Accounting
17. Why is the Income Statement not affected by changes in Inventory?
The Income Statement does not account for changes in Working Capital
5. What produces a higher valuation: a decrease in WACC by 1%, or an increase to PGR by 1%?
● WACC because it hits the model in more places (in NPV of UFCFs and TV)
● Also, a lower cost of capital would boost our valuation
2. Maintenance vs. Incurrence covenants? Dependent on Credit Agreements.
● Maintenance covenants: Checked quarterly (mostly bank debt)
○ Minimum EBITDA / int. exp.
○ Maximum Debt / EBITDA
● Incurrence covenants: block actions throughout the Tenor of any debt agreement (bonds)
○ Prevents M&A
○ Prevents issuance of new debt
14. What does floor valuation mean?
● LBO models are often used as a “floor” (minimum) valuation, because PE firms usually don’t realize synergies, and try to pay the lowest possible price to hit a targeted IRR of 20-25%
9. What are two attributes that will make any M&A deal Accretive?
1. All stock deal
2. Acquirer has a higher P/E (Target has a lower P/E, buying additional “cheap” earnings)
● Note: P/E only matters in an all-stock deal because (Equity Value / Net Income)
28. What are some key line items in SG&A?
Operating expenses like Advertising, marketing, salaries, utilities, legal expenses, etc.
9. What are the three ways the tax-rate influences or changes our DCF?
● Unlevered FCF projections (tax-effected)
● Beta calculations (tex-effected)
● WACC, via Cost of Debt (tax-deductible)
● Note: anywhere where we use [* (1-mt)] in our DCF.
11. Who typically delays the Bankruptcy process?
● Management who will lose their jobs
● Creditors and Equity holders who expect to realize 0% recovery
3. How do I find the amount of leverage to use in a deal?
● Analyze Debt Comps & Leverage ratios for comparable firms and transactions in the industry to find the median leverage ratios
● Assess credit profile, credit agreements, and collateral
● If you have above-average Coverage Ratios, you may have the capacity to take on more debt than the median Leverage levels in the comps
17. What is the break-even point in M&A (where: Acc./Dil. = $0.00)?
Where accretion = weighted cost of acquisition (of all incremental financings utilized)
23. What is the difference between Capital leases and Operating leases?
● Operating Lease (liability on BS): Rent (operating exp) is above the EBIT line, so not in EV
● Capital Lease (liability on BS): Rent is below EBIT, so add to EV (produces higher valuation)
7. Would a 5% increase in EBITDA, or a 5% increase in the Exit Multiple produce a higher valuation?
● EBITDA because it hits the model in more places (in the sum of UFCFs & TV, whereas exit multiple is only affecting the TV)
● UFCF: EBITDA ↑ => UFCF ↑ = Valuation ↑
● TV: EBITDA ↑ * Multiple = Valuation ↑
5. Why would two different 5-year bonds trade at YTM of 5% and 40%?
● Maybe the 5% YTM is secured by assets, and you assume you receive repayment
● Maybe the 40% YTM is unsecured in a distressed company, low demand => Price has dropped
11. What is Management Equity Rollover in an LBO, how do you treat it?
● It lowers the Equity Contribution required by the sponsor to fund the deal, thus IRR increases
● We do not add or subtract MGMT Equity to our MOIC calc (it is “free” money)
20. What are some ways to make a deal more accretive?
● Use more Equity if the P/E multiple is very high (lower cost of equity)
● Project / realize more synergies
● Lower the transaction value or premium paid for the deal
● Using more cash/ debt if the cost of equity is very high
● Use lower-yielding debt/ credit facilities to lower Pro-forma interest expense
5. Issue $100 of PIK notes, with 10% interest. Beginning of Year 2 you retire the PIK debt (t=40%)?
Y0:
I/S: X
CF: CFf ↑ 100
BS: Cash ↑ 100, PIK Debt ↑ 100
Y1:
I/S: PIK interest ↑ 10, NI ↓ 6
CF: CFo ↓ 6, CFo ↑ 10 (add non-cash PIK int)
BS: Cash ↑ 4, RE ↓ 6, PIK Debt ↑ 10
BOY 2:
I/S: X
CF: CFf ↓ 110 (BV) (BV = intitial +PIK int)
BS: Cash ↓ 110, PIK Debt ↓ 110
32. List 8 valuation methods:
● DCF, Comps, Precedent transactions, NAV, DDM, Liquidation, and sum-of-parts
● LBO and Merger Models (are a type of valuation/model, but are called “ability to pay models”)
