Solutions to

End-of-Chapter Questions

Chapter 2: Accounting Overview

1. What is an income statement and why is it important?

An income statement shows the revenues, costs, and profits of a com-
pany over a period of time. It is important because it contains some
of the most basic and important metrics used to analyze a company’s
operating performance and profitability.

2. What is a balance sheet and why is it important?

A balance sheet shows the financial position of a company and spe-
cifically the company’s assets, liabilities, and shareholders’ equity at a
given point in time. It is important because it contains key metrics used
to understand and analyze a company’s financial stability and to meas-
ure the book value of key types of assets (such as cash, inventory, and
PP&E) and key types of liabilities (such as debt).

3. What is a cash flow statement and why is it important?

A cash flow statement shows the net cash flows relating to a com-
pany’s operating, investing, and financing activities for a period of
time corresponding to the time period of the income statement. It is
important because it helps one understand how much cash a company
generates or uses from its operations, and lists key sources and uses
of cash.

4. What are the differences between accrual accounting and cash‐based

accounting?
Accrual accounting recognizes revenue when a firm sells goods or
services, and attempts to match the costs associated with producing
those revenues and record them at the same time. Cash‐based account-
ing recognizes revenues and costs when cash is received or spent.
5. What are the advantages of accrual accounting versus cash‐based
accounting?
The advantages of accrual accounting are that because revenues and
costs are matched, the income statement reflects a much more accurate
and meaningful measure of profitability than does cash‐based account-
ing. In addition, accrual accounting provides less opportunity for man-
agement to manipulate its operating performance by timing purchases
or sales.

6. How is EBITDA calculated?

EBITDA is calculated as earnings before interest and taxes (EBIT), or
synonymously, operating income plus depreciation and amortization.

7. Why is EBITDA a frequently used metric in corporate finance?

EBITDA is a proxy for operating cash flow, and it is easy to calculate.

8. Why does EBITDA not equal operating cash flow?

While EBITDA is a proxy for operating cash flow, it ignores many
uses of cash, such as capital expenditures and the change of working
capital.

9. In a period of inflation (rising prices), which method of inventory (LIFO

or FIFO) would likely result in a higher level of inventories on the
balance sheet?
In a period of inflation, the FIFO method of inventory will likely re-
sult in a higher level of inventories on the balance sheet because older
inventory at lower prices will be used first, leaving the value of newer
inventory at higher prices on the balance sheet.

10. What is the difference between an operating lease and a capital lease?
In an operating lease, the lessee does not take risk of ownership, and
the rent that it pays is treated as an expense. In a capital lease, the les-
see does take risk of ownership and enjoys some of the benefits, and the
lease is treated as if the company owned the property and borrowed to
help finance the property.

11. What is a deferred tax asset or liability?

A deferred tax asset or deferred tax liability is a balance sheet item
reflecting the difference between taxes reported on financial statements
and taxes actually paid to the government, mostly resulting from timing
differences.
12. Give an example of a transaction that would result in a deferred tax
asset or liability.
An example of a transaction that would result in a deferred tax is if
a company depreciated an asset using a different method for financial
reporting purposes than for tax reporting purposes. For instance, a de-
ferred tax liability would be created if the asset was depreciated using a
straight‐line method for financial reporting and an accelerated method
for tax reporting.

13. Why do we depreciate fixed assets?

Fixed assets are depreciated so as to try to match the cost of the fixed
assets with the benefits of using them (i.e., to generate revenues).

14. What are intangible assets?

Intangible assets are assets that have no physical or tangible form.
Examples of intangible assets include in‐process research and develop-
ment (R&D), patents and trade secrets, trademarks and copyrights, and
a special category called goodwill.

15. What is goodwill?

Goodwill is a special type of intangible asset that is created when a
company makes an acquisition. Goodwill reflects the excess purchase
price over the fair market tangible book value of the acquired com-
pany’s assets.

16. Explain how the three financial statements are integrated.

The three financial statements are integrated in a number of ways.
For example, everything contained in the income statement will affect
net income, and net income affects retained earnings on the balance
sheet and is also the first line of the cash flow from operations section
of the cash flow statement. Similarly, every change on the balance sheet
must be reflected as a use or source of cash on the cash flow statement
and will affect cash. Moreover, the cash flow statement can be thought
of as a “bridge” between the income statement and the balance sheet.

17. If a company incurs $10 (pretax) of depreciation expense, how does

that affect the three financial statements?
On the income statement, depreciation is an expense, so operat-
ing income (EBIT) declines by $10. Assuming a tax rate of 40 per-
cent, net income declines by $6. On the cash flow statement, net in-
come decreased $6 and depreciation increased $10, so cash flow from
­ perations increased $4. Finally, on the balance sheet, cumulative de-
o
preciation increases $10 so net PP&E decreases $10. We know from
the cash flow statement that cash increased $4. The $6 reduction of net
income caused retained earnings to decrease by $6. Note that the bal-
ance sheet is now balanced. Assets decreased $6 (PP&E −10 and cash
+4), and shareholders’ equity decreased $6.

Chapter 3: Finance Overview

1. What is the primary role of the financial system?

The primary role of the financial system is to efficiently and optimally
allocate savings to investments.

2. Who are some of the key players in the financial system?

Some of the key players in the financial system are savers such as in-
dividuals, borrowers such as individuals, companies and governments,
and the financial institutions that are supposed to bring them together.

3. What is the primary role of financial institutions?

The primary role of financial institutions is to efficiently match sav-
ers and borrowers, specifically by providing information gathering and
distribution, risk sharing, and liquidity.

4. What are some examples of institutional investors?

Some examples of institutional investors include pension funds, in-
surance companies, and endowments.

5. What are some examples of alternative investments?

Some examples of alternative investments include private equity, ven-
ture capital, and hedge funds.

6. Why is money today worth more than money tomorrow?

Money today is worth more than money tomorrow for at least three
reasons. First, there is risk associated with receiving and being able to
use the money the longer out in the future you go. Second, in an infla-
tionary environment, money has less purchasing power in the future.
Third, money today could be invested and earn some return.

7. What is a discount rate?

A discount rate, also referred to as an investor’s opportunity cost of
capital, is the return required by investors to invest in a project of a
specified level of risk for a specified time period. The discount rate is
also the rate used to present value cash flows.

8. Conceptually, how do you estimate a discount rate?

Conceptually, you can estimate a discount rate by taking the risk‐
free rate for the appropriate time period and adding the expected in-
flation rate and an appropriate risk premium for an investment at that
level of risk.

9. What is the basic present value formula?

The basic present value formula is: Cash flow in a certain time period
divided by one plus the discount rate raised to the appropriate time
period.

10. How do you value a perpetuity?

You can value a perpetuity by taking the perpetual cash flow and
dividing by the appropriate discount rate.

