2016

EDITION

INVESTMENT BANKING
INTERVIEW
PREPARATION PACK

Volume 2
Structured Answers to TECHNICAL
QUESTIONS That Are Always Asked

MARK HATZ
 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Copyright © 2013 by Mark Hatz. All rights reserved.

No part of this publication may be redistributed, copied, photocopied or duplicated in any form or by
any means, including electronic information storage and retrieval systems, without Mark Hatz’s prior
written consent.

While the publisher and author have used their best efforts in preparing this book, they make no
representations or warranties with respect to the accuracy or completeness of the contents of this
book and specifically disclaim any implied warranties of merchantability or fitness for a particular
purpose. The strategies and advice found herein may not be suited to your situation. The author and
publisher of this book shall not be liable for any profit or loss or any personal or commercial
damages.

Copyright © by Mark Hatz – All Rights Reserved 2

 Volume 2: Structured Answers to Technical Questions That Are Always Asked

CONTENTS

FOREWORD .................................................................................................... 5
I. ACCOUNTING ........................................................................................... 6
1. What do you know about financial statements? Walk me through Balance Sheet, Income
Statement, and Cash Flow Statement ........................................................................................ 6
2. What are accrued / deferred revenues and expenses? .............................................................. 8
3. How do you account for receivables? Walk me through the three financial statements taking a
simple example ........................................................................................................................... 9
4. How do you account for unearned revenues? .......................................................................... 11
5. How do you account for Inventory? .......................................................................................... 13
6. How do you account for depreciation? ..................................................................................... 16
7. What depreciation methods do you know? .............................................................................. 17
8. What are minority interests? .................................................................................................... 18
9. What are investments in associates? ........................................................................................ 18
10. What are the three consolidation methods you know? ........................................................... 19
11. You acquire a company on 01/01/N with cash that sits on your balance sheet. Under each of
the three consolidation methods, how do you consolidate the target balance sheet at
acquisition date, and the target income statement after a year of operations? ..................... 20
12. What if this time you buy 80% of a company 50% in cash from debt you raised and 50% in
stock? What is the operation’s impact on A’s consolidated balance sheet at acquisition date?
.................................................................................................................................................. 30
13. You are buying an apartment that you will be selling in 5 years: what are the financial
statements of the investment holding company at acquisition date, at end of year one and at
exit date? Assume the apartment is bought for 100, 20% with equity, 80% in cash from debt
(linear repayment over 10 years, at a 4% interest); apartment price goes up 2% every year;
rent is 5% of apartment value and maintenance charges are 2 every year; no taxes ............. 32

II. VALUATION, CAPITAL STRUCTURE & RETURNS ANALYSIS ........................37

14. What are the valuation methodologies you know? .................................................................. 37
15. What is a DCF? ........................................................................................................................... 37
16. How do you do a DCF? .............................................................................................................. 38
17. How do you calculate FCFE? ...................................................................................................... 45
18. What is a Dividend Discount Model? ........................................................................................ 45

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

19. What is APV? ............................................................................................................................. 47

20. Now tell me about comps and transaction multiples ............................................................... 50
21. I am asking you to work on comps. Walk me through building a comps file? .......................... 51
22. Let’s dig into EV and market capitalization, what is the treasury stock method? .................... 52
23. How do you calculate net debt?................................................................................................ 52
24. Why do you adjust net debt in your multiple calculation? ....................................................... 55
25. What is an average EV/EBITDA multiple? ................................................................................. 56
26. Do you know how to build an LBO model? ............................................................................... 56
27. In your LBO model output, can you tell me what sources of funds you would typically have
and what their cost / return would be? ................................................................................... 64
28. In your LBO model output, what credit statistics would you show? ........................................ 66
29. In your LBO model output, what would be a typical IRR to equity investors? ......................... 67
30. What would be a good LBO candidate? .................................................................................... 67
31. What are the three sources of value creation in an LBO? ........................................................ 68
32. What are the LBO exit strategies you know? ............................................................................ 70
33. What is EVA and residual income valuation? ............................................................................ 71
34. How would you value a private company? ............................................................................... 73
35. How would you value the orange juice bar from across the street? ........................................ 74
36. Between DCF, comps, transaction multiples and LBO, which method would typically give you
the highest valuation? .............................................................................................................. 75
37. What are the advantages and limitations of each of the valuation methods we have
discussed?................................................................................................................................. 76
38. What valuation discounts do you know? .................................................................................. 77

III. MERGER ANALYSIS ..................................................................................79

39. What is accretion / dilution? ..................................................................................................... 79
40. Assume a simple 100% acquisition where acquirer has a P/E of 20, target has a P/E of 10,
after-tax cost of debt is 5%, with no synergies and no transaction or financing costs: can you
tell me if the operation is accretive or dilutive to the acquirer’s earnings in the case of a 100%
stock, a 100% debt and a 50% stock / 50% debt transaction? ................................................. 80

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

FOREWORD

How to be successful at investment banking technical interviews? General advice:

① A positive attitude and solid financial knowledge is what will get you hired.

② Too many candidates think the technical interview is only about valuation questions. It is wrong.
Study accounting (especially the interaction between the primary financial statements) as much
as valuation methods.

③ You really understand a concept when you can summarize it. So, be short in your answers. Let
the interviewer ask you for the precisions He needs.

④ An important point, when you are applying for a junior position, is to not sound arrogant in the
way you answer technical questions. Being concise and summarizing concepts will help in that
regard.

Practice makes perfect. But at the end of the day, it is all about motivation. My question to you: how
bad do you want the job?

Good luck with the interviews.

Mark Hatz

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

I. ACCOUNTING

1. What do you know about financial statements? Walk me through Balance Sheet, Income
Statement, and Cash Flow Statement

The Income Statement reflects the firm’s accounting profit earned over a given financial year. It sums
up all sources of income and expenses to arrive at net profit for the year. Income statement does not
reflect cash flow, as it may include non cash items such as accrued / deferred revenues or expenses,
depreciation, amortization of goodwill, gains and losses on investing and financing activities, or
pension expense for example. The net profit to common shareholders after distribution of dividends
goes into the company’s retained earnings on the balance sheet.

Cash Flow Statement on the other hand shows effective cash flow made by the company in the same
financial year. There are three sources of cash flow: operations, investing and financing activities.
Cash Flow from Operations under the indirect method starts from Group net income and adjusts it
for all the non cash elements discussed above, and may redistribute some items to the Cash Flow
from Investing and cash Flow from Financing sections (like interests for example). The total annual
cash flow goes to the firm’s cash balance on the balance sheet.

The balance sheet is not a flow of profit or cash, but simply a picture of the financial situation of the
firm at financial year end. It displays how the company has been financing its assets: equity and
liabilities on the one hand, current and noncurrent assets on the other, both balancing.

If I had to come up with a simplified structure of all three statements, here is what I would get:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Balance Sheet Income Statement

Non Current Assets Equity Revenues
Goodwill Common Equity - COGS
Other Intangibles Retained Earnings Gross Margin
(9)
PP&E Other Comprehensive Income - SG&A(1)
Investments in Associates Total Common Equity EBITDA
Other Financial Investments Minority Interests - Depreciation
EBIT
+/- Other Operating Income & Expenses (2)
Non Current Liabilities - Net Interests (3)
LT Financial Debt Profit Before Tax
Current Assets Pensions & Other Benefits - Taxes
Inventories + Income from Associates and JVs (4)
Receivables Current Liabilities Group Net Income
Marketable Securities ST Financial Debt - Minority Interests
Cash & Cash Equivalents Payables Net Income to Common Shareholders

Cash Flow Statement

Cash Flow from Operations
Group Net Income
- Income from Associates and JVs - Net(5)
+ Depreciation
+ Goodwill Impairement
+/- Gains & Losses on Investing
& Financing Activities
+ Pension Expense
- Pension Contribution
+/- ∆ in Working Capital

Cash Flow from Investing Activities

Net Capex(6)
Net Financial Investments (7)
Div. received from controlled entities

Cash Flow from Financing Activities

Debt Drawdown
Debt Repayment
Share Issuance
Share Repurchase
Cash Dividends (8)

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Note:

(1) Selling, General and Administrative expense, includes marketing / advertizing costs, as well as
employee costs and pension expense
(2) Asset impairment, Gains & Losses on asset sales, restructuring costs
(3) Interests incurred on debt liability but also earned on cash and debt investments
(4) Income from associates and JVs most often comes on an after-tax basis below EBIT
(5) Income from associates and JVs is removed, as this is a non-cash item. It comes on a net basis,
i.e. adding back dividends received from associates and JVs
(6) Purchase and sale of PP&E
(7) Includes investments in associates
(8) Dividends paid out to shareholders, as opposed to payable which go in the liability section of BS
(9) Accounts for various items like unrealized gains and losses on securities available for sale under
GAAP, or for the capitalized amount of annual changes in pensions actuarial assumptions,
differences in expected and actual plan asset return, and past service

2. What are accrued / deferred revenues and expenses?

Accrued and deferred items are accounting entries that allow to differentiate between economic
activity and cash flow.

Accrued revenues and expenses are revenues and expenses that were earned / incurred during the
year (that is why they appear in the income statement) but that have not been cashed in / paid for
yet (i.e. with no impact on cash flow). Accrued revenues come increase the firm’s receivables balance
(asset), while accrued expenses increase its accrued expenses payable balance (liability). Receivables
can be revenues earned from a sale that will be cashed in two months later; an accrued expense can
be periodic wages, interest, taxes, or utilities expenses that incurred during the year but were still to
be paid at year end. Accrued revenues and expenses sit on the balance sheet until they are paid for.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Conversely, deferred revenues and expenses were cashed in or paid for in advance but were not
recognized in the income statement. Deferred revenues increase the firm’s unearned revenue
balance (liability), while deferred expenses grow its prepaid expense balance (asset). Those stay on
the balance sheet until being recognized in the income statement.

