M&I 400 Basic

Walk me through the 3 basic financial statements

1. Income Statement

• you list all of your revenues and your expenses and then you subtract total expenses from total revenues to arrive at NET INCOME

1. Balance Sheet

• lists the company's assets, liabilities, and stockholders equity

• assets = liabilities + stockholders equity

1. Statement of Cash Flows

• start with net income, adjust for non-cash expenses and working capital changes, and then list cash flow from investing and financing activities to arrive at NET CHANGE IN CASH (i.e. company started with 100M in cash and ended with 5M, you net change must be -95M)

major line items for each of the financial statements

IS:
revenue - COGS= gross profit - SG&A = net operating income - interest expense - other variable expenses = pretax income - income taxes = net income
BS:
A- cash, AR, inventory, PPE. L- AP, accrued expenses and debt. SE- common stock, retained earnings
SoCF:
Net Income, depreciation and amortization, stock-based compensation --> CASH FLOW FROM OPERATIONS, capital expenditures -->CASH FLOW FROM INVESTING, sales/purchase of securities, dividends issued --> CASH FLOW FROM FINANCING

How do the 3 statements link together?

BegRE + NI = EndRE
net income from the income statement flows into SE on the Balance Sheet and the top line of the SoCF
changes to balance sheet items show as working capital changes on the SoCF
investing and financing activities affect the BS accounts such as PPE, debt, and equity

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

SoCF because it gives a true picture of how much money the company is ACTUALLY generating, independent of all non-cash expenses that you might have. Cash flow is the #1 thing to look at when evaluating the overall financial health of a business

Walk me through how depreciation going up by $10 would affect the statements?

IS: Operating income declines by $10 because depreciation goes into SG&A or COGS which is subtracted from revenue to find NOI. if the tax rate was 40% then NI would decrease by 6
SoCF: the NI at the top of the SoCF would decrease by $6, but the $10 depreciation expense would be added back, so OVERALL cash flows from operations increases by $4
BS: PPE asset decreases by $10 because of depreciation and cash increases by $4 because of the changes to overall cash flow. Since NI decreased by $6, SE goes down by six, making sure both sides balance

If Depreciation is a non-cash expense, why does it affect the cash balance?

Because it is tax-deductible. Since taxes are a cash expense, depreciation decreases the amount of taxes you pay

Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?

IS and BS because you can create a SoCF from these two and the cash flow is the most important thing to look at when examining the financial health of a business.

Where does depreciation usually show up on the IS?

It could be its own line item under expenses. It can also be embedded in COGS or Operating Expenses
DEPRECIATION ALWAYS REDUCES PRE-TAX INCOME

What happens when accrued compensation increases by $10?

Operating expenses on the IS go up by $10. Pre-tax income falls by $10, and assuming a 40% tax rate, NI falls by $6

SoCF: NI is down by $6 and accrued compensation will increase cash from operating expenses flow by 10 so there is an overall increase of 4

BS: Cash is up by 4 so assets are up by 4. Expenses are up by 10 and NI is down by 6 making a total of +4 on the right-hand side

What happens when inventory goes up by $10, assuming that you pay for it with cash

IS: nothing happens to the IS
SoCF: decreases cash flow from operations by $10, so it decreases the net change in cash by that amount too
BS: one asset inventory increases by 10 while the other asset, cash, decreases by 10 causing a net change of zero to the BS

Why is the Income Statement not affected by changes in Inventory?

The expense associated with buying inventory is shown on the balance sheet as a decrease in cash or an increase in accounts payable.

The expense is recorded when the goods associated with it are sold- so if inventory is just sitting in a warehouse is is not in COGS on the IS. It is not in this until it is transformed into a product and sold

Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?

IS:
there would be no changes on the IS yet because nothing has been produced or sold.
SoCF:
the investment in factories is shown under the Cash Flow from Investing Activities section (a net REDUCTION in cash flow by $100). The $100 worth of debt raised to buy these factories would show up as an ADDITION to the cash flow, cancelling out the investment activity. CASH NUMBER STAYS THE SAME

BS:
PPE goes up by $100 (assets up by $100), debt is up by $100 too liabilities up by 100 so both sides balance

Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

Apple must pay the interest expense and record the depreciation.

