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Technical Finance
Interview Prep
W W W. WA L L S T R E E T P R E P. C O M
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Usage and Terms
Usage
• The tutorial and enclosed models are proprietary to Wall Street Prep and are designed for illustrative and
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prohibited without the expressed, written permission of Wall Street Prep, Inc. The self-study course is
designed for illustrative purposes only and does not, in any way, constitute any investment thesis or
recommendation.
Copyright
• Wall Street Prep, Inc. All rights reserved. “Wall Street Prep,” “WSP,” and various marks are trademarks of
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Technical Finance Interview Prep
Basic Accounting
W W W. WA L L S T R E E T P R E P. C O M
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Basic Accounting
Accounting questions
• Accounting questions are a near certainty in any technical finance interview.
• Accounting questions can generally be broken out into 3 types:
Understanding the 3 core financial statements “Walk me through the income statement (IS)?”
How the 3 statements are linked / accrual concepts “How are the 3 financial statements connected?”
• By the end of this section, you will be able to answer the most common basic accounting questions.
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Basic Accounting
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Basic Accounting
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Basic Accounting
Liabilities 12/31/2018
Accounts Payable (AP) 0
Debt 50,000
Total Liabilities 50,000
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Basic Accounting
• COGS: You used up all your inventory (cups, lemons and sugar). Your cost of goods sold (COGS)
expense is $20,000. Direct expenses are recognized during the period sold as COGS. Notice we didn’t
spend cash during the period, but rather matched the expenses to revenues earned. This is a key accrual
concept called “the matching principle.”
• SG&A: During the year, you hired a cashier and paid her $15,000 in cash. This is recognized in a
separate expense category called sales, general, and administrative expenses (SG&A). SG&A applies
to any operating expenses not directly associated with making the product.
• Depreciation expense: Remember the lemon squeezer you bought for $30,000 that you estimated had a
useful life of 3 years? You’ve used up 1/3 of its life. Thus, you have to recognize $30,000/3 years =
$10,000 this year as an expense called depreciation expense. Since you paid for the equipment up
front, this depreciation expense is noncash. Accrual accounting at work again.
• Interest expense: Recall that you have a loan and must pay 10% x $50,000 = $5,000 this year. That’s
called interest expense.
• Taxes: You have to pay 40% of your pretax profits in taxes.
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Basic Accounting
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Basic Accounting
Income Statement
For the year ending 12/31/2019
Comments
“sales” Revenues 100,000 Received $80 cash, $20 still owed
“top line” Cost of goods sold (COGS) (20,000) Sold all inventories, so no cash out during period
“turnover” Gross profit 80,000
% Gross profit margin 80% Gross profit/revenue
“earnings before interest
taxes depreciation and Selling, general & administrative (SG&A) (15,000) Paid employee salary in cash
amortization” EBITDA 65,000 Arguably the most widely used profit metric
“earnings before interest Depreciation & amortization (D&A) (10,000) $30,000 / 3 years. “straight-line” depreciation.
& taxes” Operating Income (aka EBIT) 55,000
Earnings per share (EPS) $3.00 Net income / Weighted average shares outstanding
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Basic Accounting
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Basic Accounting
Balance Sheet
Change from
Cash changes during the period Assets 12/31/19 prior year
Cash revenue +80,000
Cash 140,000 +40,000
SG&A -15,000 Paid employee cash
Interest expense -5,000 Paid bank cash
Accounts Receivable (AR) 20,000 +20,000
Tax expense -20,000 Paid IRS cash Inventories 0 -20,000
Change in cash +40,000 Property, plant and equipment 20,000 -10,000
Total Assets 180,000 +30,000
Noncash changes during the period
Noncash revenue +20,000 Accounts receivable Liabilities 12/31/19
COGS expense -20,000 Inventory reduction Accounts Payable (AP) 0
Depreciation expense -10,000 PP&E reduction Debt 50,000
Total Liabilities 50,000
Income Statement
For the year ending 12/31/2019 Shareholders' Equity (SE)
Revenues 100,000 Common Equity 100,000
Cost of goods sold (COGS) (20,000) Retained Earnings 30,000 +30,000
Selling, general & administrative (SG&A) (15,000)
Depreciation & amortization (D&A) (10,000)
Total Shareholders' Equity 130,000 +30,000
Interest expense (5,000)
Pretax profit (EBT) 50,000 Liabilities and Equity 180,000 +30,000
Taxes (20,000)
Net Income 30,000
Hey, there’s a lot going on here. We should probably have a financial statement
that just tracks cash changes. We’ll call it “the cash flow statement”
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Basic Accounting
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Basic Accounting
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Basic Accounting
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Basic Accounting
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Basic Accounting
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Basic Accounting
• At year end, you spent $40,000 on a new lemonade stand (no depreciation recorded in current year).
• The company bought shares of Google for $100,000 cash.
• You borrowed an extra $100,000 from the bank (no new interest recorded in current year).
