Wall Street Prep Training Manual

Technical Finance
Interview Prep

v WWW.WALLSTREETPREP.COM
Wall Street Prep Training Manual

Accounting

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v
Welcome to financial
accounting!

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This course is
different from most
accounting courses…

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We’re not going to do
a lot of lecture…

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We’re going to learn
almost entirely
through exercises…

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Because we have a
very important goal...

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To keep you
conscious

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So let’s go!

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Let’s quickly start
with some basics…

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Accounting

Balance Sheet Concept Review

Assets Liabilities
(what we own) (third parties funding our assets)

Examples
Examples
Debt
Cash
Money we owe vendors
Money owed to us
Inventory
Machines
Land Equity
(internal sources funding our
Intellectual Property assets)

Examples
Stock issuance
Profits

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Exercise A
Let’s open a
lemonade stand

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Accounting

Opening balance
• It’s December 31, 2018 and you decide to open a lemonade stand.
• You incorporate and make yourself the sole owners (all the stock certificates are in
your name).
• Your open up a business checking account into which you put $100,000 of your own
money and borrow $50,000 from the bank.
• The bank agrees to lend you the $50,000 at a 10% annual interest rate. You won’t
have to pay back the loan for 5 years.
• Since you own 100% of the company, you arbitrarily set the company’s number of
shares outstanding at 10,000.
• Of the $150,000, you spend $20,000 on lemons, sugar and cups (inventories).
$20,000 is enough to make 100,000 cups ($0.20 per cup).
• You also purchase a lemon squeezer and a lemonade stand (property, plant and
equipment) for $30,000 (you estimate a useful life of PP&E of 3 years).
• You report under US GAAP

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Accounting

Create an opening balance sheet

Balance sheets always show stuff

at a specific point in time – it’s a
snapshot of what you own and
owe.

Assets are the things you own. It’s

a summary of how you used your
funds – currently just your loan
(debt) and your own money
(equity).

They always equal each other!

“Hey
what’s
retained
earnings?” Liabilities and equity is a
summary of the sources of your
funds.

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Accounting

The world’s simplest balance sheet

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Accounting

You start selling lemonade in 2019!

• Revenue
◽You sell lemonade for $1.00 per cup and sold 100,000 cups for
$100,000.
◽However, you collected only $80,000 in cash (customers still owe you
$20,000).
$100,000
◽Your revenue is __________________
• Accrual accounting
◽Why can you recognize all $100,000 even through you only got paid
for $80,000?

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Accounting

You start selling lemonade in 2019!

• Cost of goods sold
◽Direct expenses are recognized during the period as COGS. You used
up all your inventory (cups, lemons and sugar).
20,000
◽Your COGS is ___________.
◽How much cash did you actually spend in 2019 on direct expenses
(remember you bought the inventory before the year started).
0 You just used up existing inventory
◽Cash spent on direct expenses in 2019 ___________________________________.

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Accounting

A little more about COGS

• COGS is not only inventory – other common examples of COGS include
◽Direct labor wages
◽Factory overhead
◽Transportation & shipping costs
◽Other direct service costs

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Accounting

You start selling lemonade in 2019!

• Selling, general & administrative
◽During the year, you hired a cashier and paid her $15,000 in cash.
◽This is recognized in a separate expense category called sales,
general, and administrative expenses (SG&A).
◽SG&A applies to any operating expenses not directly associated with
making the product, which would go into COGS.

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Accounting

A little more about SG&A

• Common SG&A items include
◽Wages
◽Advertising & marketing costs
◽Rent
◽Utilities
◽Corporate overhead

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Accounting

You start selling lemonade in 2019!

• Depreciation expense
◽Recall that you estimated a 3-year life on your $30,000 lemon
squeezer.
◽After 1 year, you’ve used up a third of its life.
◽Thus, you must recognize $30,000/3 years = $10,000 this year as an
expense called depreciation expense.
◽Since you paid for the equipment up front, this depreciation expense
is noncash.
◽Accrual accounting at work again.

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Accounting

You start selling lemonade in 2019!

• Interest expense
◽Recall that you have a loan and must pay 10% x $50,000 = $5,000 this
year. That’s called interest expense.
• Taxes
◽You must pay 40% of your pretax profits in taxes.

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Accounting

Create an income statement for 2019

Gross profit margin is your

“sales” gross profit – divided by
“top line” revenue – it tells you what
“turnover” percent of sales you keep
after accounting for direct
expenses
“earnings before
interest taxes
depreciation and
amortization” What’s amortization?
When the thing you’re
“earnings before depreciating is an intangible
interest & taxes” asset (like a patent or
customer list), the expense
is called amortization
“earnings before instead of depreciation.
taxes”

“bottom line”

There are many

names for profit in
finance

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Accounting

The world’s simplest income statement

Income Statement
For the year ending 12/31/2019
Comments
Revenues 100,000 Received $80k cash, $20k still owed
Cost of goods sold (COGS) (20,000) Sold all inventories, so no cash out during period
Gross profit 80,000
% Gross profit margin 80% Gross profit/revenue

Selling, general & administrative (SG&A) (15,000) Paid employee salary in cash
EBITDA 65,000 Arguably the most widely used profit metric

Depreciation & amortization (D&A) (10,000) $30,000 / 3 years. “straight-line” depreciation.

Operating Income (aka EBIT) 55,000

Interest expense (5,000) $50,000 x 10%

Pretax profit (EBT) 50,000

Taxes (20,000) 40% tax rate

Net Income 30,000

Earnings per share (EPS) $3.00

Shares outstanding 10,000

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Accounting

The income statement isn’t enough

• What happened to your cash position during the year?
• Because the income statement uses the accrual principle, it includes noncash
expenses and recognizes revenue when it’s earned rather than when cash is
received. As such, the income statement doesn’t actually tell you if you
generated any actual cash
• Over time profitability and cash flows converge but in the short term they
can diverge
◽ Imagine a company that shows positive net income but can’t seem to
collect any of its sales because its customers pay on credit and take forever
to pay – or just don’t pay at all.
◽ In this case, the income statement might show great profits while the
company runs out of cash and goes bankrupt.
• That’s why investors also closely track cash via the cash flow statement

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Accounting

Net income vs. cash flows

• The income statement is great because it matches revenues with
expenses to provide investors with a picture of profitability undistorted
by the timing of cash flows.
• But cash flows matter: Sometimes even more than profitability.
• Calculate how much cash our lemonade stand generated in 2019

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Accounting

Net income vs. cash flows

Cash revenue +80,000
SG&A -15,000 Paid employee cash
Interest expense -5,000 Paid bank cash
Tax expense -20,000 Paid IRS cash
Change in cash +40,000

• This is the “direct method” for calculating cash during the period –
simply take cash receipts, less disbursements.

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Accounting

Net income vs. cash flows

• The direct method may be the most intuitive way to calculate cash
during the period, but the more common way is the “indirect method”
• The indirect method starts with net income (from the income
statement) and makes adjustments get to cash. Both approaches yield
the same result but the indirect is more popular.
• Let’s try the indirect method…
Net income +30,000 <--From income statement
D&A +10,000
Noncash revenue (accounts receivable) - 20,000
Noncash COGS (inventory) 20,000
Change in cash +40,000 <--This is how much cash you got in 2019

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Accounting

The cash flow statement layout

• The cash flow statement is broken down into three components, each of which
provides some additional insight into how the business is being managed:

Cash from operations:

Reconciles net income to cash generated from operations.

Cash from investing:

Looks at cash used to purchase PP&E (capital expenditures) or make
acquisitions. It will account for any cash proceeds from the sale of
any assets.

Cash from financing:

Looks at inflows of cash from investors such as banks and shareholders as
well as the outflow of cash to shareholders as dividends or to lenders as
repayments of debt.

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Accounting

The world’s simplest cash flow statement

The depreciation & amortization addback

is usually the biggest adjustment on the
CFS

Working capital
• The $20,000 increase in A/R on the B/S
needs to be treated as a reduction to net
income because net income captures
$100,000 in revenues and we just want
the $80,000 in cash here.
• The $20,000 reduction in inventories on
the B/S needs to be treated as an
increase to net income because net
income captured a $20,000 COGS
expense that was non-cash
• These two items illustrate a broad rule:
Increases in assets are reflected in the
cash flow statement as outflows, while
decreases in assets are reflected in the
CFS as inflows…. more on this shortly

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Accounting

The world’s simplest cash flow statement

Cash flow statement
For the year ending 12/31/2019

Net income 30,000

Depreciation & amortization 10,000

Changes in operating assets & liabilities

Accounts receivable (A/R) (20,000)
Inventories 20,000
Cash from operations 40,000

Capital expenditures 0
Other investments 0
Cash for investing 0

New debt borrowing 0

Pay-down of debt 0
New equity issuance 0
Dividends 0
Cash from financing 0

Beginning cash – 12/31/2018 100,000

Net change in cash 40,000
Ending cash – 12/31/2019 140,000

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Accounting

How the income statement connects to the balance sheet

Cash changes during the period

Cash revenue +80,000
SG&A -15,000 Paid employee cash
Interest expense -5,000 Paid bank cash
Tax expense -20,000 Paid IRS cash
Change in cash +40,000

Noncash changes during the period

Noncash revenue +20,000 Accounts receivable
COGS expense -20,000 Inventory reduction
Depreciation expense -10,000 PP&E reduction

Income Statement
For the year ending 12/31/2019
Revenues 100,000
Cost of goods sold (COGS) (20,000)
Selling, general & administrative (SG&A) (15,000)
Depreciation & amortization (D&A) (10,000)
Interest expense (5,000)
Pretax profit (EBT) 50,000
Taxes (20,000)
Net Income 30,000

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Accounting

How the income statement connects to the balance sheet

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Accounting

EBITDA things

EBITDA, as important as it is,

is never presented formally
on the income statement
because it is a “non-GAAP”
measure. It might be
disclosed elsewhere in
footnotes or in press releases.
But even if it isn’t explicitly
disclosed you can figure it out.
Guess how? (Hint: Where is
the D&A)

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Accounting

Financial reporting
• Calculate Apple’s EBITDA for 2018

The cash flow statement will

almost always explicitly add
back D&A to net income.

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Accounting

Discussion:
• Why does EBITDA matter so much?
• Is it more important than net income or
cash flows?

36
Exercise B
Let’s take it up a
notch

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Accounting

Additional transactions during the year:

• You bought $30,000 in inventories to replenish supply ($20,000 cash, $10,000 on supplier
credit)
• You sold $5,000 in gift cards of which $2,000 were redeemed during the year (assume the
same 80% gross profit margin on the extra lemonade sold)
• You paid $10,000 in utilities for 2019 and an additional $2,500 as prepayment for Q1 2020
• Your employee has earned a $4,000 year end bonus, which you have yet to pay
• On the last day of the year, you spent $40,000 on a new lemonade stand (assume no
depreciation from this stand was recorded in current year)
• In the middle of the year you used $100,000 of your cash to invest in treasuries and other
marketable securities with an annualized return of 2%
• You borrowed an extra $200,000 from the bank (no new interest recorded in current year)
• You paid yourself a $10,000 dividend
• Update the Income Statement, Balance Sheet and Cash Flow Statement

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Accounting

Before we continue…
• As you may have already noticed, every single transaction can be
viewed as having two sides:

Examples of transactions
Buying a plant Buying inventory Issuing stock
Paying an invoice
with cash on credit To raise cash
Source of Cash The creation of an Cash Additional equity
funds (asset goes down) accounts payable (asset goes down) investors are the
(a liability goes up) source of funds
(“credit”)
(equity goes up)

Use of The plant Inventory The reduction of Cash

funds (asset goes up) (asset goes up) accounts payable (asset goes up)
(liability goes down)
(“debit”)

• It is because of this equivalence that assets will always equal liabilities

plus equity.
• It is two sides of the same coin.
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Accounting

Before we continue…

Use of funds Source of funds

“Debit” “Credit”

Liabilities & Liabilities &

Assets Equity Assets Equity
⇧ ⇩ ⇩ ⇧

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Accounting

Inventory
• You bought $30,000 in inventories to replenish supply ($20,000 cash,
$10,000 on supplier credit)

Financial statement impact

Balance Sheet Income statement Cash flow statement
(Retained earnings)
• $30,000 - Inventory (Debit) • No impact Cash from operations
• $20,000 - Cash (Credit) • $30,000 outflow from increase in
• $10,000 - Accounts payable inventory
(Credit) • $10,000 inflow from increase in A/P

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Accounting

Deferred / unearned revenue

• You sold $5,000 in gift cards of which $2,000 were redeemed during
the year (assume same 80% gross profit margin on extra lemonade
sold)
• Let’s tackle the revenue side of the gift card sales first (we’ll deal with
the incremental COGS on the next slide)
Gift card sales
Balance sheet Income statement Cash flow statement
• $5,000 - Cash (Debit) • Recognize only the • Since net income is the starting
• $3,000 - Deferred revenue earned revenue (so line, the $2,000 in revenue is
liability (Credit) $2,000) already captured in net income
• $2,000 - Retained earnings • The remaining $3,000 hits the cash
(Credit) flow statement via the increases in
deferred revenue on the balance
sheet (in the cash from operations
section)

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Accounting

Deferred / unearned revenue

• You sold $5,000 in gift cards of which $2,000 were redeemed during
the year (assume same 80% gross profit margin on extra lemonade
sold)
Impact of additional COGS

Balance sheet Income statement Cash flow statement

• $400 - Inventory (Credit) • COGS must be • There is no cash impact – the

• $400 – Retained earnings matched to inventory used as the $400 COGS
(Debit) revenue so $400 expense was already purchased
(20% x $2,000) • But… COGS lowered net income and so
As a result, inventory during the inventory adjustment in CFO needs
the year changed as follows: to go up by $400 to negate the decline in
• Beginning Inventory - net income
$20,000 • This is already accomplished simply by
• Plus: Purchases - $30,000 capturing the year over year increases
• Less: COGS - $20,400 to inventory as outflows on the CFO
• Ending inventory - $29,600 section by reducing the ending
inventory balance by $400 from
$30,000 to $29,600

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Accounting

Prepaid expenses
• You paid $10,000 in utilities for 2019 and an additional $2,500 as
prepayment for Q1 2020

Financial statement impact

Income statement Cash flow statement Balance sheet
• SG&A for 2019 utilities • None because it $10,000 - Retained earnings (Debit)
already flows $10,000 - Cash (Credit)
through lowering
net income
Income statement Cash flow statement Balance sheet
• No expense recognized • Reflect increases $2,500 - Prepaid expenses (Debit)
in 2019 for 2020 in prepaids as $2,500 - Cash (Credit)
prepayments outflows in CFO

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Accounting

Accrued expenses
• Your employee has earned a $4,000 year end bonus, which you have yet
to pay

Financial statement impact

Income statement Cash flow statement Balance sheet

• SG&A expense recognized • Reflect increases in $4,000 - Retained earnings (Debit)

even though noncash accrued liabilities as $4,000 – Accrued wages (Credit)
because it is earned inflows in CFO

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Accounting

New purchases of fixed assets (PP&E)

• On the last day of the year, you spent $40,000 on a new lemonade stand
(assume no depreciation from this stand was recorded in current year)

Financial statement impact

Income statement Cash flow statement Balance sheet

• No impact • Cash outflow from investing $40,000 – PP&E (Debit)

activities (“capital expenditures”) $40,000 – Cash (Credit)

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Accounting

Investment income
• In the middle of the year you used $100,000 of your cash to invest in
treasuries and other marketable securities with an annualized return of
2%
Financial statement impact

Income statement Cash flow statement Balance sheet

• Interest income • Cash outflow in cash $100,000 – Marketable securities (Debit)

(remember only a half from investing activities $100,000 – Cash (Credit)
year’s worth)

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Accounting

Borrowing
• You borrowed an extra $200,000 from the bank (no new interest
recorded in current year)

Financial statement impact

Income statement Cash flow statement Balance sheet

• No impact • Cash inflow in cash from $200,000 – Cash (Debit)

financing activities $200,000 – Debt (Credit)

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Accounting

Common dividends
• You paid yourself a $10,000 dividend

Financial statement impact

Income statement Cash flow statement Balance sheet

• No impact • Cash outflow (cash from $10,000 – Retained earnings (Debit)

financing) $10,000 – Cash (Credit)

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Accounting

You started with revenue of $100,000.

