Sources of market knowledge:
www.bloomberg.com
www.deal.com
www.financialnews.com
www.factset.com
Thompson One Banker
Capital IQ
Deal Focus
SEC10Q / 10K
TECHNICAL
What is GDP?
Definition
Gross Domestic Product (GDP) is the broadest measure of aggregate economic activity and
encompasses every sector of the economy.
Why Do Investors Care?
GDP is the all-inclusive measure of economic activity. Investors need to closely track the
economy because it usually dictates how investments will perform. Investors in the stock market
like to see healthy economic growth because robust business activity translates to higher
corporate profits. Bond investors are more highly sensitive to inflation and robust economic
activity could potentially pave the road to inflation. By tracking economic data such as GDP,
investors will know what the economic backdrop is for these markets and their portfolios.
The GDP report contains a treasure-trove of information which not only paints an image of the
overall economy, but tells investors about important trends within the big picture. GDP
components such as consumer spending, business and residential investment, and price
(inflation) indexes illuminate the economy's undercurrents, which can translate to investment
opportunities and guidance in managing a portfolio.
What are housing starts?
Definition
Housing starts measure initial construction of residential units (single-family and multi-family)
each month. A rising (falling) trend points to gains (declines) in demand for furniture, home
furnishings and appliances.
Why Do Investors Care?
Two words...Ripple Effect. This narrow piece of data has a powerful multiplier effect through the
economy, and therefore across the markets and your investments. By tracking economic data
such as housing starts, investors can gain specific investment ideas as well as broad guidance for
managing a portfolio.
Home builders usually don't start a house unless they are fairly confident it will sell upon or
before its completion. Changes in the rate of housing starts tell us a lot about demand for homes
and the outlook for the construction industry. Furthermore, each time a new home is started,
construction employment rises, and income will be pumped back into the economy. Once the
home is sold, it generates revenues for the home builder and a myriad of consumption
opportunities for the buyer. Refrigerators, washers and dryers, furniture, and landscaping are
just a few things new home buyers might spend money on, so the economic "ripple effect" can
be substantial especially when you think of it in terms of more than a hundred thousand new
households around the country doing this every month.
Since the economic backdrop is the most pervasive influence on financial markets, housing starts
have a direct bearing on stocks, bonds and commodities. In a more specific sense, trends in the
housing starts data carry valuable clues for the stocks of home builders, mortgage lenders, and
home furnishings companies. Commodity prices such as lumber are also very sensitive to housing
industry trends.
What is the current market scenario?
Why is inflation important?
Inflation directly affects the interest rate. The interest rate must be higher than inflation because
lending money is healthy for the economy. The core inflation rate gets rid of food, energy, and power
since these indicators fluctuate more in price. Some inflation (1-2%) is a sign of a healthy economy.
Interest rates drive markets. Bernanke is targeting inflation via the interest rates. Oil went up to 76, up
from the 30’s a year ago. Everything else like gas is also going up. They are trying to pass through
inflation through the consumers as the pricing power is still there. As long as the core inflation rate
doesn’t go up, people aren’t too worried about it. Stagflation is what people on the street are the most
concerned with (high interest rates without the growth in spending, similar to the 1970’s).
How does international trade flow affect the capital markets?
We currently have about a 650B per anum trade deficit. We are buying much more than we currently
sell. Foreigners are putting money back into the US to buy our assets, not just to invest. We can see this
happening in the currency as the strength of the USD is slowly collapsing. China is pegging the Yuwan to
the Dollar since they have a controlled economy. The Chinese currently have about 1 trillion USD in held
assets. They peg the Yuwan and hold it to the dollar on a very tight band. As soon as the international
community stops holding USD, the prices of US bonds drop, they stop buying bonds, and the U.S.
interest rates go up. People are watching the Chinese to predict the future flows. You will see it first in
the currency, and then in a decline in trades, etc. A trade deficit is not necessarily a bad thing if it is
offset by higher investment spending, higher consumer spending and government spending.
What do you think is going to happen to interest rates over the next year?
What is an inverted yield curve?
The answer is that long-term investors will settle for lower yields now if they think rates -and the economy -- are going even lower in the future. They're betting that this is their last
chance to lock in rates before the bottom falls out.
Our example comes from August 1981. Earlier that
year, Federal Reserve Chairman Paul Volker had
begun to lower the federal funds rate to forestall a
slowing economy. Recession fears convinced bond
traders that this was their last chance to lock in 10%
yields for the next few years.
As is usually the case, the collective market instinct was right. Check out the GDP chart
above; it aptly demonstrates just how bad things got. Interest rates fell dramatically for the
next five years as the economy tanked. Thirty year bond yields went from 14% to 7% while
short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year
was brutal (see chart below). Long-term investors who bought at 10% definitely had the last
laugh.