3. How do you account for receivables? Walk me through the three financial statements taking a
simple example

Assuming 10 of receivables in year N, a 30% tax rate, no minority shareholders and a 15% payout
ratio, changes in the three statements balances are:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Year N Balance Sheet Year N Income Statement

Equity +6 Revenues +10
(1)
Retained Earnings +6

Current Assets +6
Receivables +10 - Taxes @ 30% (3)
Cash (4) Net Income +7

- Dividends (1)

Year N Cash Flow Statement

Cash Flow from Operations
Net Income +7
∆ in Receivables (10)

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Cash dividends (1)

Total Cash Flow (4)

Note:

(1) Change in Retained Earnings = Net Income to Common Shareholders – Dividends

Now let’s assume the 10 receivables get cashed in during year N+1:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Year N+1 Balance Sheet Year N+1 Income Statement

Current Assets +0
Receivables (10)
Cash +10

Year N+1 Cash Flow Statement

Cash Flow from Operations
∆ in Receivables +10

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow +10

4. How do you account for unearned revenues?

Assuming 10 of unearned revenues in year N, a 30% tax rate, no minority shareholders and a 15%
payout ratio,

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Year N Balance Sheet Year N Income Statement

Current Assets +10 Current Liabilities +10

Cash +10 Unearned Revenue +10

Year N Cash Flow Statement

Cash Flow from Operations
∆ in Unearned Revenues +10

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow +10

The next year, the 10 unearned revenues get recorded in the income statement:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Year N+1 Balance Sheet Year N+1 Income Statement

Equity +6 Revenues +10
(1)
Retained Earnings +6

Current Assets (4) Current Liabilities (10) - Taxes @ 30% (3)

Cash (4) Unearned Revenue (10) Net Income +7

- Dividends (1)

Year N+1 Cash Flow Statement

Cash Flow from Operations
Net Income +7
∆ in Unearned Revenues (10)

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Cash dividends (1)

Total Cash Flow (4)

Note:

(1) Change in Retained Earnings = Net Income to Common Shareholders – Dividends

5. How do you account for Inventory?

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Let’s assume the firm has 10 of purchases in year N, all bought on credit from suppliers. 5 of the
inventory balance are used in the year N revenue generation. No taxes, no dividends, no minority
interests.

Year N Balance Sheet Year N Income Statement

Equity (5)
(2)
Retained Earnings (5) COGS (5)

Current Assets +5 Current Liabilities +10

(1)
Inventory +10-5=+5 Payables +10
Net Income (5)

Year N Cash Flow Statement

Cash Flow from Operations
Net Income (5)
∆ in Inventories (5)
∆ in Payables +10

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow +0

Note:

(1) Inventory N = Inventory (N-1) + Purchases – COGS

In year N, 10 gets purchased on credit from supplier (payables increase by 10), but the change in
inventory balance is only 10-5=5 because there are 5 of inventory balance that are used in annual
revenue generation (COGS decrease by 5)

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Inventory management is key, as too much inventory may bring cash flow problems, expenses
(storage, insurance), or even losses (if items become obsolete), while too little inventory may
translate into lost sales and lost customers
(2) Change in Retained Earnings = Net Income to Common Shareholders – Dividends

Now, the following year, suppliers got fully paid: cash goes down, as well as payables:

Year N+1 Balance Sheet Year N+1 Income Statement

Current Assets (10) Current Liabilities (10)

Cash (10) Payables (10)

Year N+1 Cash Flow Statement

Cash Flow from Operations
∆ in Payables (10)

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow (10)

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

6. How do you account for depreciation?

Assuming no taxes, no minority interests and no dividends:

Balance Sheet Income Statement

Non Current Assets (10) Equity (10)
PP&E (10) Retained Earnings (10)

Depreciation (10)

Net Income (10)

Cash Flow Statement

Cash Flow from Operations
Net Income (10)
Depreciation +10

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow +0

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

7. What depreciation methods do you know?

The straight line depreciation method, which is the one that is most often used, depreciates the asset
equally over its useful life, i.e. until the value of the asset reaches salvage value:

Annual straight line depreciation amount = (Acquisition Cost – Salvage value) / useful life

Acquisition cost is the historical purchase cost of the asset, salvage value is the estimated value of
the asset at the end of useful life, and useful life is the number of years until the asset value reaches
salvage value.

Example: asset bought for $100, $20 salvage value, depreciated equally over 4 years.

Depreciation year 1 = (100 - 20) / 4 = 20

10 get depreciated every year during 8 years until the asset gets sold at $20.

The accelerated depreciation method is less often used, but has the advantage of depreciating an
asset essentially in the beginning of its useful life, when it is most productive:

Annual accelerated depreciation amount = (Accelerator / useful life) x Book value of asset

- Where Book value of asset = Acquisition cost – Accumulated depreciation

Under the double-declining depreciation method, the accelerator is 2.

Example: asset bought for $100, $20 salvage value, useful life of 4 years, depreciated according to
the double-declining depreciation method.

Depreciation year 1 = (2 / 4) x 100 = 50

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Depreciation year 2 = 0.5 x 50 = 25

Depreciation year 3 = 0.5 x 25 =12.5

Depreciation year 4 = 25 – 20 = 5

In year 4 (the last year), the opening book value of the asset is 25, so another 5 need to be
depreciated to get down to the salvage value of 20.

Notice that depreciation is higher in the early years when the asset is most productive.

8. What are minority interests?

Minority interests exist when a company does not fully own all of its subsidiaries. If parent company
P owns only 80% of its subsidiary S, it will consolidate according to the acquisition method 100% of S’
assets and liabilities on its own balance sheet, and will open a minority interests row in the equity
section. It will consolidate 100% of S’ revenues and expenses, and will open a minority interests row
below Group net income.

9. What are investments in associates?

When a company invests in another company in exchange for a significant influence on its financial
and strategic decisions (most often through a 20%-50% stake), the target is called an associate.
Under the equity method, investments in associates sit on the company’s balance sheet under non
current assets, and the company’s after-tax share of the associate’s income is recorded on the
income statement below EBIT.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

10. What are the three consolidation methods you know?

① Acquisition Method ② Equity Method ③ Proportionate Conso.

Investments in Associates
Type of Investment Business Combinations Joint-Ventures
and Joint Ventures

Degree of Influence on Significant Influence and

Control Shared Control
Target(1) Shared Control

Ownership Over 50% 20%-50% and 50% 50%

Not allowed under GAAP

Comment - - Not allowed under IFRS
(since 01/01/2013)(2)

Note:

(1) The choice between consolidation methods is not dependent on the percentage ownership
acquired, but on the resulting degree of influence on the target. Ownership percentages shown
in the chart above are just an indication of usual ownership levels associated with each situation.
For example, if you have a 15% stake in a company and three of its five board sits, you would still
exert significant influence
(2) Until January 2013, proportionate consolidation used to be allowed under IFRS only in the case
of JVs. This makes the acquisition and equity methods the two most commonly used
consolidation methods today

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

11. You acquire a company on 01/01/N with cash that sits on your balance sheet. Under each of
the three consolidation methods, how do you consolidate the target balance sheet at
acquisition date, and the target income statement after a year of operations?

Let’s assume the following Target balance sheet at acquisition date:

01/01/N Balance Sheet (T) 01/01/N Bala

Assets 40 Equity 10

Liabilities 30

1. Acquisition method
1.1. At acquisition date

Assuming:

- 80% ownership
- Target equity valued at 100 by acquirer
- No premium paid on acquisition price
- Simplified situation of an all cash transaction (from the acquirer cash balance)
- Acquirer does not refinance the target debt
- Goodwill: no appraisals of target asset and liability book values. They already are at fair
value on the balance sheet
- Goodwill: no target off-balance sheet intangibles identified

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Under the acquisition method, the target assets and liabilities are consolidated on the acquirer’s
balance sheet, while minority interests are added to equity. Goodwill is also added to the acquirer’s
assets, since A paid more than the fair value of the target identifiable net assets (the acquisition
values target equity at 100, while the target fair value of identifiable net assets is 10). And of course,
because the acquirer pays the shareholders of T from its own cash balance, its cash flow statement
gets debited by the same amount.

01/01/N Balance Sheet (A Conso) 01/01/N Income Statement (A Conso)

Assets T +40
Minority Interests (2) +20
(1)
Goodwill +90

Liabilities T +30

Cash (80)

01/01/N Cash Flow Statement (A Conso)

Cash Flow from Operations

Cash Flow from Investing Activities

80% Acquisition of T (80)

Cash Flow from Financing Activities

Total Cash Flow (80)

Note:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

(1) Goodwill is the amount the acquirer “overpays” for the target and is most often justified by
expected synergies from the combination.

Goodwill = Acquisition price – Fair value of identifiable net assets of the target

It is the excess of purchase price over the target identifiable net assets, i.e. after reevaluation to
fair value of each of the target asset and liability, and after inclusion of off-balance sheet
intangible assets (such as trademarks, licenses, in-process R&D, and sometimes even key
relationships). Goodwill is a non-current, indefinite-lived, intangible asset that is not amortized
but rather tested annually for impairment. Later goodwill writedowns can be significant red flags,
a sign that the combined entity failed to meet expectations, that synergies did not materialize,
and as a result implies overpayment of the target and error in judgment of the acquirer.

