Kellogg Valuation Help

Guide to preparing for a career in Investment Banking Kellogg School of Management
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Guide to preparing for a career in
Investment Banking

Author: Gabriele Lucano, Kellogg Class of 2005

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Table of Contents

Evaluation methods and their characteristics

Technical questions Finance

Technical questions Accounting

Technical questions Financial Markets

Technical questions Miscellaneous

Technical questions Investment Banking

Personal/ fit questions

Sample Cheat Sheet

Resources for latest financial and economic news

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Evaluation methods and their characteristics

What is firm value?
For a company that is publicly traded:
Firm Value or Enterprise Value = Equity Value + Net Debt
Where
Net Debt = Debt Excess Cash
There is a quantity of cash that may be needed for operations and cannot be used to pay debt.
Thus, we cannot subtract all the cash we have.
Equity Value = (Number of Shares) x (Price of Share)
Debt Value = market value of debt

Firm Value = Enterprise Value = Total Assets = Equity + Net debt

What do we do if debt is not traded and thus, we do not have a market value of debt
available?
If the yield has not significantly changed since the issue of the debt then the book value is a good
proxy of the value of the remaining coupon payment and principal (In fact on the book we
always consider the yield at the time the debt was issued and then we expense the interest each
year using this yield. We adjust the bond payable account for coupon payment, both for the case
of a bond issued at premium or at discount.) In case, the yield has changed since the issue, either
because the company has become riskier or because the interest rate has changed, then we have
to recalculate the market value of the debt. To do so we look at the cash flow that the debt
contract has promised in the future and discount it at the right yield to find the market value.

How do we calculate the firm value?
Since it is impossible to Value each single asset, we go the other way around. We know that
Value of Assets = Liabilities + Market Value of Equity
Thus, we calculate the value of liabilities and equity to get the value of the firm.

Why do we use the market value of equity and market value of debt?
We use market value of equity because we want to find the market value of assets. The market
value of assets is given by the discounted free cash flow to assets. The free cash flow to assets is
then divided between the equity holders and the debt holders. If we assume that the equity is
C Cl la ai im ms s
E Ex xc ce es ss s
C Ca as sh h
F Fi ir rm m
V Va al lu ue e
E Eq qu ui it ty y
D De eb bt t
= =
4
fairly priced by the market then the market has incorporated all the information about the future
cash flow to assets (considering part is going to equity holders and part to debt holders). If the
market has fairly priced the securities, i.e. it has evaluated the present value of cash flow to
equities and the present value to debts; the firm becomes a portfolio of the securities at their
market value. Thus, we say that the value of assets is the present value of the cash flow to assets
that can either go to equity holders or to debt holders.

How can equity be higher than firm value?
Net debt can be negative when excess cash is much higher. In fact the equity of such a company
will be highly valuable in the market because the firm is sitting on a pile of cash.

What are the most common valuation methods?
Valuation is an art. Below are four most common methods of valuation:
- Discounted Cash Flow
- COMPS or Comparable Analysis or Multiples
- Comparable Transactions
- Leveraged Buy Out (LBO)

What are the components of a Discounted Cash Flow?
DCF is composed of two components:
- The Present Value of Free Cash Flow (FCF) a company generates over a certain
number of periods (usually 5 or 10)
- The Present Value of a Terminal Value:
o Calculated by applying a constant growth rate to the last year FCF
o Calculated by applying a multiple to the last Periods FCF (or EBITDA)

Once we have the value for the Cash Flow over the specific period (5-10 years) and the terminal
value, we need a cost of capital (a discount rate) to discount the cash flow appropriately; a
discount rate that correctly prices the systematic risk of the cash flow to assets. This FCF is the
unlevered free cash flow. Some common formulas to calculate FCF are summarized below:

EBIT(1-t) + Depreciation Capital Expenditure Working Capital Increases =FCF

In the case we have amortization,

EBITA(1-t) + Depreciation Capital Expenditure Working Capital Increases =FCF

Or

Net Income + (1-t) Interest Expenses + Depreciation Capital Expenditure Working
Capital = FCF

Or

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Cash Flow from Operations Increases in Required Cash Balance + (1-t) Interest Expenses
Capital Expenditure = FCF

Why do we use cash flow?
Cash flow is what drives value of what the stock holders get. We are trying to evaluate the assets
of the firm and Free Cash Flow is the Cash flow to assets that we have. Assets are generating a
cash flow and this is what the assets are currently worth. FCF drives the valuation of the assets as
it goes to equity holders and to debt holders.
Cash Flow is not net Income. Net income captures non-cash expenses like depreciation and
interest expense depending on the companys debts. Net Income thus, doesnt give the true value
of the cash flows to the assets. Also net income is affected by the capital structure and thus, can
vary widely without any changes in cash flows the assets are generating. The interest expense
increases because the debt has increased but this does not mean that the assets are generating less
cash flow.

How do we calculate terminal (also called residual) value?
The residual value is extremely important since it often accounts for the majority of a companys
value. There are two ways to calculate the residual value:

1. Perpetual growth of the last years projected FCF: Assume that the firm will grow
indefinitely at rate g, and that the discount rate will be r. Then,

g r
g FCF
g r
FCF
FV
+
=
=
) 1 (
10 11
10

After this we discount the residual value to get its present value, as we will discount the
expected free cash flow we have for specific periods. It is often difficult to come up with a
reasonable growth rate, so often the second method, i.e. multiple method is used to calculate
the residual value and the implied growth rate is calculated from this residual value.

2. A multiple of either FCF
10
or of EBITDA
10
is used to give the residual value. Banks use
this one very often. This eliminates the uncertainty in g in the first method. The
terminal value found has to be discounted to its present value using the discount rate.

How do we discount the cash flows and the terminal value to get the present value?
We can use:

1. WACC: weighted average cost of capital
2. APV: adjusted present value (it separates the value of operating cash flow from the effect
of financing and the related debt tax shield)

What is WACC?
The cost of capital is in general defined as the expected return on a portfolio of companys all of
the existing securities. WACC is the cost of capital of a firm calculated assuming the firm is a
portfolio of its equity and after-tax debt. It is calculated as the weighted average of the cost of
equity and after-tax cost of debt.
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How do we find asset beta (un-levered beta) for a non public company?
1. We look for similar companies/ventures.
2. We calculate their beta by running a regression on past stock data (or look into
Bloomberg). Since share price reflects dividends, the stock return is adjusted for
dividends as it should be. The betas we find are Equity Beta. Then, we find debt betas for
these comparable companies. We can find debt betas on Bloomberg or if debts are not
traded, look at the historical return on comparable debt issue, e.g. corporate bond with
same rating (that is bond carrying comparable default risk and similar maturity).
3. We then unlever equity beta and find asset beta.
4. We unlever each Beta by eliminating the part of the risk associated with the debt. We
have to eliminate the risk of the debt as we want to remove the affect of the financial
structure of the comparable firms.
5. Once we have asset betas, we average them and this is the asset beta for our target
company. We assume here that the cash flow from the assets of the subject firm, as it
were a whole unique large project, have same risk as the asset of the companies we look
at as comparable.
6. Now we lever this asset beta again with the target firms capital structure as we want
equity beta for the company we are evaluating (the leverage ratio chosen for the levering
is an assumption as it is not a constant). Thus, we find equity beta.
7. We can then apply the CAPM to find the expected return on equity (levered) for the
subject company.
8. With the return on equity from step 7 and return on debt from step 2, we calculate
WACC. WACC considers the effect of the debt tax shield that we have and thus, we
average the return considering the after tax debt return.

( ) ( ) | |
. securities more include that indcies other as
or market stock the of 80% captures that 500 P & S on return the as ed approximat be can market on the Return
ly. historical 9% - 8 about be to considered generally is market on the premium risk The
bill. y on treasur Return
~ ~
= =
=
te riskfreera r
where
r r E r r E
f
f Market equity f equity
|

What is beta? What is CAPM?
Beta represents the sensitivity of the stock to the entire stock market. Beta is the measure of the
systematic risk of a security: the risk we have to carry to get the rewards. CAPM is the model
that prices the systematic risk. CAPM shows that the expected premium on equity is directly
proportional to equitys beta and the return premium on the market.

What risk free rate do we use?
We use the return on the treasury bill/ bond. We have to use the return on a period similar to the
one we are evaluating. Remember that the treasury bonds have positive beta. The treasury bonds
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have more risk and the investor wants to be paid to carry that risk. The bonds carry risk is given
as bonds are exposed to inflation risk and interest rate risk. For example, beta on 30 year
Treasury bond is 0.13. The return premium of treasury bond vs. treasury bill over 30 years is
about 1.19% (the return of a treasury bill over 30 years is calculated by considering 30
subsequent investments of 1 year each).

How do we calculate debt beta?
Most corporate debt is not traded and so, its market value cannot be observed directly. We can
look at securities issued by companies that have same risk of default and similar maturity. Then
we can run a regression of the excess return of the debt vs. the excess return of market to find
debt beta. The return on debt is defined as:

1 t
t 1 t t
PriceDebt
Interest PriceDebt PriceDebt
+

Debt beta for Blue Chip companies is typically in the range 0.1 0.3. For healthy firms book
value of debt is usually not far from market value of debt because the yield at which we issue has
not changed dramatically and therefore, managers usually use the book value of debt. If the yield
has changed dramatically then we have to recalculate the market value of debt by discounting the
promised cash flow by the higher yield. The cash flow that is generated by the assets either goes
to shareholders or to creditors. The company is like a portfolio of Equity and Debt. We can have
more than one kind of equity and their betas can be different and so, we should add any more
terms as needed, e.g. a third term can be added for preferred stock.

Debt
e marketvalu
Equity
e marketvalu
asset
Equity Debt
Debt
Equity Debt
Equity
red BetaUnleve | | |
|
|
.
|
\
|
+
+
|
|
.
|
\
|
+
= =

How do we calculate the unlevered beta for a comparable company?
Once we have the equity beta and debt beta for the comparable company, we can use the
following formula to calculate the unlevered beta.
Debt
e marketvalu
Equity
e marketvalu
e marketvalu
asset
Equity Debt
Debt
Equity Debt
Equity
| | |
|
|
.
|
\
|
+
+
|
|
.
|
\
|
+
= = Unlevered Beta

Unlevering takes away the financial risk that we have due to the fact that the company has debt.

How do we calculate the equity beta for the target company?
Once we have found the beta unlevered for the comparable company we can say that this is the
asset beta of the company we are evaluating. Now we have to lever this beta again for the target
Company. We have to use the Target Companys leverage ratio for this. By putting the unlevered
beta and debt beta in the following equation we can get the equity beta for the target company.

debt
et t
Equity
et t
unlevered asset
Debt Equity
Debt
Equity Debt
Equity
| | | |
arg arg
|
|
.
|
\
|
+
+
|
|
.
|
\
|
+
= =

8

How do we calculate WACC?
WACC is an asset rate that considers the effect of the debt tax shield by blending the return on
equity and the after tax return on debt.

( ) ( )
debt
et t
equity
et t
WACC asset
r
equity debt
debt
r
Equity Debt
Equity
r r t
|
|
.
|
\
|
+
+
|
|
.
|
\
|
+
= = 1
arg arg

Notice that this formula accounts for the debt tax shield that we have and the benefit that the tax
shield generates by reducing the rate at which we discount the cash flow. As WACC is a blended
rate of return on debt and equity, it is unlevered and that is why we use an unlevered cash flow to
discount. We find a FCF that does include the effect of interest expenses because we use a
discount rate that is unlevered in the form of WACC.

How do we find an appropriate capital structure to calculate the WACC?
Usually we would use the leverage ratio that the market can tolerate, i.e. the ratio that generates a
level of equity that the firm can service. If we believe that the market is incorporating all the
information about future cash flows that assets can generate into the equity, then the market must
also be evaluating the amount of debt the firm can carry. Thus, we use a debt to equity ration in
WACC that the market can tolerate.

What is the benefit of debt tax shield?
It takes into account the benefit of leveraging up the company, and therefore the benefit of the
debt tax shield in the term ( ) t 1 . Thus, the benefit of financing is included in the WACC
because we capture the effect of the tax shield in the ( ) t 1 term that gives us at the end a lower
rate of discount that increase the present value of the Cash flows.

