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IB - Practice (GUIDE)
Terms in this set (98)
What does "spreading the comps" mean?
Calculating relevant multiples for comparable companies and summarizing them for easy analysis
Why do you project out free cash flows in a DCF?
FCFs represent the amount of cash that could be paid out to debtholders and equityholders
What is Net Working Capital?
Current assets - current liabilities
Provides an indication of a company's solvency, ability to use short term assets to meet upcoming debt obligations
What happens to FCF as net working capital increases?
FCF decreases as an increasing to NWC represents a use of cash
What happens when a customer collects cash but does not record it as revenue?
Common in subscription based companies, where companies collect upfront payments before performing a service or delivering a good.
The journal entry is a debit to cash and credit to a liability called deferred or unearned revenue
Why might companies with similar growth and profitability have different valuations?
- Intellectual property
- Superior management leadership
How do you decide which valuation methodology to use?
You don't pick just one, but rather use multiple valuation techniques to provide a more rounded valuation.
Each valuation has different assumptions, however you might believe one valuation methodology is superior to another and assign it more weight
What is an Initial Public Offering (IPO)?
The first time a previously private company goes public
Two primary purposes:
1. Raise capital
2. Allow original investors to cash out some or all of their investment
What is a primary vs. secondary market?
Primary: Where a bond or stock is sold for the first time in an initial offering
Secondary: Where securities trade between market participants post-issuance
What is the capital asset pricing model (CAPM)?
Formula used to calculate cost of equity:
Risk-free + Beta * Risk Premium
What is beta?
A measure of volatility in relation to the market. The market has a beta of 1, 10-year US treasury securities have a beta of 0
If you had to pick two statements to value a company, which would you choose and why?
The balance sheet and income statement, assuming I have access to the previous period's balance sheet and this period's ending B/S and I/S
How does depreciation affect the cash balance?
Depreciation is an expense so it will reduce the amount of taxes a company pays.
Anything that impacts taxes will have a cash implication
In what scenarios could a company have negative shareholder's equity?
1. Negative net income (declining retained earnings balance)
2. Leveraged buy-out
3. Large dividend paid out to shareholders
What is the market risk premium?
The excess returns that investors require for choosing to purchase stocks or risk-free securities
What kind of investment would have a negative beta?
Gold tends to have a negative beta. When the market is doing well people move from the "safe haven" of gold into equities, and vice versa
- Results in negative correlation
How would you value a company with $50M in revenue and $5M profit?
You don't have information on historical or future cash flows so you cannot create a DCF
Assuming you know the industry you could perform a precedent transactions or comparable companies analysis
How would you value a company with no revenues?
Project company's future cash flows and create a discounted cash flow model
This is common in start ups. If you had the number of subscribers and growth rates, and comparable company's subscriber value you could put it all together to make rough revenue projections
What is the difference between APV and WACC?
WACC incorporates the effect of tax shields into the discount rate
APV adds present value of financing effects to NPV, assuming all equity
How would you calculate WACC for a private company?
Since private companies do not have market caps (no share price) and no beta you would likely just use a comparable company beta
Describe a company's typical capital structure?
Made up of debt and equity and may have multiple levels of each
Three types of debt: Senior, mezzanine, subordinated (senior has highest claims on assets so it offers the lowest interest rate)
Two types of equity: Preferred and common stock (preferred combines elements of debt and equity), common stock has the last claim on a company's assets
What are the two types of debt?
1. Bank Debt (floating rate, senior, secured,
2. High Yield (subordinated, fixed rate, PIK interest)
When should a company issue equity rather than debt to fund its operations?
1. If they believe stock price is inflated
2. If new projects will not provide immediate or consistent CFs to meet interest expenses
3. If the company wants to adjust its capital structure
4. Monetize owner's investment
Why should an investor buy preferred stock (instead of common stock)?
1. For the upside potential of equity (capital appreciation)
2. Safety of debt (guaranteed coupon payments in the form of dividends)
3. Provides a more senior claim to company's assets than common stock (still less than debt)
Why would a company distribute its earnings through dividends?
To signal to investors that the company is healthy and profitable. Potential to drive up stock price (as attracts more investors)
High operating leverage = increases to revenue funnels straight to bottom line
How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?
EBIT would decrease by $10, which would impact the FCF by $10*(1-T) = $6
However you add D&A back so the net change in free cash flow is up $4
$4 / (1+WACC)^4
Two companies with same financial profile and growth prospects. One is private and one public, which will have higher share price?