Revenues from gift cards are recognized when the
cards are redeemed and the good or service has been
provided – so in this case while $5,000 in cash was
received, $2,000 of the $5,000 was earned as revenue
– the rest is a deferred revenue liability (aka unearned
revenue)

You started with COGS of $20,000.

Due to the additional $2,000 in revenue recognized, an
additional $400 in inventory was used (we assumed
the same gross profit margin as before)

You started with 15,000 in SG&A expenses.

In addition, we now have $10,000 in utilities expenses
that need to be recognized in the current period.

Next, the $4,000 bonus is recognized in the year it was

earned, not the year it will be paid. (But since it hasn’t
been paid, it will be recognized as an accrued liability
when we get to the balance sheet).

Next year’s prepayments are not recognized in the

current period as an expense. Instead they are
recognized as a “prepaid expenses” asset on the B/S

$1,000 represents 50% of $100,000 yielding 2%

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Accounting

Income Statement
For the year ending 12/31/2019
BEFORE AFTER
Revenues 100,000 102,000
Cost of goods sold (COGS) (20,000) (20,400)
Gross profit 80,000 81,600
% Gross profit margin 80% 80%

Selling, general & administrative (SG&A) (15,000) (29,000)

EBITDA 65,000 52,600

Depreciation & amortization (D&A) (10,000) (10,000)

Operating Income (aka EBIT) 55,000 42,600

Interest expense (5,000) (5,000)

Interest income 0 1,000
Pretax profit (EBT) 50,000 38,600

Taxes (20,000) 15,440

Net Income 30,000 23,160
Dividends 0 10,000

Earnings per share (EPS) $3.00 $2.32

Shares outstanding 10,000 10,000

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Accounting

Leave this empty for now. The cash flow statement will
make calculating this easier

We spent $100,000 in cash to buy marketable securities

20,000 of revenue is still owed to you by customers

Replenished inventories, less additional $400 used for gift cards

Prepaid utilities are an asset

The 20,000 value of the original stand (30,000 less 10,000

current period depreciation) + $40,000 value of new stand

Relates to the inventories paid for with supplier credit

Employee bonus already earned but still owed

You sold some gift cards but didn’t earn the revenue
from those sales yet. When that happens, this liability
converts to revenue.

You borrowed more from the bank

Prior period RE + net income, less dividends

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Accounting

Balance Sheet
The cash flow statement will make calculating this easier
Assets 12/31/2018 12/31/2019
Cash 100,000 ??? 20,000 of revenue is still owed to you by customers
Marketable securities 100,000
Accounts Receivable (AR) 0 20,000 Replenished inventories, less additional $400 used for gift cards

Inventories 20,000 29,600

Prepaid utilities are an asset
Prepaid expenses 0 2,500
Property, plant and equipment 30,000 60,000 The 20,000 value of the original stand (30,000 less 10,000
current period depreciation) + $40,000 value of new stand
Total Assets 150,000 ???

Relates to the inventories paid for with supplier credit

Liabilities
Accounts Payable (AP) 0 10,000
Employee bonus already earned but still owed
Accrued expenses 0 4,000
Deferred revenue 0 3,000 You sold some gift cards but didn’t earn the revenue
Debt 50,000 250,000 from those sales yet. When that happens, this liability
Total Liabilities 50,000 267,000 converts to revenue.

Equity
Common Equity 100,000 100,000
Retained Earnings 0 13,160
Prior period RE + net income, less dividends
Total Equity 100,000 113,160

Total Liabilities and Equity 150,000 380,160

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Accounting

Working capital: Link from income

Always the trickiest statement
• Calculating these is
easy: increases in
assets are outflows All of these should
be linked from the
and increases in balance sheet (not
liabilities are inflows hardcoded)
• But can you explain
why? It always goes
back to accrual vs
cash: Net income
includes revenue that
hasn’t yet been
received, reflects only
the expensing of
inventories that were
used up during the
period, etc.

54
Accounting

55
Accounting

Balance Sheet
Date: 12/31/2018 12/31/2019
Link the ending cash balance
ASSETS derived in the cash flow statement
Cash 100,000 168,060 to complete the 2019 year-end
Marketable securities 0 100,000 balance sheet
Accounts receivable (A/R) 0 20,000
Inventories 20,000 29,600
Prepaid expenses 0 2,500
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,160

LIABILITIES
Accounts Payable (AP) 0 10,000
Accrued expenses 0 4,000
Deferred revenue 0 3,000
Debt 50,000 250,000
Total Liabilities 50,000 267,000

EQUITY
Common Equity 100,000 100,000
Retained Earnings 0 13,160
Total Equity 100,000 113,160

Total Liabilities and Equity 150,000 380,160

56
Exercise C
We’re going to go
ahead and
take it up
another notch
57
Accounting

Taking it up (another) notch

• In addition to cash compensation, you gave your employee restricted shares. During the year, you
recognize $7,000 in stock-based compensation expense from the issuance.
• At the beginning of the year, you raised an additional $30,000 by selling 1,000 shares to another
investor. On the last day of the year, you repurchased the shares, but because your lemonade stand
was so successful, you had to pay double ($60,000) to get the shares back.
• You raised an additional $100,000 from preferred shareholders at the beginning of the year. In
exchange you will pay a 10% annual preferred dividend.
• During the year, $3,000 worth of lemons spoiled. In accordance with GAAP, you will record this as an
operating expense (because it is not significant, you embed within cost of goods sold). However, since
you believe it is a one-time event, you will calculate a separate “non-GAAP” presentation of gross
profit, EBITDA and EBIT that ignores this expense.
• At the beginning of the year, you acquired the trademark of a competing lemonade stand for $25,000.
You changed your mind and sold it in the middle of the year for $18,000. Note: Since brands can be
renewed forever, they are considered to have “indefinite life” under GAAP; No amortization is
recorded.
• You straight-line depreciation for book purposes but the IRS allows for accelerated depreciation of
your lemonade stand (YR1: 50%, YR2: 30%, YR3: 20%). As in the prior examples, assume no
depreciation from the new lemonade stand during 2019.
• Update the Income Statement, Balance Sheet and Cash Flow Statement

58
Accounting

Stock based compensation overview

• When a company compensates an employee with stock (like stock
options or restricted stock), the value of that compensation (called
“stock-based compensation” or “SBC”) is recognized as an expense in
the same expense category as the employee’s regular cash
compensation (accrual accounting at work).
• Unlike the expense we have talked about so far, valuing SBC is
challenging because the real value will not be known for a while, and
depends on several factors, including the future share price of the
company, the likelihood that the employee stays with the company long
enough to have the SBC vest, among other factors.
• You do not need to understand how to value SBC for this course, just
that it is valued, and recognized as a non-cash expense within the same
operating expense category that the cash compensation is classified.

59
Accounting

Stock based compensation – Journal entries

• In addition to cash compensation, you gave your employee restricted
shares. During the year, you recognize $7,000 in stock-based
compensation expense from the issuance.

Financial statement impact

Income statement Cash flow statement Balance sheet
• Stock based compensation • Add-back of stock- • Lowers retained
expense based compensation in earnings via SBC
cash from operations expense on I/S (Debit)
section • Increase to common
equity (Credit)

60
Accounting

Stock based compensation – Presentation in reports

• Just like depreciation,
you won't see a line
item on the I/S
specifically identifying
SBC expense.
• SBC is included within
the operating expenses
in which the employee
is classified
• However, like
depreciation, you will
almost always find SBC
expense identified
separately on the cash
flow statement

61
Accounting

Share issuances & repurchases

• At the beginning of the year, you raised an additional $30,000 by selling
1,000 shares to another investor. On the last day of the year, you
repurchased the shares, but because your lemonade stand was so
successful, you had to pay double ($60,000) to get the shares back.
Financial statement impact

Income statement Cash flow Balance sheet

statement
No direct impact on the income statement Issuance Issuance
Does impact shares outstanding and thus earning per • $30,000 inflow • Cash (Debit)
share in cash from • Common stock
• Issuance: Shares increase by 1,000 financing (Credit)
• Repurchase: Shares decrease by 1,000 Repurchase Repurchase
• Note that shares are calculated on a weighted • $60,000 • Treasury stock
average basis so since the repurchase occurred on outflow in cash (Debit)
last day of the year, the current period share count from financing • Cash (Credit)
is not impacted by the repurchase, only the
issuance.

62
Accounting

Preferred stock
• You raised an additional $100,000 from preferred shareholders at the
beginning of the year. In exchange you will pay a 10% annual preferred
dividend.

Financial statement impact

Income statement Cash flow statement Balance sheet
• Neither the capital raise Issuance Issuance
nor the preferred Cash from the preferred • Cash (Debit)
dividends impact the stock issuance raises cash • Preferred stock (Credit)
income statement from financing Dividends
• However, net income used Dividends • Retained earnings
to calculate earnings per Preferred dividends lower (Debit)
share is after preferred cash from financing • Cash (Credit)
dividends

63
Accounting

Inventory write-down
• During the year, $3,000 worth of lemons spoiled. In accordance with
GAAP, you will record this as an operating expense (because it is not
significant, you embed within cost of goods sold). However, since you
believe it is a one-time event, you will calculate a separate “non-GAAP”
presentation of gross profit, EBITDA and EBIT that ignores this
expense.
Financial statement impact
Income statement Cash flow Balance sheet
statement
• Inventory write-down is an operating expense on A noncash • Retained
the income statement addback on earnings
• In practice, it might be embedded inside cost of cash from (Debit)
sales or identified as a separate operating line item operations • Inventory
• Often it is ignored by analysts when calculating (Credit)
EBITDA due to its infrequent nature

64
Accounting

Intangible asset sale

• At the beginning of the year, you acquired the trademark of a
competing lemonade stand for $25,000. You changed your mind and
sold it in the middle of the year for $18,000. Note: Since brands can be
renewed forever, they are considered to have “indefinite life” under
GAAP; No amortization is recorded.
Financial statement impact
Income statement Cash flow statement Balance sheet
• The gain or loss on sales of Sale proceeds: Cash • Cash (Debit)
assets – fixed or intangible – inflows from investing • Intangible asset (Credit)
is presented on the income Gain / (loss) on sale: • Retained earnings (Credit
statement and calculated as A noncash addback on for gain on sale, Debit for
the sale price - net book cash from operations. loss on sale)
value (gross carrying value
less accumulated D&A)

65
Accounting

Deferred tax liabilities

• You straight-line depreciation for book purposes but the IRS allows for accelerated
depreciation of your lemonade stand (YR1: 50%, YR2: 30%, YR3: 20%). As in the prior
examples, assume no depreciation from the new lemonade stand during 2019.

• 2019 book depreciation

◽ Recall that 2019 GAAP depreciation expense is $10,000

◽ $30k value, 3-year life, straight line depreciation

• 2019 tax depreciation

◽ Tax depreciation rate for 2019 is 50%

◽ Implies depreciation expense of $15,000 ($30,000 x 50%).

◽ $5,000 of more depreciation expense on the tax returns compared to GAAP.

66
Accounting

Impact of book/tax depreciation on 2019 taxes

• Remember that the more depreciation expense, the lower your taxes

• Since the amount of tax you actually pay is based on how the tax authorities (the IRS in
the US, for example) calculate expenses, the IRS’s higher-than-GAAP tax depreciation
expense means lower actual 2019 tax (by the amount of $5,000 x 40% = $2,000) than
what GAAP shows on the tax expense line.

• Note this is only a temporary phenomena in year 1. By year 3, book depreciation will be
higher than tax.

67
Accounting

Deferred tax liabilities capture this difference

• As a result of this book vs tax difference, when investors look at GAAP tax expense, they
don’t see actual taxes paid.

• However, GAAP reconciles this by creating a deferred tax liability in the amount of the
difference – in this case $2,000 created in 2019

• The DTL reflects that you paid less in actual taxes than what the GAAP tax expense shows

• It is a “deferred” liability because this tax will eventually be paid (in our case, by year 3)

Financial statement impact

Income statement Cash flow statement Balance sheet
• No impact Increase in deferred tax • Cash (Debit)
liability reflects as inflow in • Deferred tax liability (Credit)
cash from operations

68
Accounting

An inventory write-down hits the income statement as an expense. It can be

identified separately by the company in its own line items or not identified
separately and instead simply embedded within COGS as it is here. Notice the
distortive impact it has on gross profit. Write-downs are generally treated as non-
recurring and ignored when calculating non-GAAP profits like EBITDA.

Stock-based compensation (SBC) of $7,000 is classified within SG&A because that’s

where the employees’ regular salary is classified. SBC for employees classified under
R&D or COGS will be embedded within those categories.

Like write-downs, gains on sale (and losses on sale) are either identified separately
or embedded within a larger expense category. Gains and losses are generally
treated as non-recurring items and ignored when calculating EBITDA.

69
Accounting

Non-GAAP data will likely be

presented in this case to show
key metrics excluding the impact
of the write downs and loss on
sale.

Which gross profit margin and

EBIT looks better: GAAP or non-
For these non-GAAP adjustments, GAAP?
there is actually a loss on sale

70
Accounting

71
Accounting

Leave this empty for now. The cash flow statement will
make calculating this easier

Between the COGS, write down and new purchases, there’s

a lot going on, let’s create a side schedule to clearly lay out
everything (see next page)

During the year, you bought a trademark and sold it. Like with
inventory, a separate schedule (next page will help to show
everything)A separate schedule

You recognized $2,000 of tax expense that wont

actually paid in cash until subsequent years

Stock issuances and stock-based compensation impact

common equity

Prior period RE + net income, less dividends (including

preferred dividends)

72
 Accounting

The COGS you reference should exclude the

write down so as to not double count the
write down (since we reduce inventories
by it explicitly)

We’re at a point of
complexity where it will be
much easier to determine
end of year balances for
inventories and intangible
assets via separate
schedules below the
balance sheet.

73
Accounting

All the remaining items in the cash flow statement can be derived from the balance sheet
and income statement – no need to directly hardcode anything else

74
Accounting

75
Accounting

76
Exercise D
Let’s make a
deal

77
Accounting

Acquisition accounting basics

• We’re about to go through an acquisition scenario so let’s first make sure we
understand the basics of goodwill accounting:
• Goodwill is the amount by which the purchase price for a company exceeds its
fair market value (FMV), representing the “intangible” value stemming from the
acquired company’s business name, customer relations, employee morale.
• Goodwill is effectively an accounting plug, created only if the purchase price
exceeds the FMV of all the assets acquired.
• Complete the following exercise:
Acquirer Target Adjustments Pro forma
Purchase price (cash) $100 Assets $200 $65
Target assets $65 Goodwill $0 $0
Target liabilities $25
Book value of net assets Liabilities $140 $25
Goodwill Equity $60 $40

78
Accounting

Acquisition accounting basics

Acquirer Target Adjustments Pro forma
Purchase price (cash) $100 Assets $200 $65 -$100 $165
Target assets $65 Goodwill $0 $0 +$60 $60
Target liabilities $25
Book value of net assets $40 Liabilities $140 $25 $165
Goodwill $60 Equity $60 $40 -$40 $60

79
Accounting

Acquisition accounting & EPS

• At year-end, you acquired a hot dog stand business for $80,000 in cash
with the following fair value of assets and liabilities: $10,000 in
accounts receivable, $50,000 in PP&E, $5,000 in accounts payable.
• Additional detail relating to the restricted stock issuance: 700 shares of
restricted stock were issued to the cashier at the beginning of the year,
of which 200 shares vested right in the middle of the year. Assume all
unvested restricted stock will eventually vest and are considered
dilutive securities until then.
• Update the Income Statement (including basic and diluted EPS),
Balance Sheet and Cash Flow Statement

80
Accounting

Acquisition accounting
• At year-end, you acquired a hot dog stand business for $80,000 in cash with the following
fair value of assets and liabilities: $10,000 in accounts receivable, $50,000 in PP&E,
$5,000 in accounts payable.