Inverted yield curves are rare. Never ignore them.
They are always followed by economic slowdown -or outright recession -- as well as lower interest rates
across the board.
What are some stocks that you follow?
What does an I-banker do?
I Banks assist public and private corporations in raising funds in the capital markets ( both equity and
debt), as well as in providing strategic advisory services for M&A. Provide financial advice to corporate
clients, especially on security issues and M&A deals. You prepare pitches for the client with the
expectation that you’ll be rewarded with a mandate when the client is ready to undertake a transaction.
Once mandated, I banks prepare all material for the deal and executes the deal (coordinate with
bidders, or negotiate with a merger target)
How do banks undertake risk?
Through Proprietary Trading which is done by a special set of traders who do not interface with clients
and through Principal Risk. This risk is undertaken by a trader after he buys or sells a product to a client
and does not hedge his total exposure.
What is a possible conflict of interest?
Equity researchers trading positive stock ratings for I Banking deal, or to initiate coverage on a company
in order to develop relationships that lead to highly profitable I bank business.
What are the capital markets?
Capital markets divisions are where traded financial products are born. Bankers here produce the core
financial products for companies and institutions looking to raise money. The two main products are
stocks, traded on the equity capital markets (ECM) and bonds, traded on the debt capital markets
(DCM).
What are the three basic ways to value a company?
The three most common ways to value a company:
Discounted Cash Flow (DCF) – “Intrinsic Valuation” The value of a firm is the present value of all future
unlevered (taking out the effects of capital structure, effects of taxes and debt) after tax, free cash flows.
A basic DCF involves forecasting free cash flow for the firm over a specific time horizon and discounting
these cash flows back at the weighted average cost of capital (WACC).
Free cash flow (FCF) is usually defined as:
Operating Income (also known as EBIT from the Income Statement) * (1-Tax Rate, 35-40%)
Plus: Depreciation and Amortization (or other Non-Cash Charges) (From the SCF – operations)
Less: Capital Expenditures (the expenditures necessary to maintain the required capital intensity) (From
the SCF)
Plus or Minus: Change in Net Working Capital (difference between beginning and ending WC. This is the
difference between current liabilities and current assets. Three components are inventories,
receivables, and payables)
Generally, you would forecast a FCF number for each year over a certain time horizon (usually 5 or 10
years) based on the company’s (management’s) projected long-range growth plan, and then attach a
terminal value (TV) for the firm. The TV represents the firm as a growing perpetuity. You can estimate
the TV one of two ways:
TV= Final Year FCF (1+g)/(r-g) (academic approach) (use GDP for the growth rate for a mature company,
and WACC for the r)
TV= Exit Multiple based on EBIT or EBITDA (real world approach)
For the TV, the company must be in steady state growth. The CAPEX must be equal to depreciation.
The future CF should also be a probability weighing of the potential outcomes.
The FCFs and the TV are then discounted back at the WACC. The WACC should reflect the financial risk
associated with the projected capital structure (based on a market value). This value is known as the
Enterprise Value. By subtracting out net debt (debt outstanding-less cash), you are left with an equity
value for the firm. The equity value divided by the number of diluted shares outstanding is the per share
value. (Whew!!!)
DCF results should be presented as a RANGE of estimated values, not a single estimate.
DCF tends to be overvalued because of projections by management.
Trading Comparables (Comps) – “Relative to peers” This method involves finding comparable (this can
be tricky) companies in the marketplace and determining at what multiple they trade to a variety of
factors. This is similar to the acquisition comparables except the multiples are derived from current
trading prices rather than the prices paid in change of control transactions. For example, if comparable
companies have firm values anywhere from 5x-10x EBIT, and the company I am valuing has $100 million
in EBIT, then the company could be worth anywhere from $500 million to $1 billion dollars. If you are
asked about this, the best way is to give a quick example like the one described above. Trading comps
are tough to find exact matches to your firm. You want to look at industry group, business mix,
geographic location, size, leverage, margins, growth prospects, and shareholder base. You have to get a
spread of different companies to get a rough estimate. Some common variables include enterprise
value, EBITDA, and EBIT. You can get the company comparables from the NAICS (North American
Industry Classification System) code, as well as from FactSet. You also want to make sure that you
identify “pure plays” or those companies that closely resemble the company you’re evaluating.
Using the appropriate multiple for the industry and the individual company to be valued will more
accurately reflect the true value of the enterprise.
Use of these comps will give you a TRADING VALUE. You will need to add a “control premium” to obtain
an ACQUISITION VALUE.
Acquisition Comparables – “Relative to other transactions” This approach is based on the principle that
similar assets should trade or sell at similar prices. These are acquisitions that happened in the past.