IS:Depreciation expense of $10 would show up on the IS, decreasing the net operating income by $10
Interest Expense of $10 would also show up on the IS, decreasing the pre-tax income by another $10
DECREASE OF 20$ in total. Assuming a tax rate of 40%, income after tax= $12

SoCF: $12 is the income that is plugged in at the top of the statement. Depreciation is a non-cash expense so it is added back, bringing the cash flow up $10….overall decrease of $2

BS: Cash is down by 2 (assets), PPE is down by 10, so overall assets are down by 12. NI is down by 12 on SE so the side
s balance ****DEBT UNDER LIABILITIES DOES NOT CHANGE BC WE ASSUME NONE OF IT IS PAID BACK

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

After 2 years, the factory value is $80 because of 2 years of 10% depreciation. this means we will write-off $80 of PPE

IS: $80 write-off shows up on the pre-tax income line. Assuming 40% tax rate, NI becomes $48, an overall decrease of $32

SoCF: Net income is DOWN BY $32 but the write-off is a NON CASH EXPENSE so it is added back, so it increases by $80…overall increase of $48. Financing cash flows has a $100 charge for the loan payback so it falls by $100. OVERALL change of -$52

BS: Cash is down by $52 (from SoCF) and PPE is down by 80 (total assets down by 132). Debt is down 100 cuz it was paid off and NI (i.e. SE) was down by 32 so overall down 132. they BALANCE

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?

IS: no changes
SoCF: working capital changes (increase of $10 of inventory), decrease of $10 on Cash from Operating Activities, so OVERALL cash flow is down by 10

BS: inventory (asset) up by 10, cash (asset) down by 10. it BALANCES

Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

IS: The sale of $10 worth of ipods is a COGS expense. $20 is recorded as a revenue. Gross profit is up by $10. Assuming a 40% tax rate, profit is up by $6

SoCF: Net income is up by $6. Inventory decreased by $10 so $10 cash inflow from operating activities. so OVERALL increase of $16

BS: cash is up by $16, inventory is down by $10 ($6 increase in assets). Net income up by $6, so the sides BALANCE

Could you ever end up with negative SE? What does that mean?

Yes, 2 scenarios.

1. Leveraged buyouts with dividend recapitalizations. This means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative
2. It can also happen if the company has been losing money consistently and therefore has a declining RE balance
   *can be a cause for concern and demonstrate a struggling company

What is working capital? How is it used?

Working Capital= current assets - current liabilities

Positive- company can pay off its short-term liabilities with its short-term assets.

What does negative working capital mean? is that a bad sign?

IT means that the company does not have enough current assets to cover its current liabilities.

Not always a bad sign- depends on the situation.

1. companies with subscriptions or long-term contracts have negative WC because of high DEFERRED REVENUE BALANCES
2. retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative WC because customers pay upfront so they use this cash to pay off their AP rather than keeping a large balance of cash on hand. Reveals business efficiency
3. other cases, it does indicate something is wrong- financial trouble and possible bankruptcy (EX. customers don't pay quickly and upfront and the company has a high debt balance

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a writedown of $100.

IS: $100 write-down shows up in the pre-tax income line. 40$ tax rate, NI declines by $60

SoCF: NI is down by $60 but the write-down is a non-cash expense, so $100 is added back for an overall increase cash flow of $40

BS: cash (an asset) is up by $40 and whatever asset they wrote down is down by $100 so overall decrease of $60 in assets. NI IS also down by $60 so the two sides balance

Walk me through a $100 "bailout" of a company and how it affects the three statements?

With an equity investment from the government…
IS: no changes
SoCF: cash flows from financing increases by $100 to reflect the government's investing, so the Net Change in Cash is a $100 increase
BS: The $100 increase in cash is shown as a $100 increase in assets. SE would also go up by $100 because of the bailout, allowing the 2 sides to balance

Walk me through a $100 write-down of debt- as in OWED debt, a liability- on a company's BS and how it affects the 3 statements

when a liability is written down, it is a GAIN on the IS (when its an asset it is a LOSS) so pre-tax income increase by $100. Assuming a 40% tax rate, net income increases by $60

SoCF: $60 increase in NI shown at the top of the statement…SUBTRACT the write-down, so you end up with a net change of -$40

BS: cash (assets) down by $40, $60 increase in NI is shown on SE and debt (liabilities) is down by $100, so net change of -$40

When would a company collect cash from a customer and not record it as revenue?

