IB Accounting Valuation Qualitative Subset Questions and Answers

IB Accounting Valuation Qualitative Subset Questions and Answers How do you value a company? Intrinsic valuation (DCF) versus Relative valuation (Multiples) What is the appropriate discount rate to use in an unlevered DCF? Weighted average cost of capital (weighted average of cost of debt / cost of equity) What is typically higher, the cost of debt or the cost of equity? Cost of equity, comes with higher risk and larger upside potential. Debt is paid first in capital stack. How do you calculate the cost of equity? Using CAPM, CoE = risk free rate (rf) + b*market risk premium mr = (eri - rf), b = beta, eri, = expected return on investment How do you calculate beta (unlevered and levered)? b (unlevered) = b (levered) / [1+(debt/equity)(1-t)] — important because it normalizes using assumption of no-debt b (levered) = b (unlevered) / [1+(debt/equity)(1-t)] How do you calculate unlevered/levered free cash flow for DCFs? UFCF = EBIT(1-tax) + D&A - CapEx - changes in working capital FCF = net income + D&A - CapEx - changes in working capital - mandatory debt payments What is the appropriate numerator for a revenue multiple? Enterprise value. EV = equity value + debt + pref. Equity - cash & cash eq. EBITDA, EBIT, revenue, unlevered cash flow = enterprise value (unlevered, pre-debt) EPS, after-tax cash flows, book value (levered, post-debt) How would you value a company with negative cash flows? DCF will be the primary method When should you value a company using revenue multiple versus EBITDA? Preferable for companies with positive cash flow to use EBITDA, for companies with negative cash flow EBITDA will be meaningless and use revenue. Two identical companies (industry, operations, growth opps, risk, returns on capital), one with PE 10, the other with PE 15. Which would you prefer to own? A rational investor would choose to pay less per unit share assuming all other characteristics besides PE are equal. Why does CapEx increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc., do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings? CapEx is capitalized because of the timing of its estimated benefits. PP&E, for instance, will benefit the firm for many years and help it produce cash flow. Other cash outflows, such as payroll, taxes, etc. benefits operations only in that period being analyzed and should be expensed then. Walk me through a cash flow statement. SCF is broken down into three parts: Cash flows from operating activities: Start with net income (from income statement), and add back major non-cash expense adjustments that were made on the income statement (D&A, deferred taxes, working capital) to derive cash flows from operating activities. Cash flows from investing activities: CapEx, asset sales, purchase of intangible assets, and purchase/sale of investment securities to arrive at cash flow from investing activities. Cash flows from financing activities: Repurchase/issuance of debt and equity and paying out of dividends to arrive at cash flow from financing activities. Add cash flows from operating activities, investments and financing to derive total change of cash. Beginning-of-period cash balance plus change in cash allows you to arrive at end-of-period cash balance. What is working capital? WC = current assets (property, inventory, cash) - current liabilities (wages, taxes, utilities, rent), indicates how much cash is tied up in the business, and how much cash is needed t pay off short term obligations (maturing within next 12 months) Is it possible for a company to show positive cash flows but be in grave trouble? Yes. For example, a company can be making unsustainable improvement in working capital (selling off inventory and delaying payables), or can lack sustainable revenues going forward in the pipeline. How is it possible for a company to show positive net income but go bankrupt? One explanation could be the deterioration of working capital (ie. Increasing AR, or lowering AP), and financial shenanigans. If one buys a piece of PP&E, what is the impact on the three financial statements? IS: no immediate effect on income statement BS: cash decreases, and PP&E increases by the same amount SCF: cash outflow from cash from investing activities to same value of PP&E After: IS: depreciation reduces net income BS: PP&E decreases by annual depreciation rate, retained earnings decreases SCF: deprecation value is added back to cash flow from operations (since non-cash expense) Why are increases in AR a cash reduction on the cash flow statement? Revenue is recorded after goods/services are delivered, so taxes have already been paid on this cash despite it not having been received. AR is most literally cash that is owed back to that business. How is the income statement linked to the balance sheet? Net income flows into retained earnings What is goodwill? An asset that captures excess of the purchase price over fair market value of an acquired business. What is a deferred tax liability and why might one be created? Deferred tax liability is a tax expense amount reported on a company's income statement that is not actually paid to the IRS at that time period, but is expected to be paid in the future It arises because when a company actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting period. What is a deferred tax asset , and why might one be created? Deferred tax asset arises when a company actually pays more in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in revenue recognition, expense recognition (warrant expense), and net operating losses (NOLs) can created deferred tax assets. Walk me through the three financial statements. "The three financial statements are the income statement, balance sheet, and statement of cash flows. The income statement is a statement that illustrates the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year. Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity. Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating. Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year." How are the three financial statements linked together? The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement. In terms of the balance sheet, net income flows into stockholder's equity via retained earnings. Retained earnings is equal to the previous period's retained earnings plus net income from this period less dividends from this period. In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period. Why is the SCF important and how does it relate to the income statement? The income statement shows a company's accounting-based profitability. It illustrates a company's revenues, expenses, and net income. Income statement accounting uses what is called accrual accounting. Accrual accounting requires that businesses record revenue when earned and expenses when incurred. Under accrual method, revenues are recognized when earned - not necessarily when cash is received - while expenses are matched to associated revenue - again not necessarily when cash goes out the door. The benefit of the accrual method is that it strives to show a more accurate picture of the companies profitability. However, focusing on accrual based profitability without looking at cash inflows and outflows is very dangerous, not only because companies can more easily manipulate accounting profits than they can cash profits, but also because not having a handle on cash can potentially make even a healthy company go bankrupt. Those shortcomings are addressed by focusing on the cash flow statement. The cash flow statement identifies all of the cash inflows and outflows of a business over a certain period of time. The statement utilizes cash accounting. Cash accounting is the system used to keep track of actual cash inflows and outflows. What this really means is that since not all transactions are made with cash (i.e., accounts receivable), such transactions would be backed out of the cash flow statement. Cash accounting literally tracks the cash coming into and out of the business. One final point on cash vs. accrual accounting is that the differences between the two accounting systems are temporary timing differences that will eventually converge. The key to financial analysis is to use both statements together. In other words, if you have incredibly high net income, such net income should be supported by strong cash flow Walk me through the accounting for the following transaction: If I issue $100mm of debt and use that to buy new machinery for $50mm, walk me through what happens in the financial statements when the company first buys the machinery and in year 1. Assume 5% annual interest rate on debt, no principal pay down for the 1st year, straight-line depreciation, useful life of 5 years, and no residual value. If the company issues $100mm of debt, assets (cash) goes up by $100mm and liabilities (debt) goes up by $100mm. Since the company is using some of the proceeds to buy machinery, there is actually a second transaction that will not affect the total amount of assets. $50mm of cash will be used to buy $50mm of PPE; thus, we are using one asset to buy another one. This is what happens when the company first buys the machinery. Because we have issued $100mm of debt, which is a contractual obligation, and because we are not paying down any part of the principal, we must pay interest expense on the entire $100mm. So, in year 1 we must record corresponding interest expense which is the interest rate times the principal balance. Interest expense for the 1st year is $5mm ($100mm * 5%). And, since we now have $50mm of new machinery, we must record depreciation expense (as required by matching principle) for use of the machinery. Since the problem specifies straight-line depreciation, useful life of 5 years, and no residual value, depreciation expense is $10mm (50/5). Both interest expense and depreciation expense provide tax shields of $5mm and $10mm, respectively, and will ultimately reduce the amount of taxable income. Company A has $100 of assets while company B has $200 of assets. Which company should have a higher value? You: Given that we only know the total amount of assets for both company A and B and nothing else, it is impossible to say whether A or B is more valuable. Would I be able to ask you some questions about both companies? Interviewer: Sure You: Would you be able to tell me what industry these two companies operate in? Interviewer: They are both consumer products companies. You: Can I assume that both companies have similar expected asset turnover (revenue/assets), leverage, return on asset, re-investment rates and profit margins? Interviewer: Yes, let's assume this is correct. You: Okay, thank you. Based on this information, it appears that we are comparing two companies with similar returns on capital, long term growth rates, and costs of capital. Since these elements are the primary drivers of value for a business, as long as both companies generate returns above