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Investment Banking Interview Questions
Terms in this set (127)
Three main financial statements
Income Statement: Rev-COGS-Expenses= NI
Balance Sheet: Assets=Liabil +Shar. Equity
Statement of Cash Flows= Beginning Cash + CF from Operations + CF from Investing + CF from Financing= Ending Cash
How are the three financial statements connected?
- NI flows from Income Statement into cash flow from operations on Cash flow statement
-NI minus Dividends is added to retained earnings from the prior period's balance sheet to come up with retained earnings on the current period's balance sheet
-Beginning cash on the CF statement is cash from the prior period's Balance Sheet, and Ending Cash on the CF statement is Cash on the current period's Balance Sheet
Income Statement connections
-Net Income is the beginning point for the cash flow statement
-Interest expense on the income statement is calculated from debt on the Balance Sheet
-Depreciation and Amortization is calculated based on property, plant, and equipment from the balance sheet. A $10 increase in depreciation expense will result in the $10 reduction in net PP&E and a $10 x (1-T) in net income
-Net income minus dividends paid = addition to retained earnings on the Balance Sheet
Cash Flow Statement
-Organized into Cash Flow from Operations, investing, and Financing
-Net income is the one of the first lines and come from the Income Statement
- Adjust for non-cash items (like Depreciation and Amortization) from the Income Statement
-Adjust for change in working capital, which is calculated from changes in current assets and current liabilities on the Balance Sheet
-One of the final lines will be change in cash
-Beginning cash (which comes from prior period's Balance Sheet) plus change in cash yields ending cash balance on the current period's balance sheet
-Debt is affected by Cash Flow from financing, which would include mandatory amortization of debt, optional amortization, repayments, new debt issuance, etc.
-Cash balance is determined from the cash flow statement as described above
-Assets like PP&E and goodwill are reduced in value by depreciation and amortization
-Retained earnings is increased/decreased by net income minus dividends paid as described above
Walk me through the major line items of an Income Statement
-First line represents revenues or sales, then you subtract COGS to get Gross Margin
-Then you subtract operating expenses from gross margin to give you operating income. From operating income, you subtract interest expenses and any other expenses (or add other income), such as tax payments or interest earnings, and what's left is NI
Three components of Statement of Cash Flows
-Cash from operations, cash from investing, cash from financing
If you could use only one financial statement to evaluate the financial state of a company, which would you choose?
- I would want to see the Cash Flow Statement so I could see the actual liquidity position of the business and how much cash it is using and generating
-The income statement can be misleading due to non-cash expenses that may not truly be affecting the overall business.
-The balance sheet alone just shows a snapshot of the company at one point in time, without showing how operations are actually performing. But whether a company has a healthy cash balance and generates significant cash flow indicates whether it is probably financially stable, and this is what the CF would show
What is the difference between the income statement and statement of cash flows?
A company's sales and expenses are recorded on its Income Statement. The Statement of Cash Flows record what cash is actually being used during the reporting period and where it is being spent. Other items included on the Cash Flow Statement could be issuance or repurchase of debt or equity and capital expenditures or other investments. Amortization and depreciation will be reflected as expenses on the Income Statement, but they will be added back to net income on the Cash Flow Statement since they are expenses but not actually a use of cash
What is the link between the balance sheet and net income?
-The profits generated on the income statement after any payment of dividends are added to shareholder's equity on the Balance Sheet under retained earnings
-Debt on the Balance Sheet is used to calculate interest expense on the Income Statement
-Property, plant and equipment on the Balance Sheet is used to calculate depreciation expense on the income statement
-There are many other links, but above are the main ones
What is the link between the Balance Sheet and the Statement of Cash Flows
-Beginning cash on CF comes from the prior reporting period's Balance Sheet
-Cash from operations is calculated using changes in the Balance Sheet accounts-- Net working capital (current assets-current liabilities) and other changes in assets and liabilities that cannot be classified as investing or financing activities
-Cash flow's depreciation adjustment is calculated on the Balance Sheet's net property, plant, and equipment (PP&E)
-Investments in PP&E come from the Balance Sheet and are accounted for under investment activities on the Cash Flow Statement
-Ending cash on the CF statement goes back onto the Balance Sheet
What is EBITDA?
-EBITDA= Earnings before Interest, Taxes, Depreciation, and Amortization
-It's a high-level indicator of a company's financial performance
-Removes the effects of financing and accounting decisions such as interest and depreciation
-Good way to compare performance of different companies
-Serves as a rough estimate of free cash flow, and is used in the EV/EBITDA multiple to quickly establish a company's high-level valuation
How could a company have positive EBITDA and still go bankrupt?
