INTERVIEWING FOR WALL STREET AND

BEYOND

INCLUDES OVER 200 COMPREHENSIVE BEHAVIORAL, CASE AND

TECHNICAL QUESTIONS AND ANSWERS FOR FINANCE INTERVIEW
PREPARATION

ASHISH KOHLI

Investment Banker; Visiting Professor, Indian School of Business and NYU Tandon
School of Engineering; Director, Corporate Relations and Career Management,
Simon Business School, University of Rochester

MBA, Kellogg Graduate School of Management; Chartered Accountant

 Third Edition
This publication contains the opinions and ideas of its author. All information is subject to change without notice.
The author cannot guarantee the accuracy of the information contained herein. The advice and strategies contained
herein may not be suitable for your situation. The author specifically disclaims any responsibility for any liability,
loss, or risk, professional or otherwise, which is incurred as a consequence, direct or indirect, of the use and
application of any part of this book.

No part of this book may be reproduced or transmitted in any form or by any means, electronic, mechanical,
photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the United States
Copyright Act, for any purpose, without the express written permission of the author. Please address requests for
permission to use the content of this book to the author.

The author requests that you send any suggestions including but not limited to any errors you have noticed in the book,
content to be added or deleted, and suggestions on how to improve the book to him directly at
trainingakohli@gmail.com.

To order additional copies of the book please contact us at trainingakohli@gmail.com.

Copyright 2018 by Ashish Kohli. All rights reserved.

Published by AshishKohli, Inc.

Printed in the United States

iv
Introduction
“Choose a job you love, and you will never have to work a day in your life.”
– Confucius
Like many others, I was drawn into the world of finance by the allure of an exciting, fast-paced
and intellectually stimulating work environment. It was a career where an individual had the
potential to be rich and powerful while still being young. I had just finished high school when the
movie Wall Street was released. Men and women, dressed impeccably in designer suits had
meetings in upscale restaurants. They flew on private jets, worked in offices with unparalleled
views and completed landmark deals that made headlines in prominent newspapers. It seemed to
be one of the few jobs where you could earn enormous professional respect and limitless
compensation at a young age. I was determined to become one of “them”, but I didn’t fully
understand what these people actually did for a living and how I could land one of those jobs.

Twenty years ago New York, London and Hong Kong were the primary destinations if you wanted
to build a career in finance. With the strong economic growth in emerging markets including the
BRIC nations of Brazil, Russia, India and China, new financial centers have emerged around the
world. This trend is evident in the U.S. as well, with hedge funds and asset management firms
moving to locations outside New York City.

Investment banking, trading, asset management, private equity, and hedge funds have attracted
and continue to attract some of the best and brightest talent in the world. While these are often
among the most competitive and sought-after jobs, many other excellent jobs in finance are often
overlooked. Finance positions in corporations, public accounting firms and consulting firms can
be tremendously stimulating, challenging and ultimately rewarding.

I teach at some of the leading undergraduate and MBA programs around the world, and I coach a
number of executives at prominent companies globally. Whether they seek their first jobs or look
to transition into a different role in finance, many of the students and professionals I work with
have similar questions when it comes to financial careers. Some of those questions include:

• What are the different positions available in finance, and what do these people do on a
daily basis?
• Which major companies hire finance graduates?
• What is the typical format for finance interviews?
• What qualifications, skills and personality traits do recruiters look for?
• What kinds of questions can be expected for the various finance jobs, i.e., investment
banking vs. equity research vs. sales and trading vs. rotational finance programs at a
corporation?

In retrospect, as I embarked on a career path, I wish there had been a resource to provide me with
an overview of the different jobs available in finance and how to best prepare for obtaining one.
This book is that resource! It offers a comprehensive overview of the numerous finance jobs
available as well as a guide to help you prepare for interviews for those jobs. This book provides
many sought-after answers to the questions described above and includes a comprehensive list of
common behavioral and technical interview questions asked, and answers sought, by hiring
managers and industry experts.

Structure of the Book

This book is meant to prepare you for jobs on Wall Street as well as other opportunities in the
finance industry. It is divided into three parts summarized below:

Part One: Overview of Careers in Finance

Part One will assist you in determining what career in finance may be appropriate for you. It
provides an overview of the diverse opportunities in finance and identifies the key players in each
field. Part One describes in detail the duties performed by investment bankers and equity research
professionals and details a typical day in the life of an individual working in these jobs. You will
also learn about the hierarchy for these roles along with typical compensation earned as your career
advances.

Part Two: How to Land Your Dream Finance Job

Part Two focuses on how to secure the position that you are interested in. It describes in detail how
to make a compelling resume, cover letter, and LinkedIn profile that will emphasize your skills
and the qualities that make you suitable for the position. It provides tools to do self- assessment,
set goals, and create a personal value proposition. It highlights key strategies to network for the
role and how to sell yourself—how to convince the interviewer you are the most appropriate
candidate.

Part Three: Behavioral, Case and Technical Questions to Land Your Dream Finance Job
Part Three provides a comprehensive set of behavioral, case and technical questions and answers
that recruiters will ask while you are interviewing for these jobs. It includes questions regarding
accounting, valuation, mergers and acquisitions as well as leveraged buyouts.

I want you to benefit from my many years of working as an investment banker at some of the
leading global banks. I have led the financial modeling, accounting, valuation, mergers and
acquisition, leveraged buyouts, and other technical training programs for analysts, associates and
senior executives at some of the largest banks and corporations in the world. I have had the
opportunity to lead the recruiting efforts for these banks at some of the most prestigious schools
in North America, Europe and Asia. I have also coached thousands of individuals from various
educational and professional backgrounds. Working with them, I have discovered similarities in
what the candidates seek and the mistakes they make. My experiences motivated me to prepare
this guide to enable you to break into the finance career of your dreams.

I believe this book will serve as a valuable resource for undergraduate and graduate students as
well as experienced professionals looking for positions in finance. I wish you luck and the very
best in the finance career you would like to pursue.
Chapter 1: Organizations Hiring
Finance Professionals
“I don’t think anybody has invented a pastime that’s as much fun, or keeps
you as young, as a good job”
– Frederick Hudson Ecker

A career in finance is fast-paced and always changing. Many factors affect the types of jobs as
well as the number of opportunities available in a particular field of finance. These include the
availability of talent and concentration of companies in a specific area. Fluctuations in the major
financial markets and the economy have an impact on finance hiring. Recently, regulatory changes,
as well as cost considerations, are also leading to the growth of finance jobs in certain areas and
fields.

Finance jobs exist in major financial centers including New York, London, Hong Kong, Singapore,
Zurich and Tokyo as well as other smaller and larger cities in the U.S. and globally. Venture capital
industry which originated in the U.S. and more so in the Silicon Valley and Boston is expanding
to other centers in the U.S. including San Francisco, New York and Texas. In the last few years, it
has also expanded globally with India, China, U.K, Germany, Israel attracting a significant amount
of venture investment. The financial industry lost a high number of jobs during the financial crisis
of 2008-2009 when the Dow Jones Index fell from a high of 14,164 on October 9, 2008 to a low
of 6,594 on March 5, 2009. A number of banks had investigations by regulatory authorities that
led to the banks spending substantial sums of money on compliance that led to the growth in risk
management and compliance jobs. In recent years, cost considerations, as well as the availability
of talent, has resulted in a trend to outsource a number of back-office jobs from the major financial
centers to other cities in the U.S. such as Salt Lake City and Buffalo and also internationally to
India and Philippines. Hiring for finance positions increased substantially in the U.S. in 2017 when
the Dow Jones Index reached an all-time high of 24,837.5 on December 29, 2017 and certain
banking stocks were trading at or close to their all-time highs. On January 2, 2018, the Nasdaq
closed above 7,000 for the first time and closed at an all-time closing record of 7,006.9 while the
S&P 500 closed at a record closing high of 2,695.8. The Nasdaq went down to 6,631 in March
2020 and closed at an all-time-high of 14,095 on February 12, 2021.

Buy-side vs. sell-side roles Some people might differentiate certain finance jobs as sell-side and
buy-side jobs. Sell-side positions typically are those where you are selling something and
collecting a fee either directly or indirectly. An example of a direct fee is an investment banker
who provides services for an acquisition and collects a fee. Sell-side equity research analysts in a
bank sell their reports to the asset managers and individual investors and collect a fee indirectly
through trading commissions generated by their firm. Buy-side, on the other hand, refers to when
you work for companies which are investors, for example, asset management companies, private
equity as well as hedge funds. It is easier to move to the buy-side if you have had experience
working for the sell-side, for example, investment banking experience is helpful to move into
private equity.

i
Organizations hiring finance positions The organizations that hire finance professionals include
banks, corporations, asset management firms, insurance companies as well as alternate asset
managers including hedge funds and private equity. In Table 1.1, we have provided below types
of organizations that employ finance professionals.

Table 1.1: Types of Firms Hiring Finance Professionals

1. Investment banks
2. Commercial banks
3. Corporations including rotational programs in finance
4. Traditional asset management companies
5. Accounting firms
6. Private equity firms
7. Hedge funds
8. Real estate companies
9. Rating agencies, consulting firms, FinTech and others

We will briefly describe the key finance positions in these firms in this chapter. Some of the
organizations might have an overlap regarding jobs, for example, an investment bank will have an
asset management division and there will be asset management companies outside an investment
bank who also manage money for institutional clients.

I. INVESTMENT BANKS

Investment banks Investment banks are financial institutions that provide a number of services
and products to corporations, government agencies and individuals. They advise companies on
buying and selling their businesses. They also help companies and governments raise equity and
debt capital to finance their operations and growth. They provide trading activities in commodities,
currencies, stocks and bonds and support the market so that they can be liquid. They also help
individuals and institutions preserve and grow their capital. As of March 1, 2017, the large
investment banks were JPMorgan, Bank of America Merrill Lynch, Goldman Sachs, Morgan
Stanley, Citi, Barclays, Credit Suisse and Deutsche Bank.

Front office vs. middle office vs. back-office Jobs in an investment bank can be broken into three
main departments namely front office, middle office and back office. Front office jobs are
functions where professionals conduct revenue-generating transactions. These include investment
bankers, traders, salespeople and research. The middle office function of a bank includes trade
support, risk management reconciliations and oversight of the fund. After a trade has been
executed, middle office professionals ensure that the trade has been properly reported with correct
buy and sell prices, trades have been entered correctly to the database and report on the transaction
regarding fees charged by banks and amount of money involved in the transactions. Middle office
professionals also help in managing risks taken by individual traders as well as ensure that the firm
is not taking excessive risks.

