RX / Debt
What are causes of financial distress? (Name 5 examples)
Operational:
● Substitution by a competitor -- uncompetitive product
● Poor management (bad capex spend, misused resources)
● Acquisition that has gone badly
● Unrealistic business plan causes overleverage
Non-operational:
● Macro downturn
● Maturity wall, liquidity crunch and unable to pay interest
● Litigation claims / tort liabilities (PG&E)
● Fraud
● Covenant breach (leverage or interest coverage maintenance covenant)
You have company with 10mm EBITDA, trades at 10x, has 30mm debt and 5mm cash. What’s the equity value?
$75 million
Difference between HY and bank debt?
● Interest rate: higher for HY, lower for bank debt
● Interest rate: floating rate for bank debt to minimize duration risk (risk associated with the sensitivity of a bond's price to a one percent change in yield), and fixed rate for HY
● Collateral: yes for bank debt, no for HY
● Maturity: longer for bank debt, and lower for HY
● Covenants: restrictive / incurrence for HY, maintenance for bank debt
● Mandatory amortization: yes for bank debt, no for HY
● Seniority: Senior for bank debt, junior for HY
What is the difference between a merger and a acquisition?
A merger occurs when individual organizations decide to join their forces and give rise to a new business entity. On the other hand, an acquisition is a situation wherein a larger, financially stronger organization takes over a smaller one. The latter ceases to exist, and all of its operations and assets are acquired by the larger business enterprise.
Trade-offs between raising debt vs equity for a company?
Debt:
● Save on taxes through interest tax shield
● No dilution of ownership
● Upside for the debtors is capped at face value
Equity:
● Don’t have to pay interest
● No covenants involved, so more freedom in operations
● Good if the stock is overvalued
If you were a creditor, would you want a lien from A/R or factory for a distressed company?
Accounts receivable
What happens to Equity Value, Enterprise Value and P/E ratio when you buy back $500 worth of shares with cash.
a. Equity value goes down, because there’s fewer shares
b. Enterprise Value doesn’t change because equity value goes down, but cash goes down by the same amount
c. P/E ratio goes down, because of the same reason as #1
What is a Revolving Credit Facility collateralized with?
working capital
What was the largest M&A deal of 2023?
ExxonMobil Acquires Pioneer Natural Resources for $60b
Tell me about the effects on the three statements when you change from LIFO to FIFO accounting
Think in terms of inflation/deflation, and depending on it, COGS would change
● i.e. Deflation: From LIFO to FIFO: recent inventory is cheaper (COGS higher)
Cash flow wise: higher tax benefit tax shield from expensing it more increase in the CF at the beginning of the year, but it will cancel out eventually
● Opposite for inflation
● Opposite for from FIFO to LIFO
How do you know if the yield on a bond is attractive?
● Look at yields of comparable comps’ bonds
● Compare it to a PE investment (usually 20%+ is a good sign)
● Look at the company’s fundamentals and see if the value of the assets can flow through your security at the current market price
You’re modeling a 5-year projection of a company and your boss tells you to increase capex by $100. Can cash flow from operations in your model change, and if so how?
Yes, because now you have depreciation for the new PP&E you purchased.
What is a FILO facility
you answer this Ben
Company's A & B merge, revenues were $100 each. On day of the merger they announce combined revenue of $240. What are the two reasons this could happen?
1. Switch to LIFO to FIFO accounting
2. Minority interest added together >50%. Reporting an additional $40 from another company
Which is best for the company: 10 decrease in capex, 10 increase in revenue due to higher volume or 10 increase in revenue due to price increase?
Rank them in order.
Think of Free Cash Flow = EBIT (1-Tc) +D&A – capex – NWC
10 decrease in capex is the best, then 10 increase due to price increase and 10 increase due to higher volume.
EBITDA = 200, firm valued at 7x. Secured debt of 700, Unsecured debt of 1000. What price does each security trade at?
EV = 200*7 = 1400. Secured debt is covered, so price =100. There’s only 700 left for 1000 of unsecured debt, so price = 70
What do you discount Net Operating Losses by?
Cost of equity, since you apply NOL to EBT, which is after interest
In Year 1, EBITDA = $5 and firm is valued @10x. In Y2, EBITDA = $10 and firm is valued at 5x. What is the IRR?
Assume 50/50 equity / debt split
Entry EV = $50; Entry Debt = 25, Entry Equity = $25
Exit EV = $50; Exit Debt = $25; Exit Equity = $25
The P/e of a target company is 10x. You acquire it using only debt with interest = 10%. Accretive or dilutive?
Seller's yield = 1/10 = 10%. Cost of acquisition = after tax cost of debt = 10%(1-T)
Cost of acquisition < Seller's Yield. Accretive
What are the four conditions to differentiate an Operating Lease VS. Capital Lease
1. Transfer of ownership at the end of the period
2. Option to purchase the asset at a discounted price at the end of the term
3. Term of the lease is at greater than 75% of the useful life
4. PV of the lease payments is greater than or equal to 90% of FMV
You purchase a long-dated bond (say 100 years, doesn’t matter) at T=0 with a 7% coupon and a YTM of 7%. One year later, you collect the coupon and sell the bond at a YTM of 11%. What is your return on investment?
Long-dated bond, so ignore principal appreciation. You bought the bond at par. You sold
at YTM of 11%... coupon is 7% so yield of 11% = 7 / price, so price = 63. You also collect $7 in coupon payments. So total return is 70 / 100 = 30% loss.
You have a company levered at 5x with an interest coverage ratio of 5x. What is the interest rate on their debt?
Debt / EBITDA = 5 and EBITDA / Interest expense = 5
EBITDA = (r x Debt) = 5
r x (debt/EBITDA) = 1/5
r x 5 = 1/5
r = 1/25 = 4%
In an LBO, you have a choice of buying back debt at a 50% discount. Namely, face value of debt is 200 but you can buy it for 100 now. You plan to exit the investment in 5 years.
Should you do it?
Depends on your expected IRR. By buying back debt at half the value, you’re basically getting back 2x of your investment (you pay 100 cash now, but you have 200 more in equity value when you exit). As IRR = 15% for investment to 2x in 5 years, you should do it if your expected IRR is less than 15%. But you shouldn’t if your expected IRR is
higher than 15%.
P/E of a target company is 10x. You acquire it using 20% cash, 20% debt, and 60% stock. Foregone interest on cash = 2%; interest = 10%; tax = 40%.
The Acquirer's P/E is 8x. Dilutive or accretive?
Seller's yield = 1/10 = 10%
Weighted average cost of acquisition=
20%(2%)(1-40%) + 20%(10%)(1-40%) + 60%(1/8) = 8.94%
Cost of acquisition < Yield. Accretive
How does buying back debt at a discount flow through the three statements? Face Value = 800, you buy it back at 200, Tc=40%
IS: gain of 600, so EBT is up by 600, NI is up by 360
CF: start with +360 from NI, but subtract non-cash gain, so cash flow from operations is -240. Cash flow from financing section also records -200 for buying back debt. So net change in cash is -440.
BS: Cash is down by 440, so asset side is down by 440. Liabilities decrease by 800 as debt is gone now, but equity is up by 360 from RE that came from NI.
Both assets and liabilities & equity side is down by 400 and balance.