1. web-based subscription software
2. cell phone carriers that cell annual contracts
3. magazine publishers that sell subscriptions
   SUBSCRIPTIONS

you record revenue when the SERVICE IS PERFORMED not when the cash is collected

if cash collected is not recorded as revenue, what happens to it?

it goes into the Deferred Revenue (liability) BS account

what is the difference between accounts receivable and deferred revenue?

Accounts Receivable is when someone paid for a product/service on credit. The service has been performed or the product delivered but the company has not collected the cash yet

Deferred Revenue is when you have collected the cash but not performed the service or delivered the product yet.

how long does it usually take for a company to collect its AR balance?

generally within 40-50 days (higher for companies selling high-end items and vice versa)

Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs accrual accounting?

cash-based: the company would record revenue from the TV once they charge the customer's credit card, receives authorization, and deposits the funds in its account (REAL TIME)

accrual: the company would record revenue as soon as the sale happened but instead of recognizing an inflow in cash they recognize an inflow in AR

What is the difference between cash-based and accrual accounting?

cash-based recognizes revenues and expenses when cash is received and paid out

accrual recognizes revenues when collection is reasonably certain and recognizes expenses when they are incurred rather than when they are paid out in cash

How do you decide when to capitalize rather than expense a purchase?

if the asset has a useful life >1 year, it is capitalized (put on the BS rather than being shown as an expense on the IS). Then it is depreciated or amortized over a number of years

ex. purchasing factories, equipment, and land

Why do companies report both GAAP and non-GAAP earnings?

many companies have non-cash charges like amortization of intangibles and deferred revenue write-down on their IS. as a result, some argue that IS under GAAP no longer reflect how profitable most companies truly are. non-GAAP earnings are almost always higher because these expenses are NOT included

A company has a positive EBITDA for the past 10 years but it recently went bankrupt. How could this happen?

1. the company is spending too much on capital expenditures (not reflected in EBITDA but would result in a negative cash flow)
2. the company has high interest expense and is no longer able to afford its debt
3. the company's debt all matures on one date and it is unable to refinance it due to a "credit crunch" and it runs out of cash completely when paying back the debt
4. it has significant one-time charges (litigation) and those are high enough to bankrupt a company

***EBITDA excludes investments in and depreciation of long-term assets, interest, and one-time charges, all of which could bankrupt the company

Normally Goodwill remains constant on the BS- why would it be impaired and what does Goodwill Impairment mean?

happens when a company has been acquired and the acquirer re-assesses its intangible assets and finds that they are worth much less than they originally thought. Acquisition where the buyer "overpaid" for the seller and can result in a large net loss on the IS. it can also happen when a company discontinues part of its operations and must impair the associated goodwill.

Goodwill- asset that appears when a buyer acquires another business. The amount over the combined value of the acquired company's assets that the buyer paid for the company

under what circumstances would Goodwill increase?

if the company re-assesses its value and finds that the company it acquired is wroth MORE than it thought

How much do you know about what you actually do in Restructuring?

Restructuring bankers advise distressed companies. Distressed companies include companies going bankrupt, in the midst of bankruptcy, or getting out of bankruptcy. The bankers help them change their capital structure to get out of or avoid bankruptcy or assist with a sale of the company.

What are the 2 different sides of a Restructuring deal? Do you know which one we usually advise?

Bankers can advise the debtor (the company itself) or the creditors (anyone who has lent the company money. often multiple parties). There are operational advisors who help with the actual turnaround. Blackstone and Lazard advise DEBTOR. Houlihan Lokey advises the creditors

Why are you interested in Restructuring besides the fact that it is a hot area currently?

You gain a very specialized skill-set and the work is more technical/interesting than things like M&A. You get broader exposure because you see the good and not so good sides of companies. You operate within a legal framework

How are you going to use your experience in Restructuring for your future career goals

legal and better technical skills. Access to work at a Distressed Investments or Special Situations Fund which you can only really get access to by being in Restructuring.

How would a distressed company select its Restructuring bankers?

there are only a few banks with good practices because it requires extremely specialized knowledge and relationships. They are selected on their experience doing similar deals in similar industries as well as their relationship with all the other parties involved in the deal process. Many more parties than a normal M&A or financing deal does (lawyers, shareholders, debt investors, suppliers, directors, management, and crisis managers)

Why would a company go bankrupt in the first place?