-Bankruptcy occurs when a company can't make its interest or debt payments. Since EBITDA is Earnings BEFORE Interest, if a required interest payment exceeds a company's EBITDA, then if they have insufficient cash on hand, they would soon default on their debt and could eventually need bankruptcy protection
-value of a firm as a whole, to both debt and equity holders. To calculate EV in its simplest form, you take the market value of equity (aka the company's market cap), add the debt and the value of outstanding preferred stock, add the value of any minority interests the company owns, and then subtract the cash the company currently holds
-Market cap + Debt + Preferred Stock + Minority interest - Cash
What is net debt
Total debt minus cash on its balance sheet. Net debt assumes that a company pays off any debt it can with excess cash on the balance sheet
If EV is $150mm and Equity value is $100mm, what is net debt?
(Assume no minority interest or preferred stock)
Net debt= $50mm
Why do you subtract cash from EV?
-Cash has already been accounted for within the market cap
-Also, because cash can be used either to pay a dividend or to reduce debt, effectively reducing the purchase price of the company
What is the difference between equity value and Enterprise value?
-Equity value= Enterprise value - net debt
-Enterprise value= Equity value + net debt
When looking at the acquisition of a company, do you look at equity value or enterprise value?
-Because the acquiring company must purchase both liabilities and equity in order to take over the business, the buyer will need to assess the company's EV, which includes both the debt and equity
When calculation EV, do you use the book value or the market value of equity?
-Market value of the equity because that represents the true supply-demand value of the company's equity in the open market
Could a company have a negative book Equity Value?
-A company could have a negative book equity value if the owners are taking out large cash dividends or if the company has been operating for a long time at a net loss, both of which reduce shareholders' equity.
What is the difference between public Equity Value and book value of equity?
-Public equity value is the market value of the company's equity; while book value is just an accounting number. A company can have negative book value of equity if it has been taking large cash dividends, or running at a net loss; but it can never have a negative public Equity Value, because it cannot have negative shares or a negative stock price
What is valuation and what is it used for?
-Valuation is the procedure of calculating the work of an asset, security, company, etc.
What are some ways you can value a company?
-Simplest is market valuation (public equity value based on public markets)
-Enterprise value, comparable company analysis, precedent transactions, discounted cash flow, leveraged buyout valuation, liquidation valuation
Comparable Company Multiples Analysis,
- By using comparable company multiples analysis (To calculate EV or Equity Value)
--> Most common-used multiples are Enterprise value/EBITDA
--> P/E, EV/EBIT, Price/Book, EV/Sales
--> EV/Proven Reserves, EV/Production (Energy)
--> EV/Visitors (Internet)
NOTE: EV/EBITDA multiple is TOTAL VALUE of firm, whereas P/E is only valuing ONLY EQUITY
Market Valuation/Market Capitalization
- Market value of equity is used only for publicly traded companies
--> multiply shares outstanding by stock price
-A precedent transaction analysis is based on the idea that a company's worth can be determined by looking at the prices paid for similar companies in similar situations in the past
-This valuation technique results in the highest valuation due to the inclusion of a "control premium" the buyer is willing to pay for the assumed "synergies" they hope will occur after the purchase
LBO (Leveraged Buyout)
-When a firm (usually a private equity--PE--firm) uses a higher than normal amount of debt (known as leverage) to finance the purchase of a company
-The private equity firm will purchase the equity of another company, using percentage (anywhere from 10%-40%) of its own capital and financing the remainder with debt through bank loans, bonds, or a combo of the two. The Private equity firm then uses the cash flows from the acquired company to pay off debt over time with the goal of increasing the value of their equity.
-When the private equity firm is ready to sell the company, the debt has been mostly paid and the PE firm-- as the majority of equity owners of the company-- can collect most of the profits from an IPO or sale of the business. Since a smaller equity check was needed up front due to higher level of debt used to purchase the company, this can result in higher returns to the original investors if they had paid for the company entirely with their own equity (without debt)
- Uses the value of the company if they simply sold all its assets
--> This could be used if company has different divisions with different margins, growth rates, et.
Which of the valuation methodologies will result in the highest valuation?
- Precedent Transaction- due to projected synergies
- DCF- those building the models are optimistic
- Market Val
How do you value a private company?
- Same way as regular valuation except you can't use straight market valuation
-DCF can be complicated because of absence of an equity beta, which would make calculating a DCF difficult.
- In this case, use the equity beta of a close comp in your WACC calculation
-If you're using comps of publicly traded companies a 10-15% discount may be required as a 10-15% premium is paid for a public company's relative liquidity
What does spreading comps mean?