Such multiples represent an index of recent market prices paid by other acquirers and accepted by other
sellers. If comparable companies have been sold for 5x-10x revenues, and my company has $100 million
in revenues, then my company may be worth anywhere from $500 million to $1 billion dollars. This is
also tough to do because of the timing of deals. Something done during the tech boom, etc. will be
completely different than now. Also synergies are different because of control, and the extra premium
you pay. Was the comparable a hostile or friendly takeover? You then come up with a spread of
multiples: low, high, mean, median. Per share values can be obtained by dividing Equity Values by fully
diluted shares outstanding.
They key to comparable valuation is picking the right set of comps. Obviously picking companies in the
same industry is necessary, but also think about other factors such as: capital structure (companies who
use more leverage may trade differently than companies with all equity financing), size, seasonality, and
operating margins. Some common variables include enterprise value, EBITDA, and EBIT. Last twelve
months (LTM) EBITDA is the most common multiple used.
Synergies are often unique to the specific transaction so it is tough to compare.
Some common multiples include: Enterprise value/EBITDA, enterprise value/EBIT, enterprise
value/revenues, equity value/net earnings
It is important to consider all three approaches and to present a spread (football field: DCF, trading, and
acquisition comps) to the company being valued. Each approach has its advantages and disadvantages
in a particular case. Make sure to footnote all assumptions and make notes of all sources and
calculations.
Other valuation methods include liquidation value and Leveraged Buyout or “affordability analysis”
however, interviewers generally stick to the first three.
Which will place a higher value on the company, equity comparables or M&A comparables and why?
M&A comparables will be higher due to a control premium that must be paid and synergies expected to
be derived from the deal
What kind of multiples would you use to value a company?
Revenue/Total Market Cap, EBIT or EBITDA / Total Market Cap, Net Income, Price/Book Value
Enterprise value should be used for any financial results above the line, Equity value should be used for
below the line.
What is beta?
Beta is how sensitive the stock is to the market. It is the volatility of the individual stock in comparison
to the volatility of the total market. The market has a beta of 1, and stocks that have a beta less than 1
(Georgia power) are less risky than the market. Stocks that have a beta greater than 1 (tech and
internet companies) tend to be more risky in comparison to the market.
How do you unlever at beta?
BL = Bu * [1+(1-T)*D/E] (Hamada formula)
T = tax rate; D/E = debt/equity ratio
Unlevering Beta removes the benefit of leverage from performance. It allows you to compare assets on
apple to apple basis without regarding financial decisions.
How do you value a private company?
You would take a few similar public companies and unlever the beta to remove the impact from
financial risk. Then you would take the average and relever the betas.
What has a cheaper cost of capital, Equity or Debt?
Debt has the cheapest cost of capital. There are two reasons. First, using debt allows corporations to
deduct interest payments, which lowers the cost. Second, debt holders would be paid off before equity
holders in the event of liquidation, so the risk of not being paid back is less for debt holders than equity
holders. My general rule of thumb is that the more senior the claim, the lower the cost of capital. Here is
a breakdown of costs of capitals form lowest to highest.
1. Debt
2. Subordinated Debt (Mezzanine Debt)
3. Preferred Stock
4. Equity
How do you determine the Cost of Debt and Equity?
Debt- Does the company have any debt outstanding? If so, use the Yield to Maturity (YTM) on the bonds
as the cost of debt. If there are no bonds outstanding, look at comparable companies' YTMs. Preferred
stock can be found the same way.
Equity - use the Capital Asset Pricing Model (CAPM). If you don't know the Beta use the average
unlevered betas from a set of comparable companies, then relever the beta and then use this as the
“predicted beta” in the CAPM with the “target” capital structure given by the company’s management.
What is the CAPM?
CAPM stands for capital asset pricing model is the way in which we calculate our cost of equity. Rf +
Beta (market premium). Market premium is the Market rate – Risk Free Rate. (Rm - Rf).
What are the assumptions / limitations of the CAPM?
The assumptions of the risk-free rate that it is from the 10 yr (or associated) Treasury Note, and that the
U.S Treasury has never defaulted. Another assumption is the market rate for the risk premium. We
must ask ourselves what market return we should use? S&P500, Wilshire, DJIA, or the entire global
marketplace??
What is the Average Cost of Capital (WACC)?
WACC is the cost of capital for the firm, with a weighted amount of both equity and debt.
How do I determine the Weighted Average Cost of Capital (WACC)?
To determine the WACC, find out what percentage debt and equity are of the total capital structure and
multiply these numbers by your cost of debt (1-t) and your cost of equity.
For example:
Capital structure= 100, Debt= 50, Equity=50, Cost of Debt= 8%, Cost of Equity=12%.