So, why impair goodwill? Because goodwill becomes an expense as soon as one realizes the
target was overpaid.

There are two calculating methods for goodwill.

Full goodwill = Acquisition price of a 100% stake – Fair value of identifiable net assets of the
target of a 100% stake
Partial goodwill = Acquisition price of the stake bought – Fair value of identifiable net assets of
the target of the stake bought
In our example, full goodwill would be 100 – 10 = 90, while partial goodwill would be (80% x 100)
– (80% x 10) = 72
Our case shows full goodwill, as it is consistent with the concept of control and the full
consolidation of assets under the acquisition method.

(2) Under the full goodwill method, minority interests that sit on the balance sheet are based on the
acquisition price, while under the partial goodwill method, it is based on the fair value of
identifiable net assets.

In our example, under full goodwill, we get minority interests of 20% x 100 = 20, while under
partial goodwill we would have had 20% x 10 = 2

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

1.2. After a year of operations

One year has passed, and it is now time to consolidate our target’s income statement.

In that regard, let’s also assume, for learning purposes:

- A pays a dividend of 5
- T pays a dividend of 10
- A standalone net income of 100
- T cash net income of 10, i.e.:
o No accrued / deferred revenues or expenses
o No depreciation
o No pensions
o No goodwill impairment
o No gains or losses on investing or financing activities
- No investing activity and no financing activity apart from dividends mentioned above

A’s income statement shows 100% of T’s revenues and expenses, before removing the minority
share of T’s net income below Group net income, to get to net income to common shareholders.

Net income to common after distribution of dividends to A shareholders goes directly into
retained earnings on the balance sheet.

Because under the acquisition method the cash generated or spent by T is fully consolidated on
A’s balance sheet, the 10 dividends from T to A and T’s minority shareholders appear in the cash
flow statement of A.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

31/12/N Balance Sheet (A Conso) 31/12/N Income Statement (A Conso)

Retained Earnings +8-5=+3

(2)
Minority Interests +2-2=+0

T Revenues and Expenses +10

Group Net Income +10
Cash +3 Minority Interests (20%x10)=(2)
Net Income to Common +8

Dividends (5)

31/12/N Cash Flow Statement (A Conso)

Cash Flow from Operations
Group Net Income(1) +10

Cash Flow from Investing Activities

Dividends received from T 80%x10=8

Cash Flow from Financing Activities

Dividends to A Shareholders (5)
Dividends paid by T (10)

Total Cash Flow +3

Note:
(1) The operating cash flow starts with group net income (as opposed to net income to common
shareholders), because the cash of the target is fully consolidated on A’s balance sheet under the
acquisition method
(2) ∆ in minority interests = minority share of T net income – dividends paid by T to its minority
shareholders

2. Equity method

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

2.1. At acquisition date

Same assumptions, but with the difference that A gets significant influence over T through the
acquisition of a 20% stake.

The investment in T is recorded on A’s balance sheet in non current assets. There is no consolidation
of the target assets and liabilities.

01/01/N Balance Sheet (A Conso) 01/01/N Income Statement (A Conso)

Invt in Associates +20

Cash (20)

01/01/N Cash Flow Statement (A Conso)

Cash Flow from Operations

Cash Flow from Investing Activities

Investment in Associates (20)

Cash Flow from Financing Activities

Total Cash Flow (20)

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

2.2. After a year of operations

A’s share of T’s after tax net profit is added to A’s income statement. This most often comes on an
after-tax basis below EBIT.

A’s consolidated cash flow from operations removes income from associates, as this is a non-cash
item, but adds back A’s share of the dividends paid by T.

The investment in associates balance on the balance sheet moves according to A’s share of T’s
earnings for the year, after accounting for dividends received.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

31/12/N Balance Sheet (A Conso) 31/12/N Income Statement (A Conso)

Retained Earnings +2-5=(3)

Invt in Associates +2-2=+0

Cash (3) Income from Associates +2

Net Income +2

Dividends (5)

31/12/N Cash Flow Statement (A Conso)

Cash Flow from Operations
Net Income +2
- Income from Associates (2)
+ Dividends from Associates +2

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Dividends to A Shareholders (5)

Total Cash Flow (3)

Note:
(1) ∆ in Investment in Associates = A’s Share of T’s net income during the year – A’s share of
dividends paid by T during the year

3. Proportionate consolidation
3.1. At acquisition date

Under the same assumptions, but now assuming A gets the shared control of T through the
acquisition of a 50% stake.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

A pays 50% of T’s equity market value plus premium directly from its cash account to T’s
shareholders. 50% of T’s assets and liabilities get consolidated on its balance sheet, and a goodwill of
50 – 5 = 45 is added to its non current assets.

01/01/N Balance Sheet (A Conso) 01/01/N Income Statement (A Conso)

50% Assets T 50%x40=+20

Goodwill(1) +45
50% Liabilities T 50%x30=+15

Cash (50)

01/01/N Cash Flow Statement (A Conso)

Cash Flow from Operations

Cash Flow from Investing Activities

Aquisition of 50% of T (50)

Cash Flow from Financing Activities

Total Cash Flow (50)

Note:

(1) Partial goodwill

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

3.2. After a year of operations

Under the same assumptions, 50% of T’s revenues and expenses are added to A’s income statement.

50% of the 10 dividends paid by T are consolidated in A’s cash flow statement, as under the
proportionate consolidation, the target’s cash is only consolidated at 50% on the acquirer’s balance
sheet. A also records +5 of dividends from T in its cash flow statement.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

31/12/N Balance Sheet (A Conso) 31/12/N Income Statement (A Conso)

Retained Earnings +5-5=+0

Cash +0 50% of T Revenues & Expenses +5

Net Income +5

Dividends (5)

31/12/N Cash Flow Statement (A Conso)

Cash Flow from Operations
Net Income(1) +5

Cash Flow from Investing Activities

Dividends received from T 50%x10=+5

Cash Flow from Financing Activities

Dividends to A shareholders (5)
50% of Dividends paid by T 50%x(10)=(5)

Total Cash Flow +0

Note:

(1) Under the proportionate consolidation method, 50% of T’s cash is consolidated on A’s balance
sheet

12. What if this time you buy 80% of a company 50% in cash from debt you raised and 50% in
stock? What is the operation’s impact on A’s consolidated balance sheet at acquisition date?

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Assuming the same target balance sheet as in the previous question:

01/01/N Balance Sheet (T) 01/01/N Bala

Assets 40 Equity 10

Liabilities 30

Let’s once again assume:

- 80% ownership
- Target equity valued at 100 by acquirer
- No premium paid on acquisition price
- Acquirer does not refinance the target debt
- Goodwill: no appraisals of target asset and liability book values. They already are at fair
value on the balance sheet
- Goodwill: no target off-balance sheet intangibles identified

The difference now is that A acquires T 50% in cash and 50% in stock.

A raises new debt and issues stocks on its balance sheet, to pay 80% of T equity:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

01/01/N Balance Sheet (A Conso) 01/01/N Income Statement (A Conso)

Assets T +40 Common Equity +40
Minority Interests +20
Goodwill +90

Liabilities T +30
Acquisition Debt +40
Cash +0

01/01/N Cash Flow Statement (A Conso)

Cash Flow from Operations

Cash Flow from Investing Activities

80% Acquisition of T (80)

Cash Flow from Financing Activities

Debt Drawdown +40
Share Issuance +40

Total Cash Flow +0

13. You are buying an apartment that you will be selling in 5 years: what are the financial
statements of the investment holding company at acquisition date, at end of year one and at
exit date? Assume the apartment is bought for 100, 20% with equity, 80% in cash from debt
(linear repayment over 10 years, at a 4% interest); apartment price goes up 2% every year;
rent is 5% of apartment value and maintenance charges are 2 every year; no taxes

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

① At acquisition date (01/01/N)

20 of equity and 80 of debt are raised to finance the acquisition: there is no impact on cash because
the cash raised is used for payment, however equity and debt increase on the balance sheet, as well
as assets (apartment +100):

01/01/N Balance Sheet 01/01/N Income Statement

Apartment +100 Equity +20

Debt +80

01/01/N Cash Flow Statement

Cash Flow from Operations

Cash Flow from Investing Activities

Apartment Purchase (100)

Cash Flow from Financing Activities

Acquisition Debt +80
Equity Raised +20

Total Cash Flow +0

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

② At the end of year one (31/12/N)

At the end of the year, the income statement shows rent income, maintenance charges, and
interests on the acquisition debt. Debt principal repayment is also added to the cash flow statement
and reduces the debt balance on the balance sheet. The increased asset value of the apartment that
is marked to market on the balance sheet is an unrealized gain that we can find in the equity section
as other comprehensive income:

31/12/N Balance Sheet 31/12/N Income Statement

Apartment +2 Retained Earnings (0.1) Rent Income 5%x102=+5.1

Other Compr. Income +2
Maintenance Charges (2)
Debt (8)
Interests (3.2)
Cash (8.1)
Net Income (0.1)

31/12/N Cash Flow Statement

Cash Flow from Operations
Net Income (0.1)

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Debt Repayment 10%x(80)=(8)

Total Cash Flow (8.1)

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③ At exit date (01/01/N+5)

5 years after the acquisition, we assume the asset is sold at 110 (book value): the asset disappears
from the balance sheet, as does the outstanding debt balance assuming full reimbursement, and
cash is made on the sale. A 10 gain is “realized” in the income statement and the accumulated other
comprehensive income on the balance sheet goes down.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

01/01/N+5 Balance Sheet 01/01/N+5 Income Statement

Apartment (110) Retained Earnings +10

Other Compr. Income (10) Realized Gain on Sale of Asset +10

Debt (50)

Cash +60
Net Income +10

01/01/N+5 Cash Flow Statement

Cash Flow from Operations

Cash Flow from Investing Activities

Sale of Apartment +110

Cash Flow from Financing Activities

Debt Repayment (50)

Total Cash Flow +60

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

II. VALUATION, CAPITAL STRUCTURE & RETURNS

ANALYSIS

14. What are the valuation methodologies you know?

I know the most commonly used methods like DCF, trading and transaction multiples and LBO, but
am also familiar with other interesting ones like DDM, APV (Adjusted Present Value), EVA (Economic
Value Added), residual income, adjusted book value, or even real options.