Calculating relevant multiples from comparable companies and summarizing them for easy analysis and comparison. It can be challenging when a company's data and financial information must be scoured to conduct necessary research
Would you be calculating Enterprise Value or Equity Value when using multiple based on free cash flow or EBITDA?
EBITDA and free cash flow represent flows that are available to repay holders of a company's debt and equity, so a multiple based on one of those two metrics would describe the value of the firm to all investors.
Walk me through a DCF
1) Project the company cash flows for about 5 years using the standard formula (FCF is EBIT time 1 minus tax rate, plus depreciation and amortization, minus capital expenditures, minus net working capital)
2) Predict free cash flows beyond 5 years using either terminal value multiple or the perpetuity method (To calculate perpetuity, establish a terminal growth rate, usually about the rate of inflation or GDP growth, a low single-digit %.
3) Multiply Year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus the growth rate. (Discount rate is the WACC)
-Use that rate discount all your cash flows back to year zero. The sum of the present value of all those cash flows is the estimated present EV of the firm according to discounted cash flow model
How do you calculate a firm's terminal value?
There are two ways to calculate terminal value. --The first is the terminal value multiple method. To use this method, you choose an operation metric (most commonly EBITDA) and apply a comparable company's multiple to that number from the final year of projections.
-The second method is perpetuity growth method where you choose a modest growth, usually just a bit higher than inflation rate or GDP growth rate, and assume that the company can grow at this rate infinitely. You then multiply the FCF from the final year by 1 plus the growth rate, and divide that number by the discount rate (WACC) minus the assumed growth rate
- FCF10 (1+G)/ (WACC-g)
What is WACC and how do you calculate it?
-WACC is the acronym for Weighted Average Cost of Capital
-It is used as the discount rate in a discounted cash flow analysis to calculate the present value of a company's cash flows and terminal value. It reflects the overall cost of a company's raising new capital, which is also a representation of the riskiness of investing in the company.
-Mathematically, WACC is the percentage of equity in the capital structure times the cost of equity (Calculated by the capital assets pricing model) plus percentage of debt in the capital structure times one minus the corporate tax rate times the cost of debt-- current yield on outstanding debt-- plus percentage of preferred stock in the capital structure times the cost of preferred stock if there is any preferred stock outstanding
All else equal, should the WACC be higher for a company with $100 million of market cap or a company with $100 billion of market cap?
-Without knowing more information about companies, it is impossible to say. If the capital structures are the same, then the larger company should be less risky and therefore have a lower WACC. However, if the larger company has a lot of high-interest debt, it could have higher WACC
How do you calculate free cash flow?
Free cash flow is EBIT times 1 minus the tax rate plus Depreciation and Amortization minus Capital Expenditures minus the Change in Net Working Capital
Why do you project out free cash flows for the DCF model?
The reason you project FCF for the DCF is because FCF is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company
When would you want to use a DCF?
If you have a company that has very unpredictable cash flows, then attempting to project those cash flows and create a DCF model would not be effective or accurate. In this situation you will most likely want to use a multiples or precedent transactions analysis
What is NWC?
-Current Assets - Current liabilities= NWC
--> It is a measure of a company's ability to pay off its short term liabilities with its short-term assets. A positive number means they can cover their short-term liabilities with their short-term assets. A negative number indicates that the company may have trouble paying off its creditors, which could result in bankruptcy if cash reserves are insufficient
What happens to free cash flow if NWC increases
- You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa
When would a company collect cash from a customer and not show it as revenue? If it isn't revenue, what is it?
-This typically occurs when a company is paid in advance for future delivery of a good or service, such as a magazine subscription. If a customer pays for delivery of 12 months of magazines in advance, cash from that purchase goes onto the Balance Sheet as cash, but also increases deferred revenue, a liability.
-As each issue is delivered to the customer over the course of the year, the deferred revenue line item will go down, reducing the company's liability, while a portion of the subscription payment will be recorded as revenue
Difference between accounts receivable and deferred revenue
-Accounts receivable is money a company has earned from delivery of goods or services but has not collected yet. Deferred revenue is the opposite, money that has not yet been recorded as revenue because it was collected for good or services not yet delivered
Why might there be multiple valuations of a single company?
Each method of valuation will generate different values because it is based on different assumptions, different multiples, or different comparable companies and/or transactions.
Why might two companies with similar growth and profitability have different valuations?
The difference in valuation could reflect some sort of competitive advantage that isn't represented on the financial statements. Perhaps the more valuable company is a market leader in a key region or owns uniquely valuable intellectual property or enjoys a significantly stronger management track record.
How do you determine which valuation methodology to use?