11. How do you value a perpetuity with constant growth?

You can value a perpetuity with constant growth by taking the next
period’s cash flow and dividing by the discount rate less the constant
growth rate.

12. How do you calculate the future value of an amount of money?

You can calculate the future value of an amount of money by taking
the present value and multiplying by one plus the discount rate raised
to the number or periods.

13. How should companies decide whether or not to invest in a project?

In theory at least, companies should decide whether or not to invest
in a project if the project’s internal rate of return (IRR) is greater than
the project’s discount rate or hurdle rate, or if the net present value
(NPV) of the project is greater than zero.

14. How do you calculate net present value?

You calculate net present value by summing each period’s cash flow
divided by one plus the discount rate raised to each time period.

15. How do you calculate the internal rate of return?

You calculate the internal rate of return by solving for the discount
rate in an equation where zero equals the sum of each period’s cash flow
divided by one plus the discount rate raised to each time period.
16. What kinds of things should companies include in cash flow when ana-
lyzing NPV or IRR?
When analyzing NPV or NRR, cash flow should include all of the
cash flows that directly relate to the project, including the initial invest-
ment as well as ongoing costs and capital expenditures, working capital
requirements, and revenues and profits.

17. What kinds of things should companies not include in cash flow when
analyzing NPV or IRR?
When analyzing NPV or NRR, companies should not include sunk
costs or any allocation of expenses that would need to be spent regardless.

18. Under what circumstances will the net present value equal zero?
Net present value will equal zero when a project’s IRR is exactly
equal to the discount rate used in the NPV formula.

19. What is capital structure?

Capital structure reflects a company’s choice of funding, and specifi-
cally its makeup of debt and equity.

20. Which is more expensive, debt or equity, and why?

Equity is more expensive because it is riskier than debt, has less cer-
tain cash flows, is subordinate to debt in a bankruptcy or liquidation,
and because dividends, unlike interest, are not tax deductible.

21. Why does adding more debt to the capital structure raise the cost of debt?
Adding more debt to a company’s capital structure raises the cost of
debt because it raises the risk of distress and bankruptcy, which results
in a significant loss of value, and therefore makes all of the company’s
debt riskier.

22. Why does adding more debt to the capital structure raise the cost of
equity?
Adding more debt to a company’s capital structure raises the cost of
equity because debt raises the risk of distress and bankruptcy, which re-
sults in a significant loss of value to the company and usually a complete
loss of value to equity holders. Moreover, more debt requires higher
levels of interest, which reduces the flexibility of management.

23. Why is the cost of capital U‐shaped?

The cost of capital is U‐shaped because debt is less expensive than
equity but also because adding debt raises the cost of both debt and
equity due to bankruptcy costs, agency costs, and the potential loss of
tax deductions if interest expense exceeds operating income.

24. What are some advantages and disadvantages to issuing debt?

Some advantages to issuing debt include a lower cost of capital than
equity, given it is less risky to investors and because interest is tax de-
ductible. Some disadvantages to issuing debt include an increased risk
of financial distress or bankruptcy; mandatory payment of interest
expense, which reduces the flexibility of management; and covenants,
which may restrict the company’s ability to issue more debt and penal-
ize the company if it does not maintain certain operating performance
and/or leverage.

25. What are some advantages and disadvantages to issuing stock?

Some advantages to issuing stock include no mandatory dividend
payments, the least risk‐adverse investor class, and currency that can be
used for acquisitions. Some disadvantages to issuing stock include the
highest cost of capital of any type of funds, the highest transaction costs
to raise the funds, and vulnerability from activist investors.

26. What is the difference between secured debt and unsecured debt?
Secured debt is debt that is secured or collateralized by specific assets.
Unsecured debt is not secured by specific assets.

27. What has a higher cost: secured debt or unsecured debt? Why?
Unsecured debt has a higher cost of capital because the debt is not
collateralized by specific assets.

28. What is preferred stock?

Preferred stock, while technically a form of equity, is a hybrid security
that has features of both debt and equity. It is a mandatory dividend ob-
ligation, like interest, though the dividend can be deferred. It has a cost
of capital in between that of debt and common stock.

29. What are some different ways in which a company can return money to
investors?
A company can return money to investors by paying back or retiring its
debt, by issuing dividends to stockholders, and by buying back its stock.

30. What are the pros and cons of dividends versus stock buybacks?
Some investors, such as widows and orphans and non‐taxable inves-
tors, prefer dividends, while taxable investors and investors who do
not need income generally prefer stock buybacks. Moreover, most of
the time, capital gains tax rates are lower than taxes paid on dividend
payments. Also, companies generally have more flexibility with stock
buybacks than they do with dividends since cutting dividends sends a
negative signal to the market.

31. How do you value a bond?

You can value a bond by computing a bond’s net present value by
summing each period’s cash flow (coupon payments and principle pay-
ment) divided by one plus the appropriate market interest rate raised to
the cash flow’s time period.

32. What is yield to maturity, and how do you calculate it?

Yield to maturity represents an investor’s average return earned on
a bond that is held to maturity. You can calculate yield to maturity
by using the IRR formula. Specifically, set the bond’s price equal to
the sum of each period’s cash flow (coupons and principle payment)
divided by one plus the YTM to appropriate time period and solve for
the YTM.

33. What is yield to call, and how do you calculate it?

Yield to call represents an investor’s average return earned on a
bond that is called at the first possible call date. You can calculate
yield to call the same way as yield to maturity, except substitute the
call price for the par value and use the first call date instead of the
maturity date.

34. What is yield to worst, and how do you calculate it?

Yield to worst represents an investor’s lowest possible average return
earned on a bond that is either called or held until maturity. If there is
only one call date, the yield to worst is calculated as the lesser of the
yield to call and the yield to maturity. If there are multiple call dates, it
is calculated as the lesser of the lowest yield to call rate (given each call
date) and the yield to maturity.

35. What is a bond’s current yield, and how do you calculate it?
A bond’s current yield reflects the bond’s annual coupon divided by
the bond price.

36. If interest rates rise, what will happen to the price of a bond?
If interest rates rise, the price of a bond will fall.
37. What is duration and why is it important?
Duration reflects the average maturity of a bond or, equivalently, the
average amount of time to each cash flow (the coupon payments and
the principal payment). Duration is important because it helps measure
a bond’s sensitivity to interest rate changes and helps institutional inves-
tors match their investment income with their expected liabilities.

38. What are the key assumptions of the Black‐Scholes formula for pricing
options?
The key assumptions of the Black‐Scholes formula used for pricing
options are the risk free interest rate, the underlying stock price, the ex-
ercise price, the stock’s expected volatility, and the time until maturity.