15. What is a DCF?

A DCF is an absolute valuation measure, where value is the sum of the firm’s cash flows to infinity,
discounted at the cost of capital.

DCF is most commonly used by sellers, as they can incorporate their operational and financial
assumptions in the projection of cash flows. Aggressive assumptions give sellers a chance to justify a
higher company value.

Buyers with asymmetrical information on the target (especially in the case of private companies) will
base their valuation less on DCF. They will in any case rarely pay more than what the value implied by
trading and transaction multiples.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

 Advantages of DCF: the company is valued solely on its operational potential, not relative to
the value of other companies or transactions

- Limitations of DCF: highly dependent on operational, WACC and perpetual growth rate
assumptions (a 1% reduction in WACC can easily result in a 10% value gain for example)

16. How do you do a DCF?

2 steps to get to Enterprise Value (EV):

1. Project free cash flows to infinity

1.1 Calculate cash flows for the interim period

You first want to calculate your FCFFs1 for an “interim period”, i.e. for the years you have visibility
over, or up until maturity when you expect the company to achieve a more stable growth rate. The
interim period is usually around 5 to 10 years.

FCFF = EBIT (1 – T) + Depreciation – Fixed Capital Investment – Working Capital Investment

FCFF = EBITDA (1 – T) + (Depreciation x T) – Fixed Capital Investment – Working Capital Investment

FCFF = Net Income + Interests (1 – T) + Depreciation – Fixed Capital Investment – Working Capital
Investment

FCFF = Cash Flow from Operations + Interests (1 – T) – Fixed Capital Investment

1
Or “unlevered free cash flows”, since they are before debt service. Conversely, free cash flows to equity are
“levered free cash flow”, as they are what is left to equity holders after debt service

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Where:

- Fixed Capital Investment = Net Capex, i.e. Purchase – Sale of PP&E

- Working Capital Investment = ∆ in Receivables + ∆ in Inventory - ∆ in Payables
- Cash Flow from Operations = Net Income + Depreciation – Working Capital Investment
- Interests = Net Interests, i.e. interest expense - interest income
- If you have minority interests, choose to start your FCFF calculation from Group Net
Income (as opposed to Net Income to Common Shareholders), since under the
corresponding acquisition method, you would consolidate 100% of the subsidiaries cash
on your balance sheet

Remember this formula is a simplification of FCFF, which in practice would also adjust net income for
all non cash items (like pension expense, goodwill impairment, gains and losses on investing and
financing activities, etc.) as well as any other non-cash current asset and non-debt current liability - in
the same way you would adjust net income to get to Cash Flow from Operations in a Cash Flow
Statement.

1.2. Calculate WACC and terminal value

Once you lose visibility over the cash flows, or as soon as you expect the company to start its
maturity phase, you calculate the remaining cash flows to infinity using either a constant growth or a
multiple method.

Both methods are interchangeable, the multiple method will for example always be used in the case
of an LBO, in line with the LBO exit multiple.

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Terminal Value = FCFFn x (1 + g) / (WACC – g)

Terminal Value = EBITDAn x LTM EV/EBITDA terminal multiple

Where:

- FCFFn is the last projected FCFF of the interim period

- WACC = Weighted Average Cost of Capital
- g is the annual growth rate of cash flows to perpetuity; in practice, choose a LT growth
rate like the country GDP LT growth rate, or the inflation rate (g is typically around 2.5%
for Western countries)
- EV/EBITDA multiples are most commonly used under the multiple method as this is the
preferred valuation multiple in LBOs, but one could also have other multiples like
revenue or EBIT multiples for example

Now, the WACC is a weighted average of the cost of debt and the cost of equity 2. From the
company’s perspective, it is the value lost to debt and equity holders to achieve projected FCFFs.
From the investors’ perspective, it is a weighted average of the return they expect to get from their
investment in the company.

WACC = we re + wd (1 – T) rd

Where:

- Wd = Weight of debt in capital structure = market value of debt / market value of debt
and equity; if the company debt is not distressed (i.e. is investment grade), the book
value of debt is a reasonable proxy of its market value. Also, we typically assume the
market values of debt and equity are equal to their target weights. If this is not the case,
you should use the target weights

2
The WACC formula should include all sources of capital, i.e. if the company is also financed through
a hybrid form of financing like preferred stock, the formula becomes:
WACC = we re + wd (1 – T) rd + wp rp

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

- We = Weight of equity in capital structure = market value of equity / market value of debt
and equity
- re = company cost of equity
- rd = company cost of debt
- T = company marginal tax rate, because the measure is forward-looking; the cost of debt
is after-tax to reflect the tax shield created through interest expense. You will find T in
the financial statements footnotes

The cost of debt is the cost the company pays today on LT debt. You can find details of it in the
footnotes of the financial statements.

According to the CAPM (Capital Asset Pricing Model), the cost of equity, is the cost of risk-free
financing, plus the equity market risk premium, adjusted for the firm’s sensitivity to market volatility:

Re = rf + ße (rm – rf)

Where:

- rf = Risk free rate

- ße = Beta equity or “levered”
- rm = Market return

The risk free rate typically used is the rate of a 10-year government bond of the relevant country.
Check it on Bloomberg, Factset or Capital IQ, for example.

The market risk premium, (rm – rf) is in practice found using the ex-post method. Check Elroy
Dimson’s research paper on historical risk premia around the world. However, WACC and cash flows
are forward-looking measures, and projected market risk premiums are more accurate. The ex-ante
method anticipates market return by taking a marketcap weighted average of the expected returns
of all the individual stocks in the market using a discounted dividend model. Let’s take an example.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Focusing on France, we first calculate the expected stock return of each of the 40 companies in the
index using a DDM. Inputs are current stock price, dividends and dividend growth rate; output is the
expected stock return.

Current Share Price = Div 1 / (1 + re) + Div 2 / (1 + re)2 + Div 3 / (1 + re)3 + (LT Div / (re – g)) / (1 + re)3

The market return rm is a marketcap weighted average of the individual expected stock returns.

And Market Risk Premium = rm - rf

Beta is a measure of the company’s sensitivity to market volatility or systematic risk. Systematic risk
or market risk is risk that equity investors cannot diversify away through diversification. That is why
bearing systematic risk, as opposed to unsystematic / specific risk, calls for compensation. The higher
the beta, the higher the required cost of equity.

Where to find betas? Beta can be historical or projected. Historical beta implies doing a simple
regression of a stock’s historical3 returns over those of an index. Remember to choose the index that
is most relevant to the stock (in terms of company size, industry, geography, etc.), and to be
consistent in how returns are calculated (if the index return includes dividends, the stock returns
should also do). Historical betas however do not reflect future betas, which tend to be closer to one.
That is why historical betas should be adjusted with Blume’s formula:

Adjusted beta = (2 / 3) x historical beta + (1 / 3) x 1

In practice, regressions take too much time, and projected betas are preferred as they are more
accurate. Professionals use Barra betas, from a US company called Barra, which calculates predicted
or fundamental betas based on the variance and covariance estimates derived from their risk
models. They find Barra betas on data bases like Bloomberg or Factset.

3
Last year to last three years for example

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Now, how to calculate levered beta in the cost of equity equation? The levered beta of your firm is
an average or median of the peers’ betas, adjusted for your company’s tax rate and gearing 4. Let’s
take an example:

Unlevered X Target X Target Tax Relevered

Peer Levered Beta Gearing Tax Rate
Beta Gearing Rate Beta

A 1.16 45% 15% 0,84 30% 33% 1.01

B 1.02 24% 33% 0,88 30% 33% 1.06

C 1.22 56% 28% 0,87 30% 33% 1.04

D 0.95 23% 33% 0,82 30% 33% 0.99

E 1.02 18% 33% 0,91 30% 33% 1.09

Median 1.02 24% 33% 0,87 30% 33% 1.04

We are looking for Company X’s levered beta. We identify 5 peers and collect their levered or equity
betas (Barra betas). Based on their respective gearings and tax rates, we get to an unlevered or asset
beta, according to formula ßa = ße / (1 + (1 – T) x (Debt / Equity)). Using the same formula and
applying Company X’s target5 gearing and tax rates, we arrive at unlevered betas. In our example,
1.04 will be company X’s levered beta in the calculation of its cost of equity.

2. Discount free cash flows at WACC

Now that we know interim cash flows and terminal values, we can discount them at the WACC,
which we also have.

4
i.e. Debt to Equity ratio
5
We use LT target rates, because WACC should be a forward-looking measure

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Enterprise Value = FCFF1 / (1 + WACC)1 + FCFF2 / (1 + WACC)2 + … + FCFFn / (1 + WACC)n + TV / (1 +

WACC)n

Where:

- n is the number of years in the interim period

- TV is the terminal value

If you are asked to value the stock of a company,

Equity value = Enterprise value – Adjusted net debt

Share price = Equity value / Number of diluted shares

You would always present valuation as a range, never as a single number. Enterprise value outputs
take the form of sensitivity tables, which sensitize EV, Equity or Share Price for various WACC,
terminal value growth rate / multiple, or operating assumptions.