The back-office function consists of administrative support departments including information

ii
technology, accounting and human resources. There has been a recent trend to outsource back-
office operations to regional centers like Salt Lake City as well as globally. Some of the functions
performed by the back office will include i) ensure that trades comply with regulations; ii) ensure
that client accounts are issued with agreed upon processes and iii) ensure that trades are within
regulatory guidelines and also all the parties to the trade have been sent trade confirmations and
agree to the trade terms.

Structure of an investment bank An investment bank has many divisions including investment
banking, equity and fixed income research, sales and trading, private wealth management and asset
management. They also have other divisions such as prime brokerage, risk management, treasury
and securities services and private equity. We have outlined in Exhibit 1.1 the organizational chart
of Morgan Stanley1, a leading global investment bank and we will briefly discuss some of the main
front office groups within the bank. Morgan Stanley breaks its business into three distinct entities
namely institutional securities which comprises of investment banking, sales and trading, research
and prime brokerage, private wealth management and asset management.

Exhibit 1.1 Organizational Chart of Morgan Stanley

1
Morgan Stanley website as of September 30, 2014.

iii
Investment banking group primarily assists clients to raise capital and provides advisory services.
Capital raising can be for public and private companies and can include both debt and equity. It
depends on the growth stage of the company. Initially, an investment banker can help a company
raise capital from venture capitalists. Later, they can help the company go public via an initial
public offering. After a company is already public, an investment banker can raise additional equity
or debt capital for the company. Advisory services can include mergers and acquisitions and
restructuring advice regarding the capital structure of a company.
Sales and trading roles can be in different areas including equities, fixed income, commodities
and currency. Both sales and traders are separate jobs in the banks. Traders execute the orders they
get from the salespeople and try to make sure that the risk for the firm is mitigated. Traders in the
bank on the sell-side are also market makers as they have to develop a market for securities they
trade and have taken the responsibility of being a market maker. They have to be ready to give
clients a price at which they would buy and sell the security thereby facilitating liquidity.
Salespeople work closely with traders and research personnel at the banks to develop and maintain
relationships with institutional clients. They respond to institutional client requests for updates on
the market in general or particular securities. Salespeople execute orders given by the clients.
Salespeople also generate new trading ideas and try to get orders from clients to give to traders to
execute.
Research at the investment banks includes equity, fixed income, commodities, interest rates and
currency research. Equity research analysts analyze macro, industry and company-specific factors
to evaluate stocks globally and recommend investment opportunities to their clients regarding buy,
sell or hold a stock. Macro research provides insights and thematic trends in global markets as well
as opinions on political trends in an ever-changing environment to leverage the market thematic
into investable ideas for clients. The macro team includes economics, strategy, index, and
quantitative research teams.
Economics research focuses on macroeconomic factors, foreign exchange, interest rates as well as
commodities research forecasting prices of commodities including gold, oil and natural gas. In
strategy research, analysts provide their views, forecasts and recommendations on the markets
globally to enable asset allocation for clients. Fixed income research analysts provide investment
recommendations on the corporate credit of companies which includes investment grade as well
as high yield research.
Prime brokerage division of an investment bank provides hedge funds with a number of bundled
services. Core services include clearing, settlement, and custody of the securities, margin
financing, securities lending and consolidated reporting. A prime broker enables hedge fund
managers to trade with multiple brokers and access various markets and products, such as equities,
fixed income, commodities, and currency, as well as derivatives products including options,
futures and swaps. The prime broker consolidates their client’s securities and cash balances in one
master account and provides consolidated reporting, margin financing and efficient back-office
processing.
Additional services provided include capital introductions which is a service that facilitates the
introduction of hedge funds managers through investor conferences and networking events to
potential fund investors such as pension funds, endowments, foundations, family offices, sovereign
wealth funds, insurance companies and private banks. Business consulting services assist clients

iv
in managing and growing their businesses from start-up to growth and maturity stages. They solve
business issues in fund structuring, real estate, human resources operations and technology.
Private wealth management professionals perform certain core functions. First, they prospect for
new clients while ensuring that they retain existing clients, an activity that demands excellent sales
and marketing skills. Second, they understand their clients’ risk appetite, investment objectives
and investment time frame. Third, for a fee, they find suitable investments for their clients keeping
in mind their clients’ investment objectives, which may include retaining capital and asset
protection, providing steady income and long-term growth of assets. Fourth, they evaluate the
performance of those investments and report to their clients on a regular basis.
In private wealth management, wealth managers, also sometimes referred to as financial advisors,
secure, develop and manage comprehensive wealth management solutions for their clients. Clients
include individuals and families such as corporate executives who have generated their wealth
from high paying jobs and founders and managers of companies that have recently gone public or
who have sold companies in the private or public markets. Financial advisors also target
professionals, including doctors and lawyers, entrepreneurs and individuals who have acquired
wealth through inheritance. Clients also include small businesses and institutions such as non-
profits and foundations, family offices, private equity and trading firms, smaller hedge funds and
law firms.
Asset management is also called investment management in certain banks. Clients of the asset
management division include sovereign wealth funds, pension plans, central banks, insurance
companies, endowments, foundations, individuals and family offices. The investments made by
asset managers are across multiple asset classes such as money markets, equities, fixed income,
commodities, hedge funds, private equity and real estate. JP Morgan had $1.7 trillion of assets
under management as of December 31, 2015, and 20,975 employees in the asset management
division which included wealth management also.
II. COMMERCIAL BANKS

Commercial bank is the term used in the U.S. to distinguish a normal bank from an investment
bank. Commercial banks include retail banking, commercial banking and corporate banking. As
of March 31, 2016, JP Morgan, Bank of America, Wells Fargo and Citi were the largest
commercial banks in the U.S. Many commercial banks also provide investment banking services.
A commercial bank will provide retail, commercial and corporate banking services besides other
products.
Retail banking is also referred to as consumer banking. It provides deposit, lending, cash
management and investment services to consumer and small business customers. Retail banking
serves its customers through a variety of channels including branches, self-service terminals,
telephone service centers and Internet and mobile banking digital channels. Products offered
include personal bank accounts such as checking and savings accounts, certificates of deposit,
debit and credit cards, home mortgages and equity lines of credit, auto finance, education finance
as well as investment products for retirement and investing.
Commercial banking provides product and services to middle market companies with annual
revenues of $20 million to $1 billion. The range of revenues of companies could differ from each
bank, for example, as of June 30, 2016, Wells Fargo commercial bank provided services to
companies with revenues ranging from $20 million to $500+ million and JP Morgan commercial

v
bank range of revenues was $20 million to $2 billion. Products include treasury management such
as accounts payable and accounts receivable products which help in electronic payables and
receivable, electronic payroll options and commercial credit cards. Liquidity management
products include cash sweep where companies can invest unallocated funds or reduce debt and
interest payments.
Commercial financing products include traditional asset-based lending including revolving lines
of credit and term loans, junior and senior secured financing and accounts receivable financing,
i.e., factoring and inventory financing. Banks provide business equipment financings such as
financing for commercial trucks and trailers, healthcare equipment financing as well as equipment
used for the construction of streets, highways, bridges and tunnels. Banks also have a commercial
real estate financing group where they provide loans for acquisition and construction as well as
interim and bridge financing.
Corporate banking provides products and services to large corporations, financial institutional
and public sector organizations. The main difference between commercial banking and corporate
banking is the size of the client served, with corporate banking serving larger clients. The products
are similar to commercial banking and include treasury and liquidity management products,
traditional asset based lending, business equipment financing and commercial real estate. Given
that many clients including Fortune 500 companies would have international operations, a number
of products cater to their needs including foreign currency exchange where banks buy and sell
foreign exchange as well as provide foreign currency hedging products. Corporate bankers work
closely with the investment bankers and have an ongoing dialogue on capital markets ideas and
advice on M&A.
III. CORPORATIONS

Corporations such as Fortune 500 companies, large corporates as well as middle market
companies will have a number of finance roles including financial planning and analysis, treasury,
corporate development and investor relations. Many companies have a rotational program that
ranges from 18 months to 3 years where undergraduates and masters in business administration
(MBA) students rotate around different groups and choose a group upon completion of the
program.
Financial planning and analysis (FP&A) includes budgeting and forecasting revenues and
expenses for the company. FP&A involves analyzing historical results and preparing budgets
keeping in mind the financial needs of the firm and then measure future actual results against the
budget. Cost analysis includes understanding the cost of products for a manufacturing company
and establish opportunities to reduce costs and improve processes. It also involves working closely
with marketing and sales business units on pricing decisions.
FP&A function also is involved in strategic planning, management reporting, financial analysis,
capital planning and business modeling of new ventures and investments. An FP&A professional
would evaluate capital proposals and justify uses of capital, for example, whether a company
should purchase or lease the equipment. FP&A professional will partner with key executives in
different functions and divisions to advise them on financial compliance, headcount, investments
and other financial issues. They also provide finance decision-support analytics like long-range
and annual strategic planning and analysis of results.

vi
Treasury is responsible for a company’s financing and investing activities. Treasury professionals
will ensure working capital management and short-term and long-term funding needs of the
company is assessed. Capital is raised from either banks or capital markets through bank loans,
commercial paper, bond and stock issuance to meet the cash needs of the company. Treasury
professionals manage the company’s relationship with the banks and explore investment
opportunities for surplus funds. The treasury group evaluates the capital structure of the company,
identifies the distribution and retention policies including how much dividend if any needs to be
distributed to shareholders. Treasury professionals also evaluate various avenues to raise capital
and assesses the likely returns from each source.
Treasury group will also manage currency, interest rate, commodity and other risks for the
business. They provide the business with exchange risk forecasts and work with insurance
companies to minimize premiums. They also manage the company pension plans and other
retirement programs.
Corporate development group executes a company’s strategy and involves corporate finance,
strategy and business development skills. Finance experts in corporate development evaluate
acquisition targets, divestitures, investment options, partnerships and licensing deals. For new
product development, the corporate development group will research new business opportunities
from a finance and marketing perspective and create a business case, build financial models and
present recommendations to management.
For mergers and acquisitions, direct investments and joint ventures, corporate development will
produce valuation models such as comparable company, precedent transactions, discounted cash
flow analysis and also do build vs. buy analysis. They will perform due diligence on projects,
negotiate and execute deal terms, be involved in the integration of the acquisitions and manage the
investment banking relationships.
Leadership or rotational development programs in finance are programs within larger
corporations, banks and insurance companies for recent undergraduates and MBA students which
focus on developing future leaders in the finance function of an organization as well as
management leaders of the company. Rotations are generally for 3-6 months within a particular
function of finance such as FP&A, treasury, corporate development, internal audit, investor
relations and tax. Before completing the program, associates typically begin planning their
transition to a regular, full-time position within the company.
IV. ASSET MANAGEMENT FIRMS