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Basic Accounting
Capital expenditures
Other investments
Cash for investing
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Basic Accounting
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Basic Accounting
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Basic Accounting
Liabilities 12/31/19
Accounts Payable (AP) 10,000 +10,000
Debt 150,000 +100,000
Income Statement Total Liabilities 160,000
For the year ending 12/31/2019
Revenues 100,000 Shareholders' Equity (SE)
Cost of goods sold (COGS) (20,000) Common Equity 100,000
Selling, general & administrative (SG&A) (15,000)
Depreciation & amortization (D&A) (10,000)
Retained Earnings 20,000 +20,000
Interest expense (5,000) Total Shareholders' Equity 120,000 +30,000
Pretax profit (EBT) 50,000
Taxes (20,000) Liabilities and Equity 280,000 +30,000
Net Income 30,000
Dividend 10,000
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Basic Accounting
Stand Example
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Technical Finance Interview Prep
Intermediate
Accounting
W W W. WA L L S T R E E T P R E P. C O M
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Intermediate Accounting
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Intermediate Accounting
Liabilities 12/31/2018
Accounts Payable (AP) 0
Debt 50,000
Total Liabilities 50,000
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Intermediate Accounting
Income Statement
For the year ending 12/31/2019
Comments
“sales” Revenues 100,000 Received $80 cash, $20 still owed
“top line” Cost of goods sold (COGS) (20,000) Sold all inventories, so no cash out during period
“turnover” Gross profit 80,000
% Gross profit margin 80% Gross profit/revenue
“earnings before interest
taxes depreciation and Selling, general & administrative (SG&A) (15,000) Paid employee salary in cash
amortization” EBITDA 65,000 Arguably the most widely used profit metric
“earnings before interest Depreciation & amortization (D&A) (10,000) $30,000 / 3 years. “straight-line” depreciation.
& taxes” Operating Income (aka EBIT) 55,000
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Intermediate Accounting
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Intermediate Accounting
Balance Sheet
Change from
Cash changes during the period Assets 12/31/19 prior year
Cash revenue +80,000
Cash 140,000 +40,000
SG&A -15,000 Paid employee cash
Interest expense -5,000 Paid bank cash
Accounts Receivable (AR) 20,000 +20,000
Tax expense -20,000 Paid IRS cash Inventories 0 -20,000
Change in cash +40,000 Property, plant and equipment 20,000 -10,000
Total Assets 180,000 +30,000
Noncash changes during the period
Noncash revenue +20,000 Accounts receivable Liabilities 12/31/19
COGS expense -20,000 Inventory reduction Accounts Payable (AP) 0
Depreciation expense -10,000 PP&E reduction Debt 50,000
Total Liabilities 50,000
Income Statement
For the year ending 12/31/2019 Shareholders' Equity (SE)
Revenues 100,000 Common Equity 100,000
Cost of goods sold (COGS) (20,000) Retained Earnings 30,000 +30,000
Selling, general & administrative (SG&A) (15,000)
Depreciation & amortization (D&A) (10,000)
Total Shareholders' Equity 130,000 +30,000
Interest expense (5,000)
Pretax profit (EBT) 50,000 Liabilities and Equity 180,000 +30,000
Taxes (20,000)
Net Income 30,000
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Intermediate Accounting
• You sold $5,000 in gift cards of which $2,000 were redeemed during the year
• You paid $10,000 in utilities for 2019 and an additional $2,500 as prepayment for Q1 2020
• Your employee has earned a $4,000 year end bonus, which you have yet to pay
• You bought $30,000 in inventories to replenish supply ($20,000 cash, $10,000 on supplier credit)
• On the last day of the year, you spent $40,000 on a new lemonade stand (assume no depreciation from
this stand was recorded in current year)
• In the middle of the year you used $100,000 of your cash to invest in treasuries and other marketable
securities with an annualized return of 2%
• You borrowed an extra $200,000 from the bank (no new interest recorded in current year)
• You paid yourself a $10,000 dividend
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Intermediate Accounting
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Intermediate Accounting
Income Statement
For the year ending 12/31/2019 Revenues from gift cards are recognized when they
BEFORE AFTER cards are redeemed and the good or service has been
Revenues 100,000 102,000 provided – so in this case while $5,000 in cash was
received, $2,000 of the $5,000 was earned as revenue
Cost of goods sold (COGS) (20,000) (20,000) – the rest is a deferred revenue liability (aka unearned
Gross profit 80,000 82,000 revenue)
% Gross profit margin 80% 80%
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Intermediate Accounting
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Intermediate Accounting
Balance Sheet
The cash flow statement will make calculating this easier
Assets 12/31/2018 12/31/2019
Cash 100,000 ??? 20,000 of revenue is still owed to you by customers
Marketable securities 100,000
Accounts Receivable (AR) 0 20,000 Replenished inventories
Inventories 20,000 30,000 Prepaid utilities are an asset
Prepaid expenses 0 2,500
Property, plant and equipment 30,000 60,000 The 20,000 value of the original stand (30,000 less 10,000
current period depreciation) + $40,000 value of new stand
Total Assets 150,000 ???
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Intermediate Accounting
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Intermediate Accounting
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Intermediate Accounting
Balance Sheet
Assets 12/31/2018 12/31/2019
Cash 100,000 167,900
Marketable securities 100,000
Accounts Receivable (AR) 0 20,000
Inventories 20,000 30,000
Prepaid expenses 0 2,500
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,400
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Intermediate Accounting
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Intermediate Accounting
Extra credit I
• In addition to cash compensation, you gave your employee restricted shares. During the year, you
recognize $7,000 in stock based compensation expense from the issuance.
• At the beginning of the year, you raised an additional $30,000 by selling 1,000 shares to another
investor. On the last day of the year, you repurchased the shares, but because your lemonade stand was
so successful, you had to pay double ($60,000) to get the shares back.
• You raised an additional $100,000 from preferred shareholders at the beginning of the year. In exchange
you will pay a 10% annual preferred dividend.
• During the year, $3,000 worth of lemons spoiled. You believe this is a one-time expense.
• At the beginning of the year, you acquired the trademark of a competing lemonade stand for $25,000.
