Investment Banking Technicals

Explain the time value of money. Is money today worth more than money next year due to inflation?

No. The time value of money means that a dollar today is worth more than a dollar received in the future because that money can be invested today and earn a return.

Inflation does make money less valuable over time, but the TIME VALUE of money is about the potential returns of an investment made today.

What does the “Discount Rate” mean?

The Discount Rate represents your opportunity cost or “targeted annualized return.” Basically, if you don’t invest in THIS company, how much COULD you earn over the long term by investing in other similar companies?

It tells you the potential returns and the risk of other, similar opportunities.

If the discount rate is higher, both the potential returns and the risk are higher, and vice versa.

Why is the discount rate higher if the potential returns are higher? Shouldn’t a company with higher potential returns have a lower discount rate, making it more valuable?

The Discount Rate is higher because potential returns and risk move together. If an investment has the potential to generate much higher returns, it also has a greater chance of losing money. Investors need a higher return to compensate for taking on that additional risk.

4. What is WACC?

Weighted Average Cost of Capital. It’s the most common discount rate used to value companies. (% equity in a company’s capital structure * the cost of that equity) + (the % debt in that company’s capital structure * cost of debt).

For example if a company uses 60% equity and 40% debt, and cost of equity is 10% and cost of debt is 5%, the WACC is 60%*10% + 40% * 5% = 8%

Basically, if you invested proportionally in the company's Debt and Equity, WACC is the average annualized return you would expect to earn over the long term.

How much would you pay for a company that generates $100 of cash flow every single year into eternity?

company value = (discount rate - cash flow growth rate) if cash flow growth rate < discount rate

if cash flow doesn’t grow at all, company value = cash flow / discount rate

so if your discount rate is 10% you’d pay $100/10% = $1,000.

A company generates $100 of cash flow today, and its cash flow is expected to grow at 5% per year for the long term. You could earn 10% per year by investing in other, similar companies. How much would you pay for this company?

Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate

100/(10% - 5%) = $2,000

What does “Present Value” mean, and what makes it change? How does it differ from Net Present Value?

The present value of a company is its future cash flows discounted by the discount rate

for many stocks that’s around 10%

Tells you how much a company is worth today based on its future performance and your returns expectations

It increases if a company’s future cash flow or growth rate increases, or if discount rate decreases

How to discount (assuming a constant discount rate) = future cash flow / (1+ discount rate) ^ year number

On the other hand, net present value means that you take the PV and subtract the asking price of the company

If the NPV is positive that means the company is worth more than its current price

What does the internal rate of return (IRR) mean? How do you calculate it?

The IRR is the annual compounded rate of return earned on an investment. Technically, it’s the discount rate that makes NPV equal 0.

For example, if I invest $1,000 today and receive $2,000 in five years, the IRR is the annual return that would grow $1,000 into $2,000 over that period. In this case that’s 14.9%.

To calculate it, I would enter the initial investment as a negative cash flow and all future cash flows as positive values, then apply Excel's IRR function.

What affects the IRR? How do these factors differ from the ones that affect the Present Value?

Many factors are the same: higher cash flows, growth rates, future sales values increase the IRR

Major difference is that the discount rate doesn’t affect the IRR because you are solving for the Discount Rate when you calculate the IRR

Another difference is that upfront price affects the IRR but does not affect the PV

How do you use the IRR, Discount Rate, and Present Value to make investment decisions?

You compare the IRR to the discount rate to see if the investment is worth your time and money. If the IRR > discount rate investing makes sense

Comparing PV to the upfront price does same thing. If PV of future cash flows > upfront price it makes sense to invest

What are the three financial statements, and why do we need them?

balance sheet, income statement, cash flow statement
Balance sheet is a snapshot of company’s assets, liabilities, and equity at a specific point in time. Assets must = liabilities + equity

Income statement is a company’s revenue, expenses, and taxes over a period of time (such as quarterly or yearly)

The Cash Flow Statement shows the movement of cash through the business and includes cash flow from operating, investing, and financing activities.