Financial statement impact

Income statement Cash flow statement Balance sheet
• No impact • Cash purchase price Debits
reflected as cash from • Accounts receivable
investing • PP&E
• Note: Revisit changes in A/R • Goodwill
and accounts payable to Credits
make sure you are not • Accounts payable
capturing the increases to • Cash
these items in CFO

81
Accounting

Stock based compensation

• Additional detail relating to the restricted stock issuance: 700 shares of restricted stock
were issued to the cashier at the beginning of the year, of which 200 shares vested right
in the middle of the year.

Financial statement impact

Basic & Diluted EPS Impact Cash flow Balance sheet

statement
• No income statement impact but vesting impacts the No impact No impact
share count (technically shares
• Once restricted shares vest they become actual shares move from one
and should be counted as “basic” shares equity account into
• Assume all unvested restricted stock will eventually vest another but it’s a
and are considered dilutive securities wash)
• Shares are calculated on a weighted average basis,
meaning when vesting happens midyear, calculate the
average as average of shares @ beginning and shares @
end

82
Accounting

The acquisition will

have an impact on all of
these line items

83
Accounting

Accounts receivable,
PP&E and accounts
payable are now
increased. We already
have a schedule for
PP&E that we just need
to adjust, while we
create schedules for
A/R and A/P.
Since you paid way more than the
fair value of the assets (net of
liabilities) you acquired, the excess
of the purchase price over the fair
value of these net assets is reflected
as goodwill

84
Accounting

85
Accounting

It is important to make sure that the

acquisition cash outflow is not
double counted and should only be
captured in cash from investing. The
changes to A/R and A/P need to be
relinked to only capture non-
acquisition changes (since the
acquisition cash flows are already
reflected in CFI).

86
Accounting

87
Accounting

Relink Cash, A/R, A/P and PP&E from

the schedules to capture the
acquisition and add goodwill

Once everything was linked correctly,

your balance sheet will balance

88
Accounting

89
Accounting

Since the acquisition happened at the end of the year, there is no

income statement impact. In subsequent years, as the business
generates additional revenues and expenses related to the
acquisition, this will be reflected

It’s easier to calculate basic and diluted shares in a separate schedule

Since EPS uses weighted average shares, we include half a

year’s worth of the 200 vested restricted stock in the share
count, arriving at a total of 11,100 shares.

90
Accounting

91
Exercise E
Let’s talk debt, baby

92
Accounting

Capital Structure
• Pick up from Exercise C except now imagine that on December 31 of 2018 (the day
you started your business) you actually borrowed 5 tranches of debt:
◽ 10,000 - Revolving Credit Facility L+400, 1% floor, paid at year end
◽ 10,000 – Term Loan, 5 Years L+450, 1% floor, paid at year end with 2,000
principal amortization (required paydown) in each year, also paid at year end
◽ 20,000 – 7 Year Note 8% Coupon, paid at year end
◽ 10,000 – 8 Year Note 10% Coupon, paid-in-kind (PIK)
◽ Assume Libor is 1.5%
• In addition, you had to pay financing fees in cash upfront of 2% of the principal for
each tranche except for the revolver1
• Update the Income Statement (including EPS), Balance Sheet and Cash Flow
Statement
1 Revolver commitment fees (fees on undrawn amounts are capitalized as an asset rather). We will ignore these fees here.

93
Accounting

PIK and accrued interest

• Some loans enable borrowers to defer paying a portion / or all of the interest, by adding it
to the principal

• Interest expense still appears on the income statement!

PIK Interest Example: A 3-year, $1,000 loan @ 10% PIK

Year 1 Year 2 Year 3 At maturity
Loan (BOP) 1,000 1,100 1,210
PIK interest 100 110 121
Loan (EOP) 1,100 1,210 1,331 (1,331)
I/S impact (interest expense) 100 110 121 0
Cash impact1 0 0 0 (1,331)

1 Since this increases interest expense but is non-cash, it is added back as a non cash expense in cash from operations

94
Accounting

Financing fees
• When a company borrows money, either through a term loan or a bond, it
usually incurs third party financing fees (called debt issuance costs) to
bankers, lawyers and anyone else involved in arranging the financing
• Accounting rules were changed in 2015, calling for deducting these fees
directly against the carrying amount of the debt liability as you see below for
Sealed Air Corp:

Source: Sealed Air 05/10/2017 10-Q

95
Accounting

Financing fees
• Over the term of borrowing, these fees will be amortized, and that
amortization will be classified within interest expense on the income
statement
• Like PIK interest, since this increases interest expense but is non-cash,
it is added back as a non cash expense in cash from operations

96
Accounting

Bank debt usually requires

scheduled principal payments
Notes usually pay a fixed Includes both the PIK interest over the term of the loan, while
coupon, while loans and and cash interest bonds and notes are balloon
payments at the end of the term
the revolver are priced off
LIBOR + spread

Financing fees are

Libor floor means even if
amortized over the term of
LIBOR dips below a
the debt and included in
minimum floor, the lender
interest expense
will receive at least the
libor floor + spread

97
Accounting

98
Accounting

Opening cash needs to be

modified to reflect the
financing fees, as does
debt

Ending debt will have to

factor in the PIK interest,
debt paydown and
financing fee amortization

99
Accounting

Reinput interest expense

to reflect the new
borrowing terms and
financing fees

100
Accounting

All noncash interest

expense and fees are
added back in cash from
operations while principal
payments are included in
cash from financing

101
Accounting

102
Accounting

103
Exercise F
(Advanced)
Noncontrolling
interests

104
Accounting

Noncontrolling interests
• Picking up from Exercise D, except now imagine that on December 31 of 2018 (the
day you started your business) you also acquired a digital marketing firm with the
following details:
◽ You acquire 80% of the target for $300k; Remaining 20% with now
“noncontrolling interests”
◽ You finance with $100k in cash and a $200k, 5-year note at 10% cash interest

At the acquisition date the target had the During 2019, the target generated the following:
following fair value of assets and liabilities
$25,000 in accounts receivable Revenue of $90,000
$20,000 in intangible assets COGS of $8,000
$12,000 in accounts payable. SG&A of $30,000
No other expenses
40% tax rate

Update the Income Statement, Balance Sheet and Cash Flow Statement

105
Accounting

The first thing to do is calculate goodwill.

There’s a lot to do so we do it in a
separate schedule below and then we’ll
link back up to the balance sheet. Also
remember that this happened on
12/31/2018 so the consolidation of these
assets and liabilities should already be
reflected on the opening balance sheet.

Under the consolidation method, you’re

pretending like you bought the whole
thing when calculating goodwill so you
determine the implied total purchase
price, and subtract net book value.

Of course you don’t own the whole thing,

so to account for that, you calculate the
value of noncontrolling interests by
taking the implied total purchase price
(as if you bought 100%) and multiply by
the % you didn’t acquire (20% here).

106
Accounting

107
Accounting

Next we turn to the income

statement. There’s a lot to do so we
do it in a separate schedule below
and then we’ll link back up.

Again, you’re lumping all of the

targets revenue and expenses as if
you own all of it.

Of course you don’t own the whole

thing so you need to calculate the
net income from the target that you
don’t get and reduce your total
consolidated net income by this
amount to arrive at “net income to
common.”

108
Accounting

Fine point: The NCI is after tax

because the consolidation method
brings in all the target’s pretax
income and we need to show full
consolidated tax expense on that.

However, when we go back to the

income statement, we will see that
to get from consolidated net
income to “net income to
common”, we need to remove the
NCI after tax, since the
noncontrolling interests are the
ones who pay the tax on their
portion of income.

109
Accounting

Link the now consolidated

revenue and expenses to the
income statement.

Recall that the new

borrowing is $200k @ 10%,
plus the original borrowing
of $50k at 10%

Because we use up all

our $100k in initial cash
to fund the deal, we no
longer have that cash to
generate investment
income

Notice the new separation

of net income to
consolidated and net
income to common

110
Accounting

111
Accounting

Nothing to do here but understand

what’s going on:
We link net income to consolidated –
not to common because these are
consolidated financials.

Recall this acquisition happened on

12/31/2018 so the $100,000 cash we
spent would have been reflected in
the prior year CFS

Also, since we used up the $100,000

on the acquisition, we will not use it
for investing in marketable securities
as we had in the prior examples

112
Accounting

See if you can link everything

properly to the balance sheet

We originally started with $100k in cash but used it

up immediately to fund the acquisition

You acquired a bunch of A/R in the deal so should be

reflected on the opening B/S

The deal created goodwill on the opening B/S. Recall you also have the
hot dog stand goodwill generated during the year so the 12/31/2019
will be greater than the 12/31/2018 goodwill

The $200k in acquisition goes here. There’s no principal amortization

during the year so the balance will be the same in both periods.

NCI at the beginning is the NCI balance created in the transaction.

During the year, the NCI grows by the portion of net income
belonging to the NCI (which to the consolidated entity is the NCI
expense.

Notice that this is presented as a separate, unique kind of equity.

Retained earnings grows by net income to common, not consolidated

Relink total equity to include NCI

113
Accounting

114
Wall Street Prep Training Manual

Valuation

v
Valuation

4 types of valuation questions

General valuation Discounted cash flow (DCF)

and corporate finance
“Walk me through a DCF.”
“How do you value a company?”
“When would a DCF be an
“What’s the difference between inappropriate valuation method?”
enterprise value and equity value?”
“What’s the difference between
levered and unlevered FCF?”

Comps (Trading and Transaction) Industry/product specific

“Which multiples are the most popular in “How do you value a bank? (or XXX industry)?”
valuation?”
“How do you value a private company?”
“When would comps be preferable to DCF?”
“How do you value Bitcoin?”

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Valuation

Introduction to valuation
• Valuation is … the process of determining the “right” value of a
business.
• Valuation is NOT … an exact science;
Several approaches are used.
• Valuation is … influenced by the
objectives of those doing the
valuation.

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Valuation

Valuation is central to many areas of finance

Investment Banking (“The Sell Side”)

• When the client is the buyer: What is the best (usually lowest) price we can negotiate?
• When the client is the seller: What’s the best (usually highest) price we can negotiate?
• When the client is a company going public: What’s the right pricing for our IPO?

“The Buy Side” Corporations

• Should we buy, sell or hold positions in • How do we enhance the value of our
a given security? company?
• Will this investment yield the desired • How will operating, financial, and investment
return? decisions affect the company’s value?

118
Valuation

Download the “Buy Side vs Sell Side” Cheat Sheet

• https://www.wallstreetprep.com/knowledge/finance-careers-
overview/

119
Valuation

Enterprise value vs equity value

• When valuing a company, we have to be clear about “value of what?”
• Specifically finance professionals often explicitly want to value two (very
related) things:
◽ Equity value
▸ The value of the business to the owners.
▸ Equity value is the amount you would get to put in your pocket
if you sold your lemonade stand.
◽ Enterprise value
▸ In addition to equity value, finance professionals also want to
explicitly value the enterprise.
▸ What is the enterprise? It is the value of the operations – not the
equity.

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Valuation

Price of house: $1,000,000

• The above is enterprise value. It’s independent of how you funded
the house.

Equity value is the value to the

owners, after all obligations are
accounted for. It DOES depend
on how you funded the house.

Enterprise value and

equity value are linked
Mortgage: $800,000 Equity value If the house value jumps from
That’s your debt $200,000 $1,000,000 to $1,500,000, your
equity value jumps to $700,000.

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Valuation

Enterprise value vs equity value

• Let’s dig a little deeper: Enterprise value is the value of a company’s operating assets,
less its operating liabilities.
◽ Operating assets: All assets except for cash & other investment assets.
◽ Operating liabilities: All liabilities except for debt & debt-like liabilities.
• Getting from enterprise value to equity value: Add the assets and subtract the
liabilities that are excluded in the enterprise value calculation:

Includes straight debt (loans, revolver, bonds) as well as debt-like

“Enterprise value” instruments like capital leases, non-controlling interests, preferred stock

(Operating assets – operating liabilities) + (cash – debt) = Equity value

This is the formula you’ll see Includes cash as well as nonoperating assets like
everywhere. Finance marketable securities, short term investments,
professionals often just net cash equity investments
against the debt in this formula to
arrive at a “net debt” figure.
Or, more simply:
Enterprise value – net debt = Equity value
122
Valuation

Balance Sheet

Assets 12/31/2018 12/31/2019 What’s the equity value and enterprise

Cash 100,000 167,900 value of our lemonade stand at
Marketable securities 100,000 12/31/2019?
Accounts Receivable (AR) 0 20,000
Inventories 20,000 30,000 Approach 1: Direct
Prepaid expenses 0 2,500
Operating assets
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,400 Operating liabilities
Enterprise value

Liabilities 12/31/2018 12/31/2019 Equity value

Accounts Payable (AP) 0 10,000
Acrrued expenses 0 4,000 Approach 2: Indirect
Deferred revenue 0 3,000
Equity value
Debt 50,000 250,000
Total Liabilities 50,000 267,000 Net debt
Enterprise value

Shareholders' Equity (SE)

Common Equity 100,000 100,000
Retained Earnings 0 13,400
Total Shareholders' Equity 100,000 113,400

Total Liabilities and Shareholders’

Equity 150,000 380,400

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Valuation

Balance Sheet

Assets 12/31/2018 12/31/2019 What’s the equity value and enterprise

Cash 100,000 167,900 value of our lemonade stand at
Marketable securities 100,000 12/31/2019?
Accounts Receivable (AR) 0 20,000
Inventories 20,000 30,000 Approach 1: Direct
Prepaid expenses 0 2,500
Operating assets 112,500
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,400 Operating liabilities 17,000
Enterprise value 95,500

Liabilities 12/31/2018 12/31/2019 Equity value 113,400

Accounts Payable (AP) 0 10,000
Acrrued expenses 0 4,000 Approach 2: Indirect
Deferred revenue 0 3,000
Equity value 113,400
Debt 50,000 250,000
Total Liabilities 50,000 267,000 Net debt (17,900)
Enterprise value 95,500

Shareholders' Equity (SE)

Common Equity 100,000 100,000
Retained Earnings 0 13,400
Total Shareholders' Equity 100,000 113,400

Total Liabilities and Shareholders’

Equity 150,000 380,400

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Valuation

Book value doesn’t usually tell you that much

• So are we done? Does our lemonade stand really have equity of 113,400 and an
enterprise value of 95,500?

• No … our lemonade stand’s value is not a function of what the balance sheet tells
us.

• In fact, businesses are usually worth more than their “book” values because real
value is a function of future expectations, not historical carrying values

Do finance professionals ever rely on “book values”?

• Yes, when valuing financial institutions. That’s because the balance sheet values of
bank assets (loans and investments) and liabilities (deposits) tend to not deviate
too far from actual fair value (unlike PP&E and intangible assets).

• The other major exception is when doing a “liquidation analysis” for a troubled
company.

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Valuation

Book value vs. market value

• For a publicly traded company, the equity market value is readily
observable via the company’s share price x shares outstanding
(market capitalization).
• For private companies, there is no readily observable market value
and yet investors are constantly valuing, selling and acquiring private
companies.
• In both these scenarios, what’s the analysis that enables investors to
determine the right value?