You changed your mind and sold it in the middle of the year for $18,000. Note: Since brands can be
renewed forever, they are considered to have “indefinite life” under GAAP; No amortization is recorded.
• You straight-line depreciation for book purposes but the IRS allows for accelerated depreciation of your
lemonade stand (YR1: 50%, YR2: 30%, YR3: 20%). As in the prior examples, assume no depreciation
from the new lemonade stand during 2019.
Update the Income Statement, Balance Sheet and Cash Flow Statement
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Intermediate Accounting
Extra credit I
Like write-downs, gains on sale (and losses on sale) are either identified separately
or embedded within a larger expense category. Gains and losses are generally
treated as non-recurring items and ignored when calculating EBITDA.
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Intermediate Accounting
Extra credit I
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Intermediate Accounting
Extra credit I
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Intermediate Accounting
Extra credit II
• At year-end, you acquired a hot dog stand business for $80,000 in cash with the following fair value of
assets and liabilities: $10,000 in accounts receivable, $50,000 in PP&E, $5,000 in accounts payable.
• Additional detail relating to the restricted stock issuance: 700 shares of restricted stock were issued to
the cashier at the beginning of the year. At year end, 200 shares were vested.
Update the Income Statement, Balance Sheet and Cash Flow Statement
Calculate Basic and Diluted EPS
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Intermediate Accounting
Extra credit II
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Intermediate Accounting
Extra credit II
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Intermediate Accounting
Extra credit II
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Technical Finance Interview Prep
Valuation
W W W. WA L L S T R E E T P R E P. C O M
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Valuation
“When would comps be preferable to DCF?” “How do you value a private company?”
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Valuation
Introduction to valuation
• Valuation is … the process of determining the “right” value of a business.
• Valuation is NOT … an exact science; Several approaches are used.
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Valuation
• When the client is the buyer: What is the best (usually lowest) price we can negotiate?
• When the client is the seller: What’s the best (usually highest) price we can negotiate?
• When the client is a company going public: What’s the right pricing for our IPO?
• Should we buy, sell or hold positions • How do we enhance the value of our
in a given security? company?
• Will this investment yield the desired • How will operating, financial, and investment
return? decisions affect the company’s value?
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Valuation
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Valuation
• Equity value
• The value of the business to the owners.
• Equity value is the amount you would get to put in your pocket if you sold your lemonade stand.
• Enterprise value
• In addition to equity value, finance professionals also want to explicitly value the enterprise.
• What is the enterprise? It is the value of the operations – not the equity.
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Valuation
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Valuation
• Getting from enterprise value to equity value: Add the assets and subtract the liabilities that are
excluded in the enterprise value calculation:
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Valuation
Balance Sheet
Assets 12/31/2018 12/31/2019 What’s the equity value and enterprise
Cash 100,000 167,900 value of our lemonade stand at
Marketable securities 100,000 12/31/2019?
Accounts Receivable (AR) 0 20,000
Inventories 20,000 30,000 Approach 1: Direct
Prepaid expenses 0 2,500
Operating assets
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,400 Operating liabilities
Enterprise value
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Valuation
Balance Sheet
Assets 12/31/2018 12/31/2019 What’s the equity value and enterprise
Cash 100,000 167,900 value of our lemonade stand at
Marketable securities 100,000 12/31/2019?
Accounts Receivable (AR) 0 20,000
Inventories 20,000 30,000 Approach 1: Direct
Prepaid expenses 0 2,500
Operating assets 112,500
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,400 Operating liabilities 17,000
Enterprise value 95,500
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Valuation
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Valuation
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Valuation
Comparable Comparable
Discounted Cash
Company Transactions Other
Flow Analysis
Analysis Analysis
Value a company Value a company by Value a company by Leveraged buyout (LBO) analysis:
by finding similar looking at the looking at the future A specific type of valuation approach
companies that are amount buyers have cash flows it can that looks at the value of a company to
public and have paid for acquiring generate and discount new acquirers under a highly leveraged
readily observable similar companies in them to the present to scenario with specific return
market prices. the recent past. arrive at a present requirements. We’ll talk about this
value of your business. approach later, but it’s basically a hybrid
of DCF and comps valuation.
Because these approaches arrive at a company’s
value by looking at the value of similar companies, Liquidation analysis: Value a company
these approaches fall under the umbrella of Because the DCF arrives at under a worst case liquidation scenario.
“relative valuation.” a company value by
looking at the company’s
specific cash flow
forecasts and risks, the While the DCF and comps are the most
DCF approach is a type of common valuation approaches, there are
“intrinsic valuation”, as often other, specific valuation approaches
opposed to “relative that are included in analyses when it makes
valuation.” sense to do so. For our purposes, we’ll spend
less time on them because they don’t tend to
come up nearly as much in interviews.
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Technical Finance Interview Prep
DCF
W W W. WA L L S T R E E T P R E P. C O M
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DCF
• We can express this formulaically as (we denote the discount rate as r):
• So, let’s say you’re promised $1,000 next year and decide you’re willing to pay $800. We can express this
(and solve for r) as:
• If I make the same proposition but instead of only promising $1,000 next year, let’s say I promise $1,000
for the next 5 years. The math gets only slightly more complicated:
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DCF
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DCF
• Both should theoretically lead to the same enterprise value and equity value at the end (though in
practice it’s actually pretty hard to get them to exactly equal).
• The unlevered DCF approach is the most common!
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DCF
• You can’t keep forecasting cash flows forever. At some point, you must make some high level
assumptions about cash flows beyond the final explicit forecast year by estimating a lump-sum
value of the business past its explicit forecast period.
