LBO MODELING EXAM FROM WALL STREET PREP
EXAM QUESTIONS WITH 100% CORRECT ANSWERS
"What is the impact of share issuance on EPS? - CORRECT ANSWER The major impact to EPS is that the actual share count increases, thereby decreasing EPS. However, there is sometimes an impact on net income. That's because assuming share issuances generate cash for the company, there will be higher interest income, which increases net income and EPS slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the negative impact to EPS from a higher share count."
"What is the impact of share repurchases on EPS? - CORRECT ANSWER The major impact to EPS is that the actual share count is reduced, thereby increasing EPS. However, there is sometimes an impact on net income. That's because assuming share repurchases are funded with the company's excess cash, any interest income that would have otherwise been generated on that cash is no longer available, thereby reducing net income - and EPS - slightly. Because returns on excess cash for most companies are low, this impact is usually very minor and doesn't offset the positive impact to EPS from a lower share count."
"How do you calculate earnings per share? - CORRECT ANSWER Earnings per share (EPS) is calculated as net income divided by the company's weighted average shares outstanding during the period.
There are two ways to measure EPS - Basic and Diluted. Basic
EPS is net income divided by the actual shares, while Diluted EPS is net income divided by actual shares and shares from potentially dilutive securities such as options, restricted stock, and convertible bonds or stock."
"How do operating leases affect the three financial statements? - CORRECT ANSWER Under US GAAP, companies can choose to account for leases as operating or capital leases.
Operating leases primarily only impact the income statement. When leases are accounted for as operating leases, lease (rent) payments are treated as operating expenses like wages and utilities: Regardless of whether you sign a 1-year lease or a 30-year lease, every time you pay the rent, cash is credited and an operating expense is debited.
The only significant balance sheet impacts have to do with timing differences between payments (prepaid and accrued rent) and the matching of rent payments to when the tenant benefits from that rent (leading to balance sheet accruals for smoothing of rent escalations and upfront rent incentives like a free month). Starting in 2019, operating leases will no longer be allowed under US GAAP."
"How can a profitable firm go bankrupt? - CORRECT ANSWER To be profitable, a company must generate revenues that exceed expenses. However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it is unable to get favorable terms from suppliers and must pay cash for all inventories and supplies, what can occur is that despite a profitable income statement, the company suffers from liquidity problems due to the timing mismatch of cash inflows and outflows.
While reliably profitable companies who simply have these working capital issues can usually secure financing to deal with it, theoretically, if financing becomes unavailable for some reason (the 2008 credit crisis is an example where even profitable companies couldn't secure financing), even a profitable company could be forced to declare bankruptcy."
"How should increases in inventory get handled on the cash flow statement? - CORRECT ANSWER Increases in inventory, as well as any other working capital assets, reflect a usage of cash and should thus be reflected as an outflow on the cash from operations section of the cash flow statement. Conversely, increases in working capital liabilities represent a source of cash and should be presented as an inflow in the section."
"Do inventories get captured on the income statement? - CORRECT ANSWER There is no inventory line on the income statement, but it does get captured, if only partially, and indirectly in cost of goods sold (and potentially other operating expenses).
For example, COGS is recognized on the income statement during a period, regardless of whether the associated inventory was purchased during the same period. That means that a portion of the COGS line on the income statement will likely reflect a portion of inventory used up. That's why the other two financial statements are better for understanding what is happening to inventory. Specifically, the cash flow statement shows the year-over-year changes in inventory, while the absolute balance of beginning and end-of-period inventory can be observed on the balance sheet."
"How does selling a building impact the 3 statements? - CORRECT ANSWER If I sell a building for $10 million that has a book value of $6 million on my balance sheet, I will recognize a $4 million gain on sale on the income statement which will - ignoring taxes for a moment - increase my net income by $4 million.
On the cash flow statement, since the $4 million gain is non-cash, it will be subtracted out from net income in the cash from operations section. In the investing section, the full cash proceeds of $10 million are captured. On the balance sheet, the $6 million book value of the building is removed, while retained earnings increases by $4 million. The net credit of $10 million is offset by a $10 million debit to cash that came from the cash flow statement.
Stop here for non-finance students. Business students should expand as follows:
The gain on sale will also however result in higher taxes. Assuming a 25% tax rate, I will pay $1 million in additional tax - 25% of $4 million - which will be recognized on the income statement. This lowers retained earnings by $1 million and is offset by a $1 million credit to cash."
"What are the financial statements you'll typically find in a 10K? - CORRECT ANSWER You will find an income statement, cash flow statement, and balance sheet. Those are the three core financial statements. In addition, companies also include a statement of shareholders' equity and statement of comprehensive income."
"What are some common equity multiples? - CORRECT ANSWER P/E, Price/Book, Equity/Levered Cash Flows."
"Why might one company trade at a higher multiple than another - CORRECT ANSWER Superior fundamental performance such as better growth prospects, higher return on invested capital, lower cost of capital (WACC), stronger cash flows."
"What's included in net debt? - CORRECT ANSWER Net debt includes all types of debt - short-term and long-term, loans and bonds. It includes other non-equity financial claims such as preferred stock and non-controlling interests. From this gross debt amount, cash and any other non-operating asset such as short-term investments and equity investments should be subtracted to arrive at net debt."
"Can a company have negative net debt? - CORRECT ANSWER Yes. Negative debt simply means that a company has more cash than debt. For example, Apple and Microsoft have massive negative net debt because they hoard so much cash. In these cases, companies will have enterprise values lower than their equity value.
Note: If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise value just represents the value of a company's operations - which excludes any non-operating assets. When you think of it this way, it should come as no surprise that companies with a lot of cash (which is treated as a non-operating asset in the prevailing definition of enterprise value) will have higher equity than enterprise values."
"Assume a company has ROA of 10% and a 50/50 debt-to-equity capital structure. What is the ROE? - CORRECT ANSWER Return on assets = net income/average assets, while return on equity = net income / average equity. Imagine a company with $100 in assets. An ROA of 10% implies $10 in net income. Since the debt/equity mix is 50/50, the return on equity is $10/$50 = 20%.
