Accounting
Walk me through the 3 financial statements.
The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement.
The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement.The Balance Sheet shows the company’s Assets – its resources – such as Cash, Inventory and PP&E, as well as its Liabilities – such as Debt and Accounts Payable – and Shareholders’ Equity. Assets must equal Liabilities plus Shareholders’ Equity. The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company’s net change in cash
Rank the 3 valuation methodologies from highest to lowest expected value.
Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.
Walk me through a DCF.
we should all know this
Why would you use leverage when buying a company?
To increase your returns. 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.
What is the angle formed by the hands of the clock when it is 1:45?
142.5 degrees. If we just think of the clock hour hand at 1 and the minute hand at the 45 position (near 9 o’clock), that is 120 degrees since they are 4 “numbers” apart, and each number on the clock represents 30 degrees (360/12). However, recall that the hour hand has already moved by the time the minute hand has reached the 45 position – it is now closer to 2 o’clock. 45 represent ¾ of an hour, so the hour hand will have moved ¾ of 30 degrees, or 22.5 degrees. If we add them together, we see that 120 + 22.5 = 142.5
Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?
You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).
List at least 5 valuation methodologies that you know. How would you present these Valuation methodologies to a company or its investors?
Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.
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
Walk me through a basic merger model
A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases. Step 1 is making assumptions about the acquisition – the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one. Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer’s Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS.
Two companies, each with 50 revenue, merge. Together they now have 110 in revenue. Assuming no synergies, how is this possible?
The standalone revenues likely included intercompany sales or accounting differences. Once consolidated, revenue recognition policies or reporting basis changed, leading to higher reported revenue without actual economic synergies
What is Working Capital? How is it used?
Working Capital = Current Assets – Current Liabilities. If it’s positive, it means a company can pay off its short-term liabilities with its short- term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.” Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt). The point of Operating Working Capital is to exclude items that relate to a company’s financing activities – cash and debt – from the calculation.
Should you use the book value or market value of each item when calculating Enterprise Value?
Technically, you should use market value for everything. In practice, however, you usually use market value only for the Equity Value portion, because it’s almost impossible to establish market values for the rest of the items in the formula – so you just take the numbers from the company’s Balance Sheet.
How do you calculate WACC?
The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred).
In all cases, the percentages refer to how much of the company’s capital structure is taken up by each component. For Cost of Equity, you can use the Capital Asset Pricing Model and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.
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.
Company A can produce oil at $50 / barrel. Company B can produce oil at $30 / barrel. Oil sells for $70 today, and will sell for $100 in a year. Which company would you rather invest in?
If Depreciation is a non-cash expense, why does it affect the cash balance?
Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash
expense, Depreciation affects cash by reducing the amount of taxes you pay
How do you value a private company?
You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:
• You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps.
• You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price.
• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
• A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.
Explain why we would use the mid-year convention in a DCF.
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.
What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?
An Earnout is a form of “deferred payment” in an M&A deal – it’s most common with private companies and start-ups, and is highly unusual with public sellers. It is usually contingent on financial performance or other goals – for example, the buyer might say, “We’ll give you an additional $10 million in 3 years if you can hit $100 million in revenue by then. Buyers use it to incentivize sellers to continue to perform well and to discourage management teams from taking the money and running off to an island in the South Pacific once the deal is done.
You have 25 horses and a race track that races 5 horses. If you can only compare speed by racing the horses, how do you find the 3 fastest horses in the group?
Conduct 5 races and find the top from each heat.
Race the top 5 and the find the fastest horse.
Take 2nd and 3rd from finals heat, and 2nd and 3rd from heat of the fastest horse, and 2nd from the heat of the second fastest heat. Determine the second and third fastest.
What happens when Accrued Compensation goes up by $10?
For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation). Assuming that’s the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.
How do you value banks and financial institutions differently from other companies?
For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:
• You screen based on assets or deposits in addition to the normal criteria.
• You look at metrics like ROE (Return on Equity, Net Income / Shareholders’
Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on.
• You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA.
Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:
• In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple.
• In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book Value) – basically how much the returns exceed your expectations.
Why do you have to un-lever and re-lever Beta, and how do you do it?
When you look up the Betas on Bloomberg (or from whatever source you’re using) they will be levered to reflect the debt already assumed by each company. But 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. To get that, we need to un-lever Beta each time. But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Explain how a Revolver is used in an LBO model.
You use a Revolver when the cash required for your Mandatory Debt Repayments exceeds the cash flow you have available to repay them. The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment – Cash Flow Available to Repay Debt). The Revolver starts off “undrawn,” meaning that you don’t actually borrow money and don’t accrue a balance unless you need it – similar to how credit cards work. You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments. Within the debt repayments themselves, you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans.
There are muscle and liver isoforms of glycogen phosphorylase (GP). Which of the following is true about the allosteric regulation of GP by AMP? Think about what you learned in class.
a. AMP inhibits both liver and muscle GP.
b. AMP only stimulates muscle GP.
c. AMP only inhibits liver GP.
d. AMP stimulates both liver and muscle GP
e. AMP only inhibits muscle GP
f. AMP only stimulates liver GP.
b. AMP only stimulates muscle GP.