• That lump sum is called the “terminal value.”
3. Discounting the cash flows to the present at the weighted average cost of capital
• The discount rate that reflects the riskiness of the UFCFs is called the weighted average cost of
capital (WACC). Because unlevered free cash flows represent all operating cash flows, these cash
flows “belong” to both the company’s lenders and owners.
• As such, the risks of both providers of capital need to be accounted for using appropriate capital
structure weights (hence the term “weighted average” cost of capital). Once discounted, the present
value of all UFCFs is the enterprise value.
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DCF
• Therefore, if a company has any non-operating assets such as cash or has some investments just
sitting on the balance sheet, we must add them to the present value of UFCFs.
• For example, if we calculate that the present value of Apple’s unlevered free cash flows is $700
billion, but then we discover that Apple also has $250 billion in cash just sitting around, we should
add this cash.
5. Subtract debt and other non-equity claims
• Similarly, if a company has any loan obligations (or any other non-equity claims against the
business), we need to subtract this from the present value.
• What’s left over belongs to the equity owners. In our example, if Apple had $50 billion in debt
obligations at the valuation date, the equity value would be calculated as:
$700 billion (enterprise value) + $200 billion (non-operating assets) – $50 (debt) = $850 billion
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DCF
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DCF
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DCF
Two-stage DCF
• To figure out the value of a business today, theoretically you have to find the present value of ALL future
unlevered free cash flows.
• Finance professionals usually only explicitly forecast unlevered free cash flows for 5-10 years and then
make a very simplified assumption about the value of all unlevered free cash flows thereafter, called the
terminal value (TV). TV is the value the company will generate from all future unlevered FCFs after the
explicit forecast period (stage 1).
• Breaking up the value of a company into two stages is the prevailing practice and is called a 2-stage DCF
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DCF
Terminal value
• There are two prevailing approaches to calculating the terminal value:
1. The growth in perpetuity approach
• The growth in perpetuity approach requires that we make an explicit assumption for a perpetual
annual growth % of UFCFs after the last year of stage 1 at a constant WACC (denoted as ‘r’ in the
formula below).
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DCF
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DCF
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DCF
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DCF
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DCF
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DCF
• The UFCFs we forecasted are not a sure thing because companies may not achieve the UFCFs we
expect. Even worse, companies can go bankrupt.
• The DCF values a company by calculating the PV of those UFCFs. Another way to think of this is an
attempt to figure out what an investor today might be willing to pay for those uncertain UFCFs.
• To do that, you’d need to figure out what kind of return the investors want. And to do that, you
would need to quantify the riskiness of those UFCFs somehow. That’s because an investor’s return
requirements fundamentally depend on how they perceive the risks of those future UFCFs.
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DCF
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DCF
Cost of equity
Risk free rate +β x equity risk premium
Cost of Tax shield
debt
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DCF
WACC
Debt weight Market value of a company’s debt. Can be approximated by using a company’s book value of debt.
The equity weight Market value of a company’s equity (either market cap or comps derived equity value)
Cost of debt The yield on a company’s debt. Cost of debt ≠ nominal interest rate (i.e. coupon rate)
Tax rate The tax rate the company expects to face going forward
Cost of equity Cost of equity = Risk free rate + β x equity risk premium
Cost of equity
Risk free rate Yield on a default-free government bond. The current yield on a U.S. 10-year bond is the preferred
RFR for U.S. companies. Front page of WSJ, financial data sites all show up to date yields
Beta β measures a company’s sensitivity to systematic (market) risk.
• β = 0 means no market sensitivity (cash, for example)
• β < 1 means low market sensitivity (consumer staples, for example)
• β > 1 means high market sensitivity (luxury goods, for example)
• β < 0 negative market sensitivity (gold, for example). Bloomberg is good source for β
Equity risk ERP measures the incremental risk of investing in equities over risk free securities. The ERP usually
premium (ERP) ranges from 4-6%.
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DCF
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DCF
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DCF
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DCF
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DCF
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DCF
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DCF
2. The WACC
3. Terminal value assumptions: Long-term growth rate and the exit multiple
• Each of these assumptions is critical to getting an accurate model.
• In fact, the DCF model’s sensitivity to these assumptions, and the lack of confidence finance
professionals have in these assumptions, (especially the WACC and terminal value) are frequently cited as
the main weaknesses of the DCF model.
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DCF
In summary …
Divided by diluted
shares outstanding
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DCF
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DCF
Perpetuity approach
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DCF
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DCF
• Debt and equivalents include straight debt (loans, revolver, bonds) as well as debt-like instruments like
capital leases, non-controlling interests and preferred stock.
• Cash and equivalents include cash as well as non-operating assets like marketable securities, short-term
investments and equity investments.
Net Debt
Debt & equivalents
1. Debt / Capital Leases Net Debt
2. Non-controlling interests
3. Preferred Stock Enterprise
Less: Non operating assets Value
1. Cash & equivalents Equity
2. Other non op. assets Value
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DCF
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DCF
DCF Advantages
• Theoretically, the most sound method of valuation.
• Less influenced by temperamental market conditions or non-economic factors.
DCF Disadvantages
• Present values obtained are sensitive to assumptions and methodology.
• Terminal value represents a significant portion of value and is highly sensitive to valuation assumptions.
• Need realistic projected financial statements over at least one business cycle (5 to 10 years) or until cash
flows are “normalized.”
• Sales growth rate, margin, investment in working capital, capital expenditures and terminal value
assumptions along with discount rate assumptions are key to the valuation.