their cost of capital, the firm with the larger assets deserves a higher valuation because they are both effectively "converting" their assets into profitability with equal efficiency, given similar risks and expected growth. Tell me about the three most important financial statements and what is their significance The three main financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. Speaking about their significance, the income statement provides the revenue and expenses of a company and shows the final net income that it has made over a period of time. The balance sheet signifies the assets of a company such as a plant, property & equipment, cash, inventory, and other resources. Similarly, it reports the liabilities which include the Shareholders' equity, debt, and accounts payable. The balance sheet is such that the assets would always equal the Liabilities plus shareholders equity. Lastly, there is a cash flow statement that reports the net change in cash. It gives the cash flow from the operating, investing and financing activities of the company. In case you have the chance to evaluate the financial viability of the company which statement would you choose and why? It would be the cash flow statement. The reason being that it provides a true picture of how much cash the business is generating in actual terms. The cash flows are hence the main thing you actually pay attention to while you are analyzing the overall financial health of the business. Let's say that the depreciation expense goes up by $100. How would this affect the financial statements? Income Statement: With the depreciation expense decreasing Operating Income would decline by $100 and assuming a 40% tax rate, Net Income would go down by $60. Cash Flow Statement: The Net Income at the top of the cash flow statement goes down by $60, but the $100 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $40. With no further changes, the overall Net Change in Cash goes up by $40. Balance Sheet: On the asset side because of the depreciation the Plants, Property & Equipment goes down by $100, and Cash is up by $40 from the changes on the Cash Flow Statement. Imagine a situation where a customer pays for a mobile phone with a credit card. What would this look like under cash-based vs. accrual accounting? In the case of cash-based accounting, the revenue would not be accounted for until the company charges the customer's credit card, obtains authorization and deposits the funds in its bank account. After this entry would be shown as revenue in the income statement and also as cash in the balance sheet. As against in accrual accounting, it would be shown as Revenue right away. But it would yet not appear as Cash in the Balance Sheet, rather it will be shown as Accounts Receivable. Only after the amount is deposited in the company's bank account, it would be reported as cash. What is the formula for calculating WACC? WACC = Cost of Equity Proportion of Equity + Cost of debt Proportion of debt (1-tax rate). Where, The cost of equity calculated using the Capital Asset Pricing Model (CAPM). The formula is Cost of Equity = Risk free rate + Beta* Equity risk premium Cost of Debt = The risk-free rate is basically the yield of a 10-year or 20-year US Treasury Beta is calculated based on how risky are the comparable companies and equity Risk Premium is the percent by which stocks are expected to out-perform "risk-less" assets. The proportion is basically the percentage of how much of the company's capital structure is taken up by each of the components. There are two companies P and Q which are exactly the same, but one P has debt whereas Q doesn't have any. In this case, which of the two companies would have a higher WACC? In this scenario company, Q would have a higher WACC, because debt is less expensive than equity. The interviewer at this juncture might ask you the reasons why debt is considered to be less expensive? The answer is as follows; Interest on debt is tax-deductible (hence the (1 - Tax Rate) multiplication in the WACC formula). Debt holders would be paid first in a liquidation or bankruptcy. Instinctively, interest rates on debt are usually lower than the Cost of Equity numbers you see. As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will. Describe the ways in which a company is valued Precedent transaction analysis This is also called as Transaction Multiple Valuation This is when you look at how much others have paid for similar companies to determine how much the company is worth. To use this method effectively you need to be extremely familiar with the industry of the company you are valuing as well as the normal premiums paid for such a company. Comparable Company Analysis Comparable company analysis is similar to Precedent Transactions Analysis except you are using the whole company as an assessment unit, not the purchase of a company. So to use this method you would also look for out similar companies to the one you are valuing and look at their price to earnings, EBITDA, stock price and any other variables you think would be a pointer of the health of a company. Discounted Cash Flow Analysis This is when you use future cash flow, or what the company will make in the upcoming years, to determine what the company is worth now. To calculate DCF you need to work out what the probable or future cash flow is for a company for the next 10 years. Then work out how much that would be in today's terms by "discounting" it at the rate that would give a return