Book value vs. market value

• Google has an equity book value of $153b per the company’s 2017 10K.
• Google shares trade at $1,200.
• With 700m shares outstanding, this implies an equity market value (market cap) of $840 billion.
• Google has $100b in cash, $4b in debt per the company’s implying (market) enterprise value of $840b + ($4b-$100b)
= $744b.

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Valuation

Most common valuation methods in finance

Comparable Comparable
Discounted Cash Flow
Company Transactions Other
Analysis
Analysis Analysis

Value a company by Value a company by Value a company by Leveraged buyout (LBO) analysis:
finding similar looking at the amount looking at the future A specific type of valuation approach that
companies that are buyers have paid for cash flows it can looks at the value of a company to new
public and have acquiring similar generate and discount acquirers under a highly leveraged
readily observable companies in the them to the present to scenario with specific return requirements.
market prices. recent past. arrive at a present value We’ll talk about this approach later, but it’s
of your business. basically a hybrid of DCF and comps
valuation.
Because these approaches arrive at a Liquidation analysis: Value a company
company’s value by looking at the value of under a worst case liquidation scenario.
similar companies, these approaches fall under Because the DCF arrives
at a company value by
the umbrella of “relative valuation.”
looking at the company’s
specific cash flow
While the DCF and comps are the most
forecasts and risks, the
common valuation approaches, there are
DCF approach is a type
often other, specific valuation approaches
of “intrinsic valuation”,
that are included in analyses when it
as opposed to “relative
makes sense to do so. For our purposes,
valuation.”
we’ll spend less time on them because they
don’t tend to come up nearly as much in
interviews.

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Wall Street Prep Training Manual

DCF

v
DCF

Before we get started: Present value basics

• The DCF approach requires that we forecast a company’s cash flows into the future and
discount them to the present in order to arrive at a present value for the company.
That present value is the amount investors should be willing to pay (the company’s
value).

• We can express this formulaically as (we denote the discount rate as r):

• So, let’s say you’re promised $1,000 next year and decide you’re willing to pay $800.
We can express this (and solve for r) as:

• If I make the same proposition but instead of only promising $1,000 next year, let’s say
I promise $1,000 for the next 5 years. The math gets only slightly more complicated:

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DCF

Present value basics

• In Excel, you can calculate this fairly easily using the PV function (see
below). However, if cash flows are different each year, you will have
to discount each cash flow separately:

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DCF

Unlevered vs levered DCF

• The premise of the DCF model is that the value of a business is purely a function of its future cash
flows. Thus, the first challenge in building a DCF model is to define and calculate the cash flows that
a business generates. There are two common approaches to calculating the cash flows that a
business generates.

◽ Unlevered DCF approach

▸ Forecast and discount the operating cash flows. That gets you enterprise value. Then,
when you have a present value, just add any non-operating assets such as cash, and
subtract any financing related liabilities such as debt. That will get you equity value.

◽ Levered DCF approach

▸ Forecast and discount the cash flows that remain available to equity shareholders after
cash flows to all non-equity claims (i.e. debt) have been removed. That gets you equity
value. Add back net debt and you will get enterprise value.

• Both should theoretically lead to the same enterprise value and equity value at the end (though in
practice it’s actually pretty hard to get them to exactly equal).

• The unlevered DCF approach is the most common!

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DCF

6 steps to building a DCF

1. Forecasting unlevered free cash flows (UFCFs)

• Step 1 is to forecast the cash flows a company generates from its core operations after accounting for all
operating expenses and investments. These cash flows are called “unlevered free cash flows.”

2. Calculating terminal value

• You can’t keep forecasting cash flows forever. At some point, you must make some high level assumptions
about cash flows beyond the final explicit forecast year by estimating a lump-sum value of the business
past its explicit forecast period.

• That lump sum is called the “terminal value.”

3. Discounting the cash flows to the present at the weighted average cost of capital

• The discount rate that reflects the riskiness of the UFCFs is called the weighted average cost of capital
(WACC). Because unlevered free cash flows represent all operating cash flows, these cash flows “belong”
to both the company’s lenders and owners.

• As such, the risks of both providers of capital need to be accounted for using appropriate capital structure
weights (hence the term “weighted average” cost of capital). Once discounted, the present value of all
UFCFs is the enterprise value.

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4. Add the value of non-operating assets to the present value of UFCFs

• The ultimate goal of the DCF is to get at what belongs to the equity owners (equity value).

• Therefore, if a company has any non-operating assets such as cash or has some investments just
sitting on the balance sheet, we must add them to the present value of UFCFs.

• For example, if we calculate that the present value of Apple’s unlevered free cash flows is $700
billion, but then we discover that Apple also has $200 billion in cash just sitting around, we should
add this cash.

5. Subtract debt and other non-equity claims

• Similarly, if a company has any loan obligations (or any other non-equity claims against the
business), we need to subtract this from the present value.

• What’s left over belongs to the equity owners. In our example, if Apple had $50 billion in debt
obligations at the valuation date, the equity value would be calculated as:

$700 billion (enterprise value) + $200 billion (non-operating assets) – $50 billion (debt) = $850 billion

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6 steps to building a DCF

6. Divide the equity value by the shares outstanding

• The equity value tells us what the total value to owners is.
• But what is the value of each share?
• In order to calculate this, we divide the equity value by the
company’s diluted shares outstanding.
• For public companies, the equity value per share that the DCF spits
out can now be compared to the market share price.

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Calculating the unlevered free cash flows (FCF)

• Here is the unlevered free cash flow formula:

Unlevered FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures

• EBIT: Earnings before interest and taxes. This represents a company’s GAAP-based operating profit.

• Tax rate: The tax rate the company is expected to face. When forecasting taxes, we usually use a
company’s historical effective tax rate.

• D&A: Depreciation and amortization.

• Change in NWC: Annual changes in net working capital. Increases in NWC are cash outflows while
decreases are cash inflows.

• Capital expenditures: Represents cash investments the company must make in order to sustain the
forecast growth of the business. If you don’t factor in the cost of required reinvestment into the business,
you will overstate the value of the company by giving it credit for EBIT growth without accounting for the
investments required to achieve it.

How does compare unlevered FCF to cash from operations?

Instead of net income, tax-adjusted EBIT is the starting point – which represents accounting profits just from operations (as
opposed to just to equity owners which is what net income shows). The rest are the same adjustments you would see on a cash
flow statement to get to cash from operations, less capital expenditures (which is usually the big piece of the investing activities
section).

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Two-stage DCF
• To figure out the value of a business today, theoretically you have to find the
present value of ALL future unlevered free cash flows.
• Finance professionals usually only explicitly forecast unlevered free cash flows
for 5-10 years and then make a very simplified assumption about the value of all
unlevered free cash flows thereafter, called the terminal value (TV). TV is the
value the company will generate from all future unlevered FCFs after the explicit
forecast period (stage 1).
• Breaking up the value of a company into two stages is the prevailing practice and
is called a 2-stage DCF
• Formula for a 2-stage DCF with a 5 year explicit forecast period:
UFCF1 UFCF2 UFCF3 UFCF4 UFCF5 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
Enterprise value = + + + + +
(1+wacc)1 (1+wacc)2 (1+wacc)3 (1+wacc)4 (1+wacc)5 (1+wacc)5

Notice that the terminal value itself

needs to be discounted back to the
present because it reflects the value
of the future cash flows at the final
explicit forecast year!

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Terminal value

• There are two prevailing approaches to calculating the terminal value:

1. The growth in perpetuity approach

• The growth in perpetuity approach requires that we make an explicit assumption for a perpetual annual
growth % of UFCFs after the last year of stage 1 at a constant WACC (denoted as ‘r’ in the formula below).

2. Exit EBITDA multiple method

• The big problem with the perpetuity approach above is that it forces finance professionals to explicitly
guess the perpetual growth rate of a company. In practice, it’s usually a range between 3-5% because it’s
in-line with macroeconomic growth expectations and anything higher is considered unjustifiable. A way
around having to guess a company’s long-term growth rate is to guess the EBITDA multiple the company
will be valued at the last year of the Stage 1 forecast. A common way to do this is to look at the current
enterprise value (EV) /EBITDA multiple the company is trading at (or the average EV/EBITDA multiple of
the company’s peer group) and assume the company will be valued at that same multiple in the future. For
example, if Apple is currently valued at 9.0x its last twelve months (LTM) EBITDA, assume that in 2022 it
will be valued at 9.0x its 2022 EBITDA.

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DCF

Imagine that we calculate the following UFCFs for

Apple:

Refers to
changes in
‘net working
capital’

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DCF

But Apple is expected to generate UFCFs beyond

2022 so now what?

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DCF

Let’s also try the EBITDA approach

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DCF

Growth in perpetuity vs. exit EBITDA multiple

method
• Investment bankers and private equity professionals tend to be more
comfortable with the EBITDA multiple approach because it infuses
market reality into the DCF.
• A private equity professional building a DCF will likely try to figure out
what he/she can sell the company for 5 years down the road, so this
arguably provides a valuation that factors in the EBITDA multiple.
• However, this approach suffers from a significant conceptual problem: It
uses current market valuations in the DCF, which arguably defeats the
whole purpose of the DCF.
• Making matters worse is the fact that the terminal value often represents
a significant percentage of the value contribution in a DCF, so the
assumptions that go into calculating the terminal value are all the more
important.

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Getting to enterprise value: Discounting the cash

flows by the WACC
• Quantifying the discount rate, which in this case is the weighted average cost of capital (WACC), is a
critical field of study in corporate finance.

• You can spend an entire college semester learning about it.

Here’s the bottom line:

1. Risk & return are two sides of the same coin:

• The UFCFs we forecasted are not a sure thing because companies may not achieve the UFCFs we
expect. Even worse, companies can go bankrupt.

• The DCF values a company by calculating the PV of those UFCFs. Another way to think of this is an
attempt to figure out what an investor today might be willing to pay for those uncertain UFCFs.

• To do that, you’d need to figure out what kind of return the investors want. And to do that, you
would need to quantify the riskiness of those UFCFs somehow. That’s because an investor’s
return requirements fundamentally depend on how they perceive the risks of those future UFCFs.

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Getting to enterprise value: Discounting the cash

flows by the WACC
2. Both debt and equity risk/return must be reflected:
• The UFCFs that we are discounting belong to both lenders (debt) and owners (equity) because
UFCFs are unlevered, meaning they are the cash flows that operations of the business generates
regardless of the debt/equity mix (think back to the house example).
• As these UFCFs will be generated, lenders get interest and principal payments. Any remaining
UFCFs belong to owners. The cost of debt is what lenders charge for taking the risk of lending.
It is more or less the interest rate and is thus fairly straight forward. From the company’s
perspective, interest payments are tax deductible (“tax shield”), so if you have to pay 5%
interest and your tax rate is 25%, the actual cost to you is 5% x (1 – 25%) = 3.75%.
• Owners get whatever remains of the UFCFs. Because they get 2nd priority after lenders, for
every $1 equity investors contribute, they expect a higher return than what lenders expect for
every $1 they lend. That expected equity return is called the cost of equity (from the
company’s perspective it’s a cost that comes in the form of ownership dilution). Quantifying
this cost is really hard.
• It’s also worth noting that the timing and amount equity investors will inevitably get back is far
less defined. Theoretically, they’ll get it eventually in the form of dividends. However,
companies have complete freedom to decide when to pay those; Many just keep pouring the
residual UFCFs back into the business in lieu of dividends. But the money belongs to equity
investors whether it’s distributed as dividends or whether it’s sitting in the company’s bank
account.
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Getting to enterprise value: Discounting the cash

flows by the WACC
3. Capital structure determines the cost of capital weights
• The appropriate discount rate to use in the unlevered DCF has to blend the cost of debt and cost
of equity. The appropriate weight placed on both costs depends on the company’s expected
capital structure (debt/equity mix) over the discount period. That’s why its called a weighted
average cost of capital – it’s weighing cost of debt and cost of equity based on the debt/equity
mix in the capital structure.

4. Putting it all together – the WACC formula

Cost of equity
Cost of Tax shield Risk free rate +β x equity risk premium
debt

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The debt weight The equity weight

Debt as a % of Debt as a % of total
total capital capital

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The WACC formula Cost of equity

Risk free rate +β x equity risk premium

WACC
Debt weight Market value of a company’s debt. Can be approximated by using a company’s book value of debt.

The equity weight Market value of a company’s equity (either market cap or comps derived equity value)
Cost of debt The yield on a company’s debt. Cost of debt ≠ nominal interest rate (i.e. coupon rate)
Tax rate The tax rate the company expects to face going forward
Cost of equity Cost of equity = Risk free rate + β x equity risk premium

Cost of equity
Risk free rate Yield on a default-free government bond. The current yield on a U.S. 10-year bond is the preferred
RFR for U.S. companies. Front page of WSJ, financial data sites all show up to date yields

Beta β measures a company’s sensitivity to systematic (market) risk.

• β = 0 means no market sensitivity (cash, for example)
• β < 1 means low market sensitivity (consumer staples, for example)
• β > 1 means high market sensitivity (luxury goods, for example)
• β < 0 negative market sensitivity (gold, for example). Bloomberg is good source for β
Equity risk premium ERP measures the incremental risk of investing in equities over risk free securities. The ERP usually
(ERP) ranges from 4-6%.

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Getting to equity value: Subtracting net debt

• Recall this is really 2 steps: Adding the value of cash and other non-
operating assets and subtracting debt and equivalents:

Here is Apple’s 2016 year-ending

balance sheet. The non-operating
assets are its cash and equivalents,
short-term marketable securities and
long-term marketable securities. As
you can see, they represent a
significant portion of the company’s
balance sheet.

Unlike operating assets such as PP&E,

inventory and intangible assets, the
carrying value of non-operating
assets on the balance sheet is usually
fairly close to their actual value.
That’s because they are mostly
comprised of cash and liquid
investments that companies
generally can mark up to fair value.

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Getting to equity value: Subtracting net debt

Here is Apple’s 2016 year-ending

liabilities. You can see it has
commercial paper, current portion of
long-term debt and long-term debt.
These are the three items that would
make up Apple’s non-equity claims.

As with the non-operating assets,

finance professionals usually just use
the latest balance sheet values of these
items as a proxy for the actual values.
The market value of debt doesn’t
usually deviate too much from the
book value unless market interest
rates have changed dramatically since
the issue, or if the company’s credit
profile has changed significantly.

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Getting to equity value: Subtracting net debt

• Apple has a substantial negative
net debt balance.
• For companies that carry
significant debt, a positive net debt
balance is more common, while a
negative net debt balance is
common for companies that keep a
lot of cash.

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From equity value to equity value per share

• Once a company’s equity value has been calculated, the next step is to
determine the number of shares that are currently outstanding to get to
value per share.
• To do this, take the current actual share count from the front cover of the
company’s latest annual (10K) or interim (10Q) filing. For Apple, it is:

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From equity value to equity value per share

• Next, add the effect of dilutive shares.
• These are shares that aren’t quite common stock yet, but that can
become common stock and thus be potentially dilutive to the
common shareholders (i.e. stock options, warrants, restricted stock
and convertible debt and convertible preferred stock).
• Assuming 50 million dilutive securities for Apple, we can now put all
the pieces together (next page).

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DCF

From equity value to equity value per share

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The DCF is sensitive to assumptions. Garbage in =

Garbage out
• What are the key assumptions in a DCF?
1. The operating assumptions (revenue growth and operating margins)

2. The WACC

3. Terminal value assumptions: Long-term growth rate and the exit

multiple
• Each of these assumptions is critical to getting an accurate model.
• In fact, the DCF model’s sensitivity to these assumptions, and the lack
of confidence finance professionals have in these assumptions,
(especially the WACC and terminal value) are frequently cited as the
main weaknesses of the DCF model.

