCF?

EBIT is a good proxy for cash flows. It can be used in DCF if you are trying to find thefirm value since EBIT will give you unlevered cash flows.

Q. How do you go from P/E to ROE? Or How do you go from ROE to Ke

P/E = 1/ROE x Price/Book ratio

ROE x Price/Book = Ke (cost of equity) why is this???

Q. What are some reasons why you would have a positive cash flow and a negative

cash flow?

Will have positive cash flows if net income is generated mainly through cash sales andpayments are made through payables. If there are sales of assets and no CAPEX. If thereare debt offerings and no repayments of debt or no dividends. Opposite for negative cashflows. If net income is generated through sales on account and payments are made bycash. If there are no sales of assets and high CAPEX and if there is repayment of debt andno issuance and if there are dividends distributed.

Q. Why add back depreciation and amortization to find Unlevered Free Cash Flow?

Depreciation and amortization are non cash expenses, meaning they will reduce yourEBIT on paper but in reality there is no cash outflow from that expense.

Q. I see you worked for Company X. What valuation methods would you use to

value Company X and why? Which companies would you use as comparables and

why? What multiples would you use to compare and why?

Q. How would you go about valuing a company whose stock you were considering

buying?

Q. What project in a previous job or class involved valuing a company and how did

you value that company?


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Talk about Amazon and dwell. How used DCF to find firm value, which betas you used,which discount rates you used, how you determined terminal value.

Q. How do you value a company with no revenue?

Based on comparables. If it is a company with a pending patent then value it as a put

option.

Q. Tell me how you would go about valuing a privately held construction company?

What if there are no publicly traded peers?Would use multiples based on comparables in the industry. If there are no publicly tradedpeers then forecast potential cash flows and use them? No idea

Q. What are the main issues in valuing a privately held firm?Acquiring betas, discount rates, cash flows.

Q. How would you value a non-U.S. company?

With multiple analysis of comparable non-US firms. Can do DCF valuation withappropriate discount rates?

Q. How would you value a company with no earnings such as a start up?

Would use revenue multiples, what else?

Q. How do you compute a terminal value on a DCF?If it's a strategic deal, you'll probably use a perpetuity model since they want the asset forthe long term. If it's a financial deal the sponsor will want to sell in the terminal year andyou'll use a multiple, like EV/EBITDA.There are two methods. You can use terminal EBIDTA exit multiples and you can viewthe final year FCF as a growing perpetuity. Multiply final year EBIDTA by a multiple ofcomparable firms. Take final year FCF and apply appropriate growth rate, discount bydiscount rate minus growth rate. Discount this total value to present date.

Q. How do you determine your Free Cash Flows? Why is there a need to calculate

it?You can calculate either unlevered free cash flows or levered free cash flows. Unleveredfree cash flows = EBIT(1-T) + depreciation & amortizationincrease in WCCAPEXLevered free cash flows = NI + depreciation & amortizationincrease in WCCAPEX+ (Debt issuancedebt repayment).

FCFF = Net income + Noncash charges (such d&A) + Interest expense * (1-Tax rate) -Capex - Working capital expenditures = Free Cash Flows to the Firm (FCFF)

FCFE = Net income + Noncash charges (such d&A) - Capex + Net borrowing - Net debtrepayment - Working capital expenditures = Free Cash Flows to the equity (FCFE)

Q. Where do you get EBIT?

Income statement, same as operating income


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Q. What is EBIT?

Earnings before interest and taxes. A proxy for cash flows.

Q. What is EBITDA?

Earnings before interest, taxes, depreciation & amortization. Proxy for cash flows withoutincluding depreciation, D&A is always added back to EBIT to get EBITDA forcalculations of FCFF

Q. Why is EBITDA a surrogate for operating cash flows?

Q. What is the difference between EBIT and Operating Income?

EBIT includes non operating income

Q. What type of discount rate would I use in valuing the cash flows of a particular

company?

For firm valuation would use the WACC, use the cost of debt from bonds outstandingand use the cost of equity from CAPM model based on the levered beta of the company,risk free rate, and market returns.For equity valuation would use the CAPM rate which is the return on equity consisting ofrisk free rate, levered beta, and market returns.

Q. What is the value ratio?Selecting companies with low P/E ratios who pay out high dividends and low price tobook ratio.

Q. What is price to book value?Price per share divided by book value per share (equity/# of shares) Whether you'repaying too much for what would be left if the company went bankrupt immediately.

