All Basic Shuffled Flashcards

Question

Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a company’s balance sheet and how it affects the 3 statements.

Answer 1

* This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. * On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down – so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. * On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it balances. *If this seems strange to you, you’re not alone – see this Forbes article for more on why writing down debt actually benefits companies accounting-wise:* http://www.forbes.com/2009/07/31/fair-value-accounting-markets-equities-fasb.html

Answer 2

Obviously you use this whenever you’re looking at a Leveraged Buyout – but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a "floor" on a possible Valuation for the company you’re looking at.

Answer 3

These days, many companies have “non-cash” charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. • **_As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded._**

Answer 4

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you’re valuing. Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4 billion. To get the "football field" valuation graph you often see, you look at the minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology.

Answer 5

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they’re out-of-the-money then you count the face value of the convertibles as part of the company’s Debt.

Answer 6

You should start by saying, "it depends" but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Answer 7

Equity Value is the market value and Shareholders’ Equity is the book value. Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders’ Equity could be any value. For healthy companies, Equity Value usually far exceeds Shareholders’ Equity.

Answer 8

Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.

Answer 9

* Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. * It often happens in acquisitions where the buyer “overpaid” for the seller and can result in a large net loss on the Income Statement (see: Microsoft/Skype). * It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

Answer 10

1. Purchase and Exit Multiples have the biggest impact on the returns of a model 2. The amount of leverage (debt) used also has a significant impact 3. Lastly, operational characteristics such as revenue growth and EBITDA margins

Answer 11

Other methodologies include: 1. Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive 2. Replacement Value – Valuing a company based on the cost of replacing its assets 3. LBO Analysis – Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range 4. Sum of the Parts – Valuing each division of a company separately and adding them together at the end 5. M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth 6. Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value

Answer 12

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it has already collected in cash but is waiting to record as revenue.

Answer 13

Dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions To figure out the numbers, you would look at: **1. "Debt Comps"** showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently **2. The rules**: for example, you would never lever a company at 50x EBITDA A. Even during the bubble leverage rarely exceeded 5-10x EBITDA

Answer 14

* Generally you would look at Comparable Companies/ Precedent Transactions to determine this. * You would use the combined company’s LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of whatever companies you’re looking at, and apply that to your own EBITDA figure to get a rough idea of how much debt you could raise. * You would also look at "Debt Comps" for companies in the same industry and see what types of debt and how many tranches they have used.

Answer 15

It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead. You might see Equity Value / Revenue if you’ve listed a set of financial institutions and non-financial institutions on a slide, you’re showing Revenue multiples for the nonfinancial institutions, and you want to show something similar for the financial institutions. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

Answer 16

* To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. * Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders’ Equity. * The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow Statement.

Answer 17

Yes here are the shortcuts: 1. Create some form of Income Statement 2. Track how the Debt Balances change 3. Show cash is available to repay debt by creating type of CFS to show how much * 4. You do not need to create a full Balance Sheet* A. Bankers sometimes skip this if they are in a rush. B. Full Balance Sheet is not strictly required, ***because you can just make assumptions on the Net Change in Working Capital*** rather than looking at each item individually.

Answer 18

These represent the value over the "fair market value" of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price. More specifically, Goodwill and Other Intangibles represent things like the value of customer relationships, brand names and intellectual property – valuable, but not true financial Assets that show up on the Balance Sheet.

Answer 19

1. They represent the premium paid to the "fair market value" of the company 2. They act as a "plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side

Answer 20

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and the Deferred Revenue balance decreases.

Answer 21

Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?" He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations. In some industries there is also a large gap between EBIT and EBITDA – anything that is very capital-intensive, for example, will show a big disparity. Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx.

Answer 22

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company’s assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

Answer 23

The most common example is taking out a mortgage when you buy a house. Here’s how the analogy works: **1. Down Payment:** Investor Equity in an LBO **2. Mortgage:** Debt in an LBO **3. Mortgage Interest Payments:** Debt Interest in an LBO **4. Mortgage Repayments:** Debt Principal Repayments in an LBO **5. Selling the House:** Selling the Company / Taking It Public in an LBO

Answer 24

Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with: 1. Companies on the brink of bankruptcy. 2. Financial institutions, such as banks, that have large cash balances – but Enterprise Value is not even used for commercial banks in the first place so this doesn’t matter much.