on investment. Then you add in the terminal value of the company and that will tell you how much the company is worth. Which are the situations in which we do not use a DCF in the valuation? We would not use a DCF in the valuation if the company has unstable or unpredictable cash flow or when debt and working capital serve a fundamentally different role. For example, financial institutions like banks do not re-invest debt and working capital forms a major part of their balance sheets- so here we do not use a DCF for such companies. List the most common multiples used in a valuation Valuation questions are very common in investment banking interviews. These are relative valuation techniques given below- EV/Revenue EV/EBITDA EV/EBIT P/E P/BV Briefly explain leveraged buyout? A leveraged buyout (LBO) is when a company or investor buys another company using mostly borrowed money, loans or even bonds to be able to make the purchase. The assets of the company being acquired are usually used collateral for those loans. Sometimes the ratio of debt to equity in an LBO can be 90-10. Any debt percentage higher than that can lead to bankruptcy. Explain the PEG ratio? This stands for Price/earnings to growth ratio and takes the P/E ratio and then accounts for how fast the EPS for the company will grow. A stock that is growing rapidly will have a higher PEG ratio. A stock that is finely priced will have the same P/E ratio and PEG ratio. So if a company's P/E ratio is 20 and its PEG ratio is also 20 some might argue that the stock is too expensive if another company with the same EPS has a lower P/E ratio, but that also means that it's growing faster because the PEG rate is 20. What is the formula for Enterprise Value? The formula for enterprise value is: the market value of equity (MVE) + debt + preferred stock + minority interest - cash. Why do you think the cash is subtracted in the formula for enterprise value? The reason why cash is subtracted is that it is regarded as a non-operating asset and because Equity Value indirectly accounts for it. Why do we consider both enterprise value and equity value? Enterprise value signifies the value of the company that is attributable to all investors, whereas equity value represents the portion available to equity shareholders. We consider both because equity value is the number the public at large sees, while enterprise value represents its true value. What does it signify, if a company has a negative enterprise value? The company could have negative enterprise value when the company has extremely large cash balances or an extremely low market capitalization or both. This could occur in companies that are on the brink of bankruptcy or Financial institutions such as the banks, which have large cash balances. Briefly explain the process of a buy-side M&A deal Lots of time is spent completing research on the potential acquisition targets and with the company, you are representing, go through multiple cycles of selection and filtering. Based on the feedback from them narrow down the list and decide which ones are to be further approached. Meetings are conducted to gauge the receptivity of potential seller. Serious discussions with the seller take place which calls for in-depth due diligence and figuring out the offer price. Negotiate the price and other key terms of the purchase agreement. Announce the M&A deal/transaction. Briefly explain accretion and dilution analysis In order to gauge the impact of the acquisition to the acquirer's earnings per share (EPS) and also compare it with the company's EPS if the acquisition would have not been executed accretion and dilution analysis is undertaken. In simple words, we could say that in the scenario of the new EPS being higher, the transaction will be called "accretive" while the opposite would be called "dilutive." Given a situation where 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, in a situation where a company with a low P/E acquires a company with a high P/E, the transaction would be dilutive to the acquirer's Earnings per Share (EPS). The reason for this is that the acquirer will have to shell out more for each rupee of earnings than the market values its own earnings. Therefore in such a situation the acquirer would have to issue proportionally more shares in the transaction. What are the synergies and its types? Synergies are where the buyer gets more value than out of an acquisition than what the financials would predict. There are basically two types of synergies - Revenue synergy: the combined company can cross-sell products to new customers or up-sell new products to existing customers. Because of the deal, it could be possible to expand in new geographies. Cost synergies: the combined company could amalgamate buildings and administrative staff and can lay off redundant employees. It could also be in a position to close down redundant stores or locations. How does Goodwill get created in an acquisition? Goodwill is an intangible asset that mostly stays the same over years and is not amortized like other intangibles. It only changes when there is an acquisition. Goodwill is basically the valuable assets that are not shown like financial assets on the balance sheet. For example, brand name, customer relationship, intellectual property rights, etc. Goodwill is basically the subtraction of the book value of a company from its equity purchase price. It signifies the value over the "fair market value" of the seller that the buyer has paid.