The WACC is= .5*8%(1-T)+ .5*12
Note: Always use the MARKET VALUE of common equity and preferred stock, and the BOOK VALUE of
debt.
How do you estimate the cost of debt?
You can take the existing debt for the company or current yields on their bonds, from the footnote. If
they have no debt you can use LIBOR plus a spread (risk premium BBB about 2.5 % points). You can also
consult with the DCM group for a 10 year maturity on new issue rate at the credit rating corresponding
to the targeted capital structure. Finally, you can look at the yield on new issues of comparable
companies since the cost of debt is a function of the risks associated with a given business/industry.
How do I come up with debt to equity ratio if the company has no debt?
You would want to use the target capitalization structure projected by the management.
If my capital structure is optimized, what also should be optimized?
Return on Equity. Basically you have the optimal amount of equity to produce your net income.
What are some ways to defend against a hostile takeover?
Buyback the stock to increase the share price. Institute a “poison pill” to trigger to shareholders rights
plan that dilutes the takeovers ownership. “Ugly up” or lever up the balance sheet to take on more debt
and payout dividends. Stagger the board and election timelines. Create a “White Knight” to bring in
someone to come in and take over the company. Create a very expensive “golden parachute” for
current executives when they are released/fired that greatly affects the value of the firm.
Define cash earnings per share.
Cash Earnings=NI + Depreciation and Amortization + Deferred Taxes.
What is operating leverage?
Operating leverage is a percent of a company’s fixed costs versus variable costs.
A company is listed as an ADR on an American exchange. The ration of shares on the home exchange
to ADR shares is 6 for 1. If the ADR earnings per share is $6 what is the EPS for a share listed on the
home exchange?
$1, treat as if a 6 for 1 stock split occurred.
Suppose you have a company where EBITDA has been rising for the past several years and that
company suddenly declares bankruptcy, name some reasons for why that could have happened?
Companies declare bankruptcy because they have no cash (liquidity crunch); the best answer would be
to walk down the cash flow statement and describe how each of the sections could contribute to a
bankruptcy filing:
- Working capital crunch (receivables could be rising; could be getting pushed on payables; might be
required to build significant inventory)
- Capex requirements could be large (ie telecom)
- Might not be able to refinance a maturing issue
- Litigation (ie Philip Morris posting tobacco bond)
What are some common coverage ratios?
Coverage ratios measure a company’s ability to meet its debt obligations. EBITDA/Interest, EBITDA –
CAPEX/Interest, EBIT/Interest
What multiples might you use to value Google and Georgia Power?
Since Google is a tech company and is equity driven you would use equity value multiples (below the
line). Since Georgia Power is a utility company it has higher debt and CAPEX so you would consider
multiples of Enterprise Value (above the line).
What is the current ratio?
The current ratio is current assets/current liabilities. This is the firm’s ability to repay short-term
obligations using short term assets, and measures a company’s liquidity.
What is the quick ratio?
The quick ratio is similar to the current ratio but you subtract inventories from current assets. Current
assets – Inventory / Current Liabilities.
What is the difference between enterprise value and equity value?
Enterprise value is the value available to both the equity and debt holders (equity value + net debt) –
use with revenue, EBITDA, and EBIT. It is the value of the entire firm.
Equity value is the value of the company available to the equity holders – use with net income, book
value.
Equity value (market value) = shares outstanding x current stock price. Latest shares outstanding should
be taken from the cover page of the latest 10K/Q.
Equity Value multiples: (below the line, just equity)
Applicable only to equity shareholders
Equity value/net income, equity value/book value, price/EPS, PE/growth rate
How do you calculate the enterprise value of a firm?
Enterprise Value = Equity Value (i.e. shares outstanding under Treasury method * price) + net debt
(debt* – cash) + preferred stock + minority interest
*Use market value of debt.
Enterprise Value multiples: (above the line, includes debt)
Applicable to ALL capital holders
Enterprise value/sales, enterprise value/EBITDA, enterprise value/EBIT
If no debt is assumed, Equity Value and Enterprise Value will be equal.
What is EBIT?
Earnings Before Interest and Taxes. EBIT is the income stream available to all investors (including debt
holders and preferred shareholders). It is the income from operations before the effects of the
financing and taxes. It is also the income that is independent of capital structure.
From the income statement, it is defined as: Gross profit (sales minus COGS) – SG&A – Depreciation and
Amortization – Any other recurring operating expenses = EBIT (also know as “the line” or operating
income)
When calculating EBIT using this method, use Dep and Amort from the Income Statement (if available)
How do you back into your EBIT?
EBITDA less depreciation less amortization. (This is most often the same as operating income.)
How do you come up with a company’s EBITDA?
EBIT + Depreciation and Amortization (taken from the Statement of Cash Flows).