You need the 3 financial statements there’s always a difference between the company’s net income and cash flows. Statements let you estimate the cash flow more accurately.

How do the financial statements link together?

The Income Statement ends with Net Income, which becomes the starting point of the Cash Flow Statement.

The Cash Flow Statement then adjusts Net Income for non-cash items such as Depreciation and Amortization, as well as changes in working capital items like Accounts Receivable, Inventory, and Accounts Payable. This gets you to Cash Flow from Operations.

Add up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom of the CFS.

The net change in cash balance flows onto the Balance Sheet as Cash, and Net Income also increases Shareholders' Equity through Retained Earnings.

What’s the most important financial statement?

Cash flow statement

It tells you how much cash a company generates, so almost all valuation is based on it.

The Income Statement isn’t as helpful because it includes non-cash items like depreciation and doesn't include certain cash expenditures like CapEx.

How might the financial statements of a company in the U.K. or Germany be different from those of a company based in the U.S.?

Income Statements and Balance Sheets tend to be similar, but you may need to rearrange the CFS for companies that use IFRS. For example, they often start the CFS with something other than net income like operating income.

How do you know when a revenue or expense line item should appear on the Income Statement?

1) corresponds to the period being reported

2) affects the profit available to common shareholders

For example, revenue is recognized when products or services are delivered but long-term assets like factories are expensed over multiple years through depreciation

A company collects cash payments from customers for a monthly subscription service one year in advance. Why do companies do this, and what is the cash flow impact?

Because of the time value of money, it’s better to collect cash today rather than later in the future.

This boosts cash flow because the company gets cash before providing the service.

These payments are recorded as Deferred Revenue, and an increase in Deferred Revenue increases CFS

Why is Accounts Receivable (AR) an Asset but Deferred Revenue (DR) a Liability?

AR is an Asset because it provides a future benefit to the company. The company is promised to get cash from customers in the future.

Deferred Revenue is a Liability because it represents a future obligation. The company has already collected cash from customers but still needs to SPEND MONEY to deliver the product or service.

What are “Deferred Taxes,” and how do they affect the statements?

Deferred taxes represent cases when the taxes shown on the Income Statement are different from the taxes actually paid to the government.

They arise because accounting rules and tax rules recognize certain expenses at different times, which creates temporary differences that reverse in the future.

For example, a company may record an impairment expense on a factory today, which reduces accounting profit, but the government may not allow a deduction until the factory is actually sold.

A junior accountant in your department asks about how to fund the company’s operations via external sources and how they impact the financial statements. What do you say?

Debt and Equity are the two main ways to fund a company’s operations with outside money.

At first, both debt and equity only show up on CFS in cash from financing. They boost a company’s cash balance.

With Equity, the company’s share count increases which means that existing investors get diluted. They own a smaller percentage of the company.

With Debt, the company must pay interest. That gets recorded on the Income Statement because it reduces Net Income and Cash.

Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your department asks you why your firm did this – how would you respond?

You need to create Goodwill and Other Intangible Assets to ensure the Balance Sheet stays balanced.

Most acquirers pay premiums for target companies for things that aren’t fully captured on the balance sheet like customer relationships or trademarks. This throws the BS off balance.

For example if the seller had $400 in Common Shareholders’ equity but you paid $1000 for the company, the asset side of your BS would decrease by $1,000 but the L&E side would decrease by only $400.

To bridge the gap you create “Other Intangible Assets” and Goodwill where you add the remaining $600.

What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities? How do Net Operating Losses (NOLs) factor in?

Deferred tax assets are potential future cash-tax savings for the company, and deferred tax liabilities are future cash-tax payments for the company.

DTLs often arise because of different depreciation methods. For example, when companies speed up depreciation to reduce how much taxes they have to pay in the short term but increase it in the future.

DTAs may arise when the company loses money and has a net operating loss. They also arise when a company deducts an expense for book-tax purposes but can’t deduct it for cash-tax purposes (for example stock based compensation)

What is Working Capital? What does it mean if it’s positive or negative?

