IB 400 QUESTIONS

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

1. No, TVM means you can invest monay today and earn something off that

2. INflation makes money less valuable over time but TVM is more associated with the potential returns on an investment

3. TVM is about potential returns of investments made today

1. What does Discount Rate mean?

1. Represents opportunity cost or “targeted annualized return for an investor

2. If I choose not to invest in this company, how much I could earn over a long term by investing in another similar company with same risk

3. DR represents potential returns and the risk of other similar opportunities

4. High Discount rate High → Potential returns and risk is higher

1. Why is the Discount Rate higher if the potential returns are higher? Shouldn’t a company with higher potential returns have a lower Disount Rate, making it more valuable?

1. Potential Returns and Risk Move Together

2. A higher risk in an invesmtent means investors will determien a higher return

1. What is WACC

1. Weighted Average Cost of Capital  — the most common Discount Rate used in valuing companies 

2. Formula = (Cost of Equity) %Equity + [(Cost of Debt) %Debt * (1-TaxRate)]

3. Represents: Average annual returns you’d expect to earn if you invested proportionally in the DEBT and EQUITY of a company and held for long term

How much would you pay for a company that generates $100 of Cash Flow every single year for infinity

1. Perpetuity → Company Value  = Cash FLow/((Discount Rate - Cash Flow Growth Rate))

2. This question depends on the targeted yield and Discount Rate

3. If targeted yield is 10% —> Value = 100/10% = $1000

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

   1. Using the formula “Company Value  = Cash FLow/((Discount Rate - Cash Flow Growth Rate))”

1. Using the formula “Company Value  = Cash FLow/((Discount Rate - Cash Flow Growth Rate))”

   1. Discount rate - 10%

   2. Cash Flow Growth Rate = 5%

2. Value = 100(10% - 5%) = 100/5% = $2000

What does Present Value mean and what causes it to change? How does this differ from net Present value?

1. Present Value of some asset: Future cash flow discounted at an appropriate discount rate

   1. Tells us what a company asset is worth today based on its potential future performance and likely expectations 

   2. What makes it increase:

      1. If company expected future cash flow or growth rates increase 

      2. If company discount rate decreases 

2. Net Present Value: Take the PV of future cash flow and subtract the upfront cost of the company or investment

1. What does Internal Rate of Return (IRR) mean? How do you calculate it?

1. The discount rate for an investment at which the Net Present Value will equal 0

2. “Effective compounded rate of return on an investment”

3. Example:

   1. 1000 investment today that turns to 2000 in 5 years 

   2. IRR is the return needed on that 1000 compounded each year to reach 2000

   3. 14.9%

1. What affects IRR? How do these factors differ from one that affect the Present Value 

1. Factors:

   1. Higher Cash Flows

   2. Growth Rate

   3. Future Sale Values 

2. Major difference:

   1. Discount Rate does not affect IRR because you are solving for Discount Rate when calculating IRR

   2. Upfront price affects IRR 

1. How do you use IRR, DIscount Rate, and Present Value to make an investment decision 

1. Calculate IRR & Discount Rate

   1. If IRR > Discount Rate → Worthwhile investment

2. Calculate Present Value

   1. Compare to Upfront Asking Price 

   2. If PV > Upfront Cost → Worthwhile investment

1. What are the 3 financial statements and why do we need them?

1. Income Statement: Shows company’s revenue, expenses, and taxes over a specific period and always ends with Net Income

2. Balance Sheet: Snapshot of company’s assets, liabilities, and Shareholder’s Equity. Assets must equal Liabilities + Equity

3. Cash Flow Statement: Starts with Net Income → Adjusts for non-cash items and changes in operating assets and liabilities → Shows cash flow for Investing and Financing Activities → End with net change in cash for the company and their ending cash balance 

4. Need: We need financial statements because there will always be a difference between company Net Income and cash flow generated → Allow us to forecast cash flow more accuratel y

1. How do the Financial Statements link together?

1. Income Statement → Revenue → Gross profit → Operating Income → Net Income

2. Cash Flow → Net Income starts at top —> Adjust for non-cash items for operations → link those items to balance sheet

3. Adjust for investing activities

4. Adjust for financing activities 

5. Ending cash at bottom of CFS → Cash on Balance Sheet in Assets 

6. Net Income, Stock issuances, repurchases, compensation, dividends → Equity side 

7. Link all other separate line items to CFS on corresponding Balance Sheet lines 

   1. Subtract links on Asset side, add on L&E side 

8. Check Assets = Liability + Shareholder’s Equity

1. What’s the most important financial statement 

1. Cash Flow statement is most important → tells how much cash a company generates → cash is king in valuation 

2. Why not Income Statement? – Because has a lot of non-cash expenses 

How might the financial statements of a company in Europe differ than US based companies?