If a company is considering an all-stock acquisition, what is the easiest way to determine (roughly)
whether or not the acquisition will be accretive or dilutive?
The quick way is to look at P/E multiples. If the acquirer's P/E is higher than the target's, the acquisition
will likely be accretive and vice versa. For instance, if the acquirer's P/E is 20, and the target's is 10, then
you are able to pay less per dollar of earnings for the target.
What is accretion/dilution analysis?
This is the affordability analysis and the price the acquirer is able to pay. If the after tax costs are
greater than the after tax benefits, the transaction is dilutive. Also, if PE ratio of the target company is
greater than the acquirer, the deal is dilutive. It will cost more per dollar of earnings to acquire the
company. You are essentially paying with a “lower valued” currency in this case, and more shares are
issued.
Companies with high P/E ratios like to use stock for an acquisition since they are getting an accretive
deal.
Why might a company buy back its own stock?
When a company feels the stock is undervalued and believes it can make money by investing in itself.
You are looking at acquiring a company, but that company has a negative book value of equity. Is this
a big deal?
You would want to see why the BV of equity is negative, and there could be several reasons:
- Could be from negative net income over the past several years - this might a problem from an
operational perspective
- Might be due to a write-down of assets - would want to understand this but might not be as bad a
recurring negative net income
- Firm might have levered up to issue a large dividend - will leverage be an issue going forward?
Briefly walk through a discounted cash flow analysis. (including WACC)
First, you want to calculate free cash flow for a certain period of time (generally five or ten years). To
calculate free cash flow, start with after-tax EBIT and then add back D&A, subtract CAPEX and
add/subtract and decrease/increase in working capital.
Next, you want to determine the appropriate discount rate for the cash flows, the WACC. The cost of
debt is determined using the current yields on the company's existing debt issues (where bonds are
trading) and tax affecting them. The cost of equity is generally determined by CAPM (ie risk-free rate
plus company's beta multiplied by the equity risk premium). WACC=D/(D+E)*(1-T)*Kd + E/(D+E)*Ke
Next, you would calculate a terminal value for the firm either using a multiple of EBITDA or a perpetuity
growth rate on the firm's free cash flow.
- Multiple Method - Multiply the final year's EBITDA by an appropriate EBITDA multiple for the firm
(based on comparables)
- Perpetuity Growth Method - multiply the final year's free cash flow by (1+growth rate) and divide that
by (r-g)
You would next calculate the PV of the terminal value
Next, you would determine the PV of the free cash flows for the given period (dividing the cash-flows by
WACC)
Finally, you would add the PV of the terminal value to the PV of the free cash flow to determine the
value of the firm
If you are going to graph a company's cost of capital, with the cost on the Y-axis and with the
company's leverage level across the X-axis (from 0% leverage to 100% leverage), what would the
graph look like?
It would look approximately like a smile; the cost of capital would initially decline as you add leverage,
however as the firm becomes increasingly levered, the cost of capital would increase due to bankruptcy
risk
Why would two companies merge? What major factors drive M&A?
Synergies (revenue - cross-selling; expenses - cost cutting); could exploit economies of scale, common
distribution channels, elimination of a competitor, etc., defensive (do not want someone else to acquire
them), enter new geographic markets. The point of a merger is to increase shareholder value above the
value of the two companies independently. You can have conglomerate, horizontal, and vertical
mergers.
Why not merge?
Because of a lack of synergies, clash of corporate culture, and creation of anti-trust issues with the FTC.
Why might a firm choose debt over equity financing?
Assuming the firm has the ability to take on additional leverage without damaging its creditworthiness,
the firm might choose this in order not to dilute ownership; also, up to a reasonable level, debt can be
seen as having a lower cost than equity. It can benefit from tax shields. Also if the firm has immediate
steady CF and is able to make their interest payments.
Why would a company issue stock rather than debt to fund its operations?
If the company believes the stock price is inflated. When the project the capital is being raised for might
not produce predictable CF in the immediate future. The company has no access to the debt capital
markets. If the company wants to change is D/E ratio
If you believe interest rates will fall, should you buy or sell bonds?
Buy, because bond prices rise as interest rates fall. The reason for this is that outstanding bonds with
fixed rate coupons which are paying interest at a set rate react to interest rates. When interest rates go
down, these bonds are still paying interest at the same fixed rate. Thus, they become more valuable
because interest rates in the market are going down, so the value of these bonds go up.
What are some drivers of share value?
Projected earnings growth or decline, cost of equity or debt, expected time horizon of growth or decline,
and capital efficiency.
Walk me through your thought process on opening up a new coffee shop in Decatur.
You would first take a look at the strategy decisions (location, foot traffic, competitor analysis). You
would then determine how to finance your operation. You would then determine how to price your
products that you’re going to sell. You would then determine how best to use the cash on your balance
sheet. Finally, you would determine the value of your company and if you should sell it off, or acquire
other companies.