Traditional asset management firms manage investments for institutions, financial advisors and
individuals. Clients include sovereign wealth funds, corporations, public and private pension and
retirement plans, central banks, insurance companies, endowments, foundations, family offices
and individuals. The large firms include BlackRock, Vanguard Asset Management, State Street
Global Advisors, Fidelity Investments, BNY Mellon Investment Management, JP Morgan Asset
Management, PIMCO, Capital Group, Prudential and Goldman Sachs Asset Management.
Traditional asset management firms can have funds that are actively managed or passively
managed. Actively managed funds are run by fund managers aided by researchers who make buy
and sell decisions regularly but have higher fees. Passively managed funds track a market-
weighted portfolio or an index and have lower fees, for example, Vanguard 500 equity index fund
tracks the S&P 500 index. There is a trend in recent years of money shifting from actively managed

vii
funds to more passively managed funds. According to Morningstar Inc., in 2016, investors pulled
a net $342.4 billion from U.S. based actively managed funds while pouring a record $506.6 billion
into U.S. passively managed funds. Traditional asset management firms have many positions
including equity and credit research analyst, portfolio manager, product manager and account
manager.
Equity and credit research analysts analyze various industries and companies within them,
highlight risks and make investment recommendations to the portfolio managers. Equity analysts
usually cover a particular industry, talk to sell-side research analysts, management teams and other
industry contacts, build and update financial models and monitor economic trends. Depending on
how large the fund is and its structure, credit analysts may specialize in one or more industries and
work on a particular level of the debt capital structure, i.e., investment grade bonds, high yield or
junk bonds, bank debt and convertible debt.
Portfolio managers develop, present and execute specific trading strategies in the industry or
particular equity or fixed income strategy covered by them. They ensure that they maximize returns
keeping in mind client objectives. They prepare research notes and updates on markets and support
the account managers by updating existing customers on market conditions, investment
philosophy, process and performance.
Account managers discuss investment strategy and objectives with the clients, outline the current
outlook and strategy of the asset management firm, and educate clients on the firm’s broad set of
investment strategies, products and services. They work closely with portfolio managers to
monitor portfolios and update clients on global macroeconomic conditions and portfolio
performance. Account managers will proactively identify and address all service related client
issues and work closely with various internal departments to meet all client requirements.
Product managers have product level expertise and are responsible for the development and
oversight of a variety of equity, fixed income and other products. Products are based on the asset
classes such as U.S. equities or fixed income, or international equities or fixed income and include
credit, long duration, inflation-linked, structured products and derivatives-based products
providing exposure to equities, real estate and commodities.
Product managers take a lead role in the development of new strategies and ongoing support of
existing strategies. They work closely with portfolio managers and support them on the roadshows
and conferences. They also communicate with internal and external legal team and compliance
teams to ensure that the products comply with rules and regulations.
V. ACCOUNTING FIRMS
Accounting firms have many positions besides audit and tax such as corporate finance, valuation
and business modeling, transaction advisory services and risk advisory. The groups offering these
positions may be called by a different name by certain firms and all firms may not provide all these
services. The major accounting firms include the Big Four firms, i.e., Deloitte,
PricewaterhouseCoopers, Ernst & Young and KPMG as well as other large firms such as RSM
U.S. and Grant Thornton.
Corporate finance includes M&A, capital advisory, restructuring and other special situations as
well as fairness opinion and board advisory services. Mergers and acquisitions practice enables
companies and private equity investors to identify and then execute M&A transactions. Capital
advisory services provide clients with independent and objective advice on capital structure and

viii
strategies. They also provide advice on equity and debt private placements, refinancings and
recapitalizations. Special situations group assist in developing financing options for companies
facing financial issues or a potential default of their debt.
Transaction advisory services include due diligence support for both buy-side and sell-side
engagements for private equity firms and strategic corporate buyers. It involves analyzing
historical financial statements and evaluating operational trends to identify sustainable earnings
for companies in different industries. The findings are usually summarized and communicated to
the client in the form of a written engagement report.
Valuation and business modeling services include valuation for financial reporting and audit
purposes comprising of assistance in reporting fair values to comply with accounting standards.
This includes purchase price allocation, goodwill and long-lived asset impairment testing as well
as assessing the fair value of employee options. Valuations are also done for M&A, capital raises,
joint ventures, strategic alliances and divestiture strategies as well as for tax and compliance
purposes such as valuing estate transfers and gifts made during the lifetime.
Valuation can also be for complex securities such as options, warrants, preferred and common
stock in private companies, convertible bonds, financial derivatives and other contingent assets
and liabilities. Valuation professionals gather data and identify qualitative and quantitative factors
which could impact valuation. They build financial models, perform accounting and financial
analysis, perform valuation and then summarize their findings in a report to the client or the
auditors if done for audit purposes.
Business modeling can be for various purposes including building models to quantify and evaluate
strategic decisions, modeling to prepare for bids, spreadsheets and database tools to quantify and
forecast specific business operations as well as restructuring and financing models to reflect
financing options.
VI. PRIVATE EQUITY FIRMS

Private equity (PE) firm is an investment management company that invests in early-stage start-
ups as well as operating public and private companies. They exit their investments through an
initial public offering (IPO), merger or acquisitions (M&A) or a recapitalization. PE firms charge
a periodic management fee and a percentage of the profits of the funds they manage. PE firms
obtain their capital from investors that include sovereign wealth funds, pension funds,
endowments, insurance companies, high-net-worth investors, family offices and foundations. PE
firms can be categorized as venture capital, growth equity, leveraged buyouts, fund of funds and
mezzanine funds.
Venture capital firms invest in start-up private companies with the goal of exiting the investment
through an IPO or an M&A transaction. Venture capitalists focus on high-growth companies in
biotech and technology-intensive industries such as software and telecom. Alternate energy and
social media have recently become popular investments for venture capitalists. Leading venture
capital funds include Andreessen Horowitz, Accel Partners, Bessemer Venture Partners, Kleiner
Perkins Caufield and Byers, New Enterprise Associates, Sequoia Capital and SoftBank.
Growth equity PE firms typically take a minority stake in companies that are looking to expand
operations, enter new markets and pursue strategic acquisitions. These companies may also be
looking to restructure their balance sheet by reducing the amount of leverage or monetize a portion
of management’s ownership. Companies that pursue growth capital are more mature than venture

ix
capital and use little if any leverage at the time of investment. Leading growth equity private equity
firms include General Atlantic, Madison Dearborn Partners, Norwest Venture Partners, Summit
Partners and Technology Crossover Ventures.
Leveraged buyout (LBO) PE funds acquire a private or public company through a leveraged
buyout using a significant amount of borrowed capital to meet the cost of the acquisition. The
typical exit strategy for an LBO PE firm is to sell the company or take it public again in 3-5 years.
LBO PE firms also make operational improvements to the company after the acquisition to
enhance their monetary returns on the investment. Companies pursuing LBOs are more mature
than venture capital firms and tend to generate predictable operating cash flows to service the debt.
Leading LBO firms include Appolo Group, Bain Capital, Blackstone Group, KKR, TPG Capital
and Warburg Pincus.
Fund of funds are asset managers that allocate capital among many private equity funds, including
both venture capital and LBO funds. This provides a way of diversifying the private equity risk
for certain types of investors including high net worth individuals, family offices and smaller
institutions as they can own some part of hundreds of companies by investing in a few private
equity funds. Leading fund of funds PE firms include Abbott Capital Management, Adams Street
Partners, AIG Investments, Commonfund Capital and Hamilton Lane.
Mezzanine funds provide the layer of financing which is between a company’s senior debt and
equity and hence fills the gap between the two. They receive securities which have greater seniority
than common equity but carry more risk or are junior to the senior debt in a company’s capital
structure. This type of debt is typically not secured by the company’s assets and are used by
companies to further their growth through expansion projects, acquisitions, recapitalizations and
leveraged and management buyouts. Mezzanine debt in conjunction with senior debt reduces the
amount of equity required to be put in. Since the most expensive form of capital is equity,
mezzanine debt enables to create a capital structure that secures the most funding, lowest cost and
enhances the return to equity holders. Leading mezzanine funds include Blackstone Group, GSC
Group, Oaktree Capital Management and Siguler Guff.
VII. HEDGE FUNDS

Hedge fund (HF) is an alternative investment vehicle that can invest in various strategies and
asset classes including stocks, bonds, real estate and commodities. A HF is different from a mutual
fund in that it is not as heavily regulated as a mutual fund and is not required to register with the
Securities and Exchange Commission. Investing in hedge funds (HFs) is limited to accredited
investors, having a certain minimum level of income and assets as well as institutional investors.
They charge a fixed asset management fee of 1%-2% plus also a performance fee based on a share
of the profits that range between 20%-30%. Regarding liquidity, most mutual funds offer daily
liquidity, but in a hedge fund, your money is locked for a period of time. HFs are more flexible
than mutual funds and can use leverage, sell short and use derivatives. HFs can be grouped based
on the strategies they employ. The four common HF strategies, global macro, event driven, equity
hedge fund strategies and relative value are highlighted below. Though most HFs specialize in a
particular strategy at first, many funds later develop additional areas of expertise and become
multi-strategy HFs by employing many strategies.
Global macro funds seek to make returns from macroeconomic imbalances and geopolitical
events. These funds can invest in any asset class or investment vehicles that include equity, fixed