What are the drawbacks of WACC?
1. It assumes that the capital structure of the firm and therefore, the Debt/(Debt+Equity)
ratio and Equity/(Debt+Equity) ratio remains same during the life of the company. This is
restrictive and an approximation. If it changes sensibly as it does in an LBO we cannot
use WACC.
2. WACC assumes that the company can take advantage of tax savings, i.e., the company
will make profit in order to actually pay for taxes.
3. WACC includes the effect of the debt tax shield we get by leveraging up the firm but it
does not account for the cost of financial distress, i.e., the cost of additional default risk
due to leveraging up of the firm. Anyway it is very difficult to formally model the effect
of financial distress on the return on debt and therefore model it into WACC.
4. For conglomerates we need to calculate a WACC for each of the divisions since the risk
that the assets bear may be different for each division and also the way divisions are
leveraged may be different.

What is the relation between equity and asset beta?
The rate of return that you have on the asset (or the unlevered) is lower than the return on equity
or the leveraged beta.
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( )( ) t | | | | + = 1
Debtt Asset Asset equity
E
D

The shareholders demand an increase in return for the additional risk that the leveraging of the
firm brings. The return on asset is lower that the return on equity that we have.

How long do we project the cash flow for in a DCF analysis?
Usually we project cash flows for a time period between 5 to 10 years. In case, there is a
company for which we cannot clearly project the cash flow for more than 2-4 years, we will use
a shorter time horizon.

What is APV (Adjusted Present Value)?
It is the more academic method to evaluate a firms worth. It is another method to discount the
unlevered cash flow for the specific period and the terminal value (again found using either
perpetuity growth model or the multiple model). In this case we separate the evaluation of the
operations from the evaluation of the benefit we derive from Financing. Thus, we will need to
calculate the NPV of financing (i.e. the tax shield benefit) and also the cost of financial distress.
If we didnt include the cost of financial distress, it would literally say that the more we lever,
higher is the value of the firm but this is absurd. This is why we have to include the cost of
financial distress as levering up increases the risk of bankruptcy of the firm.

What are steps to calculate value of a firm using APV?
1. DCF value of the unlevered free cash flow discounted with the unlevered equity cost
(value as all equity financed)
plus
2. Present Value of the tax shield
Minus
3. Present Value Cost of financial distress. This is the reducing value of the company.

While debt adds Value to the firm because interest is tax deductible and therefore the firm pays
fewer taxes and has more cash, the debt also increases the risk to the company. Too much debt
could result in losses due to too much interest expense and this probability of loss should be
considered in the valuation. In the WACC we included the effect of interest in the calculation,
but did not included the cost of financial distress. We discount the free cash flow and the
terminal value using the return on asset which is an unlevered return. We go through the same
steps as we did in the DCF analysis.
- That is we look for a comparable company.
- We find the Beta Equity for this company, and the Beta Debt.
- We unlever beta and we find Beta Asset

debt
et t
Equity
et t
unlevered asset
Debt Equity
Debt
Equity Debt
Equity
| | | |
arg arg
|
|
.
|
\
|
+
+
|
|
.
|
\
|
+
= =

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- Then applying the CAPM we find the return on the assets.

( ) ( ) | |
asset free risk return r
where
r r E r r E
f
f Market asset f asset
=
+ = |

- We use this to discount the unlevered free cash flow (of the specific period we examine
5-10 years) and the terminal value.

- To this we have to add the value of the tax shield. To calculate the value of levering up
the company we can calculate the debt tax shield in any year of the specific period we are
analyzing. D/V and E/V need not be constant in the periods. The interest expenses for
each year are:
Interest expenses = Debt r
debt

Thus, the tax shield for each year is: Debt r DTS
debt
=t

Which discount rate do we apply to debt tax shield to calculate the present value of the
debt tax shield?
If we assume that the risk of using the tax shield is as much as the risk of the asset (that is as
risky as the cash flow assuming company has profits on which it will pay taxes and thus, can
have a tax shield) then we use the return on asset (i.e. the cost of unlevered equity). If we say that
the risk of capturing the tax shield is as much as the risk on debt then we use return on debt. In
particular, we should also judge the probability that the company has to use the debt tax shield
which is dependent on the probability of the company actually being profitable and paying taxes.

What does cost of financial distress cover?
- direct bankruptcy cost like court fees
- indirect bankruptcy costs like difficulty of managing a company that is undergoing
restructuring (additional cost of supplies)
- conflicts of interest between bondholders and stakeholders may lead to poor operating
and investing decisions that may add to losses (stakeholders may try to play games at
expenses of bondholders; the contract should avoid this but there is a cost of setting up
the contract and enforcing it)

What are the differences between WACC and APV?
The main difference between the WACC and the APV is that the WACC takes the target ratio
Debt/(Debt+Equity) as constant whereas APV removes the effect of this target ratio in
calculation the value of the assets from the cash flows and takes it into account in calculating the
debt tax shield. The APV is more an academic method and it is often problematic to find data to
apply it. Investment banks in general use WACC.

What are COMPS or Comparable Analysis or Multiples? Why is this method useful?
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COMPS are often more relevant because at the end of the day it is what the investors or someone
who is acquiring the company, is willing to pay. COMPS are fundamental for IPO (remember
there is an IPO discount that applies in order to favor the large investors that take reasonably
large positions so that they do no dump and sell the stock immediately after buying it, giving bad
signal to the market).

How do we calculate COMPS?
We can evaluate a company looking at the current trading prices of comparable companies in
several ways. The most common steps to calculate COMPS are as follows:
1. For comparable companies we will calculate at how many multiple of certain operating
data the companies are traded.
2. After doing so we apply multiples derived from these publicly traded companies to the
subject companys operating data.
Some of the most common multiples are P/E, EBITDA multiple, Sales Multiple and EBIT
multiple. For example,

EBITDA
FirmValue
iple EBITDAmult =

Why do we use market value of equity and debt?
We do so because we are trying to evaluate the assets of a company and we need to get the firm
value that is related to the present value of the cash flow that the assets generate. If we assume
that the equity and debt are fairly price, i.e. if we assume that the shareholders are incorporating
all the information on hand about the future cash flow the assets are able to generate and
correctly evaluating equity and debt according to the portion of free cash flow then the market
value of equity and debt represents the actual value of the firm.

What are firm value and equity value multiple?
- Firm value multiples
o Revenues
o EBITDA
o EBIT
- Equity value multiples
o Earnings
o Book value
Typically we focus on firm value multiples to minimize distortion arising from varying financial
structures, tax regimes etc. Calculating COMPS is a simple mathematical exercise but requires
an in-depth understanding of the subject company and its peers.

What corrections if any need to be made to COMPS?
If a Firm is leasing its buildings and another owns the building, then a correction for the lease
amount needs to be made. In EBITDA of the company that is leasing we have the effect of the
operating leasing expense that the company registers any given year. We can do two things,
either add this back to the EBITDA of the company with operating lease or subtract the same
amount from the company that owns the assets. In case we do it from the company that is
expensing the operating leasing we have EBITDAR.
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What time period do we look at for calculating the COMPS?
Remember to look consistently at the operating data from the same period that is the last 12
months (and correct for differences in the timing of operating year for a company; that is when a
company closes its books for the year). We might look at prospective 12 months in future as
well. We can create a multiple based on past operating data or we may create a multiple based on
prospective operating data of companies.

Can we illustrate the COMPS with an example?
Below is the table with COMPS calculated for a semi-conductors business:
Company Firm value Equity (no debt
here)
Sales EBITDA Earnings Sales Multiples EBITDA
multiples
P/E ratio
A 900 900 220 115 82 4.09 7.83 10.98
B 700 700 190 90 60 3.68 7.78 11.67
C 650 650 280 68 42 2.32 9.56 15.48
D 320 320 150 45 26 2.13 7.11 12.31
Average 3.06 8.07 12.61
Sales EBITDA Earnings
Target Company 180 70 40
Firm value Equity value net debt is 100
Firm Value using Sales Multiple 550.345 450.345
Firm Value using EBITDA Multiple 564.7914891 464.7914891
Equity Using P/E Ratio 604.2615921 504.2615921

How are various ratios related to each other?
If multiple of P/E ratio is highest then
P/E ratio>EBIT multiple>EBITDA multiple>Sales Multiple
and
Sales>EBITDA>EBIT>Earnings
Remember that P/E ratio is affected by the capital structure of the company as the interest
payments are affecting the value of earnings. In case of EBITDA interest expense has not effect
and thus, it is free of the capital structure effects. Remember that firm value multiple are
EBITDA, EBIT and Sales because these are related to cash flow that assets are generating.
EBITDA and EBIT are proxies for free cash flows or cash flow to assets. Earnings and book
value multiple are equity value multiples because they are related to what goes to equity
shareholders. They are proxies for cash flow to equity, in terms of either retained earnings or
dividends. Once we have the Equity market value, we can add the net debt to get the asset value
(or firm value).

How are COMPS different for conglomerates?
Remember that the conglomerates must be valued by analyzing each of the divisions separately;
the assets have different risk and it does not make sense to find a single multiple. We have to
find a comparable company for each division

What is comparable transactions method?
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In this method, we compare how acquirers have historically valued similar targets based upon
valuation multiples. We look at recent past transactions and how much was paid for acquiring
the company, i.e. how much was paid to buy all the equity and then we can calculate the implied
firm value. This is also called the precedent transaction method.

What is the difference between COMPS and comparable transactions?
There are two key differences
- Control premiums
- Potential synergies
A value derived from comparable transactions includes both of the above. When we acquire 70%
of a company we get a premium from getting control of the company that we dont get if we
acquire a single share. It is difficult to distinguish premium from synergies. This value will
always be higher compared to the COMPS value because we include the control premium and
potential synergies.

Can we illustrate the comparable transactions with an example?
Company Firm Value Net debt
Equity
Market Value Sales EBITDA Earning EBITDA Multiple Sales Multiple P/E Ratio
A 2100 100 2000 70 17 (12) 123.529 30 -166.6667
B 3000 200 2800 75 18 (8) 166.667 40 -350.0000
Average 145.098 35.000 -258.333
Target 80 20 (10)
Now Target Company has debt for 100
EBITDA Multiple
Min 2470.6 100 2370.6
Max 3333.3 100 3233.3
Average 2902.0 100 2802.0
Sales Multiple
Min 2400.0 100 2300.0
Max 3200.0 100 3100.0
Average 2800.0 100 2700.0
P/E ratio - equity value multiple
Min 2000.0 100 1900.0
Max 4200.0 100 4100.0
Average 3100.0 100 3000.0

What is a Leveraged Buy Out (LBO)?
It is a strategy used by financial buyers in order to place minimal equity capital in a deal and
finance the rest of the acquisition with debt. The debt tax shield gives a high benefit to the buyer.
Buyers do an LBO to leverage up the firm and actually turn it around by bringing in good
management and financial discipline. This is the point, if the current management were able to
do the same they would just lever it up themselves but because the current management cant do
itself, it gets bought out. The targets of LBO are firms that have steady cash flow so that a certain
financial discipline can be introduced and thus, the firm can be restructured while paying down
the debt. LBO investors enhance return by earning the spread between interest expense and cash-
on-cash return.
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What to look for in an LBO?
- Is the company attractive for an LBO? Has the company steady free cash flow? How
much debt the firm can serve. Look at the FCF that can be used to pay the debt in 5-10
years.
- It is important to notice that the LBO buyer is someone who has the managerial
capability to introduce a high financial discipline and lead a restructuring of the company.
If the secret was only in the leveraging up the firm then the current management could
have done it on its own.

What drives the FCF?
- Revenue
- COGS (Margin)
- SG&A
- CapEx
- Working Capital

What are the steps in LBO analysis?
1. Project the FCF.
2. Look at the return buyer requires from the company.
3. The capital structure is related to how much the market is willing to accept as leverage. In
a LBO we would like to have as much senior debt as possible and the rest subordinated
debt (it is more expensive than senior debt). We lever up 5 times EBITDA. To have an
idea of capital structure look at comparable companies. The leverage usual for an LBO
today requires at least 25%-30% of equity; this also gives good signal to debt market as
the sponsor is supporting the project and thus, believes in the project.
4. At the end of the period the buyer exits through either of the following:
- IPO
- Relever up the firm and, take advantage of debt tax shield and increase return on
equity
- Sell the firm at the multiple at which it was bought or a higher multiple.
5. Get the desired return on equity. An LBO firm usually has in mind a certain return on
equity and therefore the price paid is the most the firm can pay in order to have a
reasonable leverage and the required return on equity.

How much is the split between debt and equity in a LBO?
Imagine we pay 7 times EBITDA.
In the beginning
2x EBITDA is equity
and
5x EBITDA is debt
There is a certain return we require from the equity, e.g. 25%. We find the D/E we want every
year and then value the company.