Working capital = current operational assets - current operational liabilities.

“Operational” means that you exclude items like cash, investments, debt that are related to the company’s capital structure, not core business.

It measures how much capital a company needs to fund its day-to-day operations.

Positive working capital means you need more money for operational assets than operational liabilities. Negative means that you need more cash for operating liabilities than operating assets.

Whether the sign is good or bad depends on what is driving it. For example, negetive working capital can be a good thing if it is driven by high deferred revenue and low accounts receivable, because the company is collecting cash before delivering its products or services.

On the other hand, positive working capital could be a bad thing if it is driven by a large Accounts Receivable balance, because that may indicate that the company is having difficulty collecting cash from customers.

How do you calculate Free Cash Flow (FCF), and what does it mean?

FCF is cash from from operations - CapEx.

It tells you how much cash the company generates after paying off the cost of its funding sources, for example interest on debt.

It is called the company’s “discretionary cash flow” because most items in the CFO part of the cash flow statement are required but most of the CFI and CFF are optional or non-recurring expenses (except for CapEx)

A positive and growing FCF means that the company does not need outside funding sources to keep operating and it can spend its cash flow in other ways like acquiring other companies.

A negative or declining FCF means that the company may need to raise outside funding, cut expenses, restructure, or grow a lot to survive.

What does the Change in Working Capital mean?

Change in working capital measures how a company's day-to-day operating assets and liabilities affect its cash flow.

It tells you if a company needs to spend money in ADVANCE of its growth or if it generates more cash flow as a RESULT of its growth.

For example, it is usually negative for retailers because they need to spend money on inventory to sell, and it is usually positive for subscription companies because they collect cash in advance through deferred revenue.

Change in working capital could increase or decrease FCF, which directly affects the company’s valuation

In its filings, a company states that EBITDA is a “proxy” for its Cash Flow from Operations. The company’s EBITDA has been positive, growing at 20% for the past three years. However, the company recently ran low on Cash and filed for bankruptcy. How could this have happened?

EBITDA is often used as a proxy for cash flow, but it is not the same thing as cash flow.

For example, it does not include things like acquisitions, capex, and interest expenses (and changes in working capital and non-recurring expenses).

High numbers in any of those categories, for example, a failed acquisition, could have turned the company’s cash flow negative and created this situation even if its EBITDA looked fine.

How do you calculate Return on Invested Capital (ROIC), and what does it tell you?

ROIC = NOPAT / average invested capital

NOPAT stands for net operating profit after taxes. NOPAT = operating income * (1-tax rate)

Invested Capital = Common Shareholders’ Equity + Debt + Preferred Stock – Cash

ROIC measures how efficiently a company uses its capital (both external and internal) to generate after tax profit. Higher ROIC means the company generates more profit for every dollar invested in the business.

What are the advantages and disadvantages of ROE, ROA, and ROIC for measuring company performance?

They all measure how efficiently a company uses its equity, assets, and invested capital to generate after-tax profits.

ROE and ROA are both affected by capital structure because they use net income in the numerator and average equity or average assets in the denominator.

However, they are closer to reality because net income is directly on a company’s financial statements and affects its cash balance.

ROIC is a metric we calculate ourselves that doesn’t appear on the statements. But since it does not take into account how the company is financed, it is more useful for comparing companies with different capital structures.

Compared to ROA, ROA is more useful that depend heavily on their assets to generate net income (for example, banks) while ROE is a more general measure that can be applied across many industries.

A company hires a new employee for a total cost of $100,000 per year. Walk me through how the financial statements change, assuming a 25% tax rate.

Income statement: OpEx increases by 100K, so pre-tax income is 100K lower. At a 25% tax rate, net income is 75K lower.

Cash flow statement: net income is down by 75K so cash at the bottom is down by 75K

Balance sheet: Cash is down by 75K on the assets side, so total assets are down by 75K. Equity is down by 75K because of the net income reduction. So both sides are down by 75K and balance.

