Accounting (always assume a 40% tax rate):

1. If you only had one financial statement, which would it be? What about two?
Statement of cash flows. Can get FCF and use it to run a dcf/compare to competitors. If you had
two then balance sheet and incomes statement; you can get the cash flows from these two.
2. How does $10 depreciation flow through financial statements?
Starting with the income statement, you have a $10 depreciation expense, but a $4 tax benefit.
The net income is -$6, which flows through to the statement of cash flows. Add back non-cash
expenses (depreciation) of $10 and you get an increase in cash from operations of $4. This flows
through to the balance sheet where cash increases by $4, net property, plant, & equipment
decreases by$10, and the difference from that (found in net income) is -$6 which flows into the
statement of retained earnings.
3. Your company sells goods that cost $10 for $20. How do you account for it?
Starting with the income statement, revenues of $20, cost of goods sold is $10, which gives you
income before taxes of $10. There is a tax expense of $4, and a net income of $6. This flows
through to the statement of cash flows, where you add back non-cash expenses (otherwise
known as changes in working capital )of $10 (inventory), so cash increases by $16. This flows into
the cash account on the balance sheet, inventory decreases by $10, and the difference from that
of $6 (found in the income statement), flows into retained earnings
4. A. Your company issues bonds at par for $100. How do you account for it?
On the statement of cash flows, cash from financing increases by $100. This means an increase
in cash on the balance sheet of $100, but there is also an increase of $100 in debts payable.
B. The next day the market values those bonds at $50. How do you account for it?
You do not do anything.
C. The day after that (bonds are still at $50), you buy them back. How do you account for it?
Unusual income on the income statement increases by $50, but there is a tax expense of $20 to
get to a net income of $30. This flows through to the statement of cash flows but you subtract
out non cash gains of $50 so cash from operations is -$20. Cash from financing is -$50. Net
change in cash is -$70 which is taken into account in the balance sheet cash account. Debts
payable also decreases by $100 and the difference of that is $30 (found in the income statement)
flows into the retained earnings.
5. On January 1st your company issues $100 debt at a 10% interest rate. You immediately use that
money to buy $100 of equipment that has a 10 year useful life and it is depreciated using the
straight line method. How do you account for it when this transaction takes place? At the end of
the year (assume you let the interest accrue)?
January 1st: Cash from financing increases by $100, cash from investing decreases by $100. On
the balance sheet property, plant, & equipment increases by $100, but so does debts payable.
Year end: On the income statement you have a depreciation expense of $10 and an interest
expense of $10. Income before taxes is -$20 and you have a tax benefit of $8. Net income is -$12
which flows through to the statement of cash flows. Add back non-cash expenses(depreciation of
$10) and changes in working capital (you let the interest accrue, so $10) and you have cash
increase by $8. This flows into the cash account on the balance sheet, net PP&E decreases by
$10, and interest payable increases by $10. The difference in this is -$12 (found on the income
statement) and goes into the retained earnings.
6. What is net working capital? Can you think of a case where a company can keep net working
capital negative but still be very successful?
Net working capital is current assets (excluding cash) minus current liabilities. Wal-Mart has a
great supply chain where they keep inventory relatively low, get paid right away by customers,
and don’t have to pay their supplies until the end of the month.
7. What is the difference between IRS accounting and GAAP accounting?
IRS accounting is on a cash basis, GAAP accounting is on an accrual basis.
8. What is a deferred tax asset? How do these normally arise?
A deferred tax asset is a tax benefit you get in the future. This arises when you have negative net
income one year which creates the DTA.
9. What is a deferred tax liability? How do these normally arise?
A deferred tax liability is where you owe/will owe the government money in the future for taxes
but the government has not charged you yet. This usually arises when you use accelerated
depreciation for the IRS and a slower depreciation rate on your books.
10. What are the five uses of cash?
Finance operations, pay a dividend, pay down debt, buy back equity, make an acquisition

Valuation

1. How do you value a company?

Discounted cash flows, precedent transactions, comparable companies, and in the case of a
financial sponsor a leveraged buy-out.
2. What are other ways of valuing a company?
Sum of the parts, book value, liquidation value.
3. What is a DCF? Why should I look at it?
A DCF is where you project out free cash flows for an appropriate amount of time, find the
terminal value at the end of these projections, discount the values back to the present and
then sum them. A DCF provides the ‘intrinsic value’, or what the company is worth if you just
hold onto it and decide not to sell it.