Why do we prefer companies with steady cash flow for a LBO?
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The companies we look for in LBO are those that have predictable cash flow since we need to
serve debts. We look at precisely those companies that ought to have high debt ratios. Typically
firms that are in well - established industries and do not have very high ROA. These companies
usually do not have high ROA since we lever them up and get a high return on equity. A
company with steady cash flow helps evaluate how much debt the firms cash flow can service.
The premise is crank up maximum debt with minimal equity to lever the equity return. The
buyout firm makes some operational changes to improve the business and ~5 years later a
liquidity event takes place (the company is sold). The company is sold typically at the same
multiple as going in but now is applied to a higher cash flow. This is the method to arrive at the
floor valuation or the lowest valuation. Buyouts have limited synergies; and thus, are usually not
done by strategic buyer. The price we get from a strategic buyer is usually higher because it has
more synergies.

How much can we lever a company?
It depends on how much the market tolerates. In 2003-2004 it was 5x EBITDA. Remember we
can not use WACC for a LBO valuation as the debt to equity ratio is not constant. It is ok to use
APV (we use beta asset to calculate return on asset and evaluate FCF from assets and then we
sum the effect of the debt tax shield that changes year after year since we are using excess cash
to pay back the debt).

What is the role of investment bank in a LBO?
The investment bank typically manages the entire process from bidding to closing. The typical
steps are:
- Advise the board and the LBO firm
- Provide financing
- Provide bridge loans: temporary financing advances that an investment bank will
guarantee in order to close the transaction until the LBO firm can get to the capital
market. Staple is the full financial package and bridge is a part of it.
- Underwrite debt issuance
- Pair up partners, that is match the LBO firm (also called financial sponsor) with strategic
partner / player in the industry
- Facilitate exit process

What are the recent trends of LBO?
- Increasingly focusing on operation vs. straight financial engineering and thus, teaming up
with strategic partner and industry players.
- More equity is going into the transaction then in past (equity of about 30% now versus an
historical 20%).

Can we illustrate LBO analysis with an example?
16
Very Simple LBO Model
*Please turn on iteration
Year Year Year Year Year Year
0 1 2 3 4 5
Revenue 1,000.0 1,100.0 1,210.0 1,331.0 1,464.1 1,610.5
COGS (incl. dep) 500.0 550.0 605.0 665.5 732.1 805.3
SG&A 250.0 275.0 302.5 332.8 366.0 402.6
EBIT 250.0 275.0 302.5 332.8 366.0 402.6
D&A 200.0 200.0 200.0 200.0 200.0 200.0
EBITDA 450.0 475.0 502.5 532.8 566.0 602.6
% Margin 45% 43% 42% 40% 39% 37%
Tax Payments 87.5 96.3 105.9 116.5 128.1 140.9
Bank Debt Interest - 51.8 46.6 40.1 32.1 22.4
Sr. Sub Debt Interest - 108.0 108.0 108.0 108.0 108.0
Tax shield from interest payment - (55.9) (54.1) (51.8) (49.0) (45.6)
Capex 200.0 200.0 200.0 200.0 200.0 200.0
Excess Cash 162.5 74.9 96.1 120.0 146.8 176.9
Bank Debt 900.0 825.1 729.0 609.0 462.1 285.2
Sr. Sub Debt 1,350.0 1,350.0 1,350.0 1,350.0 1,350.0 1,350.0
Equity Value 450.0 1,980.6
Equity as % of FV 17% 55%
Firm Value 2,700.0 3,615.8
Return on Equity (5yr CAGR) 34.5%
Assumptions
Entering EBITDA multiple 6.0x Assumes all equity firm
Exit EBITDA multiple 6.0x Assumes excess cash in year 0 just disappears (paid out before transaction)
Total Debt / EBITDA 5.0x Assumes capex = depr
Bank Debt / EBITDA 2.0x Assumes transaction at end of year 0
Bank Debt Int. Rate 6% Assumes no transaction fees
Sr. Sub Int. Rate 8% Assumes only bank debt can be prepaid
Sales Growth Rate 10%
GOGS as % of Sales 50%
SG&A as % of Sales 25%
D&A 200
Tax rate 35%

What are the characteristics of various valuation methods?
Discounted cash flow
- Enables to conduct detailed analysis
- Internally driven rather than market driven, usually gives the highest valuation since
projects optimistic cash flows
- Easy to incorporate with assumptions
o synergies, future restructuring plans
o Usually build some scenarios (base, optimistic, pessimistic)
- Time consuming as need detailed info
- WACC is vulnerable for change in capital structure since we assume constant ratios
- Cannot be used for LBO since the WACC assumes that the Capital Structure ratios stay
the same.
COMPS
- Easy to generate (takes only 5 min if you have templates)
- Market driven rather than internal (DCF is internal)
- Not many assumptions and therefore, clients can easily understand
17
- Not suitable for conglomerates
- Cannot incorporate company specific issues, e.g. restructuring, new product development
- Gives an evaluation of how much investors are willing to pay for share of a company
rather than the whole firm
Comparable Transactions
- Do only once for each transaction
- Difficult to find information and similar transaction
- Appropriate when finding ball park
- Incorporates the synergies and the control premium
- Very difficult to have significant data
- Makes sense to use only if a similar recent transaction has taken place
- Often if the transaction is private not much information is available
- We have to be sure that the transaction we take as comparable was involving a firm that
has similar business rational and the transaction exchange involved at least 50% of the
value of the firm
LBO
- Gives floor valuation, i.e. what is the minimum price an investor will be willing to pay

How do we position the various valuation methods?
- DCF: intrinsic and internal valuation method. It usually is the one that gives the highest
valuation since the cash flows given by the company are generally optimistic.
- COMPS: outward looking. We look at what the market is thinking and are rather short
term. This method looks at how much investors are willing to pay to purchase shares of a
company and not gain control. It looks at how much value of the company is traded and
the price at which is traded. This is the price which investors are willing to pay for a non
controlling stake of the company.
- Comparable transactions: The comparable transaction gives you a valuation that is related
to how much an investor is willing to pay for acquiring the company and thus, it includes
the premium for controlling the company and also a premium for potential synergies that
a strategic buyer may have realized.
- LBO is a floor evaluation.
These valuations are relative. Changes in market conditions and times give different results.

How do various valuation methods compare with each other?

18
617
500
600
0
100
200
300
400
500
600
700
DCF Comps Comparable
Transaction

What are the pros and cons of each valuation method?
DCF:
General advantages
- More accurate reflection of a particular firms business operations
- Considers time value and risk of returns
General disadvantages
- Required good estimation of free cash flow (EBITDA, CAPEX, growth etc) over a period
of time
- More complicated modeling required and thus more consuming and data intensive
APV vs. WACC
- APV provides more accurate reflection of firms actual debt-equity ratio in particular
period
- APV is more detailed and complicated
Comparables
300 250 350 450 400 500 550
8 x
EBITDA
12 x
EBITDA
Comparable Transaction
9 x
EBITDA
14 x
EBITDA
DCF
LBO
6x
EBITDA
8 x
EBITDA
200
19
- WACC assumes constant debt-equity ratio for the entire future FCF periods
- WACC is easier to calculate, based on easily available market betas

COMPS:
General advantages
- Incorporates market information to ensure within market rationale
- Provides comparable valuations within industry
- Less complicated (more time to shirk)
- Incorporates inaccurate market information (e.g. dotcom overzealous valuations)
- Does not provide for company specific business characteristics or capital structure

Comparable Transactions:
General advantages
- Incorporates recent market information (and hence sentiment) to capture up-to-date
investor bullishness/bearishness
- Provides comparable valuations within industry
- Less complicated
- Incorporates inaccurate market information (e.g. dotcom overzealous valuations)
- Does not provide for company specific business characteristics or capital structure

LBO:
General advantages
- Gives floor valuation
- Time-consuming

What are LBO candidate criteria?
- Steady and predictable cash flow
- Divestible assets
- Clean balance sheet with little debt
- Strong management team
- Strong, defensible market position
- Viable exit strategy
- Limited working capital requirements
- Synergy opportunities
- Minimal future capital requirements
- Potential for expense reduction
- Heavy asset base for loan collateral

What are sources of value in a LBO?
- Levering up the firm to put in maximum debt and minimum equity, increases FCF so that
can exit at the entry multiple applied to a higher FCF
- Debt tax shield
20

How will you value an orange orchard?
DCF
- Calculate FCF
- Determine discount rate
- Find terminal value
- Calculate NPV
COMPS
- Find trading multiples of companies in same industry/size
- Find range of values
Comparable Transactions
- Look at recent M&A deals and compare multiples

Given a noodles company with steady earnings and a technology company that is poised to
take off and which can be sold at a higher exit price, which would you choose for a LBO?
Noodles Factory is a good candidate for a LBO because
- Steady Cash Flow
- We need steady cash flow to pay down the interest expense on debt and principal

What are areas of value creation in a LBO?
- Financial engineering
- Operational improvements
- Private market to public market arbitrage
o Private market Public market
o Public normally valued higher because of liquidity

What are the criteria to consider when advising a client on acquisition?
- NPV > 0 (create s/h value)
- Financial Perspective:
o Consider EPS accretion/dilution
o Source of Cash
o Use of tax laws of target company/ Tax shield?
- Strategic Perspective:
o Growth in market share
o Vertical integration
o Leadership & Management
o Technological acquisition
o Regulatory & Political Change e.g. media & telecom (Telecom Reform Act of
1996); financial services (Glass-Stegall Act), Medicare Modernization Act of
2003
o Industry consolidation or preemptive measure/ Economies of Scale

21
Technical questions - Finance

Why do companies merge?
- Get access to new markets through a distribution network already in place
- Preempt the competition to avoid the competition from doing the same
- Acquire ability to bundle complementary products and give a higher value to the
customers
- Realize synergies through economy of scale and economy of scope (apply knowledge and
expertise in different sectors)
- Vertical integration

What are the issues in mergers?
- Competitive reaction
- How will the industry and market react to the merger
- Issue of antitrust
- Problem of integrating culture
- Agency costs

What is a strategic buyer?
It is a buyer that wants to acquire a company for strategic reason like access to new markets (e.g.
Microsoft that buys WebTV in order to get access to a new industry like interactive TV).
Strategic buyers are looking to expand their product offering, take advantage of the
complementarities of the products to create more appealing bundle for customers and also realize
savings through synergies.

What is a financial buyer?
LBO firm, Private Equity funds etc. represent financial buyers. The reason for buying a company
is investment, i.e. LBO will leverage up the firm, boost the return on equity and after 5 circa
years will sell out the business at a multiple that is equal to the one used to get in but now
applied to a much larger cash flow (earn the spread between cost of debt and cash to cash return).

Who will pay more, strategic buyer or financial buyer?
Valuation is higher for a strategic buyer since by the combination of two firms we expect higher
free cash flow (due to increased sales vs. the sales of the standalone company and the reduction
of expenses due to synergies). The financial buyers will not be able to exploit synergies.
It can only benefit from leveraging up the company and thus, higher tax savings due to
deductible interest expense and, savings from some sort of internal reorganization and
restructuring. However, this debt tax shield and savings from reorganization are very less
compared to the potential synergies.

What are the various ways to pay for a merger/ acquisition?
There can be a stock swap: the stock of one company is exchanged for the stock of another
company. This usually happens in mergers. A way to usually pay for acquisitions is cash, i.e.
give cash to acquire shares of the other company. The two ways will be accounted for differently
in the books. A stock swap could be particularly favored by the target company if the stock of
22
the acquiring company is highly valued and the company after the merger has a long term
prospect of growth. If the performance of the stock of the acquiring company is uncertain the
target company will probably prefer cash. We can also pay for a merger by debt or other
securities like preferred stock or a combination of all.

What factors does the payment method depend on?
- Marketing issue of the acquisition
- Relative pricing of securities
- Concern of public company (dilution perception)

What is a hostile takeover?
In a hostile takeover a buyer offers to buy a company against the wishes of the management of
the company. There is usually a tender offer associated with a hostile takeover. A buyer declares
its willingness to acquire the share of a company for a certain price (obviously at the
announcement the share price goes up).The one that makes the tender offer can refuse to buy all
shares offered if he has reached more than 51%. Lets say he has reached 75 % and does not
want to buy more than 51%. He will offer to buy 2/3 of the stock at the tender offer and 1/3 at
the price before the tender.

Why would the hostile bidder offer $40 for a stock traded at $20?
If he believes that the cash flow he will get by taking ownership of the company will be much
higher than the one expected right now by the company in current ownership. He can realize
synergies or he can increase sales by bundling with his current products etc.