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Technical Finance Interview Prep
Extra: WACC
W W W. WA L L S T R E E T P R E P. C O M
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WACC
• If the market value of a company’s equity is readily observable (i.e. for a public company), equity
value = diluted shares outstanding x share price.
• If the market value of is not readily observable (i.e. for a private company), estimate equity value
using comparable company analysis.
• The key point here is that you should not use the book value of a company’s equity value, as this
method tends to grossly underestimate the company’s true equity value and will exaggerate the debt
proportion relative to equity.
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WACC
• Most of the time you can use the book value of debt from the company’s latest balance sheet as
an approximation for market value of debt.
• That’s because unlike equity, the market value of debt usually doesn’t deviate too far from the
book value.
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WACC
Cost of debt
• Compared to calculating the cost of equity, the cost of debt is easier because loans and bonds have
explicit interest rates. For example, a company might borrow $1 million at a 5.0% fixed interest rate paid
annually for 10 years.
• The main wrinkle in calculating the cost of debt is that it’s not simply the nominal interest rate. That’s
because the nominal rate is historical and may be different than the rate the company would pay if it
borrowed currently (remember that the WACC is applied to future UFCFs so should reflect current
anticipation for future borrowing and equity costs).
• So how do you estimate the cost of debt? You have to estimate the yield on existing debt. Yield doesn’t
just look at the nominal rate, but factors in the bond price to tell you what the likely coupon rate would
be if the company borrowed today. It is the internal rate of return of a bond.
• On the next slide you can see a Bloomberg bond page for a 5.7% IBM bond, issued in 2007. Rates
plummeted since the 2007 issuance so the yield on this bond is 1.322% in 2017. That’s much closer to
what IBM would likely have to pay if it borrowed now (IBM and a few other companies are borrowing at
historically low costs of debt). The 1.322% is thus the cost of debt to use.
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WACC
1There are several types of yield. The type of yield Bloomberg quotes in its main bond description page is a yield-to-maturity measure called “bond equivalent
yield”. Technically, another measure called the “effective annual yield” provides a slightly more accurate measure but the difference is immaterial.
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WACC
Cost of debt
• Companies that do not have public debt but have a credit rating
• Use the default spread associated with that credit rating and add to the risk-free rate to estimate the
cost of debt.
• Credit agencies such as Moody’s and S&P provide yield spreads over U.S. treasuries by credit rating.
• Damodaran Online1 publishes a table that lets you map a credit rating based on interest coverage.
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WACC
Cost of equity
• Multiple competing models exist for estimating cost of equity: Fama-French, Arbitrary pricing theory
(APT) and the Capital Asset Pricing Model (CAPM).
• The CAPM, despite suffering from some flaws and being widely criticized in academia, remains the most
widely used equity pricing model in practice.
• Below is the formula for calculating the cost of equity:
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WACC
Cost of equity
• β (“beta”): β measures a company’s sensitivity to systematic (market) risk. A company with a beta of 1
would expect to see future returns in-line with the overall stock market returns. A company with a beta of
2 would expect to see returns rise or fall twice as fast as the market. In other words, if the S&P were to
drop by 5%, a company with a beta of 2 would expect to see a 10% drop in its stock price because of its
high sensitivity to market fluctuations.
• The higher the beta, the higher the cost of equity because the increased risk investors take (via higher
sensitivity to market fluctuations) should be compensated via a higher return.
• ERP (“Equity risk premium”): ERP measures the incremental risk of investing in equities over risk-free
securities. The ERP usually ranges from 4-6%, and is provided by several vendors by looking at historical
returns on the S&P over risk-free bonds.
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WACC
Calculating β Raw beta: Colgate’s (CL) “raw” beta is 0.447 based on its last 5 years share
price returns compared to the S&P 500. If you assume that relationship holds
going forward, every time the S&P 500 goes up by 1%, you’d expect Colgate to
• There are several sources go up by 0.5%. That suggests Colgate is relatively insensitive to market changes.
for getting a company’s
β including Bloomberg,
MSCI and S&P.
• All of these services
calculate beta based on
the company’s historical
share price sensitivity to
the S&P 500, usually by
regressing the returns of
both over a 60 month
period.
Raw vs adjusted beta: Many argue the raw betas are bad predictors of future beta (poor correlation)
because company specific issues uncorrelated to the market clouds the relationship. “Adjusted” beta is an
attempt to make the beta a better predictor so finance professionals generally prefer adjusted beta, but
neither one is great.
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WACC
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Technical Finance Interview Prep
W W W. WA L L S T R E E T P R E P. C O M
v
Industry Beta
Calculating industry β
• In the last slide we alluded to the problem that betas suffer from poor correlations making them bad
predictors. This is only half of the problem. The other issue is that only public companies have observable
betas. The solution to both is using the betas of comparable companies to estimate beta for the company
being analyzed. This is called the industry beta approach.
• The industry β approach looks at β of several public companies that are comparable to the company
being analyzed and applies this peer-group derived beta to the target company. The benefits are:
1. Eliminates company-specific noise
2. Enables one to arrive at a beta for private companies (and thus value them)
• We cannot simply average up all the raw betas. That’s because companies in the peer group will likely
have varying rates of leverage. And unfortunately, the amount of leverage (debt) a company has
significantly impacts its beta. (The higher the leverage, the higher the beta, all else being equal.)
• Fortunately, we can remove this distorting effect by unlevering the betas of the peer group and then
relevering the unlevered beta at the target company’s leverage ratio.
