Technical Interview Prep 2018

WALL STREET PREP TRAINING MANUAL
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
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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
Wall Street Prep, Inc.
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Technical Finance Interview Prep
Basic Accounting
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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:
Types of accounting questions Common examples
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?”
Accounting definitions “What is working capital?”
• By the end of this section, you will be able to answer the most common basic accounting questions.
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Basic Accounting
Let’s start a business!

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

Balance sheets always show stuff at a specific point
in time – it’s a snapshot of what you own and owe.
Opening Balance Sheet
Assets 12/31/2018
Cash 100,000
Accounts Receivable (AR) 0
Inventories 20,000
Property, plant and equipment 30,000 Assets are the things you own. A summary of
Total Assets 150,000 how you used your funds – currently just your
loan (debt) and your own money (equity).
Liabilities 12/31/2018
Accounts Payable (AP) 0
Debt 50,000
Total Liabilities 50,000
Shareholders' Equity (SE) They always equal each other!

Common Equity 100,000
“Hey, what’s
Retained Earnings 0
retained earnings?” Total Shareholders' Equity 100,000
Liabilities and equity is a summary of the
Total Liabilities and Shareholders’ Equity 150,000 sources of your funds.
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Basic Accounting
You spend the next year selling lemonade!

• Revenue: You sold $100,000 in lemonade but collected only $80,000 in cash (customers still owe you
$20,000). Your revenue is $100,000 – not $80,000. That accrual accounting revenue represents what
you earned, not how much cash came in.
• 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
What does your income statement look like?
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Basic Accounting
The world’s simplest income statement
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
Interest expense (5,000) $50,000 x 10%

“earnings before taxes” Pretax profit (EBT) 50,000
Taxes (20,000) 40% tax rate

“bottom line” Net Income 30,000
Earnings per share (EPS) $3.00 Net income / Weighted average shares outstanding
There are many names What’s amortization?

for profit in finance When the thing you’re depreciating is an intangible
asset (like a patent or customer list), the expense is
called amortization instead of depreciation.
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Basic Accounting
What does the year end balance sheet look like?

Hint: Remember retained earnings?
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Basic Accounting
How the income statement is connected to the balance sheet
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
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
The problem with the income statement (and accrual accounting)

• The good: The income statement is great because it adheres to accrual accounting. It matches revenues
with expenses to provide investors with a picture of profitability undistorted by the related cash flows.
But accrual accounting isn’t perfect …
• The bad #1: Accrual relies on management assumptions.

• Remember depreciation? Calculating it relied on an assumption of useful life. A company interested in
showing higher net income needs only to assume a higher useful life!
• In fact, accrual accounting requires many such assumptions that allow for management discretion
(and manipulation) and makes comparisons of profits across companies more difficult.
• The bad #2: Accrual tells you nothing about what’s happening to cash. And cash matters a lot.
• Imagine a company that shows positive accrual-based profits (net income) but can’t seem to collect any
of its sales (its customers pay on credit and take forever to pay – or just don’t pay at all). In this case,
the income statement might show a celebration-worthy amount of profits while the company runs out
of cash and goes bankrupt.
• The solution: The cash flow statement

• The cash flow statement is #3 of the big 3 financial statements. It reconciles accrual profits (net
income) to the impact of operations and other activities on cash.
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Basic Accounting
The cash flow statement layout

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

Reconciles net income to cash generated from operations.
Cash from investing:

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

Looks at inflows of cash from investors such as banks and shareholders as
well as the outflow of cash to shareholders as dividends or to lenders as
repayments of debt.
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Basic Accounting
What does the cash flow statement look like?

Let’s construct the cash from operations section first…
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Basic Accounting
Start with net income (indirect method)

Rather than directly showing what
happened to cash during the period (direct
method), the preferred presentation starts
with net income from the income
statement (indirect method).
Cash flow statement
Net income 30,000

Adjustments
How do I adjust net
income to get to cash
from operations?
Cash from operations 40,000
We already solved this earlier

using a direct approach. Now
we just have to figure out how
to get there from net income.
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Basic Accounting
Cash flow statement

The depreciation & Net income 30,000

amortization addback is Depreciation & amortization 10,000
usually the biggest
adjustment on the CFS Changes in operating assets and liabilities (aka working capital):
Accounts receivable (A/R) (20,000)
Inventories 20,000
Working capital: The most confusing part of the CFS

What ties these together is that they’re assets and liabilities directly
related to the operations of the company (as opposed to financing and
investing activities) and are thus classified here.
• Notice that the $20,000 increase in A/R on the B/S needs to be
treated as a reduction to net income because net income captures
$100,000 in revenues and we just want the $80,000 in cash here.
• Meanwhile, the $20,000 reduction in inventories on the B/S needs to
be treated as an increase to net income because net income captured Deep dive: Working capital
www.wallstreetprep.com/knowledge/working-capital-101/
a $20,000 COGS expense that was non-cash
• These two items illustrate a broad rule: Increases in assets are
reflected in the cash flow statement as outflows, while decreases in
assets are reflected in the CFS as inflows.
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Basic Accounting
Let’s take it up a notch

• Adding to our example, what if during the year, the following additional events took place:
• You bought $30,000 in new inventories to replenish supply ($20,000 in cash, $10,000 on credit).
• 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).
• You paid yourself a $10,000 dividend.
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Basic Accounting
Cash Flow Statement, Updated

Net income 30,000

Depreciation & amortization
Changes in operating assets and liabilities:

Accounts receivable
Inventories
Accounts payable
Cash from operations
Capital expenditures
Other investments
Cash for investing
New debt borrowing

Pay-down of debt
New equity issuance
Dividends
Cash from financing
Beginning cash – 12/31/2018 100,000

Net change in cash
Ending cash – 12/31/2019
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Basic Accounting
Cash Flow Statement, Updated

Net income 30,000

Depreciation & amortization 10,000 Beginning Inventories 20,000
COGS during period (20,000)
Changes in operating assets and liabilities: Purchases during period 30,000
Accounts receivable (20,000) Ending inventories 30,000
Inventories (10,000)
Cash impact (10,000)
Accounts payable 10,000
Capital expenditures (40,000)

Other investments (100,000)
Cash for investing (140,000)
New debt borrowing 100,000

Pay-down of debt 0
New equity issuance 0
Dividends (10,000)
Cash from financing 90,000
Beginning cash – 12/31/2018 100,000

Net change in cash (30,000) Net change in cash is the sum of all
three CFS sections
Ending cash – 12/31/2019 70,000
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Basic Accounting
What does the updated year-end balance sheet look like?
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Basic Accounting
Balance Sheet, Updated

Change from
Assets 12/31/19 prior year
Cash 70,000 -30,000
Investments 100,000 +100,000
Inventories 30,000 +10,000
Property, plant and equipment 60,000 +30,000
Total Assets 280,000 +130,000
Accounts Payable (AP) 10,000 +10,000
Debt 150,000 +100,000
Income Statement Total Liabilities 160,000
Revenues 100,000 Shareholders' Equity (SE)
Cost of goods sold (COGS) (20,000) Common Equity 100,000
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
It’s time for interview questions!
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Intermediate
Accounting
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Intermediate Accounting
Let’s start a business!

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

Balance sheets always show stuff at a specific point
in time – it’s a snapshot of what you own and owe.
Opening Balance Sheet
Assets 12/31/2018
Cash 100,000
Accounts Receivable (AR) 0
Inventories 20,000
Property, plant and equipment 30,000 Assets are the things you own. It’s a summary of
Total Assets 150,000 how you used your funds – currently just your
loan (debt) and your own money (equity).
Accounts Payable (AP) 0
Debt 50,000
Shareholders' Equity (SE) They always equal each other!

Common Equity 100,000
“Hey what’s retained
Retained Earnings 0
earnings?” Total Shareholders' Equity 100,000
Liabilities and equity is a summary of the
Total Liabilities and Shareholders’ Equity 150,000 sources of your funds.
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The world’s simplest income statement
Income Statement
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
Interest expense (5,000) $50,000 x 10%

“earnings before taxes” Pretax profit (EBT) 50,000
Taxes (20,000) 40% tax rate

“bottom line” Net Income 30,000
There are many names What’s amortization?

for profit in finance When the thing you’re depreciating is an intangible
asset (like a patent or customer list), the expense is
called amortization instead of depreciation.
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The world’s simplest cash flow statement
Cash flow statement

The depreciation & amortization addback For the year ending 12/31/2019
is usually the biggest adjustment on the
Net income 30,000
CFS
Depreciation & amortization 10,000
Changes in operating assets & liabilities (aka working capital):

Working capital Accounts receivable (A/R) (20,000)
• The $20,000 increase in A/R on the B/S Inventories 20,000
needs to be treated as a reduction to net Cash from operations 40,000
income because net income captures
$100,000 in revenues and we just want Capital expenditures 0
the $80,000 in cash here. Other investments 0
• The $20,000 reduction in inventories on Cash for investing 0
the B/S needs to be treated as an
increase to net income because net New debt borrowing 0
Pay-down of debt 0
income captured a $20,000 COGS
expense that was non-cash
Dividends 0
• These two items illustrate a broad rule: Cash from financing 0
Increases in assets are reflected in the
cash flow statement as outflows, while Beginning cash – 12/31/2018 100,000
decreases in assets are reflected in the Net change in cash 40,000
CFS as inflows. Ending cash – 12/31/2019 140,000
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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
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
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
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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Let’s take it up a notch… For simplicity ignore any

additional COGS related to
• During the year, the following additional transactions occurred: gift card related revenue
• 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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What does the updated income statement look like?
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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%
$10,000 in utilities are recognized in current period,