39. What are the differences between an option and a warrant?

An option does not result in new shares being issued and therefore
does not cause dilution to existing shareholders, whereas warrants are
issued by the company and result in new shares being issued.

40. How would a change in the level of the risk‐free interest rate affect the
value of a call? A put?
An increase in the level of the risk‐free interest rate will raise the value
of a call and lower the value of a put.

41. How would a change in the underlying stock price affect the value of a
call? A put?
An increase in the stock’s underlying price will raise the value of a call
and lower the value of a put.

42. How would a change in the exercise price affect the value of a call? A put?
An increase in the exercise price will lower the value of a call and
raise the value of a put.

43. How would a change in a stock’s expected volatility affect the value of
a call? A put?
An increase in the stock’s expected volatility will raise the value of a
call and raise the value of a put.

44. How would a change in the time until expiration affect the value of a
call? A put?
An increase in the time until expiration will raise the value of a call
and raise the value of a put.
Chapter 4: Financial Statement Analysis

1. What are some common SEC documents used by investment bankers?

Some of the common SEC documents used by investment bankers
include the 10‐K (annual report), 10‐Q (quarterly report), 8‐K (current
report), Schedule 14A (proxy statement), S‐1 and S‐4 (registration state-
ments), Schedule 13‐D, and Schedule 13‐F.

2. What is some of the key information found in a 10‐K?

Some of the key information found in a 10‐K includes a general busi-
ness overview, which includes information on business segments, opera-
tions, customers, suppliers, competition, recent acquisitions, risk fac-
tors, and ongoing litigation. The 10‐K also includes the three financial
statements (income statement, balance sheet, and cash flow statement),
footnotes to those financial statements, management’s discussion, and
analysis and a list of exhibits.

3. What are some of the differences between a 10‐K and a 10‐Q?

The 10‐K is typically significantly longer and contains much more
detail than the 10‐Q, in terms of business overview and footnotes to
the financial statements. The 10‐K’s financial statements are audited,
whereas the financial statements in the 10‐Q are unaudited. The 10‐K,
since it reflects an annual report, is filed once per year whereas the 10‐Q,
which reflects quarterly reports, is filed three times per year.

4. What are some key ratios that we use to analyze financial statements?
Some of the key ratios used to analyze financial statements include
growth statistics, such as revenue growth; profitably ratios, such as
gross margin, EBIT margin, and net income margin; return ratios such
as ROA, ROE, and ROIC; credit ratios, such as leverage ratios and in-
terest coverage ratios; and activity ratios, such as days sales of inventory
and accounts receivable days.

5. How would you calculate revenue growth from this year compared to
last year?
To calculate revenue growth from this year compared to last year,
divide this period’s revenue by last period’s revenue and subtract 1.

6. How would you calculate average revenue growth over the past five years?
To calculate average revenue growth over the past five years, divide
this period’s revenue by the first period’s revenue, raise that value to one
fifth and subtract 1.
7. Why might one company have higher gross margin than another?
One company might have a higher gross margin than another if it has
higher sales prices or lower direct and variable costs.

8. Why might one company have higher EBIT margin than another?
One company might have a higher EBIT margin than another if it has
higher gross margins or lower SG&A costs.

9. Why might one company have higher net income margin than another?
One company might have higher net income margin than another if
it has higher EBIT margins, lower interest expense, or a lower effective
tax rate.

10. What are the different return ratios used by bankers?

Some of the return ratios used by bankers include return on assets
(ROA), return on equity (ROE), and return on invested capital (ROIC).

11. Which return ratio is best to use when comparing companies that have
different capital structures?
Return on invested capital (ROIC) would be the best return ratio to
use when comparing companies that have different capital structures
because ROIC is neutral of capital structure.

12. What are some important examples of credit ratios?

Some examples of credit ratios include debt to equity ratio, debt to
total capitalization ratio, leverage ratios, and interest coverage ratios.

13. Would a company prefer to have a high leverage ratio or a high interest
coverage ratio?
A company would prefer to have a higher interest coverage ratio be-
cause it reflects more cash flow relative to interest expense, thus more
cash cushion. A higher leverage ratio reflects more debt relative to cash
flow.

14. How do you calculate days sales of inventory?

You calculate days sales of inventory by dividing inventory by costs
of goods sold and multiplying by 360 or 365.

15. Which is better for a company, higher days sales of inventory or lower,
and why?
It is better for a company to have a lower value for days sales of
inventory because it reflects less money tied up financing inventory.
However, if the inventory levels gets too low it may introduce risk into
the company’s production.

16. How do you calculate accounts receivable days?

You calculate accounts receivable days by dividing accounts receiva-
bles by revenue and multiplying by 360 or 365.

17. Which is better for a company, higher accounts receivable days or lower,
and why?
It is better for a company to a have a lower accounts receivable days
because the company’s customers are paying the company faster and
that money can be used for other purposes.

18. How do you calculate accounts payable days?

You calculate accounts payable days by dividing accounts payables
by costs of goods sold and multiplying by 360 or 365.

19. Which is better for a company, higher accounts payable days or lower,
and why?
It is better for a company to have a higher value of accounts payable
days because the company’s vendors are helping to finance the compa-
ny’s operations. However, too high a value can indicate financial distress
and can result in suppliers stopping selling to the customer.

20. What are different time periods that we might want to use to analyze
financial statements?
Some of the different time periods bankers use to analyze financial
statements include a full fiscal year period, the last twelve months
(LTM) period, and projected fiscal year periods.

21. How do you calculate LTM?

You can calculate LTM (last twelve months) by adding an income
statement (or cash flow statement) value for the most recent full fiscal
year to the value for the most recent year to date (YTD) period and
subtracting the corresponding value from last year’s equivalent YTD
period.

22. How do you calendarize financials? Why is this important?

You calendarize financial statements by adjusting one company’s fis-
cal year to approximate another company’s fiscal year. We multiply the
financial results (e.g., revenue) for Year 1 by the percentage of the year
that overlaps with the base fiscal year. We then multiply the results for
Year 2 by the percentage of that year that overlaps with the base fiscal
year. Adding to the two figures together approximates a company hav-
ing the base fiscal year. This is important to do to have an apples‐to‐ap-
ples comparison between companies’ operating performance especially
when economic or industry conditions have changed.

23. What are some indications that a company might be financially dis-
tressed?
Some indications that a company might be financially distressed in-
clude low interest coverage ratios or high leverage ratios, poor revenue,
cash flow or profitability, escalating accounts payable days, and declin-
ing levels of cash on the balance sheet.

24. Why might we make adjustments to a company’s financial statements?

We make adjustments to a company’s financial statements so that
we can make an apples‐to‐apples comparison between time periods or
between different companies in the same industry. Specifically we do not
want one item or unusual items to affect the various ratios and statistics
we use for comparison purposes.