• We do this as follows…
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Industry Beta
Calculating industry β
1. Unlever raw betas from peer group: Get raw beta for each company in the peer group, and unlever
using the debt-to-equity ratio and tax rate specific to each company using the following formula:
Company βLevered
Company β Unlevered = 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
1+ 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 (1−tax rate)
2. Calculate the median of all the unlevered betas: Once all the peer group betas have been unlevered,
calculate the median unlevered beta:
3. Relever the industry beta using the target company’s specific debt-to-equity ratio and tax rate using
the following formula:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
Target company βLevered = Industry βUnlevered x 1+ (1−tax rate)
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
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Industry Beta
Calculating industry β
• Here’s an example of what an industry beta calculation might look like for Apple.
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Technical Finance Interview Prep
Relative Valuation
W W W. WA L L S T R E E T P R E P. C O M
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Relative Valuation
Relative valuation
• While the DCF looks at the intrinsic cash flow-generating potential of a business to determine its value, a
seemingly simpler and more market driven approach is available: looking at how similar companies are
valued.
• This approach is called relative valuation, an umbrella term describing two valuation approaches:
• Trading comparables
• Valuing a firm by looking at the stock market value of similar companies.
• Transaction comparables
• Valuing a firm by looking at prices acquirers have recently paid for similar companies,
• While the DCF requires explicit assumptions about the future, relative valuation – or “comps” – has the
advantage of requiring no explicit assumptions about a company’s future prospects, and is based on
“reality” – observable prices for similar companies in the market.
• Of course, relative valuation has no shortage of disadvantages, and we’ll get to those shortly.
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Relative Valuation
EV multiples
EV multiples are generally more
common than equity value multiples Enterprise value (EV) multiples Equity value multiples
because they isolate how the market
values the operations of a business, EV / EBITDA P / E ratio (Share price / EPS)
regardless of the capital structure of
the business. EV/EBITDA multiples
EV / Revenue Market cap / Net income
are the most popular. Revenue EV / EBIT P / E to growth (PEG ratio)
multiples are useful for companies
with negative EBITDA or profits, or EV / Industry specific metric
when margins are fairly similar across
the entire peer group (i.e. certain
retail subsectors).
The denominators in these multiples are what’s used to standardize the absolute enterprise value or equity value to make comparisons
easier. These denominators are usually calculated on an LTM (“last twelve months”) and forward (1-year or 2-year out) basis
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Relative Valuation
• Selecting the right timeframe. (EV/LTM EBITDA vs. EV/Forward EBITDA, etc.)
• “Scrubbing” the multiple. (EBITDA should exclude nonrecurring items and should be calculated
consistently across all companies.)
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Relative Valuation
4. For each multiple, apply the calculated mean or median to the target company’s corresponding
operating metrics to arrive at a value.
• Example 1: Multiply the derived average LTM PE ratio by company’s LTM EPS to arrive at equity
value per share.
• Example 2: Multiply the derived median 1 year forward EV / EBITDA multiple by the company’s 1
year forward EBITDA projection to arrive at enterprise value.
Median
For larger peer groups, calculating relevant peer group statistic using median is
preferable to mean calculations because it limits distortions from outliers.
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Relative Valuation
Company Colgate
Share price $30.00
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200
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Relative Valuation
Company Colgate
Share price $30.00
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200
EV/Sales EV/EBITDA P/E
Peer group mean 1.38x 6.58x 16.40x
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Relative Valuation
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Relative Valuation
• Liquidity
• Thinly traded, small capitalization or poorly followed stocks may not reflect fundamental value.
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Relative Valuation
• As a practical matter, acquirers must pay a premium to compel sellers to sell; this premium can be
significant and range from 10%-50% above the standalone market price.
• As a result, deal comps will almost certainly yield a higher valuation than standalone comps.
• Finding comparable transactions is even harder than finding comparable standalone business.
• In addition, finding enough data to be able to calculate multiples tends to be much harder with deal
comps.
• The process is otherwise similar to comparable company analysis.
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Relative Valuation
1 While
EV/EBITDA and EV/EBIT multiples are the most common multiples where the synergy adjustment is made, any multiple
where the denominator benefits from synergies could be adjusted
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Relative Valuation
3. Apply the calculated mean/median to target’s corresponding operating metrics to arrive at a value.
Median
For larger peer groups, calculating relevant peer group statistic using median
is preferable to mean calculations because it limits distortions from outliers.
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Relative Valuation
Exercise
Comparable transactions
Offer Premium TV / TV / Offer price
Target Acquirer value ($b) Paid Revenue EBITDA / EPS
Roche Genentech $47 19.0% 2.00 8.00 16.00
Wyeth Pfizer $68 18.0% 3.00 12.00 20.00
Schering-Plough Merck $41 23.0% 1.50 11.00 16.00
Genzyme Sanofi $20 23.0% 2.50 13.00 18.00
Mean 20.8% 2.25 11.00 17.50
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Relative Valuation
Exercise
Comparable transactions
Offer Premium TV / TV / Offer price
Target Acquirer value ($b) Paid Revenue EBITDA / EPS
Roche Genentech $47 19.0% 2.00 8.00 16.00
Wyeth Pfizer $68 18.0% 3.00 12.00 20.00
Schering-Plough Merck $41 23.0% 1.50 11.00 16.00
Genzyme Sanofi $20 23.0% 2.50 13.00 18.00
Mean 20.8% 2.25 11.00 17.50
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Relative Valuation
• Public data seldom discusses deal protection put in place by acquirer and target.
• Values obtained often vary over a wide range and thus can be of limited usefulness.