x
income, currencies, commodities and real estate. They can have a directional strategy that predicts
that a market or trading instrument will rise or decline or relative analysis that evaluates market
trends relative to each other. Global macro funds include Balestra Capital Partners, Brevan
Howard, Bridgewater, Field Street Capital, Moore Capital, Rokos Capital, Soros Fund
Management and Tudor Investments.
Event-driven HF strategies are investments in equity, debt or preferred stock of a corporation
based on an event such as acquisitions, recapitalizations, bankruptcy and liquidations. Event-
driven strategies can be:
Activist HFs make a substantial investment in companies where they believe management and the
board is not doing enough to enhance shareholder value and use that stake to influence the decision
making at those companies including sometimes demanding a board seat on the company. Activist
HFs could ask the board and management to block a recent merger or acquisition and sell the entire
company or spin-off or divest non-core assets or part of the business. They could also engage with
the management to address changes in strategy, capital structure issues such as dividends and stock
buybacks, address corporate governance issues such as removing management and board of
directors or adding new directors to the board.
Examples of Activist HFs include Blue Harbor Group, Blum Capital, Elliott Associates, ESL
Investments, Jana Partners, Icahn, Marcato Capital, MSD Capital, Pershing Square Capital, RBR
Capital Advisors, Sageview Capital, Trian Partners and ValueAct Capital. Companies targeted by
activist investors include American International Group, Apple, Arconic Inc, Avon Products Inc,
Bristol-Myers Squibb Co., Buffalo Wild Wings Inc., Citigroup Inc., CSX Corp, DuPont, General
Electric, General Motors, Kraft Foods, McDonald’s, Microsoft, Mondelez International, Proctor
& Gamble, Tiffany & Co, Wendys, Whole Foods and Yahoo!.
Merger arbitrage or risk arbitrage is where the HF manager uses their research and analysis to
determine if a merger, acquisition or a hostile takeover will happen or not. It involves buying and
selling shares of companies involved in the acquisition or merger to take advantage of the
difference between the acquisition price and the current price of the stock. If a HF believes that a
stock-for-stock merger will go through, a simple strategy is to buy the target company stock
anticipating the price to rise and shorting the acquirer in expectation of its price falling. If the
merger is completed, the target company stock will be converted into the stock of the acquiring
company and the HF can cover its short position with the converted stock. HFs employing this
strategy include Arrowgrass Capital, Davidson Kempner, Farallon Capital Management, Glazer
Capital Management, Manikay Partners, Paulson & Co., and Taconic Capital Advisors.
Distressed securities strategy involves buying undervalued or shorting overvalued securities such
as bonds or loans of companies when they are undergoing restructuring, recapitalization or
bankruptcy. HFs using this strategy include Appaloosa Management, Elliott Associates, Paulson
& Co and Silver Point Capital.
Special situation strategy involves an HF manager identifying an upcoming event such as
restructuring, repurchasing shares, asset sales and spin-offs that can increase or decrease the value
of a company’s equity securities. EJF Capital, Pershing Square Capital Management and Third
Point are some of the HFs employing this strategy.
Equity HF strategies can be equity long-short strategies that could be market neutral or long-bias
or short-bias, fundamental value and quantitative directional strategy.

xi
Equity long-short HF strategy involves taking a long position or buying undervalued stocks that
the manager expects to increase in value and short position or selling expensive stocks that the
manager expects to decrease in value. Long-short strategies can be market neutral which hold equal
dollar amounts of long and short positions as well as can have a long bias such as a “130/30”
strategy. Here the HF will have 130% exposure to long stocks and 30% exposure to short stocks.
Few HFs will have a long-term short bias since equity markets go up over a longer period of time.
HF managers can use this strategy in a particular geographic market, for a particular industry such
as telecom, financials and oil and gas or they can use it as part of value investing or quantitative
investing strategy.
Fundamental value strategy involves buying stocks of companies that the HF manager perceives
to be undervalued. In this strategy, it is the HF structure rather than the type of asset purchased
that makes this as an alternative investment.
Quantitative directional strategy involves building on historical trends or reflective of upward
or downward movement for a security price. It involves technical analysis and trading by
predicting the direction of equity prices through the study of past prices and volume patterns and
support and resistance levels. Quantitative HFs use more sophisticated strategies than regular
technical analysis.
Relative value strategies involve buying a security and selling short a related security to take
advantage of a pricing discrepancy between the two securities and are described below. Relative
value strategies can include convertible arbitrage, fixed income and statistical arbitrage.
Convertible arbitrage strategy takes advantage of the pricing discrepancy between convertible
bonds and the common stock of the same company. The HF manager may purchase the convertible
bond issued by a company and at the same time sell the common stock of the company. If the stock
declines, the profit from the short position would make up any loss on the convertible bond position
which is a fixed income instrument. If the price of the stock goes up, the fund can profit from the
conversion of the convertible bond into stock and sell the stock at the market value hopefully by
an amount that exceeds the loss on the short position.
Fixed income arbitrage strategy takes advantage of the pricing discrepancy between fixed income
securities of various types. One example could be yield curve arbitrage where the HF manager
seeks to profit from the shifts in the yield curve by taking short and long positions in various short-
term and long-term maturity Treasuries.
Statistical arbitrage is a short-term trading strategy from a few seconds to days where hundreds
of stocks, some long and some short, are carefully matched by sector and region. It evolved out of
the simpler pairs trade strategy where fundamental or market based similar stocks are grouped in
pairs. When one stock in a pair outperforms the other, the stock that did not do as well is bought
long with the expectation that it will rise and catch up to the outperforming stock and the
outperforming stock is sold short. It involves a highly quantitative and computational approach to
equity trading with the goal to keep trading costs low given the large number of stocks involved,
high turnover of the stocks and the small size of the effects one is trying to capture.

VIII. REAL ESTATE

xii
Real estate can be characterized in four categories. Residential real estate includes single-family
homes, condominiums, co-ops, townhouses, duplexes and vacation homes. These could be newly
constructed or resale of existing homes. Commercial real estate includes hotels, offices, shopping
centers, strip malls and medical buildings. Apartment buildings used as residences but owned to
produce income will also be considered commercial. Industrial real estate includes warehouses
and manufacturing buildings used for research, production, storage and distribution of goods. The
last category is land which includes vacant land, working farms and ranches.
Real estate industry jobs can be finance focused and also not primarily be finance but involve some
knowledge of finance. We have described below a few positions for undergraduate and MBA
students focused on financial roles in real estate.
Real estate investment banking assist firms in different sectors of real estate with capital raising
through an an initial public offering or a follow-on offering and providing mergers and acquisition
services. Sectors covered include real estate investment trusts (REITs), home builders, gaming or
casinos and lodging.
A REIT is a company that owns, operates and finances income-producing real estate. REITs are
diversified or focused on a specific sector such as commercial, residential or industrial. The
shareholder of a REIT gets a share of the income of real estate assets in REITs without having to
buy and manage the property. REITs are required to pay at least 90 percent of their taxable income
to their shareholders as dividends. The majority of REITs are publicly traded though you also have
private REITs. Examples of REITs include office REITs such as Boston Properties, Brandywine,
Corporate Office, Kilroy, Piedmont and Vornado; residential REITs such as AvalonBay
Communities, Equity Residential and Essex Property Trust and self-storage REITs such as
CubeSmart, Extra Space Storage, Life Storage and Public Storage.
Home builders construct and build homes and are strong in particular geographies in the U.S.
Companies include KB Homes, DR Horton, Lennar, Pulte Homes and Hovnanian. Hotels and
resorts include companies such as Hilton Worldwide Holdings Inc., Marriott International, Choice
Hotel International Inc, Extended Stay America, Inc., Hyatt Hotels Corporations, Intercontinental
Hotel Group and Wyndham Worldwide Group. Casinos and gaming sector comprises of
companies such as Las Vegas Sands Corp, MGM Resorts International, Wynn Resorts, Ltd and
Caesars Entertainment Corporation.
Real estate development roles create new residential, office, retail, industrial and hotel properties.
Process management skills are required to bring complex projects from concept to completion
including financial analysis for analyzing new investment opportunities after they have been
sourced, coordinate with internal team to acquire construction and permanent financing and
prepare quarterly and annual operating and capital forecasts.
Acquisitions role in private equity firms requires excellent financial modeling skills and
experience in real estate transactions. The portfolio managers of the firm set specific criteria for
the acquisitions team to identify and purchase new real estate assets.
Asset management positions in real estate combine financial engineering with the understanding
of the operational productivity of the asset. Asset managers will provide direction to the property
management team regarding managing the asset including collection of rents and other revenues
and managing expenses. They will also determine the optimal timing of disposal of the assets.
Lending positions in commercial banks provide loans for construction lending, permanent
lending as well as mezzanine lending for properties to large REITs or corporate borrowers and

xiii
private developers. Bankers would market the deals to customers as well as internally to the credit
department of the bank. They would also help their clients address any of their other financial
needs including hedging, treasury management and investments.

IX. RATING AGENCIES, CONSULTING FIRMS, FINTECH AND OTHERS

Credit rating agencies (CRA) rate the ability of a debtor to make timely interest payments and
repay the principal including the likelihood of default. They rate the debt instruments which
include government bonds, corporate bonds, municipal bonds, preferred stock and mortgage-
backed securities. They may also rate the creditworthiness of the issuer of the debt which may be
state or local governments, companies, non-profit organizations or sovereign nations. The ratings
matter when they security trade on the secondary market, with higher rated debt paying lower
interest.
The industry is dominated in the U.S. by three firms Standard and Poor’s (S&P), Moodys and Fitch
which control approximately 95% of the ratings. S&P and Fitch use AAA, AA and A, and BBB
for investment grade debt with pluses and minuses such as A+ and A- for further classification and
BB, B, CCC, CC, C and D for speculative or high yield debt. Moodys uses Aaa, Aa, A and Baa
for investment grade debt and Ba, B, Caa, Ca and C for speculative debt with numbers Aa1, Aa2
and Aa3 for further classification. As of June 30, 2017, only two companies in the U.S., Johnson
& Johnson and Microsoft had AAA rating from S&P. Other rating agencies include A.M. Best
Company, Inc., DBRS, Egan-Jones Rating Company and Kroll Bond Rating Agency, Inc.
Consulting firms have a large mergers and acquisitions advisory, corporate and turnaround
restructuring units that offer opportunities for finance professionals. Some of the firms include
Alix Partners, Alvarez & Marsal, Bain & Company, Boston Consulting Group, Deloitte Consulting
LLP, EY LLP Consulting Practice, FTI Consulting, McKinsey & Company, Oliver Wyman and
PricewaterhouseCoopers Advisory Services.
FinTech is a new financial industry that applies technology to improve financial activities. The
use of smartphones for investing activities and mobile banking are examples of how technology
aims to make financial services more accessible. FinTech firms have a number of corporate finance
positions as well as business development positions where knowledge of finance is helpful. In the
U.S. some of the FinTech firms are Avant, AvidXchange, Betterment, Credit Karma, GreenSky,
Oscar, Prosper, Robinhood, SoFi, Stripe, Square and Zenefits.
Other firms that hire professionals with finance knowledge include the major stock exchanges
such as New York Stock Exchange and Nasdaq as well as financial data and analytics vendors
such as Acuris, Bloomberg L.P., Dealogic, IHS Markit Ltd, Morningstar, Inc., PitchBook, Prequin
and Thomson Reuters.

