Accounting
Walk me through the financial statements when a company’s Operating Expenses increase by $100. (25% tax rate)
Income Statement: Pre-Tax Income is down by $100, and Net Income is down by $75 at a 25% tax rate.
Cash Flow Statement: Net Income is down by $75. There are no other changes, Cash is down by $75.
Balance Sheet: Cash is down by $75, so the Assets side is down by $75, and CSE on the L&E side is down by $75 due to the reduced Net Income
What is enterprise value and the formula for it?
EV -- The value of a firms operating assets, found by taking the PV of all future CF
EV = FDSO * Share Price + Debt + Preferred Stock + NCI - Cash
What's the purpose of valuation?
To make an investment decision by seeing if a companies implied value is different than its current value
Why might one company want to buy another company?
One company might want to buy another company if it believes it will be better off after the acquisition takes place.
Why do PE firms use leverage when buying companies?
To amplify their returns. Leverage does NOT “increase returns.” Borrowing money to fund a deal makes positive returns even more positive and negative returns even more negative.
A company’s Depreciation increases by $20. What happens to the financial statements? (25% Tax Rate)
Income Statement: Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate.
Cash Flow Statement: Net Income is down by $15, but you add back the $20 in Depreciation since it’s non-cash, so Cash at the bottom is up by $5.
Balance Sheet: Cash is up by $5, but PP&E is down by $20 due to the Depreciation, so the Assets side is down by $15. The L&E side is also down by $15 because Net Income falls by $15, which reduces CSE, so both sides balance.
Why is cash subtracted in the EV formula?
It's not an operating asset, therefore, does not contribute to the future CF an asset generates
What is the formula for unlevered free cash flows?
EBIT * (1-TR) + D&A - ΔNWC - Capex
How can you analyze an M&A deal and determine whether or not it makes sense?
The qualitative analysis depends on the factors above: could the deal help the company expand geographies, products, or customer bases, give it more intellectual property, or improve its team?
Finally, EPS accretion/dilution is important in most deals because Buyers prefer to execute accretive deals, i.e., ones that increase their Earnings per Share (EPS).
Why don't strategics use debt to purchase a company?
Strategics are looking to derive operational value without the intent to sell it after a 5-7 year period, and therefore would not want the burden of debt
A customer orders a product for $100 but doesn’t pay for it in cash. Walk through the cash collection.
Income Statement: No Changes
Cash Flow Statement: Cash increases by $100
Balance Sheet: AR is down $100 but cash is up $100
A company issues $200 in Common Shares, and it uses $100 from the proceeds to pay Dividends to the common shareholders. How does EV and Equity Value change?
EV = No Change
Equity Value = Increases by 100
What does the Discount Rate mean, and what is the formula?
DR = The Discount Rate represents the opportunity cost for the investors – what they could earn by investing in other, similar companies in this industry.
WACC = %D * COD * (1-T) + %E * COE
What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?
Cash tends to be the cheapest option; most companies earn little Interest Income on it, so they don’t lose much by using it to fund deals. It’s also the fastest and easiest to close Cash-based deals.
Debt is normally cheaper than Stock but more expensive than Cash, and deals involving Debt take more time to close because of the need to market the new Debt to investors.
Stock tends to be the most expensive option, though it can sometimes be the cheapest (on paper) if the Buyer trades at an extremely high P / E multiple.
What is goodwill?
How much a company is acquired for over the value of it's net identifiable assets (a plug on the balance sheet)
Salesforce sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year.
What happens after one month has passed, and the company has delivered one month of service for $100? Assume that there are $20 in Operating Expenses associated with the delivery of the service for this one month. Combine this step with the previous one. (25% tax rate)
Income Statement: Revenue is up by $100, but Operating Expenses are up by $20, so Pre-Tax Income is up by $80, and Net Income is up by $60 at a 25% tax rate.
Cash Flow Statement: Net Income is up by $60, and part of the DR decreases by 100, so cash is down 40
Balance Sheet: Cash is down by $40, DR is down by $100, and NI is up by $60
A company issues a press release indicating that it expects its revenue to grow at 20% rather than its previous estimate of 10%. How does everything change?
EV and Equity value increase by the new PV of future cash flows from this increase in revenue
What is the formula for Cost of Equity and what does it mean intuitevely?
Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
Weighted average cost of financing formula?
Seller’s Equity Yield = (Cost of Cash * (1-TR) * % of Cash) + (Cost of Debt * (1-TR)* % of Debt) + (Buyer’s Equity Yield * % of Equity)
What is the formula for goodwill?
Equity Purchase Price – (Shareholders Equity – Target Goodwill) – asset writeups + DTL
A company buys a factory for $200 using $200 of Debt. One year passes. The company pays 10% interest on its Debt, and it depreciates 10% of the factory. It also repays 5% of the Debt principal. What happens on the statements in this first year?
Income Statement: You record $20 in Interest and $20 in Depreciation, so Pre-Tax Income falls by $40, and Net Income falls by $30 at a 25% tax rate.
Cash Flow Statement: Net Income is down by $30, but you add back the $20 of Depreciation and record $10 in Debt Principal Repayments, so Cash at the bottom is down by $20.
Balance Sheet: Cash is down by $20, and Net PP&E is down by $20, so the Assets side is down by $40. On the L&E side, Debt is down by $10 due to the principal repayment, and CSE is down by $30 due to the reduced Net Income, so both sides are down by $40 and balance.
A company has excess Cash. How do Equity Value and Enterprise Value change if the company uses the Cash to repay Debt vs. repurchase Common Stock?
Debt: EV and Equity Value do not change
Common stock: EV doesn't change, Equity Value decreases
Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity? What's the formula?
By un-levering Beta for each comparable company, you capture the inherent business risk in “the industry as a whole.” Each company might have a different capital structure, so it’s useful to remove the risk from leverage and isolate the inherent business risk.
Levered Beta = Unlevered Beta * (1 + Debt / Equity * (1 – Tax Rate) + Preferred Stock / Equity)
Pro Forma EPS equation?
(Buyer Net income + Seller Net Income – Loss on Cash * (1-T) – New Interest *(1- T) + Synergies * (1-T) / (Fully diluted shares outstanding + New Shares Issued)
Explain what DTAs and a DTLs are?
DTAs = Cash taxes > Book Taxes
DTLs = Cash Taxes < Book Taxes