Note:

(1) A DCF can also be used to directly find the company fair value of equity from the projection of
Free cash Flows to Equity (FCFE) discounted at the cost of equity.

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17. How do you calculate FCFE?

Depending on what metric you start from:

FCFE = FCFF – i (1 – T) + Net Borrowings

FCFE = Net Income + Depreciation – Fixed Capital Investment – Working Capital Investment + Net
Borrowings

FCFE = Cash Flow from Operations – Fixed Capital Investment + Net Borrowings

Where:

- FCFF = Free cash Flow to the Firm

- i = Net interest
- Net Borrowings = Debt Drawdowns – Debt Repayments
- T = Company marginal income tax rate
- CFO = Net Income + Depreciation – Working Capital Investment

18. What is a Dividend Discount Model?

A dividend discount model is sometimes used in specific industries like Financial Services, or for
mature companies that distribute dividends.

A DDM calculates the fair equity value of a company as the present value of its future dividends
discounted at the cost of equity.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

A DDM can be one or two-stage.

In a single-stage DDM, the company has reached maturity and dividends are expected to grow at a
constant rate to infinity:

∞
Divi
Equity Value = ∑
i=1 (1 + ce)i

Where:

- Divi = Dividend in year i

- ce = cost of equity

In a 2-stage model, the company projects an initial period of interim dividends with unstable growth
rates, before reaching maturity and growing at a constant rate:

Divn (1 + g)
n
Divi (ce - g)
Equity Value = ∑ +

i=1 (1 + ce)i (1 + ce)n

Where:

- g is the LT growth rate of dividends

The H-model is a two-stage DDM that projects dividends growing at a linearly declining growth rate
over an interim period, before reaching their LT growth rate.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

D0 (1 + gL) D0 x H x (gS - gL)

Equity Value = +
(ce - gL) (ce - gL)

Where:

- gS is the company growth rate of dividends in the interim period

- gL is the company LT growth rate of dividends included in the terminal value
- H=n/2
- n is the number of years in the interim period

19. What is APV?

The APV valuation method, mostly used in LBO situations or in times of crisis, answers the DCF
problematic assumption of a constant WACC throughout the years.

Under DCF, each projected cash flow is discounted every year at the same WACC, which conceptually
is not correct in a world with taxes and positive credit spreads. It is neglecting the two main6 impacts
leverage has on WACC: the tax shield reduces the cost of debt, while debt risk in the form of
bankruptcy costs7 increases the cost of debt. When debt accounts for little in the capital structure,
the tax shield effect of increasing debt will at first be higher than the bankruptcy costs effect, and
WACC will decrease. But when debt becomes a large share of the capital structure, the bankruptcy
costs will weigh more on the cost of debt than the tax shield, and WACC will rise. So DCFs should
feature WACCs that vary every year with leverage. Because it is impossible to forecast changing
WACCs out to infinity, APV chooses to value the firm as the sum of the unlevered firm value

6
Leverage has its main impact on WACC through the cost of debt, but the cost of equity will also vary with
leverage through a modified equity beta. The change in cost of equity is minor though
7
Bankruptcy costs are twofold: direct bankruptcy costs (legal and administrative expenses), as well as indirect
bankruptcy costs (company image, relationship with investors, customers, suppliers, etc.)

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

(discounting FCFFs at the unlevered cost of capital) and the present value of tax savings (discounted
at the cost of debt), minus the expected bankruptcy costs.

In practice, it is the right valuation method for firms with a changing capital structure, like in LBO
situations, or in times of crisis when credit spreads / bankruptcy costs are high. In all other cases,
professionals will still use DCFs, since WACC levels will vary little with leverage levels.

Please note that you have little chances to be asked in detail about this question. But if you
mentioned APV as a valuation methodology you know, you should be able to summarize it in a few
sentences. Your interviewer might not be 100% familiar with it, so try not to sound too pretentious in
your reply. Make a short reply. What follows below (including the formulas) is for you to understand
the concept better.

As a side note, the DCF valuation method refers to the 1958 Modigliani Miller proposition 1 of a
constant WACC regardless of capital structure under no taxes and no debt risk. In the WACC formula,
when leverage increases, equity beta and cost of equity rise on the one hand, but the capital
structure is turned more towards debt, which has a lower cost than equity and is constant at the risk
free rate. The result is no impact of changes in the capital structure on WACC. Firms should be valued
using the usual DCF formula:

WACC = we re + wd rd

ße = ßa (1 + Debt / Equity)

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

∞
FCFFt
EV = ∑
(1 + WACC)t
t=0

The 1963 Modigliani Miller Proposition 2 introduces taxes. Debt is still risk free. Under those
assumptions, equity beta still increases (although a bit less than in the first proposition), but the
higher impact is from the increased share of debt and its reduced cost through the tax shield.
Valuation-wise, the present value of tax savings is added separately to the unlevered firm value:

WACC = we re + wd (1 – T) rd

ße = ßa (1 + (1 – T) (Debt / Equity))

EV = Unlevered Firm Value + PV of Tax Savings

Where:

∞
𝐹𝐶𝐹𝐹𝑡
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = ∑
(1 + 𝑐𝑎 )𝑡
𝑡=0

∞
𝑇 × 𝑖 × 𝐷𝑒𝑏𝑡𝑡
𝑃𝑉 𝑜𝑓 𝑇𝑎𝑥 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = ∑
(1 + 𝑐𝑑 )𝑡
𝑡=0

i = Interest Rate on Debt

Ca = Unlevered Cost of Capital

Cd = Cost of Debt

Now, beyond Modigliani Miller’s propositions, APV studies the impact of leverage on WACC under
both taxes and debt risk (i.e. bankruptcy costs). WACC goes down at first when debt rises (under the

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

effect of tax shield which reduces the after-tax cost of debt), but increases later on (when bankruptcy
costs become heavy on the cost of debt). The firm value is the present value of the unlevered firm,
plus the present value of tax savings, minus the expected bankruptcy costs:

WACC = we re + wd (1 – T) rd

ße = ßa (1 + (1 – T) (Debt / Equity)) – ßd (1 – T) (Debt / Equity)

EV = Unlevered Firm Value + PV of Tax Savings – Expected Bankruptcy Costs

Where:

∞
𝐹𝐶𝐹𝐹𝑡
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = ∑
(1 + 𝑐𝑎 )𝑡
𝑡=0

∞
𝑇 × 𝑖 × 𝐷𝑒𝑏𝑡𝑡
𝑃𝑉 𝑜𝑓 𝑇𝑎𝑥 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = ∑
(1 + 𝑐𝑑 )𝑡
𝑡=0

Expected Bankruptcy Costs = Probability of Bankruptcy8 x Bankruptcy Costs9 x Unlevered Firm

Value

20. Now tell me about comps and transaction multiples

Multiples are relative valuation methods. They value the company based on what similar companies
are worth, in the case of trading multiples, or on the price that was paid in similar transactions, in the
case of transaction multiples.

8
Based on the firm’s bond rating (for a B rating, it is estimated around 25%)
9
Based on research findings. Direct costs are low. According to Shapiro and Titman, indirect costs are around
25%-30% of the firm unlevered value

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Buyers attach a lot of importance to multiples as they will find little justification for paying more than
market valuations.

 Advantages of multiples: market-based valuations tend to be more realistic than DCF valuations

- Limitations of multiples: it does not capture the firm individual operating expectations (as a DCF
would), and is most of all highly dependent on the choice of comparable companies or
transactions

21. I am asking you to work on comps. Walk me through building a comps file?

① I would first identify the right comp set. I would do a screen of companies that have the exact
same business, preferably in the same geography, with the same size, growth prospects, margin
levels and capital structure. Databases like Capital IQ can be very helpful for comparable
company screenings

② Once I have my comp set ready, I would calculate Enterprise Value and profit metrics of each of
the comparable companies. I could for example choose to show EV / Sales, EV / EBITDA, EV / EBIT
and P / E multiples for the last twelve month (LTM), one year and two years forward. This
depends on how relevant those multiples are to the industry I am looking at. Enterprise Value is
the sum of market capitalization and adjusted net debt, and essentially requires looking into the
company’s financial documents. Sales and profit metrics projections are taken directly from
analyst projections. Databases like Factset or Thomson provide very useful IBES10 forecasts in
that regard. LTM sales and profits are a calendarization of numbers from the last available
financial documents.

10
The Institutional Brokers Estimate System

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③ From those peer multiples, I can calculate a sector average or median that I can in turn apply to
my firm relevant metric, to find its EV or Equity. Premiums or discounts can be applied to the
sector multiple to reflect the specific characteristic of the company being valued (a private
company discount for example).

22. Let’s dig into EV and market capitalization, what is the treasury stock method?

When calculating the enterprise value of my multiple, I first look into market capitalization. This can
be found by multiplying the firm’s current share price by its diluted number of shares, i.e. after
accounting for in-the-money stock options, which you find using the treasury method.

In practice, the diluted number of shares under the treasury method is the number of common
shares outstanding (which you will find in the footnotes of the financial statements), plus the number
of shares from the (virtual) exercise of in-the-money stock options, minus the number of common
shares that are bought back by the company at the current share price with the proceeds from the
options exercise. Details on the number of in-the-money options and their weighted average exercise
price are also in the statements’ footnotes.