Answer 25

You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity. The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow \* (1 + Growth Rate) / (Discount Rate – Growth Rate).

Answer 26

Banks use debt differently than other companies and do not re-invest it in the business – they use it to create their "products" – loans – instead. Also, interest is a critical part of banks’ business models and changes in working capital can be much larger than a bank’s net income – so traditional measures of cash flow don’t tell you much. For financial institutions, it’s more common to use a Dividend Discount Model or Residual Income Model instead of a DCF.

Answer 27

No one in M&A takes revenue synergies seriously because they’re so hard to predict. Cost synergies are taken a bit more seriously because it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated. That said, the chances of any synergies actually being realized are almost 0 so few take them seriously at all.

Answer 28

You use Enterprise Value because those scientists or subscribers are "available" to all the investors (both debt and equity) in a company. The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is "available" to.

Answer 29

* Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. * Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4. * Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Shareholders’ Equity side is down by $6 and both sides of the Balance Sheet balance. *Note: With this type of question I always recommend going in the order: 1. Income Statement 2. Cash Flow Statement 3. Balance Sheet This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow.*

Answer 30

A merger model is 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. Step 1 is **making assumptions about the acquisition** – the price and whether it was cash, stock or debt or some combination of those. 2. Next, you **determine the valuations** and shares outstanding of the buyer and seller and project out an Income Statement for each one. 3. 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.**

Answer 31

Yes. You could also have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off. The first refers to any Research & Development projects that were purchased in the acquisition but which have not been completed yet. The logic is that unfinished R&D projects require significant resources to complete, and as such, the "expense" must be recognized as part of the acquisition. The second refers to cases where the seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-down the value of the Deferred Revenue to avoid "double-counting" revenue.

Answer 32

* Like so many things, M&A is "easier said than done." * In practice it’s very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division. * Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders. * Any deal done without both parties’ best interests in mind is likely to fail.

Answer 33

You can take a few different approaches: 1. You can create your own projections. 2. You can modify management’s projections downward to make them more conservative. 3. You can show a sensitivity table based on different growth rates and margins and show the values assuming managements’ projections and assuming a more conservative set of numbers. In reality, you’d probably do all of these if you had unrealistic projections.

Answer 34

You would use the Cost of Equity rather than WACC since we’re not concerned with Debt or Preferred Stock in this case – we’re calculating Equity Value, not Enterprise Value.

Answer 35

**1.** * At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet). * On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same. * On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance. **2.** After a year has passed, Apple must pay interest expense and must record the depreciation. * Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income would fall by $12. * On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That’s the only change on the Cash Flow Statement, so overall Cash is down by $2. * On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance. *Remember, the debt number under Liabilities does not change since we’ve assumed none of the debt is actually paid back.* **3.** * After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. * On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100. Overall, the Net Change in Cash falls by $68. * On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148 and both sides balance.

Answer 36

This is a simplification, but broadly speaking there are 2 "types" of debt: "bank debt" and "high-yield debt." There are many differences, but here are a few of the most important ones: **1. High-yield debt tends to have higher interest rates than bank debt** A. Hence the name "high-yield" **2. High-yield debt interest rates are usually fixed** A. Whereas bank debt interest rates are "floating" – they change based on LIBOR or the Fed interest rate **3. High-yield debt has incurrence covenants** A. While bank debt has maintenance covenants B. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.), while maintenance covenants require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times) **4. Bank debt is usually amortized – the principal must be paid off over time** A. Whereas with high-yield debt, the entire principal is due at the end (bullet maturity) B. Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt. Again, there are many different types of debt – this is a simplification, but it’s enough for entry-level interviews

Answer 37

Usually you use a "football field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. As an example, see page 10 of this document (a Valuation done by Credit Suisse for the Leveraged Buyout of Sungard Data Systems in 2005): http://edgar.sec.gov/Archives/edgar/data/789388/000119312505074184/dex99c2.htm

Answer 38

* You use the same Valuation methodologies we already discussed. * If the seller is a public company, you would pay more attention to the premium paid over the current share price to make sure it’s "sufficient" (generally in the 15-30% range) to win shareholder approval. * For private sellers, more weight is placed on the traditional methodologies.