• Finding all the information you need can be difficult because different bits of information are scattered
throughout different sources.
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Technical Finance Interview Prep
M&A
W W W. WA L L S T R E E T P R E P. C O M
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Valuation
M&A questions
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M&A
Introduction to M&A
• Mergers and acquisitions (M&A) is an umbrella term that refers to the combination of two businesses.
Buyer
• Accelerate time to market Seller
with new products and • Opportunity to
channels cash out or to
• Remove competition, share in the risk
achieve cost savings (buying and reward of a
a competitor is called newly-formed
horizontal integration) business.
• Achieve supply chain
efficiencies (buying a
supplier
or customer is called vertical
integration)
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M&A
Players in M&A
• There are several stakeholders in the M&A process
Buyer Seller
• Management • Management
• Board • Board
• Shareholders • Shareholders
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M&A
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M&A
Accretion / Dilution
• An important M&A analysis is called accretion/dilution analysis.
• Accretive deal: Pro forma (combined) EPS > Acquirer EPS
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M&A
Accretion / Dilution
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M&A
Deal consideration
• Acquirers pay for their acquisition by:
• Paying cash
• Issuing stock
• A combination of both
(i.e. 50% stock & 50% cash)
• The financing decision carries significant legal,
tax, and accounting implications.
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M&A
• In a 100% cash deal: No new acquirer shares must be issued, but either excess cash or new debt
finances the acquisition. This impacts the I/S via incremental interest expense, reducing PF net income
and EPS. New interest expense is often the major adjustment in a cash deal.
• In a mixed deal: Both adjustments must be made.
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M&A
3. Calculate acquirer shares issued in the transaction: Offer value / acquirer share price.
4. Calculate the pro forma shares outstanding (PFSO) = Pre-deal acquirer shares + acquirer shares issued.
5. Divide the PFNI by the PFSO to get PF EPS.
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M&A
Accretion/dilution
• Acquirer expects EPS of $1 next year, with a share price of $5 (PE = 5.0x).
• Target also expects EPS of $1 next year, but with a share price of $10 (PE = 10.0x).
• In a 100% stock deal, Acquirer must issue 2 shares to acquire one target share.
• This deal will be dilutive because 1 Acquirer share equates to owning $1 of Acquirer net income, but
Acquirer must issue 2 shares in order to acquire $1 of Target's net income.
• As a result, the incremental benefit of Target net income will not be sufficient to offset the share dilution
required to make the deal happen.
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M&A
2. Whole > Sum of the parts: The value of a business can be greater FMV
write up
than simply the sum of the individual assets when organized in a $15
certain way.
TBV
3. Overpayment: Buyers can get swept up in a bidding process, $45
over-estimate synergies, etc.
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M&A
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M&A
Other adjustments
• Let’s get back to the simple accretion/dilution example: Recall that we just lumped the acquirer and
target net incomes together.
• However, in reality there are several (sometimes very significant) adjustments to net income that will be
used in determining accretion/dilution:
• Acquisition financing
• Cost savings (synergies)
• Fees
• Accounting changes
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M&A
Acquisition financing
• In our simple example, we assumed 100% stock deal. In the case of a 100% cash (or mixed) deal, recall
that excess cash reserves must be used, or the acquirer must take on new debt to finance the acquisition.
• This new borrowing impacts the income statement in the form of incremental interest expense (or
forgone interest income), reducing the combined pro forma net income and EPS.
• In fact, the major adjustment to EPS in a cash deal is often the incremental interest expense arising from
additional debt issued to finance the deal.
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M&A
Fees
• Deal fees (IB, legal, and accounting fees): Need to be expensed as incurred on the income statement,
reducing PFNI and PF EPS.
• Financing fees: When a company borrows debt to finance an acquisition, the fees related to this
borrowing are treated differently from deal fees.
• Unlike deal fees, financing fees are not expensed . Instead, they are treated as a contra-debt, and
1
amortized over the life of the debt issuance as part of interest expense . This creates an incremental
expense which reduces PFNI over the term of the borrowing.
1Effective 2016, FASB has changed to accounting for financing fees so that instead of being capitalized as an asset and then amortized, they are
instead treated as a contra-debt item. The income statement impact is still the same (amortization is recognized over the term of the borrowing) but it
is classified within interest expense. To read more about this change at https://www.wallstreetprep.com/knowledge/debt-accounting-treatment-
financing-fees/
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M&A
Accounting adjustments
• Incremental D&A, asset write-ups, write-downs: Since target assets like PP&E and intangible assets
are written-up to fair market value in a deal, going forward, the acquirer will record higher D&A on those
written-up assets will be recorded, thereby reducing PFNI and PF EPS.
• Goodwill: Goodwill created in an acquisition does not impact the IS. There are 2 exceptions:
• Impairment: Acquirer’s have to annually “impairment test” their past acquisitions. If a deal done in
the past is determined to be a dud in hindsight, the acquirer must reduce the goodwill asset and
correspondingly recognizes an “impairment” expense on the income statement.
• Private companies: Private companies may elect to amortize their goodwill over 15 years.
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Technical Finance Interview Prep
Extra: M&A
Accounting
W W W. WA L L S T R E E T P R E P. C O M
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M&A Accounting
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M&A Accounting
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M&A Accounting
• While the GAAP basis is disclosed, the tax basis will likely be unknown to you.
• As a result, assumptions must be made and the framework introduced here provides for “rules of
thumb” in the typical context of limited information.
• A complete assessment of tax issues should always be conducted in consultation with qualified tax
advisors.