1. a company cannot meet its debt obligations/interest payments
2. creditors can accelerate debt payments and force the company into bankruptcy
3. an acquisition has gone poorly or a company has just written down the value of its assets steeply and needs extra cash to stay afloat
4. there is a liquidity crunch and the company cannot afford to pay its vendors or suppliers

what options are available to a distressed company that cant meet debt obligations

1. refinance and obtain fresh debt/equity

• advantage: least disruptive, help maintain confidence
• disadvantages- difficult to attract investors to a struggling company

1. sell the company (Either as a whole or in pieces as an asset sale)

• adv: shareholders get more value and creditors would be less infuriated, knowing the funds were coming.
• disadv: unlikely to obtain a good valuation in a distressed sale, so company might sell for a fraction of its true worth

1. restructure its financial obligations to lower interest payments/debt repayments or issue debt with PIK interest to reduce the cash interest expense

• adv: resolve problems quickly without 3rd party involvement
• disadv- lenders are reluctant to increase their exposure to the company…managers and lenders don't see eye to eye

1. file for bankruptcy and use that opportunity to obtain additional financing, restructure its obligations, and be freed of onerous contracts

• adv: could be the best way to negotiate with lenders, reduce obligations, and get additional financing
• disadv: significant business disruptions and lack of customer confidence…equity investors likely lose all their money

From the perspective of the creditors, what different strategies do they have available to recover their capital in a distressed situation?

1. lend additional capital/grant equity to company
2. conditional financing- only agree to invest if the company cuts expenses, stops losing money, and agrees to other terms
3. sale- force the company to hire an IB to sell itself or parts of itself
4. foreclosure- bank seizes collateral and forces a bankruptcy filing

How are Restructuring deals different from other types of transactions?

more complex, involve more parties, require more specialized skills, and have to follow the Bankruptcy legal code. Negotiation extends beyond two sides (not just creditors negotiating with debtors)…creditors are negotiating with other creditors

What is the difference between Chapter 7 and Chapter 11 bankruptcy?

Chapter 7- liquidation bankruptcy. The company is too far past the point of reorganization and must sell off assets and pay creditors. Trustee ensures this all happens (heart attack for cocaine addict)

Chapter 11- reorganization. The company doesn't die, but instead changes the terms on its debt and renegotiates everything to lower interest payments and the dollar value of debt repayments. (rehab for cocaine addict)

What is debtor-in-possession *DIP financing and how is it used with distressed companies?

it is money borrowed BY the distressed company that has repayment priority over all other existing secured/unsecured debt, equity, and other claims, and is considered "safe" by lenders because it is subject to stricter terms than other forms of financing.

Makes it easier for distressed companies to emerge from the bankruptcy process

How would you adjust the 3 financial statements for a distressed company when you're doing valuation or modeling work?

Adjust COGS for higher vendor costs due to lack of trust from suppliers

add back non-recurring lease expenses (again due to lack of trust) to Operating Income as well as excess salaries harder to do with a public company

Working Capital needs to be adjusted for receivables unlikely to turn into cash, overvalued/insufficient inventory, and insufficient payables

CapEx spending is often off (too high could indicate why they are going bankrupt, too low might indicate they are trying to artificially save money)

If the market value of a distressed company's debt is greater than the company's assets, what happens to its equity?

SE goes negative
Equity Market Cap (shares outstanding*share price) remains positive (it can never be negative)

In a bankruptcy, what is the order of claims on a company's assets?

1. New debtor-in-possession lenders
2. secured creditors (bank debt)
3. unsecured creditors (high yield bonds)
4. subordinated debt investors (similar to high-yield bonds)
5. mezzanine investors (convertibles, convertible preferred stock, preferred stock, PIK)
6. shareholders (equity investors)

secured- the lender's claims are protected by specific assets or collateral

unsecured- anyone who has loaned the money company without collateral

How do you measure the cost of debt for a company if it is too distressed to issue additional debt (i.e. investors won't buy any debt from them)

look at the yields of bonds or the spreads of credit default swaps of comparable companies to get a sense of this. You could also just use the current yields on a company's existing debt to estimate this

how would valuation change for distressed company?

look more at the lower range of the multiples and make all the accounting adjustments

use lower projections for a DCF and anything else that needs projections because you assume a turnaround period is required

pay more attention to revenue multiples if the company is EBITDA negative

look at liquidation valuation under the assumption that the company's assets will be sold off and used to pay its obligations

How would a DCF analysis be different in a distressed scenario?

even more of the value would come from the terminal value since you normally assume a few years of cash flow negative turnaround. Sensitivity table on hitting or missing earnings projection. Add a premium to WACC to make it higher and account for operating distress

Let's say a distressed company approaches you and wants to hire your bank to sell it in a distressed sale - how would the M&A process be different than it would for a healthy company?