All else equal the public company should have a higher share price to account for the "liquidity premium" that allows investors to easily buy and sell the security.
What could a company do with excess cash on its balance sheet?
While it is not bad to have a large cash balance, having excess cash represents a large opportunity cost that could be used elsewhere to generate returns:
1. Pay dividend
2. Pay bonuses to employees
3. Pay down debt
4. Invest in projects (PPE)
5. Repurchase equity
6. Buyout competitors
7. ST investments
What is goodwill?
Goodwill is a line item on the balance sheet listed under assets.
It is created in acquisitions when the buyer pays more for the seller than the fair market value of their assets
Goodwill represents intangibles assets such as brand name, intellectual property
Goodwill may become impaired over time and has an implication on the net income
What are items that get added back to EBITDA?
One-time non-recurring items:
1. Legal expenses
2. Disaster expenses
3. Restructuring charges
4. Debt/equity financing expenses
When building a model, what is the most common way to build A/R, A/P, inventory, depreciation and capex?
A/R = Percentage of revenue
A/P = Percentage of COGS (Days in A/P)
Inventory = Percentage of COGS
Depreciation = Percentage of prior year's PPE or can break out individual assets in a schedule
Capex = Percentage of revenue or from MD&A guidance
How/why do you unlever/relever beta?
Beta (unlevered) = Beta (levered) / [(D/E)*(1-T) + 1]
Unlevering beta removes the financial effect of debt in the capital structure. It is a measure of the risk of the company's equity
How would you calculate an equity beta?
Regress the returns of a stock against the return of the market
What would be the effect of using levered vs unlevered cash flow in DCF?
Levered FCF represents cash available to equity holders
After projecting out LFCFs you would discount using the cost of equity and would end up with equity value (not enterprise value)
What is a dividend discount model?
Similar to a discounted cash flow model but you discount dividends.
1. You project out earnings to the EPS level
2. Assume that a certain % of EPS is being paid out based on historical dividend yields
3. Discount using cost of equity
4. Calculate terminal value using an equity valuation multiple such as P/E and discount to present
Cash vs. Accrual Accounting
Cash: Revenue and expenses are recorded when cash enters and leaves company possession
Accrual: Revenues recognized under IFRS (performance substantially complete, collection reasonably assured, and amount reliably estimated). Expenses recognized as they are incurred
Tax vs. GAAP Accounting
Tax more concerned with tracking revenue and expenses in a period to see how much tax should be paid. GAAP more concerned with tracking company long term, specifically assets and liabilities (uses accrual method)
GAAP uses straight-line, Tax uses accelerated depreciation
LIFO vs. FIFO
Different accounting methods of dealing with inventory and COGS. With FIFO, the first inventory produced or purchased will be recognized when goods are sold
What is the mid-year convention in a DCF?
Used to account for fact that cash is collected equally throughout the year (not all at the end)
To do this you discount using "half-years"
How do you go from EV to per share price value in a DCF?
Work backwards to get to equity value:
Enterprise value add back cash, subtract debt, preferred, minority
Divide by FDSO. Depends on per share price so you need to enable iterative calculations in excel
Walk me through the IPO valuation process for a company that is being taken public.
Priced primarily based on comparable company analysis
Once identified a strong comp set they will perform a comp analysis
Company XYZ reported increased earnings yesterday but their stock price still dropped. Why?
1. Earnings miss
2. Entire market/industry down for the day
Is 15x a high P/E ratio?
To evaluate this you need to know the industry:
This may be high in materials but would be low in tech
If a stock has gone up 20% in the last 12 months, is the stock doing well?
That depends on a few factors:
What is the beta?
What was the return of the market?
How can a company raise its stock price
1. Repurchase shares
2. Improve operations (causing increase to EPS that will send positive single to the market)
3. Change to organizational structure or cost-cutting initiative
4. Announcement of an accretive M&A transaction
A stock is trading at $5 and another trading at $50, which has greater growth potential?
Hard to say. Which one has a larger market cap?
The smaller market cap will tend to have larger growth potential
When should a company buy back stock?
1. If it believe its stock is undervalued
2. If they have excess cash
3. If it wants to increase its stock price by increasing EPS (or sending a positive signal to the market)
Why do some stocks rise so much on the first day of trading after their IPO and others don't?
Money left on the table means the company could have completed the issuance at a higher valuation (sale price).
The difference in valuation goes to the initial investors rather than to the company
What is the default premium?
The difference between the yield on a corporate bond and a government bond with the same maturity
The difference represents the added risk of holding the corporate debt
What is default risk?