Selling, general & administrative (SG&A) (15,000) (29,000) next year’s prepayments are recognized as a “prepaid
EBITDA 65,000 53,000 expenses” asset on the B/S
The $4,000 bonus is recognized in the year it was

earned, not the year it will be paid. But since it hasn’t
Depreciation & amortization (D&A) (10,000) (10,000)
been paid, it is recognized as an accrued liability
Operating Income (aka EBIT) 55,000 43,000
Interest expense (5,000) (5,000)

Interest income 0 1,000 $1,000 represents 50% of 100,000 yielding 2%
Pretax profit (EBT) 50,000 39,000
Taxes (20,000) (15,600)

Net Income 30,000 23,400
Dividends 0 10,000
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What does the year-end balance sheet look like?
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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 ???
Relates to the inventories paid for with supplier credit

Liabilities 12/31/2018 12/31/2019
Accounts Payable (AP) 0 10,000
Employee bonus already earned but still owed
Acrrued expenses 0 4,000
Deferred revenue 0 3,000 You sold some gift cards but didn’t earn the revenue
Debt 50,000 250,000 from those sales yet. When that happens, this liability
Total Liabilities 50,000 267,000 converts to revenue.
Shareholders' Equity (SE)

Common Equity 100,000 100,000
Retained Earnings 0 13,400
Prior period RE + net income, less dividends
Total Shareholders' Equity 100,000 113,400
Total Liabilities and Shareholders’ Equity 150,000 380,400
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What does the cash flow statement look like?
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Cash flow statement

Working capital: Always the trickiest For the year ending 12/31/2019
• Calculating these is easy: increases in Net income 23,400
assets are outflows and increases in Depreciation & amortization 10,000
liabilities are inflows Changes in operating assets & liabilities (aka working capital):
• But can you explain why? It always goes Accounts receivable (A/R) (20,000)
back to accrual vs cash: Net income Inventories (10,000)
includes revenue that hasn’t yet been
Prepaid expenses (2,500)
received, reflects only the expensing of
Accounts Payable (AP) 10,000
inventories that were used up during the
Accrued expenses 4,000
period, etc.
Deferred revenue 3,000
Capital expenditures (40,000)

Other investments (100,000)
Cash for investing (140,000)
New debt borrowing 200,000

Pay-down of debt 0
Dividends (10,000)
Cash from financing 190,000
Beginning cash – 12/31/2018 100,000

Net change in cash 67,900
Ending cash – 12/31/2019 167,900
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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
Property, plant and equipment 30,000 60,000
Total Assets 150,000 380,400
Liabilities 12/31/2018 12/31/2019

Acrrued expenses 0 4,000
Deferred revenue 0 3,000
Debt 50,000 250,000
Total Liabilities 50,000 267,000

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It’s time for interview questions!
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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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Extra credit I
Stock-based compensation (SBC) of $7,000 is classified within SG&A because that’s

where the employees’ regular salary is classified. SBC for employees classified
under R&D or COGS will be embedded within those categories.
Sometimes, companies report “adjusted” EBITDA to exclude SBC – in this case,

adjusted EBITDA would be unchanged at 53,000.
An inventory write-down hits the income statement as an expense. It can be

identified separately by the company in its own line items below operating profit or
not identified separately and instead simply embedded within COGS. Write-downs
are generally treated as non recurring and ignored when calculating non GAAP
profits like EBITDA.
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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Extra credit I
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Extra credit I
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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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Extra credit II
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Extra credit II
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Extra credit II
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Valuation
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Valuation
4 types of valuation questions
General valuation Discounted cash flow (DCF)

and corporate finance “Walk me through a DCF.”
“How do you value a company?”
“When would a DCF be an
“What’s the difference between inappropriate valuation method?”
enterprise value and equity value?”
“What’s the difference between
levered and unlevered FCF?”
Comps (Trading and Transaction) Industry/product specific

“Which multiples are the most popular in valuation?” “How do you value a bank? (or XXX industry)?”
“When would comps be preferable to DCF?” “How do you value a private company?”
“How do you value Bitcoin?”
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Valuation
Introduction to valuation
• Valuation is … the process of determining the “right” value of a business.
• Valuation is NOT … an exact science; Several approaches are used.
• Valuation is … influenced by the objectives of those doing the valuation.
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Valuation
Valuation is central to many areas of finance
Investment Banking (“The Sell Side”)
• When the client is the buyer: What is the best (usually lowest) price we can negotiate?
• When the client is the seller: What’s the best (usually highest) price we can negotiate?
• When the client is a company going public: What’s the right pricing for our IPO?
“The Buy Side” Corporations
• Should we buy, sell or hold positions • 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
Download the “Buy Side vs Sell Side” Cheat Sheet

• https://www.wallstreetprep.com/knowledge/finance-careers-overview/
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Valuation
Enterprise value vs equity value

• When valuing a company, we have to be clear about “value of what?”
• Specifically finance professionals often explicitly want to value two (very related) things:
• Equity value
• The value of the business to the owners.
• Equity value is the amount you would get to put in your pocket if you sold your lemonade stand.
• Enterprise value
• In addition to equity value, finance professionals also want to explicitly value the enterprise.
• What is the enterprise? It is the value of the operations – not the equity.
52
Valuation
Price of house: $1,000,000

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

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

equity value are linked
Mortgage: $800,000 Equity value If the house value jumps from
That’s your debt $200,000 $1,000,000 to $1,500,000,
your equity value jumps to
$700,000.
53
Valuation
Enterprise value vs equity value

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

“Enterprise value” instruments like capital leases, non-controlling interests, preferred stock
(Operating assets – operating liabilities) + (cash – debt) = Equity value
Includes cash as well as nonoperating assets like

marketable securities, short term investments,
equity investments
This is the formula you’ll see
everywhere. Finance
professionals often just net cash
Or, more simply:
against the debt in this formula to
arrive at a “net debt” figure. Enterprise value – net debt = Equity value
54
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?
Inventories 20,000 30,000 Approach 1: Direct
Operating assets
Total Assets 150,000 380,400 Operating liabilities
Enterprise value
Liabilities 12/31/2018 12/31/2019 Equity value

Acrrued expenses 0 4,000 Approach 2: Indirect
Equity value
Debt 50,000 250,000
Total Liabilities 50,000 267,000 Net debt
Enterprise value

55
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?
Inventories 20,000 30,000 Approach 1: Direct
Operating assets 112,500
Total Assets 150,000 380,400 Operating liabilities 17,000
Enterprise value 95,500
Liabilities 12/31/2018 12/31/2019 Equity value 113,400

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

56
Valuation
Book value doesn’t usually tell you that much

• So are we done? Does our lemonade stand really have equity of 113,400 and an
enterprise value of 95,500?
• No … our lemonade stand’s value is not a function of what the balance sheet tells us.
• In fact, businesses are usually worth more than their “book” values because real value is a function of
future expectations, not historical carrying values
Do finance professionals ever rely on “book values”?

• Yes, when valuing financial institutions. That’s because the balance sheet values of bank assets (loans
and investments) and liabilities (deposits) tend to not deviate too far from actual fair value (unlike PP&E
and intangible assets).
• The other major exception is when doing a “liquidation analysis” for a troubled company.
57
Valuation
Book value vs. market value

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

• Google has an equity book value of $153b per the company’s 2017 10K.
• Google shares trade at $1,200.
• With 700m shares outstanding, this implies an equity market value (market
cap) of $840 billion.
• Google has $100b in cash, $4b in debt per the company’s implying
(market) enterprise value of $840b + ($4b-$100b) = $744b.
58
Valuation
Most common valuation methods in finance
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.
59
DCF
v
DCF
Before we get started: Present value basics

• The DCF approach requires that we forecast a company’s cash flows into the future and discount them to
the present in order to arrive at a present value for the company. That present value is the amount
investors should be willing to pay (the company’s value).
• We can express this formulaically as (we denote the discount rate as r):
• So, let’s say you’re promised $1,000 next year and decide you’re willing to pay $800. We can express this
(and solve for r) as:
• If I make the same proposition but instead of only promising $1,000 next year, let’s say I promise $1,000
for the next 5 years. The math gets only slightly more complicated:
61
DCF
Present value basics

• In Excel, you can calculate this fairly easily using the PV function (see below). However, if cash flows are
different each year, you will have to discount each cash flow separately:
62
DCF
Unlevered vs levered DCF

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

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

• Forecast and discount the cash flows that remain available to equity shareholders after cash flows to
all non-equity claims (i.e. debt) have been removed. That gets you equity value. Add back net debt
and you will get enterprise value.
• Both should theoretically lead to the same enterprise value and equity value at the end (though in
practice it’s actually pretty hard to get them to exactly equal).
• The unlevered DCF approach is the most common!
63
DCF
6 steps to building a DCF

1. Forecasting unlevered free cash flows (UFCFs)
• Step 1 is to forecast the cash flows a company generates from its core operations after accounting for
all operating expenses and investments. These cash flows are called “unlevered free cash flows.”
2. Calculating terminal value
• You can’t keep forecasting cash flows forever. At some point, you must make some high level
assumptions about cash flows beyond the final explicit forecast year by estimating a lump-sum
value of the business past its explicit forecast period.
• That lump sum is called the “terminal value.”
3. Discounting the cash flows to the present at the weighted average cost of capital
• The discount rate that reflects the riskiness of the UFCFs is called the weighted average cost of
capital (WACC). Because unlevered free cash flows represent all operating cash flows, these cash
flows “belong” to both the company’s lenders and owners.
• As such, the risks of both providers of capital need to be accounted for using appropriate capital
structure weights (hence the term “weighted average” cost of capital). Once discounted, the present
value of all UFCFs is the enterprise value.
64
DCF

4. Add the value of non-operating assets to the present value of UFCFs
• The ultimate goal of the DCF is to get at what belongs to the equity owners (equity value).
• Therefore, if a company has any non-operating assets such as cash or has some investments just
sitting on the balance sheet, we must add them to the present value of UFCFs.
• For example, if we calculate that the present value of Apple’s unlevered free cash flows is $700
billion, but then we discover that Apple also has $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
65
DCF

6. Divide the equity value by the shares outstanding
• The equity value tells us what the total value to owners is.
• But what is the value of each share?