Answer 39

* Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all have huge effects. * Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies.

Answer 40

Enterprise Value, because that’s how much an acquirer really "pays" and includes the often mandatory debt repayment.

Answer 41

The "standard" answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions. In reality, almost all DCFs are "too dependent on future assumptions" – it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value. But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…

Answer 42

It might be saving its cash for something else or it might be concerned about running low if business takes a turn for the worst Its stock may also be trading at an all-time high and it might be eager to use that instead (in finance terms this would be "more expensive" but a lot of executives value having a safety cushion in the form of a large cash balance).

Answer 43

Synergies refer to cases where 2 + 2 = 5 (or 6, or 7…) in an acquisition. Basically, the buyer gets more value than out of an acquisition than what the financials would predict. There are 2 types: revenue synergies and cost (or expense) synergies. 1. • Revenue Synergies: The combined company can cross-sell products to new customers or up-sell new products to existing customers. It might also be able to expand into new geographies as a result of the deal. 2. • Cost Synergies: The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.

Answer 44

The 3 main ways to select companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be. Here are a few examples: Comparable Company Screen: Oil & gas producers with market caps over $5 billion Comparable Company Screen: Digital media companies with over $100 million in revenue Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue Precedent Transaction Screen: Retail M&A transactions over the past year

Answer 45

Several possibilities: 1. The company is spending too much on Capital Expenditures – these are not reflected at all in EBITDA, but it could still be cash-flow negative. 2. The company has high interest expense and is no longer able to afford its debt. 3. The company’s debt all matures on one date and it is unable to refinance it due to a “credit crunch” – and it runs out of cash completely when paying back the debt. 4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company. ***Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges – and all of these could end up bankrupting the company.***

Answer 46

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company’s debts have been paid off. It is often used to advise struggling businesses on whether it’s better to sell off assets separately or to try and sell the entire company.

Answer 47

• It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses – every company does it differently. ## Footnote *Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.*

Answer 48

The formula is: Cost of Equity \* (% Equity) + Cost of Debt \* (% Debt) \* (1 – Tax Rate) + Cost of Preferred \* (% Preferred). In all cases, the percentages refer to how much of the company’s capital structure is taken up by each component. For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM – see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.

Answer 49

In cash-based accounting, the revenue would not show up until the company charges the customer’s credit card, receives authorization, and deposits the funds in its bank account – at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet. In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company’s bank account, it would “turn into” Cash.

Answer 50

* No company is 100% comparable to another company. * The stock market is "emotional" – your multiples might be dramatically higher or lower on certain dates depending on the market’s movements. * Share prices for small companies with thinly-traded stocks may not reflect their full value.

Answer 51

Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

Answer 52

There is an alternate formula: Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends This is less common than the "standard" formula but sometimes you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

Answer 53

Normally you use the country’s long-term GDP growth rate, the rate of inflation, or something similarly conservative. For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

Answer 54

It’s a different scenario because: 1. The PE firm does not intend to hold the company for the long-term A. It usually sells it after a few years, thus, it's less concerned with the "expense" of cash vs. debt B. It's more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront. 2. In an LBO, the debt is "owned" by the company A. Thus, they assume much of the risk B. Whereas in a strategic acquisition, the buyer "owns" the debt so it is more risky for them

Answer 55

1. To increase your returns A. Remember, any debt you use in an LBO is not "your money" i. Example: If you’re paying $5 billion for a company, it’s easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money. 2. The firm has more capital available A. Capital is used to purchase other companies because they’ve used leverage

Answer 56

Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation. It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that "proves" the value their client is paying or receiving is "fair" from a financial point of view. Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

Answer 57

It’s hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Answer 58

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you’ve set up the DCF.