25. What are some of the sources for finding non‐recurring items?
Some sources for finding non‐recurring items include a company’s
income statement, the footnotes to the income statement, the MD&A
section of 10-Ks and 10‐Qs, the press release, 8‐K, and conference call
transcript corresponding to a company’s earnings announcement, and
equity research reports.

26. What are some examples of non‐recurring items?

Some examples of non‐recurring items include restructuring costs
such as severance, gains or losses from unusual litigation, costs stem-
ming from natural or man‐made disasters, gains or losses from the sale
of assets, and losses from asset write‐downs or impairments.

27. What key questions do you need to ask yourself when adjusting for
non‐recurring items?
When adjusting for non‐recurring items, you should ask yourself
what time period the non‐recurring item affected, whether the item was
a cost or income, whether the item was operating or non‐operating, and
whether the item was disclosed pre‐tax or post‐tax.
Chapter 5: Valuation

1. How do investment bankers value companies?

Investment bankers value companies using three primary methodolo-
gies: comparable company analysis, precedent transaction analysis, and
discounted cash flow (DCF) analysis.

2. What are the primary valuation methodologies that investment bankers

use to value companies?
The primary valuation methodologies that investment bankers use to
value companies are the comparable company analysis, the precedent
transaction analysis, and the discounted cash flow (DCF) analysis.

3. What is total enterprise value?

Total enterprise value is the value of the operations of a firm attrib-
uted to all providers of capital.

4. How do you calculate total enterprise value?

You calculate total enterprise value as the market value of equity plus
debt plus preferred stock less cash plus noncontrolling interest.

5. What is the difference between total enterprise value and equity value?
Enterprise value represents the value of the operations of a company
attributable to all providers of capital. Equity value is one of the com-
ponents of enterprise value and represents only the proportion of value
attributable to shareholders.

6. What is noncontrolling interest?

The balance sheet’s noncontrolling interest reflects the percentage of
the book value of a majority, but not wholly owned subsidiary that a
company does not own.

7. Why do you add noncontrolling interest in the enterprise value

formula?
You add noncontrolling interest in the enterprise value formula
because enterprise value is used in the numerator when calculating
various valuation ratios. Because of consolidation, the denominator
(i.e., revenue, EBITDA, or net income) will include 100 percent of
a majority but not wholly owned subsidiary. Therefore, to be con-
sistent with the denominator, you add the value of the subsidiary
that the company does not own to the enterprise value, so both are
overstated.
8. Why do you subtract cash in the enterprise value formula?
Cash gets subtracted when calculating enterprise value because cash
is considered a nonoperating asset and because cash is already implicitly
accounted for within equity value.

9. How do you calculate the market value of equity?

A company’s market value of equity (MVE) equals its share price
multiplied by the number of fully diluted shares outstanding.

10. What is the difference between basic and fully diluted shares?
Basic shares represent the number of common shares that are out-
standing today (or as of the reporting date). Fully diluted shares equal
basic shares plus the potentially dilutive effect from any outstanding
stock options, warrants, convertible preferred stock, or convertible debt.

11. How do you calculate fully diluted shares using the treasury stock method?
To use the treasury stock method, we first need a tally of the com-
pany’s issued stock options and weighted average exercise prices. We
get this information from the company’s most recent 10‐K. If our cal-
culation will be used for a control‐based valuation methodology (i.e.,
precedent transactions) or M&A analysis, we will use all of the options
outstanding. If our calculation is for a minority interest based valua-
tion methodology (i.e., comparable companies) we will use only options
exercisable. Note that options exercisable are options that have vested
while options outstanding takes into account both options that have
vested and that have not yet vested.
Once we have this option information, we subtract the exercise price
of the options from the current share price (or per share purchase price
for an M&A analysis), divide by the share price (or purchase price), and
multiply by the number of options outstanding. We repeat this calcula-
tion for each subset of options reported in the 10‐K. (Usually companies
will report several line items of options categorized by exercise price.)
Aggregating the calculations gives us the amount of diluted shares. If the
exercise price of an option is greater than the share price (or purchase
price), then the options are out of the money and have no dilutive effect.
We then add the number of dilutive shares to the basic share count to
get fully diluted shares (plus any effect from other dilutive securities).

12. What are some examples of commonly used valuation multiples?

Probably the most common valuation metric used in banking is EV/
EBITDA. Some others include EV/sales, EV/EBIT, price to earnings
(P/E), and price to book value (P/BV).
13. What is wrong with using a multiple such as EV/earnings or price/
EBITDA?
Enterprise value (EV) equals the value of the operations of the com-
pany attributable to all providers of capital. That is to say, because en-
terprise value incorporates both debt and equity, it is not dependent on
the choice of capital structure (i.e., the percentage of debt and equity). If
we use enterprise value in the numerator of our valuation metric, to be
consistent (apples‐to‐apples) we must use an operating or capital struc-
ture neutral (unlevered) metric in the denominator, such as sales, EBIT,
or EBITDA. These metrics are also not dependent on capital structure
because they do not include interest expense. Operating metrics such
as earnings do include interest and so are considered leveraged or cap-
ital structure dependent metrics. Therefore EV/earnings is an apples‐
to‐oranges comparison and is considered inconsistent. Similarly price/
EBITDA is inconsistent because price (or equity value) is dependent on
capital structure (levered) while EBITDA is unlevered (again, apples‐
to‐oranges). Price/earnings is fine (apples‐to‐apples) because they are
both levered.

14. What are some factors to consider when picking comps?

Some factors to consider when picking comps include finding compa-
nies that are in the same industry with the same type of business model,
operate in the same or similar geographies, are of similar size, and have
similar growth and risk characteristics.

15. Walk me through a DCF.

In order to do a DCF analysis, first we need to project free cash flow
for a period of time (say, five years). Free cash flow equals EBIT less
taxes plus D&A less capital expenditures less the change in working
capital. Note that this measure of free cash flow is unlevered or debt‐
free. This is because it does not include interest and so is independent of
debt and capital structure.
Next we need a way to predict the value of the company/assets for the
years beyond the projection period (five years). This is known as the ter-
minal value. We can use one of two methods to calculate terminal value:
either the perpetuity growth (also called the Gordon growth) method or
the terminal multiple method. To use the perpetuity growth method, we
must choose an appropriate rate by which the company can grow forev-
er. This growth rate should be modest (for example, average long‐term
expected GDP growth or inflation). To calculate terminal value we mul-
tiply the last year’s free cash flow (year 5) by one plus the chosen growth
rate, and then divide by the discount rate less growth rate.
The second method, the terminal multiple method, is the one that is
more often used in banking. Here we take an operating metric for the
last projected period (year 5) and multiply it by an appropriate valua-
tion multiple. The most common metric to use is EBITDA. We typically
select the appropriate EBITDA multiple by taking what we concluded
for our comparable company analysis on a last twelve months (LTM)
basis.
Now that we have our projections of free cash flows and terminal
value, we need to “present value” these at the appropriate discount
rate, also known as weighted average cost of capital (WACC). Fi-
nally, summing up the present value of the projected cash flows and
the present value of the terminal value gives us the DCF value. Note
that because we used unlevered cash flows and WACC as our dis-
count rate, the DCF value is a representation of enterprise value, not
equity value.