1. GAAP vs IFRS

2. Income and Balance usually the same 

3. Europe statements start CFS with something other than Net Income 

4. Items are usually in more random locations as well 

5. Operating lease expenses are further split along interest and depreciation elements

1. How to know when revenue or expense line item should appear on income statement?

1. For an item to appear on Income Statement: 

   1. Correspond 100% to period shown: Because revenue and expenses are based on delivery of products and services 

   2. Affect business income available to commons shareholders 

      1. Explains why preferred dividends appear 

1. A company collects cash payments from their customers for a monthly subscription service a year in advance → why do companies do this → what is cash flow impact

1. A company collects cash payments from their customers for a monthly subscription service a year in advance → why do companies do this → what is cash flow impact

1. Why is Accounts Receivable an asset but Deferred Revenue a liability 

1. Because A/R represents a future benefit to the company in the form of additional cash coming in the future

2. D/R represents a future obligation the company must pay since they already acquired the cash but must make the future payments to satisfy the bill

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

1. Deferred Taxes: Cases where book tax shown on Income Statement do not represent what company pays in cash to government in period 

   1. Arises because of Income Statements expenses that are not tax deductible but appear above pre-tax income

   2. Can arise because of additional amounts deductible beyond what is shown 

2. Example: Employee stock based compensations which aren’t deductible until an employee actual exercises their option → will initially create negative deferred tax before turning into a deductible

How do you fund a company’s operations via external sources and how do these impact financial statements

1. Debt

   1. Initially cheaper option for most companies → Prefer over equity to some degree 

   2. Company must be able to service debt by paying interest expense and possible principal repayment → must use equity if can’t

   3. Equity & Debt both appear on CFS from Financing to boost cash balance

   4. Equity

      1. Share count increases after issuance → dilutes investors 

   5. Debt

      1. Company must now pay interest → recorded on income statement → reduce net income

1. Firm acquires company for $1000 and creates Goodwill of $400 and Other Intangible Assets of $200 on BS → Why would a firm do this?

1. Creation of Goodwill and OIA after acquisition is to ensure Balance Sheet remains in Balance 

2. Most acquirers pay premiums for target companies, not book value, so BS goes out of balance 

3. Plugging the gap:

   1. OIA represents values of items such as trademarks, intellectual property, anything related to company operations that has value to it

   2. Goodwill is anything else  

What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities? How does Net Operating Losses factor in?

1. DTA → Paying more taxes now so you can pay less later

2. DT → Paying less taxes now but having to pay more later

3. Net Operating Losses → Matters because having a year of NOL can alow us to create deferred tax assets and claim some benefit in the future

1. How do you calculate FCF – what does it mean? 

1. Using the Cash flow form operations definition; it represents company’s available cash flow it generates from core business activities after it pays all funding sources

   1. Uses CFO 

2. Positive + Growing CF → Company can easily pay off debts, doesn’t need outside funding, has cash free to grow and expand 

3. Negative + Decline CF → Company may  need outside funditng restructuring, cut expenses, realign strategies 

4. Formula: EBIT * (1-t) + D&A - Increases(Changes) in Net Operating Working Capital - CAPEXM

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

1. Working Capital is officially a company’s Current Assets - Current Liabilities – but the definition we want to use specifically is 

   1. Current Operational Assets - Current Operational Liabilities – Change in Net Operating Working Capital 

   2. Tells us if a company needs more operational assets or operational liabilities – the difference between them 

2. Positive Difference – Efficiency depends on the individual account balances

   1. For example, if minimal inventory & A/R but higher Deferred Revenue → Positive is a sign of high efficiency 

   2. But, A/R is high → difficulty collecting cash from customers → more of a bad sign

1. What does Change in Working Capital Mean 

1. Current Period WC - Previous Period WC → tells IF a company needs to spend in advance of its growth or if it generates more cash as a result of its growth 

   1. Positive Change → Cash outflow

   2. Negative Change → Cash Inflow

   3. Depending on the context of the company, its sector/industry, stage of growth → CWC can offer a useful metric to seeing the organics of its growth

2. It tracks how the short-term liquidity and day-to-day cash requirements of a business expand or shrink over time

3. Is a part of FCF calculation → directly affects valuation 

1. We see in a company’s filings –. EBITDA is a proxy for its Cash Flow from Operations. And EBITDA has been positive and growing 20% for the past 3 years. Despite this, the company recently ran low on Cash and filed for bankruptcy → How come this happened. 

1. Using the formula— EBITDA = Operating Income + D&A

   1. Even if EBITDA is a proxy, it is not a perfect representation of CFO  – a bunch of line items are messing

      1. Because it excludes CapEx, Acquisitions, interest Expenses, Change in Working Capital 

   2. A high value in one of these, such as acquisition, can have a major impact on the year’s cash flow and potentially drive it negative

How do you calculate ROIC and what does it mean?

