Basic IB Questions

Walk me through the three financial statements

IS: Gives company revenues and expenses

BS: Shows companies assets - PPE, cash inventory. Liabilities such as debt and accounts payable
and shareholders equity
Assets \= Liabilities +SE

CF\= Begins with Net Income, adjusts for non cash expenses and working capital changes. Then lists cashflow from financing and investing activities. Then shows Net cash Change

What happens to bonds when interests rate rise and why?

When interests rate goes up, value of bonds goes down.

- Because investors will want to sell old bonds and buy new ones with higher intrersts rates thus declining the price

Can you Give me examples of line items on each Financial Statement

IS: Revenue, COGS, Operating Income, pretax income, Net income

BS: Cash, Accounts Receivable and Payable, Debt, Share holders Equity

CF: Net Income, Depreciation and Amatorization, Stock based compensation, Changes in operating assets/ liabilities. Cash Flows from operating and financing. Capital Expenditures. Dividends

How do the three statements link together

Net Income from IS flows to shareholders equity on the Balance sheet and top of the Cash Flows

Changes to Balance Sheet items appear as working capital changes on the Cash Flow statement. and investing and financing activities affect BS items like PPE, Debt and SE.

If you had to choose one statement which and why

Cash Flows because it shows the true picture of how much cash the company is generating, independent of all the non cash expense you have. Thats what most important cash flow

If you can only use two statements which ones and why

Balance Sheet and Income statement

- Those two also create the Cash flow Statement

What Happens in depreciation goes up $10

IS:
Operating Income goes down $10.
Assuming 40% Tax rate, Net income goes down 6$.
CF:
Net Income goes down 6$ but Depreciation goes up 10$. So overall cash flow from Ops goes up 4$
BS:
Plants Property and Equipment goes down 10. But our cash is up 4.
Overall.
Assets are down by $6. Net Income is also down 6 so that means shareholders equity is down 6

If Depreaciation is non cash expense why does it affect cash balance

Because it is a tax deductible

What happens when Inventory goes up by $10. Assuming paid in cash

IS: No changes

CF: Inventory is an asset so that decreases Cash Flow from Operations 10.
Change in Cash is down 10

BS: Inventory is up by $10 but cash is down by $10 so the changes cancel out

Why do we look at both Enterprise Value and Equity Value

Enterprise Value- Represents the value of the company that is attributable to all investors.

Equity Value- Represent portion that is available to shareholders.

You look at both because equity value is the number the public sees while Enterprise Value is the true value

What is the Formula for Enterprise Value?

EV \= Equity Value + Debt + Preferred Stock + Minority Interest - Cash

Why Do you need to add minority interest to the Enterprise Value?

Whenever a company owns more than 50% of the another company, it is required to report performance of other company. Even though it doesn't own 100% it has to report 100%.

This keeps the numerator and denominator reflect 100% of the majority owned subsidiaries

How do you calculated Diluted Shares?

Basic Share Count + Additional shares issued from dilutive securities.

What does it mean if a company has a negative Enterprise Value?

It means the company has a large cash balance or a low market cap.

This happens to companies on the brink of bankruptcy

It is accurate to add Debt and Equity Value when calculating Enterprise Value?

In most cases yes, because the terms of debt say debt must be refinanced in an acquisition

Why do you subtract cash for the formula for enterprise value?

Cash is subtracted because its considered a non operating asset and because equity value implicitly accounts for it

What are the three Valuation methods?

Discounted Cash Flow
Comparable company analysis
Precedent Transactions

Rank the Three Valuation methods from Highest to lowest expected value

In General but no always the case:

Precedent Transactions due to the control premium built into acquisitions
DCF - DCF depends it can be the highest or the lowest depending on assumptions
Comparables -

4th LBOS

When would you not use a DCF in a Valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows , or when debt and working capital serve a fundamentally different role.

For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you wouldn't use a DCF for such companies.

What other Valuation methodologies are there?

- Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive

- Replacement Value - Valuing a company based on the cost of replacing its assets

Sum of Parts - Valuing each diving of a company separately and then adding them back together

- LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range

Walk me through a DCF

1) Concept: a company is worth the sum of its future cash flows, discounted back to present value

2) Calculate Unlevered Free Cash Flow for the next 5-10 years: EBIT * (1-Tax) + Non-Cash Expenses +/- Changes in Operating Working Capital - Capital Expenditures

3) Calculate the Discount Rate, or Weighted Average Cost of Capital (a.k.a. "WACC"): Cost of Equity * % Equity + Cost of Debt * % Debt * (1 - Tax Rate) + Cost of Preferred * % Preferred Stock

4) Calculate Cost of Equity: Risk-Free Rate + Levered Beta * Equity Risk Premium

5) Calculate Terminal Value: Exit Multiple Method: take the EBITDA in the last year of the forecast period and multiply it by an appropriate EV/EBITDA multiple based on the comps

Gordon Growth Method: Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate)

6) Discount all forecasted FCF and terminal value using the discount rate to get to the enterprise value

Walk me through how you get from revenue to free cash flow in the projections.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT).
EBIT * (1 - tax rate) + DA + Change in Net Working Capital - CapEx

Why do you use 5 or 10 years for DCF projections?

Less than 5 years would be too short to be useful,

10 years is too difficult to predict for most companies.

What do you use for the discount rate

Weighted Average Cost of Capital

How do you calculate WACC

Weighted Cost of Equity + Weighted Cost of Debt * (1-tax rate) + cost of preferred

How do you calculate Cost of Equity

Cost of Equity \= Risk free rate + Beta * Equity Risk Premium

What is the effect if you use levered cash flow instead of unlevered cash flow

Levered Cash flow will give you Equity value

Unlevered will get you the enterprise value

If you use Levered Cash Flow, what should you use as the Discount Rate

You would use the Cost of equity instead of WACC since we don't care about about Debt or Preferred stock.

Because we are trying to find the Equity Value not Enterprise

How do you calculate Terminal Value?

Either apply a multiple or use Gordon Growth method

Gordon Growth Method: Terminal Value \= Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).

When would you use the Gordon Growth instead of Multiples to find Terminal Value

If you cannot find a good comparable company

Or if you have a reason to believe that the multiples in the industry will change significantly

What is an appropriate growth rate to use when calculating Terminal Value

You use the country long term GDP growth rate or the long term inflation rate

1-3%

Which method of calculating Terminal Value will give you a higher valuation?

Hard to say

In general multiples method will be more variable than the Gordon growth method because exit multiples have a wider range

What is the difference between a merger and an Acquisition?

Merger is if they are around the same size
Acquisition is if they are much bigger

Why would you use leverage when buying a company?

To boost your return.

Its easier to get a high return when you have less off you own money and more borrowed money.

Also gives firm more capital to use in other deals

Walk me through a basic LBO model

1. Make assumptions about Purchase price, Debt/Equity ratio, and other variables

2. Create a sources and uses section - this shows how to finance deal

3. Adjust companys income statement, Balance Sheet for new Debt and equity figurees

4. Project out the company income statement BS and Cash flows

5. Use an EBITDA exit multiple, then calculate how much equity is returned to firm

Why is an inverted yield curve bad

It suggests that short term investments are riskier than long term investments