Q."
"Define free cash flow yield and compare it to dividend yield and P/E ratios. - CORRECT ANSWER Free cash flow (FCF) yield = FCF/share price (FCF is defined as cash from operations - capital expenditures). For the purposes of this calculation, FCF is usually defined as cash from operations less investing activities.
FCF yield is similar to dividend yield (dividend per share/share price) as both are a way to gauge equity returns relative to a company's share price. Unlike dividend yield, however, FCF yield is based on cash generated, as opposed to cash actually distributed.
As a measure of fundamental value, FCF yield is more useful because many companies don't issue dividends (or an arbitrary fraction of their free cash flows). If you flip the FCF yield you get share price/FCF, which produces a cash flow version of a P/E ratio. This has the advantage of benchmarking price against actual cash flows as opposed to accrual profits. It also, however, has the disadvantage that cash flows can be volatile and period specific swings in working capital and deferred revenue can have a material impact on the multiple."
"Why might two companies with identical growth and cost of capital trade at different P/E multiples? - CORRECT ANSWER Growth and cost of capital are not the only drivers of value. Another critical component is return on invested capital. All else equal, if one of the companies has a higher return on equity, you would expect its PE ratio to be higher.
Other reasons may include relative mispricing or inconsistent calculations of EPS due to things like nonrecurring items and different accounting assumptions."
"Should two identical companies but with different rates of leverage trade at different EV/EBITDA multiples? - CORRECT ANSWER You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a company's value and profits independent of its capital structure. Technically, they will not be exactly equal because EV does depend on cost of capital so there will be some variation"
"How would you evaluate the buy vs. rent decision in NYC? - CORRECT ANSWER In order to do a proper comparison, let's assume that I have enough upfront capital to make a down-payment, otherwise obviously I have to rent. Let's also assume the investment period is 10 years.
Assuming I buy, during this investment period I have to pay monthly mortgage, real estate tax and maintenance fees (which will be offset by some tax deductions on interest and depreciation).
I assume I'll be able to sell the property at a price that probably reflects the historical growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow due to a sale, I can calculate my IRR.
I would then compare this IRR against the IRR from renting as follows: First, I would estimate the rental cost of a comparable property, factoring in rent escalations over a 10-year period. In addition, since I don't have an initial down-payment to make, I would put that money to work elsewhere - say as a passive investment in the stock market. I would assume an annual return over the 10-year period consistent with the historical long-term return on the stock market (5-7%). I would then be able to calculate an IRR based on these inflows and outflows and compare the IRRs and make a decision.
Of course, I would keep in mind that this comparison isn't perfectly apples to apples. For example, investing in a NYC property is riskier than investing in the stock market due to the leverage and the lower liquidity. NYC real estate is liquid but not as liquid as public stocks. For example, if I get two identical IRRs, I would probably go with renting, since it wouldn't appear that I'm being compensated for the added risk."
"What's the difference between levered FCF (FCFE) and unlevered FCF (FCFF)? - CORRECT ANSWER Unlevered FCF represent cash flows a company generates from its core operations after accounting for all operating expenses and investments. To calculate those, you start with EBIT which is an unlevered measure of profit because it excludes interest and any other payments to lenders. Then you tax effect EBIT and add back non-cash items, make working capital adjustments and subtract capital expenditures.
By contrast, levered FCF represent cash flows that remain after payments to lenders including interest expense and debt paydowns are accounted for. These are cash flows that belong to equity owners. Instead of starting with tax effected EBIT, you start with net income, add back non-cash items and make working capital adjustments, subtract capital expenditures and add cash inflows or outflows for cash from new borrowing, net of dept paydowns."
"Contrast the DCF approach to comps. - CORRECT ANSWER The DCF values a company based on the company's forecasted cash flows. This is viewed as the most direct and academically rigorous way to measure value, but it suffers from several drawbacks, most notably that it is very sensitive to assumptions which makes it easily to manipulate.
Comps, on the other hand, values a company by looking at how the market values similar businesses. Comps relies much more heavily on market pricing to determine value than the DCF. While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced in an acquisition, it is vulnerable to two criticisms - 1) The market isn't always right and therefore a comps analysis is simply pricing, as opposed to valuing a business and 2) There are very few truly comparable companies so you're in effect always comparing apples and oranges.
Because both approaches have drawbacks, both approaches are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa). For example, an analyst valuing an acquisition target will look the premiums and values paid on comparable transactions to determine what the acquirer must realistically expect to pay. But in addition, the analyst may value the company using the DCF to help show how far off the "intrinsic" value the market prices are. Another example of how these two valuation approaches are used together is when an investor considers investing in a business - the analyst may identify investing opportunities where comps-derived market values for companies are significantly lower than valuation derived using a DCF (although it bears repeating that the DCF's sensitivity to assumptions is a frequent criticism of its usefulness)."
"How do you calculate the terminal value? - CORRECT ANSWER There are two common approaches for calculating the terminal value:
Growth in perpetuity
Exit multiple approach.
The growth in perpetuity approach calculates the terminal value by assuming a perpetual growth rate on cash flows after the stage 1 forecast period, and inserting this assumption into the perpetuity formula:
Terminal value = Unlevered Free cash flow / (WACC - long term growth rate)
When doing a levered DCF, the perpetuity formula would be:
Terminal value = Levered Free cash flow / (Cost of equity - long term growth rate)
The exit multiple approach calculates the terminal value by applying a multiple assumption on a financial metric in the terminal year (usually EBITDA). The multiple should reflect the multiple a comparable company in a mature state would expect to trade at to reflect the fact that the company should theoretically be in a normalized mature state at the terminal year. Under both approaches, the terminal value represents a present value in the terminal year and thus both approaches need to discount the terminal value back to the valuation date."
"How would you handle stock options when calculating a company's share count? - CORRECT ANSWER Companies often issue stock options. The common convention is to include in the dilutive share count any vested (exercisable) options whose strike price is below the current share price ("in the money").