1. ROIC = NOPAT/Invested Capital

   1. NOPAT (Net Operating Profit After Tax) = Operating Income * (1- Tax Rate)

   2. Invested Capital = Common Shareholder’s Equity + Debt + Preferred Stock - Cash 

2. Definition: How efficiently a company can use its invested capital from all sources to generate after tax profits from its cor businesses 

3. Tool of measuring value creation – Efficiency of which capital is allocated to generate earnings 

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

1. ROE – How efficiency company uses Equity to generate after tax profits

   1. Uses Net Income in Numerator → Affected by capital structure

   2. A more general metric that can apply to many industries → more accurate relative to cash balance

   3. Can be overstated if high debt 

2. ROA – How efficiency company uses Assets to generate after tax profits

   1. Uses Net Income in Numerator → Affected by capital structure 

   2. Would want to use in a asset heavy company

3. ROIC – How efficiency company uses invested capital to generate after tax profits

   1. Uses NOPAT in Numerator → More capital structure neutral

   2. More removed from company capital structure

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.

1. IS: Operating Expenses up by $100,000 → Operating Income (EBIT) down by $100,000 → tax (25%) → Net Income down by $75,000

2. CFS: CFO lower by 75,000 → No adjustments → Cash at bottom down by $75,000

3. BS: 

   1. Assets → Down by $75,000 because less cash

   2. Liabilities → No change

   3. Equity → Net Income down by $75,000

1. Walk me through a $10 increase in Depreciation

1. IS: Operating Expenses up by $10 → Operating Income down by $10 → Net Income down by $7.5

2. CFS: CFO → Net Income (7.5) → Cash Adjustments of Depreciation ($10) → Cash increase of $2.5

3. BS: 

   1. Assets: 

      1. Increase by $2.5 → Cash Flow

      2. Decrease by $10 → Depreciation 

      3. Total: $-7.5

   2. Liabilities → No change

   3. Equity → Net Income down by -7.5

4. Company cash balance increases by $2.5

1.  Walk me through a $10 decrease in depreciation 

1. IS: Operating Expenses down by $10 → Pre-tax Income up by $10 → Tax (25%) -> Net Income up by $7.5

2. CFS: CFO → $+7.5 in Net Income → Adjustment of $-10 for depreciation in Net PP&E → Cash decrease of $2.5 

3. BS: 

   1. Assets: -$2.5 from cash + $10 from depreciation decrease in Net PP&E → $7.5 increase

   2. Liabilities → No change

   3. Equity → Net Income up by $7.5

4. Company cash balance decreases by $2.5

1. CEO decides to sell assets, sells a factory recorded at $100 on balance sheet for $140

1. IS: Realized gain → $40+ → Pre tax Income up by $40 → net Income up by $30

2. CFS: Net Income up by $30 

   1. CFO → subtract $40 of realized gain adjustments to avoid double counting → $-10

   2. CFI → take -$10 → Add $140 in proceeds from investment → +$130

3. BS: 

   1. Assets: 

      1. +130 → Cash increase

      2. -100 → Book value of asset sold in net PP&E

   2. Liabilities →

   3. Equity  → +30 from net income

4. The company has sold a factory for $140 but pays taxes only on the $40 gain → Cash is now up by $130 

1. Customer orders product for $100 receives it but hasn’t yet paid for it; ignore COGS and operating expenses

1. IR:

   1. Revenue increases by $100 → Pre tax income up by $100 → tax (25%) → Net Income up by $75

2. CFS

   1. Net Income up by $75 

   2. CFO → Adjustment of $-100 in A/R → $-25 change in cash

3. BS

   1. Assets → +$75</span></p><ol><li><p><span style="background-color: transparent;">$-25 in cash

   2. A/R is an asset → Increase in $100

4. Liabilities → No change 

5. Equity → Net Income $75

Cash is lower but net Income is up yet we still must pay taxes on this revenue we haven’t yet collected 

1. Now A/R is collected 

1. IS 

   1. Net Income still up $75 

2. CFS

   1. CFO → $0 in A/R now → Cash is up by $75

3. BS

   1. Assets

      1. Cash up by $75

   2. Liabilities → No change

   3. Net Income → $+75

4. We now have +75 in cash after taxes have been paid

1. Company hires marketing agency → They charge $10,000 → they deliver it → invoice the company who has 60 days to pay. Walk me through the statement. 

1. Operating income down by $10,000 → Net Income down by $7,500

2. CFS_1:

   1. CFO → Net Income down by $7,500 → + $10,000 adjustment in Accounts Payable → +2,500 change in cash

3. BS_1

   1. Assets:

      1. Cash → +$2,500

   2. Liabilities

      1. A/P —> +10,000

   3. Equity

      1. Net Income → -7,500

1. Company after 60 days pays the invoices 

1. IS_2

   1. No change

2. CFS_2

   1. A/P decreases by $-10,000 → Cash outflow increases to $10,000 → Cash is down by $10,000

3. BS_2

   1. Assets:

      1. Cash down by $10,000

   2. Liability → $-10,000 now because A/P is now lower

   3. Equity → No change 

4. Once company pays the $10k bill, it still has received the tax benefits from the previous period so all of that carries over 