Because each method has unique ability to provide useful information, you don't choose just one. The best way to determine the value of a company is to use a combination of valuation techniques. For example, if you have a precedent transaction valuation that you feel is extremely accurate, you may give that result more weight. Or if you are extremely confident in your DCF analysis, you will place more emphasis on its outcome. Valuing a company is as much an art as it is a science.
What is an Initial Public Offering? Why do companies do it?
-It is the first time a privately-held company sells shares of stock to the public market. Usually a company goes public to raise capital for growing the business or to allow the original owner and investors to cash out some of their investment
What is a primary market and what is a secondary market?
- The primary market is the market where a new stock or bond is sold the first time it comes to the market. The secondary market is where the security will trade after its IPO
What is the capital assets pricing model?
-The Capital Assets Pricing Model, referred to as CAPM, is used to calculate the required return on equity (ROE) or the cost of equity. The return on equity is equal to the risk-free rate (usually the yield on a 10-year US government bond) plus the company's beta (a measure of the stock's volatility in relation to the stock market) times the market risk premium
-Re=Rf + B (Rm-Rf)
Where do you find the risk-free rate?
Recently, the S&P downgraded the United State from AAA "risk-free" rating to AA+. The other two major rating agencies have maintained their ratings on the US government debt, however. See the section in the current events section of this guide for more information.
What is Beta?
-Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a beta of 1, while investments that are more volatile than the market have a beta greater than 1 and those that are less volatile have a beta less than 1
From the three main financial statements, if you had to choose two to analyze a company, which would you choose and why?
-Balance sheet and income statement. As long as I had the balance sheet from the beginning and end of the period, as well as the end of period Income Statement, I would be able to generate Cash Flow Statement
How does depreciation affect the cash balance if it is a non-cash expense
-Since depreciation is an expense, it will reduce the amount of taxes a company will pay. Since taxes are a cash expense, anything that affects them-- including depreciation-- will affect the cash balance
How would a $10 increase in depreciation expense affect each of the three financial statements?
- The $10 increase in depreciation will be an expense and will reduce net income by $10 times (1-the tax rate). Assuming a 40% tax rate, this will mean a reduction in net income of 60% or $6. So $6 flows to cash from operations, where net income will be reduced by $6 but depreciation will increase by $10, resulting in an increase of ending cash by $4. Cash then flows onto the Balance Sheet where it increases by $4, PP&E decreases by $10, and retained earnings decreases by $6, keeping everything in balance.
In what scenario could a company have negative shareholders equity?
-If a company has had negative net income for a long time, it would have a negative retained earnings balance, which would lead to negative shareholders equity. A leveraged buy-out could have the same effect, and so would a large dividend payment to the owners of the business
How would you calculate the discount rate for an all-equity firm?
-If a firm is all equity, then you would use CAPM to calculate the cost of equity, and that would be the discount rate
What is the market risk premium?
-The market risk premium is the excess return that investors require for choosing to purchase stocks over "risk-free" securities. It is calculated as the average return on the market (normally the S&P 500, typically around 10-12%) minus the risk free rate (current yield on a 10-year treasury)
What kind of an investment would have a negative beta?
-Gold is an investment that has a negative beta. When the stock market goes up, gold goes down.
How much would you pay for a company that makes $50 million in revenue and $5 million in profit?
-Since you have no information about historical or projected performance, and no details about the firm's capital structure, it would be impossible to do a DCF analysis. Assuming you know the firm's industry, you could identify a group of comparable companies and do a multiple analysis using the ratios from those most relevant to the company being valued
What is the difference between Adjusted Present Value and WACC?
-WACC incorporates the effect of interest tac shields in the discount rate
---> Typically calculated from actual data from Balance Sheets and used for a company with a consistent capital structure over the period of the valuation
-APV adds present value of financing effects to Net Present Value assuming all Equity Value
--> Useful where costs of financing are complex and if capital structure is changing
--> Used for leveraged buy-outs
How would you calculate the WACC of a private company?
- Since a private company has no market cap and no beta, you would most likely use the WACC for a comparable public company
Describe a company's typical capital structure?
- debt and equity
- debt can be senior, mezzanine, or subordinated
- senior offers lowest interest rate since its least risk (pays first)
- Equity is either preferred or common stock
Senior bank loans
- underwritten by an investment bank and syndicated to institutional buyers
- First priority in the event of bankruptcy
- Often secured in case of liquidation by company assets pledged as collateral
-Arranged by investment banks and sold on bond market
-May be secured or unsecured
-Bonds will normally have a fixed interest rate
- Bonds may have call or put options, may be convertible into equity, etc.