What are the effects of a hostile bid?
Sometime tender offers can generate escalation of offers. A way to contrast the hostile takeover
is to hire an investment bank to make a higher counter offer and find funds to finance a
repurchase of shares.

What are pooling and purchase methods of accounting?
Pooling is a way to account for acquisitions on books. FASB does not allow this anymore. Only
purchase method can be used for accounting acquisitions now. Therefore, we have to consider
the price we pay for the acquisition and then correctly estimate the goodwill. We identify the fair
market net value of the identifiable assets of the company being acquired and we compare it with
the price being paid for the acquisition, the difference between the two is goodwill. Goodwill is
an intangible asset that cannot be identified precisely. Other intangibles are trademarks, patents,
good reputation of the company, the human capital of the management etc.

Goodwill = Price Paid Net Fair Market Value of Identifiable Assets (Tangible and Not)

Net Fair Market Value of Assets= Fair Market Value of Asset-Market Value of Debt

Classifying in one way or the other determines the way we account for the transaction and
therefore, the taxes we pay. There were 12 rules to classify in one or the other way.
The simplest most general way to explain the rules is that if the deal is a stock for stock deal it
can be accounted for using pooling. If the deal involves a trade of cash for the acquisition of the
23
target, it will be classified as purchase. In the pooling method we simply combine financial
statements of the two companies and this result in no goodwill. Remember that in general we
cannot deduct the amortization expense related to goodwill. Now FASB requires that the
goodwill be analyzed for impairment at least every year and any impairment expense be
recognized on books. Only if we get a step up we get a chance to tax deductible goodwill
depreciation. Therefore there might be a loss incurred due to the write down of goodwill.

When is a deal accretive and when is it dilutive?
A merger is said to be dilutive when the earnings per share of the acquiring company decrease as
an effect of the merger. It is said to be accretive when the earnings per share of the acquiring
company increase after the merger. There are two ways to find out whether a deal will be
accretive or dilutive.
- The long one is adding up the earnings and looking at the number of shares of company
after the merger and finding the new earning per share, e.g.
Company A: Earnings $10M Share Outstanding 1M Earnings per share $10
Company B: Earnings $ 2M Share Outstanding 300K
Now company A will acquire company B with a stock to stock transaction, and will issue
500,000 shares. The combined company will have earnings of $12M, and 1.5M shares
which gives earnings per share of $8 after the merger. Thus, the deal is dilutive.
- A simple way is to look at the P/E ratio:
Company 1 acquires Company 2. If,

Earnings Relationship Merger Type
P/E
1
>P/E
2
ACCRETIVE
P/E
1
<P/E
2
DILUTIVE

This is because lower the P/E, the higher the earning per share. For example, Company A
has a P/E ratio of 55, while company B has a P/E ratio of 33. The merger is accretive and
the earnings per share of the acquiring company will rise.

What are various equity instruments?
They are residual claim on the firms assets and they command a higher return.
- Common Stock
- Preferred Stock
- Warrants
- Call / Put Options

What are various debt instruments?
They are fixed claim on firms assets.
- Bank Credit lines
- Investment Grade Bond
- High Yield Bonds
- Convertible Debts
- Secured/Unsecured Debt
24

Why do some stocks raise so much on the first day of trading after their IPO and others
dont? How is that there money left on the table?
The value that the markets gives can be higher than what the firm can actually generate since the
market builds up higher expectation. However, the bankers have to value the company
objectively with all the information on hand and market reaction can be irrational at times (often
the abnormal return is corrected in the long term). Thus, the stock ends up being priced lower
than what market is expecting it to be. Money left on the table means that investors are willing to
pay more than the price at which it has been offered. The difference in valuation goes as profit to
investors that bought the stock first and then sold it at a higher price. It is not easy to predict
from the feedback that the investment bank and company has during the road show as to how the
market will react. However a banker should value a company long term instead of guessing what
the market will do in the first day. If a stock trades up the first day the banker would expect that
the market will eventually correct the valuation. If the price goes up after the IPO, then the
investors that bought at IPO offer got a bargain. Investment banks say that when the stock goes
up, it generally opens up more doors for a company to raise capital in subsequent offerings. Also
this way banks have less risk of remaining with unwanted stock that they are obligated to buy.
The role of capital market in an investment bank is to collect the information from the sales
people (on the other side of the Chinese wall), aggregate it and set the value of the offer so that
the market will buy it.

What is gray market?
Let the security be traded before it has been issued (more common for debt issue) so that the
investors know what the market price will be.

What are the steps in an IPO?
1. Appointments of underwriters, a syndicate formed
2. Arrangement of spread (typically 7% for medium sized IPOs) and the green shoe option(
allow banks to sell additional share if the demand is high,15% more shares is the cap)
3. Issue registered with SEC and preliminary prospectus (Red Herring) are issued
4. Road show: meeting with potential investor to test the market.
5. book building: Underwriters build book of potential demand
6. SEC approves registration
7. Underwriters allot stock to investors (over allotment typically)
8. Trading starts. Underwriters cover short position by buying in the market or buy
exercising green shoe option.
9. Managing underwriter makes market liquid in stock and provide research on the stock

What is rights offer?
It is a way a company can raise more cash in Europe. It is very uncommon in USA. The
company gives existing shareholders the right to buy one additional share for every share they
own, at a price lower than the one at which the share trades currently at. As shareholders we can
decide to exercise the option (rights) or we can decide to sell them. The one who buys the rights
will then buy the share at the price the option gives the right to.

How can we increase stock price?
25
- Dividends increase or payment
- Increase the transparency of the financial statements
- Acquire a company which a positive NPV project
- Any positive NPV projects
- Work on the capital structure of the company and leverage up the company to increase
the value because of the debt tax shield (provided the company is profitable and it is
paying taxes, also provided the company expects to be able to service the debt in future
and has a good cash flow to do this)
- Give some signal to investors that the stock is undervalued by buying back stock (it is a
way to redistribute cash or assets to shareholders but it is not perceived as a long term
commitment)

What is in a pitch book?
It is a proposal of a merger with the rational behind the opportunity, projection of the cash flows
and the prior similar transactions the investment bank has done.

What is PEG ratio?
- Price/earnings divided by the growth rate (of earnings per share)
o More than 1 is poor
o Less than 1 is good
o Less than 0.5 is excellent

How to interpret the price drop with additional issue?
Most financial economists now interpret it not as a consequence of the additional supply but as a
result of the information effects, information that is in the prospectus. Investors may easily think
that the management is trying to exploit an overvalued stock to raise money at good terms. The
pressure is due to the information that the investors read into the management decision to issue
stocks. When the stock is issued obligatory (to satisfy some regulatory norm) then the issue does
not decrease the prices. Also investors know that management has a greater incentive to issue
equity if they are pessimistic. Debt requires having a steady cash flow and equity does not.
Therefore when a company announces an issue of debt or preferred stock there is not a fall of
stock price as in announcement of additional common shares.

What is a private placement?
Private placement is issuance of stock to private parties. This does not require registration with
SEC but it must be to less than 12 investors. Often insurance companies are not concerned with
marketability and thus, a market for not traded debt has increased. If placement is large then an
investment bank can be involved to deal with the investors.

What is influencing the yield on the bond a company wants to issue?
- Risk free rate
- The credit rating of the company that is the risk of default the company has and had in the
past
- How much a market is receptive for debt, e.g. if everybody has bought from
telecommunication companies in the past there is not much demand and we will have to
promise a higher return on the debt we issue and this more expensive
26

27
What is a bond issuance?
Issuing bond is a way to borrow money today and assume the obligation of a series of payment
to our lenders (coupon payment) and a final principal payment.

What is preferred stock?
It is a stock that receives an interest like dividends payment and has higher priority than common
stock in case of liquidation of assets. The corporations that invest in preferred stock see only
30% of the dividends received subject to tax.

What is the order of seniority to various security holders?
In order of decreasing seniority:
1. Bondholders
2. Preferred stock Holders
3. Common Stock Holders

What happens if a company buys back stock?
The Price of the stock goes up because
- Earning per share: If a company buys back stock the earning per share will increase
afterward and the investors anticipate this by driving the prices up.
- Signaling effect: a company that buys back its own stock gives a good signal of what the
company management believes of the prospects of the company, who else has better
information about the company than its own management?
- Deb Tax Shield: Buying back stock drives up the net debt, thus increasing the effect of
the debt tax shield and the valuation goes up; company is changing its capital structure by
buying back stock and replacing it with debt.
- The taxes for shareholders are different on capital gains and on dividends.

How much should a company issue in dividends?
In an ideal word with no tax etc. the dividends controversy would not exist. Sudden shifts in
dividend payout ratio are badly interpreted by the market. Company should smooth out dividends
payment. There are three major currents: high dividends, no dividends (or no importance) and
middle of the road. A company should follow middle of the road.

What happens if a company issues more stocks?
The Price of the stock goes down because
- Signaling effect: a company that sells stock instead of issuing debt may signal that
managers believe stock is overvalued and that they are taking advantage of it by raising
cash at good terms. It may also signal that the company needs to spread the risk among
more shareholders and that it cannot serve more debt (not a good signal for future
expected cash flow). Also investors know that management has a greater incentive to
issue equity if it is pessimistic.
- Earnings per share: investors believe that the earnings per share will be diluted.
Obviously the cash raised should be used in a way to increase earnings (invested in
improving productivity etc.) but usually the fear of dilution on earnings prevails.

28
- Effect of debt tax shield: if the company believes that the project for which it needs
money would be successful it would probably issue debt and keep the upside of the
investment inside the firm and take advantage also of a higher debt tax shield. By issuing
stock, the company spreads the risk amongst more shareholders and so it is not a good
sign. The flush of cash that comes inside the firm will reduce the debt and thus, reduce
the debt tax shield and so the valuation of the company.

Why would a company buy back its stock?
- Got cash and no positive NPV projects
- A company feels that its own stock is undervalued and it can use excess cash to
repurchase stock. As an example a company that has been in a period of decreasing
earnings because of a cycle in its industry may have undervalued the stock. It may decide
to buy back to increase share price to give a signal to investors about the prospects of the
company
- Investor are quickly driving down share price by selling on the market and thus, may
decide to give a signal to the market: nobody has better information that we have on the
prospect of the company and we invest in the company by buying back its share and do
not think our price should be so low
- The information content in stock repurchase is different from that in dividends.
- The company is not making a long term commitment to pay cash out to shareholders,
repurchase are one time events
- To change the capital structure and substitute equity with debt when there are no good
opportunities for investment. The fact that a company lacks opportunity for investment
should be a bad signal but shareholders prefer to have back cash than let it be invested in
a project with dubious returns. In addition, a company with higher debt will be more
cautious in the cash management.
- Repurchases are used to give a positive signal: if a company repurchase at 20% premium
over current market price than it means the stock is good value even at 20% more and
therefore, the price will increase.

What information do dividends carry?
Generally the dividends controversy is complex but the way the market reacts to dividend
announcements proves that the dividends actually carry information to the market (in an MM
world the dividend policy should not matter). The assumption in the signaling effect is that the
managers are reluctant to change dividends. The assumption management does not change
dividends unless it has a reason to leads to a significant change in the future prospect of a firm if
the dividends are changed. Therefore the signaling effect is negative if dividends are reduced and
positive if increased. Thus, a firm should pursue a policy of dividends stabilization. The findings
of studies related to abnormal returns (that is the difference between the realized return and the
return predicted by CAPM) show that in time horizon surrounding the release of information on
dividends support the hypothesis that dividends carry additional information. In particular the
assumption that the market makes is that managers are not changing dividend payments unless
they have concern about the future prospects of the firm. The study also pointed out that the
dividends carry additional information to those brought to the market by the declaration of the
earnings. And the market incorporates the information in a matter of two days. The study also
observed that the effect of dividend announcements is as strong as the effect of earnings
29
announcements. The capital market reaction to the dividend announcements strongly supports
the hypothesis that changes in quarterly cash dividends provide useful information beyond that
provided by corresponding quarterly earning numbers. In addition, the results also support the
semi-strong form of efficient capital market hypothesis that on average the market incorporates
the news and adjusts it in an efficient manner to accommodate the new dividend information.