• In order to calculate this, we divide the equity value by the company’s diluted shares outstanding.
• For public companies, the equity value per share that the DCF spits out can now be compared to the
market share price.
66
DCF
Calculating the unlevered free cash flows (FCF)

• Here is the unlevered free cash flow formula:
Unlevered FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures
• EBIT: Earnings before interest and taxes. This represents a company’s GAAP-based operating profit.
• Tax rate: The tax rate the company is expected to face. When forecasting taxes, we usually use a
company’s historical effective tax rate.
• D&A: Depreciation and amortization.
• Change in NWC: Annual changes in net working capital. Increases in NWC are cash outflows while
decreases are cash inflows.
• Capital expenditures: Represents cash investments the company must make in order to sustain the
forecast growth of the business. If you don’t factor in the cost of required reinvestment into the business,
you will overstate the value of the company by giving it credit for EBIT growth without accounting for the
investments required to achieve it.
How does compare unlevered FCF to cash from operations?

Instead of net income, tax-adjusted EBIT is the starting point – which represents accounting profits just from operations (as
opposed to just to equity owners which is what net income shows). The rest are the same adjustments you would see on a cash
flow statement to get to cash from operations, less capital expenditures (which is usually the big piece of the investing activities
section).
67
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
• Formula for a 2-stage DCF with a 5 year explicit forecast period:
UFCF1 UFCF2 UFCF3 UFCF4 UFCF5 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣

Enterprise value = + + + + +
(1+wacc)1 (1+wacc)2 (1+wacc)3 (1+wacc)4 (1+wacc)5 (1+wacc)5
Notice that the terminal value

itself needs to be discounted back
to the present because it reflects
the value of the future cash flows
at the final explicit forecast year!
68
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).
2. Exit EBITDA multiple method

• The big problem with the perpetuity approach above is that it forces finance professionals to
explicitly guess the perpetual growth rate of a company. In practice, it’s usually a range between 3-
5% because it’s in-line with macroeconomic growth expectations and anything higher is considered
unjustifiable. A way around having to guess a company’s long-term growth rate is to guess the
EBITDA multiple the company will be valued at the last year of the Stage 1 forecast. A common way
to do this is to look at the current enterprise value (EV) /EBITDA multiple the company is trading at
(or the average EV/EBITDA multiple of the company’s peer group) and assume the company will be
valued at that same multiple in the future. For example, if Apple is currently valued at 9.0x its last
twelve months (LTM) EBITDA, assume that in 2022 it will be valued at 9.0x its 2022 EBITDA.
69
DCF
70
DCF
Imagine that we calculate the following UFCFs for Apple:
Refers to changes in ‘net

working capital’
71
DCF
But Apple is expected to generate UFCFs beyond 2022 so now what?
72
DCF
Let’s also try the EBITDA approach
73
DCF
Growth in perpetuity vs. exit EBITDA multiple method

• Investment bankers and private equity professionals tend to be more comfortable with the EBITDA
multiple approach because it infuses market reality into the DCF.
• A private equity professional building a DCF will likely try to figure out what he/she can sell the company
for 5 years down the road, so this arguably provides a valuation that factors in the EBITDA multiple.
• However, this approach suffers from a significant conceptual problem: It uses current market valuations
in the DCF, which arguably defeats the whole purpose of the DCF.
• Making matters worse is the fact that the terminal value often represents a significant percentage of the
value contribution in a DCF, so the assumptions that go into calculating the terminal value are all the
more important.
74
DCF
Getting to enterprise value: Discounting the cash flows by the WACC

• Quantifying the discount rate, which in this case is the weighted average cost of capital (WACC), is a
critical field of study in corporate finance.
• You can spend an entire college semester learning about it.
• Here’s the bottom line:

1. Risk & return are two sides of the same coin:
• The UFCFs we forecasted are not a sure thing because companies may not achieve the UFCFs we
expect. Even worse, companies can go bankrupt.
• The DCF values a company by calculating the PV of those UFCFs. Another way to think of this is an
attempt to figure out what an investor today might be willing to pay for those uncertain UFCFs.
• To do that, you’d need to figure out what kind of return the investors want. And to do that, you
would need to quantify the riskiness of those UFCFs somehow. That’s because an investor’s return
requirements fundamentally depend on how they perceive the risks of those future UFCFs.
75
DCF

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

3. Capital structure determines the cost of capital weights
• The appropriate discount rate to use in the unlevered DCF has to blend the cost of debt and cost of
equity. The appropriate weight placed on both costs depends on the company’s expected capital
structure (debt/equity mix) over the discount period. That’s why its called a weighted average cost
of capital – it’s weighing cost of debt and cost of equity based on the debt/equity mix in the capital
structure.
4. Putting it all together – the WACC formula
Cost of equity
Risk free rate +β x equity risk premium
Cost of Tax shield
debt
77
The debt weight The equity weight

Debt as a % of Debt as a % of total
total capital capital
77
DCF
The WACC formula Cost of equity

Risk free rate +β x equity risk premium
WACC
Debt weight Market value of a company’s debt. Can be approximated by using a company’s book value of debt.
The equity weight Market value of a company’s equity (either market cap or comps derived equity value)
Cost of debt The yield on a company’s debt. Cost of debt ≠ nominal interest rate (i.e. coupon rate)
Tax rate The tax rate the company expects to face going forward
Cost of equity Cost of equity = Risk free rate + β x equity risk premium
Cost of equity
Risk free rate Yield on a default-free government bond. The current yield on a U.S. 10-year bond is the preferred
RFR for U.S. companies. Front page of WSJ, financial data sites all show up to date yields
Beta β measures a company’s sensitivity to systematic (market) risk.
• β = 0 means no market sensitivity (cash, for example)
• β < 1 means low market sensitivity (consumer staples, for example)
• β > 1 means high market sensitivity (luxury goods, for example)
• β < 0 negative market sensitivity (gold, for example). Bloomberg is good source for β
Equity risk 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
Getting to equity value: Subtracting net debt

• Recall this is really 2 steps: Adding the value of cash and other non-operating assets and subtracting debt
and equivalents:
Here is Apple’s 2016 year-ending

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

inventory and intangible assets, the
carrying value of non-operating assets
on the balance sheet is usually fairly
close to their actual value. That’s
because they are mostly comprised of
cash and liquid investments that
companies generally can mark up to
fair value.
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DCF
Here is Apple’s 2016 year-ending

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

finance professionals usually just use
the latest balance sheet values of
these items as a proxy for the actual
values. The market value of debt
doesn’t usually deviate too much from
the book value unless market interest
rates have changed dramatically since
the issue, or if the company’s credit
profile has changed significantly.
80
DCF

• Apple has a substantial negative net debt balance.
• For companies that carry significant debt, a positive net debt balance is more common, while a negative
net debt balance is common for companies that keep a lot of cash.
81
DCF
From equity value to equity value per share

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

• Next, add the effect of dilutive shares.
• These are shares that aren’t quite common stock yet, but that can become common stock and thus be
potentially dilutive to the common shareholders (i.e. stock options, warrants, restricted stock and
convertible debt and convertible preferred stock).
• Assuming 50 million dilutive securities for Apple, we can now put all the pieces together (next page).
83
DCF
84
DCF
The DCF is sensitive to assumptions. Garbage in = Garbage out

• What are the key assumptions in a DCF?
1. The operating assumptions (revenue growth and operating margins)
2. The WACC
3. Terminal value assumptions: Long-term growth rate and the exit multiple
• Each of these assumptions is critical to getting an accurate model.
• In fact, the DCF model’s sensitivity to these assumptions, and the lack of confidence finance
professionals have in these assumptions, (especially the WACC and terminal value) are frequently cited as
the main weaknesses of the DCF model.
85
DCF
In summary …
Projecting free Calculating the

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

per share
86
DCF
Stage 1: Unlevered free cash flow projections

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

EBIT (aka operating income)
EBIT x [1 – tax rate] (aka EBIAT or NOPAT)
Plus: Depreciation and amortization
Less: Increases in net working capital (NWC)
Less: Capital expenditures
Equals: Unlevered free cash flows
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DCF
Stage 2: Terminal value