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M&A Accounting
1 In an asset sale, goodwill is tax deductible and amortized over 15 years, along with other intangible assets that fall under IRC
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M&A
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M&A Accounting
• To account for the higher future actual taxes (vs. GAAP taxes), a DTL is recognized on the acquisition date
in the amount of the total future differences.
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M&A Accounting
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M&A Accounting
400 400
Basis 300 300
200 200
150
100
0 0
0 1 2
Years
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M&A Accounting
Revisit PPA exercise I, deal structured as stock sale (no tax step-up)
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M&A Accounting
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M&A Accounting
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M&A Accounting
1Although the acquirer can’t use the NOLs, the target can use its own NOLs to offset the target’s gain on sale
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M&A Accounting
• The practical consequence of this is that acquirers can’t enjoy an immediate lump sum benefit of NOLs,
but rather see the tax benefits stretched over time. 2
1 Long term tax exempt rate is updated monthly and can be can be found at: https://apps.irs.gov/app/picklist/list/federalRates.html
2 Tax reform enacted in 2017 now also caps the amount of NOLs that can be used to 80% of taxable income, which has the impact of pushing NOL related benefits out
into the future. Offsetting this change is a new rule that lifts 20 year NOL carryforward period and enables companies to carryforward NOLs indefinitely.
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M&A Accounting
Summary
Remember! These guidelines make several critical assumptions about tax bases and the nature of
DTAs and DTLs – consult with tax professional when appropriate
1 Calculated as (FV book basis – tax basis) x tax rate. DTL reverses over time; goodwill higher due to new DTL
2 Although acquirer can’t use NOLs, the target can use to offset gain on sale
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Technical Finance Interview Prep
LBO
W W W. WA L L S T R E E T P R E P. C O M
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LBO
LBO questions
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LBO
LBO Jargon
• Financial sponsors = Private equity investors = Financial (vs. strategic) buyers
• Leveraged buyouts = PE-backed deals = Sponsor-backed deals
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LBO
$100
You sell the house 5 years later, $250
assuming you’ve paid down
$150 of the mortgage and $400
house price increased 30%
$400
1 1
𝐹𝐹𝐹𝐹 𝑁𝑁 $400,000 5
𝐼𝐼𝐼𝐼𝐼𝐼 = −1= − 1 = 32%
𝑃𝑃𝑃𝑃 $100,000
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LBO
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LBO
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LBO
Equity IRR
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LBO
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LBO
• Operating improvements: This usually means reducing costs (massive layoffs are often associated
with LBOs) thereby growing EBITDA.
• Successful exit: Exiting within 5-7 years at a high valuation (high EV/EBITDA multiple).
• Selling to a strategic or another PE firm.
• Selling to public via IPO.
• Alternatively, sponsors can monetize without a complete exit by giving themselves dividends financed
via newly borrowed debt (dividend recap).
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LBO
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LBO
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LBO
Capital structure
• What % of a company’s value can funded by debt?
• The amount of debt that can be raised depends on:
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LBO
• Option pool
• In addition, since most LBOs have oldco management stays on to run the newco, sponsors reserve
anywhere from 3%-20% of total equity for them.
• Warrants
• Certain lenders may receive equity as a sweetener for providing financing (mezzanine lenders).
1 Management rollover has historically ranges from 2 to 5% of the total equity in LBO
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LBO
LBO debt
• Leveraged loans: Revolver & term loans A/B/C/D
• Bonds: High-yield (“speculative-grade” or “junk”) bonds
• Mezzanine finance
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LBO
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LBO
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LBO
• Usually carries the same term and similar pricing as the term loan.
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LBO
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LBO
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LBO
Covenants
• As part of a loan, lenders will impose restrictions on borrowers (covenants).
• Financial covenants
• Other covenants
• Spend limits beyond pre-specified carve-outs (“basket”), borrower pledge to include lender in any
subsequent grant of a security interest (negative pledge), and forced call in the event of a downgrade.
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LBO
Covenants
• Maintenance covenants
• Required compliance with covenants every quarter, no matter what
• Incurrence covenants
• Required compliance with covenants only when taking a specified action (issuing new debt, dividends,
making an acquisition)
• Senior debt traditionally include restrictive maintenance covenants, whereas bonds only include
incurrence covenants
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LBO
Covenants
• Increasingly, leveraged loans are “covenant-lite” and include only incurrence covenants, amounting to
60% of new loan issuances in 1H 2014.
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LBO
Mezzanine
• Financing that sits between debt and equity.
• Hedge funds and mezzanine funds are the primary Mezzanine financing structures
investors, often tailoring the investment to • Convertible debt
meet the specific needs of the deal. • Bond with warrants
• Convertible preferred stock
• Preferred stock with warrants
Caution on terminology • Unsecured with few/any covenants
Mezzanine is sometimes more loosely Pricing components
defined as financing between secured debt Target blended return of 15-20%
and equity, which would place HYBs into the
1) Cash interest / dividends
category. For consistency, we will exclusively
refer to mezzanine as financing specifically 2) PIK interest / dividends
below HYBs 3) Warrants (“equity kicker”)
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LBO
Loans
• $1.5b TLC @ L + 300 w/1% LIBOR floor, covenant-lite, 5yr
• $2.0b asset-backed revolver ($750 drawn initially), 5yr
• $4.0b TLB @ L+375 w/1% LIBOR floor, covenant-lite, 6.5yr
High yield bonds
• $2b 1st lien bonds, 7yr
• $1.25b 2nd lien bonds, 8yr
Microsoft loan: $2b sub. note at 7.25% (~50% PIK), 10yr
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