Answer 59

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

Answer 60

Generally the accounts receivable days are in the 30-60 day range, though it’s higher for companies selling high-end items and it might be lower for smaller, lower transaction-value companies.

Answer 61

Goodwill typically stays the same over many years and is not amortized. It changes only if there’s goodwill impairment (or another acquisition). Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line. There’s also a difference in terms of what they each represent, but bankers rarely go into that level of detail – accountants and valuation specialists worry about assigning each one to specific items.

Answer 62

* Depreciation is a non-cash expense * Depreciation is tax-deductible * Taxes are a cash expense * Depreciation affects cash by reducing the amount of taxes you pay

Answer 63

**Step 1** is making assumptions about: 1. Purchase Price 2. Debt/Equity ratio 3. Interest Rate on Debt 4. You might also assume something about the company’s operations, such as Revenue Growth or Margins, depending on how much information you have. **Step 2** is to create a Sources & Uses section: 1. Shows how you finance the transaction and what you use the capital for 2. This also tells you how much Investor Equity is required **Step 3** is to adjust the company’s Balance Sheet for: 1. New Debt and Equity figures 2. Add in Goodwill & Other Intangibles on the Assets side to make everything balance. **Step 4** to project out the company’s: 1. Income Statement, Balance Sheet and Cash Flow Statement 2. Determine how much debt is paid off each year A. Do this based on the available Cash Flow and the required Interest Payments. **Step 5** you make assumptions about the exit after several years: 1. Usually assuming an EBITDA Exit Multiple 2. Calculate the return based on how much equity is returned to the firm.

Answer 64

Because the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effective valuation for the target company.

Answer 65

That’s usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

Answer 66

* First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. * On the Cash Flow Statement, Net Income is down by $60 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40. * On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it’s not clear which asset since the question never stated the specific asset to write-down). Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders’ Equity is also down by $60 – and both sides balance.

Answer 67

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive. On an intuitive level if you’re paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you’re paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.

Answer 68

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate – usually the Weighted Average Cost of Capital. Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC. Finally, you add the two together to determine the company’s Enterprise Value."

Answer 69

Trick question. You don’t account for this at all in an Unlevered DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement – but we only take into account EBIT \* (1 – Tax Rate), and then a few items from Cash Flow from Operations, and then subtract Capital Expenditures to get to Unlevered Free Cash Flow. If we were looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off – the mandatory debt repayments would also reduce Levered Free Cash Flow (note: some people define Levered FCF differently, but if you think about it, repaying debt really does reduce the cash flow that can go to equity investors so it should be subtracted out here).

Answer 70

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It’s much easier to get appropriate data for exit multiples since they are based on Comparable Companies – picking a long-term growth rate, by contrast, is always a shot in the dark. However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Answer 71

$1,000. In this case the options’ exercise price is above the current share price, so they have no dilutive effect.

Answer 72

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company’s capital structure. Then you use this Levered Beta in the Cost of Equity calculation. For your reference, the formulas for un-levering and re-levering Beta are below: Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Answer 73

**_1. • 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. **_2. • Cash is also less "risky"_** than debt because there’s no chance the buyer might fail to raise sufficient funds from investors. **_3.• 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. 3. • Cash is also less risky than stock because the buyer’s share price could change dramatically once the acquisition is announced.

Answer 74

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

Answer 75

* Primarily to boost returns. * Remember, all else being equal, more leverage means a higher return to the firm. * With a dividend recap, the PE firm is "recovering" some of its equity investment in the company * And the lower the Invested Equity amount the easier to earn a higher return on a smaller amount of capital

Answer 76

Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

Answer 77

Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt or convertible preferred stock. To calculate the dilutive effect of options, you use the Treasury Stock Method (detail on this below).

Answer 78

1. **Lower the Purchase** Price in the model. 2. **Raise the Exit** Multiple / Exit Price. 3. **Increase the Leverage** (debt) used. 4. **Increase the company’s growth** rate (organically or via acquisitions). 5. **Increase margins** by reducing expenses (cutting employees, consolidating buildings, etc.). Note: These are all "theoretical" and refer to the model rather than reality – in practice it’s hard to actually implement these.