9. What is the difference between a distressed M&A deal and a Restructuring deal?
● Restructuring is one possible outcome of a distressed M&A deal
● A distressed firm’s solution is not always to restructure its debt obligations
● It may: declare bankruptcy, liquidate and run asset sales, or sell 100% of itself
● Refinance, Sale, Restructure or file for bankruptcy
4. Ideal LBO candidate?
● Strong, steady, predictable, and growing FCFs
● Clear opportunity to reduce CapEx and improve EBITDA margins
● Strong management team to continue smooth operations
● Finally, a high asset base to serve as collateral on debt for lower interest rates
8. What are some examples of synergies (where: 2 + 2 = 5)?
● Revenue Synergies (growth avenues): New: products, markets, geographies, and cross/up-selling to new/existing customers
● Cost Synergies (eliminate duplicative costs ~ easier to predict/taken more seriously): Eliminate unnecessary buildings, machinery, processes, and employees. Econ of Scale.
1. You buy equipment today for $100 with $100 of debt (by issuing a bond with interest at 10%, over 10 years). Depreciation is over 10 years with a salvage value of $0. At the beginning of year 2, you sell the equipment for $120. With a 40% tax rate, walk through the three statements for Year 0, 1, and 2?
Y0:
I/S: X
CF: CFf ↑ 100, CFi ↓ 100
BS: Cash ↑ 100, Debt ↑ 100; Cash ↓ 100, PPE ↑ 100
Y1:
I/S: Dep. Exp ↑ 10, NI ↓ 6, Int Exp ↑ 10, NI ↓ 6
CF: CFo ↓ 6, CFo ↑ 10 (add non-cash expense); CFo ↓ 6 (cash interest is cash exp)
BS: Cash ↑ 4, RE ↓ 6, Equipment ↓ 10; Cash ↓ 6, RE ↓ 6
Y2: BOY2=EOY1, so no D&A or int exp; BF of asset = $90, sell for $120, a gain of $30:
I/S: Other Income ↑ 30, NI ↑ 18
CF: CFo ↑ 18, CFo ↓ 30 (sub. non-cash gain); CFi ↑ 120 (sale)
BS: Cash ↓ 12, RE ↑ 18, Cash ↑ 120, Equip ↓ 90 (BV), A: ↑ 18, FE: ↑ 18
16. What is Non-Controlling Interest/Minority Interest?
● When a firm owns more than 50% of another company the parent company reflects 100% of the financial performance of the majority-owned subsidiary. BUT since the parent company does not own 100% of the sub, the parent company will have a line item called minority interest on its IS reflecting the portion of the sub’s net income that the parent is not entitled to (or does not own). The parent company’s balance sheet will also contain a line item called minority interest which reflects the percentage of the sub’s book value of equity that the parent does NOT own. This is the amount of minority interest we add to EV.
● Since we use EV for valuation ratios, when we pair EV with EBITDA from the parent company’s financials, these figures contain 100% of the sub’s EBITDA (even though the parent does not own 100%). In order to counteract this, we must add NCI to Enterprise Value (the value of the sub that the parent company does not own, the minority interest) so both the numerator and denominator of our metric account for 100% of the subsidiary.
19. Debt Waterfall - What is the order of payout and losses?
LTM EBITDA: 200M, court declares at 10x multiple; Sen. Secured 1st Lien TL = 1,800M; Sen. Secured 2nd Lien TL = 1,200M; Sen. Secured Bond = 500M:
● EV = 200M * 10 = 2,000M (use this to pay off debt in order of seniority)
● Pay 1,800M out to 1st Lien TL => 200M of EV remains
● Pay 200M to 2nd Lien TL => 2nd Lien loses 1,000M & Bond loses all 500M
● Fulcrum security: Point at which Obligations > EV (value breaks)
5. When is it more optimal to do a Dividend Recap or pay down more debt?
● In early years: Pay down more debt, as we assume 100% FCF sweep to lower interest expense early on
● In later years: Dividend Recap, as it boosts IRR more than a minuscule decrease to interest expense
25. What happens if the Acquirer purchases another company for a $1 billion Equity Purchase Price, but the Target’s Common Shareholders’ Equity is $1.5 billion?
● “Negative Goodwill” cannot exist per the rules of IFRS and U.S. GAAP.
● So in this situation, you record this $500 million difference as a Gain on the Income Statement.
● On the BS you don’t record any Goodwill; just add the acquired Assets and Liabilities