Walk me through a $10 increase in Depreciation, assuming a 25% tax rate

Income statement: $10 deduction in depreciation means pre-tax income is up by $10. Because of the 25% tax rate, net income is up by $7.50

Cash Flow Statement: Net income is up by $7.50. Add back $10 LESS of depreciation, which means that cash at the bottom is down by $2.50

Balance sheet: cash is down by $2.50, and net PP&E is up by $10 because of the reduced depreciation, so total assets are up by $7.50. Equity is up by $7.50 because of the increased net income. So both sides balance.

A company’s CEO has decided to sell all its assets, starting with a factory recorded at a book value of $100 on its Balance Sheet. If this factory sells for $140, how do the statements change?

$140 - $100 = a realized gain of $40

Income statement: increases pre-tax income by $40. because of the 25% tax rate, net income is up $30

CFS: Net income is up by $30, but you reverse the $40 gain in cash from operations. In cash from investing you add $140. So cash changes by 30 - 40 + 140 = $130.

BS: Cash is up by $130. Net PPE is down by its book value of $100, so total assets are up by $30. Equity is up by $30 because of the increase in net income. So both sides balance

Walk me through the financial statements when a customer orders a product for $100 and receives it but hasn’t yet paid for it. Then, walk me through the cash collection, combining it with the first step. Ignore COGS and other delivery costs for simplicity.

The first step increases accounts receivable by $100, the second step decreases accounts receivable by $100.

IS: Revenues increase by $100, so pre tax income is up by $100. With the 25% tax rate net income is up by $75.

CFS: Net income is up by $75 but the increase in accounts receivable reduces cash flow by $100 so Cash at the bottom is down by $25

BS: Cash is down by $25, but accounts receivable is up by $100 so assets are up by $75. On the L&E side, common shareholder equity is up by $75 because of the increase in net income. So both sides balance.

When the AR is collected…

IS: net income still up by $75. No other changes

CFS: net income still up by $75, and now the AR increase is reversed so the change in AR is $0. Cash from the bottom is up by $75.

BS: Cash is now up by $75, AR goes back to its original value. So assets are up $75. L&E side is still up by $75 because net income increased CSE. SO both sides balance.

A company hires a marketing agency to run an online advertising campaign for its services. The marketing agency charges $10,000 for this initial campaign, delivers it, and invoices the company, which has 60 days to pay. Walk me through the statements.

Since the company bought a service but hasn’t paid yet, and they were invoiced, this is a $10K increase in accounts payable.

IS: Operating expenses increase by $10K, so pre tax income decreases by $10K. With a 25% tax rate, net income decreases by $7.5K

CFS: net income is down by $7.5K but we add back $10K from accounts payable because the company has not paid the invoice in cash yet. Cash at the bottom is up by $2.5K.

BS: cash is up by $2.5K so total assets are up by $2.5K. On the L&E side, accounts payable is up by $10K and equity is down by $7.5K because of the decrease in net income. So both sides are up $2.5K and balance

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Your friend’s e-commerce company orders $200 of products from its main supplier. A month later, it sells these products for $500. Walk me through each step of this process SEPARATELY.

step1 is an inventory purchase and step 2 is recognizing revenye and COGS and removing inventory.

step 1…

IS: no changes because no product has been sold or delivered yet

CFS: inventory increase reduces cash flow by $200. So cash is down $200.

BS: Cash is down $200 on the assets side, inventory is up $200. Nothing changes for L&E so BS stays balanced

step 2…

IS: revenue increases by $500, COGS increases by $200, so pre tax income is up by $300. Net income is up by $225 because of the 25% tax rate

CFS: Net income is up by $225, inventory decreases by $200. That is a positive cash flow. So cash is up by $425

BS: Cash is up by $425, inventory is down by $200, so assets are up by $225. On the L&E side, equity is up by $225 because of the increased net income. SO both sides balance.