Answer 79

1. If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt 2. If they are planning on major expansion or Capital Expenditures and don’t want to be **restricted by incurrence covenants**, they might use bank debt

Answer 80

The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement. The Balance Sheet shows the company’s Assets – its resources – such as Cash, Inventory and PP&E, as well as its Liabilities – such as Debt and Accounts Payable – and Shareholders’ Equity. Assets must equal Liabilities plus Shareholders’ Equity. The Cash Flow Statement 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.

Answer 81

Although technology is more "risky" than other markets, remember that there are mature, cash flow-stable companies in almost every industry. So even if a company isn’t doing well or seems risky, the firm might buy it if it falls into one of these categories. There are some PE firms that specialize in very specific goals, such as: **1. Industry consolidation –** buying competitors in a similar market and combining them to increase efficiency and win more customers. **2. Turnarounds –** taking struggling companies and making them function properly again. **3. Divestitures –** selling off divisions of a company or taking a division and turning it into a strong stand-alone entity.

Answer 82

Technology (Internet): EV / Unique Visitors, EV / Pageviews Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Daily Production, EV / Proved Reserve Quantities Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations) Technology and Energy should be straightforward – you’re looking at traffic and energy reserves as value drivers rather than revenue or profit. For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense. For Energy, all value is derived from companies’ reserves of oil & gas, which explains the last 2 multiples; EBITDAX exists because some companies capitalize (a portion of) their exploration expenses and some expense them. You add back the exploration expense to normalize the numbers. For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a "normalized" picture of the cash flow the REIT is generating.

Answer 83

There’s no "rule" that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you’re valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead – and vice versa if it’s doing well.

Answer 84

P / E depends on the company’s capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it – you’re more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).

Answer 85

You would use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You would not use a "far in the future DCF" because you can’t reasonably predict cash flows for a company that is not even making money yet. This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!

Answer 86

* First, confirm what type of “bailout” this is – Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here’s what happens: * No changes to the Income Statement. * On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government’s investment, so the Net Change in Cash is up by $100. * On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders’ Equity would go up by $100 to make it balance.

Answer 87

1. Look at the 75th percentile or higher for the multiples rather than the Medians. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company. In practice you rarely do all of the above – these are just possibilities.

Answer 88

* LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out” – they are 2 different ways of recording the value of inventory and the Cost of Goods Sold (COGS). * With LIFO, you use the value of the most recent inventory additions for COGS * With FIFO you use the value of the oldest inventory additions for COGS * 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.***

Answer 89

This could happen for a number of reasons: • The company has just reported earnings well-above expectations and its stock price has risen recently. • It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. • It has just won a favorable ruling in a major lawsuit. • It is the market leader in an industry and has greater market share than its competitors.

Answer 90

This is a common interview mistake – incorrectly stating that Working Capital changes show up on the Income Statement. • In the case of Inventory, the expense is only recorded when the goods associated with it are sold – so if it’s just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

Answer 91

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest – Cash This formula does not tell the whole story and can get more complex – see the Advanced Questions. Most of the time you can get away with stating this formula in an interview, though. "Noncontrolling Interest" was formerly known as Minority Interest and some bankers still call it that.

Answer 92

* No changes to the Income Statement. * On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom. * On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders’ Equity.

Answer 93

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

Answer 94

* Company takes new debt solely to pay a special dividend out to the PE firm that bought it * It would be like if you made your friend take out a personal loan just so he could pay you a lump sum of cash with the loan proceeds * As you might guess, dividend recaps have developed a bad reputation, though they’re still commonly used.

Answer 95

EBITDA is available to all investors in the company – rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only the part available to equity investors.

Answer 96

Several possible reasons: 1. • The buyer wants to gain market share by buying a competitor. 2. • The buyer needs to grow more quickly and sees an acquisition as a way to do that. 3. • The buyer believes the seller is undervalued. 4. • The buyer wants to acquire the seller’s customers so it can up-sell and cross-sell to them. 5. • The buyer thinks the seller has a critical technology, intellectual property or some other "secret sauce" it can use to significantly enhance its business. 6. • The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

Answer 97

The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).

