Accounting
How would depreciation increasing by $10 affect the 3 financial statements?
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.
What is the formula for Enterprise Value?
EV = Equity Value + Debt + Preferred Stock + Minority Interest - Cash
What would you expect to have a higher beta: a manufacturing company or a technology company?
A technology company, because technology is viewed as a “riskier” industry than manufacturing.
Why would you use leverage when buying a company?
To boost your return.
Remember, any debt you use in an LBO is not “your money” – so 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.
A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used leverage.
How would you value an apple tree?
The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation).
Yes, you could do a DCF for anything – even an apple tree.
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen? (Name 3 ways)
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.
A company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each – what is its fully diluted equity value?
What if the options outstanding had an exercise price of $15 each?
Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all “in-the-money” – their exercise price is less than the current share price.
When these options are exercised, there will be 10 new shares created – so the share count is now 110 rather than 100.
However, that doesn’t tell the whole story. In order to exercise the options, we had to “pay” the company $5 for each option (the exercise price).
As a result, it now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created.
So the fully diluted share count is 105, and the fully diluted equity value is $1,050.
NOW $15: $1,000. In this case the options’ exercise price is above the current share price, so they have no dilutive effect.
Walk me through how you get from Revenue to Free Cash Flow in the projections
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 might want to confirm that this is what the interviewer is asking for.
What is an “ideal” candidate for an LBO?
“Ideal” candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as 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.
All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?
Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company. Why?
• Cash is “cheaper” than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than that. Thus, foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt.
• Cash is also less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds from investors.
• It’s hard to compare the “cost” directly to stock, but in general stock is the most “expensive” way to finance a transaction – remember how the Cost of Equity is almost always higher than the Cost of Debt? That same principle applies here.
• Cash is also less risky than stock because the buyer’s share price could change dramatically once the acquisition is announced.
MULTI-STEP ACCOUNTING!
See Kiarra Notes
What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?
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 already includes Interest and the money is therefore only available to equity investors.
Debt investors have already “been paid” with the interest payments they received.
How do you calculate the Cost of Equity?
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.
What is the difference between bank debt and high-yield debt?
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:
• High-yield debt tends to have higher interest rates than bank debt (hence the name “high-yield”).
• High-yield debt interest rates are usually fixed, whereas bank debt interest rates are “floating” – they change based on LIBOR or the Fed interest rate.
• High-yield debt has incurrence covenants while bank debt has maintenance covenants. 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).
• Bank debt is usually amortized – the principal must be paid off over time – whereas with high-yield debt, the entire principal is due at the end (bullet maturity).
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.
You have stacks of quarters, dimes, nickels and pennies (these represent $0.25, $0.10, $0.05 and $0.01, respectively, in the US monetary system for anyone international).
There are an unlimited number of coins in each stack. You can take coins from a stack in any amount and in any order and place them in your hand. What is the greatest dollar value in coins you can have in your hands without being able to make change for a dollar?
$1.19. There are a few ways to think about this, but the easiest is to start with the largest coin – quarters – first and then work your way down.
4 quarters equals $1.00, so we clearly can’t do that – but 3 quarters are ok because that’s only $0.75.
Next, we have dimes. Recall that we can use any combination of coins to make change for a dollar – if we were to have 5 dimes and put them together with the 2 quarters, that would make $1.00. So we’ll use 4 instead – there’s no combination there that would result in $1.00 when added to the quarters.
Nickels are next. Here, we can’t have any – because even a single nickel, $0.05, would add up to $1.00 when added to the 3 quarters we have ($0.75) and the 2 dimes ($0.20).
Finally, for pennies we know that we can’t have 5 pennies ($0.05) because we could then get to $1.00 using the same logic as we saw for the nickels. So 4 is the maximum here.
With that, we see that 3 Quarters + 4 Dimes + 4 Pennies = $1.19
What are deferred tax assets/liabilities and how do they arise?
They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.
Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet.
The most common way they occur is with asset write-ups and write-downs in M&A deals – an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset (see the Merger Model section for more on this).
What’s the difference between Equity Value and Shareholders’ Equity?
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.
Which has a greater impact on a company's DCF valuation - a 10% change in revenue or a 1% change in the discount rate? Why?
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.
What is a dividend recapitalization (“dividend recap”)?
In a dividend recap, the company takes on 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/she 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.
The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s profitability. What’s the difference between them, and when do you use each one?
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).
Walk me through what flows into Retained Earnings. Walk me through what flows into Additional Paid-In Capital (APIC).
Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued
If you’re calculating Retained Earnings for the current year, take last year’s Retained Earnings number, add this year’s Net Income, and subtract however much the company paid out in dividends.
APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises
If you’re calculating it, take the balance from last year, add this year’s stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.
If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amounts and everything else is held constant.
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.
What is the mid-year convention? How does the terminal value calculation change when we use the mid-year convention?
You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year – instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on. With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on.
When you’re discounting the terminal value back to the present value, you use different numbers for the discount period depending on whether you’re using the Multiples
Method or Gordon Growth Method:
• Multiples Method: You add 0.5 to the final year discount number to reflect the fact that you’re assuming the company gets sold at the end of the year.
• Gordon Growth Method: You use the final year discount number as is, because you’re assuming the cash flows grow into perpetuity and that they are still received throughout the year rather than just at the end.
A PE firm acquires a $200 million EBITDA company using 50% Debt, at an EBITDA purchase multiple of 6x.
The company’s EBITDA grows to $300 million by Year 3, and the exit multiple stays the same.
Assuming the company pays its interest and required Debt principal but generates no additional Cash, what is the MINIMUM IRR?
The Purchase Enterprise Value is $200 million * 6x = $1.2 billion, and the PE firm uses $600 million of Investor Equity and $600 million of Debt.
The Exit Enterprise Value in Year 3 is $300 million * 6x = $1.8 billion.
The PE firm realizes the minimum IRR when the Equity Proceeds are at their minimum level.
For that to happen, the company must repay no Debt and generate no additional Cash.
We already know the company generates no additional Cash, so we have to calculate the Equity Proceeds under the assumption that the company repays no Debt.
$1.8 billion – $600 million = $1.2 billion, which is a 2x multiple over 3 years.
That corresponds to a ~25% IRR (technically, 26%), so that is the minimum in this scenario.
Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?
Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest payments – instead, the interest just accrues to the loan principal, which keeps going up over time. A PIK “toggle” allows the company to choose whether to pay the interest in cash or have it accrue to the principal (these have disappeared since the credit crunch).
PIK is more risky than other forms of debt and carries with it a higher interest rate than traditional bank debt or high yield debt.
Adding it to the debt schedules is similar to adding high-yield debt with a bullet maturity – except instead of assuming cash interest payments, you assume that the interest accrues to the principal instead.
You should then include this interest on the Income Statement, but you need to add back any PIK interest on the Cash Flow Statement because it’s a non-cash expense.