In addition, any option proceeds that the company would receive from the exercise of these options are assumed to be used by the company to repurchase shares at the current share price (called the treasury stock method).
Some finance professionals use all outstanding in the money options (not just the vested in the money ones) to perform the analysis, the logic being that any options that are still unvested will be vesting soon and since they are in the money it is more conservative to include them in the share count (we agree with this view, by the way)."
"How should operating leases be treated in a DCF valuation? - CORRECT ANSWER They should be capitalized because leases usually burden the tenant with obligations and penalties that are far more similar in nature to debt obligations than to a simple expense (i.e. tenants should present the lease obligation as a liability on their balance sheet as they do long term debt).
In fact, the option to account for leases as operating lease is set to be eliminated starting in 2019 for that reason. In the meantime, when operating leases are significant for a business (retailers and capital-intensive businesses), the rent expense should be ignored from the free cash flow buildup, and instead, the present value of the lease obligation should be reflected as part of net debt."
"How would you value a private company? - CORRECT ANSWER The main difference between valuing a private and public company is availability of data - private companies are usually not required to make their financial statements and details public. Historical data is critical for performing a DCF. If you're provided private company financials, the process is similar to public companies except that private company financial disclosures are often less complete, standardized and reliable. In addition, private companies are less liquid and should thus be valued lower all else equal to reflect the liquidity premium."
"When would you value a business using a P/B ratio? - CORRECT ANSWER When book value does capture a substantial part of the true value of a business. Financial institutions are most common example."
"Walk me through a simple M&A model - CORRECT ANSWER An M&A model takes two companies and combines them into one entity. First, assumptions need to be made about the purchase price and any other uses of funds such as refinancing target debt and paying transaction and financing fees). Then, assumptions about the sources of funds need to be made - will the acquirer pay for the acquisition using cash, take on additional debt or issue equity. Once those basic assumptions are in place, the acquirer's balance sheet is adjusted to reflect the consolidation of the target.
Certain line items - like working capital can simply be lumped together. Others need a little more analysis - for example, a major adjustment to the combined target and acquirer balance sheet involves the calculation of incremental goodwill created in the transaction, which involves making assumptions about asset write ups, and deferred taxes created or eliminated.
Lastly, deal-related borrowing and pay-down, cash used in the transaction, and the elimination of target equity all need to be reflected.
In addition, the income statements are combined to determine the combined ("pro forma") accretion/dilution in EPS. This can be done as a bottom's up analysis - starting from the buyer's and seller's standalone EPS and adjusting to reflect incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write ups.
Alternatively, the accretion dilution can be a top down, whereby the two income statements are combined starting with revenue and working its way down to expenses, while making the deal related adjustments."
"Is it better to finance a deal via debt or via stock? - CORRECT ANSWER The answer depends on several factors.
From the buyer's perspective, when the buyer's PE ratio is significantly higher than the target's, a stock transaction will be accretive which is an important consideration for buyers and may tilt the decision towards stock. When considering debt, the buyer's access to debt financing and cost of debt (interest rates) will influence the buyer's willingness to finance a transaction with debt. In addition, the buyer will analyze the deal's impact to its existing capital structure, credit rating and credit stats.
From the seller's perspective, a seller will generally prefer cash (i.e. debt financing) over a stock sale unless tax deferment is a priority for the seller. A stock sale is usually most palatable to the seller in a transaction that more closely resembles a merger of equals and when the buyer is a public company, where its stock is viewed as a relatively stable form of consideration."
"What does accretion/dilution analysis tell you about the attractiveness of a transaction? - CORRECT ANSWER From a valuation perspective, an accretive deal is not necessarily indicative of value creation for the acquirer and vice versa for dilutive deals. However, significant accretion or dilution is often perceived by buyers (and public company buyers in particular) as an indication of potential investor reaction to the transaction.
Specifically, dilutive deals are feared by buyers to lead to decline in their share price after announcement. This fear is rooted in the notion that investors will apply the pre-deal PE ratio to the now-lower pro forma EPS. These concerns, while quite valid when viewed through the prism of buyers' short-term concerns about meeting EPS targets, or not actually relevant to whether a deal actually creates long term value for the acquiring company's shareholders, which is a function of intrinsic value of the newly combined company."
"If a company trades at a forward PE of 20.0x, and acquires a company trading at a forward PE of 13.0x. Assuming the deal is 100% stock-for-stock, and a 20% premium is being offered, will the deal be accretive in year 1? - CORRECT ANSWER Yes: stock for stock deals where the acquirer's PE is higher than target's are always accretive. Don't get tricked - a 20% premium just brings the target's PE to 13 + (13 x 20%) = 15.6 PE, still below the acquirer's."
"How do you calculate offer value? - CORRECT ANSWER The offer value in the context of M&A refers to the equity purchase price being offered by the buyer to acquire the seller. Like equity value, offer value is calculating by multiplying fully diluted shares outstanding (including options and convertible securities) times the offer price per share."
"How do you calculate transaction value? - CORRECT ANSWER Transaction value in the M&A context refers to the target's implied enterprise value given the offer vale. As such, the transaction value equals the target offer value plus the target's net debt."
"What are the most common balance sheet adjustments in an M&A model? - CORRECT ANSWER In an M&A analysis, some acquirer and target balance sheet line items can simply be lumped together. However, there are some line items that need to be adjusted to reflect both deal-related accounting and funding adjustments.
On the accounting side:
Goodwill: Eliminate pre-deal target goodwill and create new goodwill from the deal.
PP&E and Intangible Assets: Write up assets to fair market value as appropriate.
Deferred tax liabilities: Create new deferred tax liabilities in a stock sale (Advanced concept- if not comfortable with this adjustment do not mention it).
Target equity: Eliminate target equity from the consolidation.
On the funding side:
Debt: Create new acquirer debt (if the deal was partially funded with debt) and eliminate Target debt (Target debt is often refinanced and reflected in the new acquirer debt financing, although in rare cases it can carry over).