Answer 98

**1.** * No changes to the Income Statement. * Cash Flow Statement – Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10. * On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance. **2.** * Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6. * Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPads), which is a net addition to cash flow – so Cash Flow from Operations is up by $16 overall. These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16. * On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the other side, Net Income was up by $6 so Shareholders’ Equity is up by $6 and both sides balance.

Answer 99

1. First, the Liabilities & Equities side is adjusted – A, The new debt is added on B. The Shareholders’ Equity is "wiped out" and replaced by however much equity the private equity firm is contributing. 2. On the Assets side we then have adjustments A. The Cash is adjusted for any cash used to finance the transaction B. The Goodwill & Other Intangibles are used as a "plug" to make the Balance Sheet balance. 3. Depending on the transaction, there could be other effects as well – such as capitalized financing fees added to the Assets side.

Answer 100

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.

Answer 101

Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole – and those returns include dividends.

Answer 102

1. You would look at Comparable LBOs 2. See the terms of the debt 3. How many tranches each of them used 4. You would look at companies in a similar size range and industry A. Use those criteria to determine the debt your company can raise

Answer 103

You use it to value a company by: 1. Setting a targeted IRR (for example, 25%) 2. Then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR • *This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than strategic acquirers would.*

Answer 104

Again, keep in mind our "apples-to-apples" theme. When you look up the Betas on Bloomberg (or from whatever source you’re using) they will be levered to reflect the debt already assumed by each company. But each company’s capital structure is different and we want to look at how "risky" a company is regardless of what % debt or equity it has. To get that, we need to un-lever Beta each time. But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Answer 105

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares. Acquisition effects – such as amortization of intangibles – can also make an acquisition dilutive.

Answer 106

**The interest paid on debt is tax-deductible - so the PE firm saves money on taxes and increases cash flow as a result of having debt from the LBO** Note, however, that their cash flow is still lower than it would be without the debt... Saving on taxes helps, but the jump in Interest Expenses still reduces Net Income over what it would be for a debt-free company.

Answer 107

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

Answer 108

* The model is used as a sanity check and is used to test various assumptions. * A company would never decide to do a deal based on the output of a model. It might say, "Ok, the model tells us this deal could work and be moderately accretive – it’s worth exploring more." * It would never say, "Aha! This model predicts 21% accretion – we should definitely acquire them now!" Emotions, ego and personalities play a far bigger role in M&A (and any type of negotiation) than numbers do.

Answer 109

1. The PE firm intends to refinance the company at some point 2. They don’t believe their returns are too sensitive to interest payments 3. They don’t have plans for major expansion or selling off the company’s assets

Answer 110

In this case the discount rate is likely to have a bigger impact on the valuation, though the correct answer should start with, "It could go either way, but most of the time…"

Answer 111

A technology company, because technology is viewed as a "riskier" industry than manufacturing.

Answer 112

"Ideal" candidates have: 1. Stable and predictable cash flows 2. Low-risk businesses A. Not much need for ongoing investments such as Capital Expenditures 3. An opportunity for expense reductions to boost their margins * \*A strong management team also helps, as does a base of assets to use as collateral for debt.* * \*The most important part is stable cash flow.*

Answer 113

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 – Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital. Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You should confirm that this is what the interviewer is asking for.

Answer 114

The "official" reason: Cash is subtracted because it’s considered a non-operating asset and because Equity Value implicitly accounts for it. The way I think about it: In an acquisition, the buyer would "get" the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d really have to "pay" to acquire another company. It’s not always accurate because technically you should be subtracting only excess cash – the amount of cash a company has above the minimum cash it requires to operate.

Answer 115

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher.

Answer 116

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations. For the most part this generalization is true but there are exceptions to almost every "rule" in finance.

Answer 117

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value. Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered FCF already includes the effects of the Interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors. Debt investors have already "been paid" with the interest payments and principal re payments they received.