• We cannot reasonably project cash flows beyond a certain point.
• As such, we make simplifying assumptions about cash flows after the explicit projection period to
estimate a terminal value that represents the present value of all the free cash flows generated by the
company after the explicit forecast period.
• Analysts use both the perpetual growth and exit multiple methods to estimate terminal value
Perpetuity approach
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡 𝑥𝑥 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 Exit multiple approach
88
DCF
Discount using WACC
UFCF1 UFCF2 UFCF3 UFCF4 UFCF5 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣

Enterprise value = + + + + +
(1+wacc)1 (1+wacc)2 (1+wacc)3 (1+wacc)4 (1+wacc)5 (1+wacc)5
• Now you have enterprise value…
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DCF
Subtract net debt

• Enterprise value – net debt = equity value
• Net debt = gross debt & equivalents – cash & equivalents
• Debt and equivalents include straight debt (loans, revolver, bonds) as well as debt-like instruments like
capital leases, non-controlling interests and preferred stock.
• Cash and equivalents include cash as well as non-operating assets like marketable securities, short-term
investments and equity investments.
Net Debt
Debt & equivalents
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
Levered DCF summary
Levered free cash flows

Perpetuity approach
Net income
Plus: Depreciation and amortization
Less: Increases in working capital assets
Plus: Increases in working capital liabilities
Less: Capital expenditures
Exit multiple approach
Plus: Debt Issuance, net of repayments For levered DCF, use equity multiples such as P/B or P/E
Less: Preferred dividends 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑡𝑡 𝑥𝑥 𝑃𝑃/𝐵𝐵 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
Equals: Levered free cash flows
LFCF1 LFCF2 LFCF3 LFCF4 LFCF5 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣

𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄 𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯 = + + + + +
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)5
cost of equity r = risk free rate + Beta x Market risk premium
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DCF
DCF Advantages
• Theoretically, the most sound method of valuation.
• Less influenced by temperamental market conditions or non-economic factors.
• Can value components of business or synergies separately from the business.
DCF Disadvantages
• Present values obtained are sensitive to assumptions and methodology.
• Terminal value represents a significant portion of value and is highly sensitive to valuation assumptions.
• Need realistic projected financial statements over at least one business cycle (5 to 10 years) or until cash
flows are “normalized.”
• Sales growth rate, margin, investment in working capital, capital expenditures and terminal value
assumptions along with discount rate assumptions are key to the valuation.
92
Extra: WACC
v
WACC
WACC: The equity weight
The equity weight

Should reflect the market value of a company’s equity
• If the market value of a company’s equity is readily observable (i.e. for a public company), equity
value = diluted shares outstanding x share price.
• If the market value of is not readily observable (i.e. for a private company), estimate equity value
using comparable company analysis.
• The key point here is that you should not use the book value of a company’s equity value, as this
method tends to grossly underestimate the company’s true equity value and will exaggerate the debt
proportion relative to equity.
94
WACC
WACC: The debt weight
The debt weight

The book value is usually sufficiently close to the market value of debt that it can be used
• Most of the time you can use the book value of debt from the company’s latest balance sheet as
an approximation for market value of debt.
• That’s because unlike equity, the market value of debt usually doesn’t deviate too far from the
book value.
95
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.
Cost of debt ≠ nominal interest rate (i.e. coupon rate) Bloomberg is

the best source
Cost of debt = yield on the company’s debt for yields
96
WACC
The yield1 of 1.3% is significantly

lower than the 5.7% coupon rate
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.
97
WACC
Cost of debt
• Companies that do not have public debt but have a credit rating
• Use the default spread associated with that credit rating and add to the risk-free rate to estimate the
cost of debt.
• Credit agencies such as Moody’s and S&P provide yield spreads over U.S. treasuries by credit rating.
• Companies with no rating

• Use the interest rate on its latest long-term debt or calculate the company’s interest coverage ratio
(EBIT/interest) and apply the default spread for the credit rating most closely associated with your
company’s interest coverage ratio.
• Damodaran Online1 publishes a table that lets you map a credit rating based on interest coverage.
1 Damodaran Online: http://pages.stern.nyu.edu/~adamodar/
98
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:
Cost of equity = Risk free rate + β x equity risk premium
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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.
• The risk-free rate (RFR): The RFR measures the yield on a

default-free government bond. The current yield on a U.S.
10-year bond is the preferred RFR for U.S. companies. For
European companies, the German 10-year is the preferred
RFR. The Japan 10-year is preferred for Asian companies.
Yields on government bonds (Source: WSJ, 11/6/2017)
100
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.
101
WACC
Putting it all together: WACC in practice

• Here’s an example of how Apple’s WACC might be calculated in practice.
102
Extra: Industry Beta
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…
104
Industry Beta
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:
Industry β Unlevered = Median of peer group βUnlevered
3. Relever the industry beta using the target company’s specific debt-to-equity ratio and tax rate using
the following formula:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
Target company βLevered = Industry βUnlevered x 1+ (1−tax rate)
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
105
Industry Beta
• Here’s an example of what an industry beta calculation might look like for Apple.
106
Relative Valuation
v
Relative Valuation
Relative valuation
• While the DCF looks at the intrinsic cash flow-generating potential of a business to determine its value, a
seemingly simpler and more market driven approach is available: looking at how similar companies are
valued.
• This approach is called relative valuation, an umbrella term describing two valuation approaches:
• Trading comparables
• Valuing a firm by looking at the stock market value of similar companies.
• Transaction comparables
• Valuing a firm by looking at prices acquirers have recently paid for similar companies,
• While the DCF requires explicit assumptions about the future, relative valuation – or “comps” – has the
advantage of requiring no explicit assumptions about a company’s future prospects, and is based on
“reality” – observable prices for similar companies in the market.
• Of course, relative valuation has no shortage of disadvantages, and we’ll get to those shortly.
Deep dive: Relative vs Intrinsic Valuation in Investment Banking

https://www.wallstreetprep.com/knowledge/really-trust-dcf-model-made-investment-bankers/
108
Relative Valuation
Multiples – not absolute values

• When you try to gauge the fair value of your house by comparing to the values of houses nearby, you’re
doing a comps analysis.
• But companies are trickier to value than houses because finding truly comparable companies is difficult.
• Even if you find comparable businesses operationally, you need to standardize for various factors, most
notably size differences.
• That’s why we don’t compare absolute values but rather multiples, with some of the most popular being:
EV multiples
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
109
Relative Valuation
The primary challenges of doing a comps analysis correctly

• Selecting truly comparable companies. (Virtually impossible, so we do the best we can.)
• Selecting the right multiple. (EV/EBITDA vs. P/E vs. P/B, etc.)
• Selecting the right timeframe. (EV/LTM EBITDA vs. EV/Forward EBITDA, etc.)
• “Scrubbing” the multiple. (EBITDA should exclude nonrecurring items and should be calculated
consistently across all companies.)
110
Relative Valuation
Trading comps analysis: the process

1. Select comparable companies (peer group).
2. Pick which multiples you will use (EV/EBITDA, P/E).
3. Pick which timeframe you will use.

• Last twelve months (LTM)
• Forecast basis (1 year forward or 2 year forward)
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.
111
Relative Valuation
Comparable company analysis exercise

$ in millions, expect per share data
Company Colgate
Share price $30.00
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200
Peer group EV/Sales EV/EBITDA P/E

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

Is Colgate overvalued based on comps?
112
Relative Valuation
Comparable company analysis exercise

$ in millions, expect per share data
Company Colgate
Share price $30.00
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200
EV/Sales EV/EBITDA P/E
Peer group mean 1.38x 6.58x 16.40x
Implied Colgate enterprise value $1,375 $1,315 $1,430

Less: Colgate net debt 200 200 200
Equals: Colgate implied equity value 1,175 1,115 1,230
Colgate shares outstanding (mm) 30 30 30
Implied Colgate share price $39.17 $37.17 $41.00

Is Colgate overvalued based on comps? No No No
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Relative Valuation
Trading comps – advantages

• A reality-based valuation
• Provides a framework to value a company based on current market conditions, industry trends and
growth of companies with “similar” operating and financial statistics.
• Those who believe that markets efficiently price stocks and implicitly reflect fundamental assumptions
about industry trends, business risk, market growth, will argue that comps are a more reliable method
of valuation.
• A sanity check to DCF
• The DCF relies on and is highly sensitive to explicit assumptions about a company’s future
performance. As a result, it’s fairly easy to make the DCF say whatever you want it to say.
• A comps analysis that relies on observable market prices as a key input makes comps a critical sanity
check to the DCF valuation.
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Relative Valuation
Trading comps – disadvantages

• Apples to oranges
• Truly comparable companies are rare, and
differences are hard to account for. Explaining
value gaps between the company and its
comparables involves judgment.
• Doesn’t reflect intrinsic value

• Many people feel that the stock market is
emotional and that it sometimes fluctuates
irrationally (i.e. the market can be wrong).
• Of limited usefulness for valuing public companies

• For trading comps to be useful as a tool for valuing a public company with a readily observable market
price, you would have to argue that the market might be wrong about pricing any single company, but
in aggregate is generally right.
• Liquidity
• Thinly traded, small capitalization or poorly followed stocks may not reflect fundamental value.
115
Relative Valuation
Transaction (“deal”) comps