Q. What beta do you use in CAPM and how do you obtain it?Usually you would use leveraged beta if you are trying to find levered equity. However ifyou are doing the APV approach you would use the unlevered beta to get the unleveredreturn on equity to find the unlevered value of the firm then add back the present value ofthe tax shield from having debt. You can obtain it by regressing the stock returns to themarket returns or more mathematically its covariance between market and securitydivided by variance of market.

Q. How do you unlever a Beta? Why do you unlever a beta?Beta levered = Beta unlevered[1+(1-t)D/E].If you are trying to find the unlevered beta of a firm for APV valuation then you coulduse the levered beta and unlever it.

Q. How do you lever a Beta? Why do you lever a beta?

Beta unlevered = Beta equity times E/(D+E) plus (1-t) times D/(D+E) times Debt Beta.However Beta of debt is usually zero since all risk is usually borne by equity holders.


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If you have unlevered beta and want to get levered beta for CAPM model or for WACC.Where does the 1-t come from in the unlevering a beta equation?

Q. In calculating CAPM, do you use an asset beta or an equity beta?

In CAPM you use equity beta because you are trying to find out the required return toequity. However you can use the asset beta (unlevered beta) if you want to find theunlevered firm value for APV approach.

Q. When do you use an unlevered Beta or a levered Beta?

You would use levered beta when doing equity valuation or when doing firm valuationusing WACC. You would use unlevered beta if you are doing firm valuation with APVmethod in order to find unlevered firm value.

Q. If you have an asset beta how do you derive your equity beta?Beta equity = Beta asset/(Equity/(Debt+Equity)

Q. What companies or industries have high Betas?

Volatility in earnings is what determines beta. Three things that affect beta are financialleverage, operating leverage and industry characteristics such as cyclical businesses.High beta companies would be tech stocks, financials, and construction.

Q. You are interested in X company, what is its beta and the industry average beta?

Q. What index is used to calculate beta?Usually S&P 500 or some other market index.

Q. Is beta constant or does it vary over time?

Beta varies over time; it is dependent on earning volatility which depends on industrycharacteristics, financial leverage, and operating leverage.

Q. What do you think the beta of General Motors is? What about a high-tech stock

such as Cisco Systems?GM would have high beta of about 1.8-2. The reason is that in good economic conditionsthey will see their sales increasing, while people buy more cars. Cisco systems wouldhave a low beta of 1.1-1.3. Explain why?

Q. What number would you use for the market risk premium?

Would use historical premium of 6.8% for US.

Q. What number would you use for the risk-free rate?If forecasts are for 10 years then 10 year t bill rate.

Q. How do you calculate the Gordon Growth Model or Perpetuity Model for the

second Terminal Value?FCF(1+g)/(r-g)


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Q. What are some of the advantages and disadvantages of DCF?Advantages- Looks for fundamentals that drive value rather than what market perceptions are.-

If stock prices rise disproportionately relative to the underlying earnings and cashflows, DCF models are likely to find stocks to be overvalued, and the opposite.

Disadvantages:- DCF valuations can be manipulated to generate estimates of value that have no

relationship to intrinsic value due to the vast amount of assumptions that are needed- Need substantially more information to value a company with DCF models, since

estimates of cash flows, growth rates, and discount rates are needed.- DCF may find every stock in a sector or even a market to be overvalued if market

perceptions have run ahead of fundamentals.

Q. What is NOPLAT?Net operating profits less adjusted taxes, same as EBIT(1-T). Removes the effects ofcapital structure.

Q. Is a DCF valuation the value of equity or the enterprise value of a company?Can be either depending if you use unlevered or levered cash flows

Q. Reconcile Free Cash Flow from Net Income? Are they asking for free cash flow tofirm/equity?Net income + depreciationincrease in wc

Q. How do you find diluted shares outstanding?Total common shares + any convertible shares

Q. What is the Treasury Stock Method? When would you use it? How do you calculateit? Check in accounting bookThe component of the diluted earnings per share denominator that includes the netof new shares potentially created by unexercised in-the-money warrants and options. Thismethod assumes that the proceeds that a company receives from an in-the-money optionexercise are used to repurchase common shares in the market.

Q. How do you get the Enterprise Value (or known as firm value, total capitalization,transaction value, aggregate value, adjusted market value)?Can do market cap (equity) + net debt + preferred shares + minority interestCan do DCF with unlevered cash flows

Comparable Questions:


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Understand equity and enterprise multiples. Know them backwards and forwards andwhen you apply them, what companies would use equity multiples vs. enterprisemultiples, how it is related to debt, etc.