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In summary …

Projecting free Calculating the

cash flows (FCF) terminal value Enterprise value
(value of operations)
Project unlevered Estimate the value
free cash flows of the enterprise
over forecast at the end of the
period (typically forecast period Less: Net debt
5-10 years)
Equals: Equity value

Divided by diluted
shares outstanding

Discount at the WACC Equals: Equity value

per share

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Stage 1: Unlevered free cash flow projections

• Typical projection period is usually 5-10 years.
• Unlevered approach is most common, with the notable exception of
financial institutions,
who use the levered free cash flow approach.
Unlevered free cash flows

EBIT (aka operating income)

EBIT x [1 – tax rate] (aka EBIAT or NOPAT)

Plus: Depreciation and amortization

Less: Increases in net working capital (NWC)

Less: Capital expenditures

Equals: Unlevered free cash flows

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Stage 2: Terminal value

• We cannot reasonably project cash flows beyond a certain point.
• As such, we make simplifying assumptions about cash flows after the
explicit projection period to estimate a terminal value that represents
the present value of all the free cash flows generated by the company
after the explicit forecast period.
• Analysts use both the perpetual growth and exit multiple methods to
estimate terminal value

Perpetuity approach

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑡 = 𝐸𝐵𝐼𝑇𝐷𝐴𝑡 𝑥 𝐸𝐵𝐼𝑇𝐷𝐴 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑒 Exit multiple approach

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Discount using WACC

UFCF1 UFCF2 UFCF3 UFCF4 UFCF5 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
Enterprise value = + + + + +
(1+wacc)1 (1+wacc)2 (1+wacc)3 (1+wacc)4 (1+wacc)5 (1+wacc)5

• Now you have enterprise value…

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Subtract net debt

• Enterprise value – net debt = equity value
• Net debt = gross debt & equivalents – cash & equivalents
• Debt and equivalents include straight debt (loans, revolver, bonds) as
well as debt-like instruments like capital leases, non-controlling
interests and preferred stock.
• Cash and equivalents include cash as well as non-operating assets
like marketable securities, short-term investments and equity
investments.
Net Debt
Debt & equivalents Net Debt
1. Debt / Capital Leases
2. Non-controlling interests
3. Preferred Stock Enterprise
Less: Non operating assets Value
Equity
1. Cash & equivalents Value
2. Other non op. assets

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Levered DCF summary

Levered free cash flows Perpetuity approach

Net income
Plus: Depreciation and amortization
Less: Increases in working capital assets
Plus: Increases in working capital liabilities
Less: Capital expenditures Exit multiple approach
For levered DCF, use equity multiples such as P/B
Plus: Debt Issuance, net of repayments or P/E
Less: Preferred dividends 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑡 = 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒𝑡 𝑥𝑃/𝐵 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑒
Equals: Levered free cash flows

LFCF1 LFCF2 LFCF3 LFCF4 LFCF5 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒

𝐄𝐪𝐮𝐢𝐭𝐲 𝐯𝐚𝐥𝐮𝐞 = + + + + +
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)5

cost of equity r = risk free rate + Beta x Market risk premium

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DCF Advantages
• Theoretically, the most sound method of valuation.
• Less influenced by temperamental market conditions or non-economic
factors.
• Can value components of business or synergies separately from the business.

DCF Disadvantages
• Present values obtained are sensitive to assumptions and methodology.
• Terminal value represents a significant portion of value and is highly
sensitive to valuation assumptions.
• Need realistic projected financial statements over at least one business cycle
(5 to 10 years) or until cash flows are “normalized.”
• Sales growth rate, margin, investment in working capital, capital
expenditures and terminal value assumptions along with discount rate
assumptions are key to the valuation.
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Extra: WACC

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Extra: WACC

WACC: The equity weight

The equity weight

Should reflect the market value of a company’s equity

• If the market value of a company’s equity is readily observable (i.e. for a

public company), equity value = diluted shares outstanding x share price.
• If the market value of is not readily observable (i.e. for a private company),
estimate equity value using comparable company analysis.
• The key point here is that you should not use the book value of a company’s
equity value, as this method tends to grossly underestimate the company’s true
equity value and will exaggerate the debt proportion relative to equity.

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WACC: The debt weight

The debt weight

The book value is usually sufficiently close to the market value of debt that it can be used

• Most of the time you can use the book value of debt from the
company’s latest balance sheet as an approximation for market value
of debt.
• That’s because unlike equity, the market value of debt usually doesn’t
deviate too far from the book value.

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Cost of debt

• Compared to calculating the cost of equity, the cost of debt is easier because loans and bonds have
explicit interest rates. For example, a company might borrow $1 million at a 5.0% fixed interest
rate paid annually for 10 years.

• The main wrinkle in calculating the cost of debt is that it’s not simply the nominal interest rate.
That’s because the nominal rate is historical and may be different than the rate the company would
pay if it borrowed currently (remember that the WACC is applied to future UFCFs so should reflect
current anticipation for future borrowing and equity costs).

• So how do you estimate the cost of debt? You have to estimate the yield on existing debt. Yield
doesn’t just look at the nominal rate, but factors in the bond price to tell you what the likely coupon
rate would be if the company borrowed today. It is the internal rate of return of a bond.

• On the next slide you can see a Bloomberg bond page for a 5.7% IBM bond, issued in 2007. Rates
plummeted since the 2007 issuance so the yield on this bond is 1.322% in 2017. That’s much closer
to what IBM would likely have to pay if it borrowed now (IBM and a few other companies are
borrowing at historically low costs of debt). The 1.322% is thus the cost of debt to use.

Cost of debt ≠ nominal interest rate (i.e. coupon rate) Bloomberg is

the best source
Cost of debt = yield on the company’s debt for yields

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The yield1 of 1.3% is significantly

lower than the 5.7% coupon rate

1There areseveral types of yield. The type of yield Bloomberg quotes in its main bond description page is a yield-to-maturity
measure called “bond equivalent yield”. Technically, another measure called the “effective annual yield” provides a slightly
more accurate measure but the difference is immaterial.
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Extra: WACC

Cost of debt
• Companies that do not have public debt but have a credit rating
◽ Use the default spread associated with that credit rating and add to
the risk-free rate to estimate the cost of debt.
◽ Credit agencies such as Moody’s and S&P provide yield spreads over
U.S. treasuries by credit rating.

• Companies with no rating

◽ Use the interest rate on its latest long-term debt or calculate the
company’s interest coverage ratio (EBIT/interest) and apply the
default spread for the credit rating most closely associated with your
company’s interest coverage ratio.
◽ Damodaran Online1 publishes a table that lets you map a credit
rating based on interest coverage.
1 Damodaran Online: http://pages.stern.nyu.edu/~adamodar/

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Cost of equity
• Multiple competing models exist for estimating cost of equity: Fama-
French, Arbitrary pricing theory (APT) and the Capital Asset Pricing
Model (CAPM).
• The CAPM, despite suffering from some flaws and being widely
criticized in academia, remains the most widely used equity pricing
model in practice.
• Below is the formula for calculating the cost of equity:

Cost of equity = Risk free rate + β x equity risk premium

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Cost of equity
• β (“beta”): β measures a company’s sensitivity to systematic (market) risk. A company with a beta of 1 would
expect to see future returns in-line with the overall stock market returns. A company with a beta of 2 would expect
to see returns rise or fall twice as fast as the market. In other words, if the S&P were to drop by 5%, a company with
a beta of 2 would expect to see a 10% drop in its stock price because of its high sensitivity to market fluctuations.

◽ The higher the beta, the higher the cost of equity because the increased risk investors take (via higher
sensitivity to market fluctuations) should be compensated via a higher return.

• ERP (“Equity risk premium”): ERP measures the

incremental risk of investing in equities over risk-free
securities. The ERP usually ranges from 4-6%, and is
provided by several vendors by looking at historical
returns on the S&P over risk-free bonds.

• The risk-free rate (RFR): The RFR measures the

yield on a default-free government bond. The current
yield on a U.S. 10-year bond is the preferred RFR for
U.S. companies. For European companies, the German
10-year is the preferred RFR. The Japan 10-year is
preferred for Asian companies. Yields on government bonds (Source: WSJ, 11/6/2017)

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Raw beta: Colgate’s (CL) “raw” beta is 0.447 based on its last 5 years share price
Calculating β returns compared to the S&P 500. If you assume that relationship holds going
forward, every time the S&P 500 goes up by 1%, you’d expect Colgate to go up by
0.5%. That suggests Colgate is relatively insensitive to market changes.
• There are several sources
for getting a company’s
β including Bloomberg,
MSCI and S&P.
• All of these services
calculate beta based on
the company’s historical
share price sensitivity to
the S&P 500, usually by
regressing the returns of
both over a 60 month
period.

Raw vs adjusted beta: Many argue the raw betas are bad predictors of future beta (poor correlation)
because company specific issues uncorrelated to the market clouds the relationship. “Adjusted” beta is an
attempt to make the beta a better predictor so finance professionals generally prefer adjusted beta, but
neither one is great.

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Putting it all together: WACC in practice

• Here’s an example of how Apple’s WACC might be calculated in
practice.

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Extra: Industry
Beta

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Extra: Industry Beta

Calculating industry β
• In the last slide we alluded to the problem that betas suffer from poor correlations making them
bad predictors. This is only half of the problem. The other issue is that only public companies have
observable betas. The solution to both is using the betas of comparable companies to estimate beta
for the company being analyzed. This is called the industry beta approach.

• The industry β approach looks at β of several public companies that are comparable to the
company being analyzed and applies this peer-group derived beta to the target company. The
benefits are:

1. Eliminates company-specific noise

2. Enables one to arrive at a beta for private companies (and thus value them)
• We cannot simply average up all the raw betas. That’s because companies in the peer group will
likely have varying rates of leverage. And unfortunately, the amount of leverage (debt) a company
has significantly impacts its beta. (The higher the leverage, the higher the beta, all else being equal.)

• Fortunately, we can remove this distorting effect by unlevering the betas of the peer group and
then relevering the unlevered beta at the target company’s leverage ratio.

• We do this as follows…

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Calculating industry β

1. Unlever raw betas from peer group: Get raw beta for each company in the peer group, and unlever using the debt-
to-equity ratio and tax rate specific to each company using the following formula:

Company βLevered
Company β Unlevered =
1+ 𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡
(1−tax rate)

2. Calculate the median of all the unlevered betas: Once all the peer group betas have been unlevered, calculate the
median unlevered beta:

Industry β Unlevered = Median of peer group βUnlevered

3. Relever the industry beta using the target company’s specific debt-to-equity ratio and tax rate using the following
formula:

𝐷𝑒𝑏𝑡
Target company βLevered = Industry βUnlevered x 1+ (1−tax rate)
𝐸𝑞𝑢𝑖𝑡𝑦

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Calculating industry β
• Here’s an example of what an industry beta calculation might look
like for Apple.

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Relative Valuation

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Relative Valuation

Relative valuation
• While the DCF looks at the intrinsic cash flow-generating potential of a business to
determine its value, a seemingly simpler and more market driven approach is
available: looking at how similar companies are valued.
• This approach is called relative valuation, an umbrella term describing two valuation
approaches:
◽ Trading comparables
▸ Valuing a firm by looking at the stock market value of similar companies.
◽ Transaction comparables
▸ Valuing a firm by looking at prices acquirers have recently paid for similar
companies,
• While the DCF requires explicit assumptions about the future, relative valuation – or
“comps” – has the advantage of requiring no explicit assumptions about a company’s
future prospects, and is based on “reality” – observable prices for similar companies in
the market.
• Of course, relative valuation has no shortage of disadvantages, and we’ll get to those
shortly.
Deep dive: Relative vs Intrinsic Valuation in Investment Banking
https://www.wallstreetprep.com/knowledge/really-trust-dcf-model-made-investment-bankers/

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Relative Valuation

Multiples – not absolute values

• When you try to gauge the fair value of your house by comparing to the values of houses nearby, you’re
doing a comps analysis.

• But companies are trickier to value than houses because finding truly comparable companies is difficult.

• Even if you find comparable businesses operationally, you need to standardize for various factors, most
notably size differences.

• That’s why we don’t compare absolute values but rather multiples, with some of the most popular being:

EV multiples Enterprise value (EV)

EV multiples are generally more Equity value multiples
multiples
common than equity value multiples
because they isolate how the market EV / EBITDA P / E ratio (Share price / EPS)
values the operations of a business,
regardless of the capital structure of EV / Revenue Market cap / Net income
the business. EV/EBITDA multiples EV / EBIT P / E to growth (PEG ratio)
are the most popular. Revenue
multiples are useful for companies EV / Industry specific metric
with negative EBITDA or profits, or
when margins are fairly similar across
the entire peer group (i.e. certain retail
subsectors).

The denominators in these multiples are what’s used to standardize the absolute enterprise value or equity value to make comparisons
easier. These denominators are usually calculated on an LTM (“last twelve months”) and forward (1-year or 2-year out) basis

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Relative Valuation

The primary challenges of doing a comps analysis

correctly
• Selecting truly comparable companies. (Virtually impossible, so we
do the best we can.)
• Selecting the right multiple. (EV/EBITDA vs. P/E vs. P/B, etc.)
• Selecting the right timeframe. (EV/LTM EBITDA vs. EV/Forward
EBITDA, etc.)
• “Scrubbing” the multiple. (EBITDA should exclude nonrecurring
items and should be calculated consistently across all companies.)

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Trading comps analysis: the process

1. Select comparable companies (peer group).
2. Pick which multiples you will use (EV/EBITDA, P/E).
3. Pick which timeframe you will use.
• Last twelve months (LTM)
• Forecast basis (1 year forward or 2 year forward)

1. For each multiple, apply the calculated mean or median to the target company’s
corresponding operating metrics to arrive at a value.

• Example 1: Multiply the derived average LTM PE ratio by company’s LTM EPS to
arrive at equity value per share.

• Example 2: Multiply the derived median 1 year forward EV / EBITDA multiple by

the company’s 1 year forward EBITDA projection to arrive at enterprise value.

Median
For larger peer groups, calculating relevant peer group statistic using median is
preferable to mean calculations because it limits distortions from outliers.

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Comparable company analysis exercise

$ in millions, expect per share data

Company Colgate
Share price $30.00
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200

Peer group EV/Sales EV/EBITDA P/E

Kimberly Clark 1.00 6.00 15.00
Unilever 2.00 8.00 19.00
Procter & Gamble 1.50 6.50 17.00
Avon Products 1.00 5.80 14.60
Mean 1.38 6.58 16.40

Implied Colgate share price

Is Colgate overvalued based on comps?
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Comparable company analysis exercise

$ in millions, expect per share data

Company Colgate
Share price $30.00
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200
EV/Sales EV/EBITDA P/E
Peer group mean 1.38x 6.58x 16.40x

Implied Colgate enterprise value $1,375 $1,315 $1,430

Less: Colgate net debt 200 200 200
Equals: Colgate implied equity value 1,175 1,115 1,230
Colgate shares outstanding (mm) 30 30 30

Implied Colgate share price $39.17 $37.17 $41.00

Is Colgate overvalued based on comps? No No No
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Relative Valuation

Trading comps – advantages

• A reality-based valuation
◽ Provides a framework to value a company based on current market
conditions, industry trends and growth of companies with “similar”
operating and financial statistics.

◽ Those who believe that markets efficiently price stocks and implicitly reflect
fundamental assumptions about industry trends, business risk, market
growth, will argue that comps are a more reliable method of valuation.

• A sanity check to DCF

◽ The DCF relies on and is highly sensitive to explicit assumptions about a

company’s future performance. As a result, it’s fairly easy to make the DCF
say whatever you want it to say.