• If you’re trying to value a company for the purposes of an acquisition (i.e. you’re an investment banker
trying to help your client find a suitable acquirer), prices paid to acquire comparable companies in recent
acquisitions capture a purchase premium.
• As a practical matter, acquirers must pay a premium to compel sellers to sell; this premium can be
significant and range from 10%-50% above the standalone market price.
• As a result, deal comps will almost certainly yield a higher valuation than standalone comps.
• Finding comparable transactions is even harder than finding comparable standalone business.
• In addition, finding enough data to be able to calculate multiples tends to be much harder with deal
comps.
• The process is otherwise similar to comparable company analysis.
116
Relative Valuation
Multiples in deal comps

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

LTM and Year 1 and Year 2 forward LTM and Year 1 and Year 2 forward
EV / Revenue Offer price per share / Target EPS
EV / EBITDA Offer value / Target net income
EV / EBITDA (inc. synergies) P / E to growth (PEG ratio)
Enterprise value in the Equity value in the
context of M&A is EV / EBIT context of M&A is called
sometimes referred to EV / Industry specific metric “offer price,” “offer
as transaction value, value,” “equity purchase
or TEV (“total price”. The price per
enterprise value”) share is called “offer
price per share”.
1 While
EV/EBITDA and EV/EBIT multiples are the most common multiples where the synergy adjustment is made, any multiple
where the denominator benefits from synergies could be adjusted
117
Relative Valuation
Transaction comps analysis: The process

1. Determine universe of comparable transactions.
2. Calculate multiples.
• Offer price/EPS, Offer value/Book equity

• TEV/EBITDA, TEV/EBIT, TEV/Revenues
• Industry-specific enterprise & equity multiples
3. Apply the calculated mean/median to target’s corresponding operating metrics to arrive at a value.
Median
For larger peer groups, calculating relevant peer group statistic using median
is preferable to mean calculations because it limits distortions from outliers.
118
Relative Valuation
Exercise
Comparable Transaction Analysis Exercise

Company Eli Lilly
Share price $50.00
Shares outstanding 1.0b
LTM Revenue $20b
LTM EBITDA $6.5b
LTM Net income $5.0b
Net debt $1.0b
Comparable transactions
Offer Premium TV / TV / Offer price
Target Acquirer value ($b) Paid Revenue EBITDA / EPS
Roche Genentech $47 19.0% 2.00 8.00 16.00
Wyeth Pfizer $68 18.0% 3.00 12.00 20.00
Schering-Plough Merck $41 23.0% 1.50 11.00 16.00
Genzyme Sanofi $20 23.0% 2.50 13.00 18.00
Mean 20.8% 2.25 11.00 17.50
Implied Eli share price

Is Eli overvalued based on comps?
119
Relative Valuation
Exercise
Comparable Transaction Analysis Exercise

Company Eli Lilly
Share price $50.00
Shares outstanding 1.0b
LTM Revenue $20b
LTM EBITDA $6.5b
LTM Net income $5.0b
Net debt $1.0b
Comparable transactions
Offer Premium TV / TV / Offer price
Target Acquirer value ($b) Paid Revenue EBITDA / EPS
Roche Genentech $47 19.0% 2.00 8.00 16.00
Wyeth Pfizer $68 18.0% 3.00 12.00 20.00
Schering-Plough Merck $41 23.0% 1.50 11.00 16.00
Genzyme Sanofi $20 23.0% 2.50 13.00 18.00
Mean 20.8% 2.25 11.00 17.50
Implied Eli share price $44.00 $70.50 $87.50

Is Eli overvalued based on comps? Yes No No
120
Relative Valuation
Transaction comps – advantages

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

• Past transactions are rarely directly comparable – apples to oranges.
• Public data on past transactions can be misleading.
• Public data seldom discusses deal protection put in place by acquirer and target.
• Values obtained often vary over a wide range and thus can be of limited usefulness.
• Prevailing market conditions can lead to significant distortions.
• Premiums and appropriate multiples change over time.
• Interpretation of the data requires knowledge of the industry.
• Finding all the information you need can be difficult because different bits of information are scattered
throughout different sources.
121
M&A
v
Valuation
M&A questions
Basic M&A questions

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

“What is the difference between an asset sale/338(h)(10) election and a stock sale?”
“Why do deferred tax liabilities get created in a stock sale?”
“What is the impact of 2017 tax reform on the treatment of NOLs?”
“What is a fixed exchange ratio?”
123
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)
124
M&A
Players in M&A
• There are several stakeholders in the M&A process
Buyer Seller
• Management • Management
• Board • Board
• Shareholders • Shareholders
Investment bankers Accountants Investment bankers Accountants

(deal advisors) M&A Lawyers (deal advisors) M&A Lawyers
Regulators (SEC / FTC)
125
M&A
The role of the Most common

investment bank types of IB
in M&A engagements
Access to capital Buy-side engagement
Finding buyers & sellers Sell-side
Advice on terms & structure Fairness opinion

M&A
Work often begins long before a deal is in play

• Except for hostile transactions, deals are a product of
discussions between managements which can take a long time.
• Investment banks are often pitching M&A ideas.
• Cultivating relationships (senior bankers)
• Pitchbooks & modeling (junior bankers)
127
M&A
The role of the junior investment bankers in M&A
Building presentations & models

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

• Financial analysis
• Running a data room (sell-side)
128
M&A
Accretion / Dilution
• An important M&A analysis is called accretion/dilution analysis.
• Accretive deal: Pro forma (combined) EPS > Acquirer EPS
• Dilutive deal: Pro forma EPS < standalone EPS

• Break-even: Pro forma EPS = standalone EPS
Example: Procter & Gamble considers acquiring Colgate

• Analysts expect P&G’s standalone EPS to be $3.05 next year.
• Based on P&G’s analysis, the pro forma EPS next year would be $3.10.
• As such, the deal is considered to be $0.05 accretive.
129
M&A
Why do acquirers care about their EPS?

• Acquirers really don’t want to show lower EPS as a result of acquiring another company and will
structure deals in such a way as to minimize negative impact on their EPS.
• Acquirers are concerned that investors will view a lower EPS as a sign of lower value (in other words,
investors will view what happens to EPS in the short term as a window into the company’s actual value).
• An implicit perception is that an acquirer trades at a defined PE ratio and should the denominator (EPS)
decline, price per share will thus also likely decline.
• Of course there’s no intrinsic reason to assume the PE ratio will stay fixed (the post-acquisition company
might merit a higher PE ratio), but the concern is nevertheless real, particularly for public acquirers.
130
M&A
Accretion / Dilution
UTC expects the combination will be accretive to adjusted earnings per

share after the first full year following closing and generate an estimated
$500+ million of run-rate pre-tax cost synergies by year four.
131
M&A
Deal consideration
• Acquirers pay for their acquisition by:
• Paying cash
• Issuing stock
• A combination of both
(i.e. 50% stock & 50% cash)
• The financing decision carries significant legal,
tax, and accounting implications.
Source: Thomson Reuters
132
M&A
Major adjustments to combined “pro forma” EPS in M&A

• In a 100% stock deal: The major adjustment to acquirer’s EPS will arise because the acquirer must issue
a lot of new acquirer stock in exchange for target shares, such that PF shares = acquirer’s pre-deal shares
+ acquirer shares issued in the transaction.
• In a 100% cash deal: No new acquirer shares must be issued, but either excess cash or new debt
finances the acquisition. This impacts the I/S via incremental interest expense, reducing PF net income
and EPS. New interest expense is often the major adjustment in a cash deal.
• In a mixed deal: Both adjustments must be made.
133
M&A
Accretion / dilution process (100% stock sale)

1. Calculate pro forma net income (PFNI): Acquirer + target net income.
2. Calculate offer value: Target offer price x target shares.
3. Calculate acquirer shares issued in the transaction: Offer value / acquirer share price.
4. Calculate the pro forma shares outstanding (PFSO) = Pre-deal acquirer shares + acquirer shares issued.
5. Divide the PFNI by the PFSO to get PF EPS.
6. Compare PF EPS against acquirer’s standalone EPS.
134
M&A
Accretion / dilution process (100% stock sale)

• Accretion: When Pro Forma EPS > Acquirer's EPS
• Dilution: When Pro Forma EPS < Acquirer's EPS
• Break-even: No impact on Acquirer's EPS
135
M&A
Accretion dilution - Exercise I

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

Share price at announcement $25 $60
P/E ratio 10.0x 12.0x
EPS next year $2.50 $5.00
Shares outstanding 4,000.0 1,000.0
Net income next year
Acquirer shares issued

Offer value (offer price x target shares outstanding)
Exchange ratio (acquirer shares issued / target shares outstanding)
Accretion / Dilution ($ per share)

Accretion / Dilution (%)
136
M&A
Accretion dilution - Exercise I

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

shares issued
Share price at announcement $25 $60
Acquirer shares trade at
P/E ratio 10.0x 12.0x $25, while target shares
EPS next year $2.50 $5.00 $2.34 trade at $60. Since no
premium is being
Shares outstanding 4,000.0 1,000.0 6,400.0 offered to target
Net income next year 10,000.0 5,000.0 15,000.0 shareholders (unlikely in
the real world), target
shareholders will accept
Acquirer shares issued 2,400.0 2.4 acquirer shares in
Offer value (offer price x target shares outstanding) $60,000.0 exchange for each
target share. Thus,
Exchange ratio (acquirer shares issued / target shares outstanding) 2.40x acquirer must issue
2,400 shares to
Accretion / Dilution ($ per share) -$0.16 purchase 1,000 target
shares.
Accretion / Dilution (%) -6.3%
137
M&A
PE ratios determine accretion/dilution in stock deals