1. The company orders $200 of products from the main supplier. Month later → Sells products for $500

1. First step, inventory is purchased but revenue has not yet been recognized

2. IS_1 → No change

3. CFS:

   1. CFO → $200 outflow in inventory → Cash down by $200

4. BS_1:

   1. Assets:

      1. +$200 in inventory

      2. -$200 in Cash

   2. Liability → No change

   3. Equity → No change 

5. Now company sells inventory

6. IS_2 → +$500  in revenue ->>-$200 in COGS → Operating Income +$300 → Net Income +$225 

7. CFS_2 → Net Income +$225

   1. CFO

      1. Inventory has decreased→ Change in Current Asset → +$200

   2. Cash up by $425

8. BS_2

   1. Assets → +$225

      1. Cash → +425

      2. Inventory → Down by -$200

   2. Liability → No change

   3. Equity → +$225 Net Income~~

1. A SAAS company bills customers upfront for an entire year of service and collects cash before the contract begins. $250 contract and a $50 of delivery cost. Between Jan 1 and Dec 31 the cash is collected and revenue is recognized ins ame period

1. IS: → +$250 in Revenue + 50 COGS → +200 Operating Income → +$150 Net Income

2. CFS

   1. CFO → $+150 from Net Income —> Deferred Revenue + $250 initially but then falls ot 0 → Cash is still  +$150~

3. BS

   1. Assets:

      1. Cash + 150

   2. Liability → Deferred Revenue + 250 → -250  —> 0

   3. Equity → Net Income + 150

4. Because cash collection and revenue recognition happen in same period → Deferred Revenue changes is temporary and is immediately reversed by end of year~~~

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. 

1. First Step:

   1. Company issues 500 * 1.0 = $500 worth of Equity → Does not show up on Income Statement because it does not impact current period shareholders → Appear on CFS

   2. IS_1 → No effect

   3. CFS_1

      1. CFF → + $500

   4. BS_1

      1. Assets → + $500 cash

      2. Liabilities → No change

      3. Equity → +$500 in Retained Earnings Equity  

1. Second Step: 

   1. Company issues dividends to ALL SHAREHOLDERS → 1500 * 0.1 → $150

   2. IS_2 → No change (Common Dividends do not appear on Income Statement)

   3. CFS_2 → CFF → -$150 change in cash from Common Dividends (Dividends appear on Cash Flow from Financing)

   4. BS_2 

      1. Assets → -$150 in Cash

      2. Liabilities → No change

      3. Equity → -$150 in retained Earnings 

1. Company issues $200 of debt with 10% interest rate → walk through initial issuance and full interest payment 

1. IS_1 → No Effect

2. CFS_1 → +$200 in CFF section 

3. BS_1

   1. Assets → +$200 in Cash

   2. Liabilities → +$200 in Debt

   3. Equity → No change

4. IS_2 → Interest Expense of 200 * 10% = $20 → Pretax Income down by $20 → Net Income down by $15

5. CFS_2 → CFF → Net Income down by $15 → +200 in Debt → + $185 change in cash 

6. BS_2

   1. Assets → +$185 Cash

   2. Liabilities → +$200 in Liabilities 

   3. Equity → -$15 in Retained Earnings

1. Add in a 20% principal repayment as well

1. Note: Principal Repayment does not show up in Income Statement and is therefore not tax deductible 

2. IS → Still -$15 in Net Income with interest expense

3. CFS → -$15  in net Income + $200 in cash -$40 in principal repayment → +$145

4. BS 

   1. Assets → +$145

   2. Liabilities → +160 (because of principal repayment)
      Equity → -$15 in Retained Earnings 

1. A company that follows GAAP signs a 10 year Operating Lease on Jan 1, it will pay $160 Rent each year. Assuming a 5% discount rate, walk through financial statements over the entire first year. Round and assume PV of lease payments equals $1200. 