Answer 118

* There would be an incredibly high amount of Goodwill & Other Intangibles created if the price is far above the fair market value of the company. * Depending on how the acquisition goes, there might be a large goodwill impairment charge later on if the company decides it overpaid. * A recent example is the Microsoft / Skype deal, in which Microsoft paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and Microsoft later ended up writing down much of the value and taking a large quarterly loss as a result.

Answer 119

Possible reasons: 1. One process was more competitive and had a lot more companies bidding on the target. 2. One company had recent bad news or a depressed stock price so it was acquired at a discount. 3. They were in industries with different median multiples.

Answer 120

This is most often used when a company has completely different, unrelated divisions – a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

Answer 121

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

Answer 122

The same way you do it anywhere else: 1. Look at what comparable companies are trading at 2. Look at the multiples similar LBO transactions have had 3. Show a range of purchase and exit multiples using sensitivity tables * Sometimes you set purchase and exit multiples based on a specific IRR target that you’re trying to achieve – but this is just for valuation purposes if you’re using an LBO model to value the company.*

Answer 123

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. So even though it doesn’t own 100%, it reports 100% of the majority-owned subsidiary’s financial performance. In keeping with the "apples-to-apples" theme, you must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

Answer 124

Yes. It is common to see this in 2 scenarios: **1. Leveraged Buyouts with dividend recapitalizations –** it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative. **2. It can also happen if the company has been losing money consistently** and therefore has a declining Retained Earnings balance, which is a portion of Shareholders’ Equity. It doesn’t “mean” anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario). *Note: Shareholders’ equity never turns negative immediately after an LBO – it would only happen following a dividend recap or continued net losses.*

Answer 125

Cost of Equity = Risk-Free Rate + Beta \* Equity Risk Premium The risk-free rate represents how much a 10-year or 20-year US Treasury should yield; Beta is calculated based on the "riskiness" of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets. Normally you pull the Equity Risk Premium from a publication called Ibbotson’s. Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a "size premium" and "industry premium" to account for how much a company is expected to out-perform its peers is according to its market cap or industry. Small company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.

Answer 126

Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value. With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

Answer 127

• You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that’s the #1 thing you care about when analyzing the overall financial health of any business – its cash flow.

Answer 128

There’s no discount because with precedent transactions, you’re acquiring the entire company – and once it’s acquired, the shares immediately become illiquid. But shares – the ability to buy individual "pieces" of a company rather than the whole thing – can be either liquid (if it’s public) or illiquid (if it’s private). Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this.

Answer 129

The one without debt will generally have a higher WACC because debt is "less expensive" than equity. Why? 1. Interest on debt is tax-deductible (hence the (1 – Tax Rate) multiplication in the WACC formula). 2. Debt is senior to equity in a company’s capital structure – debt holders would be paid first in a liquidation or bankruptcy scenario. 3. Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will. Theoretically if the company had a lot of debt, the Cost of Debt might increase and become greater than the Cost of Equity but that is extremely rare – the company without debt has a higher WACC in 99% of all cases.

Answer 130

Three examples come to mind: 1. Web-based subscription software. 2. Cell phone carriers that sell annual contracts. 3. Magazine publishers that sell subscriptions. Companies that agree to services in the future often collect cash upfront to ensure stable revenue – this makes investors happy as well since they can better predict a company’s performance. Per the rules of accounting, you only record revenue when you actually perform the services – so the company would not record everything as revenue right away.

Answer 131

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios: 1. The company gets acquired or bought out and Goodwill changes as a result, since it’s an accounting “plug” for the purchase price in an acquisition. 2. The company acquires another company and pays more than what its assets are worth – this is then reflected in the Goodwill number.

Answer 132

* No changes to the Income Statement. * On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change. * On the Balance Sheet, Debt would go up and Shareholders’ Equity would go down and they would cancel each other out so that everything remained in balance.

Answer 133

Normally you look at the Comparable Companies and pick the median of the set, or something close to it. As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

Answer 134

* The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would not necessarily be cut in half. * Depending on how the deal was structured, the seller would effectively only be receiving half of what it had originally negotiated. * This illustrates one of the major risks of all-stock deals: sudden changes in share price could dramatically impact valuation.

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