Equity: Increase the existing value of acquirer equity by the value of any new acquirer equity issued in the deal.
Cash: Reduce cash by the amount of excess cash used to fund the deal and pay transaction and financing fees with a corresponding reduction to equity (for the transaction fees) and to new debt (for the financing fees)."
"What are the most common income statement adjustments in an M&A model? - CORRECT ANSWER In an acquisition, the acquirer and target income statements are consolidated, meaning they are lumped together. Some of the line items, however, need to be adjusted to reflect accounting and deal funding issues. The most common adjustments include the following:
Revenue: Increase consolidated revenue by any revenue synergies (if applicable).
Operating expenses: Reduce consolidated expenses by any expected cost synergies.
Incremental D&A from write ups: Deals usually lead to higher noncash D&A from target assets due to asset write ups. This means incremental D&A expense due to write ups need to be added to consolidated D&A.
Other expenses: Transaction fees are expensed on the income statement.
Interest expense: Acquirer interest expense is adjusted up when debt financing is used to fund the deal. Target interest expense is eliminated when target debt is refinanced. In addition, financing fees are amortized over the term of debt and the noncash expense is recognized within interest expense.
Interest income: Reduce interest income by the impact of any excess used to fund the deal.
Tax: All the adjustments above need to be tax-affected at the acquirer's tax rate.
Share count for calculating pro forma EPS: Use the acquirer's pre-deal share count and add the number of acquirer shares issued in the transaction."
"What are some balance sheet items that are commonly adjusted to fair market value in a transaction? - CORRECT ANSWER Property, plant and equity as well as intangible assets are often significantly carried at book values significantly below market values. As a result, these assets tend to be written up the most in a transaction."
"For an investment banker, why is a sell-side process typically shorter than a buy-side assignment? - CORRECT ANSWER As a practical matter, once a seller makes the decision to sell, it will usually be easier to find a buyer. So when working on behalf of the seller, the likelihood of completing a transaction tends to be higher. On the other hand, many companies regularly engage in market research and "dipping their toe in the water" type explorations of potential acquisition candidates. Thus, when working on behalf of a buyer, these engagements can drag on for months and can often end in no transaction."
"What is the impact of target NOLs in M&A? - CORRECT ANSWER Depending on the deal structure, target NOLs are either assumed by the acquirer (although their use by the acquirer is capped at an annual limit that's a function of the purchase price x the long term tax exempt rate) or are used to offset the seller's gain on sale (which, since the 2017 tax reform act, is capped at 80% of the target's taxable income)."
"Contrast asset sales vs 338(h)(10) election vs stock sales - CORRECT ANSWER In an asset sale, the seller sells the buyer assets. Each asset is contractually sold and once the buyer holds all the assets, it controls the business by virtue of having everything that made the seller's equity worth something in the first place. On the other hand, in a stock sale, the seller gives the buyer shares. Once the buyer holds all the target shares, it controls the business by virtue of being its new owner.
In both approaches the buyer ends of owning the seller, but there are significant tax differences.
In a stock sale, the buyer doesn't get a stepped-up basis in the seller's assets which means the buyer generally can't benefit from lower taxes down the road due to incremental deal related D&A. The seller on the other hand, is taxed only at the shareholder level (as opposed to both the corporate and shareholder level).
In the asset sale, the buyer gets the incremental D&A tax benefits, but the seller potentially faces double tax - first on corporate level and then on shareholder level. A 338(h)(10) is something both buyer and seller can jointly elect to do which gives you the tax treatment of an asset sale without the hassle of actually exchanging individual assets, so for analytical purposes, it is an asset sale."
"Why are deferred tax liabilities created in transactions? - CORRECT ANSWER Deferred tax liabilities are created in deals because of deal-related asset write ups. Specifically, when a company is acquired, the book bases of its assets get written up to fair market value.
However, when deals are structured as stock sales, the tax basis doesn't always get stepped up to align with the book basis write up. In this case, deferred tax liabilities are created at deal date to account for the fact that depreciation on assets written up will be higher for book purposes than for tax purposes."
"What happens to target NOLs in transactions? - CORRECT ANSWER The treatment of existing target NOLs depends on the structure of the deal.
In asset sales/338, NOLs can either be used up by the target to offset any gain on sale on the corporate level. The acquirer does not get any remaining unused NOLs - they are permanently lost.
In stock sales, the NOLs can be used by the acquirer going forward, but subject to an annual "IRC 382 limitation" - which limits the annual carryforward to a regularly published "long term tax exempt rate" times the equity purchase price."
"When might a buyer prefer to pay for a target company with stock over cash? - CORRECT ANSWER For the acquirer, the main benefit of paying with stock is that it preserves cash. For buyers without a lot of cash on hand, paying with acquirer stock avoids the need to borrow in order to fund the deal.
For the seller, a stock deal makes it possible to share in the future growth of the business and enables the seller to potentially defer the payment of tax on gain associated with the sale."
"Walk me through an LBO. - CORRECT ANSWER A leveraged buyout is similar to purchasing a house. The purchase price is funded partially by an equity investor - which is the private equity firm also called the financial sponsor. The remainder is funded through loans and bonds that the financial sponsor secures ahead of the transaction.
Once the sponsors gain control of the company, they get to work on streamlining the business - which usually means restructuring, layoffs and asset sales with the goal of making the company more efficient at generating cash flow so that the large debt burden can be slowly paid down.
The investment horizon for sponsors is 5-7 years, at which point they hope to be able to 'exit' by either 1) Selling the company to another private equity firm or strategic acquirer 2) Taking the company public, or 3) Recapitalizing the business by taking on additional debt and issuing themselves a dividend with the debt proceeds. Accomplishing this can provide financial sponsors with a high internal rate of return. Financial sponsors usually target returns of 15-25% when considering making an investment.
The keys to making this work include:
Acquiring the company at a low multiple ("getting in cheap")
Successfully restructuring and increasing cash flows
Selling at a high multiple"
"Walk me through an LBO model. - CORRECT ANSWER An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity as well as new borrowing as the two primary sources of capital. The specific impacts analyzed by the model include an equity valuation of the pre-LBO "oldco", the IRR to the various new debt and equity capital providers, impacts on the company's financial statements and ratios.