Why would a company distribute dividends?
A company by paying dividends gives a good signal about its profitability; the fact that profits
have been declared is corroborated by the payment of dividends. It means that company has cash
and thinks it will have cash in the future to do so. It is a way to support information in financial
statements that many investors may see as unreliable since earnings can be adjusted in many
ways (booking earnings in advance as an example). Dividends provide assurance that earnings
are sustainable. In fact any cuts in dividends once the company has started to pay them are
perceived as a very bad sign. Investors get excited about the change in dividends not in absolute
level of dividends payment but relative. Note that repurchase are one time while dividends are
perceived as commitment that a company makes. Also investors may pressure management to
pay dividends when they do not trust the way cash may be spent inside the firm. The fact that a
company lacks opportunity to invest should be a bad news for investors, but at the same time
investors prefer the company to give back cash instead of using that in low return investment
inside the company. Another interpretation: high dividends attract financial institutions as
corporate investors do not pay taxes on 70% dividends. Financial institutions may play a better
role in controlling management action in running the company and therefore individual investors
may well accept the dividends and the taxes on them since they have a company that is better
controlled.

What is your Beta? How do value yourself?
My human capital is probably as risky as a bond because my cash flows are pretty steady but
going into investment banking my cash flows are going to be more risky as it will increase the
cash flows. To value myself I would have to consider the cash flows I will have in the future.
I would probably say that the risk of my salary cash flow is close to bond risk. I have to evaluate
the excess return on me as the excess return on the market. It has been verified that in general the
human capital is much more similar to a bond risk then to equity risk. Thus, my beta would be
closer to the beta of debt. On the other side as a future investment banker my cash flow will be in
part much more risky than the base salary so I should apply a much higher discount rate for
those. As I am more connected to the market because of investment banking, my beta will be
close to 1.

How is the bond price calculated?
Bond Price is the net present value of the discounted cash flow that the bond involves:

( )
t
t
r
r r
C
PV
+
+
|
|
.
|
\
|
|
.
|
\
|
+
= =
1
Principal
1
1
1 Price

This formula considers discount rate r constant. But I have to consider the time structure of
money thus, the discount rate should be actually different in each period
30
The principal is the face value and the coupon is usually quoted as a percentage of the face value.
The yield or r should be different at different time periods (remember the time structure of
money and the forward rates). The yield on the bond should be calculated using the CAPM that
is considering the systematic risk of the cash flow that the bond generates and the
creditworthiness of the company that issues the bond. There is a spread over the treasury bond of
the same structure, i.e. a return premium over the risk free bond. The discount rate should also be
different for different periods due to the time structure of money. A treasury bond can be
stripped to became many zero coupon bonds, each coupon becomes a bond in itself as well the
principal becomes a bond in itself (there is a slight difference on how same maturity coupon
strips are priced and principal strips are priced because of liquidity. I have to reconstruct the
bond to redeem the principal and so for each principal I need to have also the whole stream of
previous coupons to retire the principal at the end). Thus, the time structure of money is given by
the yield curve and we can derive the yield curve by the prices of treasury strips.
Let B be the price of a treasury strip today:

Today 1 2 3 4 5
B = price today
of a zero coupon
bond maturing in
year:
B1 B2 B3 B4 B5
Then,
( )
i
i
i
y
B
+
=
1
100

Therefore we should correctly price a bond by applying different discount rate for each of the
cash flow at different periods. The forward rate is calculated as follows:

( )
( )
( )
4
3
3
3
4
4
4 , 3
1
1
1
B
B
y
y
f =
+
+
= +

The forward contract is a legally bonding contract to exchange at certain rate in the future. It is
the rate at which we discount money in the future today. So the forward rate 3,4 is the discount
rate that today we apply to a bond issued in year 3 and maturing in year 4. The actual interest
rate at time 3 will not be almost certainly be the one we fix today. It is a way to bet on future
interest rate. The forward rates are based on the expectation of what the interest rate will be
one/two/three etc. year from now and they are linked to the yield curve.

What affects the yield curve?
- Macro economic fundamentals (GDP growth, unemployment rate, etc. ) which affect
interest rate in each period
- Visibility, i.e. how visible the future is. If long term economic conditions include a lot of
uncertainty, the yield curve gets steeper due to risk premium, and vice versa.
- Demand and Supply of bonds in each duration

What is role of the Federal Bank?
31
The Fed regulates the financial markets by settings margin requirements on stock and options
and regulates bank lending. The Fed has the role of controlling the money supply. If the Fed
increases the money supply, the policy is expansionary and this boosts consumption but also can
lead to inflation. Fed controls the economy to avoid recession or inflation. The interest rates
surge because people are confident of future increase in cash flow as the economy has good
prospect. Thus, people start to borrow against future cash flow (by selling a bond as an example)
and therefore the rate goes up. In this case the Fed can not do much.

How can Fed regulate money supply?
- Open Market: Write a check and thus, increase money supply and stimulate the economy
- Sell securities to let the money leave the market and slow the economy
- Adjust interest rate and the discount rate: the rate that the Fed applies to banks on an
overnight loan or the Fed Funds Rate: the rates that banks apply to each other on
overnight loans. Lower rates allow bank to lend money at lower interest and therefore
more people start to borrow at low rate. Lowering interest rates pours money into the
economy and vice-versa.
- Reserve requirements: each bank is obliged to have a certain reserve at the Fed according
to the total deposit that customers have with the bank. Lowering the reserve requirements
allows bank to lend out more and therefore pour money into the economy
When inflation goes up the interest rate goes up. Thus, if inflation goes up the yield of bonds
goes up but the price of bonds goes down since we discount more the cash flows. A summary of
market events is illustrated below:

Event Inflation Interest Rate Yield Bond Price
Employment
Grows
UP UP UP Down
Unemployment
Grows
Down (people
have less money
to spend)
Down Down Up (I discount
les the cash
Flow)
Consumer
Confidence
lowers
Down (people
have less money
to spend is
uncertain about
future cash Flow)
Down Down Up
Stock Market
Drops
Down Down Down Up (the bad news
for market is
good news for
bond)
Company
Reports heath
yearnings
UP UP UP Down
Dollar weakens
against Yen
(Euro)
UP UP UP Down

32
Other economic indicators are also summarized.

Negative Event Signal Positive Event Signal a Negative Event
GDP UP Down
Unemployment Down UP
Inflation Down UP
Consumer Price Index Down UP
Interest rate Down UP
New Home Start UP Down
Existing home sales Up Down

How do we value perpetuity of $1,000 a year?

r
NPV
1000
=

How is the yield on a bond determined? What factors influence it?
The discount rate that we use to calculate the price of the bond is related to the risk of the cash
flow and the discount rate we have on risk free bond. It is the same concept as CAPM. The debt
will have a certain beta and the risk premium translates to a return premium (a spread over the
risk free bond the treasury bond).

What Factors affect the yield on a Corporate Bond?
The yield on a corporate bond is dependent on
- The interest rate (or yield) on a treasury bond of the same structure
- The risk on the cash flow of the bond and the creditworthiness of the company that
issues the bond (credit ratings of the company)
- The bond market demand: if many companies have already issued many bonds in the
same industry people will not have much demand for them s they want diversify their
holdings and get other industries bonds. Therefore, we have to increase the yield to
attract people to buy these bonds.
The yield of a corporate bond yield trades at a premium over the yield of treasury bond (the
spread is in basis point 100 basis point = 1%) because of the additional risk that it holds due to
the risk of default. Also risk of default has a component that is not fully diversifiable since the
default is also dependent on the market. That is if the market is bad then the bond is more likely
to default and that is why corporate bonds have a positive beta. The bond return can be easily
determined by applying the CAPM. The yield will be different in each time period in which we
discount the bond so as to capture the time value of money. To this we add the additional return
we expect because of the additional risk that the corporate bonds carry.

( ) ( ) | |
bond. treasury the i.e. risk no with bond a on return the case in this is that - assets free risk on Return
~ ~
=
=
f
f debt debt f debt
r
where
r r E r r E |

33
How do we calculate the yield to maturity?
We assume the yield constant during the time as if the yield curve were flat and we calculate the
yield that would discount the bond cash flow to present price, one it is traded at.

( ) ( )
t t
y
y
coupon
y 1
value face
1
1
1 traded is bond at which Price
+
+
|
|
.
|
\
|
+
=

We solve in y and we get the yield to maturity.

When would we issue long term debt?
Debt should match with the cash flow we can have. So we have to be very careful about the cash
flows we expect from the project to be sure we can service the debt.

If we believe that interest rates will fall, would you buy a ten year zero coupon bonds or a
ten year coupon bond?
The ten year coupon bond is less sensible to changes in the interest rate since the cash flows are
spread in time so the early cash flows are discounted less. In fact duration of the coupon bond is
lower than duration of the zero coupons bonds. Thus, if the rates fall the price of the zero coupon
bonds rises more, and thus, I would buy a zero coupon bond.

Which one is riskier - a 30 years zero coupon bond or a 30 year coupon bond?
The 30 year zero coupon bond is riskier.

If we think the interest rate will fall, should we buy or sell bonds?
We would buy bonds as they will appreciate as soon as the rate decreases.

If the 10-year treasury note rises in price, does the yield rise or fall?
If the price is higher it means that the yield has decreased.

Why can inflation hurt creditor?
If the nominal rate they lent money out is 5% and the inflation is 2% they are only clearing 3%.
If inflation rises, real interest rates go down.

The president is impeached, how will economy handle it?
Bad news for the economy, the cash flows are uncertain, people stop to borrow against the future
cash flows, interest rates go down and stock market tumbles. The economy enters a recession.

How do we fight hyperinflation?
We can do so by slowing the growth. The government can raise taxes and decrease government
spending to lower the inflation. The Fed can reduce the money supply to slow the economy.

How do you value a perpetual zero coupon bonds?
It value is zero as it never pays anything

The inflation has decreased last month but the bonds close lower. Why?
34
The bond price depends on the time value of money that is on the yield curve in the future
because I discount at a spread over the future yield. Thus, if future yields rise, the bonds close
lower.

Why is good news for the stock market bad news for the bond market?
If the stock prices decrease means that there is no confidence in future cash flow of the
companies in general and the future does not look bright. People do not borrow much against
future cash flows (since they are not sure about these cash flows any more) and the interest rates
decrease. If the interest rates decrease the yields on bond decrease and the prices of bonds go up.
The bond is a sure source of future cash flow which in this case becomes more valued today
since we discount at a lower yield.

What is the relation between unemployment and bond prices?
If unemployment goes down, future looks brighter and people have more willingness to borrow
against future cash flows to take advantage today of their employment. Thus, the consumption
grows, the inflation grows, the interest rates grow and, the yields on bonds grow. Therefore the
bond prices decrease.

How are exchange rates related?

10
$
10 , 0
1
1
|
|
.
|
\
|
+
+
=
r
r
S FS

Where r is the risk free rate in the two currencies the treasury strips. Here we assume r to be
constant in time. A currency strengthens when it buys more of a foreign currency. Forward rate
is the exchange rate that is applied today to cash flow in the future between two currencies. If the
rate that somebody quotes today for the future does not follow the relation above there might be
an opportunity for arbitrage. If the interest rate on Pound is 10% and on Dollar is 5% then today
exchange rate is 1.5 Dollars/Pound. If the interest rate on Pound increases, then Pound will
strengthen. Money will be funneled to UK where returns are higher. There is a multinational
company based in USA. If the company is selling goods manufactured in UK, and earning in
Pounds, then when the revenues are sent to USA consolidated in Dollar, the result is better if the
Pound is strong as 1 Pound buys more dollars. Result is worse if the dollar is strong. If the dollar
weakens it means that the price of imported goods will increase and the inflation will increase. If
the dollar strengthens the price of imported goods will decrease and the inflation will decrease.

( )
i
r
r
real
+
+
= +
1
1
1
nominal
therefore
real al no
r i r + ~
min

If Dollar weakens then the price of foreign goods increases, the inflation increases and the
interest rate increases. If the Dollar strengthens then the price of foreign goods decreases, the
inflation goes down and the interest rates go down as well. If inflation rate falls then the interest
rates will go down and the Dollar will strengthen. If inflation rate increases relative to the Rouble
then the Dollar will strengthen relative to the Rouble.

35
What are options?
Call Option: The right to buy at a certain price.
Put Option: The right to sell at a certain price.
If we write a Put Option we sell to somebody the right to sell, e.g. the right to sell a share of IBM
at $70 (on or before a certain deadline). Now the price of the share goes down to $50. The person
will exercise the option that is he will buy at $50 and oblige me (the writer) to buy it at $70. If
we write a Call Option we sell the right to purchase the share at a certain price, e.g. lets say $70
(on or before a certain deadline). The share goes up to $80. The person will exercise the option.
We will have to buy at $80 and sell the share at $70.