xiv
Chapter 3: Sell-Side Equity
Research
“In much of society, research means to investigate something you do not
know or understand”
– Neil Armstrong
Sell-side equity research analysts provide three core functions. First, they conduct macro level
research on a given sector and industry along with company-specific research on the stocks they
cover. Second, they build and maintain financial models, perform financial analysis and use
valuation methodologies to value a company. Third, they develop an opinion on the company’s
stock price and communicate it to their clients.
Sector, industry and company research Equity research analysts cover and write reports on
approximately 8 to 15 public companies in a particular industry within the sector. For example,
within the technology sector, analysts would cover various industries such as software,
semiconductor and Internet. Analysts cover industries such as consumer and retail, energy and
natural resources, financial institutions, healthcare, diversified industrials and technology, media
and telecom collectively referred to as (TMT). Exhibit 1.1 outlines some of the industries
covered within these sectors.
Exhibit 1.1 Examples of Sectors and Industries Covered by Equity Research Analysts
Select Industry Coverage in Equity Research
Financial Healthcare Consumer & Retail Energy and Technology, Media Diversified
Institutions Natural Resources and Telecom
Industrials
Asset Management Biotech Apparel & Footwear Electric Utilities Internet Aerospace
Banks Healthcare IT Consumer Product Exploration Media Defense
Insurance Large Pharmaceutical Drug Retailing Oil/Gas Drilling Semiconductor Diversified
Regional Banks Medical Devices Food & Beverage Oil/Gas Services Software Machinery
REITs Medical Diagnostics Restaurant Production Telecom Services Metals &
Mining

Equity research reports typically include the analyst’s investment thesis, an overview of the
company and industry, financial models, and valuation methodologies. The equity analyst uses a
top-down approach, researching the important points in the sector and industry as well as their
impact on a specific company and stock price. The research will include company-specific
drivers that can affect the stock price of the company. Analysts use company filings, investor
presentations and data sources such as Bloomberg and Capital IQ to conduct research. They also

1
speak with management and investor relations personnel at companies, read industry
publications and attend industry conferences.
Perform financial analysis and value companies The research analyst and their team build a
company model that includes historical and projected financial statements. They will take
guidance from the company and continuously update the model for recent earnings and new
information including acquisitions, divestitures and changes in operating assumptions of the
company. The associate will build a model and take input from the research analyst. Analysts
value companies using DCF and comparable company valuation methodologies. They also use
other methods such as net asset value and sum-of-the-parts analysis.
Provide and communicate an opinion on a company’s stock price Equity analysts will
recommend that clients buy, hold or sell a given stock1. Analysts publish a price target for the
stock when they issue their report. A price target reflects the view of the analyst as to what the
stock price will be at the end of a certain period from the date of publishing the report. The
period is generally 12 months or 18 months, depending on the standard used by a brokerage firm.
Clients of sell-side equity research will include external and internal clients. External clients
include buy-side firms such as pension funds, hedge funds, family offices, other asset
management funds and individual investors who buy research. Buy-side firms use sell-side
research to test the assumptions they have developed about a company and to further understand
the industry. Research analysts also provide corporate access to the institutional clients by
connecting company management with clients through conferences as well as visits to company
and client offices. Internal clients include traders, sales traders and equity salespeople within the
banks. Traders generate new stock ideas with the help of analysts. The internal sales force uses
research to understand key themes about particular stocks and industries, which they can then
market to their institutional clients. Though there is a “Chinese Wall” 2 between investment
banking and equity research, research helps investment bankers develop relationships with
companies. For example, high-quality research could be a reason that a company chooses to do
business with a particular investment bank, which could then lead to further new business
including mergers and acquisitions advisory and other advisory services for the bank.

1
Brokerage firms use their own methodologies. Some firms may have a simple rating structure like buy, sell or hold a stock whereas some firms
use different ratings including strong buy, outperform, hold, underperform and sell. Investors must look at the firms rating methodology
described with the report to understand the meaning of these ratings.
2
A Chinese Wall consists of procedures that ensure no conflict of interest arises between investment banking and research. It also provides a
physical separation of the two departments. It protects the independence of a research analyst, it prohibits firms from promising favorable
research reports to their clients, and it protects analysts from retaliation if they publish unfavorable reports on a company.

2
TYPES OF SELL-SIDE EQUITY RESEARCH FIRMS

Research firms can be grouped into various categories base on the size of the firm and the types
of companies they cover, i.e., large, mid-cap or small-cap companies 3 . Some firms are
independent but others are part of a bank that provides other services such as investment
banking. We have grouped the firms into four categories based on these factors.
Bulge bracket investment banks These are the nine large global investment banks that deal
with research products in almost all sectors and industries. They mainly focus on large-cap and
mid-cap companies.

Commercial banks A number of commercial banks have equity research divisions along with
sales and trading and investment banking capabilities. They also focus on covering large-cap and
mid-cap companies.

Full-service, middle-market and boutique investment banks These banks cover mainly large
and mid-cap companies, though the focus is more on mid-cap companies, to which they provide
the bulk of their research and from which they receive most of their revenues.

Independent research and boutique firms These firms are not conflicted since they provide
only research coverage to clients and do not provide investment banking services. Some of the
larger independent research firms focus on large and mid-cap clients, but the smaller boutique
firms focus on the small-cap companies that often are not covered by the larger banks.
Exhibit 1.2 gives examples of equity research firms in the previously described categories.

Exhibit 1.2 Types of Equity Research Firms

Bulge Bracket Banks

Bank of America/ML Credit Suisse JP Morgan
Barclays Capital Deutsche Bank Morgan Stanley
Citigroup Goldman Sachs UBS
Commercial Banks
BB&T Capital Markets HSBC RBC Capital Markets
BMO Capital Markets ICICI (India) Standard Chartered

3
Though the definition of large, mid- and small-cap varies among firms, generally companies having a market capitalization over $10 billion are
considered large-cap, companies with a market capitalization between $2 billion and $10 billion are considered mid-cap, and companies below $2
billion market capitalization are considered small-cap.

3
 Full Service and Middle Market Banks
Cowen Group Piper Jaffray Stifel Nicholaus
Jefferies & Company Raymond James William Blair
Independent Research and Other Boutique Firms
Sanford Bernstein First Analysis Securities Brean Murray, Carret & Co
MorningStar Harbinger Research, LLC. Prime Equity Research

KEY RESEARCH PRODUCT OFFERINGS

Equity analysts provide a number of products to their clients. These products include:
Initiating company report This is the first report that a research analyst writes on a company
when he/she picks up research coverage on the company. This could occur either after a
company has completed an IPO or when the analyst starts covering a new company that has
existed for some time. This report is extremely descriptive and includes a discussion of macro
drivers such as economic growth, interest rates, inflation and unemployment that affect the stock
market and sector as a whole. It provides an overview and recent developments in the sector as
well as industry analysis. It also includes a company-specific analysis including discussion of
keys customers, suppliers and the management team of the company as well as a detailed
valuation of the company’s stock. These reports are usually 15 to 75 pages long.

The initiation report could have various sections including i) an investment summary that
highlights the key investment points in the report upfront for a number of investors who may not
have time to read the whole report, ii) an industry overview that provides analysis on various
aspects including growth rates, trends and competitive advantages of players in the industry; iii)
a company overview, which provides information on the company’s customers, products, and its
strengths and weaknesses; iv) valuation summary covering various methods used, including DCF
and comparable company analysis, and it explains why the stock should be bought or sold at the
particular price, v) risk factors that address both industry and company specific risks, vi) a
company financial model that includes assumptions about how the analyst has projected the
company’s income statement, cash flow and balance sheet.

Continuing company research reports An analyst will write approximately 6 to 12 reports on a

company during the year. These will be short notes of approximately 2 to 10 pages and provide
new information to clients based on certain important events. For example, analysts write a
report after a company announces its quarterly earnings, and update their financial models and
business assumptions based on those results. Companies might also update their estimates based
on a number of material events, including but not limited to significant acquisitions or
divestitures, or changes to business strategy. An analyst might write a note after they attend an

4
analyst and investor day4, meet with management, and after attending industry conferences and
trade shows.
Industry reports Analysts occasionally write industry reports on the sector and industry they
provide coverage on. In these reports, analysts could highlight a certain theme in an industry or
present results of a survey. Reports could also involve cross-collaborating with analysts in
different sectors and regions, and with, macro analysts covering the economy and regional equity
markets.

TYPICAL EQUITY RESEARCH HIERARCHY

Exhibit 1.3 provides a snapshot of a typical career path at a bulge bracket bank.

Exhibit 1.3 Typical Hierarchy at a Bulge Bracket Bank within Equity Research

.
Global
Head of
Research

Regional Head of
Research

Managing Director/ Senior Analyst

Develop franchise, Manage team,
Focus on clients

Executive Director/ Senior Analyst

Manage team, Focus on clients,
Review Reports

Vice President/Junior Analyst

Cover sub-sector, Manage client list, Assist senior analyst,
Review and write reports

Associate
Develop models, Industry and company research, Write notes, Assist in
stock calls, Sales relationships, and Develop client list

Junior Associate
Write Notes, Develop models, Research companies and industries, Assist sales &
trading, Service client requests

4
A public company may hold an analyst and investor day to share important information and meet with investors and analysts. This day can be
held wherever the company chooses and does not necessary have to be at the headquarters of the company.

5
Junior associates, who have undergraduate degrees, work for two to three years before becoming
an associate. An associate typically works for three to five years prior to becoming an analyst
directly responsible for stock coverage. This length of time can vary widely, depending on the
opportunities at the firm and the performance of the associate. Exhibit 1.4 describes the typical
hierarchy and career path at an equity research group of a bulge bracket bank, but smaller size
banks and research firms have varying structures that could be lean. For example, they may have
only two levels, associates and analysts, reporting to the head of research. One key difference is
that in investment banking, an analyst is the junior person and the associate is senior to the
analyst. In research, it is the opposite, where the analyst is the senior person on the team.

Junior associates They typically join after an undergraduate program majoring in business,
economics, engineering, accounting or sciences. In reality, no degree serves as a pre-requisite,
but a typical candidate must possess certain core skills such as communication, analytical ability,
and passion for stocks and equity markets. Junior associates gather and analyze industry and
company data to assist analysts in doing research. They will also update and build financial
models on the companies they cover as well as perform valuation work and share their results
with the senior members of the team. They will respond to data and information requests from
internal and external clients, and to some extent, they also help the senior analyst write research
reports.