Q. What are the difference between public comparables and acquisition comparables?

Acquisition comparables are used to derive the relative value of a company based onprecedent transactions in a given industry. Acquisition comparables will be higher due topremium paid and synergies to be derived from the merger/acquisitionPublic comparables are derived from public company 10-K/10-Qs

Q. Why dont you compare Net Income to Enterprise Value?

Q. What is difference between Enterprise Value and Equity Value?Enterprise value is the value of the firms total debt and market value of equity, whileequity value is just the market value of equity

Public or Trading Comparables Questions:

Q. Pick a company. What multiples would you use for that company? What if it was astart-up? What if it had high CAPEX that was unusual?

Q. What determining factors would you use to find comparable companies for a publiccomp?

Q. How would you do a public comparable?

Q. How do you find the appropriate market value for a company?

Q. You are interested in company X, what multiples would you use to compare it to itspeers?

Q. How would you find information for a comp?Capital IQ, 10-K/10-Q of companies

Q. When do you use public vs. acquisition?

Q. You said you were interested in health care, what is an average P/E multiple in thisarea.

Acquistion or Transaction Comparables Questions:

Q. What are the key factors in determining your comparable transactions?

Q. What is included in the price paid for an acquisition?Control premium and synergies to be derived from the deal


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Q. What is the difference between offer value and equity value?Same thing?

Q. What is the difference between transaction value and enterprise value?

Same thing?

Q. How would you determine the deal list for acquisition comps?

Q. What are some shortcomings of acquisition comps?

Q. What multiples would you use for acquisition comps?

Random Questions:

Q. Company A and B are in the restaurant business. Company A is buying company B.What things would company A want to know?

Q. What is an option? You're talking to a CEO about how he could use options. Whatwould you say?

Q. How would you value and compare a private all equity company vs. a publiccompany with equity and debt?

Q. How do you calculate the cost of debt for a private company?

Q. If valuing an all-equity company, how would you calculate the cost of equity?

Q. If you were advising a client on an acquisition and your client was willing to paybetween $800M - $1B and you knew a PE outfit was about to make a bid for $850M,what would you offer to preempt their bid?

Q. If company A owned its stores and company B leased its stores, which would havethe higher EBITDA?

Q. Its 10pm and you have a pitch to prepare for morning what would you do toprepare a valuation for the client company?

Q. If a target company has a higher P/E than the acquirer in an all-stock deal, will theacquisition be accretive or dilutive?

Q. What are the benefits of pooling versus purchase method in an acquisition?

Q. You said you were interested in technology, what's the average debt load for atechnology company?

Q. What is an LBO and how is it structured?


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Q. What make a company a good candidate for an LBO?

Q. How do you ref out a model? (more geared towards former analysts). When a modelblows up, what are the three ways to fix it?

Q. In a secondary offering, if you could only choose one method of valuation, which onewould you use? Why?

Q. What is operating leverage?

Q. Tell me how you have modeled with equations in the past?

Q. Do you have an analytical mind? Show me.

Q. What are the benefits of pooling versus purchase method in an acquisition?

Q. Heres a whiteboard. Stand in front of it and present a chapter from your favoritefinance textbook. You have five minutes.

Q. Do you know the relationship between the price and yield on the bond?

Q. How you developed your core finance skills (analytical ability, good communicationskills, strong work ethic)?

Q. What is an option? You're talking to a CEO about how he could use options. Whatwould you say?

Q. Tell me about the stock a stock that you follow? (what are we suppose to say)

Q. What does liquidity allow an investor?

Q. If you worked for the finance division of our company, how would you decidewhether or not to invest in a project?

Q. Why might a technology company be more highly valued in the market in terms ofP/E than a steel company?

Q. When should a company raise money via equity?

Q. When should a company raise funds using debt?

Q. How would one price the different elements of a convertible bond? (not as likely of aquestion)


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Q. Your client wants to buy one of two banks. One is trading at 12xP/E and the othertrades at a 16xP/E. Which should your client try to buy? Do you even have enoughinformation to determine this?

Q. What are some ways to determine if a company might be a credit risk?

Q. How does compounding work? Would I be better off with 10% annually, semi-annually or daily?

Q. For a bond, what is duration? Why is duration important?

Q. What is the difference between preferred stock and regular stock?

Q. How can a company raise its stock price?

Q. What is a leveraged buyout? Why lever up?

Q. Your boss uses the DCF model for high growth company with low earnings. What doyou think of this strategy?

Q. Can I apply CAPM in Latin America markets?

Q. How do you value a company with NOLS (Net Operating Losses)?

Q. Why would a company do a share repurchase or buyback?

Q. What are the pros and cons of a company going public?

Q. Why would a company decide to issue a convertible bond or equity or debt?

Valuation

What are the three main valuation methodologies?