Subordinated/ High yield bonds
-Similar to mezzanine binds, but lower in capital structure
-Hybrid of bond and common equity
- Preferred will pay a constant dividend to it shareholders, and the principle value of the preferred can gain value as well
- Common stock is traded on a public exchange
When should a company issue equity rather than debt to fund its operations
- If a company believes its stock price is inflated, issuing stock can raise a lot of capital relative to ownership sold.
- If the projects to be funded may not generate predictable cash flows in the immediate future, the company would want to avoid the obligation of consistent coupon payments required by the issuance of debt.
-Issuing stock is also an effective way to adjust the debt/equity ratio of a company's capital structure or to monetize the owners' investment
When should an investor buy preferred stock?
- Buy preferred stock for the upside potential of equity while limiting risk and assuring stability of current income in the form of a dividend. Preferred stock's dividends are more secure than those from common stock, and owners of peferred stock enjoy a superior right to the company's assets (inferior to debt holders) should they go bankrupt
Why would a company distribute its earnings through dividends to common stockholders?
-The distribution of a dividend signals that a company is healthy and profitable, thus attracting more investors, potentially driving up the company's stock price
What is operating leverage?
-Relationship between a company's fixed and variable costs. A company with more fixed costs has a higher level of operating leverage.
-High operating leverage means that much of any increase in leverage will fall straight to the bottom line in the form of profit
How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?
-a $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT (1-T) by $10 (1-T) assuming a 40% tax rate, it drops EBIT (1-T) by $6, but you must add back the $10 depreciation in the calculation of Free Cash Flow. Therefore our FCF increases by$4 and your valuation will increase by the present value of that $4.
- PV of the $4 increase in year 4 = $4/(1+WACC)^4
If you have two companies that are exactly the same in revenue, growth, risk, etc, but one is private and one is public, which companies share would be higher priced?
- Public company is likely to be higher priced
--> Liquidity premium investors will pay for the ability to trade their stock quickly and easily on public exchanges
--> "transparency premium" that derives from the public company's requirement to make their audited financial documents public
What could a company do with excess cash on its balance sheet
- Should have enough cash to prevent itself from bankruptcy in downturn
--> pay dividend
--> reinvest in plants, equipment, personnel pr merketing
--> Pay off debt, buy back shares, or buy out a competitor, supplier, or distributor
What is goodwill and how does it affect net income
- Goodwill is an intangible asset included in the company's Balance Sheet
- Goodwill may include things like intellectual property rights, brand name, or customer relations
-Goodwill is acquired when purchasing a firm if the acquirer pays more than the book value of its assets. When something occurs to purchasing a firm if the acquirer pays more than the book value of its assets. When some thing occurs to diminish value of the intangible assets, goodwill must be "written down" in a process much like that for depreciation
-Goodwill is subtracted as a non-cash expense and therefore reduces net income
What are some examples of items that may need to get added back to EBITDA to get a better sense for the financial health of company?
- one-time, non-recurring items like legal expenses, one-time disaster payments or events, restructuring charges, debt/equity financing expense, etc. Any items that are not likely to continue from one year to the next may be added back to EBITDA
When building a model, what is the most common way to project items like accounts receivable, accounts payable, inventory, depreciation, capital expenditures
-A/c rec is normally projected as a percentage of revenues or using a ratio like Days Sales Outstanding
- A/c pay is normally projected as a percentage of COGS or using a ratio like Days Payable Outstanding
- Inventory is normally projected as a percentage of cogs or using a ration like Inventory Days
- Depreciation can be calculated very simply using a percentage of prior years' PP&E or can be calculated at the individual asset level using different schedules, useful lives, etc.
-Capex is normally projected as a percentage of revenues, or from company guidance you will have a relatively good idea of what capex requirement are going forward
How/why do you lever/unlever Beta?
- Blevered= Bunlevered (1 + [(1-T)(Debt/Equity)]
- By unlevering beta, you remove financial effects of debt in the capital structure
-Unlevered beta shows you the risk of a firm's equity compared to the market
- Comparing unlevered betas allows investors to see how much risk they will be taking by investing in a company's equity (i.e. buying stock in the public market)
- When you have a company that doesn't have beta, Company A, you can find comparable Company B, takes its levered beta, unlever it, and then relever it using Company A's capital structure to come up with their beta
How do you calculate equity beta?
- In order to calculate an equity beta, you must perform a regression of the return of the stock versus the return of the market as a whole (the S&P 500). The slope of the regression line is the beta.
What would be the effect of using levered free cash flow rather than unlevered free cash flow in your DCF model?
- If you were to use the levered free cash flow in your DCF, you would end up with the Equity Value of the company rather than the Enterprise Value since the cash flows you are finding the present value for are after the debt investors had repaid, therefore indicating how much cash would be available to equity investors, not to all investors
What is a dividend discount model?
