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Breaking into Wall Street

Concept
Cost of equity

What impacts a DCF


analysis more
change in discount
rate or terminal value?

Reasons for M&A

Building a Merger or
Accretion/Dilution
model

100% Stock Deals and


P/Ex

Determining
Accretion / Dilution for
all Deals

Explanation
Alternative formula to CAPM:
Cost of equity = (Dividends per Share / Share Price) + Growth Rate
of Dividends
Generally not used as not all companies issue dividends. Useful for
companies in industries such as Utilities that issue and grow dividends at
stable, predictable rates.
1% increase/decrease in Discount rate makes far more of an impact that
1% increase/decrease in revenue, revenue growth or EBIT margins
because Discount rate affects everything in the analysis.
A Discount rate difference of 1% impacts analysis far more than a 1%
increase or decrease in Terminal Value because Terminal Value is a large
number and 1% is tiny.
Consolidation eg, four major players in the industry, no. 3 wants to
merge with no. 4 to take on no. 1 and 2 more effectively
Geographical expansion
Undervaluation of sellers business
Economies of scale
View seller as a threat
Gain access to patents, technology etc
Determine purchase price
Determine purchase method (cash, stock, debt)
Project financial profiles and statements of both buyer and seller
Valuation
Tax rates
Revenue
Operating income
Interest Income or (Expense)
Pre-Tax income and Net income
Shares outstanding and EPS
Combine buyer and sellers income statements
Calculate Goodwill and allocate purchase price
Combine balance sheets and adjust for acquisition effects
Adjust the combined income statement for acquisition effects
Calculate accretion/dilution and create sensitivity tables
In an all-stock deal, if buyer has higher P/E than seller, deal is accretive; if
buyer has lower P/E, it will be dilutive.
Eg. If seller has P/E 10x, you get $0.10 for each dollar you pay
(inverse of 10x). If seller has P/E of 8x, you get $0.125 for each dollar
you pay.
First, determine a few key variables:
Cost of cash = Foregone I/R on cash*(1 Buyers tax rate)
Cost of debt = I/R on debt*(1 Buyers tax rate)
Cost of stock = Reciprocal of Buyers P/E multiple
Yield of seller = Reciprocal of sellers P/E multiple
Take weighted average of each of buyers cost, eg. If 100% stock or 5050 stock/cash or 33-33-33 stock/cash/debt/, then compare to Yield of
seller. If it is less, will be accretive.
Note that synergies, new D&A etc are not been accounted for in this
formula, so this is really just a rough way of calculating accretion/dilution.

Also does not account for premium paid for seller.

Acquisition effects and


synergies

Cost synergies

LBO

*If buyer is confident about realising synergies, they will use more
cash than stock in the acquisition as they want all synergies to
themselves rather than to share with target.
Foregone interest on cash: buyer loses interest it would have
otherwise earned if it uses cash for acquisition, reducing pre-tax
income, net income and EPS.
Additional interest on debt: buyer pays additional interest expense
if it uses debt, reducing pre-tax income, net income and EPS.
Additional shares outstanding: if buyer pays with stock, it must
issue additional shares, reducing EPS.
Combined financial statements: after acquisition, sellers financial
statements are added to buyers, with few adjustments
Creation of goodwill & other intangibles: these balance sheet
items represent the premium that buyer paid over the sellers
shareholders equity, to ensure B/S balances.
PPE and Fixed asset write-up: you may write up values of these
assets in an acquisition, under the assumption that the market values
exceed the book values
Deferred tax liabilities: normally you write off sellers existing DTLs,
and then create new ones based on Buyers tax rate*(PPE and fixed
asset write-up and newly created intangibles)
Deferred tax assets: in most deals, you write these off completely,
depending on sellers tax situation
Transaction and financing fees: you expense legal and advisory
fees and deduct them from cash and retained earnings at the time of
the transaction, but you capitalise financing fees and then amortise
them over 5-10 years, or as long as newly issued Debt remains on
B/S.
Inter-company accounts receivable and accounts payable: you
may eliminate some of the combined AR and AP balances because
the buyer might owe the seller money and vice versa. Once they are
in the same company, this no longer make sense.
Deferred revenue write-down: accounting rules state you can only
recognise the profit portion of the sellers deferred revenue postacquisition. So you often write own the expense portion of the sellers
deferred revenue over several years in a merger model.
Reduction in force: i.e. laying off employees, getting rid of duplicate
functions
Building consolidation: if both buyer and seller lease buildings in
same city, consolidate into one larger space and save on rent.
In LBO, FCF refers to Cash flows from operations less Capex
Circular referencing and interest payments: in LBO models you
average the beginning and ending debt balances to determine annual
interest expense, but that also creates a circular reference because
the ending Debt balance depends on how much cash flow you had,
after paying for interest, and interest itself depends on ending debt
balance
What affects IRR?
- Purchase price
- % debt and % equity
- Exit price
- Revenue growth rate, EBITDA margins, interest rates, anything
else that affects cash flow on financial statements