The three main valuation methodologies are (1) comparable company analysis, (2)precedent transaction analysis and (3) discounted cashflow (DCF) analysis.

Of the three main valuation methodologies, which ones are likely to

result in higher/lower value?Firstly, the Precedent Transactions methodology is likely to give a higher valuation thanthe Comparable Company methodology. This is because when companies are purchased,the targets shareholders are typically paid a price that is higher than the targets currentstock price. Technically speaking, the purchase price includes a control premium.Valuing companies based on M&A transactions (a control based valuation methodology)
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will include this control premium and therefore likely result in a higher valuation than apublic market valuation (minority interest based valuation methodology).

The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuationthan the Comparable Company analysis because DCF is also a control basedmethodology and because most projections tend to be pretty optimistic. Whether DCFwill be higher than Precedent Transactions is debatable but is fair to say that DCFvaluations tend to be more variable because the DCF is so sensitive to a multitude ofinputs or assumptions.

How do you use the three main valuation methodologies to concludevalue?

The best way to answer this question is to say that you calculate a valuation range foreach of the three methodologies and then triangulate the three ranges to conclude avaluation range for the company or asset being valued. You may also put more weighton one or two of the methodologies if you think that they give you a more accurate

valuation. For example, if you have good comps and good precedent transactions buthave little faith in your projections, then you will likely rely more on the ComparableCompany and Precedent Transaction analyses than on your DCF.

What are some other possible valuation methodologies in addition tothe main three?

Other valuation methodologies include leverage buyout (LBO) analysis, replacementvalue and liquidation value.

What are some common valuation metrics?

Probably the most common valuation metric used in banking is Enterprise Value(EV)/EBITDA. Some others include EV/Sales, EV/EBIT, Price to Earnings (P/E)and Price to Book Value (P/BV).

Why cant you use EV/Earnings or Price/EBITDA as valuationmetrics?

Enterprise Value (EV) equals the value of the operations of the company attributable toall providers of capital. That is to say, because EV incorporates all of both debt andequity, it is NOT dependant on the choice of capital structure (i.e. the percentage of debtand 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 notdependant on capital structure because they do not include interest expense. Operatingmetrics such as earnings do include interest and so are considered leveraged or capitalstructure dependant metrics. Therefore EV/Earnings is an apples to oranges comparisonand is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (orequity 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 bothlevered.
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Enterpri se Value and Equity Value

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 andrepresents only the proportion of value attributable to shareholders.

What is the formula for Enterprise Value?

The formula for enterprise value is: market value of equity (MVE) + debt + preferredstock + minority interest - cash.

How do you calculate the market value of equity?

A companys market value of equity (MVE) equals its share price multiplied by thenumber of fully diluted shares outstanding.

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 ofthe reporting date). Fully diluted shares equals basic shares plus the potentially dilutiveeffect from any outstanding stock options, warrants, convertible preferred stock orconvertible debt. In calculating a companys market value of equity (MVE) we alwayswant to use diluted shares. Implicitly the market also uses diluted shares to value acompanys stock.

How do you calculate fully diluted shares?

To calculate fully diluted shares, we need to add the basic number of shares (found on thecover of a companys most recent 10Q or 10K) and the dilutive effect of employee stockoptions. To calculate the dilutive effect of options we typically use the Treasury StockMethod. The options information can be found in the companys latest 10K. Note that ifthe company has other potentially dilutive securities (e.g. convertible preferred stock orconvertible debt) we may need to account for those as well in our fully diluted sharecount.

How do we use the Treasury Stock Method to calculate dilutedshares?

To use the Treasury Stock Method, we first need a tally of the companys issued stock

options and weighted average exercise prices. We get this information from thecompanys most recent 10K. If our calculation will be used for a control based valuationmethodology (i.e. precedent transactions) or M&A analysis, we will use all of the optionsoutstanding. If our calculation is for a minority interest based valuation methodology(i.e. comparable companies) we will use only options exercisable. Note that optionsexercisable are options that have vested while options outstanding takes into account bothoptions that have vested and that have not yet vested.
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Once we have this option information, we subtract the exercise price of the options fromthe current share price (or per share purchase price for an M&A analysis), divide by theshare price (or purchase price) and multiply by the number of shares outstanding. Werepeat this calculation for each subset of options reported in the 10K (usually companieswill 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 isgreater than the share price (or purchase price) then the options are out-of-the-money andhave no dilutive effect.