The probability a company will not be able to make interest payments or principal repayments
The higher the default risk, the higher the interest rate
What is the difference between a bond and a consumer loan?
Bond: Issued by a company and traded on markets or OTC
Loan: Issued by bank and not traded on a public market
Bank Debt vs. Bonds
Bank Debt: Lower interest, floating rate, maintenance covenants, amortized at a certain % per year
High Yield Bonds: Higher interest, fixed rates, PIK interest, call protection (to ensure bonds remain outstanding)`
Why would a company use bank debt rather than high-yield bonds?
Bank debt is normally secured by assets and therefore commands a lower interest rate
Trade-off: Typically has maintenance covenants and is amortized
Why might two bonds from the same issuer at same price be trading at different prices?
There could be multiple reasons: A putable or convertible bond would demand a premium, and callable would trade at a discount
Yield to Maturity vs. Yield to Worst?
YTM: Assumes holder will hold to maturity and collect all interest payments and principal
YTW: Assumes holder may not hold to maturity given circumstances such as call of the bond or default of the company
When should a company issue debt instead of equity?
1. If it is cheaper than issuing equity
2. Interest payments are tax deductible and provide tax shields
3. If stock is undervalued
What is PIK Interest?
Paid in Kind:
Bond will increase in face value each year by PIK interest rate
- Payout is at maturity
What is duration?
Weighted average maturity of cash flows: Price sensitivity to changes in interest rates
What factors affect exchange rates?
1. Differences in interest rates
2. Differences in inflation
3. Budget deficits
4. Public debt
5. Trade policies
What are forward contracts?
Type of derivative that arranges for the delivery of an asset sometime in the future at an agreed price
Futures vs. Forward Contracts?
Futures: Highly standardized (traded on public markets)
Forwards: Privately negotiated (Traded OTC)
What factors influence the price of an option?
1. Stock price
2. Exercise price
4. Time to expiry
5. Interest Rate
6. Dividend payouts
What does "in the money" money?
The difference between the exercise price and market price creates value:
Call: In the money when exercise price < market price
Put: In the money when exercise price > market price
Why would two companies want to merge?
2. Grow in size
3. Vertical or horizontal integration
4. Gain IP or competitive advantage (secret sauce)
What are some reasons two companies would not want to merge?
Don't believe synergies will materialize
- Merger may be driven by CEOs or management's ego
- Investment banking fees could be prohibitive
What is the Black-Scholes model?
Way to value asset options
1. Current price of asset
2. Exercise price of option
3. Time until expiry
4. Risk-free rate
5. Volatility of returns
6. Dividend yield
What are synergies?
The idea is that the consolidation of two companies results in a company that is more valuable than the individual sum of the two companies together.
Cost synergies or revenue synergies
What is the difference between a strategic buyer and a financial buyer (sponsor)?
Strategic buyer is looking to acquire a company for strategic purposes (gain market share, gain competitive advantage, realize synergies)
Financial buyer is a group of investors who purchase a company as an investment to sell in the future
What is a stock swap?
When a company purchases another company by issuing new stock of the combined company to the former owners of the company being acquired, rather than paying them in cash
What is the difference between FDSO and share outstanding
Share outstanding: All shares that have been issued
FDSO: The share count if all "in the money" shares were exercised
Would I be able to purchase a company at its current stock price?
Likely not, given that the purchase of a majority stake requires payment of a control premium
All else equal, how would one company prefer to pay for another?
If a company has sufficient cash they would choose cash since it is the 'cheapest' option.
However, if they want to keep a large cash balance they may prefer other methods.
If their stock is inflated or trading at an all time high they may consider issuing equity
What is a tender offer?
Often a hostile takeover technique. It occurs when a company or individual offers to purchase the stock of the target company for a price higher than the market price
- Attempt to take control over company without management approval
If company A purchases company B, what will the combined company's balance sheet look like?
Sum of the two companies' balance sheets plus the addition of "goodwill", an intangible asset to account for premium paid on top of company B's actual assets
Goodwill vs. Other Intangible Assets?
Similarity: They are both non-physical assets
Goodwill is only impaired, while other intangibles are amortized over a fixed number of years
Is the deal accretive or dilutive?
Need to know:
1. How much they paid
2. How the payment was financed
If all stock: If company A has higher P/E then it is accretive
What is the treasury stock method?
A way of calculating a hypothetical number of shares outstanding based on "in the money" options and warrants.
Under IFRS you assume all the proceeds from exercising will go towards repurchase of the stock at the current price
Are most mergers stock swaps or cash transactions and why?