◽ A comps analysis that relies on observable market prices as a key input

makes comps a critical sanity check to the DCF valuation.

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Trading comps – disadvantages

• Apples to oranges
◽ Truly comparable companies are rare,
and differences are hard to account for.
Explaining value gaps between the
company and its comparables
involves judgment.

• Doesn’t reflect intrinsic value

◽ Many people feel that the stock market
is emotional and that it sometimes
fluctuates irrationally
(i.e. the market can be wrong).

• Of limited usefulness for valuing public companies

◽ For trading comps to be useful as a tool for valuing a public company with a readily observable
market price, you would have to argue that the market might be wrong about pricing any single
company, but in aggregate is generally right.

• Liquidity
◽ Thinly traded, small capitalization or poorly followed stocks may not reflect fundamental value.

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Transaction (“deal”) comps

• If you’re trying to value a company for the purposes of an acquisition (i.e.
you’re an investment banker trying to help your client find a suitable
acquirer), prices paid to acquire comparable companies in recent
acquisitions capture a purchase premium.
◽ As a practical matter, acquirers must pay a premium to compel
sellers to sell; this premium can be significant and range from 10%-
50% above the standalone market price.
◽ As a result, deal comps will almost certainly yield a higher valuation
than standalone comps.
• Finding comparable transactions is even harder than finding comparable
standalone business.
• In addition, finding enough data to be able to calculate multiples tends to
be much harder with deal comps.
• The process is otherwise similar to comparable company analysis.

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Multiples in deal comps

• Generally the same multiples used in trading comps are used to value companies in deal comps.
• When cost savings are expected to accrue to the acquirer post acquisition (“synergies”) due to the
ability to reduce overlapping workforces, corporate overhead and office space, those expected cost
savings are sometimes disclosed.
• When that’s the case, you’ll often see an EV/EBITDA or EV/EBIT multiple1 where the target’s
EBITDA and EBIT have been adjusted up to reflect the reported synergies, which leads to a lower
purchase multiple (and facilitates comparisons across both strategic and financial deals).

Enterprise value (EV)

Equity value multiples
multiples
LTM and Year 1 and Year 2
LTM and Year 1 and Year 2
forward
forward
Offer price per share / Target
EV / Revenue
Enterprise value in
EPS Equity value in the
the context of M&A is EV / EBITDA Offer value / Target net income context of M&A is
sometimes referred called “offer price,”
to as transaction EV / EBITDA (inc. synergies) P / E to growth (PEG ratio) “offer value,” “equity
value, or TEV (“total EV / EBIT purchase price”. The
enterprise value”) price per share is
EV / Industry specific metric called “offer price per
share”.

1 While EV/EBITDA and EV/EBIT multiples are the most common multiples where the synergy adjustment is made, any
multiple where the denominator benefits from synergies could be adjusted
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Transaction comps analysis: The process

1. Determine universe of comparable transactions.

2. Calculate multiples.

• Offer price/EPS, Offer value/Book equity

• TEV/EBITDA, TEV/EBIT, TEV/Revenues
• Industry-specific enterprise & equity multiples
3. Apply the calculated mean/median to target’s corresponding
operating metrics to arrive at a value.

Median
For larger peer groups, calculating relevant peer group statistic using median
is preferable to mean calculations because it limits distortions from outliers.

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Relative Valuation

Exercise
Comparable Transaction Analysis Exercise
Company Eli Lilly
Share price $50.00
Shares outstanding 1.0b
LTM Revenue $20b
LTM EBITDA $6.5b
LTM Net income $5.0b
Net debt $1.0b

Comparable transactions
Offer Premium TV / TV / Offer price
Target Acquirer value ($b) Paid Revenue EBITDA / EPS
Roche Genentech $47 19.0% 2.00 8.00 16.00
Wyeth Pfizer $68 18.0% 3.00 12.00 20.00
Schering-Plough Merck $41 23.0% 1.50 11.00 16.00
Genzyme Sanofi $20 23.0% 2.50 13.00 18.00
Mean 20.8% 2.25 11.00 17.50

Implied Eli share price

Is Eli overvalued based on comps?

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Relative Valuation

Exercise
Comparable Transaction Analysis Exercise
Company Eli Lilly
Share price $50.00
Shares outstanding 1.0b
LTM Revenue $20b
LTM EBITDA $6.5b
LTM Net income $5.0b
Net debt $1.0b

Comparable transactions
Offer Premium TV / TV / Offer price
Target Acquirer value ($b) Paid Revenue EBITDA / EPS
Roche Genentech $47 19.0% 2.00 8.00 16.00
Wyeth Pfizer $68 18.0% 3.00 12.00 20.00
Schering-Plough Merck $41 23.0% 1.50 11.00 16.00
Genzyme Sanofi $20 23.0% 2.50 13.00 18.00
Mean 20.8% 2.25 11.00 17.50

Implied Eli share price $44.00 $70.50 $87.50

Is Eli overvalued based on comps? Yes No No

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Transaction comps – advantages

• Recent comparable transactions can reflect supply & demand for saleable assets.
• Realistic in the sense that past transactions were successfully completed at
certain multiples or premiums. Indicates a range of plausibility for premiums offered.
• Trends, such as consolidating acquisitions, foreign purchases, or financial purchasers may become
clear.

Transaction comps – disadvantages

• Past transactions are rarely directly comparable – apples to oranges.
• Public data on past transactions can be misleading.
• Public data seldom discusses deal protection put in place by acquirer and target.
• Values obtained often vary over a wide range and thus can be of limited usefulness.
• Prevailing market conditions can lead to significant distortions.
• Premiums and appropriate multiples change over time.
• Interpretation of the data requires knowledge of the industry.
• Finding all the information you need can be difficult because different bits of information are scattered
throughout different sources.
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M&A

v
M&A

M&A questions

Basic M&A questions

“What are some reasons that a company might acquire another business?”
“Walk me through an M&A model”
“Are dilutive acquisitions always bad for the acquirer?”
“How do you calculate goodwill?”
“Is it better for buyers to finance a deal with debt or stock?”

Advanced M&A questions

“What is the difference between an asset sale/338(h)(10) election and a stock sale?”

“Why do deferred tax liabilities get created in a stock sale?”

“What is the impact of 2017 tax reform on the treatment of NOLs?”

“What is a fixed exchange ratio?”

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M&A

Introduction to M&A
• Mergers and acquisitions (M&A) is an umbrella term that refers to the
combination of two businesses.

Buyer Seller
• Accelerate time to market • Opportunity to
with new products and cash out or to
channels share in the risk
• Remove competition, achieve and reward of a
cost savings (buying a newly-formed
competitor is called horizontal business.
integration)
• Achieve supply chain
efficiencies (buying a supplier
or customer is called vertical
integration)

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M&A

Players in M&A
• There are several stakeholders in the M&A process

Buyer
Seller
• Management
• Management
• Board
• Board
• Shareholders
• Shareholders

Investment
Accountants Investment bankers Accountants
bankers
M&A Lawyers (deal advisors) M&A Lawyers
(deal advisors)

Regulators (SEC / FTC)

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M&A

The role of the Most common

investment types of IB
bank in M&A engagements

Access to capital Buy-side engagement

Finding buyers & sellers Sell-side

Advice on terms & structure Fairness opinion

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M&A

Work often begins long before a deal is in play

• Except for hostile transactions,

deals are a product of discussions
between managements which
can take a long time.
• Investment banks are often
pitching M&A ideas.
◽ Cultivating relationships
(senior bankers)
◽ Pitchbooks & modeling
(junior bankers)

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M&A

The role of the junior investment bankers in M&A

Building presentations & models

• Pitchbooks & live deal decks (both buy-side &
sell-side)
• Offering memorandum (OM) aka CIM (sell-side)
• Fairness opinions

Facilitating due diligence

• Financial analysis
• Running a data room (sell-side)

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Accretion / Dilution
• An important M&A analysis is called accretion/dilution analysis.
◽ Accretive deal: Pro forma (combined) EPS > Acquirer EPS
◽ Dilutive deal: Pro forma EPS < standalone EPS
◽ Break-even: Pro forma EPS = standalone EPS

Example: Procter & Gamble considers acquiring Colgate

• Analysts expect P&G’s standalone EPS to be $3.05 next year.
• Based on P&G’s analysis, the pro forma EPS next year would be $3.10.
• As such, the deal is considered to be $0.05 accretive.

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M&A

Why do acquirers care about their EPS?

• Acquirers really don’t want to show lower EPS as a result of acquiring
another company and will structure deals in such a way as to
minimize negative impact on their EPS.
• Acquirers are concerned that investors will view a lower EPS as a
sign of lower value (in other words, investors will view what happens
to EPS in the short term as a window into the company’s actual
value).
• An implicit perception is that an acquirer trades at a defined PE ratio
and should the denominator (EPS) decline, price per share will thus
also likely decline.
• Of course there’s no intrinsic reason to assume the PE ratio will stay
fixed (the post-acquisition company might merit a higher PE ratio),
but the concern is nevertheless real, particularly for public acquirers.

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M&A

Accretion / Dilution

UTC expects the combination will be accretive to adjusted earnings

per share after the first full year following closing and generate an
estimated $500+ million of run-rate pre-tax cost synergies by year four.

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M&A

Deal consideration

• Acquirers pay for their

acquisition by:
◽ Paying cash
◽ Issuing stock
◽ A combination of both
(i.e. 50% stock & 50% cash)
• The financing decision carries
significant legal,
tax, and accounting implications.

Source: Thomson Reuters

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M&A

Major adjustments to combined “pro forma” EPS in

M&A
• In a 100% stock deal: The major adjustment to acquirer’s EPS will
arise because the acquirer must issue a lot of new acquirer stock in
exchange for target shares, such that PF shares = acquirer’s pre-deal
shares + acquirer shares issued in the transaction.
• In a 100% cash deal: No new acquirer shares must be issued, but
either excess cash or new debt finances the acquisition. This impacts
the I/S via incremental interest expense, reducing PF net income and
EPS. New interest expense is often the major adjustment in a cash
deal.
• In a mixed deal: Both adjustments must be made.

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Accretion / dilution process (100% stock sale)

1. Calculate pro forma net income (PFNI): Acquirer + target net income.

2. Calculate offer value: Target offer price x target shares.

3. Calculate acquirer shares issued in the transaction: Offer value /

acquirer share price.
4. Calculate the pro forma shares outstanding (PFSO) = Pre-deal acquirer
shares + acquirer shares issued.
5. Divide the PFNI by the PFSO to get PF EPS.

6. Compare PF EPS against acquirer’s standalone EPS.

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Accretion / dilution process (100% stock sale)

• Accretion: When Pro Forma EPS > Acquirer's EPS
• Dilution: When Pro Forma EPS < Acquirer's EPS
• Break-even: No impact on Acquirer's EPS

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M&A

Accretion dilution - Exercise I

Assumptions
1. Acquirer purchases 100% of target by issuing additional stock to purchase target shares
2. No premium is offered above target's current share price

Acquirer Acquirer
Target Target
Pro forma Pro-forma
Share price at announcement $25 $60
Share price at announcement $25 $60
P/E Ratio 10.0x 12.0x
P/E ratio
EPS Next year $2.50 $5.00 10.0x 12.0x
Shares outstanding 4,000.0 1,000.0
EPS next year $2.50 $5.00
Net income next year
Shares outstanding 4,000.0 1,000.0
Acquirer shares issued
Net income next year
Offer value (offer price per share x target shares outstanding)
Exchange ratio (acquirer shares issued / target shares outstanding)
Acquirer shares issued
Accretion/Dilution ($ per share)
Offer value (offer price
Accretion/Dilution (%) x target shares outstanding)
Exchange ratio (acquirer shares issued / target shares outstanding)

Accretion / Dilution ($ per share)

Accretion / Dilution (%)

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M&A

Accretion dilution - Exercise I

Assumptions
1. Acquirer purchases 100% of target by issuing additional stock to purchase target shares
2. No premium is offered above target's current share price

Acquirer
Acquirer Target
Target Calculating acquirer
Pro-forma Pro forma
Share price at announcement $25 $60 shares issued
Share price at announcement $25 $60
P/E Ratio 10.0x 12.0x Acquirer shares trade at
P/E ratio
EPS Next year 10.0x
$2.50 12.0x
$5.00 $25, while target shares
Shares
EPS nextoutstanding
year 4,000.0
$2.50 1,000.0
$5.00 $2.34 trade at $60. Since no
Net income next year premium is being offered
Shares outstanding 4,000.0 1,000.0 6,400.0 to target shareholders
Net income
Acquirer next issued
shares year 10,000.0 5,000.0 15,000.0 (unlikely in the real
Offer value (offer price per share x target shares outstanding) world), target
Exchange ratio (acquirer shares issued / target shares outstanding) shareholders will accept
Acquirer shares issued 2,400.0
2.4 acquirer shares in
Offer value (offer price x target
Accretion/Dilution ($ per share) shares outstanding) $60,000.0 exchange for each target
Accretion/Dilution (%) share. Thus, acquirer
Exchange ratio (acquirer shares issued / target shares outstanding) 2.40x
must issue 2,400 shares
to purchase 1,000 target
Accretion / Dilution ($ per share) -$0.16 shares.
Accretion / Dilution (%) -6.3%

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M&A

PE ratios determine accretion/dilution in stock

deals
• A deal is accretive when a high PE company acquires a low PE company (and vice
versa).

Accretion/dilution
• Acquirer expects EPS of $1 next year, with a share price of $5 (PE = 5.0x).
• Target also expects EPS of $1 next year, but with a share price of $10 (PE =
10.0x).
• In a 100% stock deal, Acquirer must issue 2 shares to acquire one target share.
• This deal will be dilutive because 1 Acquirer share equates to owning $1 of
Acquirer net income, but Acquirer must issue 2 shares in order to acquire $1 of
Target's net income.
• As a result, the incremental benefit of Target net income will not be sufficient to
offset the share dilution required to make the deal happen.
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M&A

Goodwill and acquisition accounting

• Before we go deeper into the accretion dilution, we need to understand basic acquisition
accounting.
• Under both GAAP and IFRS, an acquisition is viewed as the purchase of target assets and
assumption of target liabilities (net assets or book value of equity), which are written up to reflect
their fair market values (FMV).
◽ Since many assets are commonly carried at below FMV on target BS Goodwill
How much goodwill
(PP&E, intangibles, LIFO inventory), they require write-up upon an should be recognized on a
acquisition. $100 purchase price for
• If the purchase price is greater than the FMV of the net assets, the excess acquiring a company with
a $45 book value with a
is recognized as an accounting asset plug called goodwill.
FMV write up of $15?
• But why would anyone pay above FMV for a company’s net assets???
1. Synergies: Cost savings to the acquirer push the value beyond FMV. Goodwill
$40

2. Whole > Sum of the parts: The value of a business can be greater FMV
than simply the sum of the individual assets when organized in a write up
$15
certain way.
3. Overpayment: Buyers can get swept up in a bidding process, TBV
over-estimate synergies, etc. $45

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M&A

Purchase price allocation – Exercise I

Adjusting the target balance sheet in accordance with PPA

Purchase price of target: 1,000.0

FMV of target PP&E 400.0

Target balance sheet Step 1 Step 2 Step 3

Pre-deal Elimination of Adjust Calculate New

Target BS existing GW to FMV new GW Target BS

Cash 100.0

PP&E 300.0

Goodwill 50.0

Total assets 450.0

Deferred tax liabilities 0.0

Debt 50.0

Equity 400.0

Total liabilities & equity 450.0

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M&A

Purchase price allocation – Exercise I

Adjusting the target balance sheet in accordance with PPA

Purchase price of target: 1,000.0

FMV of target PP&E 400.0

Target balance sheet Step 1 Step 2 Step 3

Pre-deal Elimination of Adjust Calculate New

Target BS existing GW to FMV new GW Target BS

Cash 100.0 100.0

PP&E 300.0 100.0 400.0

Goodwill 50.0 (50.0) 550.0 550.0

Total assets 450.0 1,050.0

Deferred tax liabilities 0.0 0.0

Debt 50.0 50.0

Equity 400.0 (50.0) 100.0 550.0 1,000.0

Total liabilities & equity 450.0 1,050.0

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M&A

Other adjustments
• Let’s get back to the simple accretion/dilution example: Recall that
we just lumped the acquirer and target net incomes together.
• However, in reality there are several (sometimes very significant)
adjustments to net income that will be used in determining
accretion/dilution:
◽ Acquisition financing

◽ Cost savings (synergies)

◽ Fees

◽ Accounting changes

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M&A

Acquisition financing
• In our simple example, we assumed 100% stock deal. In the case of a 100% cash (or
mixed) deal, recall that excess cash reserves must be used, or the acquirer must take
on new debt to finance the acquisition.