1. Company records Operating Lease Assets ($1200) & Operating Lease Liability ($1200) on BS 

2. Depreciation for Operating Leases = ROU Rental Expense - Interest Expense

3. $1200 * 5% = $60

4. Depreciation = $160 - $60 = $100

5. IS → -$160 in rental expense → Pre Tax Income down by $160 —> Net Income down by $120

6. CFS

   1. Net Income down by $120

   2. Operating Assets increase by $1200 

      1. Decreases by $100 due to Depreciation

   3. Operating Liabilities increase by $1200

      1. Decreases by $100 due to Depreciation

   4. Both OA and OL cancel each outer up

   5. Cash is down by $120

7. BS

   1. Asset:

      1. Cash is down by $120

      2. Operating Asset up by $1100

   2. Liability

      1. Operating liability up by $1100

   3. Equity

      1. Retained earnings down by $120

1. Now do the same question but under IFRS

1. Under IFRS, Depreciation is calculated by PV of Lease Payments/Payment Period

2. Deprecation = 1200/10 = $120

3. Initial Interest Expense = $1200 * 5% = $60

4. Leave Principal Repayment = $160 - $60

5. IS

   1. Depreciation → Down by $120

   2. Interest Expense → Down by $60

   3. Pre Tax Income → Down by $180

   4. Net Income → Down by $135

6. CFS

   1. Net Income down by $135

   2. Add $120 in Depreciation

   3. Operating Asset and Liability offset each other

   4. -$100 in Lease Principal Repayment 

   5. Cash down by $15

7. BS

   1. Assets = $965:

      1. Cash is down by $15

      2. Operating Lease Asset up by $1080 ($1200 - Depreciation)

   2. Liability

      1. Operating Lease Liability up by $1080 ($1200 - Depreciation)

   3. Equity

      1. Retained Earnings down by $135

1. A company buys a factory for $200 using $200 of Debt. What happens initially on statements?

1. IS → No Change

2. CFS:

   1. CFO

      1. -$200 on Capex 

   2. CFF

      1. +$200 from Debt Issuance 

3. BS

   1. Asset:

      1. +$200 in Net PPE

   2. Liability

      1. +200 in Debt

   3. Equity

      1. No change

1. Now, one year passes and the company pays 10% interest on its Debt, depreciates 10% of factory, repays 5% of debt principal. What happens now? 

1. Interest Expense = 200 * 10% = $20 → Goes on IS

2. Principal Repayment = 200 * 5% = $10 → Not on IS, but on CFS 

3. Depreciation = $200 * 10$ = $20 → Goes on IS and is Tax Deductible 

4. IS

   1. Interest Expense of $20 → Depreciation of $20 Pre Tax Income down by $40 —> Net Income down by $30

5. CFS

   1. Net Income → -$30

   2. CFO

      1. Depreciation: +20$ → Asset book value now at $180

   3. CFF

      1. Principal Repayment: -$10 → Debt now at $190

   4. Cash -$25

6. BS

   1. Asset

      1. Net PP&E → $-20$

      2. Cash → -20

   2. Liability

      1. Debt → $-$10

   3. Equity

      1. Retained Earnings → -$30

1. Now at the end of this year, company decides to sell factory for $220 and use proceeds to repay remaining Debt Principal 

1. Starting Net PP&E = $180

2. Starting Debt Principal = $190

3. Selling $220 over book value of $180 → Realized Gains of $40

4. IS

   1. Realized Gains $40 —> Pretax Income up by $40 → Net Income up by $30 

5. CFS

   1. Net Income up by $30 

   2. CFO: 

      1. Realized Gains is a non-cash (-$40) 

   3. CFI

      1. Proceeds from sale of Asset (+$220)

   4. CFF

      1. Debt Repayment (-$190)

   5. Cash ⇒ +$20

6. BS

   1. Asset

      1. Cash +$20

      2. PP&E -$180

   2. Liabilities → Debt (-$190) 

   3. Equity

      1. Net Income → +$30

1. Walmart purchases $200 of inventory on credit → sells it for $400 →  record $100 in Operating Expenses 

1. What is step 1 with just inventory purchase 

2. IS_1 → No change

3. CFS_1 

   1. CFO

      1. Accounts Payable → +$200

      2. Inventory → -$200

   2. $0 Change

4. BS_1

   1. Assets

      1. +$200 in inventory

   2. Liability

      1. +$200 in A/P

   3. Equity

      1. No Change

5. Now, sale and delivery of product occur and supplier is repaid 

6. IS_2

   1. +$400 Revenue

   2. -$200 in COGS

      1. $200 in Gross Profit

   3. -$100 in OpEx

   4. Pre Tax Income up by $100 

   5. Net Income up by $75

7. CFS_2

   1. +75 from Net Income 

   2. CFO

      1. Inventory has decreased → Change in Current Asset → +$200
         A/P goes to 0 (-$200 in Cash)

8. BS_2

   1. Assets

      1. Cash +$75

      2. Inventory -$200

   2. Liabilities

      1. A/P -$200

   3. Equity

      1. Net Income up by $75

9. Although both sides are down by $125 → Cash is up by $75

   1. If you combine steps 1 and 2 together → Total Assets and Total L&E would be up $75 collectively

EqV to EV bridge

• TEV = EqV - Cash + Debt + Preferred Stock + Noncontrolling Interests 

1. Tell me what Equity Value and Enterprise Value mean? No calculations

1. Equity Value represents everything a company has that is available to its equity investors; Enterprise Value represents the value of the company’s core business operations available to ALL investors: debt, common, preferred, etc/

1. Can you give me a real life analogy? 

1. Say I buy a house worth $500K for $100k Down. 

   1. If I were to value this investment, the $100k Down is all that is available to the Equity Investor – therefore it acts as the Equity Value. If I were to had put in$250K down, then my Equity Value would have been $250k

   2. Now my enterprise value is unaffected by the capital structure. If I had put $0 down, $400k down, etc, the EV would always be $500K. That's the value of to me and everyone else who has money tied up in this asset. 