1. QUICKER because the company needs to sell or they will go bankrupt
2. FEWER up front up marketing materials for time's sake
3. creditors initiate the process rather than the company itself
4. the sale CANT FAIL

• sale
• bankruptcy
• restructuring

Normally in a sell-side M&A process, you always want to have multiple bidders to increase competition. Is there any reason they'd be especially important in a distressed sale?

YES. in a distressed sale you have almost zero negotiating leverage because you represent a company that is about to die….the only way to improve the price for your client is to have multiple bidders

The 2 basic ways you can buy a company are through a stock purchase and an asset purchase. What's the difference, and what would a buyer in a distressed sale prefer? What about the seller?

stock purchase- acquire 100% of a company's shares as well as its assets and liabilities

• used for large, public, healthy companies that want to be acquired
  DISTRESSED SELLER PREFERS A STOCK PURCHASE (rid of all their liabilities)

asset purchase- only acquire certain assets and ASSUME only certain liabilities (you can pick and choose exactly what you are getting

• used for divestitures, distressed M&A, and smaller private companies
  BUYER OF DISTRESSED COMPANY PREFERS THIS (pick and choose)

Sometimes a distressed sale does not end in a conventional stock/asset purchase- what are the other possible outcomes?

1. foreclosure
2. general assignment
3. section 363 asset sale (Faster, less risky version of normal asset sale)
4. chapter 11 bankruptcy
5. chapter 7 bankruptcy

Normally M&A processes are kept confidential - is there any reason why a distressed company would want to announce the involvement of a banker in a sale process?

the company does this if they want more bids/want to increase competition to drive a higher purchase price

Are shareholders likely to receive any compensation in a distressed sale or bankruptcy?

most of the time, NO. if a company is distressed, the value of its debts and obligations exceed the value of its assets- so equity investors rarely get much out of a bankruptcy or distressed sale especially ones that end in liquidation

Let's say a company wants to sell itself or simply restructure its obligations- why might it be forced into a Chapter 11 bankruptcy?

Aggressive creditors force this to happen0 if they won't agree to the restructuring of its obligations or they can't finalize a sale outside court, they might force a company into Chapter 11 by accelerating debt payments

Recently, there has been news of distressed companies like GM "buying back" their debt for 50 cents on the dollar. What's the motivation for doing this and how does it work accounting-wise?

motivation: use excess BS cash to buy back debt on the cheap and sharply reduce interest expenses and obligations going forward. it works because the foregone interest on cash is lower than whatever interest rate they're paying on debt, so they reduce their net interest expense no matter what.

Accounting: BS cash goes down and debt on the L and SE side goes down by the same amount

What kinds of companies would most likely enact debt buy-backs?

Over-leveraged companies (ones with too much debt) that were acquired by PE firms in leveraged buyouts during the boom years, and now face interest payments that they have trouble meeting along with excess cash

why might a creditor might have to take a loss on the debt it loaned to a distressed companies?

happens to lower-priority creditors ALL THE TIME. secured creditors ALWAYS come first and get first claim to all the proceeds from a sale or a series of asset sales….if a creditor is lower on the totem pole, they only get what's left of the proceeds so they have to take a loss on their loans/obligations

What is the end goal of a given financial restructuring?

it does NOT change the amount of debt outstanding in and of itself.
it CHANGES the terms of the debt, such as interest payments, monthly/quarterly principal repayment requirements and the covenants

what's the difference between a Distressed M&A deal and a restructuring deal?

restructuring is one possible outcome of a Distressed M&A deal. A company can be distressed for many reasons but the solution is not always restructure debt obligations.

• declare bankruptcy
• liquidate and sell off assets
• sell 100% to another company

what is the difference b/w acquiring just the assets of a company and acquiring it on a current liabilities assumed basis

acquire the assets of a distressed company- literally get just the assets
acquire liabilities as well- make adjustments to account for the fact that a distressed company's working capital can be extremely skewed

• "owed expense" line items (Accounts Payable and Accrued Expenses) are often higher than they would be for a healthy company so subtract the difference if you're assuming current liabilities

RESULT: deduction in valuation (valuation is lower if you're assuming current liabilities)

How could a decline in a company's share price cause it to go bankrupt?