23. How do you calculate net debt?

Net debt is not only financial debt minus cash. There are several adjustments to be made.

Adjusted Net debt = Financial debt – Cash & cash equivalents + Unfunded pension liabilities +
Minority interests – Associates & JVs + Leases + Preferred stocks + Convertible debt

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① Financial debt

Interest-bearing debt, both short-term and long-term, at market value. Book value is a reasonable
proxy when the company’s debt is not distressed and is still investment grade, in which case the
variations in market value are little.

② Cash & cash equivalents

Cash balance from the balance sheet. Should include short term financial investments and
marketable securities.

③ Unfunded pension liabilities

Accounting for pensions into net debt truly depends on the sector. Check if analysts do include or
exclude pension liabilities in net debt.

Most often though, the unfunded share of pension liabilities is added to net debt as a long-term
financial obligation to employees. Remember, the pension item that sits under liabilities, is only the
share of the obligation that has not yet been financed, i.e. the Projected Benefit Obligation (PBO) (i.e.
benefits accumulated by employees over the years minus those paid), minus the fair value of Plan
Assets (which is the sum of what has been contributed and the plan return, minus benefits paid). The
unfunded pension liability should cover both pension and other post-retirement benefits.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

In parallel, analysts would add back pension expense11 to EBITDA and EBIT. Considering pensions as a
form of highly senior debt, EBITDA and EBIT need to be a flow to all equity and debt holders. If EV in
the numerator is financed by both equity and debt holders, EBITDA and EBIT in the denominator
should also be a flow to all investors. That is why pension expense is added back to both. Other
analysts would simply clean the pension expense in the income statement. They would add back
pension expense, and only remove the service cost, which is the compensation share of pension
expense, as opposed to the financing and investing share12.

④ Minority interests

Under the acquisition method, revenue, EBITDA and EBIT all imply a 100% ownership of subsidiaries.
(Profits to minority shareholders are only deducted below group net income). To be consistent,
include both common and minority equity in the numerator.

⑤ Associates and JVs

For the same consistency reasons, analysts choose to remove them from net debt. Profits from
associates and JVs under the equity method most often appear on an after tax basis right above
group net income. Revenue, EBITDA and EBIT in the denominator will exclude profits from associates
and JVs, that is why you would remove them from EV in the numerator.

11
From SG&A
12
Pension expense = current service cost + interest cost – expected return on plan assets +/- amortization of
deferred gains and losses – amortization of prior service cost

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

⑥ Leases13

Add back capital leases to net debt (no adjustment needed on income statement); some analysts
would also add back the off-balance sheet capitalized value of operating leases to net debt (in that
case, lease expense should also be added back to EBIT).

⑦ Preferred stocks

Consistency reasons.

⑧ Convertible debt

Same consistency reasons. Treat as equity if in-the-money (i.e. if exercise price is lower than current
share price), as debt otherwise.

24. Why do you adjust net debt in your multiple calculation?

13
Remember there are two types of leases. Financial or capital leases are a form of asset purchase with stapled
debt financing. Accounting-wise, you buy an asset that is capitalized on your balance sheet, with debt, so a
finance lease obligation is created in your balance sheet liabilities. The asset is depreciated annually in the
income statement and a financial interest is deducted on the lease. Conversely, operating leases do not appear
in assets and liabilities, only a rent charge is deducted annually in the income statement, usually above EBIT

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

To include equity-like (e.g. in-the-money stock options or convertible debt) and debt-like (e.g. leases)
sources of financing that are not included in market capitalization plus bank debt, and for consistency
reasons between the multiple numerator and denominator.

25. What is an average EV/EBITDA multiple?

It depends on the industry and on which year EBITDA is projected for.

A typical EV / 1-year forward EBITDA multiple could be 8 times. But it could also be 5 times or 16
times.

26. Do you know how to build an LBO model?

What is an LBO? It is the highly levered buyout of a target by private equity investors with the
objective to improve operations and sell a few years later at a significant return. Returns have three
sources: financial leverage, operations improvement, and multiple expansion14.

An LBO model analyzes investor returns, based on a set of assumptions that include entry and exit
price, leverage, and investment horizon.

A back-of-the-envelope LBO analysis15 starts with a summary of the transaction capital structure:
how do I finance (“sources”) what I am buying (“uses”)?

14
Difference between entry and exit multiple

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Sources Uses
$m x EBITDA % Total $m x EBITDA % Total

Existing Debt 2 Equity Purchase Price 100

Term Loan 2 Existing Debt 50

Bullet Loan 2 Retained Cash 30

Senior Debt Financing Fees 10

New Equity Investors 5 = 3 - 4 Transaction Fees 5

Retained Equity 4

Equity 3 = 1 - 2

Existing Cash 2

Total Sources 1 Total Uses 1

① Start with uses. What you buy first is the equity stake of common shareholders. Based on a prior
valuation exercise, you have an idea of what you would pay for the firm’s EV (let’s say 10x LTM
EBITDA for example), so the equity purchase price of a private company simply is EV – Net Debt –
Minority Interests – Preferred Shares. Make sure to include the cost of options, convertibles and
any other potentially dilutive securities. For a public company, the equity purchase price is the
company stock price x (1+tender premium) x the diluted number of shares (i.e. diluted for in-the-
money options).
The target’s existing debt would typically be refinanced. This is because existing debt covenants
would most often prohibit post-LBO leverage levels. Bank debt can usually be refinanced without
penalty, but high yield bonds would typically feature a call premium, which would then be
included in the uses table.
A target cash reserve can also be funded (obligation to maintain a certain amount of cash on the
target balance sheet; $30m in our example).

15
Full modeling would require the projection of the entire three financial statements

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Financing fees attached to the various debt instruments are paid for at close, capitalized over the
life of the loans, and amortized annually. They are calculated as a percentage of each debt
instrument ($10m in our example).
Transaction fees (of various nature16; $5m in our example) are paid for and expensed at close,
and come reduce the value of shareholders’ equity. They are usually calculated as a percentage
of the transaction EV.

Total sources equals total uses.

② Now, how do you finance the operation? You would first add as much debt as what banks are
ready to lend you. In our example, to make it simple, we have limited debt to senior debt: from
the target existing debt17 and additional debt in the form of an amortizing term loan and a bullet
loan18.

You could also use existing cash from the target balance sheet as a financing source.

③ Equity is a “plug” equivalent to additional sources needed after raising debt and factoring in
target cash.

④ Investors can be new or existing.

16
Transaction fees can include advisory fees as a % of transaction EV, fixed expenses such as legal and
accounting fees, and even a fee to the sponsor
17
Existing debt can either be refinanced or rolled over in the operation. Most often, existing debt is refinanced,
as existing debt covenants will typically prohibit post-LBO leverage levels. We still choose to keep existing debt
as a financing source for learning purposes. Whenever debt or equity is rolled over, it appears both in sources
and uses
18
In practice, senior debt would be broken down into several tranches, and would come on top of
subordinated debt (such as high yield and mezzanine debt)

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Now that you are set on the transaction capital structure, your aim is to find LBO returns. How do
you calculate return to equity investors? It is the sum of cash outflows to investors (dividends
accumulated over investment period and equity proceeds at exit), compared to their cash inflows
(equity initially invested). To find the firm equity value at exit, you should know enterprise value and
net debt. Enterprise value is easy, it is based on a fixed multiple which you decide to exit at. Net debt
implies projections of debt and cash balances. Your debt schedule is directly based on capital
structure assumptions. Cash balance is based on opening cash and cash flows (FCFADS19, debt service
and dividends).

Below is a roadmap of the steps to investor returns:

Y1 Y2 Y3 Y4 Y5

A FCADS

B Debt & Interests

C Cash Balance = Opening Cash + FCADS - Debt Service - Dividends

D Equity = EV - Debt + Cash

E Total Cash Flows to Sponsor = % Equity + % Dividends

F Sponsor Returns (Based on Total Cash Flows to Sponsor)

Let’s first project FCADS over the investment period:

19
Free Cash Flow Available for Debt Service

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A FCFADS Y1 Y2 Y3 Y4 Y5

EBIT (1-T)

+ Depreciation

- i (1-T) Interest expense from debt schedule, interest income from cash projections

+/- Δ in Working Capital

= Cash from Operating Activities

+ Cash from Investing Activities

= FCFADS

FCFADS is the sum of cash flow from operating activities and cash flow from investing activities.

Now, let’s calculate debt and interests.

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B Debt Schedule Y1 Y2 Y3 Y4 Y5

Cash Opening Balance From Cash Balance Projections ( C )

- Min Cash Balance
+ FCADS
= Cash Available for Debt Repayment
- Scheduled Debt Repayments Sum of scheduled repayments for each debt instrument (below)
= Cash Available for Sweep

Debt Opening Balance

Revolver Opening
+ Drawdown
- Repayment
Revolver Closing
LIBOR Based on 3-month LIBOR curve
Interest 3.25% Spread = LIBOR + 3.25% spread
Commmitment Fee 2.00% Fee on undrawn amount
Total Interest = Interest Expense + Commitment Fee

Existing Debt Opening

+ Drawdown
- Scheduled Repayment
- Cash Sweep
Existing Debt Closing
Interest 3.00% Spread

Term Loan Opening (Amortizing)

+ Drawdown
- Scheduled Repayment
- Cash Sweep
Term Loan Closing
Interest 3.75% Spread

Bullet Loan Opening

+ Drawdown
- Scheduled Repayment
- Cash Sweep
Bullet Loan Closing
Interest 7.00% Fixed

Debt Closing Balance

Interest Expense

The total debt opening balance is equal to the previous year’s ending balance, except for year one,
which represents the total debt in the new capital structure (from the sources table).