4. How do you calculate terminal value (both ways) = The value of a bond at
maturity, or of an asset at a specified, future valuation date, taking into account
factors such as interest rates and the current value of the asset, and assuming a
stable growth rate?
Exit multiple method, where you assume at the end of the period you assume the company is
sold for similar multiples at what recent transactions have been occurring at. Perpetuity
method where you assume the company continues to grow at one rate forever.
((Last year of projections fcf) x (1 + perpetuity growth rate)) / (discount rate – perpetuity growth rate)
5. Which way of calculating terminal value is more common?
Exit multiple method.
6. What is the typical long term growth rate under the perpetuity growth method?
2.5-3.0% because that is what the historic GDP is (you can’t assume it grows fast than the
GDP otherwise that company will take over the world).
7. How long do you project out cash flows?
Usually between 3-10 years, but it can be longer under unusual circumstances.
8. How do you get to free cash flows from (revenue/operating cash flows/net
income)?
From revenues: revenues minus cost of goods sold gives you gross profit, minus supplies,
general & administrative, and depreciation and amortization gives you EBIT. Tax affect EBIT
to give you Earnings Before Interest After Taxes, then add back depreciation & amortization,
subtract out changes in working capital and capital expenditures to get (unlevered) FCF.
From operating cash flows: subtract capital expenditures,
From net income: Add back interest, tax affect it, add back depreciation & amortization,
subtract changes in working capital and cappex.
9. Let’s say a company has had great free cash flow for the past 100 years and it
declares bankruptcy. Why would this happen?
It probably has taken on a lot of debt and can no longer pay down the principal/interest.
10. What is the discount rate you use?
Weighted average cost of capital.
11. How do you calculate it?
*Assuming the capital structure is just debt and equity:
(Debt / Debt + Equity) x Cost of Debt x (1 – marginal tax rate) + (Equity / Debt + Equity) x Cost of Equity
12. Where do I find cost of debt?
Look at Bloomberg on the debts outstanding and look at the yield to maturities.
13. And the cost of equity?
Capital Asset Pricing Model: Risk-Free Rate + Levered Beta (Expected Market Return – Risk-Free Rate)
14. How do I lever beta (Beta is a measure of the volatility, or systematic risk, of a
security or a portfolio in comparison to the market as a whole)?
Levered Beta = Unlevered Beta x (1 + (Debt / Equity) x (1 – tax rate))
15. Which one is more expensive? Why?
Equity is more expensive because when a company declares bankruptcy they get paid last.
Numerically, the cost of equity takes into account the leverage ratio making equity more
expensive. There is also a tax benefit associated with debt.
16. What if I have a private company?
Find closest competitors, unlever their betas, average that, then lever it back up at your
company’s leverage ratio and tax rate.
17. What does the end value of the DCF give you?
Enterprise value.
18. Can I get equity value from a DCF?
Use levered fcf instead of unlevered fcf and make the cost of equity the discount rate.
19. What is an LBO? Why should I look at it?
An LBO is used as a benchmark for private equity firms to see whether or not they can make
an appropriate return on a company by buying it with primarily debt and using free cash
flow to pay down this debt and build equity over time. You project out the free cash flows for
the holding periods, build in a debt schedule, find the terminal value, discount these values
to the present and sum them. It is important to see whether or not a financial sponsor might
pay more for a company that a strategic acquirer.
20. Why is leverage important?
Leverage helps reduce the initial amount of equity needed, which helps to increase the
internal rate of return.
21. How do I calculate leverage?
Leverage is some form debt in the numerator (total debt, net debt, total senior secured)
divided by EBIT/EBITDA/EBITDAR/ect.
22. How much equity contribution do you usually see in LBO’s?
35-40%
23. What are common leverage amounts? Why?
4-7x Net Debt / EBITDA. You use fcf to pay down debt over the holding period, so you want a
leverage amount similar to how many years you plan on holding the company.
24. What is IRR?
Internal rate of return; what discount rate is required to make the net present value of all
cash uses/sources equal to 0.
25. How can I increase IRR?
Using more debt and less equity, increase fcf, paying a lower multiple, selling at a higher
multiple, finding synergies between a platform and add-in/tuck-on, industry is more
appealing at end of holding period than beginning, hiring very experienced management,
moving the headquarters to a more tax friendly environment.