1. Why do we need both? What if we just use one and stick with it – what are we missing out

1. The reason is that some valuation methodologies and analyses produce Equity Value whereas some produce EV; so we need to move between them → that allows us to benchmark different companies easier

2. There are certain merits to both that can make it more accurate depending on the company

   1. EV can be advantageous because it is not affected by capital structure

   2. But EqV is still important since valuation is usually on behalf of the commons shareholder, so we care more about how much a company is worth to them

1. What is the difference from Current and Implied EV. Give a real life example. 

1. Current EV is based on the current market share price for the company, share count, and balance sheet prices. Can be over or under valued depending on the state of the market.  

2. Implied is gotten when you use a valuation methodology, such as a DCF, to value the company’s intrinsic value based on set prediction s

3. An example; you have a house. It’s listed on a marketplace at $500k. The list price is equivalent to the current EV since it reflects what the market has it for. But if you were to do your research and due diligence, calculating all the amenities, future trends, and projections, you would determine an implied value or EV that is based on what you believe.  If you were to calculate it to be worth $450k, the intrinsic value would be difference than the current and suggest the asset is overvalued. 

1. What is the difference between Basic Equity Value and Diluted Equity Value 

1. Basic Equity refers to what is owned by Common Shareholders → Common Shares Outstanding * Current Share Price

2. Diluted Equity Value includes dilutive securities — options, warrants, restricted units, convertibles. The formula → Diluted Shares Outstanding * Current Share Price 

   1. Dilutive Securities can be calculated using Treasury Stock Method and “If Converted Method” for convertibles 

   2. Generally, Diluted Equity Value is a more accurate measure of company’s worth to shareholders

1. With a company’s Diluted Equity Value. How to move from Equity Value to Enterprise Value

1. Take Equity Value - Non Operating Assets + Liability & Equity Lines that represent other investor groups beyond Common Shareholders

2. EV = Equity Value - Cash + Debt + Preferred Stock + Noncontrolling Interests 

3. Non-Operating Assets examples:

   1. Cash, Investments, Equity Investments, Assets Held for Sale, Net Operating Losses

4. L&E Line items

   1. Debt, Preferred Stock, Underfunded Pensions, Noncontrolling Interests, sometimes Leases

1. Why do we subtract Equity Investment and add Non Controlling Interest in the EV calculation?

1. The reason is we want EV to be a more comparable baseline. We want to subtract Equity Investments, since they are considered non-core assets – if you didn’t subtract then it would be treating it as part of the core business’s operations

2. We want to add Non Controlling Interests because when a company has a majority stake in another, accounting treats it as 100% of that company’s financials appear on the parent company. We want to remove those non-controlling elements so it accurately reflects what we own in this other company. 

1. Explain the proper treatment of pensions in Enterprise Value 

1. Only Defined Benefit Pensions will factor in, Defined COntribution Plans will not since they don’t appear on Balacne Sheet

2. Add Unfunded or Underfunded Pensions in TEV because they represent another investor groups

3. Adjust too if tax deductible 

Should you add Operating Leases into Enterprise Value calculation? What about Finance leases?

1. Finance Leases -> Depends on Valuation Multiple you use

   1. You should generally add Finance Leases because most metrics such as EBITDA exclude Finance Lease Interest and Depreciation

   2. If you use any other metric that excludes certain expenses, it’s best to add

2. Operating Leases → Depends on if GAAp or IFRS

   1. If GAAp → Best not add because it corresponds on IS as Rent, which is usually deducted to calculate your EBIT or EBITDA

      1. Only use in metrics that add back Rental Expense (Like EBITDAR)

   2. If IFRS → Easier to add Operating Leases because metrics exclude full Lease Interest and lease Depreciation 

1. Give example of a company action that affects: Equity Value but Not Enterprise Value, Enterprise Value but not Equity Value, Not Enterprise and Equity Value

1. Equity Value but Not Enterprise Value

   1. Issuing $100 in stock and keeping the cash on hand will change shareholder Equity but keep Net Operating Assets unchanged

2. Enterprise Value but not Equity Value 

   1. Issuing $100 of Debt an uses it to buy a factory → Net Operating Assets are changed but shareholder equity hasn’t 

3. BOTH

   1. Issuing $100 in stock and using that to buy a factory to boost Net PP&E → Changes Net Operating Asset and Shareholder Equity

1. Is it possible for Equity Value to be Negative. What about Enterprise Value?

1. Not possible for Equity Value based on Current Price → Possible for EV since Cash can exceed Equity Value 

1. Say you compare two companies, A and B. A is financed with %100 Equity whereas B is financed with %50 Equity and %50 Debt. On paper their EV should be the same, but is it in real life?

1. Usually not if we calculated Implied Enterprise Value. Although EV is considered to be capital structure neutral,, more accurately it is to be said its “less affected”. 

2. Capital Structure Affects Discount Rate → more debt = more default risk. If you to value a company based off of PV of future expected cash flows  and apply WACC discount rate, you would get different valuations and implied EV.  