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The total debt ending balance is the sum of each debt instrument’s closing balance.

You will notice that we have included a revolving credit facility on top of the various debt
instruments in our new capital structure (which are the existing debt, a term loan and a bullet loan).
The revolver line did not appear in our sources table because it was not used to fund the acquisition.
Instead, a bank committed to lend a certain amount (let’s say $50m) that can be drawn down
anytime at the company’s discretion. This committed amount can be borrowed, repaid and re-
borrowed indefinitely over the investment period.

Each debt instrument’s closing balance is the sum of the opening balance, plus any drawdown, minus
any repayment.

Repayments can be scheduled repayments (i.e. according to credit agreement), or optional

repayments: this is what we call a cash sweep. Any cash available after scheduled debt repayments
will be used to make optional repayments and repay the debt earlier. Bank debt has more
prepayment option than subordinated debt like high yield bonds or mezzanine. Those optional
repayments (cash sweep), are made according to seniority: cash available for sweep is used to pay
down the revolving facility first (as it is the most senior facility). What is left will go to less senior
credit facilities based on seniority.

There is usually no additional drawdown projected, apart from revolver drawdowns which happen
any time the cash available for debt repayment does not cover scheduled repayments.

Interests can be floating or fixed, and are usually calculated based on an average of opening and
closing debt balances (as interests are usually paid quarterly and coupons semiannually). The
revolver also has a commitment fee on undrawn amount every year. Let’s look into cash.

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C Cash Balance Y1 Y2 Y3 Y4 Y5

Cash Opening Balance

+ FCADS

+ Revolver Drawdown & Repayment

- Debt Repayments (scheduled and cash sweep)

- Dividends % Sweep Reserve Distribute a % of the cash that remains after debt service and that
50% 30 is above the cash reserve
Cash Closing Balance
Interest Income 1,00%

The closing cash balance is the sum of the opening cash balance, FCADS, revolver drawdown
(assuming no other debt drawdown than those at transaction close), debt repayments, and dividends
(typically 0 in a leveraged transaction). This assumes no equity issuance or repurchase during the
investment period.

Now that we can calculate net debt, equity is enterprise value minus net debt (assuming no minority
interest or preferred shares):

D Equity Proceeds Y1 Y2 Y3 Y4 Y5

Enterprise Value Based on a fixed exit multiple

- Debt

+ Cash

Equity Proceeds

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Total cash flows to sponsor are the sum of their equity proceeds at exit year and their accumulated
dividends over the investment period20:

E Total Cash Flows to Sponsor Y1 Y2 Y3 Y4 Y5

Sponsor Equity Proceeds = Equity proceeds x sponsor share of equity

Sponsor Dividends = Dividends x sponsor share of equity

Total Cash Flows to Investors

Returns over the investment period are presented in two forms: a percentage annual return (IRR),
and a cash on cash multiple (“by how much did I multiply my initial investment?”):

F Sponsor Returns Y1 Y2 Y3 Y4 Y5

Sponsor IRR Expected annual return to sponsor over investment period

Sponsor Cash on Cash Return = Sum of sponsor accumulated dividends & equity proceeds
at exit year / equity invested

A typical LBO output would include three elements: the transaction capital structure (Sources and
Uses table) that would include debt assumptions, a debt paydown chart and credit ratio statistics, as
well as IRR and cash on cash returns sensitized for entry and exit multiples and investment horizon,
in the form of sensitivity tables.

27. In your LBO model output, can you tell me what sources of funds you would typically have and
what their cost / return would be?

20
Sponsor share of equity at exit assumes no equity dilution from management performance equity or
mezzanine equity kicker

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Financing Source Costs Lending Parameters Likely Sources

Senior Debt (35-45%)(1) ▪ LIBOR + 325-425 bps ▪ Senior Debt leverage = ▪ Commercial banks
▪ Fees: 1.5 - 2.0% 2.5x to 3.5x LTM EBITDA ▪ Credit Companies
▪ 6 - 8 year maturity ▪ Insurance Companies
▪ CDOs

Subordinated Debt (15- ▪ 10-year Treasury bond ▪ Total leverage = 4.5x to ▪ Public market
35%)(2) yield + 600 bps 5.5x LTM EBITDA ▪ Insurance companies
▪ Fees: 2.5 - 3.0% ▪ Total Interest Coverage > ▪ CDOs
2.0x ▪ Mezzanine funds (higher
▪ 7-10 year bullet with non- cost of capital; may
call 3-5 year provision include warrants)

Equity (30-40%) ▪ 20-25% ▪ 3-5 year target exit ▪ LBO funds

▪ Fees: Sponsor will strategy ▪ Investment banks
sometimes take an ▪ Merchant banks
upfront deal fee and an ▪ Management investors
ongoing management ▪ Strategic companies
fee

Note:

(1) A simple senior debt structure would typically include an amortizing A tranche and a longer,
bullet B tranche
(2) Subordinated debt would typically include high yield bonds and mezzanine debt. Mezzanine debt
has a higher return than high yield bonds

Senior debt is the cheapest financing source, but weighs on the company’s flexibility through heavy
covenants (restrictions on acquisitions, debt drawdowns and dividend payments) and its amortizing
structure (which forces the company to use a significant portion of its cash flow to quickly repay
senior debt principal).

On the other hand, subordinated debt brings flexibility to the company with lighter covenants and a
bullet structure, but this comes at a higher cost. Subordinated debt typically features public high
yield bonds and mezzanine, which usually is a combination of subordinated debt or preferred stock
with warrants or some other “equity quicker” (like PIK or payment-in-kind for example).

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Banks require that equity investors contribute at least 25-30% equity to the transaction. Equity
holders bear the highest level of risk in the transaction, and typically require a return above 25%.

28. In your LBO model output, what credit statistics would you show?

The two primary sources of risk in an LBO are financial leverage and liquidity:

① Leverage ratios measure the company’s level of debt relative to its cash flows. The most
commonly used ratios include:

Total Debt

EBITDA

Senior Debt

EBITDA

② Coverage ratios measure the firm’s ability to make principal repayments and interest payments

Interest coverage ratios measure the firm’s ability to pay interest on debt. The most common ratios
include:

EBITDA

Interest Expense

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

(EBITDA – Capex)

Interest Expense

The debt service coverage ratio (DSCR) measures the firm ability to service its debt:

Cash Available for Debt Service

DSCR =
Principal Repayments & Interest Expense

29. In your LBO model output, what would be a typical IRR to equity investors?

A typical IRR to equity investors would be 25%. However, this will depend on leverage, expectations
on operations improvement, and multiple expansion.

30. What would be a good LBO candidate?

An ideal LBO candidate would be a company that can generate strong, steady and predictable cash
flows. It would be a mature company with a significant market share, little fixed capital and working
capital investment needs, in an industry with low cyclicality and high barriers to entry.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

It would be a company with opportunities for immediate operations improvement (e.g. synergies
with other portfolio companies, working capital, divestible assets), with a strong management team
(already in place or new).

Exit strategy should be viable.

31. What are the three sources of value creation in an LBO?

LBO returns increase with financial leverage, operations improvement and multiple expansion. We
will illustrate the concept with a simple example.

① Financial Leverage

Pre-Transaction Entry – Year 0 Exit – Year 3

Assets Equity Assets Equity Assets Equity
25 Equity value increases 60
Market as debt is repaid
100 100 100 Debt 100
Value Assuming constant
75 multiples and CFs Debt
40

Cash Flows 20 20 20
Multiple 5x 5x 5x

Increase in EV 0%

Increase in Equity 140%

IRR 34%

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Assuming constant entry and exit multiples, and no improvement in cash flows, the acquisition debt
raised in year 0 gets paid down over the three years of investment, which mechanically increases
equity value at exit. IRR, which is based on entry and exit equity values increases sharply.

② Operations Improvement

Exit – Year 3
Pre-Transaction Entry – Year 0 Assets Equity
Assets Equity Assets Equity 75
Valuation increases
25 with CFs
Market 150
100 100 100 Debt Assuming constant Debt
Value
multiples and no debt
75 repayment 75

Cash Flows 20 20 30
Multiple 5x 5x 5x

Increase in EV 50%

Increase in Equity 200%

IRR 44%

Cash flow increases at exit, exit multiple has not moved, so firm value increases. At the same time,
debt has stayed the same, so equity increases.

③ Multiple Expansion

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Exit – Year 3
Pre-Transaction Entry – Year 0
Assets Equity
Assets Equity Assets Equity
25 Valuation increases 45
Market with multiple expansion 120
100 100 100 Debt Debt
Value Assuming constant CFs
75 and no debt repayment 75

Cash Flows 20 20 20
Multiple 5x 5x 6x

Increase in EV 20%

Increase in Equity 80%

IRR 22%

Multiple has expanded at exit, cash flow has not moved, so firm value increases. At the same time,
debt has stayed the same, so equity increases.

32. What are the LBO exit strategies you know?

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① Sale ② IPO ③ Recapitalization

to Strategic to Financial Leverged Debt

Buyer Sponsor Recap Renegotiation
+ Synergies + Full exit + Management + Partial exit of + Debt has to be
justify a support invested renegotiated
premium over + Increased equity through when
selling price future liquidity an exceptional covenants are
+ Full exit of equity dividend that broken,
unlike other can be company
partial exits financed cannot service
Advantages (higher through debt or is not
disclosure company cash profitable
requirement) or new debt
+ Exit
contributes to
improvement
of PE fund IRR

- Detrimental to - No premium - Partial exit - No real exit - No exit

management paid over - Long process - Equity
team which selling price - Heavy investors may
may be - Buyer will try regulations even be
replaced to push target - IPO valuation required by
Limitations price down to discount banks to inject
maximize additional
return funds

33. What is EVA and residual income valuation?

Economic Value Added is a measure of the firm’s economic profit, i.e. the profit to equity and debt
investors that is generated above what is simply required by the cost of capital.