16. How do you calculate free cash flow?

Free cash flow equals EBIT less taxes plus D&A less capital expendi-
tures less the change in working capital.

17. Why do you use unlevered free cash flow?

You use unlevered free cash flow because we want the DCF value
concluded to be enterprise value.

18. What is the terminal value and how do you calculate it?
Terminal value is the value of the company beyond the projection
period. We can use one of two methods for calculating terminal value:
either the perpetuity growth (also called the Gordon growth) method
or the terminal multiple method. To use the perpetuity growth meth-
od, we must choose an appropriate rate by which the company can
grow forever. This growth rate should be modest (for example, aver-
age long‐term expected GDP growth or inflation). To calculate ter-
minal value we multiply the last year’s free cash flow (year 5) by one
plus the chosen growth rate, and then divide by the discount rate less
growth rate.
The second method, the terminal multiple method, is the one that
is more often used in banking. Here we take an operating metric for
the last projected period (year 5) and multiply it by an appropri-
ate valuation multiple. The most common metric to use is EBITDA.
We typically select the appropriate EBITDA multiple by taking what
we concluded for our comparable company analysis on a last twelve
months (LTM) basis.
19. Why do you present value the cash flows?
You present value the cash flows because we want to calculate the
enterprise value of the company at today’s value. Since money today
is worth more than money tomorrow, we need to discount or present
value all of the cash flows and the terminal value.

20. Conceptually, what does WACC represent?

Conceptually, WACC represents the company’s blended cost of funds
or, alternatively, the investors’ blended required return for investing in a
company of this type of risk.

21. What is the formula for WACC?

The formula for WACC is the cost of debt multiplied by the percent-
age of debt in the capital structure multiplied by one minus the tax rate,
plus the cost of equity times the percentage of equity in the capital struc-
ture, plus the cost of preferred stock times the percentage of preferred
stock in the capital structure.

22. How do you calculate the cost of equity?

To calculate a company’s cost of equity, we typically use the Capital
Asset Pricing Model (CAPM). The CAPM formula states that the cost of
equity equals the risk‐free rate plus the multiplication of beta times the
equity risk premium. The risk‐free rate (for a U.S. company) is generally
considered to be the yield on a 10‐ or 20‐year U.S. Treasury bond. Beta
should be levered and represents the riskiness (equivalently, expected
return) of the company’s equity relative to the overall equity markets.
The equity risk premium is the amount that stocks are expected to out-
perform the risk free rate over the long‐term.

23. What is the CAPM formula?

The CAPM formula states the cost of equity equals the risk‐free rate
plus the multiplication of beta times the equity risk premium.

24. What is beta?

Beta is a measure of the riskiness of a stock relative to the broader
market (for broader market, think S&P 500). By definition the “mar-
ket” has a beta of one (1.0). So a stock with a beta above 1 is perceived
to be more risky than the market and a stock with a beta of less than 1 is
perceived to be less risky. Beta is used in the Capital Asset Pricing Model
(CAPM) for the purpose of calculating a company’s cost of equity. Beta
is calculated as the covariance between a stock’s return and the market
return divided by the variance of the market return.
25. Why do you unlever and lever beta?
In order to use the CAPM to calculate our cost of equity, we need to
estimate the appropriate beta. We typically get the appropriate beta from
our comparable companies (often the mean or median beta). However,
before we can use this “industry” beta, we must first unlever the beta of
each of our comps. The beta that we will get (say, from Bloomberg or
Barra) will be a levered beta.
Recall what beta is: in simple terms, how risky a stock is relative to
the market. Other things being equal, stocks of companies that have
debt are somewhat riskier that stocks of companies without debt (or
that have less debt). This is because even a small amount of debt in-
creases the risk of bankruptcy and also because any obligation to pay
interest represents funds that cannot be used for running and growing
the business. In other words, debt reduces the flexibility of management,
which makes owning equity in the company riskier.
In order to use the betas of the comps to conclude an appropriate beta
for the company we are valuing, we must first strip out the impact of
debt from the comps’ betas. This is known as unlevering beta. After un-
levering the betas, we can now use the appropriate “industry” beta (i.e.,
the mean of the comps’ unlevered betas) and relever it for the appropri-
ate capital structure of the company being valued. After relevering, we
can use the levered beta in the CAPM formula to calculate cost of equity.

26. What is the formula for unlevering and levering beta?

Unlevered Beta = Levered Beta / (1 + ((Debt/Equity) × (1 – Tax Rate)))
Levered Beta = Unlevered Beta x (1 + ((Debt/Equity) × (1 – Tax Rate)))

27. How do you calculate the cost of debt?

To calculate the cost of debt, we can use one of three methods. The
first method is to calculate the weighted average cost of debt for each of
the comparable companies based on each company’s different types of
debt outstanding, and the appropriate interest rates and yields on each
of those types of debt. Then we can take the mean/median or use judg-
ment to conclude the appropriate cost of debt for the company being
valued. The second method is to take the average credit rating for the
comparable companies and look up the appropriate yield to maturity
on bonds of that credit rating. The third, though least accurate, method
is to take the interest expense for each comparable company and divide
by the company’s average debt balance. Then take the mean/median or
use judgment to approximate the cost of debt for the company being
valued. For any of the methods we then need to multiply by one minus
the tax rate to calculate the post‐tax cost of debt.
28. How would you value a biotechnology startup with one potential
blockbuster drug that is currently in clinical trials?
To value a biotechnology startup without current revenue you would
probably need to run a DCF assuming the drug passes clinical trials and
goes to market. However, you would probability weight the DCF value
based on the likelihood that the drug does indeed pass trials.

29. How do you use the three main valuation methodologies to conclude
value?
The best way to answer this question is to say that you calculate a
valuation range for each of the three methodologies and then triangu-
late the three ranges to conclude a valuation range for the company or
asset being valued. You may also put more weight on one or two of the
methodologies if you think that they give you a more accurate valua-
tion. For example, if you have good comps and good precedent transac-
tions but have little faith in your projections, then you will likely rely
more on the comparable company and precedent transaction analyses
than on your DCF.