It depends, but they tend to be stock swaps for two reasons:
1. Equities are trading at record highs
2. Owners commonly want maintain an equity stake so they would prefer stock over cash
You are advising a client in the potential sale of a company. Who would you expect to pay more for the company: a competitor or an LBO fund?
The competitor, assuming they are a strategic buyer. They would pay more for the potential synergies that they could realize.
LBO fund would offer a lower price commensurate with a 20-25% IRR that they expect to make after 5 years
What is a leveraged buyout? How is it different from a merger?
A leverage buyout is when an LBO fund takes over another company by purchasing a company with a relatively high level of debt then paying it off wit the cash flows produced by the firm.
By the time of sale, 3-7 years, the business will have little debt and the PE firm will collect a higher % of the selling price or use excess cash to pay themselves a dividend
What would be a real-life example of an LBO and what are the different pieces?
Example: Purchasing an apartment to rent out
Down payment = equity investment
Mortgage = debt
Interest payments on mortgage = interest payments on debt
Principal payments are from CFs generated by operations (rent)
Sale of the property would represent the exit through sale or IPO
How could a firm increase the returns on an LBO acquisition?
1. Increase the sale price at time of exit
2. In model, you could increase projections for acquired company's earnings and CFs
3. Lower purchase price
4. Increase amount of leverage (however this puts stress on the company being acquired)
How do you pick purchase multiples and exit multiples for an LBO?
Precedent transactions analysis or public company comparables analysis
What makes a company an attractive target for a leveraged buyout?
1. Stable cash flows
2. Strong management
3. Replaceable management
4. Cost cutting opportunities
5. Non-cyclical industry
Why would a PE firm buy a company that was considered more risky than a typical LBO candidate?
When they purchased distressed companies they can negotiate lower purchase prices.
The PE firm will put in place a new capital structure and work with management to improve the business, hoping to resell the business for a higher multiple and valuation
What is a dividend recap?
Typically occurs in the middle of a PE firm's investment in a company that has been performing well and paying down debt
As leverage ratios decrease, the PE firm may issue additional debt and return a portion of the cash raised to owners
What are appropriate coverage and leverage ratios for a business through an LBO or other acquisition?
This is highly dependent on the industry and how much debt the market is willing to bear, determined by deals that have been closed recently.
All else equal, higher leverage and lower coverage will demand a higher rate of return
Typical LBO deals are levered somewhere between 2 and 10 times
What is the "tax-shield" created by an LBO?
The company issuing the debt will be paying interest on that debt. Since it is an expense it is tax-deductible, reducing the amount of taxes the company pays
What is venture capital?
Specific type of private equity where a VC firm provides financial capital to high-potential, high-risk companies.
In return they require a significant private equity stake, and generally board seats and votes to help the company through the growth process
What are deferred tax assets and deferred tax liabilities, and how are they created?
Created in M&A transactions through the write-up and write-down of assets
If asset is written up, the company experiences a gain and a DTL is created (higher depreciation expense in the short term)
In an LBO, what would be the ideal amount of leverage to put on a company?
In order to maximize returns, the acquiring firm wants to finance the deal with the least amount of equity as possible. However they need to be careful to not overburden the company with too much debt (bankruptcy/default risk)
What are the three types of mergers and what are the benefits of each?
Horizontal: Merger with competitor that will ideally result in synergies
Vertical: Merger with supplier to hopefully result in cost cutting
Conglomerate: Merger with company in completely unrelated business done for market expansion or to diversify platform
What is an exchange ratio and why would a company use it?
A way of financing an acquisition by assigning a number of shares in the company to be exchanged for each existing share in the original company
"I will give you 2 shares of company X for each share of company Y"
What are some defensive tactics that a target firm may employ to block a hostile takeover?
1. Poison pill shareholders rights plan
2. Pac-Man defense (turnaround and try and takeover other company)
3. White knight
What kind of assumptions would you have to make when coming up with a new Income Statement for the combined company in a merger model?
1. Revenue synergies on combined revenue line (leveraging each other's customer base, cross selling)
2. Cost cutting synergies (normally added back to operating income)
Which type of synergy is most important?
Cost saving synergies are more quantifiable since it is easier to see where employees may be eliminated or redundant branches shut down. Both types of synergies are important however cost synergies are generally given more importance
Why would a company choose to not use cash to finance an acquisition?
2. Stock is trading at inflationary prices or all time high
3. Low to no leverage and willing to take on debt
What are some recent trends in investment banking?
1. Consolidation of banks
2. Global expansion
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