General Questions

Question 1

Walk me through what flows into Additional Paid-In Capital (APIC).

Answer 1

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises

Question 2

What is the Statement of Shareholders’ Equity and why do we use it?

Answer 2

This statement shows everything we went through above – the major items that
comprise Shareholders’ Equity, and how we arrive at each of them using the numbers
elsewhere in the statement.

Question 3

What are examples of non-recurring charges we need to add back to a company’s
EBIT / EBITDA when looking at its financial statements?

Answer 3

• Restructuring Charges
• Goodwill Impairment
• Asset Write-Downs
• Bad Debt Expenses
• Legal Expenses
• Disaster Expenses
• Change in Accounting Procedures

Question 4

How do you project Balance Sheet items like Accounts Receivable and Accrued
Expenses in a 3-statement model?

Answer 4

• Accounts Receivable: % of revenue.
• Deferred Revenue: % of revenue.
• Accounts Payable: % of COGS.
• Accrued Expenses: % of operating expenses or SG&A.

Question 5

How should you project Depreciation & Capital Expenditures?

Answer 5

The simple way: project each one as a % of revenue or previous PP&E balance

The more complex way: create a PP&E schedule that splits out different assets by their
useful lives, assumes straight-line depreciation over each asset’s useful life, and then
assumes capital expenditures based on what the company has invested historically.

Question 6

Why do you subtract cash in the formula for Enterprise Value? Is that always
accurate?

Answer 6

The “official” reason: Cash is subtracted because it’s considered a non-operating asset
and because Equity Value implicitly accounts for it.

Question 7

How do you account for convertible bonds in the Enterprise Value formula?

Answer 7

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.

Question 8

How do you take into account a company’s competitive advantage in a valuation?

Answer 8

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

Question 9

I’m looking at financial data for a public company comparable, and it’s April (Q2) right now. Walk me through how you would “calendarize” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.

Answer 9

TTM = Most Recent Fiscal Year + New Partial Period – Old Partial Period
So in the example above, we would take the company’s Q1 numbers, add the most
recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year.

For US companies you can find these quarterly numbers in the 10-Q; for international
companies they’re in the “interim” reports.

Question 10

What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?

Answer 10

Trick question.

For Unlevered Free Cash Flow, use Enterprise Value,

For Levered Free Cash Flow you would use Equity Value

Question 11

How do you take into account a company’s competitive advantage in a valuation?

Answer 11

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.

Question 12

What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Answer 12

Take Cash Flow From Operations and subtract CapEx – that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Question 13

How do you calculate WACC?

Answer 13

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred)

Question 14

How do you get to Beta in the Cost of Equity calculation?

Answer 14

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.

Question 15

Why do you have to un-lever and re-lever Beta?

Answer 15

keep in mind our “apples-to-apples” theme

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

Question 16

Which method of calculating Terminal Value will give you a higher valuation?

Answer 16

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

Question 17

Should Cost of Equity be higher for a $5 billion or $500 million market cap
company?

Answer 17

e higher for the $500 million company, because all else being equal, smaller
companies are expected to outperform large companies in the stock market (and therefore be “more risky”)

Question 18

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 18

If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500 million company

If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.

Question 19

Cost of Equity tells us what kind of return an equity investor can expect for
investing in a given company – but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 19

Trick question.

Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole

Question 20

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 20

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends

Question 21

Two companies are exactly the same, but one has debt and one does not – which one will have the higher WACC?

Answer 21

one without debt will have a higher WACC up to a certain point,
because debt is “less expensive” than equity.

However, the above is true only to a certain point. Once a company’s debt goes up high enough, the interest rate will rise dramatically to reflect the additional risk and so the Cost of Debt would start to increase

Question 22

Why is wacc for company with no debt higher?

Answer 22

• Interest on debt is tax-deductible (hence the (1 – Tax Rate) multiplication in the WACC formula).
• Debt is senior to equity in a company’s capital structure – debt holders would be paid first in a liquidation or bankruptcy.
• 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.

Question 23

What about a 1% change in revenue vs. a 1% change in the discount rate?

Answer 23

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…”

Question 24

What types of sensitivity analyses would we look at in a DCF?