Associates They might join after obtaining an MBA or other graduate degrees, including masters
in finance, financial engineering and economics. But associates also could be undergraduates
who have received promotions or have experience in the industry they would like to cover.
Research associates develop and maintain financial models including earnings and valuation
models. In addition, they assist the research analyst in writing company and industry reports.
They have regular interaction with the firm’s equity sales force and respond to requests for
information, and to calls from internal and external clients.

Junior analysts or vice presidents Junior analysts are associates who have been promoted to
vice presidents. They also could be individuals who have relevant industry background or have
worked as investment bankers or in other relevant finance jobs and made the transition to
research. Junior analysts cover a sub-sector and review the associates’ work. They also assist
senior analysts in managing client relationships and writing research reports.

Senior analyst or executive director or managing director These are analysts who, after
several years of experience being directly responsible for a group of stocks, have been promoted
to executive director or managing director. A senior analyst will supervise a team of two to five
people, depending on the size of the firm and the industry being covered.

Head of research The head of research is responsible for all of the equity research analysts at
the firm. Global banks also have regional heads of research reporting to the global head of
research.

6
TYPICAL WORK DISTRIBUTION FOR AN EQUITY
RESEARCH ANALYST AND ASSOCIATE IN A DAY

Equity research analysts and associates at a bulge bracket bank spend their day on tasks that
could include research, financial modeling, report writing, and speaking to internal and external
clients. Exhibit 1.4 outlines typical percentages of the workday by their task.

Exhibit 1.4 Typical Percentages of the Workday by Task by Senior Analyst and Research
Associate

Senior Analyst Research Associate

Writing
15% Investor
Writing
Interaction
Investor 25%
Modeling 15%
Interaction Capital
35% 5%
Markets
5%

Working
Industry with sales /
Research traders
20% 10%
Modeling
Capital 20%
Markets
5% Working Industry
with sales / Research
traders 25%
20%

Sector, industry and company research Research involves understanding important data that
could impact a company’s stock price. Macro factors such as GDP growth, inflation, interest
rates, exchange rate, sector growth rates, risks in the sector and costs of raw materials can
influence the profits of a company. Company-specific data can relate to a company’s products
and customers, new growth opportunities, and barriers to entry in the business. Other factors to
understand are company-specific risks, financial and operational targets, strategies set by
management, and capital expenditure needs of a company. Data collection comes from various
sources such as market data provider firms, for example, Bloomberg and Capital IQ. Analysts
and associates also read companies regulatory filings and trade publications, conduct surveys,
meet the management team, and attend conferences. Next, they identify the critical information
in the sector and company, which could materially impact a company’s stock price. For example,
expansion into a small market might not impact a company’s earning, but if the company makes
a large acquisition, that action potentially could enhance its earnings.

7
Financial modeling and valuation Research associates will typically build a company model
with historical and projected financial statements using key operating assumptions that they
make. They continuously update the model when quarterly earnings are announced and when
new information is available, including acquisitions, divestitures and changes in operating
assumptions. The associate generally builds the model and takes input from the research analyst
and the company. For valuation, associates will typically build DCF and comparable company
models; they also use other methods such as net asset value and sum-of-the-parts analysis.
Associates are expected to be proficient in financial modeling. Certain companies issue
guidance5 that can be used as a rough guide to make projections. A good financial model is
dynamic and easy to amend if inputs change.

Data analysis Besides financial modeling, analysts and associates evaluate the company and
industry data using basic and advanced statistics. Regression, one statistical tool they use to
determine the relationship between two or more variables, can assist in forecasting and
modeling. For example, a regression can be used to see whether a company’s revenues and
profits are related or not. It also can be used to see how historical changes in interest rate impact
a company’s stock price.

Report writing Research analysts regularly update their clients with their views on the earnings
results, industry trends or any interesting analysis they have performed regarding the companies
and industry that they cover. In preparing reports, analysts emphasize their opinions and provide
information concerning the anticipated impact on a company’s stock price rather than just stating
facts for their clients. For example, certain investors who want a summary of the content may
find reporting quarterly earnings of a company by an analyst to be helpful. Most investors will
typically look for the analyst to provide a view of how those earnings could affect the company’s
stock price. The content in reports should be substantiated with in-depth research, and it should
be forward-looking and include unique aspects that are not already known by market
participants.

Communicate ideas to internal and external clients through written reports Research
associates work with other groups, including internal clients like traders and institutional
salespeople as well as external clients such as mutual funds and pension funds. They assist
traders in generating new stock trading ideas and also help the internal sales force understand the
key ideas relating to particular stocks or an industry; these reports can be marketed to
institutional clients. For external clients, analysts clarify any issues on a particular industry and
provide further information on the company or the industry. Importantly, the analysts are seen as
a direct link to a given company by many institutional clients and can relay to them industry

5
Certain Public companies that have stable, predictable businesses can provide guidance to the investors, analysts and the market about their
expectations. Guidance is generally given quarterly and for the next year. It can include revenues, adjusted net income not including one-time
charges and gains, capital spending, and margins.

8
chatter on a particular company. The analyst needs to decide the appropriate communication
channels to clients—emails, in-person meetings, telephone conversations, and individual or
group presentations. Client communications should be simple to comprehend, supported by facts
and concise; and it also should have a conclusion to guide investors to make decisions.

Marketing To help institutional investors understand a company’s story, research analysts and
associates take companies on the road to meet with these investors. This is a great way for buy-
side clients to meet with managers of these companies in person and ask them questions.

Attending conferences Research analysts attend industry conferences to meet with management
teams of private and public companies in their industry. Doing so enables the analyst to stay
attuned to the latest industry developments. At the conferences, research analysts gain insights
on private companies that could go public in the near future or produce a product impacting the
industry as a whole.

New equity offerings Within the compliance parameters of an offering, research analysts
conduct due diligence on a company and educate the bank’s internal sales force and bankers. The
analysts also take calls and arrange meetings with investors to educate them about the company.

DAY IN LIFE – ASSOCIATE

Exhibit 1.5 illustrates a typical day in the life of an equity research associate at a bulge bracket
bank. An equity research associate can expect to work 60-80 hours a week.

Exhibit 1.5 An Associate Shares a Look at His Typical Workday

Time Activity

6:30am Wake up.

7:00am Take the subway to work and read The Wall Street Journal en route.

7:30am Check various news sources including Bloomberg, FactSet and CNBC for any
interesting information on the industry and companies I cover. Also check the
futures and see if any stocks we cover in the group have moved during pre-market
trading. Futures trade 24 hours a day, which allows market participants to see
the prices of stock or an index before stock markets opens for trading. This
early check indicates whether the market will be up or down at the start of the
trading session. I respond to emails and requests for data by a senior analyst and
clients as well as prepare copies of the research note that a senior analyst
published for salespeople and traders.

8:30am Listen to pre-market daily morning call/meeting with offices from all over the U.S.
Participants exchange research, sales and trading ideas. Through a note, a senior

9
 analyst makes a recommendation about a particular stock or any new updates on
the companies covered in the industry; other analysts in the firm share their news,
too. Institutional salespeople and traders may have questions arising from the
analysts’ recommendations, and we’ll address those during and after the call.
Institutional salespeople will use these ideas in calls with their clients to generate
trading revenues for the firm.

9.30am The stock market opens. If the stocks we cover are highly volatile, I identify
possible reasons and communicate them to the analyst, salespeople and clients.

10:00am I begin work on an initiating report on a company that we plan to start providing
research on next week. I study various sources to formulate the industry sections
of the report, and I update the financial model and perform a DCF analysis and
comparable company valuation. At the end of the day, the senior analyst will
review my work and give feedback. I also answer any queries from equity
salespeople and investors after the market has opened.

12:00pm I grab lunch to eat at my desk. A few times a week, I eat a quick lunch with
other associates.

12:30pm I prepare a package of materials for the senior analyst. These include a list of
questions regarding the new company in our industry that I’m researching as well
as a summary analysis of their financial statements We will use these when we
meet with the management of the company at their offices. I look for any
interesting post-lunch news on the companies we cover. I meet with the
management of the new company and listen to their presentation. The senior
analyst will ask questions, and I will take notes, and sometimes I also ask relevant
questions. We regularly meet with management teams to update our research and
follow up with a quick update to investors if any positive or negative news comes
up during the meeting.

3:00pm I prepare materials for a company that will report its quarterly results in the
evening. Companies report their financial results after the stock market closes.
Preparation may include working on the model, setting up an earnings note and
making a list of questions for the analyst to ask company representatives during
the earnings call. Companies hold calls for analysts after they report results.

4:00pm The stock market closes.

4:00pm If a company has reported today, I compare the reported results with our
estimates. I start updating our company model and update the list of questions the
senior analyst can ask during the earnings call. If no company has reported, I

10
 continue to work on the initiating coverage note.

5:00pm I listen to the company call and assist the senior analyst in writing the earnings
review note and also update the company financial model. After a review with the
senior analyst, I will leave voicemails or send emails to clients that provide our
view on the company’s results.

6:30pm I sit down with the senior analyst and take his comments on the initiating report I
am working on. I make a plan for the next day and week because the senior
analyst is traveling for a few days.

7:00pm I grab reading material for the subway and later in the night and leave for home
unless multiple companies have reported and an earnings review note needs to be
finished. During earnings season, which would be once a quarter, I leave for home
around 11 p.m. or midnight.

10.00pm Remotely log in to check email and respond to any questions from editors on the
research note. I make sure that the note is accurate before it is published.

DAY IN LIFE – ANALYST

Exhibit 1.6 illustrates a typical day in the life of an equity research analyst at a bulge bracket
bank. An equity research analyst generally works over 60 hours a week and frequently travels to
meet management teams and institutional clients. The workday can be shown in three segments:
prior to the market opening, work done when the market is open and after-market hours.

Exhibit 1.6 An Analyst Shares His Typical Workday

Time Activity

Pre-market I primarily spend time dealing with the internal sales force and calling buy-side and
opening other clients.

6:00am Wake up.

6:30am Take a taxi or subway to work and read The Wall Street Journal and other financial
magazines like Barrons on my iPad.

7:00am I check various news sources and news sent by my associate on the industry and
stocks I cover. I check email, responding to key clients and salespeople and then
call a salesperson who wanted information on a stock we cover. I undertake crucial
preparation for presenting a note on the stocks we cover to salespeople during the

11
 morning call. One company we cover announced an acquisition in the morning so I
ask my associates to do further work on the company and update the model.