Basically, the company bought some inventory, turned it into a product, sold the product, and profited $300 from it. They paid $75 in tax and now have $225 in additional cash.

A Software-as-a-Service (SaaS) company bills customers upfront for an entire year of service and collects the cash before the contract begins. Walk me through the process for a $250 contract with a $50 delivery cost between January 1 and December 31 of the year. COMBINE the cash collection and revenue recognition.

IS: revenue is up by $250, COGS is up by $50 so pretax revenue increases by $200. Assuming a 25% tax rate net income is up by $150.

CFS: Net income increases by $150. Deferred revenue was up by $250 at the beginning of the year but decreases by $250 throughout the year. So in Dec 31st, cash is up by $150.

BS: Cash is up by $150 so total assets go up by $150. ON the L&E side, deferred revenue increases by $250 but then goes down by $250, so equity is only up by $150 because of the increased net income. Both sides balance

A company with 1000 shares issues 500 new shares worth $1.00 on January 1 to fund its business. Then, it decides to issue Dividends per Share of $0.10 to all its shareholders at the end of the year. Walk me through both steps SEPARATELY on the statements.

Step 1: The company issues 500 new shares at $1 per share so they raise $500 of equity

IS: no changes because issuing stock is a financing activity, not revenue.

CFS: Cash flow from financing increases by $500 so cash is up by $500.

BS: Cash is up by $500 on the assets side, equity increases by $500, so both sides balance

step 2: the company has 1500 shares outstanding pays them 10 cents each so it issues $150 total divideds.

IS: No changes because common dividends do not appear on the Income Statement.

CFS: Cash Flow from Financing decreases by $150, so Cash decreases by $150.

BS: Cash is down by $150 on the asets side, equity is down $150 on the L& E side so it balances.

A company issues $200 of Debt at a 10% interest rate. Walk me through the entire first year on the statements, including the initial issuance and the full interest payment. COMBINE both steps.

step 1: company issues $200 of debt

IS: No changes because issuing debt is a financing activity, not revenue

CFS: Cash Flow from Financing increases by $200, so Cash increases by $200.

BS: Cash is up $200 on the asset side, debt is up $200 on the L&E side so it balances.

step 2: The company pays $20 in interest expense (200 * 10%)

IS: Interest expense increases by $20, so pre tax income is down by $20. At a 25% tax rate that brings net income down by $15

CFS: net income is dowm $15. Debt issuance increases cash flow by $200, so cash is up $185.

BS: Cash is up $185, so total assets are up $185. On the L&E side debt is up by $200 and equity is down $15 because of net income reduction. So both sides are up $185 and balance

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A company that follows U.S. GAAP signs a 10-year Operating Lease on January 1. It will pay $160 in Rent each year. Assuming a 5% Discount Rate, walk me through the financial statements over this entire year. For simplicity, you may “round” and assume the Present Value of the lease payments equals $1,200.

The 5% discount rate means that the interest expense is 5% * $1,200 = $60. So depreciation is $160 - $60 = $100. On the financial statemnets, that looks like this:

IS: operating expenses up by $160 because of rent. So pre-tax income is down $160. Assuming 25% tax rate net income decreases $120.

CFS: Net income is down $120, but operating lease assets and liabilities increase by $1,200, which cancel out. Then they both decrease by $100 because of depreciation. SO cash is down $120 at the bottom.

BS: On assets side, cash is down $120, operating lease assets are up by $1,100 so total assets are up by $980. On the L&E side, operating lease liabilities are up by $1,100 and equity is down $120 so L&E is up by $980 and both sides balance.

A company buys a factory for $200 using $200 of Debt. What happens, INITIALLY, on the statements?

IS: No changes

CFS: NO net change in cash because the $200 factory purchase counts as CapEx, which reduces cash flow, and the $200 debt issuance increases cash flow.

BS: PPE is up by $200, so assets go up by $200. Debt is up by $200 so L&E increases by $200 and BS stays balanced.