- Like DCF, but uses dividends rather than FCF
- Rather than projecting out free cash flow, you project the earnings per share of the business
- Assume that a certain percentage of EPS is being paid out as a dividend based on the historical dividend policy and how much cash the company wants to retain on its balance sheet
- Project out the dividends for the next 5-10 years just as you would with free cash flow, and then discount them back and sum them like in a DCF, but rather than using WACC, you are going to use cost of equity for the firm
- For the terminal value, you will want to use an equity valuation multiple like P/E, and then discount that back to year 0, just as you would a DCF
- The sum of the PV's of all the dividends is the per share value of the company
Difference between cash-based and accrual accounting
- Cash-based: A company won't recognize expenses or revenues until the cash is actually disbursed or collected
- Accrual accounting: A company will recognize expenses and revenues when it has entered into a transaction or agreement that will require it to pay or be paid, even if cash won't change hands until sometime in the future. Most companies use accrual accounting since credit cards are so prevalent
Difference between tax accounting and GAAP accounting?
- Tax accounting: is used to calculate just what income tax a company owes in a year
--> just revenues and expense for given year and cash based
--> Depreciation is accelerated
-GAAP accounting: tracks a company long-term, so it tracks assets and liabilities as well and is accrual-based
--> Depreciation is straight-line
Difference between LIFO and FIFO
- Different methods of dealing with inventory and COGS in a company's accounting policy
-LIFO (Last in first out)= Last inventory produced or purchased will be the first to be recognized when goods are sold
-FIFO (First in first out)= first inventory produced or purchased will be the first recognized when goods are sold
What is the mid-year convention in a DCF?
-Since cash is not collected all at once at the end of the year, you account for that in the way you discount the cash flows
- In order to do this, you will discount using "half-years," which assumes that all the cash is collected in the middle of the year, which is a more reasonable assumption
-For example, the 4th year's cash flow number would be discounted using 3.5 years to assume the cash is collected midway between the end of year 3 and the end of year 4
How do you go from the EV you would calculate using a DCF to a per share price for a public company?
- Once you come up with you EV, you add cash and then subtract debt, preferred stock, and minority interest to come up with Equity Value
-Once you have Equity Value, you must use excel to calculate a per share price based on the number of fully diluted shares outstanding
- However, the number of fully diluted shares will depend on the share price, so you will have to use the iterations function in Excel in order to calculate this
Walk me through the IPO process for a company that is being taken public
- Investment bank leading the deal will price the company primarily on publicly traded comparable companies
- Once the banking team has identified a strong comps set, they will perform a comparable companies analysis
MERGERS AND ACQUISITIONS
What are some reasons that two companies would want to merge?
- Synergies the companies should create by combining their operations
- Other reasons: gaining a new market presence, an effort to consolidate their operations, gaining brand recognition, gorwing in size, or gaining the rights to some property (physical or intellectual) that they couldn't gain as quickly by creating or building it on their own
What are some reasons two companies would not want to merge
- Synergies that company hopes to gain don't materialize
- Do a merger for management ego and/or wanting media attention
- Investment banking fees associated with going through a merger
What are synergies?
- the concept of synergies is that the combination of two companies results in a company that is more valuable than the sum of the values of the two individual companies coming together. The reasons for synergies can be either cost-saving synergies like cutting employees, reducing office size, etc. Or it can include revenue generating synergies such as higher prices and economies of scale.
What is the difference between strategic buyer and financial buy?
- Strategic buyer and financial buyers are very different. A strategic buyer is usually a company looking to buy another company in order to enhance the business strategically, through cost cutting, synergies, gaining property, etc. A financial buyer is traditionally a group of investors, such as private equity firm, buying a company purely as an investment, looking to generate a return for their investors and carry for the fund
Which will normally pay a higher price for a company, a strategic buyer or financial buyer?
- A strategic buyer will normally pay a higher price due to their willingness to pay a premium for the synergies of lowering costs, improving the existing business, and/or revenue synergies. The financial buyer typically looks at the company purely in terms of returns on a standalone basis unless they have other companies in their portfolio that could significantly improve operations of the target
Can you name two companies that you think should merge?
... (Think synergies, gain foothold in new market, consolidation of operations, or brand recognition)
What is a stock swap?
-A stock swap is when the acquired company purchases another company by issuing new stock of the combined company to the former owner of the company being acquired, rather than paying in cash
What is the difference between shares outstanding and fully diluted share?
-A stock swap is 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 in cash.
What is the difference between shares outstanding and fully diluted shares?