To build an LBO, start with identifying the uses of funds - how much oldco equity will be paid, any oldco debt that needs to get refinanced, as well as any fees. Based on this, make assumptions about the sources of funds: How much and the type of debt capital needs to be raised, with the residual being funded by sponsor equity.
Ideally, the operations are forecasted over 5-7 years (the expected holding period), and a complete 3 statement model is built so that the LBO debt assumptions correctly impact the income statement and cash flow statement.
In getting the correct cash flow forecasts, it is important to build a debt schedule that accurately modifies debt based on the flow of excess cash or deficits.
Next, exit assumptions need to be made - most notably around what the exit EV/EBITDA multiple will be. Based on this assumption and the existing state of the balance sheet at the presumed exit date, IRR and cash on cash returns can be estimated for the sponsors (and any debt providers as well).
Lastly, scenarios and sensitivity analysis can be added to provide users with different ways to look at the model's output - one common sensitivity is to back into the implied oldco equity value based on explicit sponsor hurdle rates and/or operating assumptions."
"What kind of company usually makes for a good LBO candidate? - CORRECT ANSWER Companies that make good LBO candidates have steady, predictable cash flows with little cyclicality, minimal ongoing capital expenditures and working capital investment requirements, perhaps with subsidiary businesses that can be immediately sold to help pay down debt."
"What ratios or metrics would you want to look at to figure out if a company is over-levered? - CORRECT ANSWER I would first look at its overall capital structure and compute its Debt/Equity ratio. Since rates of leverage that are considered acceptable can vary across industries, I would compare across companies of similar size and operating in the same industry.
Next, I would look at interest coverage ratio (EBIT/Interest expense) and leverage ratio (Debt / EBITDA) and compare to my universe of comparable companies. If, for example, the company I'm looking at has some combination of a high Debt/Equity ratio, a low interest coverage ratio, and a high leverage ratio, that's an indication that the business might be over-levered."
"What is the maximum leverage in an LBO typically based on? - CORRECT ANSWER Debt to equity mix in private equity deals has hovered around 60% debt / 40% equity as M&A activity stabilized since the 2008 financial crisis. However, leverage varies across industries.
The more predictable the cash flows, the larger the tolerance for higher debt to equity mix. Debt/EBITDA - a measure of leverage relative to profitability has hovered in the 5.0-7.0x range and is pressured upward as overall valuations increase.
When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. It has come down because of the risks inherent to high debt burdens."
"Since senior debt is cheaper, why don't financial sponsors fund the entire debt portion of the capital structure with senior debt? - CORRECT ANSWER Senior lenders will only lend up to a certain point - usually 2.0-3.0x EBITDA, beyond which only costlier debt is available. This is because the more debt a company incurs, the higher its risk of default. The lowest rate senior debt enjoys the lowest risk due to its seniority in the capital structure and imposes the strictest limits on the business via covenants, requires secured interests). Subordinated, junior debt is less restrictive, but requires highest interest rates."
"Where do financial sponsors typically get their money? - CORRECT ANSWER Financial sponsors (or private equity firms) raise capital to fund their investments from Insurance companies, pension funds, endowments, high net worth individuals, and financial institutions."
"When analyzing the viability of undertaking an LBO, how do private equity firms estimate the value of the business in the exit year? - CORRECT ANSWER The most common approach is to assume that the company will be exited at the same EV/EBITDA multiple that it was acquired at.
For example, if sponsors are contemplating an LBO where the purchase price reflects a 10.0x EV/EBITDA multiple, the exit year assumption (usually 5-7 years from the LBO date) will likely be that they will be able to sell at the same 10.0x multiple. Because of the importance of this assumption in determining the attractiveness of the deal to a financial sponsor (i.e. the deal's IRR), this exit multiple assumption is often sensitized and IRRs are presented for a range of possible exit multiples."
"What is the impact of the 2017 tax reform? - CORRECT ANSWER Probably the most significant thing that happened is that corporate tax rates were reduced from $35 to 21%. There were also reductions to S Corporations and LLCs, but the impact is a little murkier and not as significant as the corporate tax reduction. There were 3 other significant impacts:
Companies now face limits on how much interest expense can be deducted for tax purposes. While the formula is a little more complicated, companies can roughly deduct interest up to 30% of the company's EBITDA. This offsets the lower tax rate benefits for highly levered companies like PE portfolio companies.
Companies are now able to accelerate depreciate for tax purposes even more than they could before, which lowers upfront tax bills. This lowers taxes even further for capital intensive businesses.
Companies can no longer carryback NOLs, but they can carryforward indefinitely instead of just 20 years. Also, companies can use NOLs to offset only 80% of current period income (prior to tax reform, NOLs could be used to offset 100% of current period income)."
"What is the difference between a recapitalization and an LBO? - CORRECT ANSWER An LBO is accounted for as an acquisition, which means assets are written up and goodwill is recognized. A recapitalization is mechanically the same thing but accounted for not as an acquisition but as a simple recapitalization - asset bases carryover unchanged, with no goodwill recognized. Because no goodwill is recognized, negative equity is often created in a recapitalization because the offer price is often significantly higher than the book value of equity."
"What's the difference between a bond and a loan? - CORRECT ANSWER While some features of loans and bonds can overlap, the key differences are that a loan is a private transaction between borrower and lender. The lender is either a single bank or a small syndicate of banks or institutional investors. The cost is often priced off LIBOR plus a spread, the loan is often secured by company assets and the terms are very strict (strict covenants), while the repayment of principal can happen over time or as a bullet payment at the end. Because of the collateral, earlier principal repayments and restrictions, loans are less risky for lenders and thus generally command lower interest rates than bonds.