What do I do with excess cash on the balance sheet?
Pay out dividends (you must commit to doing this indefinitely, as it is tough to retract, though the
company will begin to be valued differently), buy back stock (looks good on a temporary basis and
investors think the share price is undervalued so it is a perceived confidence), pay down debt, acquire
competitors, and reinvest in the business. There is currently LOTS of excess cash within companies.
Why might it be negative to have too much cash on the balance sheet?
Too much cash will lower the enterprise value of the firm since TEV = equity value + debt – CASH +
minority interest + preferred stock.
Would I offer to buy a company at its current stock price?
Usually not, because there is usually a control premium above and beyond the current value of the
stock.
Who is Ben Bernanke and what does he do?
Chairmen of the Federal Reserve Bank that is responsible for setting monetary policy (discount lending
rate). The fed reserve releases money and pulls money back in through the overnight lending rate. This
is done to fight inflation or otherwise control or stimulate the economy by controlling the availability of
spending money to companies and consumers.
Where do you get credit ratings?
Fitch, Moody’s, and S&P.
What corporate bond would have a higher coupon, AAA or BBB?
BBB
How do you value a company that is not CF positive, has no public comps, nor any acquisition comps?
Look at distribution, production methods of other companies and see if you can find any operational
similarities. (i.e. find value drivers and see if there are companies that could be comps). You can also
make reasonable assumptions about projected revenues and CF for future years.
Give me an example of a coverage ratio?
EBITDA/interest expense: shows ability of the firm to generate sufficient cash flow to cover fixed
charges (this is also a good ratio for LBO analysis to determine how much debt the company can take
cover); (EBITDA-CAPEX)/interest expense: shows ability to cover interest expense after spending for
CAPEX
Why might a company go public?
An IPO means that the company has a public currency, can more easily undergo M&A, and it will reduce
future borrowing costs.
What is an LBO?
An LBO is an acquisition that is funded primarily with debt. There tends to be a “leverage” of 5-7x
EBITDA. The value is created primarily through “de-leveraging” as strong cash flows are needed to pay
down the debt. An LBO analysis is typically what a “financial sponsor” can afford to pay. LBO investors
get a substantial benefit from a tax shield on debt. LBO investors enhance the returns by earning the
spread between the interest expense and the cash on cash return.
What types of companies make good LBO targets?
Has predictable, stable operating CF; mature, steady industry; well-established products; limited capex
and product development expenses; undervalued or out of favor; owned by a motivated seller; not
highly levered.
Why are LBO’s so prominent right now?
LBO’s are a strategic move to make some money via the tax shield on debt, because of the cost of public
companies because of SOX, there is a lot of private money in the market right now, and interest rates
are still historically very low. PE firms are looking at EBITDA multiples in 7’s when they used to be in the
5’s. PE firms really lever up companies and take them private because they aren’t regulated by how
much debt they have (unlike public companies). Although they have higher risk, they have a very high
return as well. Some are over 20% returns in their first year, although many are predicting a 7-8%
default rate.
Conglomerate X has a significant amount of debt maturing next year. With debt markets still tight,
what options does the company have?
If the company does not have excess cash, it could sell some of its assets (but would lose cash flow from
that unit) or issue equity (these are the two primary answers)
How would you value the naming rights of a stadium?
You could look at comparables (adjusting for market differences, football, concerts, demographics, TV
rights, size of stadium) to get the intrinsic value; you would then think about market specific details and
willingness to pay of potential buyers (key points understand valuation is based on intrinsic value and
willingness to pay).
How would a stock split affect the P/E ratio of a company?
It would not affect the P/E ratio since it doubles the number of shares. The price is divided by two as
well as the earnings.
Talk me through what happens when you purchase a plant?
In an all-cash purchase, in the first year your cash will decrease, PPE increases (balance sheet), and
CAPEX increases (SCF).
If you finance the acquisition, PPE increases, and your Notes Payable Increases. Also CAPEX will increase
(SCF).
At the end of the year, your PPE decreases because of your increase in Accumulated Depreciation.
What is a convertible bond?
A bond which the holder may convert to a set number of shares of common stock
What is an investment grade bond?
A bond judged likely enough to meet payment obligations that banks are allowed to invest in it. Ratings
of AAA, AA, A, and BBB by S&P, and ratings of Aaa, Aa, A, Baa by Moody’s
What is a junk bond?
A high yield bond that is below investment grade. They are generally unsecured.
What is “real” interest rate?
Nominal rate of interest – Expected inflation
What is Gross Profit Margin?
Gross profit / sales
What is return on equity (ROE)?
Net income / equity
What is the P/E ratio?