I believe the share goes up
I buy a Call Option
I write a Put Option
I believe the share goes down
I buy a Put Option
I write a Call Option

Obviously if we have bought a Call option to buy at $70 and the share goes down to $60 we will
not exercise the option. We loose the money we paid for the option and the writer gain the
money we paid for the option. Similarly if we have bought a Put Option to sell at $70 and the
share is at $80 we do not exercise. The price of an option depends on:
- Price of underlying security: if the price of share increases the value of a call option
increases. We have the rights to buy at $100 and the price rises to 105 -110- etc. then the
value of the option increases.
- Exercise (Strike) price: We can buy a call option to buy a stock at $100 or $110. The
lower is the strike price; the higher is the value of the call option.
- Volatility: higher is the volatility of the underlying security, higher is the price of the
option as it increases the potential upside of exercising the option. This increases the
value of both call and put option.
- Time to expiration: longer the time we have to exercise higher is the price of the option.
We have more chances to get at the convenient price to exercise.
- Interest Rate: if the interest rates are high the exercise price in the future has a lower
present value and thus, this increases the value of option.
- Dividends: large payout in dividends means that the potential for capital appreciation of
the stock is lower and thus, higher dividend payout lower value of the call option.

What are Forwards?
It is a contract to exchange a good in the future at a certain price we fix today. It is a deferred
delivery sale of some assets at a certain agreed upon price.

What are Futures?
It is a type of a forward contract that calls for the delivery of an asset or its cash value at a
specified delivery or maturity date at an agreed upon price. The price is called the futures price
and it is to be paid when the contract matures. The trader who commits to purchase the
commodity on the delivery date is in long position and the one that agrees to deliver the
commodity is in short position. Futures are standard forward contracts that can be traded on
exchanges.

36
What is a swap?
It is an exchange of future cash flows. Most common is the exchange rate swap. We agree today
on an exchange rate in future to apply on a future cash flow. Another common swap is the
interest swap, e.g. We have to pay each year $800,000 in coupon. We decide to enter an interest
swap with a company B. Company B gives us each year $800,000 and we pay company B
(LIBOR)*(10,000,000). We have now a floating interest rate on the payment we have to make
every year.

Which one is more valuable - a December put Option for Amazon or a January Put Option
for Amazon?
A January put Option: longer is time to expiration higher is the price.

Which one is more valuable - a December Call Option for Amazon or a December Call
Option for BellSouth all the rest being equal?
The Amazon stock is more volatile and therefore the Amazon option is more valuable.

If the strike price of a put option is below the current price of underlying securities, will we
exercise the option?
No. You will have to buy at high price and oblige me to purchase low. You are out of the money

If the current price of underlying securities is above the strike price of a call option we
have, will we exercise the option?
Yes. Someone will buy low from us and sell at a higher price in the market.

We issue a perpetual debt, what is the effect on the share price?
We have to consider that the perpetual debt is providing us a tax shield and so we have to value
the debt tax shield. This is going to be:

D
r
D r
DTS =

= t
t

It is perpetuity and therefore the present value is simply the tax rate multiplied by the debt value.
Now this assumes that the debt was fairly priced, otherwise we have two different rates.

What are the issues in calculating beta for foreign investments?
Beta represents the marginal contribution to the risk of the market portfolio. The basis is that
what matters as a benchmarking return is the return that investors may have on what they
consider the market portfolio (the highest diversification). This is what they consider as the best
they can diversify. Obviously if we are in USA then there is a general reluctance in investing
abroad and therefore for the investor the market is the US market today. In the future if they will
diversify more then it would be probably necessary to measure the beta by running a regression
on the excess return on the world portfolio. Now it is useful to imagine a Swiss company that is
investing in Switzerland. The company is evaluating the excess return of the assets as compared
to the excess return of the Swiss market. It estimates the beta of the assets (as we know by
looking at comparable companies) but relative to the Swiss portfolio because we assume that the
Swiss investors are investing in the Swiss market mainly and they see that as their market (as
37
their maximum diversification). Now if a Swiss company is to invest in US and wants to
estimate the beta of assets. Again it will estimate the beta of the return on assets by comparing to
the Swiss market (just derive beta equity and beta debt from regression of excess return vs.
excess return on the Swiss market). Since the way the assets in US are generating cash flow is
probably less correlated with the Swiss market than it would if it were located in Swiss market,
the beta is going to be lower. Actually since we assume that Swiss investors are not diversifying
their market portfolio by investing abroad, this represents an opportunity of diversification that
they did not exploit otherwise (although they could very easily do it by just buying stock of a
company operating in US which is active in same industry).This is because if Swiss investors are
holding Swiss portfolio then an investment in US can diversify further their portfolio and reduce
their risk. Also we have to notice that when we measure beta or systematic risk vs. a specific
market we assume that the shareholders are investing only in domestic stock that is they do not
diversify further. US investors are not yet heavily investing in an internationally diversified
portfolio and if this will happen in the future then we will have to consider the fact that we will
probably need to estimate beta relative to the world market portfolio. Today we assume that US
investors are using as benchmark the US market portfolio and the risk free rate and that they can
invest in the two and create the efficient portfolio that matches their tolerance for risk, and then
they will get the return they want. Imagine we are a US firm investing in France. We want to
come with a reasonable value for the discount rate for this. We will have to look at comparable
French companies in the industry we are investing in. We will have to convert their stock price
into Dollar to take care of the exchange rate issue. Then we will have to run a regression of the
excess return of these stocks (vs. the US risk free rate) and the excess return of the US market.
This will give us the beta equity and with usual consideration we will find beta assets and relever
up to the target companys capital structure.

Why you can have different valuation for a company?
There are different methods to get to a valuation of a company that make different assumptions.

What are some common anti-takeover tactics?
Poison pill
Golden Parachutes
White Knight
Macaroni defense
Lobby for shareholder disapproval
Sell gem assets to no longer be attractive bid

Poison Pill: With this strategy, the target company aims at making its own stock less attractive to
the acquirer. There are two types of poison pills. The first is the "flip-in," which allows existing
shareholders (except the acquirer) to buy more shares at a discount. The second is the "flip-over,"
which allows stockholders to buy the acquirer's shares at a discounted price after the merger. If
investors fail to take part in the poison pill by purchasing stock at the discounted price, the
outstanding shares will not be diluted enough to ward off a takeover.
- The target issues a large number of new securities, often preferred stock, to existing
shareholders. These new securities usually have severe redemption provisions, such as
allowing holders (other than the acquirer) to convert the security into a large number of
38
common shares if a takeover occurs. This immediately dilutes the percentage of the target
owned by the acquirer, and makes it more expensive to acquire 50% of the target's stock.
This form of poison pill is sometimes called a shareholder rights plan because it is
intended to give management (and possibly shareholders) the right to approve an
acquisition, potentially requiring the acquirer to pay a premium for control of the target.
- The target takes on large debts in an effort to make the debt load too high to be attractive-
-the acquirer would eventually have to pay the debts.
- The company buys a number of smaller companies using a stock swap, diluting the value
of the target's stock.
Golden parachute: is a clause in an executive employment contract that provides the executive
with a significant severance package in the case that the executive loses their job through firing,
restructuring, or even scheduled retirement. This can be in the form of cash, equity, and other
benefits, and is often accompanied by an accelerated vesting of stock options.

White Knight: A firm might hire an investment bank or another firm to come out with a counter
offer that is higher that the one made by the other company.

Macaroni defense: This is a defensive strategy by which the target company issues a large
number of bonds that come with the guarantee that they will be redeemed at a high price if the
company is taken over. Why is it called Macaroni Defense? Because if a company is in danger,
the redemption price of the bonds expands, kind of like Macaroni in a pot! This is a highly useful
tactic, but the target company must be careful it doesn't issue so much debt that it cannot make
interest payments.

Why might a company choose to issue debt instead of equity?
There might be several reasons:
- The company stock may be undervalued in the market and therefore we would not raise
money at good terms and we will depress the stock further.
- Debt tax shield: issuing debt implies interest expenses (and coupon payment) and the
interest expenses are tax deductible and thus, increase the cash flow. We can get the
deduction of interest and therefore we can boost the return on equity (in fact we add a
financial risk and the beta on equity will increase).
- The cost of issuing debt and issuing equity: by issuing equity we distribute the upside of
the investment while by issuing debt we keep it inside. The expected return on equity is
higher than the expected return on debt as equity is more expensive than debt.
- Imagine we have a company that is valued at 4M. We need 1M for a project that will
raise the value of the company to 10M. We issue equity that is 20% of the company to
raise 1M. Then when the company is valued at 10M this additional equity we sold is
valued at 2M and therefore the cost of the operation is 1M that goes outside the company.
Now if we issue debt and the cost of interest is 300,000 then we have at the end kept the
value inside the company and have given the older shareholders much more. By issuing
equity we dilute the earnings per share, and the price of stock goes down.
- Also if we expect that the project will not pay cash flow in the early year than you can
arrange a debt that allows you to pay later
- By issuing debt the company does not dilute the earnings per share by distributing on
39
more shareholders, but keeps the upside of the investment inside the company.
- The Debt/Equity ratio obviously has to be such that we can issue more debt.

Why might a company choose to issue equity and not debt?
There might be several reasons.
- Take advantage of high trading (overvalues) price of stock: A company may decide to
issue equity if the current price of the stock in the market is high (inflated) as the
company can raise money (on very good term).
- Cash Flow is not predictable: the company may not have a very predictable cash flow
(e.g. in case of a start up) that is needed to make regular coupon payments, and in
addition issuing equity spreads risk amongst shareholders. The failure of paying back
debt can push a company in bankruptcy.
- Adjust the Debt/Equity ratio. By issuing equity we can delever the firm and change the
Debt/Equity ratio that determines in part the bond rate. Therefore, we can raise cash
through equity, pay off some debt and have a better rating on bond and eventually
refinance through lower yield bond.

What could a company do with excess cash on the balance sheet?
- If a company has prospect of growth in the industry it is operating in and finds a project
with positive NPV, it should invest in it if it maximizes shareholder value.
- If there are no profitable investing opportunities then the company can distribute cash in
form of dividends.
- A company can buy back its own share to give a signal of the prospect of company and
therefore, increase the price of the shares. Also it increases earnings per share and
increases debt tax shield.
Why would an investor buy preferred stock?
- To have the upside of an equity but at the same time have interest payment like dividends
(certainty of cash flow)
- To be more senior in case of liquidation
- A corporation will invest in preferred stock because only 30% of the gains are taxable

How do you calculate the firm value for the firm below?
Shares outstanding 100,000
Stock price $20
Debt $500,000
Cash and equivalents $500,000
Firm Value = Equity Value + Net Debt
Net Debt = Debt Excess Cash = $500,000-$500,000 = 0 if we assume no specific level of cash
is required for the business to function
Share Outstanding*Stock Price= $20*100K= $2M Equity Market Value
Firm Value = $2M + 0 = $2M

How would you evaluate the creditworthiness of a tuna manufacturer with three factories
in different locations throughout the U.S.?
I would look at comparable companies that have similar operations and that are actually rated
and see their creditworthiness. I would look at the cash flow that a company has to repay in
40
interest expenses. I would look at the projected cash flow of the company and the ability of a
company to serve those debts. Therefore I would look at the FCF of the company.

Company A trades at P/E of 20. Company B trades at P/E of 10. Both are considering
acquiring Company C, which trades at P/E of 15. For which of the two acquiring
companies would the deal be dilutive? For which would it be accretive? Explain why for
each.
For Company A it is Accretive
For Company B it is said to be Dilutive.
Company A has a P/Ea>P/Ec and therefore it will be accretive.
The earning per share will increase for A after the merger. It will depend on the sum of earnings
after the merger and the number of total share we will have after the merger.

What would have a greater impact on valuation, a 10% reduction in revenues or 1%
reduction in discount rate?
A reduction in revenue will generate a reduction of free cash flow although we will pay lower
taxes if everything stays the same and thus, a reduction in valuation. The reduction in discount
rate will increase valuation. If we apply simply the Gordon Growth Model and we say that

r
ow freeCashFl
Value =

with g=0.
Then
( )
r
FCF
Value
9 . 0
= and
01 . 0
=
r
FCF
Value .
The two are the same for a starting discount rate of 11%. If discount rate is lower than 11% then
impact is higher for the reduction in discount rate. If starting discount rate is higher than 11 %
then the impact is higher for reduction in FCF. The two impacts are opposite. Remember that if
we analyze a reduction of FCF of 20% and a reduction of rate of 0.02 then the indifference is at
12 % and so forth so on.