30. Of the three main valuation methodologies, which ones would you ex-
pect to give you higher or lower value?
First, the precedent transactions methodology is likely to give a higher
valuation than the comparable company methodology. This is because
when companies are purchased, the target’s shareholders are typically
paid a price that is higher than the target’s current stock price. Techni-
cally speaking, the purchase price includes a control premium. Valu-
ing companies based on M&A transactions (a control‐based valuation
methodology) will include this control premium and therefore likely
result in a higher valuation than a public market valuation (minority
interest based valuation methodology).
The discounted cash flow (DCF) analysis will also likely result in a
higher valuation than the comparable company analysis because DCF is
also a control‐based methodology and because most projections tend to
be pretty optimistic. Whether DCF will be higher than precedent trans-
actions is debatable, but it is fair to say that DCF valuations tend to be
more variable because the DCF is so sensitive to a multitude of inputs
or assumptions.

31. What are the advantages and disadvantages of each of the three main
valuation methodologies?
An advantage of the comparable company methodology is that it
uses current market values to conclude value. Assuming there are good
comparable companies, it is usually the most important method when
valuing a company and is indeed the way in which the public market
does typically value publicly traded companies. However, it is less useful
if there are few or no good comparable companies, or if you are valuing
a company that has no revenue or EBITDA or net income.
An advantage of the precedent transaction methodology is that it re-
flects the value that buyers were actually willing to pay for companies.
Remember that at the end of the day, value is what someone is willing
to pay. It can also be the most useful methodology when there are many
very recent and very relevant transactions. However, a large disadvan-
tage is that valuation multiples are highly sensitive to market conditions,
and often precedent transactions will reflect deals that occurred over
many years and over different types of market conditions. Plus, deal
dynamics can play an important role in determining the purchase price
of a transaction, and these deal dynamics may have a material impact
on valuation multiples for a particular deal that may make that deal less
relevant. Finally, valuation multiples for this methodology tend to show
a wider range of values than do the comparable company methodology.
An advantage of the discounted cash flow methodology is that it can
be performed for any type of company, even a pre‐revenue company.
Because it is so variable to the forecasts and other impacts, it is also easy
to conclude a wide range of values from the DCF, which is helpful when
you need to match a preconceived notion of value. Finally, it is theoreti-
cally the correct way to value a company. A very large disadvantage of
the DCF is that it is very sensitive to the cash flow forecasts, WACC,
and terminal multiple or perpetuity growth factor, which makes it very
unreliable.

32. What are some other valuation methodologies that you might use to
value a company?
Other valuation methodologies include leverage buyout (LBO) analy-
sis, sum of the parts analysis, replacement value, and liquidation value.

Chapter 6: Financial Modeling

1. Why are models circular?

Models can be circular for a number of reasons, but the most com-
mon reason relates to interest. If the model shows that the company
needs more cash, the model will draw down from the revolving credit
facility. Drawing down from the revolving credit facility will result in
more interest expense, which will require more money, which will lead
to a larger drawdown, which will result in more interest expense, and
so forth. Similarly, excess cash will result in more interest income, which
will result in more cash and more interest income, and so forth.

2. What are some best practices for building financial models?

Some best practices for building models include keeping all of the
financial statements on one tab, having no hardcodes on the model tab,
having a separate tab for assumptions, being consistent with format-
ting and formatting as you go, keeping a list of your assumptions and
sources, turning off gridlines, saving often, and saving new versions.

3. How do you calculate the revolver?

Note that there are several formulas you can use to calculate the
change to the revolver. One such formula is as follows. To calculate the
change to the revolver, you can take the negative of the minimum of
the beginning revolver balance and everything else that happens to cash
during that period including the beginning cash balance.

4. How might you forecast revenue for a retailer?

You might forecast revenue for a retailer simply by growing last
period’s revenue by some growth rate. You might also forecast revenue
by multiplying the number of stores or store square footage by some
appropriate metric for sales per store or sales per square footage. In
a very detailed model, you might forecast revenue by aggregating the
revenue forecast for each store or even for each product sold by the
company.

5. How might you forecast revenue for a telecommunications company?

You might forecast revenue for a telecommunications company sim-
ply by growing last period’s revenue by some growth rate. You might
also forecast revenue by multiplying average revenue per user by the
number of users. You might forecast the number of users each period by
adding last period’s users plus new users less churn.

6. Why is it important to spread historical financials when building

models?
It is important to spread historical financials when building models
for several reasons. First, you will calculate certain ratios and statistics
based on the historical financial statements that you can use to help se-
lect your model drivers and assumptions. Second, the historical balance
sheet is the beginning balance sheet for your forecast model. Third, it
is important to compare historical financial statements with projected
financial statements to determine the reasonableness of your forecasts,
and to help spot modeling mistakes and/or poorly chosen assumptions.

7. Walk me through building a model.

First, you need to learn about the company, its industry, and the fac-
tors that will drive the company’s business. Second, you need to spread
the historical financial statements and calculate key statistics such as
growth rates and margins from those statements. Next, you need to se-
lect your model drivers and assumptions. After that, you can model the
three financial statements, beginning with the income statement, then
the balance sheet, and finally the cash flow statement. You will also
include other supporting schedules such as the debt schedule. Assum-
ing the model balances, you should stress‐test it, and then check it to
make sure your assumptions are reasonable and that you do not have
any modeling or linking errors. Finally, you can create any supporting
schedules or exhibits that you need, and perform any additional analy-
sis such as a DCF analysis.

8. What is the best way to check a model?

Once a model has been stress‐tested and the balance sheet balances,
the best way to check a model is to print it out and analyze the results.
Compare the projected results with historical results and look for any
large increases or decreases from year to year. Also, calculate key ratios
with a calculator and compare them to the results from the model print-
out. If there are figures that look odd or unreasonable, then go back into
Excel and check the model formulas and assumptions.

Chapter 7: Mergers and Acquisitions

1. Why might one company want to acquire another company?

There are a variety of reasons why companies make acquisitions, in-
cluding both the stated and unstated reasons. One reason is that the
buyer’s own organic growth has slowed or stalled, and needs to grow
in other ways (via acquiring other companies) in order to satisfy the
growth expectations of Wall Street. Another prominent reason is that
the buyer expects the deal to result in significant synergies. The buyer
may also view the target as undervalued, or view its own stock as over-
valued. Or, the CEO of the buyer wants to be CEO of a larger company,
either because of ego or legacy, or because he or she will get paid more
and have a higher profile. Other reasons include diversification or to
prevent a competitor from making the acquisition.
2. Explain the concept of synergies and provide some examples.
In simple terms, synergy occurs when 2 + 2 = 5—that is, when the
sum of the value of the buyer and the target as a combined company is
greater than the two companies valued apart. Most mergers and large
acquisitions are justified by the amount of projected synergies. There are
two categories of synergies: cost synergies and revenue synergies. Cost
synergies refer to the ability to cut costs of the combined companies due
to the consolidation of operations (for example, closing one corporate
headquarters, laying off one set of management, shutting redundant
stores, etc.). Revenue synergies refer to the ability to sell more products/
services or raise prices due to the merger (for example, increasing sales
due to cross‐marketing, co‐branding, etc.). The concept of economies of
scale can apply to both cost and revenue synergies.

