IBC Technical Flash Cards (W1)

lock in weirdo

What is IRR?

Stands for Internal Rate of Return. Essentially, the expected rate of return on the asset/investment. Also, the discount rate the NPV of Future FCF equal to 0.

How to make decisions with IRR.

If IRR>hurdle rate, this investment creates value for the firm. This means that the investment returns more than your cost of capital. If IRR< hurdle rate, this investment returns less than your cost of capital, destroying value.

What is the formula for WACC?

Cost of Equity*(Weight of Equity in Capital Structure) + Cost of Debt*(Weight of Debt in Capital Structure)*(1-Tax Rate)

How would you calculate weight of equity and weight of debt?

Equity: E/E+D
Debt: D/E+D

What is WACC conceptually?

WACC is the percentage return that companies must earn on investment to satisfy the collective demand of shareholders and debt holders.

What is the formula for Cost of Equity?

Risk Free Rate+ Beta(Equity Premium)

What is the formula for Equity Premium?

Market Return - Risk Free Rate

What is Beta?

Beta is the volatility of a stock or asset. It measures an asset’s return sensitivity to market returns.

What does a beta of 1 mean? What about 2? What about 0?

A beta of 1 means that an asset moves in line with the market return.
A beta of 2 means that an asset moves double the market return.
A beta of 0 means that an asset’s return has no correlation to the market return.

What is the formula for Cost of Debt?

Pre-tax borrowing rate*(1-T)

What is Cost of debt conceptually?

The required return on investment by lenders. This is interest.

What is cost of equity conceptually?

The required rate of return on investment by equity investors.

What is the Risk-Free Rate?

The risk-free rate is the theoretical return on investment on an investment with 0 risk.
In practice, this tends to be the 10-year treasury yield.

What is a purchase price multiple? Give an example.

A purchase price multiple is a multiple that relates the purchase price of the business, typically EV, to a financial metric like EBITDA. This is particularly helpful in comps analysis.

What is an accretive acquisition?

Post deal EPS is greater than standalone EPS

What is a dilutive acquisition?

Post deal EPS is less than standalone EPS

How do you know if an ALL STOCK deal is accretive or dilutive?

If it is an all-stock deal, if the acquirer’s EPS is greater than the target’s, then the deal will be accretive. If the acquirer’s EPS is less than the target’s, then the deal is dilutive.

How do you know if a CASH/DEBT deal is accretive or dilutive?

If the target’s earnings yield (NI/purchase price) is greater than the acquirer’s financing costs, then the deal is accretive. If the target’s earning yield is less than the acquirer’s financing costs, then the deal is dilutive.

You can do a full model using Pro Forma EPS

Walk me through the steps for a merger model analysis of accretion or dilution using the pro-forma EPS.

First, you find the pro-forma net income by adding the target NI to the acquirer NI plus synergies and subtract interest from new debt. Then calculate pro-forma shares outstanding. Divide pro-forma NI by pro-forma shares outstanding.
If that number is greater than the acquirer’s EPS, then the deal is accretive. Otherwise, it is dilutive.

What is EV/EBITDA?

It is a valuation multiple ratio. It measures a company’s value to its core operational profitability. It focuses on earning power from core business operations.

What is EV/EBIT?

It is a valuation multiple ratio. It measures a company’s value to its core operational profitability. Unlike EBITDA, it factors in D&A. You want to use this ratio with companies with high D&A or CapEx.

What is EV/Revenue?

It is a valuation multiple ratio. It measures a company’s value by its ability to generate revenue. You typically use this ratio with high-growth companies, or tech companies, which may not have a positive NI or EBITDA.

What is the P/E ratio?

Share Price/EPS. Tells you how much investors are willing to pay per dollar of earnings.

What is the P/B ratio?

Price to book ratio. Calculated by Share Price/Book Value of Assets. Shows how much money investors are willing to pay for one dollar of a company’s book value. Typically used for banks or insurance companies who may have volatile earning streams.

Go from EqV to EV

Start with Equity Value (# of diluted shares outstanding*share price) add NCI add preferred stock add debt and debt equivalents. Then subtract cash and cash equivalents.