• A deal is accretive when a high PE company acquires a low PE company (and vice versa).
Accretion/dilution
• Acquirer expects EPS of $1 next year, with a share price of $5 (PE = 5.0x).
• Target also expects EPS of $1 next year, but with a share price of $10 (PE = 10.0x).
• In a 100% stock deal, Acquirer must issue 2 shares to acquire one target share.
• This deal will be dilutive because 1 Acquirer share equates to owning $1 of Acquirer net income, but
Acquirer must issue 2 shares in order to acquire $1 of Target's net income.
• As a result, the incremental benefit of Target net income will not be sufficient to offset the share dilution
required to make the deal happen.
138
M&A
Goodwill and acquisition accounting

• Before we go deeper into the accretion dilution, we need to understand basic acquisition accounting.
• Under both GAAP and IFRS, an acquisition is viewed as the purchase of target assets and assumption of
target liabilities (net assets or book value of equity), which are written up to reflect their fair market
values (FMV).
• Since many assets are commonly carried at below FMV on target BS Goodwill
How much goodwill should be
(PP&E, intangibles, LIFO inventory), they require write-up upon an recognized on a $100 purchase
acquisition. price for acquiring a company
with a $45 book value with a
• If the purchase price is greater than the FMV of the net assets, the excess FMV write up of $15?
is recognized as an accounting asset plug called goodwill.
• But why would anyone pay above FMV for a company’s net assets???
Goodwill
1. Synergies: Cost savings to the acquirer push the value beyond FMV. $40
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.
139
M&A
Purchase price allocation – Exercise I
Adjusting the target balance sheet in accordance with PPA

Purchase price of target: 1,000.0
FMV of target PP&E 400.0
Target balance sheet Step 1 Step 2 Step 3
Elimination
Pre-deal Adjust Calculate New
of existing
Target BS to FMV new GW Target BS
GW
Cash 100.0
PP&E 300.0
Goodwill 50.0
Total assets 450.0
Deferred tax liabilities 0.0

Debt 50.0
Equity 400.0
Total liabilities & equity 450.0
140
M&A

Elimination
of existing
GW
Cash 100.0 100.0
PP&E 300.0 100.0 400.0
Goodwill 50.0 (50.0) 550.0 550.0
Total assets 450.0 1,050.0
Deferred tax liabilities 0.0 0.0

Debt 50.0 50.0
Equity 400.0 (50.0) 100.0 550.0 1,000.0
Total liabilities & equity 450.0 1,050.0
141
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
142
M&A
Acquisition financing
• In our simple example, we assumed 100% stock deal. In the case of a 100% cash (or mixed) deal, recall
that excess cash reserves must be used, or the acquirer must take on new debt to finance the acquisition.
• This new borrowing impacts the income statement in the form of incremental interest expense (or
forgone interest income), reducing the combined pro forma net income and EPS.
• In fact, the major adjustment to EPS in a cash deal is often the incremental interest expense arising from
additional debt issued to finance the deal.
Cost savings (synergies)

• Often the main rationale of an acquisition is to make a significant cut in expenses by eliminating
overlapping R&D efforts, closing down manufacturing plants, and employee redundancies.
• Synergies will reduce expenses and thus increase pro forma net income (PFNI) and pro forma EPS (PF
EPS).
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M&A
Fees
• Deal fees (IB, legal, and accounting fees): Need to be expensed as incurred on the income statement,
reducing PFNI and PF EPS.
• Financing fees: When a company borrows debt to finance an acquisition, the fees related to this
borrowing are treated differently from deal fees.
• Unlike deal fees, financing fees are not expensed . Instead, they are 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/
144
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.
145
M&A
Accretion / dilution – Exercise II

• Let’s try to put all this together with a mini merger model.
146
M&A
147
M&A
148
M&A
149
M&A
Accretion / dilution – Exercise II, solution
150
M&A
151
M&A
152
M&A
Presentation of accretion dilution analysis

• Analysis is usually presented using a data table in Excel.
• Since the analysis is done pre-deal, it is rooted in assumptions like the offer price, the form of
consideration, and the interest rate on borrowing.
• Should be easy to change key assumptions and to see how those changes affect the accretion/dilution
outcome.
153
Extra: M&A
Accounting
v
M&A Accounting
Book versus tax differences in M&A

• Up until now, we have been discussing the effect on the GAAP balance sheet.
• Since companies prepare 2 sets of books – 1 in accordance with GAAP (book) and the other with tax
rules, we need to address issues that emerge when there are differences.
155
M&A Accounting
Book versus tax differences in M&A

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

TRANSACTION All types Stock Sale Asset Sale or 338(h)(10)
STRUCTURE election
CHANGE IN YES NO YES
BASIS? Book basis gets written Tax basis of assets Tax basis does get
The carrying up (or down) to FMV does not get stepped stepped up (or down)
values of assets up (or down) to FMV to FMV
and liabilities
156
M&A Accounting
Deferred taxes in M&A

• In this section, we will discuss the accounting and real implications of these differences.
• Keep in mind:
• While the GAAP basis is disclosed, the tax basis will likely be unknown to you.
• As a result, assumptions must be made and the framework introduced here provides for “rules of
thumb” in the typical context of limited information.
• A complete assessment of tax issues should always be conducted in consultation with qualified tax
advisors.
157
M&A Accounting

• When deals are structured as asset sales/338(h)(10): Target’s book and tax balance sheets both get
marked up to fair value, with excess getting recorded as goodwill.
• The now-higher-valued assets lead to higher future D&A, reducing taxable income, creating future tax
savings for the acquirer.
• Additionally, unlike book accounting, tax accounting allows goodwill to be amortized1, often adding
significant future tax savings for acquirers in asset sales.
1 In an asset sale, goodwill is tax deductible and amortized over 15 years, along with other intangible assets that fall under IRC
section 197. Goodwill is not deductible in stock sales.
158
M&A Accounting

• When deals are structured as stock sales: Target’s book BS gets marked up, but the tax BS doesn’t; this is
mostly temporary since the assets getting written up will be depreciated over time.
• GAAP accounts for the temporary difference between the book and tax basis of assets and liabilities via
the creation, on deal day, of deferred tax assets and liabilities (DTAs and DTLs).
• Two major exceptions to this are land and goodwill, which don’t get depreciated or amortized, creating
permanent differences and as a result no deferred taxes.
159
M&A

• Let’s revisit our purchase price allocation exercise. Recall that the PP&E of the target company was
written up from $300 to $400. What is the impact of the PP&E write up on future net income?
Tax basis of PP&E: $3001

FMV of PP&E: $400
Nature of PP&E: Fully depreciable (i.e. no land, no savage value)
Depreciation method: Straight-line2

Useful life: 2 years
Tax rate: 40%
Book P&L post-deal Tax P&L post-deal
Year 1 Year 2 Year 1 Year 2
Revenues (all cash): 1,000 1,000 1,000 1,000
Cash expenses 500 500 500 500
Depreciation
Pre-tax profit
Tax
Net income
1 Since the actual tax basis is usually unknown unless provided by the target, a common assumption is that the pre-deal book basis equals the tax basis.
2 We assumed straight-line for simplicity. In actuality, IRC and most tax codes outside the US call for an accelerated depreciation method (MACRS in the U.S).
160
M&A Accounting
Purchase price allocation – Exercise I solution

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

Year 1 Year 2 Year 1 Year 2
Revenues (all cash): 1,000 1,000 1,000 1,000
Cash expenses 500 500 500 500
Depreciation 200 200 150 150
Pre-tax profit 300 300 350 350
Tax 120 120 140 140
Net income 180 180 210 210
• To account for the higher future actual taxes (vs. GAAP taxes), a DTL is recognized on the acquisition date
in the amount of the total future differences.
161
M&A Accounting
Exercise: Deferred taxes in M&A

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

On acquisition 1 year 2 years
date post-deal post-deal
Cash
PP&E +100.0
Deferred tax liability

Equity
Total liabilities & equity
Do assets = liabilities & equity?
162
M&A Accounting
Exercise: Deferred taxes in M&A

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

On acquisition 1 year 2 years
date post-deal post-deal
Cash +360.0 +360.0
PP&E +100.0 (200.0) (200.0)
Deferred tax liability +40.0 (20.0) (20.0)

Equity +60.0 +180.0 +180.0
Total liabilities & equity +100.0 +160.0 +160.0
Do assets = liabilities & equity? Yes Yes Yes
163
M&A Accounting

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

500
400 400
Basis 300 300
200 200
150
100
0 0
0 1 2
Years
164
M&A Accounting
Revisit PPA exercise I, deal structured as stock sale (no tax step-up)

Elimination
of existing
GW
Cash 100.0
PP&E 300.0
Goodwill 50.0
Total assets 450.0
Deferred tax liabilities 0.0

Debt 50.0
Equity 400.0
Total liabilities & equity 450.0
165
M&A Accounting
Revisit PPA exercise I

Elimination
of existing
GW
Cash 100.0 100.0
PP&E 300.0 100.0 400.0
Goodwill 50.0 (50.0) 590.0 590.0
Total assets 450.0 1,090.0
Deferred tax liabilities 0.0 40.0 40.0

