Why might two companies have a different cost of equity?

They have different betas. The beta of a stock measures that stock’s sensitivity to movements in the overall stock market. More volatile stocks have a beta higher than one; less volatile stocks have a beta less than one.

In an all-stock transaction, a company with a lower P/E is buying a company with a higher P/E. What is the effect of this transaction? What happens if you use debt/cash to make part of the above transaction? Why?

The point of this question is to get you to say whether the acquisition is accretive or dilutive. Generally, companies do not want dilutive acquisitions since they destroy shareholder value. The combined company’s ratio will have a higher P/E than the acquirer originally did (but lower than the seller, obviously). However, since more shares will have to be issued by the lower P/E company (than would have been needed if the acquirer had a higher P/E ratio), the combined company will have a lower EPS (dilutive acquisition). Typically, the company with the higher growth rate and growth potential commands a higher P/E . The opposite is true for companies with lower P/E ratios. If you throw in debt/cash, fewer shares will be needed for the acquisition, thus the transaction will be less dilutive, and potentially accretive.

If a company changes its method of inventory valuation from LIFO to FIFO in an inflationary environment, what is the impact on the three financial statements?

If a company changes its method of inventory valuation from LIFO (last in, first out) to FIFO (first in, first out) in an inflationary environment, it means that the cost of goods sold (COGS) will fall, since goods purchased earlier are being charged to COGS and ending balance of inventory will rise since recently purchased goods will now be reflected in ending inventory. This means that income will rise in the I/S, and value of assets will increase in the B/S.

Of the three main valuation methods (DCF, Public comparables and transaction comparables), rank them in terms of which gives you the highest price. Which one typically yields the highest valuation?

Simple answer – it depends. Depends on discount rate in DCF model, depends on the comparable companies used, depends on whether the market is hot/cold and the companies are overvalued/undervalued for no good reason. Generally, however, transaction comps would give the highest valuation, since a transaction value would include a premium for shareholders over the actual value. The second highest valuation would probably be the DCF, since there are a lot more assumptions that are involved (growth rate, discount rate, terminal value, tax rates, etc), but it can also be the most accurate depending on how good the assumptions are.

If you had to pick one statement to look at (balance sheet, cash flow, income statement), which one would it be and way?

No right answer – can go with whichever one you like. Each has its advantages: income statement – shows the profitability of a company, trends in sales/expenses, margins, etc; balance sheet is a great way to see what items make up the company’s assets and who the company needs to pay back for those assets. Personally, I would go with the cash flow statement. At the end of the day, cash is king. A company that has positive income but very little cash is in deep trouble. Cash flows are used for DCF models, not net income. The cash flow statement allows observing important performance metrics from both income statements and balance sheets such as net income, depreciation, sources and uses of funds, changes in assets and liabilities.

Name two common ways companies can manage their earnings?

1) Changing accounting practices under GAAP (e.g. switching between S‐L Depreciation and Double Declining Balance; changing between LIFO and FIFO; etc…).

2) “Big bath” (taking negative hits in an already bad year and basically just writing the year off) or “Cookie Jar Accounting” (reducing top‐line revenues in good years and keeping them on reserve for bad years).

What type of a company would be a good candidate for an LBO?

It is difficult to define the characteristics of a typical LBO candidate, but the following things are very important:

• Good management (MOST IMPORTANT): could be new or old, but they need to be motivated, competent, qualified, and correctly incentive.If the management is old, you probably want to give them some equity interest in the company as an incentivizing tool. If the management is new, you need to find the right incentives.
  

• Strong cash flow: cash flow should be healthy, steady, and predictable to allow for easy borrowing from creditors.
  

• Massive required cash outflows for CapEx and R&D shouldn’t be necessary to the ongoing success of the company.
  

• Exit strategy: Financial sponsor should have a strategy for exiting the company within an appropriate timeframe by either: selling the company to a strategic or financial buyer or IPOing the company. The exit multiple should be at least the acquisition multiple assuming the sponsor has improved the profitability of the profitability of the portfolio company.
  

• Market niche: good niche in the markets for their product lines.
  

• Steady stream of revenues and a client base that is not overly dependent on a few large customers.
  

• Steady growth pattern, as growth in profitability will accelerate the repayment of debt; growth will also help the valuation of the company if the sponsor is looking to IPO the company.
  

• Work force: must be flexible and willing to participate, as business plans change and assets are often redeployed after an LBO.
  

• Skeletons in the boardroom: litigation or environmental concerns could be dealbreakers since these issues could make it difficult to attain financing.
  

• Technology: state‐of‐the‐art technology helps ensure maximum efficiency and profitability; also decreases need for large CapEx in the future.
  

• Buried treasure: deal‐makers are always looking for untapped or hidden resources such as, real estate, exclusive licenses, rights, patents, contracts, franchises, etc… from which maximum value has yet to be unleashed.
  

• Costs: a company must have the capacity and willingness to cut costs.
  

Define Beta for a layman

Beta tells you how much the price of a given security moves relative to movements in the overall market.

A Beta of 1 means that if the market moves, the stock moves in unison with the market.

A Beta < 1 means that if the market moves a certain amount, the stock will move less than that amount

A Beta >1 means that if the market moves a certain amount, the stock will move more than that amount.

What kind of multiples should I use to do a comparable company analysis on ABC company? How would I calculate them?

Common ratios used to compare equity performance:

• Price / EPS
• Market Value / Net Income
• Market Value / Book Value
• Price to Earnings / Growth Rate (“PEG Ratio”)
  

Common ratios used to compare enterprise performance:

• Enterprise Value (EV) / EBITDA
• EV / EBIT
• EV / Sales (generally only appropriate for volume driven businesses or those with negative earnings)
  

How would you evaluate the credit worthiness of a company if you were a bank?

A creditor’s measure of an individual’s or company’s ability to meet debt obligations. Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

• Limit the borrower’s ability to weaken their balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.
• Allow for monitoring the debt requiring audits and monthly reports
• Allow the lender to decide when he can recall the loan based on specific events or when financial ratios like debt/equity, or interest coverage deteriorate.
  

Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively.

Visualize the income statement of any company you have audited. Take me through its key line items.

• Revenues: Source of income that arises from the sale of goods and/or services and is recorded when it is earned.
• Expenses: Costs incurred by a business over a specified period of time to generate therevenues earned during that same period of time. Commonly includes COGS and SG&A.
• Net Income: Revenue minus expenses.
  

How do you value companies in emerging markets other than DCF?

There are three major ways to valuation:

• Comparable Companies
• Precedent Transactions
• DCF Analysis
  

Other methodologies:

• Liquidation Valuation – valuing company’s assets assuming they are sold off then subtracting liabilities to determine how much capital an equity investor receives.
• Replacement Value – based on cost of replacing assets.
• LBO Analysis – determine how much a PE firm could pay for a company to hit a target IRR in the range of 20‐25%.
  

Valuations in emerging markets. How would you value a bond issued by a company in an emerging market?

• Comparable companies and their bonds
• Study economic trends – inflation, GDP growth
• Determine risk and associated risk premium bond purchasers willing to pay in that market
  

Advise a client how to expand into the consumer market in Mexico. (Valuation issues, whose WACC would you use etc.).

• Use acquirer’s WACC
• Study economic trends – inflation, GDP growth – and government involvement
• Review different industries within the consumer market
• Determine which company/industry has the lowest risk
• Company comparables
• Review debt possibilities
• DCF issues – difficult to project over 10-year period
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