1. If the company issues $200 in Common Shares. How do Equity Value and Enterprise Value change?

1. CSE → Increases by $200 → EqV up by $200

2. NOA → No Change → TEV No change

1. The company decides to issue $200 in Common Stock and acquire another business for $100.

1. CSE → Up by $200 → EqV up by $200

2. NOA → Up by $100 → TEV up by $100

1. What if company used that $100 to acquire an asset instead

1. CSE → Up by $200 → EqV up by $200

2. If this new asset is part of Operating or Core elements –? NOA → Up by $100 → TEV up by $100

   1. If not → No change

1. Company issues $100 in Debt to purchase new factory.

1. CSE → No change

2. +$100 in Debt → $100 in Operating Asset → +$100 in NOA → +$100 in TEV

1. Company issues 100 in Common and $100 in Preferred, lets $200 in cash sit there

1. NOA → Preferred Stock issuance does not impact CSE → +$100 in CSE → EqV up $100

2. TEV formula → EqV + Preferred + NCI + Debt - Cash → +$100in EqV +$100 in Preferred -$200 in Cash → $0 Change

1. Company issues $10 in common dividends and $10 in preferred dividends 

1. CSE → both common and preferred dividends affect CSE → EqV down by $20

2. NOA → No Change → TEV no change

1. Company issues $150 of Debt and $50 of Common → Acquires $175 of PPE and $25 of Short Term Investments. 

1. CSE → +$50 because of Common stock issuance → EqV + $50

2. NOA  → +$175 in NOA → TEV up $175

1. The company issues $50 of debt to buy a new factory. However after this purchase its EV has increased by $100 instead of $50. The coworker claims it’s because of the debt issued to make the purchase. And debt increases TEV → is he correct?

1. No; debt issuance does not contribute to EV because the purchase method doesn’t matter. It’s more likely that the reason TEV went up is the market value of the factory is $100 which could impact its implied EV based on PV of future cash flows. 

1. Company purchases $100 of Inventory using Cash 

1. CSE → No change 

2. NOA → +$100 → TEV increases by $100

1. What if that $100 in inventory is now sold for $200 → walk through entire process assuming it all happened in one period

1. First → +$200 in Revenue → (-$100 in COGS) +$100 in Pre Tax Income → +$75 in Net Income

   1. CSE → +$75 → EqV up $75

   2. TEV → -$100 in Inventory. → If we lump both statements together and assume the purchase and sell of inventory is in the same period → $0 change in TEV

1. Company has 200 outstanding shares at current price of $10. It also has 50 options at an exercise price of $8 each. What is Diluted EqV

1. Basic Eqv → 200 * 10 - $2000.

   1. Option strike price is less than Current share price → In the money → Apply Treasury Stock Method 

   2. Investors exercise stock → 50 * 8 = $400 added in cash

   3. Company buys back shares at current price → $400//10 → 40 new Shares 

   4. Diluted Share Price = 200 + 50 - 40 = 210 Diluted Shares

   5. Diluted EqV = 210 * 10 = 2100

1. A company has 10,000 shares outstanding and a current share price of 20$. It also has 100 options at an exercise price of $10, 50 restricted stock units, and 100 convertible bonds at a conversion price of 10 dollars and a par value of $100. What is diluted equity value

1. Assume Options are in the money and get exercised → 100 new shares will be created → Company will receive 100 * 10 = $1000 in proceeds

2. Because share price is $20 → company repurchases 50 shares with proceeds → +50 net additional shares outstanding 

3. Add 50 RSU as if they were counted as common shares → 100 additional shares outstanding 

4. Because share price exceeds conversion price of convertible bonds → Convertibles bonds convert into shares → divide par value by conversion price → $100/$10 = 10 New shares per bond → 100 bonds * 10 shares per bond = 1000 new shares

5. Overall +1100 new shares

6. Diluted Share Count = 11,000

7. Diluted Equity Value = $222,000

1. Public companies already have Market Cap and Share prices. Why do we need to value them at all since these numbers already tell us how much they’re worth

1. Because Market Cap and Share Price reflect Current Value according to the Market → but the market could be wrong

2. We value companies to see if the market is correct and whether the value may change depending on our viewpoint and what we know based on how we expect it to do  + other factors 

1. Advantages and disadvantages of 3 main valuation methodologies

1. Public Comp: 

   1. Advantages: Based on real market data,quick to calculate and explain, don’t depend on any future assumptions 

   2. Disadvantages: Possible there aren’t any true comparable companies, less accurate for volatile/thinly traded companies, analysis could be undervaluing the company’s long-term potential 

2. Precedent Transaction:

   1. Advantages: based on real prices that companies have been sold for, can reflect industry trends more accurately

   2. Disadvantages: data can be misleading, may not be any true comparable transactions, specific deal terms and conditions can distort multiples sold 

3. DCF Analysis:

   1. Advantages:According to finance theory it is the most correct, less subject to market fluctuations, better reflects company-specific factors and the long-term rends

   2. Disadvantages: very dependent on far-in-the future assumptions, disagreement over proper calculations for key figures such as COE and WACC

1. Which of 3 main methodologies will produce highest implied value

1. Theoretically, any methodology could produce the highest implied value spending on industry, time period, and assumptions

2. Being said → usually Precedent Transaction wil produce higher implied value than other 2 → because of “Control Premium” that buyers pay to seller 

3. DCF tends to produce the most variable output but it’s really dependent on your assumptions. PT will more often than not produce higher values than Public Comps. 