MARKET CAP DOES NOT EQUAL SHAREHOLDERS' EQUITY. SHARE PRICE OF THE COMPANY DOES NOT AFFECT SE (a book value)

actually: as a result of the share price drop, customers, vendors, suppliers and lenders will be more reluctant to do business with the company

• revenue falls
• accounts payable and accrued expenses rise

Bear Sterns 2008: overnight lenders lost confidence as a result of the drop in share price and BS ran out of liquidity (liquid assets such as cash) as a result (BIG problem when your entire business depends on overnight lending

What happens to Accounts Payable Days with a distressed company?

they RISE and the avg. AP Days might go well beyond "normal" for the industry

Let's say a distressed company wants to raise debt or equity to fix its financial problems rather than selling or declaring bankruptcy. Why might it not be able to do this?

debt (borrowing money to be repaid with interest): sometimes if the company is too SMALL or investors don't believe it has a credible TURNAROUND PLAN, they will refuse to lend ay sort of capital

equity (raising money by selling shares of the company): same as above, but WORSE- since equity investors have lower priority than debt investors. PLUS, for a distressed company, getting enough equity can mean selling 100% or almost 100% of the company due to depressed market cap

Will the adjusted EBITDA of a distressed company be higher or lower than the value you would get from its financial statements?

MOST CASES= higher because you're adjusting for higher-than-normal salaries, one-time legal and restructuring charges and more

Would you use levered cash flow for a distressed company in a DCF since it might be encumbered with debt?

NO. really important to analyze cash flows on a debt-free basis because they might have higher-than-normal debt expenses

Let's say we're doing a Liquidation Valuation for a distressed company. Why can't we just use the Shareholders' Equity number for its value? Isn't that equal to Assets minus Liabilities?

you need to ADJUST the values of the assets to reflect how much you could get if you sold them off separately. For example, you may assume you can only recover 50% of the book value of a company's inventory if you tried to sell it off separately. because you adjust assets, you cannot just use the SE number

What kind of recovery can you expect for different assets in a Liquidation valuation

Cash: close to 100% cuz it is the most liquid asset
Investments: varies a lot by what they are but you might get close to 100% for the ones closest to cash, but significantly less than that for equity investments in other companies
AR: less than what'd you get for cash because many customers might not pay a distressed company
Inventory: less than cash or AR because inventory is of little use to a different company
PP&E- similar to cash for land and buildings and less than cash for equipment
Intangible assets: 0%. no one will pay you anything for Goodwill or the value of a brand name

How would a LBO (leveraged buyout transaction) model for a distressed company be different?

purpose: figure out how quickly the company can pay off its debt obligations as well as what kind of IRR (internal rate of return) any new debt/equity investors can expect (rather than determining the PE firm's IRR)

other than that pretty much the same….different kinds of DEBT (debtor-in-possession), possibly more tranches, and the returns will be lower because it is a distressed company, but SOMETIMES bargain deals can be very profitable

MORE LIKELY TO TAKE THE FORM OF AN ASSET RATHER THAN STOCK PURCHASE

what is an LBO

Leveraged buyout transaction. the ACQUISITION of a company that is funded using a significant amount of DEBT. The assets of the company being acquired and those of the acquiring company are used as collateral for the financing

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 only represents the portion AVAILABLE to shareholders (equity investors)

look at both BECAUSE Equity Value is the number the public at large sees while Enterprise Value represents its TRUE value

When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?

Enterprise Value because that's how much an acquirer REALLY pays and includes the often mandatory debt repayment

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 Enterprise Value

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as a part of its OWN performance….so even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's (a company controlled by a holding company) financial performance.

You must add Minority Interest to get the EV so that your numerator and denominator both reflect 100% of the majority-owned subsidiary

How do you calculate fully diluted shares?

take the basic share count and ADD IN the dilutive effect of stock options (calculate this using the Treasury Stock Method) and any other dilutive securities such as: warrants, convertible debt or convertible Preferred Stock

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each- what is its fully diluted equity value?

Basic equity value= $1000.

first note that the options are all "in-the-money" (their exercise price is less than the current share price), so when they are exercised there will be 10 new shares created. the share count increases to 110. To exercise the options, we had to pay the company $5 for each option….they now have $50 in additional cash, which is used to buy back 5 of the new shares we created. SO THE FULLY DILUTED SHARE COUNT is 105, and the FULLY DILUTED EQUITY VALUE IS $1050

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its fully diluted equity value?