- Shares outstanding represent the actual number of shares of common stock that have been issued as of the current date. Fully diluted shares are the number of shares that would be outstanding if all "in the money" options were excersized
What is a cash offer?
- A cash offer is payment in cash for ownership of a corporation
Would I be able to purchase a company at its current stock price?
- Due to the fact that purchasing stake in a company will require paying a control premium, most of the time a buyer would not be able to simply purchase a company at its current stock price
Why pay in stock versus cash?
- Have to pay taxes on cash
- If owners buy stock, they could reap benefits from price rising
- Current market performance affects decision
All else equal, how would one company prefer to pay for another?
- Cash because its the cheapest source of capital
- On the other hand, a company wanting to keep a significant cash buffer would prefer other ways of financing the transaction
- If a company feels its stock price is inflated, it would prefer to use that to pay for the acquisition. In short, the preferred means of payment always depends upon the circumstances of the acquisition, the company, and the market
What is a tender offer?
- A tender offer is often a hostile takeover technique. It occurs when a company or individual offers to purchase the stock of the target company for a price usually higher than the current market price in an attempt to take control of the company without management approval
Describe a recent M&A transaction you have read about
Know price and multiples paid, whether it was a merger or acquisition, and the banks working on the deal. Also know the primary reason behind the M&A transactions
If company A purchases Company B, what will the combined company's Balance Sheet look like?
- The new Balance Sheet will be simply the sum of the two companies' Balance Sheets plus the addition of "goodwill," which would be an intangible asset, to account for any premium paid on top of Company B's actual assets
What is the difference between goodwill and other intangible assets?
- Goodwill and other intangible assets are similar in nature in that they are both non-physical assets carried on a company's Balance Sheet. The main difference between the two is that goodwill is only reduced in the event of a goodwill impairment or acquisition, whereas other intangible assets are amortized over a fixed number of years
What is the difference between an accretive merger and a dilutive merger, and how would you go about figuring out whether a merger is accretive or dilutive?
-An accretive merger is one in which the acquiring company's earnings per share will increase following the acquisiton. A dilutive merger is one in which the opposite occurs
-The quickest way to figure out is a merger accretive or dilutive is to look at the PE rations of the firms involved in the transaction. If the acquiring firm has a higher PE ration than the firm it is purchasing, the merger will be accretive because the acquirer will pay less per dollar of earnings for the target company than where the target's stock is currently trading
Company A is considering acquiring Company B. Company A's P/E ratio is 50 times earnings, whereas company B's P/E ratio is 20 times earnings. After Company A acquires Company B, will Company A's earnings per share rise, fall, or stay the same?
- Since the P/E of the firm doing the purchasing is higher than that of the firm it is purchasing, the new company's EPS will be higher, therefore creating an accretive merger
What is the treasury stock method?
- Treasury stock method is a way of calculating a hypothetical number of shares outstanding based on current options and warrants that are currently "in the money." The methodology involves adding the number of "in the money" options and warrants to the number of common shares currently outstanding, and then assuming all proceeds from exercising the options will go towards repurchasing stock at the current price.
If a company has 1,000 shares outstanding at $5 per share and also has 100 options outstanding at an exercise price of $2 per share, what is the company's fully diluted Equity Value?
-Since there are 1,000 shares at $5 each, the current market cap would be $5,000. Since all the options are in the money because the exercise price is below the current price, you assume they are exercised. This means that there will be 1,100 shares in the market and another $200 ($2 exercise price x 100 options) given to the company. That $200 is assumed to be used to buy back 40 shares ($200/$5 current price), leaving 1,060 shares in the market, at a price of $5 per share, making the Equity Value $5,300
Are most mergers stock swaps or cash transactions and why?
- This varies. In strong market many mergers are stock swaps mainly because the prices of company stock are so high, but also because the current owners may desire stock in the new company as they anticipate further growth in a strong market
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
- If the competitor is a strategic buyer, you would expect the competitor to pay more for the company. A strategic buyer would derive additional benefits (synergies) and therefore higher cash flows from the purchase than would an LBO fund, which is traditionally a financial buyer
What is a leveraged buyout? How is it different from a merger?
- Essentially, an LBO takes place when a fund wants to buy a company using more debt than cash with the intention of exciting the investment usually within three to seven years perhaps after changing the management to increase profitability.
-What makes it a leveraged buyout is the the fact that the acquiring firm will fund the purchase of the company with a relatively high level of debt and then pay off the debt with the cash flows produced by the firm.
-This means that by the time the fund is ready to sell the company, the business will ideally have little to no debt, and the PE firm will collect a higher percentage of the selling price and/or use the excess cash flow to pay themselves a dividend since the debt has been reduced or paid off.
What would be a real-life example of an LBO and what are the different pieces?