The concept of the treasury stock method is that when employees exercise options, thecompany has to issue the appropriate number of new shares but also receives the exerciseprice of the options in cash. Implicitly, the company can use this cash to offset the costof issuing new shares. This is why the diluted effect of exercising one option is not onefull share of dilution, but a fraction of a share equal to what the company does NOTreceive in cash divided by the share price.

Why do you subtract cash in the enterprise value formula?

Cash gets subtracted when calculating Enterprise Value because (1) cash is considered anon-operating asset AND (2) cash is already implicitly accounted for within equityvalue. Note that when we subtract cash, to be precise, we should say excess cash.However, we will typically make the assumption that a companys cash balance(including cash equivalents such as marketable securities or short-term investments)equals excess cash.

What is Minority Interest and why do we add it in the Enterprise Valueformula?

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 companyreflects 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 financialstatements. But since the parent company does not 100% of the sub, the parent companywill have a line item called minority interest on its income statement reflecting theportion of the subs net income that the parent is not entitled to (the percentage that itdoes not own). The parent companys balance sheet will also contain a line item calledminority interest which reflects the percentage of the subs book value of equity that theparent does NOT own. It is the balance sheet minority interest figure that we add in theEnterprise Value formula.

Now, keep in mind that the main use for Enterprise Value is to create valuationratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take, say, sales or EBITDAfrom the parent companys financial statements, these figures due to the accountingconsolidation, will contain 100% of the subs sales or EBITDA, even though the parentdoes not own 100%. In order to counteract this, we must add to Enterprise Value, thevalue of the sub that the parent company does not own (the minority interest). By doingthis, both the numerator and denominator of our valuation metric account for 100% of thesub, and we have a consistent (apples to apples) metric.
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One might ask, instead of adding minority interest to Enterprise Value, why dont we justsubtract the portion of sales or EBITDA that the parent does NOT own. In theory, thiswould indeed work and may in fact be more accurate. However, typically we do not haveenough information about the sub to do such an adjustment (minority owned subs arerarely, if ever, public companies). Moreover, even if we had the financial information of

the sub, this method is clearly more time consuming.

Discounted Cash F low (DCF)

Walk me through a Discounted Cash Flow (DCF) analysis

In order to do a DCF analysis, first we need to project free cash flow for a period of time(say, five years). Free cash flow equals EBIT less taxes plus D&A less capitalexpenditures less the change in working capital. Note that this measure of free cash flowis unlevered or debt-free. This is because it does not include interest and so isindependent of debt and capital structure.

Next we need a way to predict the value of the company/assets for the years beyond theprojection period (5 years). This is known as the Terminal Value. We can use one oftwo methods for calculating terminal value, either the Gordon Growth (also calledPerpetuity Growth) method or the Terminal Multiple method. To use the Gordon Growthmethod, we must choose an appropriate rate by which the company can grow forever.This growth rate should be modest, for example, average long-term expected GDPgrowth or inflation. To calculate terminal value we multiply the last years free cash flow(year 5) by 1 plus the chosen growth rate, and then divide by the discount rate less growthrate.

The second method, the Terminal Multiple method, is the one that is more often used in

banking. Here we take an operating metric for the last projected period (year 5) andmultiply it by an appropriate valuation multiple. This most common metric to use isEBITDA. We typically select the appropriate EBITDA multiple by taking what weconcluded for our comparable company analysis on a last twelve months (LTM) basis.

Now that we have our projections of free cash flows and terminal value, we need topresent value these at the appropriate discount rate, also known as weighted averagecost of capital (WACC). For discussion of calculating the WACC, please read the nexttopic. Finally, summing up the present value of the projected cash flows and the presentvalue of the terminal value gives us the DCF value. Note that because we used unleveredcash flows and WACC as our discount rate, the DCF value is a representation of

Enterprise Value, not Equity Value.

What is WACC and how do you calculate it?

The WACC (Weighted Average Cost of Capital) is the discount rate used in a DiscountedCash Flow (DCF) analysis to present value projected free cash flows and terminal value.Conceptually, the WACC represents the blended opportunity cost to lenders and investorsof a company or set of assets with a similar risk profile. The WACC reflects the cost ofeach type of capital (debt (D), equity (E) and preferred stock (P)) weighted by the
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respective percentage of each type of capital assumed for the companys optimal capitalstructure. Specifically the formula for WACC is: Cost of Equity (Ke) times % of Equity(E/E+D+P) + Cost of Debt (Kd) times % of Debt (D/E+D+P) times (1-tax rate) + Cost ofPreferred (Kp) times % of Preferred (P/E+D+P).