Bonds, on the other hand, must be registered with the SEC and are thus public transactions. Because bonds are issued to institutional investors and then trade freely on the secondary bond market, the investor base is broad and diverse, comprised of a variety of institutional investors. Corporate bonds are usually priced as a fixed rate, with payments made semi-annually, with longer terms than loans, with a balloon payment at maturity. Bonds come with less restrictive covenants and are usually unsecured. As a result, they are riskier for investors and thus command higher interest rates than loans."
"Debt cheat sheet - CORRECT ANSWER "
"How are loans usually priced? - CORRECT ANSWER Loans are usually priced off LIBOR plus a spread. In addition, loans often include a LIBOR floor, so an example would be a pricing of L + 3% (300 basis points) with a LIBOR floor of 2%, so the interest rate can never dip below 5%."
"What's the difference between a bond's coupon rate and the bond's current yield? - CORRECT ANSWER The coupon rate ("nominal yield") represents a bond's coupon divided by its face (par) value. The current yield on a bond equals the bond's coupon payment divided by the bond's price. For example, a bond trading at 90 with a $100 face value and a $6 coupon has a 6% coupon rate and a current yield of 6.66% ($6/90). While the coupon rate is always the same, the current yield fluctuates based on the market price of a bond."
"What is the treasury yield curve and what does its shape tell you? - CORRECT ANSWER The yield curve in general is just a plot of the relation between the yield and term of otherwise similar bonds. The treasury yield curve plots treasury bond yields across their terms. It's the most common and widely used yield curve as it sets a "risk free" benchmark for other bonds (corporate, municipal, etc.).
A treasury yield curve is normally upward sloping because all else equal, an investor would prefer a 1-year, 3% bond than being locked into a 30-year, 3% bond.
However, investors' expectations about future interest rates impact the slope as well. When investors think the Fed will raise interest rates in the future, investors will increase demand for short term treasuries to avoid getting locked into low but a soon-to-be higher long-term rate. This increase in relative demand for short term treasuries will lower short term yields and raise long term yields, creating a self-fulfilling prophecy."
"What does an inverted yield curve tell you? - CORRECT ANSWER An inverted yield curve means that yields on longer maturities are lower than shorter maturities of otherwise comparable bonds, like treasuries. Normally, yield curves are upward sloping as issuers must pay a premium to entice investors to keep their capital locked up for a longer term. When the yield curve inverts, it is usually a harbinger of an economic slowdown and recession. In fact the last 7 recessions were preceded by an inversion of the yield curve and it is considered a strong leading indicator by economists and investors alike. The inversion happens as investors anticipate market interest rates to decline down the road (presumably because they expect a slowdown and thus expect monetary policy makers to eventually lower rates to stimulate the soon-to-be slowing economy) and thus prefer the safety of long term maturities at the current higher rates over investing in shorter maturities and having to re-invest at the lower expected future rates."
"What's the difference between current yield and yield to maturity? - CORRECT ANSWER The current yield on a bond equals the bond's coupon payment divided by the bond's price. Current yield is a way to discuss coupon rates when bond price deviates from par. For example, a bond trading at 90 with a $100 face value and a $6 coupon has a 6% coupon rate and a current yield of 6.66% ($6/90).
Unlike YTM, current yield is not the true yield of a bond as it does not capture any yield associated with principal recovery, nor does it assume the reinvestment of coupon payments. The yield to maturity ("YTM") is the internal rate of return of a bond. YTM takes into account coupon payments, principal recovery, assumes reinvestment at the same rate (an iterative process), and time to maturity."
"What is the relationship between bond prices and interest rates? - CORRECT ANSWER There is an inverse relationship between bond price and interest rates. For example, if market interest rates go up (due to a Fed interest rate raise or other market conditions), this has the impact of making the interest being offered by currently outstanding debt seem less attractive given the availability of comparable investments with now higher interest rates all else equal. The price of outstanding bonds will thus drop."
“Do companies prefer straight-line or accelerated depreciation? - CORRECT ANSWER For GAAP reporting purposes, companies generally prefer straight-line depreciation. That's because a company will record lower depreciation in the early years of the asset's life than if they had used accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income than under accelerated depreciation."
"Do companies depreciate land? - CORRECT ANSWER No, land is considered to have an indefinite life and is not depreciated."
"Can companies amortize goodwill? - CORRECT ANSWER Under GAAP, public companies are not allowed to amortize goodwill. Instead, it must be tested annually for impairment.
The longer answer is that under GAAP, public companies are not allowed to amortize goodwill and must instead test it annually for impairment. However, private companies may elect to amortize goodwill. In addition, for tax reporting purposes, goodwill may be amortized over 15 years under some circumstances."
"A company acquired a machine for $5 million in 2003 and has since generated $3 million in accumulated depreciation. In addition, the PP&E now has a fair value of $20 million. Assuming GAAP, what is the value of that PP&E on the company's balance sheet? - CORRECT ANSWER The short answer is $2 million. Except for certain liquid financial assets which can be written up to reflect fair market value, companies must carry the value of assets at their historical cost."
"Do you amortize intangible assets? - CORRECT ANSWER Intangible like customer lists, copyrights and patents - assets that have a finite life - are amortized, while others like trademarks (and goodwill) are considered to have indefinite lives and are not amortized."
"How do capital leases affect the three financial statements? - CORRECT ANSWER Leases treated as capital leases (as opposed to operating leases) create an asset and associated liability for the thing that is being leased. For example, if a company leases a building for 30 years, the building is recognized as an asset on the lessee's balance sheet with a corresponding debt-like liability. The income statement impact is the depreciation expense associated with the building, as well as interest expense associated with the financing."
"Is it bad if a company has negative retained earnings? - CORRECT ANSWER Not necessarily. Retained earnings will be negative if the company has generated more accounting losses than profits. This is often the case for early-stage companies that are investing heavily to support future growth. The other component of retained earnings is common or preferred dividends, which could contribute to a lower or even negative retained earnings."