EVA1 = NOPAT1 – (Book Value of Invested Capital0 x WACC) = BV0 of Invested Capital x (ROCE – WACC)

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Where:

- NOPAT = EBIT (1 – T)
- BV of Invested Capital = BV of Equity + BV of Debt
- ROCE = Return on Capital Employed = NOPAT1 / (BV0 of Invested Capital)

The sum of future EVA flows discounted at the WACC is called Market Value Added:

∞
EVAi
MVA = ∑
i=1 (1 + WACC)i

Firm value is the sum of today’s book value of invested capital and MVA.

EV = BV0 of Invested Capital + MVA

Similarly, residual income is the income to equity holders that is generated above what is required by
the cost of equity.

Residual Income1 = Net Income1 – (BV0 of Equity x ce) = BV0 of Equity x (ROE – ce)

Where:

- ce is the company cost of equity

- ROE = Return on Equity

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The fair value of equity is the sum of today’s book value of equity and discounted future residual
income flows.

∞
RIi
Fair Value of Equity = BV0 of Equity + ∑
i=1 (1 + ce)i

Where:

- RI = Residual Income
- ce = Cost of Equity

EVA and residual income valuation methods are attractive in the sense that most of the value is in
today’s book value, as opposed to DCFs where terminal value accounts for most of the value and is
highly dependent on assumptions.

NOPAT and net income however are accounting measures that can be easily manipulated. EVA and
residual income methods are used very rarely by professionals.

34. How would you value a private company?

Private companies will typically not disclose financial information. Without historical financial
statements, it will be difficult to use any valuation method based on cash flow projections such as
DCF or LBO valuation.

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A solution would be to use trading multiples, with two conditions however: you can identify a group
of publicly traded peers, and you have knowledge of some measure of firm profit.

Transaction multiples that you could relatively easily find in press articles or databases, would also be
helpful, provided you have some measure of firm profit.

From that multiple valuation analysis, reconciling equity value with enterprise value may be difficult
if you have limited net debt or earnings information on the company.

Please note that once access is granted to the private company financial statements, DCF, LBO and
multiples will all be part of the valuation exercise.

35. How would you value the orange juice bar from across the street?

Following on what has been said in the previous answer, it all depends on how much financial
information you have at hand.

The bar must be private. Until you have a chance to sit with management to discuss financial
statements, you will forget DCF approaches.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

You may get in the press an idea of the firm’s historical revenues, and if you are lucky the firm may
even be comparable to a group of publicly traded chain outlets, so that you could imply the firm
enterprise value.

If you can find in the news what sales have been made in the last year, transaction multiples would
also give you an idea of the firm’s enterprise value.

Now, the decision to buy or sell would require advisors to the seller or buyers to sit with
management of the target to discuss financial performance. This is when you would be able to use all
valuation methods.

36. Between DCF, comps, transaction multiples and LBO, which method would typically give you
the highest valuation?

Highest 1 Transaction Multiples & DCF

2 Trading Multiples

Lowest 3 LBO Model

Valuation would typically be highest using transaction multiples, as those include a control premium.
DCF would also rank on top, as this method is that of sellers, which will easily choose aggressive cash
flow, g and WACC assumptions.

LBO would give the lowest value. This is because cost of capital is extremely high in LBO situations.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

Trading multiples would come in between.

37. What are the advantages and limitations of each of the valuation methods we have discussed?

EVA /Res.
Multiples DCF DDM APV LBO
Income
+ Realistic + Absolute + Absolute + Absolute + Absolute + Valuation is
market valuation valuation valuation valuation associated
valuation measure: measure measure measure with returns
based on + Preferred to + Most of the
instrinsic DCF for value is in
cash flows companies today's book
with a value, as
changing opposed to
Advantages capital terminal
structure value
(LBOs), and
in times of
crisis when
credit
spreads are
wide

- Relative - Highly - Minority - Rarely used - Based on - Highly

valuation dependent stake accounting dependent
measure: on WACC and valuation metrics that on cash flow
might not g method can be easily projections,
reflect assumptions - Company manipulated leverage and
intrinsic (EVA / RI must pay - Rarely used multiples
potential of preferred) dividends assumptions
company - Not adpated
Limitations - Highly to a company
sensitive to with a
choice of moving
comps capital
structure
(APV
preferred)

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38. What valuation discounts do you know?

① Holding Company Discount

The market value of a holding company is worth less than the sum of its subsidiaries’ market values.
A holding company will have investments in different industries: the holding company’s financial
statements may lack clarity, and any investment into the holding company may imply different risk
levels or betas (specific to each subsidiary).

A 15-25% discount would typically be applied to the sum-of-the-parts.

② Minority Discount

This is a discount for lack of control, i.e. the investor’s ability to influence financial and strategic
decisions.

Typically around 15-25%.

③IPO Discount

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A discount will be applied to IPO candidates to compensate investors for the documented LT
underperformance of IPOs, as well as the failure of many, or simply to minimize the underwriter risk
to place the shares with investors.

IPO discounts are typically around 10-15%.

④ Marketability Discount

A discount applied to private companies for their lack of liquidity (i.e. the ability to sell quickly at a
fair price).

Typically around 20-30%.

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III. MERGER ANALYSIS

39. What is accretion / dilution?

The percentage change in earnings per share is a critical tool used by the public and shareholders to
measure the success of an acquisition. An operation is accretive when on a combined basis it
increases the acquirer’s earnings per share. It is dilutive when it decreases earnings per share.

Accretion / dilution measures whether the addition of net income and after-tax synergies have more
weight on earnings per share than transaction costs and the effects of financing, which are additional
after-tax interests and an increased number of shares:

NIA + NIT + Synergies (1 – T) – Interests (1 – T) – Amortization of Transac. & Fin. Costs (1 – T)

New EPSA=
Number of SharesA + Shares IssuedA

Where:

- NIA = Net Income to Common Shareholders of Acquirer

- NIT = Net Income to Common Shareholders of Target
- T = Acquirer Income Tax Rate
- Synergies can be revenue, costs or financial synergies
- Interests are additional interests paid on new debt, and interest income lost when
acquirer cash is used in the financing of the transaction
- Transaction and financing costs are usually amortized over several years

Note:

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

(1) if the acquisition brings minority interests (acquirer buys less than 100% of target), all metrics in
the numerator should be to common shareholders only (for consistency reasons with the
denominator)

40. Assume a simple 100% acquisition where acquirer has a P/E of 20, target has a P/E of 10, after-
tax cost of debt is 5%, with no synergies and no transaction or financing costs: can you tell me
if the operation is accretive or dilutive to the acquirer’s earnings in the case of a 100% stock, a
100% debt and a 50% stock / 50% debt transaction?

Acquirer P / E = 20, i.e. return on equity invested is 1 / 20 = 5%

Target P / E = 10, i.e. return on equity invested is 1 / 10 = 10%

① 100% stock

NIA + NIT
New EPSA=
Number of SharesA + Shares IssuedA

Let’s assume each share is $1. Because the acquirer has a P / E of 20, each dollar invested in equity,
i.e. each share, earns 5% in net income. To maintain the same EPS ratio, I need to invest each share
at a 5% return. On the contrary, each share issued to acquire the target would get a return of 10%, so
that EPS would increase and the operation would be accretive.

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 Volume 2: Structured Answers to Technical Questions That Are Always Asked

② 100% debt

NIA + NIT - Interests (1 – T)

New EPSA=
Number of SharesA

The ratio will increase if NIT > Interests (1 – T). In our example, each dollar invested in debt would get
10% in net income and incur a 5% after-tax interest cost. The operation would be accretive.

③ 50% stock / 50% debt

NIA + NIT - Interests (1 – T)

New EPSA=
Number of SharesA + Shares IssuedA

It is difficult to tell in cases of mixed sources of financing. Need to model.

Copyright © by Mark Hatz – All Rights Reserved 81

The “Investment Banking Interview Preparation Pack” was designed to help, in a
mentoring-style, undergraduate and MBA students secure analyst or associate positions in
M&A at top financial institutions, whether bulge bracket or boutique investment banks.
Mark Hatz’s unique approach to investment banking interview preparation is to have
candidates focus on the interview questions they are guaranteed to be asked at some
point of the interview process, and offer insider advice on what professionals would
expect to hear in the candidates’ answers for their performance to be considered
successful.

MARK HATZ is an entrepreneur, co-founder of a boutique

investment bank focused on emerging markets. Mark started his
career at Goldman Sachs and Perella Weinberg Partners, and
worked in London, Paris and Dubai. He holds a Masters degree
in Management from ESCP Europe, a Bachelors degree in Law
from the Sorbonne University, and has passed the two first
levels of the CFA examination.

Mark has a solid understanding of the investment banking

interview process. He participated in recruiting analysts at
Perella Weinberg in London as well as full-time associates most
recently at a boutique investment bank in Dubai. His recruiting
experience also draws on the dozens of interviews He got out of
college with various financial institutions such as Moelis,
Greenhill, Evercore, Blackstone, Rothschild, Morgan Stanley and
JP Morgan, to name a few.