Answer 24

• Revenue Growth vs. Terminal Multiple
• EBITDA Margin vs. Terminal Multiple
• Terminal Multiple vs. Discount Rate
• Long-Term Growth Rate vs. Discount Rate

Question 25

What discount period numbers would I use for the mid-year convention if I have a stub period – e.g. Q4 of Year 1 – in my DCF?

Answer 25

Question 26

If EBITDA decreases, how do Unlevered FCF and Levered FCF change?

Answer 26

If EBITDA decreases, it means that Revenue has dropped, or that COGS or Operating Expenses have increased. As a result, both Levered FCF and Unlevered FCF will also decrease

Question 27

Two companies have the same amount of Debt, but one has Convertible Debt, and the other has traditional Debt. Both companies have the same Operating Income, Tax Rate, and Equity Value. Which company will have a higher P / E multiple?

Question 28

Why do you NOT subtract Goodwill when moving from Equity Value to Enterprise Value?

Answer 28

Goodwill reflects the premiums paid for previous acquisitions

Question 29

Why do you subtract only part of a company's Deferred Tax Assets (DTAs) when calculating Enterprise Value?

Answer 29

you should subtract ONLY the Net Operating Losses (NOLs) in the DTA because those are considered Non-Operating Assets

Question 30

How do you factor in Working Capital when moving from Equity Value to Enterprise Value?

Answer 30

You don’t

Question 31

Why do you subtract Equity Investments, AKA Associate Companies, when moving from Equity Value to Enterprise Value?

Answer 31

Non-Operating Assets since the Parent Company has only minority stakes But add back NCI since 100% consolidation!!!

Question 32

Could a company have negative Common Shareholders’ Equity (CSE) on its Balance Sheet? If no, why not? If yes, what would it mean?

Answer 32

Yes, it could. Just think about the main items that link into CSE: Net Income and Dividends. If a company’s Net Income is repeatedly negative, CSE will eventually turn negative.

Question 33

What are some items that are deductible for Book-Tax but not Cash-Tax purposes, and how do they affect the Deferred Tax line items?

Answer 33

Examples include Stock-Based Compensation (when initially granted), the Amortization of Intangibles, and many Write-Down and Impairments (for Goodwill, PP&E, etc.). reduce book taxes but do not save cash taxes

Question 34

Now, a company that follows IFRS does the same thing. Assume that it splits the Rental Expense into 60% Interest and 40% Depreciation and walk me through the statements over the year, also in one step.

Answer 34

Income Statement: Depreciation is up by $40, and the Interest Expense is up by $60, so Pre-Tax Income falls by $100, and Net Income falls by $75 at a 25% tax rate. * Cash Flow Statement: Net Income is down by $75, but you add back the $40 of Depreciation. Operating Lease Assets and Liabilities both increase by $1,000, offsetting each other on the CFS. In Cash Flow from Financing, you subtract the $40 of Depreciation in the “Repayment of the Capital Element” line. So, Cash at the bottom is down by $75. * Balance Sheet: Cash is down by $75, and Operating Lease Assets are up by $960 due to the initial $1,000 increase and $40 of Depreciation, so Assets are up by $885. On the L&E side, the Lease Liabilities are up by $960 due to the initial $1,000 increase and the $40 Capital Element Repayment. CSE is down by $75 due to the reduced Net Income, so the L&E side is up by $885, and both sides balance.

Question 35

For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records $40 in Depreciation. Walk me through the financial statements.

Answer 35

Income Statement: The $20 in increased Depreciation reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate, so the company saves $5 in taxes. * Cash Flow Statement: Net Income is down by $15, and you add back the $20 in Depreciation as a non-cash expense. However, the company recorded $40 of Depreciation for Cash-Tax purposes, so it actually reduced its Cash Taxes by $10, not $5. You record this additional $5 as a positive in the Deferred Income Taxes line on the CFS. Cash at the bottom is up by $10. * Balance Sheet: Cash is up by $10 on the Assets side, and Net PP&E is down by $20, so the Assets side is down by $10. On the L&E side, the Deferred Tax Liability is up by $5, and CSE is down by $15 due to the reduced Net Income, so the L&E side is also down by $10, and both sides balance.