1. Which is worth more. A $500 Million EBITDA healthcare company or a $500 million EBITDA industrials company? Assume growth rates and margins are the same

1. The answer matters on what company you think will produce more FCF: Working capital, Capex

2. In this instance – Healthcare is generally a less asset-heavy industry than industrials. Usually less working capital and capex. Also right now → argument could be made healthcare has more growth potential

3. But there is an argument to be made that if the Discount Rate is higher for healthcare → offset these factors. → Need more information 

1. Walk me through how you use public comps and precedent transactions in a valuation 

1. First step for both is always selecting an appropriate universe → based on industry, size, and geography, and time

2. Second, choose appropriate metrics and multiples → calculate them for all companies 

3. Third, for each multiple in the set we can calculate the minimum, 25th percentile, median, 75th, and maximum

4. Fourth, we can apply these financial metrics to estimate our target company’s implied value based on the median

1. Can you give me a few examples of how you might screen for “similar” Comparable Public Companies and Precedent Transactions

1. For Comps → Screen based on geography, industry, and size

2. Precedent → All the above + time

1. How to decide which metrics and multiples to use in these methodologies

1. Start by looking at a company’s economics and see the sales-based metrics that actually drive its values

   1. Mature Companies → EBITDA, EBIT, Net Income

   2. High Growth & Loss → Revenue

   3. Capital Intensive → EBITDA, FCF

   4. Asset-heavy → P/BV

   5. Banks → P/BV, P/E

   6. SaaS → Revenue, EBITDA

2. From there, use corresponding multiples that fit with the metrics we identified 

1. Why do we look at both Historical and Projected metrics in these methodologies 

1. Historical Metrics allow us to make conclusions based on what has actually happened in real life → but we must be careful of non-recurring items that can deceive the numbers 

2. Projected Metrics now are useful because we’re assuming our company will operate in a consistent steady state → but they will be les reliable since we are extrapolating data that doesn’t have any historical data backing it up

1. When calculating forard multiples for comparable companies, should you use each company’s current equity value or current enterprise value, or should we project htem to get a year 1 or year 2

1. NEVER PROJECT EITHER -> always use either current EqV or EV

2. THat’s because the current EqV and EV already reflect past performance and people’s future expectations → projecting metrics would mean were trying to prejudice what future expectations people would have in the future

1. How do we interpret public comps? What does it mean if the median multiples are above or below the ones of the company we’re valuing

1. Interpretation depends on how company’s growth rates and margins compare to those of the comparable companies → most relevant if our growth rages and margins are similar

2. If growth rate & margins are similar, but multiples are different → could mean company we are valuing is mispriced 

1. What is a Liquidation Valuation, and when is it useful and not so useful

1. You value a company by estimating the MARKET VALUE of all its assets, add them up, and subtract its liabilities (assume full repayment of all liabilities based on proceeds from sale of all its assets)

2. → Gives us Implied Equity Value (Net Assets, not Net Operating Assets)

3. Useful for distressed companies → tells us how much they’d be worth if they liquidate and how much different lender groups might receive 

4. Less useful for healthy, growing companies → will significantly undervalue them

1. How does Dividend Discount Model differ form DCF

1. In a DDM → we are projecting Dividends either on a per-share figure or as a percentage of Net Income

2. Discount Dividends to Present Value using Cost of Equity

3. Add PV of Dividends to PV of Terminal Value to calculate implied EqV → divide by diluted share count

4. Essential in industries like commercial banks an insurance → useful in other industries that pay regular dividends 

1. Why might you use an M&A premium analysis to value a company?

1. M&A Premium analysis applies to public companies only → we are looking at acquisitions of similar public companies and calculating the premium each buyer paid for each seller

2. Ex: Seller’s share price was 12.00 but buyer paid $150 → premium is 25%

3. We then use these percentages of value our company by looking at median premiums in sets of deals 

4. Supplement to Precedent Transactions where we can value company beside standard multiples

5. NOTE: CANNOT INDICATE A COMPANY IS CURRENTLY UNDERVALUED

1. Advantages and Disadvantages of Sum-of-the-part valuation

1. Value each division of company separately and then add them to determine company’s implied value 

2. Works well for:

   1. Conglomerates with very different divisions that operate in different industries 

3. Disadvantages

   1. Takes far more time and effort since we’re basically treating each division and comparison as it’s own separate entity

   2. Might not have enough information to use it → companies rarely disclose metrics by division or corporate overhead expenses 

1. How do we set up an LBO valuation → when is it useful?

1. Use LBO Model 

2. Intuition: PE firm usually target some IRR → work backward → determine maximum price a PE firm would pay to achieve a targeted IRR