APV

Definitive Agreement

Quick IRR calculations


- Doubling money in 5 years = 15% IRR
- Tripling money in 5 years = 25% IRR
- Doubling money in 3 years = 26% IRR
- Tripling money in 3 years = 44% IRR
Use of bank debt in LBO: If the PE firm or the company is concerned
about meeting interest payments and wants a lower-cost option, they
might use bank debt; they might also use bank debt if they are
planning on major expansion or Capital Expenditures and dont want
to be restricted by incurrence covenants.
Use of high yield debt: If the PE firm intends to refinance the
company at some point or they dont believe their returns are too
sensitive to interest payments, they might use high-yield debt. They
might also use the high-yield option if they dont have plans for major
expansion or selling off the companys assets.
Discount unlevered free cash flows with unlevered cost of equity (=
risk free rate + Beta unlevered*Market risk premium)
Calculate tax shield: DTS = tax rate*cost of debt*amount of debt
Value of firm = discounted unlevered FCF using unlevered cost of
equity + present value of tax shield present value of financial
distress
Discount rate to use for debt tax shield: If we assume risk of using tax
shield is same as risk of asset, use cost of unlevered equity (asset
beta). If risk of tax shield is same as risk of debt, use cost of debt
Difference between WACC and APV: WACC has a constant D/E
whereas APV removes this effect of a constant D/E.
Costs of financial distress:
- Bankruptcy cost like court fees
- Indirect bankruptcy costs like difficulty of managing a company
undergoing restructuring
- Conflicts of interest between bondholders and shareholders
leading to poor operating and investing decisions that may add to
losses
DA spells out the finalized deal terms that the buyer and seller are
agreeing to.
The Buyer and Seller, Price (per share, or lump sum for private
companies) and type of transaction
- Exchange ratios and collars
- Earn outs: Does the buyer pay the seller a portion of the
purchase price only if certain milestones, such as specific
revenue and EBITDA numbers, are achieved in the years after
the deal closes?
Treatment of outstanding shares, options, RSUs and other dilutive
securities
Representations and Warranties
Covenants
Solicitation (no shop vs go shop)
Termination fee: normally 2-3% of equity purchase price
Indemnification
Material adverse change and Material adverse effect