To estimate the cost of equity, we will typically use the Capital Asset Pricing Model(CAPM) (see the following topic). To estimate the cost of debt, we can analyze theinterest rates/yields on debt issued by similar companies. Similar to the cost of debt,estimating the cost of preferred requires us to analyze the dividend yields on preferredstock issued by similar companies.

How do you calculate the cost of equity?

To calculate a companys cost of equity, we typically use the Capital Asset PricingModel (CAPM). The CAPM formula states the cost of equity equals the risk free rateplus the multiplication of Beta times the equity risk premium. The risk free rate (for aU.S. company) is generally considered to be the yield on a 10 or 20 year U.S.

Treasury Bond. Beta (See the following question on Beta) should be levered andrepresents the riskiness (equivalently, expected return) of the companys equity relativeto the overall equity markets. The equity risk premium is the amount that stocks areexpected to outperform the risk free rate over the long-term. Today, most banks tend touse an equity risk premium of between 4% and 5%.

What is Beta?

Beta is a measure of the riskiness of a stock relative to the broader market (for broadermarket, think S&P500, Wilshire 5000, etc). By definition the market has a Beta of one(1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and astock with a Beta of less than 1 is perceived to be less risky. For example, if the market

is expected to outperform the risk-free rate by 10%, a stock with a Beta of 1.1 will beexpected to outperform by 11% while a stock with a Beta of 0.9 will be expectedto outperform by 9%. A stock with a Beta of -1.0 would be expected to underperform therisk-free rate by 10%. Beta is used in the capital asset pricing model (CAPM) for thepurpose of calculating a companys cost of equity. For those few of you that rememberyour statistics and like precision, Beta is calculated as the covariance between a stocksreturn and the market return divided by the variance of the market return.

When using the CAPM for purposes of calculating WACC, why do youhave to unlever and then relever Beta?

In order to use the CAPM to calculate our cost of equity, we need to estimate theappropriate Beta. We typically get the appropriate Beta from our comparable companies(often the mean or median Beta). However before we can use this industry Beta wemust first unlever the Beta of each of our comps. The Beta that we will get (say fromBloomberg or Barra) will be a levered Beta.

Recall what Beta is: in simple terms, how risky a stock is relative to the market. Otherthings being equal, stocks of companies that have debt are somewhat more risky thatstocks of companies without debt (or that have less debt). This is because even a small
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amount of debt increases the risk of bankruptcy and also because any obligation to payinterest represents funds that cannot be used for running and growing the business. Inother words, debt reduces the flexibility of management which makes owning equity inthe company more risky.

Now, in order to use the Betas of the comps to conclude an appropriate Beta for thecompany we are valuing, we must first strip out the impact of debt from the compsBetas. This is known as unlevering Beta. After unlevering the Betas, we can now use theappropriate industry Beta (e.g. the mean of the comps unlevered Betas) and relever itfor the appropriate capital structure of the company being valued. After relevering, wecan use the levered Beta in the CAPM formula to calculate cost of equity.

What are the formulas for unlevering and levering Beta?

Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Debt/Equity)))

Levered Beta = Unlevered Beta x (1 + ((1 - Tax Rate) x (Debt/Equity)))

Which is less expensive capital, debt or equity?

Debt is less expensive for two main reasons. First, interest on debt is tax deductible (i.e.the tax shield). Second, debt is senior to equity in a firms capital structure. That is, in aliquidation or bankruptcy, the debt holders get paid first before the equity holders receiveanything. Note, debt being less expensive capital is the equivalent to saying the cost ofdebt is lower than the cost of equity.

Mergers and Acquisit ions

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 acquirors EarningsPer Share (EPS) and compare how the new EPS (proforma EPS) compares to what thecompanys EPS would have been had it not executed the transaction.

In order to do the accretion/dilution analysis, we need to project the combined companysnet income (proforma net income) and the combined companys new share count. Theproforma net income will be the sum of the buyers and targets projected net incomeplus/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 thetransaction.

The proforma share count reflects the acquirors share count plus the number of shares tobe created and used to finance the purchase (in a stock deal). Dividing proforma netincome by proforma shares gives us proforma EPS which we can then compare to theacquirors 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
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using 1-year and 2-year projected net income and also sometimes last twelve months(LTM) proforma net income.