• This new borrowing impacts the income statement in the form of incremental interest
expense (or forgone interest income), reducing the combined pro forma net income
and EPS.

• In fact, the major adjustment to EPS in a cash deal is often the incremental interest
expense arising from additional debt issued to finance the deal.

Cost savings (synergies)

• Often the main rationale of an acquisition is to make a significant cut in expenses by
eliminating overlapping R&D efforts, closing down manufacturing plants, and
employee redundancies.
• Synergies will reduce expenses and thus increase pro forma net income (PFNI) and pro
forma EPS (PF EPS).
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M&A

Fees
• Deal fees (IB, legal, and accounting fees): Need to be expensed as
incurred on the income statement, reducing PFNI and PF EPS.
• Financing fees: When a company borrows debt to finance an
acquisition, the fees related to this borrowing are treated differently
from deal fees.
• Unlike deal fees, financing fees are not expensed . Instead, they are 1

treated as a contra-debt, and amortized over the life of the debt

issuance as part of interest expense . This creates an incremental
expense which reduces PFNI over the term of the borrowing.

1Effective 2016, FASB has changed to accounting for financing fees so that instead of being capitalized as an asset and then amortized, they are
instead treated as a contra-debt item. The income statement impact is still the same (amortization is recognized over the term of the borrowing)
but it is classified within interest expense. To read more about this change at https://www.wallstreetprep.com/knowledge/debt-accounting-
treatment-financing-fees/

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M&A

Accounting adjustments
• Incremental D&A, asset write-ups, write-downs: Since target assets
like PP&E and intangible assets are written-up to fair market value in a
deal, going forward, the acquirer will record higher D&A on those
written-up assets will be recorded, thereby reducing PFNI and PF EPS.
• Goodwill: Goodwill created in an acquisition does not impact the IS.
There are 2 exceptions:
◽ Impairment: Acquirer’s have to annually “impairment test” their
past acquisitions. If a deal done in the past is determined to be a dud
in hindsight, the acquirer must reduce the goodwill asset and
correspondingly recognizes an “impairment” expense on the income
statement.
◽ Private companies: Private companies may elect to amortize their
goodwill over 15 years.
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M&A

Accretion / dilution – Exercise II

• Let’s try to put all this together with a mini merger model.

214
M&A

Accretion / dilution – Exercise II

215
M&A

Accretion / dilution – Exercise II

216
M&A

Accretion / dilution – Exercise II

217
M&A

Accretion / dilution – Exercise II, solution

218
M&A

Accretion / dilution – Exercise II, solution

219
M&A

Accretion / dilution – Exercise II, solution

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M&A

Presentation of accretion dilution analysis

• Analysis is usually presented using a data table in Excel.
• Since the analysis is done pre-deal, it is rooted in assumptions like the
offer price, the form of consideration, and the interest rate on
borrowing.
• Should be easy to change key assumptions and to see how those
changes affect the accretion/dilution outcome.

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Extra: M&A
Accounting

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Extra: M&A Accounting

Book versus tax differences in M&A

• Up until now, we have been discussing the effect on the GAAP balance
sheet.
• Since companies prepare 2 sets of books – 1 in accordance with GAAP
(book) and the other with tax rules, we need to address issues that
emerge when there are differences.

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Extra: M&A Accounting

Book versus tax differences in M&A

• Depending on how a deal is structured, there can be a major
difference between the carrying values of assets for book vs. tax
purposes.
• Here is the “book versus tax” paradigm in M&A.

BOOK (GAAP) TAX

TRANSACTION All types Stock Sale Asset Sale or 338(h)(10) election

STRUCTURE

CHANGE IN BASIS? YES NO YES

The carrying values of Book basis gets written up (or Tax basis of assets does not get Tax basis does get stepped up (or
assets and liabilities down) to FMV stepped up (or down) to FMV down) to FMV

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Extra: M&A Accounting

Deferred taxes in M&A

• In this section, we will discuss the accounting and real implications of
these differences.
• Keep in mind:
◽ While the GAAP basis is disclosed, the tax basis will likely be
unknown to you.
◽ As a result, assumptions must be made and the framework
introduced here provides for “rules of thumb” in the typical
context of limited information.
◽ A complete assessment of tax issues should always be conducted
in consultation with qualified tax advisors.

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Extra: M&A Accounting

Deferred taxes in M&A

• When deals are structured as asset sales/338(h)(10): Target’s book
and tax balance sheets both get marked up to fair value, with excess
getting recorded as goodwill.
◽ The now-higher-valued assets lead to higher future D&A,
reducing taxable income, creating future tax savings for the
acquirer.
◽ Additionally, unlike book accounting, tax accounting allows
goodwill to be amortized1, often adding significant future tax
savings for acquirers in asset sales.

1 Inan asset sale, goodwill is tax deductible and amortized over 15 years, along with other intangible assets that fall under IRC section 197. Goodwill is not deductible in
stock sales.

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Extra: M&A Accounting

Deferred taxes in M&A

• When deals are structured as stock sales: Target’s book BS gets
marked up, but the tax BS doesn’t; this is mostly temporary since the
assets getting written up will be depreciated over time.
• GAAP accounts for the temporary difference between the book and
tax basis of assets and liabilities via the creation, on deal day, of
deferred tax assets and liabilities (DTAs and DTLs).
◽ Two major exceptions to this are land and goodwill, which don’t
get depreciated or amortized, creating permanent differences
and as a result no deferred taxes.

227
Extra: M&A Accounting

Purchase price allocation – Exercise I

• Let’s revisit our purchase price allocation exercise. Recall that the
PP&E of the target company was written up from $300 to $400. What
is the impact of the PP&E write up on future net income?

Tax basis of PP&E: $3001

FMV of PP&E: $400
Nature of PP&E: Fully depreciable (i.e. no land, no savage value)

Depreciation method: Straight-line2

Useful life: 2 years
Tax rate: 40%
Book P&L post-deal Tax P&L post-deal
Year 1 Year 2 Year 1 Year 2
Revenues (all cash): 1,000 1,000 1,000 1,000
Cash expenses 500 500 500 500
Depreciation
Pre-tax profit
Tax
Net income
1 Since the actual tax basis is usually unknown unless provided by the target, a common assumption is that the pre-deal book basis equals the tax basis.
2 We assumed straight-line for simplicity. In actuality, IRC and most tax codes outside the US call for an accelerated depreciation method (MACRS in the U.S).

228
Extra: M&A Accounting

Purchase price allocation – Exercise I solution

Tax basis of PP&E: $300
FMV of PP&E: $400
Nature of PP&E: Fully depreciable (i.e. no land, no savage value)
Depreciation method: Straight-line
Useful life: 2 years
Tax rate: 40%

Book P&L post-deal Tax P&L post-deal

Year 1 Year 2 Year 1 Year 2
Revenues (all cash): 1,000 1,000 1,000 1,000
Cash expenses 500 500 500 500
Depreciation 200 200 150 150
Pre-tax profit 300 300 350 350
Tax 120 120 140 140
Net income 180 180 210 210

• To account for the higher future actual taxes (vs. GAAP taxes), a DTL is recognized on
the acquisition date in the amount of the total future differences.

229
Extra: M&A Accounting

Exercise: Deferred taxes in M&A

• Identify the affect of the PP&E write-up on deal-day, and the changes
to the GAAP balance sheet in years 1 and 2.

Select balance sheet items

1 year 2 years
On acquisition date post-deal post-deal

Cash

PP&E +100.0

Deferred tax liability

Equity

Total liabilities & equity

Do assets = liabilities & equity?

230
Extra: M&A Accounting

Exercise: Deferred taxes in M&A

• As the PP&E depreciates, the DTL is reversed, until both book and tax
bases converge to 0, at which point the DTL fully reverses itself.

Select balance sheet items

1 year 2 years
On acquisition date post-deal post-deal

Cash +360.0 +360.0

PP&E +100.0 (200.0) (200.0)

Deferred tax liability +40.0 (20.0) (20.0)

Equity +60.0 +180.0 +180.0

Total liabilities & equity +100.0 +160.0 +160.0

Do assets = liabilities & equity? Yes Yes Yes

231
Extra: M&A Accounting

Deferred taxes in M&A

• You may have noticed that this initial DTL is simply the tax Remember that in
an asset sale or
rate times the write-up. 338(h)(10) election,
no DTL is created
• This is no coincidence. In fact, we can now formulate a because the book
and tax bases both
general rule for calculating deferred taxes in a stock sale: get an increase in
basis

DTL created in M&A stock sale = (FV book basis – tax basis) x tax rate

Book vs Tax Basis of PP&E

500

400 400

300 300
Basis

200 200
150
100

0 0
0 1 2
Years

232
Extra: M&A Accounting

Revisit PPA exercise I, deal structured as stock sale

(no tax step-up)
Adjusting the target balance sheet in accordance with PPA

Purchase price of target: 1,000.0

FMV of target PP&E 400.0

Target balance sheet Step 1 Step 2 Step 3

Pre-deal Elimination of Adjust Calculate New

Target BS existing GW to FMV new GW Target BS

Cash 100.0
PP&E 300.0
Goodwill 50.0
Total assets 450.0

Deferred tax liabilities 0.0

Debt 50.0
Equity 400.0

Total liabilities & equity 450.0

233
Extra: M&A Accounting

Revisit PPA exercise I

Adjusting the target balance sheet in accordance with PPA

Purchase price of target: 1,000.0

FMV of target PP&E 400.0

Target balance sheet Step 1 Step 2 Step 3

Pre-deal Elimination of Adjust Calculate New

Target BS existing GW to FMV new GW Target BS

Cash 100.0 100.0

PP&E 300.0 100.0 400.0
Goodwill 50.0 (50.0) 590.0 590.0
Total assets 450.0 1,090.0

Deferred tax liabilities 0.0 40.0 40.0

Debt 50.0 50.0
Equity 400.0 (50.0) 60.0 590.0 1,000.0
Total liabilities & equity 450.0 1,090.0

Observe that the creation of the DTL led to a lower FMV of equity, which in turn led
to higher goodwill than had a DTL not been recorded.

234
Extra: M&A Accounting

Target pre-deal DTLs

• An interesting question arises with the respect to the treatment of
pre-deal DTAs and DTLs on the target’s BS.
• Pre-existing DTLs (asset sales/338(h)(10)): Book and tax bases are
both revalued to FMV so existing DTLs are eliminated (with a
corresponding increase in equity).
• Pre-existing DTLs (stock sales): Existing DTLs are retained because
there is no tax basis step-up so differences persist (and magnified via
the new write-ups).

235
Extra: M&A Accounting

Target pre-deal DTAs in asset sales/338(h)(10)

• The treatment of existing DTAs depends on the nature of the DTAs.
An often substantial DTA represents future potential benefits from
historical losses (NOLs) that can be applied against future income.
• DTAs from NOLs: Acquirer cannot benefit from target NOLs so DTAs
from NOLs are eliminated.1
• Other DTAs: DTAs from other issues (like revenue recognition) carry
over.

1Although the acquirer can’t use the NOLs, the target can use its own NOLs to offset the target’s gain on sale

236
Extra: M&A Accounting

Target pre-deal NOLs in stock sales

• When a company acquires a target with large NOLs, the IRS places an
annual limit on the amount of NOLs that can be carried forward,
calculated as:
Annual limit = Purchase price x % LT tax exempt rate1

• The practical consequence of this is that acquirers can’t enjoy an

immediate lump sum benefit of NOLs, but rather see the tax benefits
stretched over time. 2

1 Long term tax exempt rate is updated monthly and can be can be found at: https://apps.irs.gov/app/picklist/list/federalRates.html
2 Tax reform enacted in 2017 now also caps the amount of NOLs that can be used to 80% of taxable income, which has the impact of pushing NOL related benefits
out into the future. Offsetting this change is a new rule that lifts 20 year NOL carryforward period and enables companies to carryforward NOLs indefinitely.

237
Extra: M&A Accounting

Summary
Deal structure Stock Sale Asset Sale or 338(h)(10)

Change in book basis? YES YES

Change in tax basis? NO YES

Goodwill tax deductible? NO YES

New DTL created? YES1 NO

Existing DTLs eliminated? NO YES

Existing NOLs usable by acquirer? YES but limited under IRC 382 NO2

Non-NOL related DTAs carry over YES YES

to acquirer?

Remember! These guidelines make several critical assumptions about tax bases and the nature of DTAs and DTLs –
consult with tax professional when appropriate

1 Calculated as (FV book basis – tax basis) x tax rate. DTL reverses over time; goodwill higher due to new DTL
2 Although acquirer can’t use NOLs, the target can use to offset gain on sale

238
Wall Street Prep Training Manual

LBO

v
LBO

LBO questions

General LBO questions

“What is the rationale for undertaking an LBO?”
“What are typical exits for a private equity investor?”
“Name characteristics of a good LBO candidate.”
“How does the 2017 tax reform impact LBOs?”

LBO /modeling analysis

“Walk me through an LBO model.”
“What are the key assumptions in an LBO model?”
“What is the impact of leverage on LBO returns and why?”
“Why is an LBO considered a floor valuation?”
“What is the typical capital structure in an LBO?”
“What are the typical debt tranches in an LBO?”
“How is the maximum leverage in an LBO typically determined?”

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LBO

Leveraged buyout (LBO)

• Acquisition where a significant part of the purchase price is funded with debt.
◽ Term Loans
◽ Revolving Credit Lines
◽ Bonds
• The remaining portion is funded with equity by the financial sponsors.
• Company undergoes a recapitalization to a now highly leveraged financial
structure.
• Company becomes a new company – from oldco to newco.
• Companies acquired by PE can be either private or public.

LBO Jargon
• Financial sponsors = Private equity investors = Financial (vs. strategic) buyers
• Leveraged buyouts = PE-backed deals = Sponsor-backed deals
241
LBO

What is the basic intuition underlying an LBO?

• If you’ve bought a house with a mortgage, you’ve done an LBO
(basically):

Buying a $500k house Selling a $650k house

$100 You sell the house 5 years later,

assuming you’ve paid down $150 of the $250
mortgage and house price increased
$400
$400 30%

Mortgage Equity Mortgage Equity

Equity investor IRR = 32%
Cash-on-cash return = 4.0x

1 1
𝐹𝑉 𝑁 $400,000 5
𝐼𝑅𝑅 = −1= − 1 = 32%
𝑃𝑉 $100,000
242
LBO

What is the basic intuition underlying an LBO?

• As the term leveraged buyout might suggest, LBO debt is a large component of the
overall sources of funds in a transaction.
• LBOs have historically used significant amounts of debt (as high as 80% of the
total source of funds in the 1980s) and has since come down to around 50% of the
overall source of funds, with the remainder usually coming from sponsor equity
(see below).

243
LBO

LBO analysis on a cocktail napkin

• Let’s get the LBO mechanics under our belt using the Dell LBO.