What is a registration statement?
The document that is filed to SEC for an IPO is called the registration statement. It contains
information about proposed financing, history of the firm, management history, existing
business, and plan for future. A part of this goes into the prospectus. The Red Herring is a
preliminary version of the prospectus the company can circulate before the SEC has approved
the registration Statement. In the prospect we may find:
- Details of the Issue and the amount that will be raised, fees for the underwriters, possible
additional shares that can be bought by underwriter.
- Some disclaimer on the fact that no other information but the one contained is to be
trusted and the information must be considered valid on the date
- Offerings: details of the share offered.
- Use of proceeds
- History of the company
- Certain consideration on the risk of the company
41
- Dividends policy
- Management biography and curriculum
- Executive compensation
- Details of the role of underwriter: amount that each underwriter will buy (and obviously
sell on the market)
- Legal matters
- Financial statements of the company
Underwriters earn the spread between the price they buy shares from the company at and price
they sell shares in the market at.

What is capitalized interest? How does it impact net income?
If you take a loan to construct an asset, interest on that debt during the period of construction can
be capitalized subject to Accounting Standards / FASB. Income is higher to the extent of
capitalized interest

What is duration?
Duration measures how long from today it will take one to receive the cashflow related to a
security or a portfolio. For a security or a portfolio with multiple cash flows it is the value-
weighted average of when you receive the cash flows.

42
Technical questions Accounting

What happens in the transition from FIFO to LIFO?
First of all when a company is evaluating the changes from FIFO to LIFO it has to make the
assumption that the inventory at the end of the last period was representing a LIFO situation.
This is necessary since a company will not generally have the history of the past purchase data in
order to reconstruct the LIFO layer it would have accumulated in the past using the LIFO rules.
Second if we are in an inflationary environment and the prices are increasing then the COGS in
an accounting period will be increasing for LIFO. Therefore the company will have a higher
expense for the period and will pay lower taxes (this is a way to pay lower takes). The net effect
is a reduction of net income. The cash flow for the period does not change if we consider that the
purchases we have made are the same.

Suppose you are buying a new fixed asset part cash and part debt. Take me through how
it affects all the financial statements.
The journal entries would be
Property Plant Equipment (A) (Debit) 100
Cash (A) (Credit) 50
Long term debt (L) (Credit) 50
The income statement will be affected by the increase in depreciation expense that we start to
recognize as soon as we acquire a fixed asset, and by the interest expense we have on servicing
the debt. For statement of cash flow, we register cash out flow in the investing section for the
part we paid with cash. For the debt we recognize the cash in flow in the financing section. Also
the net income and depreciation will get affected in the operations section of the statement of
cash flow.

What are the changes in the three statements if we have to write down some debt that we
have?
If we write down a liability then we would have to record a gain for the period.
Long Term debt (L) dr 1000
Gain on write down of long term debt (SE) cr 1000
This will show up in the income statement (it should show up below the line although the
temptation is to show it up above the line) and increase the income before tax. This will increase
the tax expense and also the tax payable in the report for tax filings. Also if we pay taxes in cash
then we would have a use of cash. Thus, we will not have any correction in the statement of cash
flow and therefore we will have a lower cash flow.

What are major lines in cash flow?
Beginning balance of cash flow Cash Flow from Operation Cash flow from Investing Cash
Flow from Financing gives you the ending balance of cash.

What happen if we increase the capital expenditure?
- On the income Statement: we will increase the depreciation and net income will go down.
- On the balance sheet we will see an increase in the balance of assets
- If we pay it by cash we will see a decrease in cash
- In the following year we are going to have depreciation charge and this will decrease the
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net income and affect the retained earnings.

What is EBITDA?
Earning Before interest Tax Depreciation Amortization. We can use it to get to the Unlevered
Free Cash Flow

EBITDA Modified Tax CAPEX Working Capital Increases= FCF

The modified tax is EBIT *(1-t) since we have to capture the effect of depreciation on taxes or
we can say:

FCF = (1-t)*EBIT + Depreciation Capex Working Capital Increase

Working Capital = Current Assets Current Liabilities

Working Capital = Inventory + Account Receivables Accounts Payable

What is the link between balance sheet and cash flow?
Cash flow starts with the balance of cash we derive from balance sheet. Net income is derived
from income Statement and then we derive the changes in assets and liabilities as source and use
of cash. The statement of cash flow must reflect all the changes in assets and liabilities accounts
we have in balance sheet from beginning of the period till the end of the period. Also retained
earnings account is linked with the dividends payment we have for the period. Net income goes
only to beginning of cash flow as starting point or to the retained earnings.

Where can we find the depreciation expense?
We can always find that in statement of cash flow. The depreciation add back is always in cash
flow statement. Depreciation expenses are often mixed with COGS so we cannot get them out of
income statement.

Walk me through the major line items of a cash flow statement.
The statement of cash flow is divided in to three major sections:
- Cash Flow form Operations: It starts with the net income, we add back the non cash
expenses and we subtract non cash gains. In this section, we consider the effect of
changes in working capital. Also the cash outflow and inflow due to interest expenses are
included in the cash flow from operations (accounts like interest payable while the
interest expenses are in net income already anyways)
- Cash Flow from Investing: we register here the cash outflow or the cash inflow due to
investing activity in long lived assets or in securities.
- Cash Flow from Financing: Cash derived from the financing activity of a company like
issuance of equity or debt or the cash outflow due to payment to creditors for maturity of
debt, payment of dividends etc.

Say you knew a companys net income. How would you figure out its cash flows?

44
Net Income + (1-t) * Interest Expenses + Depreciation Capex Increase in Working
Capital = FCF

What is the difference between a balance sheet and an income statement?
Income statement registers the revenue and the expenses of a firm in an accounting period (the
expenses that can be attributed as costs as they were needed to produce the income) and the
statement of cash flow registers the actual flow of cash during an accounting period. The balance
sheet is the statement on which the financial position of a company at the end of a specific
accounting period if shown. It is based on the accounting equation:

Assets = Liabilities + Shareholders Equity

where shareholders equity is book value of contributed capital plus retained earnings from the
income statement. The income statement reports the revenue and expenses (gains and losses
incurred over a specific accounting period). The link between the two is mainly in the retained
earnings account balance

Retained Earning Ending on Balance Sheet = Retained Earning Beginning on Balance Sheet +
Net Income dividends

Dividends are not expenses but are distribution of assets to shareholders and therefore are double
taxed. Also the interest expenses are due to the debt the company carries on the balance sheet
and the interest that matures over the accounting period.

How do you account for operating lease and capital lease?
Operating leases are off balance sheet: the future liabilities do not appear on balance sheets and
there is a separate reporting in the foot notes of the 10Q and 10K. The operating leases appear as
an expense in the accounting period for that year and it is obviously a cash outflow. For the
capital lease at the inception of the lease, we debit an asset account, and we credit a liability
Leasehold (A) dr 1000
Lease obligation (L) cr 1000
Then each year we recognize a depreciation expense on the leasehold (with straight line
depreciation over the same number of years):
Depreciation (TSE) dr 100
Leasehold (A) cr 100
Interest Expenses (TSE) 80
Lease Obligation (L) dr 10
Cash (A)cr 90
A lease can be classified as a capital lease if:
- If the assets at the end of the lease will stay with the lessor
- If there is a bargain purchase option for the lessor
- If the duration of the lease is longer than 75% of economic life of the assets
- If the PV all the lease payment is higher than 90% of the purchase price of the assets
It is very similar to a loan we make; we will debit cash and credit a loan payable. Then in each
period we will recognize interest expense, we will credit cash for the amount we pay each month
and then we will debit the lease obligation partly for the amount of principal that we pay out.
45
What is goodwill? How does it affect net income?
Goodwill is an intangible asset (other intangible assets are brand name, patents, trademarks and
rights). It arises when we combine two companies and we use the purchase method of
accounting. The goodwill is the difference between the price paid for the acquisition and the net
fair market value of the identifiable assets where

Net value of identifiable assets = Fair Market Value of Identifiable Assets Market Value of
Debt

Remember that the market value of debt can be different form the book value (imagine for some
bonds the price changes if the interest rate changes). Goodwill can affect net income through the
amortization expenses that are associated to goodwill amortization or through the impairment
charge that we may record when we have to impair an indefinite life of the goodwill.

What is the difference between purchase and pooling?
They are two methods of accounting for a combination of two companies. The way one method
was applicable over the other depended on 12 rules. A simple way to look at the12 rules would
have been to say the goodwill depreciation expenses are not tax deductible and therefore do not
have any influences on free cash flow. At the same time the company was always trying to avoid
the yearly charges given by the depreciation expenses and therefore the company always tried to
inflate the fair market value of assets in order to get lower goodwill. Now FASB requires
impairment of goodwill, a test for impairment must be conducted every year at a minimum. In
purchase method the value of identifiable assets is written up to fair market value and goodwill
(as an asset) is recorded as the difference between the price paid for the acquisition of the firm
and the fair market value of net identifiable assets. The effect is that the fair market value of the
asset is generally higher than the book value the asset and therefore the depreciation expense if
higher. Note that the goodwill starting from end of 2001 must be impaired (goodwill with
unidentifiable useful asset). It is no longer possible to amortize goodwill.

What are deferred taxes? How do they arise?
Deferred tax liabilities arise when there is a reversible difference between the income before tax
in the statements for financial reporting and taxable income for tax return purposes. It occurs
when taxable income is less than book income for financial reporting. As an example the
different depreciation schedules that are used for financial statement and for tax purposes will
give rise to a difference between the tax expenses and tax payable. The difference will be
reverted over time as depreciation in income statement will be charged for longer period vs. the
depreciation used for the taxable income that uses MACRS (MACRS will charge higher
deductible expenses in early years). Deferred tax assets arise when the income before tax for
financial reporting purposes is lower than the taxable income, i.e. when we recognize an expense
earlier in financial reporting than in tax reporting. Therefore, the tax expenses are lower than tax
payable. This happen as an example because of the warranty expenses: in financial statements
we consider the warranty expenses in the period in which we book the related revenues of the
product we sold but for tax purpose we can deduct only when we actually incur the expenditure.
The same goes for Bad Debt allowances. The entries for the journal are:
Tax Expenses (SE) Dr 200
Deferred tax Liabilities (L) Cr 80
46
Tax Payable (L) Cr 120
The deferred tax liability is a way to account for some liabilities that we will have in the future
and the payment we will have to make for that. If a charge is not a tax deductible expense, we
will not consider it either for the calculation of the tax expenses or for the calculation of the tax
payable. It is not a reversible difference and it will not give rise to deferred taxes liabilities.
Another example is the earnings on municipal bonds; they are not taxable and thus, will not give
rise to deferred tax liabilities.

What is working capital?
Working Capital = Current Assets Excluding Cash Current liabilities
Increases in working capital are a use of cash and decreases of working capital are a source of
cash, e.g. when we decrease account receivable we get cash.

How do you account for an investment?
Trading: usually the way banks record the holding of security for trading. Balance sheet records
market value at all points and gains and losses hit the income statement.
Minority Passive Interest: typically for less than 20% ownership stake
- The investment is always recorded in the balance sheet at the current market value
- The unrealized gain and loss flows directly to the shareholders equity account and no
effect on income statement (net income)
- Earnings of the firm invested in have no effect on investors balance sheet, income
statement etc.
- Upon sales the realized gains and losses appear on the income statement
This is used also for securities available for sales.
Minority Active Interest: typically between 20%-50% ownership stake. Also called equity
method
- We record the investment as an asset at the initial acquisition cost
- The earnings of the company invested in will increase the value of investment; we credit
investment and debit an equity account called as equity in earnings of affiliates
- The dividends declared by the company invested in are recorded as a debit in cash and a
credit of the investment that decreases the investment asset
- Changes in market value are not recognized
Majority Interest: Controlling ownership stake over 50%. It is as the equity method but we sum
up the accounts of each of the two companies at the end of the year. In case of corporate
Acquisition we have to follow the Purchase method of accounting. Below are the steps for
purchase method of accounting:
- We write up the asset of the company we acquire at the fair market value
- We recognize a goodwill (Price paid Fair Market Value of Identifiable Net Asset) that
is no more amortized (the goodwill is tested for impairment at least every year)
The pooling method of accounting could be used if 12 rules were respected but essentially the
spirit of the test was to verify that the two entities would have functioned as a single one. In
pooling the acquisition had to be stock for stock and the entities were also refrained from
disposing of significant operations shortly before and after the acquisition. The pooling allowed
the acquiring company to add the balance in the accounts of the acquired company at the book
value (recognize the investment in the acquired company at the book value: contributed capital
and the retained earnings of the acquired company were to carry over and the net assets were to
47
be recorded at the book value). Thus, no goodwill was recognized and no track of a purchase
price higher than the book value of the asset was recorded anywhere. Pooling has been
eliminated because:
- No acquisition or very few ended up in a mutual sharing of ownership as the acquiring
company owned a majority of the stock of the combined company. Managers of
acquiring company stayed at their place.
- The market value of the assets acquired was not shown anywhere although the number of
share exchange did indicate the price paid.
- The combined company could sell the assets of the acquired company and record a gain
afterward since the market value was much higher than the book value recorded.