"What's more important: the income statement or the cash flow statement? - CORRECT ANSWER hey are both important and any serious analysis requires using both. However, I would think that the cash flow is slightly more important because it reconciles net income, the accrual-based bottom line on the income statement to what's happening to cash, while also showing you the critical movement of cash during the period. Without the cash flow statement, I can only see what's happening from an accrual profitability standpoint. The cash flow statement on the other hand can alert me to any liquidity issues, as well as any other major investments or financial activities that do not hit the income statement.
The one situation in which I would prefer the income statement is if I also have the beginning and end-of-year balance sheet. That's because I could reconcile the cash flow statement simply by looking at the balance sheet year over changes along with the income statement."
"Why are increases in accounts receivable a cash reduction on the cash flow statement? - CORRECT ANSWER Since cash flow statements start with net income, and net income captures all of a company's revenue - not just cash revenue - an increase in accounts receivable suggests that more customers paid with credit during the period and so an adjustment down needs to be made to net income when arriving at cash since the company never actually received those funds - they're still sitting on the balance sheet as receivables."
"Which section of the cash flow statement captures interest expense? - CORRECT ANSWER Interest expense is recognized on the income statement and thus gets indirectly captured in the cash from operations section."
"How does buying a building impact the 3 statements? - CORRECT ANSWER Cash goes down by the purchase price and is reflected in the cash from investing section. On the balance sheet, the offsetting entry to the cash reduction is an increase in PP&E. There is no immediate impact on the income statement.
Over the life of the asset, depreciation expense from the building is recognized on the income statement and reduces net income by the amount of depreciation expense net of tax expense saved due to the depreciation expense. That's because depreciation is generally tax deductible.
On the cash flow statement, depreciation is added back since it is non-cash. On the balance sheet, PPE is reduced by the depreciation and is offset by a reduction to retained earnings for the depreciation expense."
"Is EBITDA a good proxy for cash flow? - CORRECT ANSWER Not really. That's because even though EBITDA does add back D&A - typically the largest non-cash expense - it does not capture any working capital changes during the period. It also doesn't capture cash outflows from taxes or interest payments. Those adjustments would need to be made to get to operating cash flows. EBITDA also doesn't capture stock-based compensation (SBC) expenses required to get to operating cash flows (although an increasingly used "adjusted EBITDA" calculation does add back SBC)"
"How are the 3 financial statements connected? - CORRECT ANSWER The financial statements are very interconnected, both directly and indirectly.
The income statement is directly connected to the balance sheet through retained earnings. Specifically, net income (the bottom line in the income statement) flows through retained earnings as an increase each period less dividends issued during the period.
The offsetting balance sheet adjustments to the increase in retained earnings impacts a variety of line items on the balance sheet, including cash, working capital and fixed assets.
The cash flow statement is connected to the income statement through net income as well, which is the starting line of the cash flow statement.
Lastly, the cash flow statement is connected to the balance sheet because the cash impact of changes in balance sheet line items like working capital, PP&E (through capex), debt, equity and treasury stock are all reflected in the cash flow statement. In addition, the final calculation in the cash flow statement - net change in cash - is directly connected to balance sheet, as it grows the beginning of the period cash balance to arrive at the end of period cash balance on the balance sheet."
"Why would a company issue equity vs. debt (and vice versa)? - CORRECT ANSWER Perhaps the greatest advantage of equity is that it has no required payments, thus giving management more flexibility around the repayment of capital (equity eventually gets it back in the form of dividends, but timing and magnitude are entirely at the board and management's discretion).
Another advantage in the case of public equity is that it gives companies access to a very large investor base. On the other hand, equity dilutes ownership, and is generally more expensive (i.e. higher cost of capital). In addition, public equity comes with more regulation and scrutiny.
An advantage of debt is that unlike equity, debt is tax-deductible (although recent tax reform rules limit the deduction for highly-levered companies). In addition, debt results in no ownership dilution and generally has a lower cost of capital. Of course, the disadvantages are that debt means the company faces required interest and principal payments, and it introduces the risk of default. In addition, debt covenants can restrict management from undertaking a variety of activities."
"How many years would it take to double a $100,000 investment at a 9% annual return (no calculator)? - CORRECT ANSWER The rule of 72 says that in order to figure out how long it would take to double an investment, divide 72 by the investment's annual return. In this case, the rule of 72 suggests that it would take approximately 72/9 = 8 years."
"Why would a company buy back (aka repurchase) shares? What would be the impact on share price and the financial statements? - CORRECT ANSWER A company buys back shares primarily as a way to move cash from the company's balance sheet to shareholders, similar to issuing dividends. The primary difference is that instead of shareholders receiving cash (in the case of dividends), a share repurchase removes shareholders, leaving a smaller shareholder base.
The impact on share price is theoretically neutral - as long as shares are priced correctly, a share buyback should not lead to a change in share price because while the share count (denominator) is reduced, the equity value is also reduced by the now lower company cash balances. That said, share buybacks can impact share price movement positively or negatively if they are perceived as a new signal about the company's future behavior or growth prospects.
For example, cash-rich but otherwise risky companies could see artificially low share prices if investors are discounting that cash. In this case, a buyback should lead to a higher share price, as the upward share price impact of a lower denominator is greater than the downward share price impact of a lower equity value numerator.
Conversely, if shareholders view the buyback as a signal that the company's investment prospects aren't great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash AND lower perceived growth and investment prospects).
On the financial statements, a $100 million share buyback would be treated as follows:
Cash is credited by $100 million
Treasury stock is debited by $100 million"
"Should two identical companies but with different rates of leverage trade at different P/E multiples? - CORRECT ANSWER P/E multiples can vary significantly due to leverage difference for otherwise identical companies. All else equal, as a company borrows money (debt), the EPS (denominator) will decline due to higher interest expense.
The impact on the share price, on the other hand, is harder to predict and depends on how the debt will be used. At the two most extreme cases, imagine the debt proceeds will go unused, generating no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment.
In this scenario, the share price can be expected to decline to such a level that the PE ratio declines. On the other hand, if the debt is used to efficiently invest and grow the business, the P/E ratio will increase."