244
LBO

LBO analysis on a cocktail napkin

The offer The financing

• In February 2013, Michael Dell and Silver • The sponsors were able to secure $11.5b in
Lake (“the sponsors”) offered Dell debt financing.
shareholders $13.88 per share. • There was also $7.7b in cash on Dell Inc.’s
• There were 1.69b shares out. B/S. They planned to use all of it to help
• Dell Inc. has $1.4b in debt, which would be fund the deal.
refinanced in the deal. • The remainder would be funded with
• LTM EBITDA was $3.5b. equity.

The exit assumptions

• Exit is assumed 5 years post-LBO.
• Assume the same LTM EBITDA at exit as the current EBITDA.
• Assume exit at the same EV/LTM EBITDA multiple as the current multiple.
• Assume debt is fully paid down.
• Assume no cash on the B/S.

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LBO

What is the expected IRR of this deal?

Use of funds Current valuation

Buyout of equity EBITDA 3.50
Oldco debt refinanced EV
EV/EBITDA
Total uses

Exit assumptions
Source of funds
EV/EBITDA
Debt 11.5 EBITDA 3.50
Existing cash on B/S 7.7 Enterprise value
Equity Debt 0.0
Total sources of funds Cash 0.0
Equity value

Equity IRR

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LBO

What is the expected IRR of this deal?

Use of funds Current valuation

Buyout of equity 23.46 EBITDA 3.50
Offer price/share 13.88 EV 17.16
Diluted shares outstdng. 1.69 EV/EBITDA 4.9x
Oldco debt refinanced 1.40
Total uses 24.86 Exit assumptions
EV/EBITDA 4.9x
Source of funds EBITDA 3.50
Debt 11.5 Enterprise value 17.16
Existing cash on B/S Debt 0.0
7.7
Equity Cash 0.0
5.66
Equity value 17.16
Total sources of funds 24.86

Equity IRR 24.8%

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LBO

What is the basic intuition underlying an LBO?

• Financial sponsors finance deals with a lot of debt and put up a relatively small amount of equity.

• As debt is paid down and the value of the business grows, sponsors earn large returns.

• Key drivers of success are:

◽ Getting in cheap: Finding businesses that for whatever reason are being undervalued (low
multiple).

◽ Leverage: LBOs) thereby growing EBITDA.

◽ SuccessfulLevering with a lot of cheap debt (cheap debt means low interest rates).

◽ Operating improvements: This usually means reducing costs (massive layoffs are often
associated with exit: Exiting within 5-7 years at a high valuation (high EV/EBITDA multiple).

▸ Selling to a strategic or another PE firm.

▸ Selling to public via IPO.

◽ Alternatively, sponsors can monetize without a complete exit by giving themselves dividends
financed via newly borrowed debt (dividend recap).

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LBO

Typical LBO exits

249
LBO

What do investors look for in finding a good LBO?

• Steady cash flows with little cyclicality

◽ Large fixed debt payments leave little wiggle room for volatile businesses.

• Minimal maintenance capital expenditures and working capital needs

◽ This is usually where sponsors can find waste and thus achieve cost savings.

• Strong management teams under pressure by their shareholders

◽ The short termism of public investors can pressure otherwise strong management teams to
optimize for short term earnings instead of a longer time horizon.

◽ Low growth companies that still generate healthy cash flows usually feel more pressure as a
public company than as a private one.

• Businesses with undervalued assets

◽ Selling off undervalued assets can immediately pay down debt.

• High equity / low debt capital structure

◽ See next page.

250
LBO

Tax savings has been a motivating factor in LBOs

• In an LBO, pretax income usually shrinks because of large interest expense and higher D&A
expenses due to asset write ups.

◽ Higher interest expense due to higher leverage:

▸ Expenses lead to lower taxes during the LBO years. The lower tax bill due to a high
interest expense is one of the appealing characteristics of an LBO.

▸ Rather than spending your money on tax, you spend it on debt service which, as we
saw in the simple house-with-mortgage example, increases your equity over time.

◽ Starting in 2018, benefits of leverage will be restricted in the US

▸ Tax reform enacted in 2017 in the United States places limits on the amount of interest
expense that can be deducted for tax purposes, so the tax advantage has been
somewhat restricted.

◽ Bonus depreciation

▸ However, this is offset somewhat by larger amounts of “bonus depreciation” that

financial sponsors (and acquirers in general) can claim for tax purposes.

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LBO

Capital structure
• What % of a company’s value can funded by debt?
• The amount of debt that can be raised depends on:
1. Size/stability of cash flows
2. Preference for defensive, less-cyclical firms
3. Reputation of sponsor and lending environment
• Not all debt is the same

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LBO

Capital structure – equity

• Sponsors Michael Dell’s
equity rollover
◽ Represent the largest source of LBO equity. In the $24b Dell LBO,
Michael Dell rolled over
• Rollover $3.6b of equity and
contributed an extra $750m
◽ In some cases, oldco management rolls over its of fresh cash
existing equity into the newco and even
contributes
new capital alongside the sponsors1.
• Option pool
◽ In addition, since most LBOs have oldco management stays on to run the
newco, sponsors reserve anywhere from 3%-20% of total equity for them.
• Warrants
◽ Certain lenders may receive equity as a sweetener for providing financing
(mezzanine lenders).
1 Management rollover has historically ranges from 2 to 5% of the total equity in LBO

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LBO

LBO debt
• Leveraged loans: Revolver & term loans A/B/C/D
• Bonds: High-yield (“speculative-grade” or “junk”) bonds
• Mezzanine finance

Loans vs. bonds – confusing terminology

Leveraged loans (also called “bank debt” or
“senior debt.” It makes up the majority of
LBO debt and is syndicated to banks (“pro
rata”) and institutional investors. Loans
represent senior tranche(s) in LBOs.

It is quite distinct from the HY bonds

(”bonds" or “junior debt”) which make up the
lower tranches. Unlike bonds, it is usually:
• Secured (1st or 2nd lien)
• Priced as a floating rate (LIBOR + spread)
• Structured with shorter maturity
• More restrictive (covenants)
• Free of SEC registration

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LBO

Leveraged loans – term loans and revolver

• Make up the majority and senior tranches of LBO debt, syndicated to
banks (“pro rata”) or institutional investors.

Loans in Carlyle’s $4.15b Ortho-clinical LBO

• Senior secured institutional loan split between a $2.175b, 7-year TLB and a
$350m, 5-year revolver. Priced at L+375, with a 1% LIBOR floor
• Ortho also issued $1.3b/6.625% notes (bonds) due 2022

Loans in Blackstone’s $5.4b Gates LBO

• Includes $2.49 billion and €200m term loans, respectively (7-year terms), a $125
million cash-flow revolver, and a $325 million asset-based revolver (5-year
terms). The term loans will be covenant-lite.
• $1.04b/6% and €200m/5.75% senior notes (bonds) will also be used to fund the
LBO.

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LBO

Leveraged loans – term loans and revolver

• Priced at LIBOR + spread
• Scheduled principal
amortization (TLs)
• No call protection (borrower
can repay
anytime)
• Most common LBO package is
an institutional Note: loans syndicated to banks is referred to as “pro rata” debt

(nonbank) term loan B/C/D

and a revolver

256
LBO

Leveraged loans – term loans and revolver

• Leveraged loans are priced at LIBOR + spread
• LIBOR floors (i.e. 1%) have become increasingly common

257
LBO

Leveraged loans – revolver

• Usually packaged alongside a term loan to the same investor base,
secured with 1st lien, priced at LIBOR + spread.
• Availability tied to borrowing-base lending formulas (usually a % of
collateral, most often A/R and inventory).
• Can be initially undrawn, partially drawn, or fully drawn:
◽ Example: Dell LBO included a $2.0b asset-backed revolver, $750
drawn initially, with a 5-year term.
• Usually carries the same term and similar pricing as the term loan.

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LBO

Leveraged loans – term loan A/B/C/D

• Term loan A ( “TLA”) are provided by banks, usually is a 1st lien loan,
with a 5 year term, packaged with a revolver.
• Term loans “B”/“C”/“D” refers to loans syndicated to institutional
investors like hedge funds, CLOs, mutual funds, and insurance
companies (and some banks).
The “B” or “C” or “D”
designation is more
• B/C/Ds are larger and more prevalent in indicative of the investor
LBOs than TLAs, often packaged base than priority. (i.e. TLc
can have higher priority
alongside revolver with no TLA. than TLb).

• B/C/Ds have looser covenants, 5-8 year terms, may be

2nd or 1st lien and require less principal amort.

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LBO

Leveraged loans – 2nd lien debt

• 2nd lien term loans have been primarily syndicated to CLO funds and
other institutional investors.
• Unlike 1st lien term loans, typically carry fixed rate, no amortization,
with a longer maturity than 1st lien debt.
• Smaller part of the LBO cap structure post-crisis, as this tranche is
where investors got in trouble during the crisis.

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LBO

High yield bonds (HYB)

• HYD (credit rating BBB- or worse) enables sponsors to increase
leverage to levels that bank debt (leveraged loans) won’t support.

High yield debt investors

Pension
Other
funds
30%(1)
28%

Mutual
Insurance
funds
companies
13%
29%

Source: S&P CIQ, LCD

1‘Other’ includes ETFs, HNW individuals, commercial banks,

hedge funds

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LBO

High yield bonds (HYB)

• Fixed coupon paid semiannually,
maturity 7-10 years, no principal
pay-down until maturity (bullet).

Bonds issued in Bain’s $6.7b LBO of BMC

• BMC’s 2013 LBO included a $1.625b bond, 8.125% coupon, priced at par, matures July
15, 2021 . Not callable for first 3 years.
• Senior tranches were comprised of a $2.88b (L+4%, 1% LIBOR floor) and a $670m
(L+4%) secured 7 year term loan and a $350m unfunded revolver (L+4%).

262
LBO

High yield bonds (HYB)

• HYBs are usually (but not always) unsecured.

263
LBO

High yield bonds (HYB) – other features

• Usually not registered with the SEC (Rule 144A) to get to market
quickly (registration can take more than 3 months).
• Usually exchanged for registered debt once SEC paperwork is done,
increasing liquidity.
• Call protections & call premiums.

Call protection & premium – example

• 10% notes due in 8 years, with 3 years of call protection (noted as NC-3).
• After year 3, bonds are callable at 105% of par, then at 103.3, 101.7 and par in the following years,
representing a par-plus-50% coupon, 33%, 17% and par

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LBO

Covenants
• As part of a loan, lenders will impose restrictions on borrowers
(covenants).
• Financial covenants
◽ Borrower must be in compliance with certain key ratios.

▸ Debt/EBITDA < 6x

▸ EBITDA/Interest > 3x

• Other covenants
◽ Spend limits beyond pre-specified carve-outs (“basket”),
borrower pledge to include lender in any subsequent grant of a
security interest (negative pledge), and forced call in the event of
a downgrade.
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LBO

Covenants
• Maintenance covenants
◽ Required compliance with covenants every quarter, no matter
what
• Incurrence covenants
◽ Required compliance with covenants only when taking a
specified action (issuing new debt, dividends, making an
acquisition)
• Senior debt traditionally include restrictive maintenance covenants,
whereas bonds only include incurrence covenants

266
LBO

Covenants
• Increasingly, leveraged loans are “covenant-lite” and include only
incurrence covenants, amounting to 60% of new loan issuances in 1H
2014.

267
LBO

Mezzanine
• Financing that sits between debt and equity.
• Hedge funds and mezzanine funds are the primary
investors, often tailoring the investment to
meet the specific needs of the deal.

Mezzanine financing structures

• Convertible debt
• Bond with warrants
• Convertible preferred stock
• Preferred stock with warrants
Caution on terminology • Unsecured with few/any covenants
Mezzanine is sometimes more loosely Pricing components
defined as financing between secured debt Target blended return of 15-20%
and equity, which would place HYBs into the
1) Cash interest / dividends
category. For consistency, we will
exclusively refer to mezzanine as financing 2) PIK interest / dividends
specifically below HYBs 3) Warrants (“equity kicker”)

268
LBO

Capital structure – bridge loans

• Bridge loans provide interim financing should the LBO debt not be
available by the closing of the deal.
• Investment banks typically provide the bridge loan commitment.

269
LBO

Expanded LBO analysis on a cocktail napkin

The offer The financing
• In February 2013, Michael Dell and Silver • The sponsors were able to secure $11.5b in debt
Lake (“the sponsors”) offered Dell financing (see next page).
shareholders $13.88 per share. • There was also $7.7b in cash on Dell Inc.’s B/S.
• There were 1.69b shares out. They planned to use all of it to help fund the deal,
• Dell Inc. has $1.4b in debt, which would be • Michael Dell will rollover 3.4b in equity and $0.8b
refinanced in the deal. in new cash.
• LTM EBITDA was $3.5b. • Silver Lake will fund the remainder.

The exit assumptions

• Exit is assumed 5 years post-LBO.
• Assume the same LTM EBITDA at exit as the current EBITDA.
• Assume exit at the same EV/LTM EBITDA multiple as the current multiple.
• Assume debt is fully paid down.
• Assume no cash on the B/S.

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LBO

Full sources of funds in Dell’s $25b LBO

Loans
• $1.5b TLC @ L + 300 w/1% LIBOR floor, covenant-lite, 5yr
• $2.0b asset-backed revolver ($750 drawn initially), 5yr
• $4.0b TLB @ L+375 w/1% LIBOR floor, covenant-lite, 6.5yr
High yield bonds
• $2b 1st lien bonds, 7yr
• $1.25b 2nd lien bonds, 8yr
Microsoft loan: $2b sub. note at 7.25% (~50% PIK), 10yr

Rollover Equity: $3.4b from Michael Dell

Equity: $0.8b from Michael Dell, remainder from Silver Lake

Existing cash on B/S: $7.7b

271
LBO

Expanded LBO analysis “on a cocktail napkin”

Use of funds Current valuation
Buyout of equity EBITDA 3.50
Offer price/share 13.88 EV
Diluted shares outstanding 1.69 EV/EBITDA
Oldco debt refinanced 1.4
Total uses Exit (5 yrs later)
EV/EBITDA
Source of funds EBITDA
Loans Enterprise value
Revolver 0.75 Debt 0.0
Term Loan C 1.50 Cash 0.0
Term Loan B 4.00 Equity value Equity %
High yield bonds Michael Dell
First-lien note 2.00 Other sponsors
Second-lien note 1.25
Microsoft loan 2.00 Equity IRR
Equity Equity % Michael Dell
Rollover Michael Dell 3.40 Other sponsors
New equity Michael Dell 0.80
New equity Silver Lake
Existing cash on B/S 7.70
Total sources of funds
272
LBO

Expanded LBO analysis “on a cocktail napkin”

Use of funds Current valuation
Buyout of equity 23.46 EBITDA 3.50
Offer price/share 13.88 EV 17.16
Diluted shares outstanding 1.69 EV/EBITDA 4.9x
Oldco debt refinanced 1.4
Total uses 24.86 Exit (5 yrs later)
EV/EBITDA 4.9x
EBITDA 3.50
Source of funds
Enterprise value 17.16
Loans
Debt 0.0
Revolver 0.75
Cash 0.0
Term Loan C 1.50 Equity value Equity % 17.16
Term Loan B 4.00 Michael Dell 74% 12.7
High yield bonds Other sponsors 26% 4.4
First-lien note 2.00
Second-lien note 1.25 Equity IRR
Microsoft loan 2.00 Michael Dell 24.8%
Equity Equity % Other sponsors 24.8%
Rollover Michael Dell 60% 3.40
New equity Michael Dell 14% 0.80
New equity Silver Lake 26% 1.46
Existing cash on B/S 7.70
Total sources of funds 24.86
273