3. What are some of the differences between a merger and a tender offer?
A merger can be used for friendly deals, while a tender offer can be
used for friendly or hostile/unsolicited deals. In a merger, the buyer and
seller negotiate the terms of the transaction and then the transaction is
put up for a vote from the seller’s shareholders. In a tender offer, the
buyer makes an offer directly to the target’s shareholders. A successful
merger will typically result in 100 percent of the shares being acquired,
while a tender offer typically will not. In a tender offer, the buyer will
typically have to effectuate a second transaction to acquire all 100 per-
cent of shares. Tender offers are also generally quicker to effectuate if
the purchase consideration is cash, while mergers are more likely if the
consideration is stock or if there are significant regulatory issues antici-
pated.

4. What are some of the pros and cons of a stock versus asset purchase?
Advantages of a stock purchase are that it can generally be executed
faster than an asset purchase, and is generally used for acquisitions or
public companies. Another advantage of a stock purchases is that the
seller is not double taxed and in certain circumstances can put off all
taxes. Disadvantages of a stock transaction are that the buyer does not
get a step‐up of tax basis, and cannot pick and choose assets to acquire
and/or liabilities to leave behind.
An advantage of an asset purchase is that buyers can pick and choose
assets to acquire, and leave behind liabilities and contingent liabilities
that it does not want. Another advantage is that buyers get a step‐up in
tax basis. A disadvantage is that there is a double layer of taxes to the
seller. Another disadvantage is that transactions often take longer as
each asset needs to be valued and transferred.
5. Do buyers generally prefer stock or asset deals?
Buyers tend to prefer deals structured as asset purchases even though
they tend to take longer to complete because of the step‐up of the tax
basis, and because of the ability to pick and choose assets and leave
certain liabilities behind.

6. Do sellers generally prefer stock or asset deals?

Sellers tend to prefer stock deals because of the single layer of taxa-
tion and because there are no bad assets or liabilities that remain.

7. Walk me through a sell‐side M&A process.

In a typical sell‐side M&A transaction, known as a two stage auction
process, the investment bank representing the seller first sends out a
teaser to prospective buyers along with a confidentially agreement. The
investment bank will then send out a Confidential Information Memo-
randum (CIM) to parties that are interested and have signed the confi-
dentially agreement. Buyers will then be expected to submit first round
non‐binding bids. The bank and the client will then select which buyers
get invited into the second round of bidding. Second round buyers will
get invited to management presentations and are given the opportunity
to do due diligence and use the data room. Binding final-round bids are
then submitted, and the sell‐side investment bank and its client will de-
cide who wins the auction. Following any further negotiations and due
diligence, the contracts will be signed and, following any regulatory or
other approval processes, the deal will close.

8. Would an investment bank prefer to be on the sell side of an M&A deal

or the buy side?
An investment bank would generally prefer to be on the sell side of an
M&A deal because the sell‐side adviser is much more likely to receive a
success fee/transaction fee for the deal being completed.

9. What are some of the marketing documents that bankers create when
working on a sell‐side M&A transaction?
Some of the marketing documents created by bankers when working
on a sell‐side M&A transaction include the teaser, confidential informa-
tion memorandum (CIM), and management presentation.

10. What analysis might be done for an M&A assignment?

Some of the analysis performed by bankers on an M&A assignment
include valuation of the target and often detailed modeling of the tar-
get. In addition, M&A–specific analysis frequently done includes an
accretion/dilution analysis, a full‐blown merger model, a contribution
analysis, and an analysis at various prices (AVP).

11. Walk me through an accretion/dilution analysis.

The purpose of an accretion/dilution analysis (sometimes also re-
ferred to as a “quick and dirty” merger analysis) is to project the impact
of an acquisition to the acquirer’s earnings per share (EPS) and compare
how the new EPS (pro forma EPS) compares with what the company’s
EPS would have been had it not executed the transaction.
In order to do the accretion/dilution analysis, we need to project the
combined company’s net income (pro forma net income) and the com-
bined company’s new share count. The pro forma net income will be the
sum of the buyer’s and target’s projected net income plus/minus certain
transaction adjustments. Such adjustments to pro forma net income (on
a post‐tax basis) include synergies (positive or negative), increased inter-
est expense (if debt is used to finance the purchase), decreased interest
income (if cash is used to finance the purchase), and any new intangible
asset amortization resulting from the transaction.
The pro forma share count reflects the acquirer’s share count plus the
number of shares to be created and used to finance the purchase (in a
stock deal). Dividing pro forma net income by pro forma shares gives
us pro forma EPS, which we can then compare to the acquirer’s original
EPS to see if the transaction results in an increase in EPS (accretion) or
a decrease in EPS (dilution). Note also that we typically will perform
this analysis using one‐year and two‐year projected net income and also
sometimes last twelve months (LTM) pro forma net income.

12. What factors can lead to the dilution of EPS in an acquisition?

A number of factors can cause an acquisition to be dilutive to the
acquirer’s earnings per share (EPS), including: (1) the target has nega-
tive net income, (2) the target’s price/earnings ratio is greater than the
acquirer’s, (3) the transaction creates a significant amount of intangible
assets that must be amortized going forward, (4) increased interest ex-
pense due to new debt used to finance the transaction, (5) decreased
interest income due to less cash on the balance sheet if cash is used to
finance the transaction, and (6) low or negative synergies.

13. If a company with a low P/E acquires a company with a high P/E in an
all‐stock deal, will the deal likely be accretive or dilutive?
Other things being equal, if the price to earnings ratio (P/E) of the
acquiring company is lower than the P/E of the target, then the deal will
be dilutive to the acquirer’s earnings per share (EPS). This is because
the acquirer has to pay more for each dollar of earnings than the mar-
ket values its own earnings. Hence, the acquirer will have to issue
proportionally more shares in the transaction. Mechanically, pro forma
earnings, which equals the acquirer’s earnings plus the target’s earn-
ings (the numerator in EPS), will increase less than the pro forma share
count (the denominator), causing EPS to decline.

14. What is an analysis at various prices?

An analysis at various prices shows the implied acquisition premium
and various valuation multiples at range of different purchase prices.

15. What is a contribution analysis?

A contribution analysis is an analysis that shows, usually in graphical
form, the percentage contribution of various metrics from both the ac-
quirer and the target that make up the combined company. Common fi-
nancial metrics include revenue, EBITDA, and net income. Non‐financial
metrics might include the number of employees, stores, or subscribers.