Price per share of common stock / earnings per share
Bonds:
Par bond: Issue price = par value. Market rate @ issuance = coupon rate
Discount bond: Issue price < par value. Market rate @ issuance > coupon rate
Premium bond: Issue price > par value. Market rate @ issuance < coupon rate
What is the Yield to Maturity of a bond?
YTM refers to the discount rate at which the present value of the bond is equal to its current market
price and represents the rate of return.
Accounting Questions
How do the 3 financial statements relate?
Income Statement: The NI flows to RE on the BS and to CFO on the SCF. The IS represents a company’s
operating performance over a specific period of time.
Balance Sheet: The BS records all of the firm’s assets and the claims against those assets. The residual
value is called shareholders equity. The debit/credit system assures that the BS always balances. The BS
records all items from the IS that did not generate cash as an asset or liability. The cash balance is taken
from the SCF.
Statement of Cash Flows: The SCF ties all 3 statements together. It must reflect ALL changes of the
balance sheet accounts. When preparing a financial model, the ending cash balance from the SCF flows
to the BS and thus completes the loop to make it balance.
Walk me through the Income Statement:
Sales (Revenues) – COGS = Gross Profit. Gross Profit – SGA = EBIT (Operating Income). Operating
Income – Interest and Taxes = Net Income (bottom line). This NI moves to RE on the BS and CFO on the
SCF.
What are the 3 sections of the Statement of Cash Flows?
Operating: NI + Depreciation +/- changes in A/R, Inventory, A/P
Investing: CAPEX
Financing: Increase in debt
Total change in cash + beginning cash = Ending Cash (goes back to the BS for the starting cash on the
next periods BS)
What are three events that reduce retained earnings?
1. Treasury stock purchase. 2. Net Loss. 3. Dividend payment.
What are the first three items on a Statement of Cash Flows?
Net income, depreciation and amortization, add backs
Why does cash flow matter?
Change in accruals
What is book value?
Assets - liabilities
Construct an accounting cash flow statement. Define the sections of the statement and detail the
components of each section.
The three parts of a cash flow statement are Operating Activities, Investing Activities, and Financing
Activities. A basic cash flow statement looks something like this:
+ Operating Activities: Net Income +Non-Cash Charges + Change in current accounts other than cash (for increases in Current Assets, + for increases in Current Liabilities) = Cash Provided by Operating
Activities
+ Investing Activities: -Capital Expenditures = Cash Provided by Investing Activities
+ Financing Activities: + Issue of Common Stock - Dividends = Cash Provided by Financing Activities
= Net increase (decrease) in cash balance +Beginning Cash Balance =Ending Cash Balance
What are the effects of FAS 141 and 142?
FAS 141 - all acquisitions accounted for under purchase method; FAS 142 - no amortization of goodwill
or indefinite life intangibles. Amortize finite life intangibles, such as patents. Goodwill should be tested
for impairment on an annual basis.
If you are in a business that wants to preserve cash, what type of inventory accounting method would
you use (LIFO or FIFO) in a time of rising prices, and why?
You would use LIFO because that would give you a higher cost of goods sold and would, thus, lower your
pre-tax income and reduce the amount of taxes owed.
What is a deferred tax liability (asset)? (The mother of all interview questions, can be a deal-maker if
you nail it)
Deferred tax liabilities (assets) arise in periods when temporary timing differences between tax and
financial reporting cause taxable income to be different from net income on the income statement.
Deferred tax liabilities (assets) represent expected increases (decreases) in the taxes payable in future
periods when these temporary timing differences reverse- at which time the deferred income tax
liabilities (assets) are written off the books.
What is the difference between the income statement and statement of cash flows?
Income statement is a revenue and expense record. The “bottom line” of the Income Statement is the
company’s earnings for the period.
The SCF is the actual cash that has come in or left the firm – consists of CF operating, investing, and
financing activities. You can have a profit on your IS, but can still go bankrupt if you don’t have cash to
make your interest payments.
What’s the link between the BS and IS?
Profit (income) generated on the Income Statement is added to SHE as RE on the BS
What is the link between the SCF and the BS?
The beginning cash on the SCF is derived from the BS. Also, to find out the changes in the CFO like
accounts payable, receivable, etc, these come from the BS. The increase or decrease in cash flow from
the prior year goes back to the BS for the next year.
What is EBITDA?
Earning before interest taxes, depreciation, and amortization.
Where is CAPEX located?
CAPEX is located on the Cash Flow from Investing on the SCF.
What is MD&A and what does it tell us?
MD&A is the management discussion and analysis and it tells us the “state of the business”. It includes
the management’s expectations and projections for future years.
What is accrual accounting?