Common Industry
Multiples

Technical Interview Cheat Sheet


Concept
Ways to value a
company

Limitations of valuation
techniques

Walk me through a DCF


analysis

Unlevered free cash flow

Free cash flow to equity /


levered cash flow
Enterprise value

WACC

CAPM
Beta

Unlevering beta

Explanation
- DCF (intrinsic value), Trading Comps + Acquisition comps (relative
valuation)
- LBO in some cases if sponsor is assumed to be backing the deal,
determine if capital structure supports high debt level, sets floor price in
valuing a company.
- We use Sum-of-the-parts to value companies with different business
segments. Each segment is valued using the same valuation
methodologies above.
- DCF: dependent on assumptions, especially around terminal value (if
more than 75% of entire valuation, too dependent on assumptions),
does not reflect actual market price which buyer is willing to pay
- Trading comps: i) finding good comps ii) does not reflect control or
synergy premium
- Acquisition comps: i) may be difficult to find good comps ii)
determining a suitable time frame to search for good acquisition comps
- Project unlevered free cash flows into the future (5 year period on
average or till a steady state)
- Determine the terminal value of the company at end of projection
period, using exit multiple or perpetuity method
- Determine target capital structure in order to arrive at a suitable
WACC
- Discount all future cash flows and terminal value to present day
- We arrive at Enterprise value of the company
- EBIT(1-t) + D&A Capex Changes in Net working capital
- EBITDA Taxes Capex Changes in Net working capital
- Net income + (1-t)*Interest expense + D&A Capex Changes in
Net working capital
- Operating cash flow Capex + After-tax interest expense After-tax
interest income
FCFE = FCFF (1-t)*Interest expense Principal repayment
Or = Operating cash flow Capex Principal repayment
EV = MV of Equity + Net Debt or
EV = MV of Equity + MV Preferred Equity + MV Minority Interest + Net
Debt + Unfunded pension liabilities and other debt-like provisions
WACC = (D/V)*After tax cost of debt + (E/V)*Cost of equity
Cost of debt = risk free rate + corporate credit spread, observable from
market price of debt, or check with DCM teams
Cost of equity relies on CAPM
- WACC represents the opportunity cost of capital or what investors
could earn on another investment with similar risk profile. Commonly
seen as internal hurdle rate.
- Interest is tax deductible, so the overall cost of debt is actually lower
- As leverage increases, WACC with taxes lowers, until it goes beyond
the optimal capital structure, after which costs of financial destress
outweigh benefits of tax shield, resulting in higher WACC (higher cost
of equity demanded by equity holders, higher debt beta).
Expected return on equity = Risk free + Levered Beta*(Market Risk
Premium)
- Measure of how much a stock moves with the market given a
corresponding change in the market. If Beta of a stock is 1.6,
movement in the market by 1% results in a 1.6% change in movement
of the stock price
- Regression coefficient of stock price against market
- Commonly used in finding out beta for private companies

Treasury stock method

Common multiples

PEG ratio
Accretion / Dilution
analysis

LBO modelling

Deferred tax assets /

- Beta unlevered = Beta levered / [1+(1-t)*(D/E)]


- Way to calculate diluted no. of shares outstanding
- Assumes that all potentially dilutive, in-the-money options, are
exercised, resulting in an increase in number of basic shares
outstanding
- Proceeds from exercising these in-the-money options are used to
repurchase outstanding shares from the market
- Calculate net increase in no. of shares outstanding
- EV/EBITDA: commonly used, independent of capital structure making
companies comparable, but does not take into account intensity of
investment (capex + depreciation)
- EV / Revenue: revenue does not translate into profitability nor cash
flows
- EV / EBIT: differences in capex policies, potential acquisition-related
amortisation changes distorting use of this multiple
- P/E: easy to understand and widely used, used to value financial
companies, but distorted by differences in accounting treatment (GAAP
vs IFRS) and also leverage
- P/B: for banks as MV of equity almost equal to BV. P/E*ROE = P/B
- Expected P/E / Expected Growth rate
- PEG =1 fairly valued, >1 overvalued, <1 undervalued
- Accretion only if combined entitys pro forma EPS > acquirers EPS
- Pro forma EPS = [Acquirers net income + Targets net income +
After-tax incremental adjustments] / [Acquirers share outstanding +
new shares issued]
- After tax incremental adjustments: Interest expense if debt is raised,
amortisation & depreciation from write-up in assets, synergies
- High P/E company acquires low P/E company in an all-stock
transaction makes the deal accretive. Dilutive if low P/E company
acquires high P/E company. Accretive/dilutive effect is lessened if
transaction uses cash and stock.
- If all cash, and assuming raised from debt, look at earnings yield
(1/EPS). Earnings yield > after tax cost of debt, deal is accretive.
- Breakeven offer price = Projected Acquirers P/E multiple * Targets
project EPS
- If acquirer is confident synergies can be fully realised, it will use 100%
cash to acquire the target. If only half sure, use 50% cash and 50%
stock.
- EPS analysis limited, because it does not tell us if the transaction
makes strategic sense or not. Any company can acquire another one
using cheap debt but they may be in completely unrelated industries
- Using maximum debt to maximise return (IRR), use as little equity as
possible
- Value created through improving operations
- Basic LBO model: i) Make assumptions around purchase price
(EBITDA multiple), D/E ratio, cost of debt, operating assumptions like
revenue growth and EBITDA margins ii) Calculate debt and equity
funding amounts used for the purchase price iii) Build income
statement iv) Calculate FCFF v) Calculate ending purchase price and
IRR
- Good LBO candidate: i) strong cash flow generation ability ii) mature,
steady, practically boring iii) well established market player iv) limited
capex and product development requirements
- Credit ratios used: i) Total debt / EBITDA ii) Net debt / EBITDA iii)
EBITDA / Interest expense iv) (EBITDA Capex) / Interest expense
- Created during acquisition process