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 acquirors earnings per

share (EPS), including: (1) the target has negative net income, (2) the targetsPrice/Earnings ratio is greater than the acquirors, (3) the transaction creates a significantamount of intangible assets that must be amortized going forward, (4) increased interestexpense due to new debt used to finance the transaction, (5) decreased interest incomedue to less cash on the balance sheet if cash is used to finance the transaction and (6) lowor negative synergies.

If a company with a low P/E acquires a company with a high P/E in anall 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 islower than the P/E of the target, then the deal will be dilutive to the acquirors EarningsPer Share (EPS). This is because the acquiror has to pay more for each dollar of earningsthan the market values its own earnings. Hence, the acquiror will have to issueproportionally more shares in the transaction. Mechanically, proforma earnings, whichequals the acquirors earnings plus the targets earnings (the numerator in EPS) willincrease less than the proforma share count (the denominator), causing EPS to decline.

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 andliabilities. Goodwill is calculated by subtracting the targets book value (written up to

fair market value) from the equity purchase price paid for the company. This equation issometimes referred to as the excess purchase price. Accounting rules state thatgoodwill no longer should be amortized each period, but must be tested once peryear for impairment. Absent impairment, goodwill can remain on a companys balancesheet indefinitely.

Why might one company want to acquire another company?

There are a variety of reasons why companies do acquisitions. Some common reasonsinclude:

- The Buyer views the Target as undervalued. - The Buyers own organic growth has slowed or stalled and needs to grow in

other ways (via acquiring other companies) in order to satisfy the growthexpectations of Wall Street.

- The Buyer expects the deal to result in significant synergies (see the next postfor a discussion of synergies).

- The CEO of the Buyer wants to be CEO of a larger company, either because ofego, legacy or because he/she will get paid more.
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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 ofthe Buyer and the Target as a combined company is greater than the two companiesvalued apart. Most mergers and large acquisitions are justified by the amount ofprojected 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 dueto the consolidation of operations. For example, closing one corporate headquarters,laying off one set of management, shutting redundant stores, etc. Revenue synergiesrefer to the ability to sell more products/services or raise prices due to the merger. Forexample, increasing sales due to cross-marketing, co-branding, etc. The concept ofeconomies of scale can apply to both cost and revenue synergies.

In practice, synergies are easier said than done. While cost synergies are difficult toachieve, revenue synergies are even harder. The implication is that many mergers fail tolive up to expectations and wind up destroying shareholder value rather than create it. Ofcourse, this last fact never finds its way into a bankers M&A pitch.

Leveraged Buyout (LBO) Analysis

Walk me through an LBO analysis

First, we need to make some transaction assumptions. What is the purchase price andhow will the deal be financed? With this information, we can create a table of Sourcesand Uses (where Sources equals Uses). Uses reflects the amount of money required toeffectuate the transaction, including the equity purchase price, any existing debt beingrefinanced and any transaction fees. The Sources tells us from where the money is

coming, including the new debt, any existing cash that will be used, as well as the equitycontributed by the private equity firm. Typically, the amount of debt is assumed basedon the state of the capital markets and other factors, and the amount of equity is thedifference between the Uses (total funding required) and all of the other sources offunding.

The next step is to change the existing balance sheet of the company to reflect thetransaction and the new capital structure. This is known as constructing the proformabalance sheet. In addition to the changes to debt and equity, intangible assets such asgoodwill and capitalized financing fees will likely be created.

The third, and typically most substantial step is to create an integrated cashflow modelfor the company. In other words, to project the companys income statement, balancesheet and cashflow statement for a period of time (say, five years). The balance sheetmust be projected based on the newly created proforma balance sheet. Debt and interestmust be projected based on the post-transaction debt.

Once the functioning model is created, we can make assumptions about the private equityfirms exit from its investment. For example, a typical assumption is that the company issold after five years at the same implied EBITDA multiple at which the company was
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purchased. Projecting a sale value for the company allows us to also calculate the valueof the private equity firms equity stake which we can then use to analyze its internal rateof return (IRR). Absent dividends or additional equity infusions, the IRR equals theaverage annual compounded rate at which the PE firms original equity investmentgrows (to its value at the exit).

While theprivate equity firms IRR is usually the most important piece of informationthat comes out of an LBO analysis, the analysis also has other uses. By assuming the PEfirms required IRR (amongst other things), we can back into a purchase price for thecompany, thus using the analysis for valuation purposes. In addition, we can utilize theLBO model to analyze the trend of credit statistics (such as the leverage ratio and interestcoverage ratio) which is especially important from a lenders perspective.