Chapter 8: Leveraged Buyouts

1. What is an LBO?
A leveraged buyout is an acquisition of a company or division of a
company by a private equity firm using debt for a substantial percent-
age of the acquisition financing.

2. Why do private equity firms do LBOs?

By using significant amounts of leverage (debt) to help finance the
purchase price, the private equity firm reduces the amount of money
(the equity) that it must contribute to the deal. Reducing the amount
of equity contributed will result in a substantial increase to the private
equity firm’s rate of return upon exiting the investment (e.g., selling the
company five years later).

3. What makes a good LBO candidate?

Characteristics of a good LBO target include steady cash flows, lim-
ited business risk, limited need for ongoing investment (e.g., capital
expenditures or working capital), strong management, opportunity for
cost reductions, and a high asset base (to use as debt collateral). The
most important trait is steady cash flows, as the company must have
the ability to generate the cash flow required to support relatively high
interest expense.
4. What would be a bad LBO candidate?
A poor LBO candidate is a company with low or unsteady cash flows,
significant business risk, high cyclicality, large capital expenditures
needs, and few salable assets.

5. What are key assumptions that go into making an LBO model?

Some of the assumptions that go into an LBO model include all of the
assumptions relating to operating performance, such as revenue growth,
costs, capital expenditures, and working capital requirements. A second
set of assumptions are the purchase assumptions, including the purchase
price, the amount of debt being raised, the types of debt being raised, and
the amount of money contributed by the financial sponsor. A third set of
assumptions are the exit assumptions including when the financial spon-
sor will exit its investment and at what valuation or valuation multiple.

6. What is an LBO model used for?

An LBO model is used for three primary purposes. The first purpose is
to analyze the expected return (IRR) to the financial sponsor and to any
other equity holders. A second purpose of the LBO model is as a valuation
methodology. A third purpose is to analyze various credit statistics over
the projection period to analyze the company’s ability to service its debt.

7. Walk me through an LBO model.

First, we need to make some transaction assumptions. What is the
purchase price and how will the deal be financed? With this information,
we can create a table of sources and uses (where sources equals uses).
Uses reflects the amount of money required to effectuate the transaction,
including the equity purchase price, any existing debt being refinanced,
and any transaction fees. The sources tells us from where the money is
coming, including the new debt and any existing cash that will be used,
as well as the equity contributed by the private equity firm. Typically,
the amount of debt is assumed based on the state of the capital markets
and other factors, and the amount of equity is the difference between
the uses (total funding required) and all of the other sources of funding.
The next step is to change the existing balance sheet of the company
to reflect the transaction and the new capital structure. This is known
as constructing the pro forma balance sheet. In addition to the changes
to debt and equity, intangible assets such as goodwill and capitalized
financing fees will likely be created.
The third and typically most substantial step is to create an integrated
cash flow model for the company—in other words, to project the com-
pany’s income statement, balance sheet, and cash flow statement for
a period of time (say, five years). The balance sheet must be projected
based on the newly created pro forma balance sheet. Debt and interest
must be projected based on the post‐transaction debt.
Once the functioning model is created, we can make assumptions
about the private equity firm’s exit from its investment. For example, a
typical assumption is that the company is sold after five years at the same
implied EBITDA multiple at which the company was purchased. Project-
ing a sale value for the company allows us to also calculate the value of
the private equity firm’s equity stake, which we can then use to analyze
its internal rate of return (IRR). Absent dividends or additional equity
infusions, the IRR equals the average annual compounded rate at which
the PE firm’s original equity investment grows (to its value at the exit).
While the private equity firm’s IRR is usually the most important
piece of information that comes out of an LBO analysis, the analysis
also has other uses. By assuming the PE firm’s required IRR (among
other things), we can back into a purchase price for the company, thus
using the analysis for valuation purposes. In addition, we can utilize the
LBO model to analyze the trend of credit statistics (such as the leverage
ratio and interest coverage ratio), which is especially important from a
lender’s perspective.

8. How do we use an LBO model for valuation?

We can use an LBO model for valuation by making several assump-
tions in addition to the operating assumptions that underlie the finan-
cial model. Specifically, these assumptions are the amount of debt raised
in the transaction, the exit multiple, the time until the investment exit,
and, most importantly, the required return (IRR) to the financial spon-
sor. By making these assumptions, we know how much the sponsor
will receive for its equity upon an exit and can back into the amount of
money the sponsor can afford to put into the deal to earn its required
IRR. By knowing the money invested by the sponsor and the amount
of debt that can be raised to do the deal, we can estimate the implied
enterprise and/or equity value today and use that figure for valuation
purposes.

9. How might we increase the IRR to a PE firm?

Some of the key ways to increase the PE firm’s return (in theory, at
least) include to reduce the purchase price that the PE firm has to pay
for the company, to increase the amount of leverage (debt) in the deal,
to increase the price for which the company sells when the PE firm ex-
its its investment (i.e., increase the assumed exit multiple), to increase
the company’s growth rate in order to raise operating income/cash
flow/EBITDA in the projections, and to decrease the company’s costs in
order to raise operating income/cash flow/EBITDA in the projections.

10. How do sources and uses work?

In an LBO model, sources and uses must be equal. Key uses include
the purchase price to buy out 100 percent of the existing equity holders,
transaction fees, and the amount of debt that needs to be refinanced.
Sources include the new debt being raised, any cash used from the tar-
get company’s existing balance sheet, and the financial sponsor’s equity
contribution. By setting sources equal to uses, and making the other
assumptions including the purchase price, we can back into the amount
of money that the financial sponsor needs to contribute.

11. How do we create the pro forma balance sheet?

To create the pro forma balance sheet for an LBO model, we start
with the most recent actual balance sheet for the target company. We
then make certain adjustments. For example, we reduce the balance
sheet for any cash used to finance the purchase price and for debt that
needs to be refinanced, and increase the balance sheet for new debt. We
wipe out old equity, and include the financial sponsor’s equity contribu-
tion as new equity. We also make adjustments for any changes to fixed
assets or intangible assets, including goodwill and financing fees. The
pro forma balance sheet reflects all of these adjustments and must bal-
ance.

12. What are considerations to whether a PE firm should do the deal?

Probably the most important consideration for a PE firm is its expect-
ed return (IRR) on the investment. However, the PE firm should also
consider the reliability of its forecasts, as well as the risk of the company
and its ability to service its debt going forward. The PE firm should also
consider the likely exits for its investment several years in the future. PE
firms may also consider doing a transaction if the acquisition will serve
as a platform acquisition for future bolt‐on acquisitions or is a bolt‐on
acquisition for an already‐acquired platform.

13. What are some key credit statistics used when analyzing an LBO?
Some of the key credit statistics typically calculated when analyzing
an LBO model include a debt to total capitalization, debt to equity, and
various leverage ratios and interest coverage ratios.