26. What is a dividend recap?
At the end of the holding period you basically re-LBO it; take on a lot more debt at the
company and pay investors a large dividend.
27. What are precedent transactions? Why should I look at it?
Looking at previous transactions to see what multiples are being paid. If a company wants to
sell itself/spin off a subsidiary, this is one of the more important valuation metrics.
28. What do I look for in precedent transactions? Why?
Similar industry/core competency, similar size, similar geography are the three big ones. You
also want a similar economic environment. After that you might want similar ratios, metrics,
multiples, credit ratings, customers, suppliers, etc. There is no perfect comp, but by finding as
similar as possible you can find the most accurate valuation as possible.
29. What are comparable companies? Why should I look at it?
Comparable companies are looking at what multiples similar companies are trading at in the
public markets. If you are thinking about taking a private company public, then you should
focus on this.
30. What do I look for in comparable companies? Why
Basically the same as precedent transactions, for the same reasons.
31. What multiples do you look at?
P/E, EV/EBITDA, EV/Sales, Debt/EBITDA, Interest Expense/EBITDA
32. Why can’t I use EV/EPS?
EPS is only available to equity holders whereas EV represents all stakeholders.
33. Which valuation usually gives you the highest amount? Second? Third? Fourth?
Precedent transactions due to control premium and synergies, DCF because of management
optimism, comparable companies because the liquidity premium, LBO in last because there
are rarely premiums.
34. When would this ranking get switched up?
If the economic environment has recently changed then there might not be any relevant
precedent transactions, changes in wacc/projected fcf/terminal value would change a DCF,
the public markets could be in a bubble or depression for comparable companies, debt prices
could be cheap or there could be synergies for an add on company in an LBO
35. How do I calculate enterprise value?
Fully diluted equity (in the money options, warrants, convertible debt) + net debt + minority
interests.
36. If I issue debt for $100, what happens to EV?
No change, debt increase of $100 is canceled out by a cash increase of $100.
37. What is minority interest?
When company A owns 60% of Company X, 100% of Company X’s earnings is recorded on A’s
books so you need to add the other 40% of Company X to account for other stakeholders.
38. What is the difference between hard synergies and soft synergies?
Hard synergies are cost savings that are almost sure to be had; soft synergies are increases
in revenue/net income which are harder to predict accurately.
39. What is EBITDA a proxy for? EBIT?
Free cash flow, operating income
40. A company with a P/E of 10 uses 100% equity to buy a company with a P/E of 12.
A. Is this accretive or dilutive?
Dilutive; you receive ten dollars upfront to give up one dollar of earning power but are
paying twelve dollars upfront to receive one dollar of earning power.
B. If the company used 50% debt and 50% equity to buy the company, what would be the
cost of debt that makes the purchase P/E neutral (assuming a 40% tax rate)?
Cost %’s can be inversed to find the PE of debt
0.5x(PE of debt)+0.5x10=PE of 12
PE of debt = 14
Cost of debt after taxes = 1/14 = 7.14%
0.0714/(1-0.40)= .1109 or 11.90% cost of debt
C. (Ignore parts A&B) If the cost of debt it is 6%, what % of equity is needed to be P/E
neutral?
y=portion of debt needed
0.06x(1-0.4)=0.036 = PE of 27.7
27.7y+10(1-y)=12
17.7y=2
Y=11.25%, so equity = 88.75%
41. Company A has a share price of $25 and 1,000,000 shares outstanding buys
Company B with 40% equity paying $15/share with 500,000 shares outstanding.
Company A has a net income of $4,000,000 and company B has a net income of
$1,000,000, cost of debt is 6% (40% tax rate), there is $250,000 (after tax) in hard
synergies. Is this accretive or dilutive?
Company B = $15x500,000=$7,500,000 paid.
$7,500,000x40%=$3,000,000 in equity;$ 7,500,000-$3,000,000=$4,500,000 in debt.
$3,000,000/$25=120,000 new shares issued.
$4,500,000x6%x(1-40%)=$162,000 interest expense from debt.
Old EPS: $4,000,000/1,000,000=$4.00
New EPS: ($4,000,000+$1,000,000+$250,000-$162,000)/(1,000,000+120,000)
=$5,088,000/1,120,000=$4.54
It is accretive ($4.54 vs. $4.00)