Why do private equity firms use leverage when buying a company?

By using significant amounts of leverage (debt) to help finance the purchase price, theprivate equity firm reduces the amount of money (the equity) that it must contribute to

the deal. Reducing the amount of equity contributed will result in a substantial increaseto the private equity firms rate of return upon exiting the investment (e.g. selling thecompany five years later).

Lets say you run an LBO analysis and the private equity firms returnis too low. What drivers to the model will increase the return?

Some of the key ways to increase the PE firms return (in theory, at least) include:

- 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 companys growth rate in order to raise operating

income/cashflow/EBITDA in the projectionsdecrease the companys costs in order to raise operatingincome/cashflow/EBITDA in the projections

What are some characteristics of a company that is a good LBOcandidate?

Notwithstanding the recent LBO boom where nearly all companies were considered to bepossible LBO candidates, characteristics of a good LBO target include steady cashflows,

limited business risk, limited need for ongoing investment (e.g. capital expenditures orworking capital), strong management, opportunity for cost reductions and a high assetbase (to use as debt collateral). The most important trait is steady cashflows, as thecompany must have the ability to generate the cashflow required to support relativelyhigh interest expense.

Accounting
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If a company incurs $10 (pretax) of depreciation expense, how doesthat affect the three financial statements?

The most common version of this type of question. Note that the amount of depreciationmay be a number other than $10. To answer this question, take the three statements oneat a time.

First, the income statement: depreciation is an expense so operating income (EBIT)declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, thecash flow statement: net income decreased $6 and depreciation increased $10 so cashflow from operations increased $4. Finally, the balance sheet: cumulative depreciationincreases $10 so Net PP&E decreases $10. We know from the cashflow statement thatcash increased $4. The $6 reduction of net income caused retained earnings to decreaseby $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 andCash +4) and shareholders equity decreased $6.

You may get the follow-up question: I f depreciation is non-cash, explain how this

transaction caused cash to i ncrease $4. The answer is that because of the depreciationexpense, the company had to pay the government $4 less in taxes so it increased its cashposition by $4 from what it would have been without the depreciation expense.

A company makes a $100 cash purchase of equipment on Dec. 31.How does this impact the three statements this year and next year?

Fir st Year: Lets assume that the companys fiscal year ends Dec. 31. The relevance ofthe purchase date is that we will assume no depreciation the first year. IncomeStatement: A purchase of equipment is considered a capital expenditure which does notimpact earnings. Further, since we are assuming no depreciation, there is no impact tonet 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 weve got a $100increase in capex so there is a $100 use of cash in cash flow from investing activities. Nochange in cash flow from financing (since this is a cash purchase) so the net effect is ause of cash of $100. Balance Sheet: Cash (asset) down $100 and PP&E (asset) up $100so no net change to the left side of the balance sheet and no change to the right side. Weare balanced.

Second Year: Here lets assume straightline depreciation over 5 years and a 40% taxrate. Income Statement: Just like the previous question: $20 of depreciation, whichresults in a $12 reduction to net income. Cash Flow Statement: Net income down $12and 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 $20so left side of balance sheet doen $12. Retained earnings (shareholders equity) down$12 and again, we are balanced.

Same question as the previous but the company finances thepurchase of equipment by issuing debt rather than paying cash.

Fir st 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
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operations. Just like the previous question, weve got a $100 increase in capex so there isa $100 use of cash in cash flow from investing activities. Now, however, in ourcash flows from financing section, weve got an increase in debt of $100 (source ofcash). 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. Lets also assume a10% interest rate on the debt and no debt amortization. Income Statement: Just like theprevious 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: Netincome down $18 and depreciation up $20. No change to cash flow from investing orfinancing activities (if we assumed some debt amortization, we would have a use of cashin financing activities). Net effect is cash up $2. Balance Sheet: Cash (asset) up $2 andPP&E (asset) down $20 so left side of balance sheet down $18. Retained earnings(shareholders equity) down $18 and voila, we are balanced.

Continuing with the last question, on Jan. 1 of Year 3 the equipmentbreaks and is deemed worthless. The bank calls in the loan. Whathappens in Year 3?

Now the company must writedown the value of the equipment down to $0. At thebeginning of Year 3, the equipment is on the books at $80 afterone years depreciation.Further, the company must pay back the entire loan. Income statement: The $80writedown causes net income to decline $48. There is no further depreciation expenseand no interest expense. Cash Flow Statement: Net income down $48 but thewritedown is non-cash so add $80. Cash flow from financing decreases $100 when wepay 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

equit

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