Debt 50.0 50.0
Equity 400.0 (50.0) 60.0 590.0 1,000.0
Total liabilities & equity 450.0 1,090.0
Observe that the creation of the DTL led to a

lower FMV of equity, which in turn led to higher
goodwill than had a DTL not been recorded.
166
M&A Accounting
Target pre-deal DTLs

• An interesting question arises with the respect to the treatment of pre-deal DTAs and DTLs on the target’s
BS.
• Pre-existing DTLs (asset sales/338(h)(10)): Book and tax bases are both revalued to FMV so existing DTLs
are eliminated (with a corresponding increase in equity).
• Pre-existing DTLs (stock sales): Existing DTLs are retained because there is no tax basis step-up so
differences persist (and magnified via the new write-ups).
167
M&A Accounting
Target pre-deal DTAs in asset sales/338(h)(10)

• The treatment of existing DTAs depends on the nature of the DTAs. An often substantial DTA represents
future potential benefits from historical losses (NOLs) that can be applied against future income.
• DTAs from NOLs: Acquirer cannot benefit from target NOLs so DTAs from NOLs are eliminated.1
• Other DTAs: DTAs from other issues (like revenue recognition) carry over.
1Although the acquirer can’t use the NOLs, the target can use its own NOLs to offset the target’s gain on sale
168
M&A Accounting
Target pre-deal NOLs in stock sales

• When a company acquires a target with large NOLs, the IRS places an annual limit on the amount of
NOLs that can be carried forward, calculated as:
Annual limit = Purchase price x % LT tax exempt rate 1
• 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.
169
M&A Accounting
Summary
Deal structure Stock Sale Asset Sale or 338(h)(10)

Change in book basis? YES YES
Change in tax basis? NO YES
Goodwill tax NO YES
deductible?
New DTL created? YES1 NO
Existing DTLs NO YES
eliminated?
Existing NOLs usable by YES but limited under IRC 382 NO2
acquirer?
Non-NOL related DTAs YES YES
carry over to acquirer?
Remember! These guidelines make several critical assumptions about tax bases and the nature of
DTAs and DTLs – consult with tax professional when appropriate
1 Calculated as (FV book basis – tax basis) x tax rate. DTL reverses over time; goodwill higher due to new DTL
2 Although acquirer can’t use NOLs, the target can use to offset gain on sale
170
LBO
v
LBO
LBO questions
General LBO questions

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

“Walk me through an LBO model.”
“What are the key assumptions in an LBO model?”
“What is the impact of leverage on LBO returns and why?”
“Why is an LBO considered a floor valuation?”
“What is the typical capital structure in an LBO?”
“What are the typical debt tranches in an LBO?”
“How is the maximum leverage in an LBO typically determined?”
172
LBO
Leveraged buyout (LBO)

• Acquisition where a significant part of the purchase price is funded with debt.
• Term Loans
• Revolving Credit Lines

• Bonds
• The remaining portion is funded with equity by the financial sponsors.
• Company undergoes a recapitalization to a now highly leveraged financial structure.

• Company becomes a new company – from oldco to newco.
• Companies acquired by PE can be either private or public.
LBO Jargon
• Financial sponsors = Private equity investors = Financial (vs. strategic) buyers
• Leveraged buyouts = PE-backed deals = Sponsor-backed deals
173
LBO
What is the basic intuition underlying an LBO?

• If you’ve bought a house with a mortgage, you’ve done an LBO (basically):
Buying a $500k house Selling a $650k house
$100
You sell the house 5 years later, $250
assuming you’ve paid down
$150 of the mortgage and $400
house price increased 30%
$400
Mortgage Equity Equity investor IRR = 32% Mortgage Equity

Cash-on-cash return = 4.0x
1 1
𝐹𝐹𝐹𝐹 𝑁𝑁 $400,000 5
𝐼𝐼𝐼𝐼𝐼𝐼 = −1= − 1 = 32%
𝑃𝑃𝑃𝑃 $100,000
174
LBO

• As the term leveraged buyout might suggest, LBO debt is a large component of the overall sources of
funds in a transaction.
• LBOs have historically used significant amounts of debt (as high as 80% of the total source of funds in
the 1980s) and has since come down to around 50% of the overall source of funds, with the remainder
usually coming from sponsor equity (see below).
175
LBO
LBO analysis on a cocktail napkin

• Let’s get the LBO mechanics under our belt using the Dell LBO.
176
LBO
LBO analysis on a cocktail napkin
The offer The financing

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

• Exit is assumed 5 years post-LBO.
• Assume the same LTM EBITDA at exit as the current EBITDA.
• Assume exit at the same EV/LTM EBITDA multiple as the current multiple.
• Assume debt is fully paid down.
• Assume no cash on the B/S.
177
LBO
What is the expected IRR of this deal?
Use of funds Current valuation

Buyout of equity EBITDA 3.50
Oldco debt refinanced EV
Total uses EV/EBITDA
Source of funds Exit assumptions

Debt 11.5 EV/EBITDA
Existing cash on B/S 7.7 EBITDA 3.50
Equity Enterprise value
Total sources of funds Debt 0.0
Cash 0.0
Equity value
Equity IRR
178
LBO
What is the expected IRR of this deal?

Buyout of equity 23.46 EBITDA 3.50
Offer price/share 13.88 EV 17.16
Diluted shares outstdng. 1.69 EV/EBITDA 4.9x
Oldco debt refinanced 1.40
Total uses 24.86 Exit assumptions
EV/EBITDA 4.9x
Source of funds EBITDA 3.50
Debt 11.5 Enterprise value 17.16
Existing cash on B/S 7.7 Debt 0.0
Equity 5.66 Cash 0.0
Total sources of funds 24.86 Equity value 17.16
Equity IRR 24.8%
179
LBO

• Financial sponsors finance deals with a lot of debt and put up a relatively small amount of equity.
• As debt is paid down and the value of the business grows, sponsors earn large returns.
• Key drivers of success are:

• Getting in cheap: Finding businesses that for whatever reason are being undervalued (low multiple).
• Leverage: Levering with a lot of cheap debt (cheap debt means low interest rates).
• Operating improvements: This usually means reducing costs (massive layoffs are often associated
with 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).
180
LBO
Typical LBO exits
181
LBO
What do investors look for in finding a good LBO?

• Steady cash flows with little cyclicality
• Large fixed debt payments leave little wiggle room for volatile businesses.
• Minimal maintenance capital expenditures and working capital needs

• This is usually where sponsors can find waste and thus achieve cost savings.
• Strong management teams under pressure by their shareholders

• The short termism of public investors can pressure otherwise strong management teams to optimize for
short term earnings instead of a longer time horizon.
• Low growth companies that still generate healthy cash flows usually feel more pressure as a public
company than as a private one.
• Businesses with undervalued assets
• Selling off undervalued assets can immediately pay down debt.
• High equity / low debt capital structure
• See next page.
182
LBO
Tax savings has been a motivating factor in LBOs

• In an LBO, pretax income usually shrinks because of large interest expense and higher D&A expenses due
to asset write ups.
• Higher interest expense due to higher leverage:
• Expenses lead to lower taxes during the LBO years. The lower tax bill due to a high interest expense
is one of the appealing characteristics of an LBO.
• Rather than spending your money on tax, you spend it on debt service which, as we saw in the
simple house-with-mortgage example, increases your equity over time.
• Starting in 2018, benefits of leverage will be restricted in the US
• Tax reform enacted in 2017 in the United States places limits on the amount of interest expense that
can be deducted for tax purposes, so the tax advantage has been somewhat restricted.
• Bonus depreciation
• However, this is offset somewhat by larger amounts of “bonus depreciation” that financial sponsors
(and acquirers in general) can claim for tax purposes.
183
LBO
Capital structure
• What % of a company’s value can funded by debt?
• The amount of debt that can be raised depends on:
1. Size/stability of cash flows

2. Preference for defensive, less-cyclical firms
3. Reputation of sponsor and lending environment
• Not all debt is the same
184
LBO
Capital structure – equity

Michael Dell’s
• Sponsors equity rollover
In the $24b Dell LBO,
• Represent the largest source of LBO equity.
Michael Dell rolled over $3.6b of
equity and contributed an extra
• Rollover
$750m of fresh cash
• In some cases, oldco management rolls over its
existing equity into the newco and even contributes
new capital alongside the sponsors1.
• Option pool
• In addition, since most LBOs have oldco management stays on to run the newco, sponsors reserve
anywhere from 3%-20% of total equity for them.
• Warrants
• Certain lenders may receive equity as a sweetener for providing financing (mezzanine lenders).
1 Management rollover has historically ranges from 2 to 5% of the total equity in LBO
185
LBO
LBO debt
• Leveraged loans: Revolver & term loans A/B/C/D
• Bonds: High-yield (“speculative-grade” or “junk”) bonds
• Mezzanine finance
Loans vs. bonds – confusing terminology

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

(”bonds" or “junior debt”) which make up the
lower tranches. Unlike bonds, it is usually:
• Secured (1st or 2nd lien)
• Priced as a floating rate (LIBOR + spread)
• Structured with shorter maturity
• More restrictive (covenants)
• Free of SEC registration
186
LBO
Leveraged loans – term loans and revolver

• Make up the majority and senior tranches of LBO debt, syndicated to banks (“pro rata”) or
institutional investors.
Loans in Carlyle’s $4.15b Ortho-clinical LBO