8:30am I listen and give information during the pre-market daily morning call/meeting.
Through a note, I make a recommendation about the acquisition that one of the
companies I cover has made and also give my opinion about how this will affect
the company and its stock price. I answer queries made by institutional
salespeople and traders during and after the call.

During market Majority of time is spent speaking with clients and management of companies that
hours we cover.

9:30am The stock market opens. If the stocks we cover show high volatility, I identify
possible reasons and communicate them to the salespeople and clients.

10:00am During market hours, institutional clients, salespeople and traders call or send
emails with questions about why a particular stock has gone up or down during
the day. If a company is expected to report earnings that evening, I might get calls
from salespeople or traders who ask my views on the company’s earnings.

12:00pm I grab lunch to eat at my desk. Sometimes I have lunch with other analysts or
meet with an institutional client or company for lunch.

12:30pm I review information prepared by my associates for the management meeting we

will have in the afternoon, and I prepare a list of questions to ask the company. I
meet with company management team and listen to their presentation. I ask them
about the product they launched earlier this month and the impact that it will
have on company revenue.

3:00pm I prepare for a company to report its quarterly results in the evening. This
preparation may include reviewing the model made by my associate, setting up
the layout for an earnings note and writing questions to ask the company during
the earnings call.

4:00pm The stock market closes.

After-market Primarily I am developing qualitative research, analyzing data, reviewing the work
hours of associates relating to financial models and report writing, and preparing for the
next day and week.

4:00pm Assuming a company has reported today, I prepare questions I can ask during the
call. If no company has reported, I review the initiating coverage note that my
associate was writing and provide comments to him about it.

12
 5:00pm I listen to the company call. I write an earnings review note and review the
updated company financial model that my associate has prepared. My team and I
will leave voicemails or send emails to clients that provide our view on the
company’s results.

6:00pm I plan for the next day and week because I am traveling for a few days. Next week,
I will take a company on a roadshow in which I would introduce the management
of the company to key buy-side clients who can meet with and question them on
an individual basis. I make sure that my associates know what they need to do
while I will be gone.

6:30pm I grab some reading material for the subway, later in the night and during my
travel and then leave for home―unless either an earnings review note needs to be
finished or unless multiple companies have reported. During earnings season,
which occurs once a quarter, I leave for home later and review the final note from
home at night.

10:00pm I remotely log in to check email and respond to any questions that my associate
will have on the research note.

COMPENSATION RANGES AND EXIT OPTIONS

Compensation for an equity research associate and analyst consists of a base salary plus bonus.
The bulk of the compensation at the senior levels typically comes from a bonus paid at the end of
the year. The bonus amount depends on the performance of the bank, the performance of the
group and individual performance. As workers rise in the hierarchy, the proportion of ESOP, in
the bonus increases.

The compensation ranges in Exhibit 1.76 apply to bulge bracket banks and can vary substantially
for boutique and middle-market firms. Even at bulge bracket firms, compensation varies based
on the performance of the individual and the bank. Associates in equity research typically start at
base salaries similar to investment bankers, but the bonuses are substantially different. This is
due to the fact that the hours worked could be less in equity research and that research is a cost
center, providing only indirect revenue from sales and trading compared to investment banking.

6
Compensation numbers are based on discussions with analysts and associates working with bulge bracket banks.

13
Exhibit 1.7 Compensation for Research Analysts and Associates at a Bulge Bracket Bank

Designation Base (in 000’s) Bonus (in 000’s) Total (in 000’s)

Junior Associate* $60 - $70 $20 - $40 $80 - $110

Associate* $80 - $100 $70 - $100 $150 - $200

Analyst (VP) $100 - $150 $100 - $150 $200 - $300

Senior Analyst (ED/MD) $125 - $250 $200 - $1,500 $325 - $1,750

*These compensation ranges are for first- through third-year junior associates and associates.

Exit options for associates Associates acquire many skills that will transfer to other fields. On
the job, they develop written and oral communications skills that enable them to provide simple,
concise explanations of complex issues. The job also involves collaborating with global teams
and building relationships with clients and colleagues within their own organizations. They build
technical skills including qualitative skills including expertise in a particular industry and an
understanding of how fundamentals and sentiment impact markets. They also develop
quantitative skills, including proficiency in financial modeling, accounting and valuation
methods. Exit options are separated into two categories below:
Within a bank or organization Some associates will continue to be promoted in their groups
and become senior research analysts and ultimately move into management positions within the
firm. Furthermore, in a large global firm, an analyst can move to an office outside the U.S. and
explore opportunities in emerging markets. Associates can move into sales and trading or
investment banking division within banks, although the more senior you become, the more
difficult it might be to make that switch. Some sell-side associates can move into an investment
management function within the bank. A few associates may also move into another sector or
industry if they realize that their interests are more aligned with that particular industry. For
example, a consumer products analyst might become a technology sector analyst covering
Internet stocks, or an analyst may move within the industry, for example, a software associate
might move into the Internet technology industry.
Outside a bank Research associates can move into a number of positions outside a bank
including i) mutual and hedge funds, where they can assist a portfolio manager in identifying
investment opportunities, ii) private equity, especially venture capital, where they can use their
industry expertise to identify new investment opportunities and help the companies grow, iii)
investment banking and capital markets at another bank, iv) move to companies in their industry
in the investor relations, financial planning and analysis, and treasury roles, v) move into
management consulting, vi) research analyst and associate opportunities at other banks or
independent research firms, and vii) become an entrepreneur based on the industry expertise
gained in a particular area.

14
EQUITY RESEARCH FIRMS
Below is a list of equity research firms in four categories described earlier in the note as of
January 1, 2016. Please note that this is not a comprehensive list and the banks are listed in
alphabetical order.

Bulge Bracket Banks

Bank of America/Merrill Lynch Goldman Sachs
Barclays JP Morgan
Citigroup Morgan Stanley
Credit Suisse UBS
Deutsche Bank AG

Commercial Banks
Bank of China (China) National Bank (Canada)
BB&T Capital Markets Nomura
BMO Capital Markets RBC Capital Markets
(Canada) (Canada)
BNP Paribas Royal Bank of Scotland
Calyon Santander Equity Research
CIBC Capital Markets Scotia Capital (Canada)
(Canada)
Dresdner Kleinwort Societe Generale
HSBC Standard Chartered Bank
ICICI (India) TD Securities (Canada)
Macquarie Group Wells Fargo Securities
Mitsubishi UFJ Financial Group Yes Bank (India)

Full-Service and Middle

Market Banks
Cantor Fitzgerald Needham & Company
CanaccordGenuity Piper Jaffray & Co.
Cowen Group Raymond James
Friedman Billings Ramsey Robert W. Baird

15
 Jefferies & Company
JMP Securities
Keefe, Bruyette& Woods
Kotak Mahindra (India)
Morgan Keegan
Independent Research Firms and
Boutique Banks
Battle Road Research
Brean Murray, Carret & Co
Brigantine Advisors
B. Riley & Co., Inc.
Capstone Investments
Caris & Company, Inc.
Chardan Capital Markets
C.L. King & Associates
Craig-Hallum Capital Group
Dudack Research Group
16
Roth Capital Partners
Sandler O’ Neill Partners
StifelNicholaus
SunTrust Robinson Humphrey
William Blair
First Analysis Securities
Harbinger Research, LLC.
Hudson Square Research, Inc.
ITG Investment Research, Inc.
Merriman Curhan Ford & Co.
Palladian Research
Prime Equity Research
Sanford Bernstein
Spelman Research Associates
Summer Street Research Partners
Chapter 13: Accounting Q&A

“You have to understand accounting and you have to understand the

nuances of accounting. It’s the language of business and it’s an imperfect
language, but unless you are willing to put in the effort to learn accounting –
how to read and interpret financial statements – you really shouldn’t select
stocks yourself”
– Warren Buffet

Accounting technical skills are very important not only for accounting positions in
corporations and accounting firms, but also for almost all types of finance positions,
including investment banking, equity research, financial planning and analysis, asset
management and private equity. The ability to read and interpret financial statements is
a critical technical skill for a successful career in accounting and finance. In a finance
interview, accounting questions test the candidate’s:

• Familiarity with all the individual components of the three financial statements,
namely, the income statement, balance sheet and cash flow statement
• Ability to link the three financial statements together. When you build a
financial model, you need to understand how the three financial statements
interact with each other
• Knowledge of advanced accounting concepts, including goodwill and deferred
taxes assets and liabilities, especially for students with business and accounting
majors
• Insight into the unique characteristics of the industry for which the candidate is
interviewing. For example, the income statement of a bank and a manufacturing
company are quite different. While interviewing for the financial institutions
group at an investment bank, the candidate must be able to walk the interviewer
through the major line items of the income statement for that sector

The questions below are related to the three financial statements as well as certain basic
terms including EBITDA and working capital.

Briefly describe the three financial statements.

The balance sheet is a summary of a company’s assets, liabilities and shareholders’

equity, that is, its financial position at a specific point in time. More broadly, the balance
sheet gives us the value of a company’s resources, i.e., assets, and the value of the claims
on those resources, i.e., liabilities and shareholders’ equity.
The income statement tells us how much money the company has earned and shows
its operating results over a given period of time, e.g. a fiscal year or a quarter. For
example, the income statement answers the question, “How much profit has the
company made for the last three-month or 12-month period?”

The cash flow statement tells us:

• how much cash has flowed in and out of the business over a given period of time
• the difference between the company’s opening cash balance and its closing cash
balance. The cash flow statement tells us opening cash, ending cash and change
in cash for the specified period
• the change in cash, classifying each line item under one of three sections,
namely, cash flow from operating activities, cash flow from investing activities
and cash flow from financing activities
• how the balance sheet and the income statement are linked. The cash flow
statement can be derived from the income statement and the balance sheet
• how the company’s net income reconciles to its ending cash balance. The cash
flow statement starts with net income and ends with the ending cash balance of
the company for that period. For example, it helps answer the question, “Why is
it that the company has $1,000 in net income on the income statement but $2,000
in cash in the cash flow statement?”

If you could pick one financial statement to determine the financial

health of a company, what would it be? If you had to select two financial
statements, which ones would you choose?

None of the three financial statements taken alone will give us a complete picture of a
company’s health. In the interview, you can justify your choice of any of the three
financial statements as long as you have a good, logical explanation for it. If asked to
select one, it is best to pick the cash flow statement. The cash flow statement is
constructed from the income statement and balance sheet and shows the sources and
uses of cash for a particular period. It also tells investors how much cash the company
is generating and whether it is enough to pay its debt service and interest obligations.