-A good real-life example of an LBO is borrowing money to purchase an apartment to rent out.
-The down payment on the apartment is equivalent to the equity investment, while the mortgage loan is the debt or "leverage" in an LBO transaction.
-The interest payment on the mortgage would be interest payment on the debt, while the principal payments on the loan are made with the cash flows you receive from renting out the apartment which is similar to amortization of the debt. -----Finally, the sale of the property, hopefully for a gain, would be exiting the investment through either a sale or an IPO.
How could a firm increase the returns on an LBO acquisition?
-Increase the sale price of monetization either through an increase in operating profits or through multiple expansion. Up front, it could negotiate a lower purchase price or increase the amount of leverage used to purchase the company, which would imply a smaller equity check with a higher internal rate of return on the capital deployed
How do you purchase multiples and exit multiples for an LBO?
-Purchase and exit multiples for an LBO transaction are determined using many of the same techniques used in general valuations for M&A transaction such as precedent transactions analysis or public company comparables analysis
What makes a company an attractive target for a leveraged buyout
-The most important characteristic of a good LBO candidate is steady cash flows.
-The firm ideally could pay off a significant portion or all the debt raised in the acquisition over the life of the investment horizon, with minimal bankruptcy risk. Some other attractive characteristics include strong or replaceable management, cost-cutting opportunities, and a non-cyclical industry.
Why would a private equity firm buy a company that was considered more risky than a typical LBO candidate?
-Many private equity firms will look to purchase companies in distressed situation or out of bankruptcy. When they do this, they typically can negotiate lower purchase prices than for companies that are performing. The PE firm will put in place a new capital structure and then work with management to improve the business, hoping to resell the business, hoping to resell for a higher multiple and valuation and earn a significant return on investment
What is a dividend recapitalization?
- A dividend recap typically occurs in the middle of a PE firm's investment in a company when that company has been performing and paying down debt, reducing leverage. The owners of the business (normally the PE firm) will go back to market looking to issue new debt both to repay the existing debt and to fund a distribution to shareholders
What are appropriate coverage and leverage ratios for a business through an LBO or other acquisition?
-This is completely dependent on the type of business. The appropriate levels are what the market is willing to bear for similar companies in similar industries, determined by what deals have been closed recently. All else equal, higher leverage or lower interest coverage is going to make the investors demand a higher interest rate on the debt because the investment is considered more risky. However, in a typical LBO or M&A deal, the company most likely will be levered somewhere between 2x and 10x, depending on the industry
What is the "tax-shield" created by an LBO?
In an LBO, the company issuing the debt will be paying interest on that debt, which is an expense. Since this interest is an expense and is tax deductible, it therefore reduces the amount of taxes the company pays, creating the "tax-shield"
What is Venture Capital?
- Venture capital is a specific type of private equity that provides financial capital to high-potential, high-risk startup companies.
-In exchange for providing this high-risk capital, the provider (usually a venture capital fund) will receive significant private equity ownership in the business.
-They will typically also get board seats and influence, in order to help these usually young businesses through the growth process.
-Many times these investments end up being worth noting, but the goal for the VC firm is to hit a couple of home runs.
-For example, Accel Partners invested $12.7 million in facebook, which ended up growing to over $8.5 billion in value.
What are deferred tax assets (DTA's) and deferred tax liabilities (DTL's), and how are they created in an M&A transaction?
-DTAs and DTLs are created in an M&A transaction through the write-up or write-down of assets.
- If an asset is written up, the company is experiencing a gain and a DTL is created because the new asset will have a higher depreciation expense in the short term, which means the company will pay lower taxes. These taxes must be paid back at some point, which is why a liability is created.
- The opposite is true when an asset is written down in value
In a leveraged buyout, what would be the ideal amount of leverage to put on a company?
- In order to maximize returns in a leveraged buyout, the acquiring firm wants to finance the deal with the least amount of equity possible. However, they need to be careful as to not the company into financial distress by overburdening the acquired company with debt
What are three types of mergers and what are the benefits of each?
- Horizontal merger= between competitor and ideally will result in synergies
- Vertical merger = Deal with supplier or distributor, which will result in cost-cutting
- Conglomerate merger is a merger with a company in a completely unrelated business and is most likely done for market or product expansions or to diversify its product platform and reduce risk expense
What is an exchange ratio?
- An exchange ratio is a way of financing an acquisition by assigning a number of shares in the new company to be exchanged for each existing share in the original company.
- For example, Company A could acquire Company B and say, "We will give you 2 shares of the new, combined Company AB for each of your shares of Company B, rather than saying, "You will receive $XX of Company AB stock for each share of Company B."