• Senior secured institutional loan split between a $2.175b,
7-year TLB and a $350m, 5-year revolver. Priced at L+375,
with a 1% LIBOR floor
• Ortho also issued $1.3b/6.625% notes (bonds) due 2022
Loans in Blackstone’s $5.4b Gates LBO

• Includes $2.49 billion and €200m term loans,
respectively (7-year terms), a $125 million cash-flow
revolver, and a $325 million asset-based revolver (5-year
terms). The term loans will be covenant-lite.
• $1.04b/6% and €200m/5.75% senior notes (bonds) will
also be used to fund the LBO.
187
LBO

• Priced at LIBOR + spread
• Scheduled principal amortization (TLs)
• No call protection (borrower can repay

anytime)
• Most common LBO package is an institutional
(nonbank) term loan B/C/D and a revolver
Note: loans syndicated to banks is referred to as “pro rata” debt
188
LBO

• Leveraged loans are priced at LIBOR + spread
• LIBOR floors (i.e. 1%) have become increasingly common
189
LBO
Leveraged loans – revolver

• Usually packaged alongside a term loan to the same investor base, secured with 1st lien, priced at LIBOR
+ spread.
• Availability tied to borrowing-base lending formulas (usually a % of collateral, most often A/R and
inventory).
• Can be initially undrawn, partially drawn, or fully drawn:
• Example: Dell LBO included a $2.0b asset-backed revolver, $750 drawn initially, with a 5-year term.
• Usually carries the same term and similar pricing as the term loan.
190
LBO
Leveraged loans – term loan A/B/C/D

• Term loan A ( “TLA”) are provided by banks, usually is a 1st lien loan, with a 5 year term, packaged with
a revolver.
• Term loans “B”/“C”/“D” refers to loans syndicated to institutional investors like hedge funds, CLOs,
mutual funds, and insurance companies (and some banks).
• B/C/Ds are larger and more prevalent in LBOs than TLAs, The “B” or “C” or “D”
often packaged alongside revolver with no TLA. designation is more indicative
of the investor base than
• B/C/Ds have looser covenants, 5-8 year terms, may be priority. (i.e. TLc can have
2nd or 1st lien and require less principal amort. higher priority than TLb).
191
LBO
Leveraged loans – 2nd lien debt

• 2nd lien term loans have been primarily syndicated to CLO funds and other institutional investors.
• Unlike 1st lien term loans, typically carry fixed rate, no amortization, with a longer maturity than 1st lien
debt.
• Smaller part of the LBO cap structure post-crisis, as this tranche is where investors got in trouble during
the crisis.
192
LBO
High yield bonds (HYB)

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

Pension
Other funds
30%(1) 28%
Mutual
funds
Insurance
13% companies
Source: S&P CIQ, LCD
29%
1‘Other’ includes ETFs, HNW individuals,
commercial banks, hedge funds
193
LBO

• Fixed coupon paid semiannually,
maturity 7-10 years, no principal
pay-down until maturity (bullet).
Bonds issued in Bain’s $6.7b LBO of BMC

• BMC’s 2013 LBO included a $1.625b bond, 8.125% coupon,
priced at par, matures July 15, 2021 . Not callable for first 3 years.
• Senior tranches were comprised of a $2.88b (L+4%, 1% LIBOR
floor) and a $670m (L+4%) secured 7 year term loan and a
$350m unfunded revolver (L+4%).
194
LBO

• HYBs are usually (but not always) unsecured.
195
LBO
High yield bonds (HYB) – other features

• Usually not registered with the SEC (Rule 144A) to get to market quickly (registration can
take more than 3 months).
• Usually exchanged for registered debt once SEC paperwork is done, increasing liquidity.
• Call protections & call premiums.
196
LBO
Covenants
• As part of a loan, lenders will impose restrictions on borrowers (covenants).
• Financial covenants
• Borrower must be in compliance with certain key ratios.

• Debt/EBITDA < 6x
• EBITDA/Interest > 3x
• Other covenants
• Spend limits beyond pre-specified carve-outs (“basket”), borrower pledge to include lender in any
subsequent grant of a security interest (negative pledge), and forced call in the event of a downgrade.
197
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
198
LBO
Covenants
• Increasingly, leveraged loans are “covenant-lite” and include only incurrence covenants, amounting to
60% of new loan issuances in 1H 2014.
199
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”)
200
LBO
Capital structure – bridge loans

• Bridge loans provide interim financing should the LBO debt not be available by the closing of the deal.
• Investment banks typically provide the bridge loan commitment.
201
LBO
Expanded LBO analysis on a cocktail napkin
The offer The financing

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

• Exit is assumed 5 years post-LBO.
• Assume the same LTM EBITDA at exit as the current EBITDA.
• Assume exit at the same EV/LTM EBITDA multiple as the current multiple.
• Assume debt is fully paid down.
• Assume no cash on the B/S.
202
LBO
Full sources of funds in Dell’s $25b LBO
Loans
• $1.5b TLC @ L + 300 w/1% LIBOR floor, covenant-lite, 5yr
• $2.0b asset-backed revolver ($750 drawn initially), 5yr
• $4.0b TLB @ L+375 w/1% LIBOR floor, covenant-lite, 6.5yr
High yield bonds
• $2b 1st lien bonds, 7yr
• $1.25b 2nd lien bonds, 8yr
Microsoft loan: $2b sub. note at 7.25% (~50% PIK), 10yr
Rollover Equity: $3.4b from Michael Dell

Equity: $0.8b from Michael Dell, remainder from Silver Lake
Existing cash on B/S: $7.7b
203
LBO
Expanded LBO analysis “on a cocktail napkin”

Buyout of equity EBITDA 3.50
Offer price/share 13.88 EV
Diluted shares EV/EBITDA
outstanding 1.69
Oldco debt refinanced 1.4 Exit (5 yrs later)
Total uses EV/EBITDA
EBITDA
Source of funds Enterprise value
Loans Debt 0.0
Revolver 0.75 Cash 0.0
Term Loan C 1.50 Equity value Equity %
Term Loan B 4.00 Michael Dell
High yield bonds Other sponsors
First-lien note 2.00
Second-lien note 1.25 Equity IRR
Microsoft loan 2.00 Michael Dell
Equity Equity % Other sponsors
Rollover Michael Dell 3.40
New equity Michael Dell 0.80
New equity Silver Lake
Existing cash on B/S 7.70
Total sources of funds
204
LBO
Expanded LBO analysis “on a cocktail napkin”

Buyout of equity 23.46 EBITDA 3.50
Offer price/share 13.88 EV 17.16
Diluted shares EV/EBITDA 4.9x
outstanding 1.69
Oldco debt refinanced 1.4 Exit (5 yrs later)
Total uses 24.86 EV/EBITDA 4.9x
EBITDA 3.50
Source of funds Enterprise value 17.16
Loans Debt 0.0
Revolver 0.75 Cash 0.0
Term Loan C 1.50 Equity value Equity % 17.16
Term Loan B 4.00 Michael Dell 74% 12.7
High yield bonds Other sponsors 26% 4.4
First-lien note 2.00
Second-lien note 1.25 Equity IRR
Microsoft loan 2.00 Michael Dell 24.8%
Equity Equity % Other sponsors 24.8%
Rollover Michael Dell 60% 3.40
New equity Michael Dell 14% 0.80
New equity Silver Lake 26% 1.46
Existing cash on B/S 7.70
Total sources of funds 24.86
205

Technical Interview Prep 2018

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WALL STREET PREP TRAINING MANUAL

Types of accounting questions Common examples

Accounting definitions “What is working capital?”

Let’s start a business!

• You report under US GAAP.

What does your balance sheet look like?

The world’s simplest balance sheet

Shareholders' Equity (SE) They always equal each other!

You spend the next year selling lemonade!

What does your income statement look like?

The world’s simplest income statement

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

Taxes (20,000) 40% tax rate

There are many names What’s amortization?

What does the year end balance sheet look like?

How the income statement is connected to the balance sheet

The problem with the income statement (and accrual accounting)

• The bad #1: Accrual relies on management assumptions.

• The solution: The cash flow statement

The cash flow statement layout

Cash from operations:

Cash from investing:

Cash from financing:

What does the cash flow statement look like?

Start with net income (indirect method)

Net income 30,000

Cash from operations 40,000

We already solved this earlier

Cash flow statement

The depreciation & Net income 30,000

Working capital: The most confusing part of the CFS

Let’s take it up a notch

• You paid yourself a $10,000 dividend.

Cash Flow Statement, Updated

Net income 30,000

Changes in operating assets and liabilities:

New debt borrowing

Beginning cash – 12/31/2018 100,000

Cash Flow Statement, Updated

Net income 30,000

Capital expenditures (40,000)

New debt borrowing 100,000

Beginning cash – 12/31/2018 100,000

What does the updated year-end balance sheet look like?

How the income statement is connected to the balance sheet

Balance Sheet, Updated

It’s time for interview questions!

Let’s start a business!

• You report under US GAAP.

The world’s simplest balance sheet

Shareholders' Equity (SE) They always equal each other!

The world’s simplest income statement

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

Taxes (20,000) 40% tax rate

There are many names What’s amortization?

The world’s simplest cash flow statement

Cash flow statement

Changes in operating assets & liabilities (aka working capital):

How the income statement is connected to the balance sheet

Let’s take it up a notch… For simplicity ignore any

What does the updated income statement look like?

$10,000 in utilities are recognized in current period,

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