What might be some common debt equivalents?

Pensions, operating leases, other fixed claims, debt-like provisions

Go from EV to EqV

Start with EV and add back cash and cash equivalents. Subtract debt, debt equivalents, preferred stock, and NCI. You are now left with EV.

Formula for FCF (short and long versions)

 NOPAT + D&A - ∆WC - CapEx - Interest(1-T)
OR
CFO-CapEx

What is NOPAT

Net Operating Profit after Tax
EBIT*(1-T)

What is FCF conceptually?

Cash a company generates after paying capital expenditures needed to maintain or expand its asset base

Formula for UFCF

NOPAT + D&A - ∆WC - CapEx 

What is UFCF conceptually?

 Cash flow available to all capital providers (debt + equity), reflects firms core operating performance independent of financing decisions.

What are the main difference between UFCF and FCF

FCF is just the value for equity holders as it is levered. Because of this, it is primarily used for equity valuation and dividends.
UFCF is value available for debt and equity holders. As such, it is used for WACC and DCF analysis.

Walk through the 5 steps of a DCF

1. Project Unlevered FCF for each future year

2. At year 10 (or final year) calculate the TV

3. Calculate WACC using the target capital structure

4. Use WACC to discount future FCF to present value

5. Calculate EV

Formula for the Perpetuity (Gordon Growth) method of calculating TV.

FCF of final year(1+growth rate)/(WACC-growth rate)

Explain the rationale behind the perpetuity method for TV

It assumes that cash flows after the projection period grow at a constant rate forever. It is based on assumptions, so it is more sensitive.

Formula for Exit Multiple TV method

Final year EBITDA*Multiple
The multiple is derived from the forward projections from comparable companies and averaged.

What is the earnings yield?

EPS/Share Price. What percentage of your investment in a company is being returned to you as earnings.

What two main items on the IS give you a tax shield?

Increase in depreciation expense and increase in interest expense.

What is intrinsic value?

Estimation of an asset’s value based on fundamentals like discounted future FCF — derives value from an inwards-looking perspective.

What is relative value?

Estimates an asset’s value based on peers using market multiples — outward-looking

What is CAPM and its formula.

CAPM is Capital Asset Pricing Model and is a way to calculate the cost of equity portion in WACC. Rf+Beta(Equity Premium). This estimates the expected return on the asset.

What is goodwill impairment?

When the book value of goodwill is greater than its fair value, meaning it needs to be written down.

What is the effect on the three statements with goodwill is impaired?

Written on the IS as an expense and decreases the value of intangibles on the BS.

What is ROIC and how is it calculated?

Return on Invested Capital. Calculated by NOPAT/Average Invested Capital

What is ROIC conceptually?

Measures how effectively a company generates profit from its invested capital base.

How do you calculate average invested capital?

(Total Equity + Total Debt) - Non-operating Cash and Investments

How do ROIC and WACC relate?

If ROIC > WACC, this signals economic profit and growth. Return on invested capital needs to be greater than the cost of capital.  

What is a sources and uses schedule.

Captures sources and uses of funding for one-time events like M&A transactions and LBOs. 

Total sources must equal total uses – there must be a funder for every piece of funding needed.

What is a TTM Multiple and its strengths?

Trailing Twelve Months Multiple.  Multiples like EV/EBITDA or P/E based on data from the last 12 months. Because it is historical data, it is less subjective. Better used for stable and mature firms

What is a forwards multiple and its strengths?

Multiples like EV/EBITDA or P/E based on future data for the next twelve months, typically. Can also be for a longer time horizon. Future looking so it is more growth forward, but subject to estimates. Better used for high-growth/tech sectors. 

What do you combine in a Merger Model

IS: Revenues and expenses, adjust for synergies, transaction costs, and any new debt used to finance the deal.

BS: Assets and liabilities, new goodwill, and any additional shares issued for the deal

Then you can figure out if the deal is going to be accretive or dilutive

XY Plot for WACC vs. Leverage: what happens?

It’s a U shaped plot. WACC initially decreases because debt is cheaper then equity and you get the tax benefits. Eventually bottoms out and leveraging too much raises the risk of default, which outweighs the tax benefits