What are the effects of an acquisition of a long term assets using cash and debt?
First effect will be on balance sheet; the PPE will go up by the amount we paid. The statement of
cash flow will see a reduction of cash for the part we paid in cash in the investing section of the
statement of cash flow. The effect on net income is an increase of depreciation that we will have
in the future. The reduction in net income will be reflected in lower retained earnings.

A firm is using LIFO, and prices on supplies start decreasing. What are effects on income
statement, balance sheet and statement of cash flow?
Income statement: the cost of goods sold decreases (if the operations level of the company
remains the same) and the company has a higher tax expenses. The net effect is that net income
increase
Balance Sheet: major effect is on the retained earnings accounts that are in the shareholders
equity part of the balance sheet.
Statement of Cash Flow: we have a higher net income and therefore a higher starting point for
changes in cash during the year.

48
Technical questions Financial Markets

1. How does the yield curve look like?

2. What did our firms stock close at yesterday?

3. What is the DJIA at today? NASDAQ? S&P500? What is the long bond at?
Treasury bill at? Fed funds rate? LIBOR? Oil? Gold? Dollar vs. Euro/ Pound?

4. Where is the market going? Bond, equity and forex? Where do you think interest
rates will be in the next 12 months?

5. What happened on the markets in the past three months?

6. Do you read the Wall Street Journal everyday? Whats on the front page today?

7. Do you watch CNBC? If yes, what programs do you watch?

8. Do you follow an industry, a stock?

9. What do you personally invest in?

10. What industry you follow and what numbers do you look at to determine if a firm is
doing well in that industry?

49
Technical questions Miscellaneous

1. If I give you $1 everyday until you die, how will you value it?

2. If you set up a hamburger joint at Kellogg, how will all the financial statements get
affected?

3. If you had to buy one stock, what will it be?

4. Why would a person buy shares from the secondary equity offering of a company?

5. Why shouldnt two companies merge?

6. What is wrong with - EV/EBIT for company 1 &2 are 8.2 and 8.7 whereas
EV/EBITDA are 7.3, 9.3?

7. Why do a LBO? Cant the company can do so its own?

8. What is ideal D/E ratio?

9. How do you get lowest WACC?

10. What is Treasury Stock method?

11. If a project has lower cost of capital than current cost of capital, should a firm
invest in that or issue dividend?

12. If negative or 0 EBITDA what do you do to calculate COMPS?

13. How do you split a conglomerates balance sheet?

14. Which one is higher cost of capital for an all equity firm or a part debt and part
equity firm?

15. Just by looking at the balance sheets how can you say which one belongs to a retail
company, consulting company and manufacturing company?

16. How do you get levered cash flows from FCF or cash flow to equity holders?

17. Why dont you take off dividends from unlevered FCF?

18. Where do the high yield and investment grade bonds lie on the D/E vs. WACC
curve?

19. Why does LBO give you the lowest value?

50
20. What is a good target for LBO?

21. What adjustments will you make to an enterprise value?

22. How can you make a deal neutral in terms of accretive and dilutive?

23. In a LBO what are the typical ratios of Total Debt/ LTM EBITDA and Senior Debt/
LTM EBITDA?

24. If you sell a PPE for 100 with a BV of 50 for which you had a note payable of 50,
how do you make entries into the balance sheet?

25. If you had to tweak the DCF value how will you do it?

26. What is capital market equilibrium?

27. What is minority interest and equity in affiliates?

28. How do you account for pensions?

29. Why pay higher taxes now?

30. What are off balance sheet financings?

31. If the target is leasing from the acquirer, then how do you adjust the EBITDA
multiple?

32. What is cost of financial distress?

33. Tell me about three major investment banking industry trends and describe them
briefly.

34. Why might a technology company be more highly valued in the market in terms of
P/E than a steel company?

35. You have a trading company and a holding company that owns a large percentage
of the outstanding shares of the trading company. Who has the lower cost of
capital: the bondholders of the trading company, bondholders of the holding
company, or common shareholders of the trading company?

51
Technical questions Investment Banking

1. Why I-Banking vs. Consulting? Sales & Trading? Research? Finance in an
Industry?

2. How does your past career qualify you for a position in investment banking? Why
are you not going back to prior career?

3. What do you hope to accomplish over the summer?

4. What department do you want to work for inside I-banking and why?

5. Who is in the bulge bracket?

6. Rank firms on Wall Street and where do we fit? Who is our competition (in the
major categories)? What differentiates our firm? What are our firms strengths?
Weaknesses?

7. Describe a typical day of an investment banking associate?

8. Do you understand lifestyle issues and why do you or dont you have a problem?

9. What is your greatest concern about investment banking?

10. Key characteristics of a good associate? Good VP? Good MD?

11. How are the roles and responsibilities of an associate different from that of a VP?
MD?

12. Where do you see yourself in the next 5 years? 10 years?

13. What did you learn from the JPMorgan case competition?

14. What are the qualities required for an I-banker?

52
Personal/ fit questions

Anything on resume is fair game + any questions below. You can come up with any of your own
creative ones.

1. Walk me through the highlights of your resume. Im interested in the decisions you
have made that
2. Why MBA? Why Kellogg?
3. Why investment banking? Why our bank?
4. What have you done at Kellogg that shows your commitment to banking?
5. What are your weaknesses?
6. What are your strengths? Why should we hire you? What do you bring to the table?
What is your USP?
7. What were your grades in college? What were your grades for the first semester at
Kellogg? What was your GMAT score? Be ready to explain any weak-points.
8. What other firms are you interviewing with and why? Are you interviewing with
consulting firms also? What career opportunities are you exploring other than I-
banking?
9. What do you understand the responsibilities of an associate/summer associate (learn
modeling, analyze financial statements, supervise and learn from analysts, support
senior to be?
10. What questions do you have for me? (five questions bank specific or personal)
11. What is your most challenging professional experience?
12. Are you a leader or a follower? Give me a leadership example. Tell me about a time
when you took responsibility for a project. What is your definition of leadership?
13. Describe a failure? What did you learn from it?
14. What was the most ethical decision you had to make?
15. What are your proudest accomplishments?
16. What did you not like about consulting?
17. What do you not like about your peers at Kellogg?
18. Most surprised you about Kellogg?
19. Difficult team experience at Kellogg?
53
20. What other business school did you apply to? Which ones accepted you?
21. What was your favorite class at Kellogg so far? Why? What was your grade?
22. Did your grades accurately reflect your ability? Why/Why not?
23. What classes are you currently taking to get ready for the summer?
24. What are your 5-10 year long term career plans?
25. What do you predict is going to happen in this industry in the next 5 years?
26. What is one word that describes you best? Why dont you give me another two words?
27. How do you work in teams? How do you handle a non-contributing team member?
28. How would your group mates characterize you? How would you characterize yourself
in the group dynamic? If I spoke with your group mates, what would they say you
needed to improve?
29. What qualities do you think make someone successful in business?
30. What do you bring to a group?
31. What do you do in spare time?
32. Tell me a joke.
33. Who has influenced you the most, besides any family members?
34. What is one skill that you think will be most important in doing your job?
35. Say you are at a meeting with a client and your MD is giving a presentation. You
suddenly notice a mistake in some of the calculations, which you have done in the
presentation. Do you tell him? When? What do you say?
36. If you were a vegetable - what would you be?
37. What do you read? What's the last book you read?
38. Are you more risk averse or risk seeking?
39. What is the riskiest thing you've ever done?
40. Lets imagine you died and are giving a speech at your funeral. What would you say?
41. How would you spend $1,000,000 besides investing it?
42. What would you like me to know about you that is not on your result?
43. What was an experience in your life that you would want to go back and change?
44. What new goals have you established for yourself recently?
45. How could you have improved your career path?
46. What does success mean to you?
54
47. What does failure mean to you?
48. What do you get passionate about?
49. What did you enjoy most about your last employment? Least?
50. How competitive are you?
51. Teach me something in five minutes
52. If we made you an offer today, would you take it?

55
Sample Cheat Sheet

23-Mar-06 GOLDMAN SACHS (GS, listed on NYSE) Investment banking
Deals - M&A
- Advised Abgenix Inc. - acquired by Amgen (MS) $2 billion - drugs
- Advised GE Insurance Solutions acquired by Swiss Re (MS) - $6.8 billion
- Advised American Pharmaceutical Partners to acquire American BioScience Inc
(ML) - $5 billion biomed/ genetics
- Advised Comcast to acquire Susquehanna Pfaltzgraff (UBS) $0.775 billion cable
TV and broadband business
- Advised ConocoPhilips to acquire Burlington Resources (MS) - $35 billion
- Advised Mentor Corp to acquire Medicis Pharmaceutical Corp - $2.4 billion drugs
- Advised Cumulus Media Partners to acquire Susquehanna Radio Corp (UBS) - $1.2
billion
- Advised Sprint Nextel to acquire Nextel Partners (MS) - $6.5 billion
- Advised Georgia-Pacific on its acquisition of Koch Industries 13.2 b
- Advised Siebel on its acquisition by Oracle (WS) 5.8b
- Goldman advised Hertz on its LBO 15b
- Goldman advised Novartis on acquisition of Chiron Corp 4.5b
- Advised United Healthcare on its acquisition of Pacific Healthcare System 8.8b
Rankings 2005
- #1 in both worldwide and US announced and completed M&A in 3Q
- #1 overall 2005 position
Financials - Stock price $131.44 [94.75-134.99]
- Market Cap - $60.51 billion
- PE Ratio 11.72
- Net earnings of $5.63 billion for the whole firm; investment banking generated net
revenues of $3.67 billion (9% higher than 2004), Record earnings in M&A and equity
underwriting offset lower earnings form debt underwriting
- Key competitors Lehman, Merrill, JPM and MS
Industry
Groups
- Industrial, Consumer, Natural Resources, Health Care, Financial Institutions, Real
Estate, Special Products, Technology, Media and Telecommunications
Product grps. - Financial advisory (mergers and acquisitions, divestitures, corporate defense activities,
restructurings and spin-offs), Underwriting (public offerings and private placements of
equity, equity-related and debt instruments)
Summer
Program
- 10 week assignment
- Quasi specialist where one is placed in a specific industry group, at least one live deal
- Experimentation with cross-staffing
- Numerous opportunities to interact with people from all levels of the firm, review
process is feedback centric and comprehensive reviews (mid-term and summer end)
Full-time
Program
- Placed on a team devoted to a specific industry determined during summer internship
- 4 weeks of training program
People - 20,888 Employees worldwide
- Henry M. Paulson, Jr. Chairman / CEO
Notes - Team based environment every decision is made in teams and people look out for
each other supportive, integrity, caring, hard work
- Culture - Hire people that fit into their culture because people can be trained in
technical areas
- Training - Management cares about the career development of junior staff
- Pride themselves on being the brand name and best in advisory business - Co workers
are smart as hires form the top 13 schools and competition is intense
- Strong hold on sell-side M&A
- Tierra Del Fuego preserved ecologically significant forestland near Chile by donating it
to wildlife conservation society
News - Record earnings in third and fourth quarters and also record overall 2005 earnings ($11
billion in bonuses)
- GS is advising NYSE and Archipelago (electronic exchange) on the merger and is also
Kellogg
Recruiting
Team
- John Gilbertson (Captain Chicago, MD)
- Wonita Williams (Industrial NY)
- Kelly Li (FIG NY)
- Andrew Knuckle (TMT NY)
56
Resources for latest financial and economic news

Wall Street Journal

Financial Times

DealBook from NYTimes

Businessweek

Barrons from Wall Street Journal

Economist

Fortune

Vault and Wetfeet (available on CMC)

Thomson Financials

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Guide to preparing for a career in Investment Banking Kellogg School of Management

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