$1000. in this case the options' exercise price is ABOVE THE CURRENT SHARE PRICE, so they have NO dilutive effect

why do you subtract cash in the formula for Enterprise Value? Is that always accuratE?

BECAUSE it's considered a non-operating asset and EV implicitly accounts for it

(in an acquisition, the buyer GETS the cash of the seller, so subtracting cash shows that the buyer effectively pays less for the company based on how large its cash balance is and REMEMBER, EV tells us how much you'd really have to PAY to acquire another company)

NOT ALWAYS ACCURATE because technically you should be subtracting only EXCESS cash (the amount of cash a company has ABOVE the minimum cash it requires to operate)

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

most cases, YES, bc the terms of a debt agreement usually say that debt MUST be refinanced in an acquisition. In most cases, a buyer will pay off a seller's debt, so it is accurate to say that any debt "adds" to the purchase price.

EXCEPTION- the buyer does NOT pay off the debt.

Could a company have a negative Equity Value? What would that mean?

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

Could a company have a negative Enterprise Value? What would that mean?

yes. it means that the company has an extremely large cash balance, or an extremely low market cap (or both)

1. companies on the brink of bankruptcy
2. financial institutions (like banks) that have a large cash balance

Why do we add Preferred Stock to get Enterprise Value?

Preferred Stock pays out a fixed dividend, and PS holders also have a higher claim to a company's assets than equity investors do. As a result, it is seen as more similar to debt than CS

How do you calculate Market Cap?

Market cap = Total outstanding shares (issued - treasury) * stock price

How do you account for convertible bonds in the Enterprise Value formula?

If the convertible bonds are in-the-money, count them as additional dilution to equity value. If they are out-of-the-money, count their face value as debt

What is the difference between Equity Value and Shareholders' Equity?

Equity Value is the MARKET VALUE and Shareholders' Equity is the BOOK VALUE.

Equity Value can never be negative because shares outstanding and stock prices can never be negative

Shareholders' Equity CAN be negative.

Healthy company: Equity Value > Shareholders' Equity

What are the 3 major valuation methodologies?

1. comparable companies
2. precedent transactions
3. discounted cash flow analysis

rank the 3 valuation methodologies from highest to lowest expected value

TRICK QUESTION- there is NO RANKING that always holds
generally…precedent transactions > comparable companies because of the Control Premium built into acquisitions

DCF is the most variable methodologies

When would you NOT use a DCF in valuation?

If the company has unstable or unpredictable cash flows (tech or bio-tech startup) OR when debt and working capital serve a fundamentally different role. I.E. Banks and financial institutions do not reinvest debt AND working capital is a huge part of their BS- so you wouldn't use a DCF

What other valuation methodologies are there?

Liquidation Valuation, Replacement Value, LBO Analysis, Sum of the Parts, M&A Premiums Analysis, Future Share Price Analysis

When would you use a Liquidation Valuation?

In bankruptcy scenarios to see whether equity shareholders will receive any capital after the company's debts have been paid off. It is often used to advise struggling businesses on whether it's better to sell of assets separately OR try to sell the entire company

When would you see Sum of the Parts?

When a company has completely different, unrelated divisions- a conglomerate like General Electric

When do you use an LBO Analysis as part of your Valuation?

Whenever you're looking at a Leveraged Buyout- but it is also used to establish how much a PE firm could pay, which is usually LOWER than what other companies would pay

What are the most common multiples used in Valuation

EV/Revenue, EV/EBITDA, EV/EBIT, P/E, P/Book

What are some examples of industry-specific multiples?

Technology: EV/Unique Visitors, EV/Pageviews
Retail/Airlines: EV/EBITDAR
Energy: P/MCFE, P/NAV
REITs: Price/FFO, Price/AFFO

When you're looking at an industry-specific multiple like EV/Scientists or EV/Subscribers, why do you use Enterprise Value rather than Equity Value?

Because those metrics are available to all capital providers, not just equity holders

Would an LBO or DCF give a higher valuation?

Usually DCF, because it includes interim cash flows and terminal value, while LBO relies mostly on terminal value

What is internal rate of return (IRR)?

A measure of an investment's rate of return. It is the discount rate that makes NPV equal zero. If IRR exceeds the hurdle rate, the project is accepted