Accrual accounting recognizes income when it is earned and expenses when they are incurred, rather
than when they are received or paid. For example, sales on credit would be recognized as revenue,
even though the debt may note be settled for some time.
Where can you find depreciation expenses in a company’s financial statements?
Depreciation is often found as a separate line item on the income statement or can be coupled with
other costs and included in the line item COGS. If it is not separately identified, you can find the exact
depreciation expense in the SCF or in the footnotes of the financial statements.
Other Questions
You won a contest that paid you one chocolate bar every day for the rest of your life. The IRS intends
to tax you for this prize, but is looking to you to justify the tax basis that you feel is appropriate for
this prize. What amount do you report for tax purposes?
This is nothing more than a valuation question. The chocolate contest scenario is intended to see if you
really understand the concepts involved in valuation of a stream of cash flows. There are questions to
ask such as 1) Can you use an average life expectancy?, 2) Will that expectancy be lowered by excessive
chocolate intake?, 3) What is the value of a candy bar?, etc.... After the parameters had been fairly
established, my answer eventually ended in a discussion of what is the appropriate cost of capital with
which to discount this chocolate-flow. Is it better to use a high cost of capital or low cost of capital?
Since you are looking to minimize the valuation (thereby lowering your tax basis) you would likely
choose the higher personal cost of capital. This will return a lower tax basis in present value. When
asked how to justify a high cost of capital, you can talk about the relative risk of your various
investments or internal rate of returns. Creativity is key in this discussion. I believe the interviewer was
looking for three things: 1) Do you understand valuation concepts and the mechanics involved?, 2) Can
you ask the right questions to frame the parameters of the valuation?, and 3) Do you understand the
meaning of cost of capital and risk?
What is 7^3 ? (Definitely a Sales & Trading type question)
The wrong way to answer this question is to try to think quietly and determine what 49*7 is in your
head. They want you to think out loud so they understand your thought process. The best way to do it is
to say " 7*7 is 49. And 7* 50 is 350, so by subtracting 7, I get 343. Try to think of other numbers where
this would work.
What is 6/7ths ?
Answer like the last one. 1/7th is approximately 0.14, and six times 14 is 84, so the answer is
approximately .84. Getting the answer right to the fifth decimal place is not what they are testing. Make
sure you know all the 8ths and 16ths too (i.e. 1/8th is .125).
How much would it cost to fill the Statue of Liberty with liters of Vodka?
Yes, I was actually asked this once. Try to break it down into pieces. Your numbers don't have to make
sense, it's just your thought process. The statue of Liberty is X high by Y wide by Z deep. From that you
can calculate a volume. Approximate how many liters that would be and then decide how much a liter a
vodka costs.
What is the current unemployment rate?
What was the lead story on the front page of the WSJ summary section today?
What kind of effect will the rise in oil prices have on the U.S. economy?
Can you describe the shape of the yield curve currently?
Where are the Dow, Nasdaq, and S&P 500 trading currently?
Where are 10-year Treasury’s trading?
Where is the Federal Funds rate?
Where is 3-month LIBOR?
Where is the dollar versus the Yen and Euro?
What is the P/E ratio and why do analysts use it?
Describe some deals you have recently read about in the news
Which of the three financial statements would you choose to value a company if you had to choose
only one?
What are some common anti-takeover tactics?
If using equity, what alternatives are there to using common equity?
What is the typical transaction process?
Say you have two high yield bonds with identical coupons and maturities, one from a supermarket
and one from a high tech company. Which one do you buy and why?
Which would you prefer: a bond or mortgage?
Describe the difference between issuing a bond at par, discount or a premium
Company A wants to buy Company B for $400m, the max they think it is worth, Company B wants
$430m. Company A could use stock v. cash for the additional $30m. Under what circumstances might
Company A agree to the additional $30m?
Calculate the firm value for the firm described below using to valuation techniques
Shares outstanding 100,000
Stock price $20
Debt $500,000
Cash and equivalents $500,000
What did our firm's stock close at yesterday?
What is LIBOR?
What indicators will be considered by Bernanke when deciding on interest rate changes?
If I gave you $1 for 10 years or $1000 today which one will you choose?
Now if I gave you $1 everyday for life and $1000, which one would you choose?
If you have closed the books of accounts and now you discover that $10 of depreciation expense was
left out, how would you go about changing the Income Statement and Balance Sheet?
What is goodwill? How does it affect net income?
What is working capital?
Who is in the bulge bracket?
What is minority interest?
If it is 1:15 pm, how many degrees are between the two clock hands?
What is a P/E (Price/Earnings) ratio and why do analysts use it?
If I have a company with three divisions, and one of the divisions is underperforming, which leads to
the stock price depression of the entire firm. What five things could I do to improve the firm's stock
price?
Of all your classmates, how many are truly qualified to do this job?