"You are evaluating a company that has net income of $100 million and a PE multiple of 15x. The company is considering raising $200 million in debt in order to pay a one-time special cash dividend to shareholders. Do you think this is a good idea? - CORRECT ANSWER The answer depends on several factors. If we make an assumption that the PE multiple stays the same after the dividend and a cost of debt of 5% (note: there's also tax impact since interest is mostly deductible but in the interview you can probably ignore taxes for simplicity), the impact to shareholders is as follows:
Net income will drop from $100 to $90 [($200 new borrowing x 5%) = $10 million]
Equity value will drop from $1,500 million (15.0 x $100 million) to $1,350 million (15.0 x $90 million).
That's a $150 million drop in equity value. However, shareholders are immediately getting $200 million. So ignoring any tax impact, there's a net benefit of $200 - $150 million to shareholders from this move.
Obviously, the assumptions we made about taxes, cost of debt and the multiple staying the same inform the result. If any of those variables are different - for example, if the cost of debt is higher, equity value might be destroyed in light of this move.
A key assumption in getting the answer here was that PE ratios will stay the same at 15x. A company's PE multiple is a function of its growth prospects, returns on equity and cost of equity. Borrowing more without any compensatory increase in investment or growth will raise the cost of equity (via a higher beta) which will pressure the PE multiple down.
So while it appears based on our assumptions that this is an ok idea, it could easily be a bad idea given a different set of assumptions. Moreover, it is possible to broadly say that borrowing for the sake of issuing dividends is unsustainable indefinitely, because eventually debt levels will rise to a point where cost of capital and PE ratios are adversely impacted. Debt should generally be used to support investments and activities that will increase firm and shareholder value rather than to extract cash from the bus"
"How would you handle restricted stock in the share count? - CORRECT ANSWER Some finance professionals completely ignore restricted stock from the diluted share count because they are unvested. However, increasingly, unvested restricted stock is included in the diluted share count under the logic that eventually they will vest, and it is thus more conservative to count them (we agree with this view, by the way)."
"How would you handle convertible preferred stock in the share count? - CORRECT ANSWER Convertible preferred stock is assumed to be converted into common stock for the purpose of calculating diluted shares if the liquidation value (also called the conversion price) of the preferred stock is lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing 10 million preferred shares, each granting the holder the right to collect either $50 per preferred share (it's liquidation value) or to convert it to 1 share of common stock. Because the current share price is the liquidation value, we would assume that the preferred stock is converted for the purposes of calculating the diluted share count.
When you do assume conversion into common stock for the purposes of calculating the share count in the context of a valuation, you should also eliminate the preferred stock from the balance sheet when calculating net debt to be consistent and to avoid double counting."
"How would you handle convertible bonds in the share count? - CORRECT ANSWER Convertible bonds are assumed to be converted into common stock if the conversion price of the bond (book value of bond / shares bond is convertible into) is lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years ago by issuing a bond convertible into 10 million shares of common stock. Because the current share price is the conversion price, we would assume that the bond is converted for the purposes of calculating the diluted share count.
When you do assume conversion into common stock for the purposes of calculating the share count in the context of a valuation, you should eliminate the convertible bond from the balance sheet when calculating net debt to be consistent and to avoid double counting."
"What's the difference between WACC and IRR? - CORRECT ANSWER The IRR is the discount rate on a stream of cash flows that leads to a net present value of 0. The WACC (or cost of capital) is the minimum required internal rate of return for both debt and equity providers of capital. Thus an IRR that exceeds the WACC is often used as criteria for deciding whether a project should be pursued."
"When valuing a company using multiples, what are the tradeoffs of using LTM vs. forward multiples? - CORRECT ANSWER Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA, EBIT and EPS forecasts are subjective. This is particularly problematic for smaller public firms, whose guidance tends to be less reliable and generally harder to come.
That said, LTM suffers from the problem that historical results are often distorted by nonrecurring expenses and income that were recognized during the period and distort the picture of recurring operating performance. That's why when using LTM results it is important to exclude nonrecurring items to get a clean multiple.
That's why both LTM and forward multiples are often presented side by side, rather than picking just one."
"What can a transaction comps analysis tell you that a trading comps analysis cannot? - CORRECT ANSWER Transaction comps can provide insight into purchase premiums that buyers and sellers should expect when negotiating a transaction."
"How would you value Bitcoin? - CORRECT ANSWER Like all currencies, Bitcoin has no intrinsic value and thus cannot be valued like a traditional cash flow generating asset. Instead, the pricing of bitcoin depends on perceptions on the probability that it will ultimately become a full-fledged currency and stable medium of exchange. There is no DCF or fundamental valuation that can be performed on Bitcoin."
"How would you value a painting? - CORRECT ANSWER A painting has no intrinsic value, generates no cash flows and thus cannot be valued in the traditional sense. The pricing of a painting is a function of what someone is willing to pay for it and not anchored by fundamentals."
"How would you value a company that has no revenue? - CORRECT ANSWER A company that has no revenue can still be valued by valuing drivers like subscribers, monthly active users."
"How would you value a private equity firm? - CORRECT ANSWER Private equity firms generate two types of cash flows: management fees and performance fees. Each have different risk profiles and thus merit a sum of the parts approach.
The first type of cash flow, and the easiest to model, is related to management fees. Private equity firms charge management fees of 1-2% on total capital raised. The most common valuation approach for this is to apply a market multiple to the current or next year forecast for management fees.
The second cash flow comes from the far more difficult to predict performance fees. Private equity firms charge 15-20% of the returns on the investments (portfolio companies) they manage. Since these fees are realized when sponsors exit their investments, they are lumpy and difficult to forecast. The investments themselves are illiquid, highly leveraged and thus highly sensitive to future market conditions.
Thus, the typical approach here is to also apply a multiple on these cash flows, but a much lower multiple than that applied to management fees."
"What does a goodwill impairment tell you about a deal? - CORRECT ANSWER Companies that have made acquisitions in the past are required to regularly estimate the value of their past acquisitions. A goodwill impairment happens when the acquiring company determines that the current value is lower than the original price paid for the target company.
For example, if an acqu