liabilities

LIFO vs FIFO

Operating leases vs
Capital leases

Calenderisation

Reasons to engage in
M&A
Key M&A considerations

Hostile takeover
defences

- DTA created when assets are being written down, less depreciation or
amortisation expense, higher taxes paid (on book). Opposite happens
for DTL (assets written up)
- In periods of rising prices, FIFO accounting leads to lower COGS and
higher net income. Opposite happens for FIFO.

- Operating leases are off balance sheet, capital leases treated as


liabilities on balance sheet
- Finance lease recognised only when criteria are met: i) PV lease
payments 90% MV of asset ii) Title of asset transferred automatically at
end of lease life iii) Term of lease is 75% of assets economic life iv)
Lessee has right to purchase the asset in the future at a price
considerably lower than fair market value v) Asset is so specialised
only the lessee can use it without substantial modification
- Converting operating lease to finance leases: i) Calculate average life
of lease by taking PV operating lease beyond certain year and dividing
that by last operating lease payment ii) Future lease payment
calculated by taking PV operating lease beyond certain year (terminal
value) divided by average life iii) Calculate NPV of operating lease (all
operating lease payments until end of lease life) iv) Calculate interest
expense v) Subtract interest expense from operating least payment,
add this figure to D&A vi) add back NPV lease obligation back to
Balance Sheet
- Early life of Operating lease, higher net income, lower operating cash
flows (more taxes paid), lower assets, lower D/E ratios compared to
Finance lease. Over time, it makes no difference
- Account for variations in fiscal year ends among comparable
companies
- Next calendar year sales = [(Month # * Current fiscal year actual
sales)]/12 + [(12 Month #)*(Next fiscal year sales)]/12
- Commercial synergies / growth opportunities
- Cost synergies / savings
- Strategic concerns
- Shareholder value
- Financial considerations: accretion/dilution, transaction structure,
capital structure, tax implications
- Strategic consideration
Poison pill (or shareholders rights plan): plan which gives
shareholders right to buy shares at a discount if one shareholder
(acquirer) buys a certain % or more of companys shares, diluting
acquirers share ownership
Staggered board of directors: groups of directors elected at
different times for multiyear terms, making it difficult for acquirer to
get majority vote
Greenmail: buy shares back from acquirer at a price it is willing to
sell
Increase leverage and spend all cash (special dividend)
Golden parachute: Provides executives with a significant
severance package if he/she loses job through firing, restructuring

Purchase Agreement key


terms

ROE breakdown

or even retirement.
Purchase Price: Stated as a per-share amount for public
companies.
Form of Consideration: Cash, Stock, Debt
Transaction Structure: Stock, Asset, or 338(h)(10)
Treatment of Options: Assumed by the buyer? Cashed out?
Ignored?
Employee Retention: Do employees have to sign non-solicit or
non-compete agreements? What about management?
Reps & Warranties: What must the buyer and seller claim is true
about their respective businesses?
No-Shop / Go-Shop: Can the seller shop this offer around and try
to get a better deal, or must it stay exclusive to this buyer?
DuPont ROE = (Net income / Pretax income)*(Pretax income /
EBIT)*(EBIT/Sales)*(Sales/Assets)*(Assets/Equity)

Or

Pitchbook content

Information
Memorandum

IPO process

ROE = (Net income/Sales)*(Sales/Assets)*(Assets/Equity)


Market overview
Transaction rationale
Competitor analysis
Historical financials
Valuation
Accretion/Dilution analysis
Synergies
Pro forma income
Used only when buyer expresses interest, signed NDA
Overview and key investment highlights
Products and services
Market
Sales & marketing
Management team
Financial results and projections
Risk factors
Appendices
Coordination: i) Planning of process ii) control and monitor work
streams
Documentation/Listing fillings: i) Prospectus ii) Due diligence iii)
Legal filings iv) Documents/contracts
Valuation / Equity story: i) Price range ii) Why is the company a
good investment?
Marketing: i) Roadshow, book building ii) Offer structure iii)
communication iv) Aftermarket (greenshoe, stabilisation)

M&A process