If asked to pick two financial statements, you should choose the income statement and
the balance sheet since the cash flow statement can be constructed from these two
financial statements. However, you would need the balance sheet for both the period in
question and the prior period to construct the cash flow statement.

What is EBITDA?

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is an indicator

of a company’s financial performance and cash flow. It is a non-generally accepted
accounting principles (GAAP) measure. Hence, you will not see EBITDA on the income
statement of a public company, rather, you would have to calculate it. EBITDA is
defined as:
 EBITDA = Revenue
Less: Expenses (excluding taxes, interest, depreciation
and amortization)

Or

EBITDA = Operating Income or EBIT (from the income statement)

Add: Depreciation and Amortization (from the cash
flow statement)

We should take depreciation and amortization from the cash flow statement because
sometimes in the income statement, depreciation and amortization may be included in
the cost of goods sold (COGS) or in the selling, general and administrative expenses
(SG&A) or in both of them and may not be broken out separately. However, they are
always added back in the cash flow statement and shown separately. In an interview, it
is easier to use the above definition as there are fewer factors to take into account.
EBITDA can also be defined as:

EBITDA = Net Income

Add: Taxes
Add: Interest Expense
Less: Interest Income
Add: Depreciation and Amortization (from the cash
flow statement)

EBITDA can be used to analyze and compare profitability between companies and
industries because it eliminates the effects of financing decisions, e.g. interest expense,
and accounting decisions, e.g. depreciation of assets. It is widely used as a measure of a
company’s cash flow and is also used in leverage covenants to analyze credit ratios, e.g.
total debt to EBITDA and EBITDA to interest expense.

Though EBITDA is widely used by the investment community, it has several drawbacks:

• It leaves out the cash required to replace old equipment, which can be significant.
It assumes that fixed assets don’t require capital replenishment, which is
probably not the case for fast-growing firms
• It ignores a company’s tax obligations, which are a cash-absorbing expense
• It may exclude certain expenses, for example, some companies may reclassify
certain operating expenses as extraordinary charges in the income statement
below EBIT to enhance EBITDA

What is working capital and net working capital?

Working capital can be used as a measure of both a company’s efficiency and its short-
term financial health. Working capital is calculated as:

Working Capital = Current Assets

Less: Current Liabilities

Current assets include cash and other assets expected to be turned into cash within one
year, such as marketable securities, accounts receivable, short-term notes receivable,
inventory and prepaid expenses. Current liabilities are obligations that the company is
expected to settle in cash within one year and include accounts payable, short-term debt
including a line of credit, the short-term portion of long-term debt and accrued expenses.

Some industries, such as manufacturing, require a high level of working capital. This is
a result of the relatively long period of time between when the manufacturing firm pays
suppliers for products that will eventually be sold and when it receives cash for the sale.
Other industries, such as retail, for instance, require little working capital because, in
most cases, retailers sell products for cash before they are required to pay suppliers for
the products, making profits readily available for reinvestment in the business.

Positive working capital means that the company is able to fund its short-term liabilities
with its short-term assets. Negative working capital means that a company is currently
unable to meet its short-term liabilities with its current assets including accounts
receivable and inventory. If a company’s working capital is negative, it may have trouble
paying back creditors in the short term.

When calculating the free cash flow for discounted cash flow (DCF) analysis purposes,
we calculate net working capital, which highlights the cash a company requires to
finance its on-going operations. It is defined as:

Net Working Capital = Current assets (excluding cash and marketable

securities)
Less: Current liabilities excluding all
short term interest bearing debt

Short-term debt includes short-term debt and the short-term portion of long-term debt

The questions below illustrate how the three financial statements are related to each
other.

What are some of the links between the income statement, balance
sheet and cash flow statement?

The three financial statements are linked to each other in various ways. For example, if
we have a company’s income statement and balance sheet, we can create a cash flow
statement. Below are examples of some of the connections between the three statements:

• Net income after dividends from the income statement goes to the top of the cash
flow statement. Additionally, net income after dividends flows from the income
statement to the retained earnings section under shareholders’ equity in the
balance sheet
• In the income statement, depreciation is an expense that is calculated on the basis
of property, plant and equipment (PP&E) shown on the balance sheet.
Depreciation expense is added back in the cash flow statement because it is a
non-cash expense. It is also added to the accumulated depreciation section of the
balance sheet, which reduces net PP&E
• If the company takes on additional debt, it affects the financing activities section
of the cash flow statement, increases the debt on the balance sheet and increases
the interest expense in the income statement

If you add $100 of depreciation expense with a 40% tax rate in the
income statement, how does it affect the income statement? Based on
that change, how does the balance sheet balance?

You are likely to be asked some version of this question to test your understanding of
how the three financial statements are related to each other. In the above scenario, the
impact on the three statements is as follows:

Income statement. Depreciation is an expense, therefore, operating income or EBIT

declines by $100. Assuming a tax rate of 40%, net income declines by $60.

Cash flow statement. Net income decreases by $60, therefore, cash flow, which starts
with net income, decreases by $60. $100 of depreciation expense is a non-cash expense,
and it is added back to the cash flow statement, thus, cash flow from operations increases
by $40. As a result of this, the ending cash balance increases by $40. This $40 then flows
to the balance sheet as cash under current assets.

Balance sheet. The $60 reduction in net income causes retained earnings to decrease
by $60. Accumulated depreciation increases by $100, thus, net PP&E decreases by $100
and cash goes up by $40, as described earlier from the cash flow statement, therefore,
assets decrease by $60. Since assets = liabilities + shareholders’ equity, the balance sheet
balances as assets decrease by $60 and liabilities + shareholders’ equity decrease by $60.

Table 1.1: Effect of $100 Increase in Depreciation Expense of the Financial

Statements
(in $)
XYZCo Summary Financial Statement for the fiscal year ended December 31, 2015
$100 INCREASE IN DEPRECIATION
CURRENT SCENARIO EXPENSE
INCOME STATEMENT INCOME STATEMENT
 Revenue $1,000 Revenue $1,000

COGS 200 COGS 200

Gross Profit $800 Gross Profit $800

SG&A 250 SG&A 250

Depreciation 100 Depreciation 200

EBIT decreases by
Operating Income / EBIT $450 Operating Income / EBIT $350 $100

Tax Expense 180 Tax Expense 140 Tax decreases by $40

Net Income $270 Net Income $210 Net income decreases by $60

BALANCE SHEET BALANCE SHEET

ASSETS ASSETS
Cash increases by
Cash $1,370 Cash $1,410 $40

Accounts Receivable - Accounts Receivable -

Inventory - Inventory -
Total Current Assets $1,370 Total Current Assets $1,410 Current assets increase by $40

Gross PP&E 300 Gross PP&E 300

Less: Accumulated Less: Accumulated Accumulated depreciation increases by
Depreciation 100 Depreciation 200 $100
Net PP&E $200 Net PP&E $100 Net PP&E decreases by $100

Total Assets $1,570 Total Assets $1,510 Total assets decrease by $60

LIABILITIES LIABILITIES

Accounts Payable - Accounts Payable -

Accrued Expenses - Accrued Expenses -

Total Current Liabilities $0 Total Current Liabilities $0

Long Term Debt 1,300 Long Term Debt 1,300

SHAREHOLDERS' SHAREHOLDERS'
EQUITY EQUITY
Retained earnings decreases by $60 since net
Retained Earnings 270 Retained Earnings 210 income
goes to retained
Other - Other - earnings
Total Shareholders' Total Shareholders'
Equity $270 Equity $210 Shareholders' equity decreases by $60

Total liabilities & equity decrease by

Total Liabilities & Equity $1,570 Total Liabilities & Equity $1,510 $60

CASH FLOW STATEMENT CASH FLOW STATEMENT

Net Income $270 Net Income $210 Net income decreases by $60
Depreciation & Depreciation &
Amortization 100 Amortization 200 Depreciation & amortization increases by $100
Cash Flow from Cash Flow from Cash flow from operations increases by
Operations $370 Operations $410 $40

Cash Flow from Investing - Cash Flow from Investing -

Cash Flow from Financing - Cash Flow from Financing -

Total Cash Flow $370 Total Cash Flow $410 Ending cash flow increases by $40
 Beginning Cash 1,000 Beginning Cash 1,000

Change in Cash 370 Change in Cash 410 Change in cash increases by $40
Ending cash increases by $40 and goes to
Ending Cash $1,370 Ending Cash $1,410 balance sheet

A company buys a car for $1,000 on January 1, 2008. How will this
affect its income statement, cash flow and balance sheet for the period
January 1, 2008 to December 31, 2008? Assume that the depreciation
method used for the car is straight-line over five years and that the tax
rate is 40% OR

How does an increase of $1,000 in capital expenditures affect the three

financial statements?

Sometimes the interviewer will withhold certain information, such as the tax rate or the
method of depreciation, and will expect you to ask for this information or make
assumptions when answering the question.

Income statement. Depreciation expense for the period January 1, 2008 to December
31, 2008 will be $1,000 / 5 = $200. Net income will be reduced by $120 as you would
get a tax benefit of $80 (40% of $200).

Cash flow statement. The company spent $1,000 to buy the car, therefore, its capex
will increase by $1,000 and there will be a $1,000 use of cash in cash flow from investing
activities. The cash flow statement starts with net income, which comes down by $120
in the cash flow statement as net income from the income statement will go to the top of
the cash flow statement. Depreciation expense is added back to the cash flow statement,
i.e., $200 is added back and the net change in cash is −$1000 − $120 + $200 = −$920.

Balance sheet. Cash goes down by $920 in the balance sheet because it has gone down
by $920 in the cash flow statement which flows to the balance sheet. Gross PP&E goes
up by $1,000 since a new car was bought. Accumulated depreciation increases by $200,
therefore net PP&E goes up by $800 ($1,000 − $200). Net income decreases by $120,
which causes shareholders’ equity to decrease by $120. Therefore, assets come down by
$120 (−$920 + $800) and shareholders’ equity decreases by $120. Thus, assets =
liabilities + shareholders’ equity and the balance sheet balances.

Table 1.2: Effect of $1,000 Purchase of a Car on the Financial Statements

(in $)
XYZCo Summary Financial Statement for the fiscal year ended December 31, 2015
CURRENT SCENARIO $1,000 CAPEX/ PURCHASE OF A CAR
INCOME STATEMENT INCOME STATEMENT
Revenue $1,000 Revenue $1,000
COGS 200 COGS 200
 Gross Profit $800 Gross Profit $800
SG&A 250 SG&A 250
Depreciation 100 Depreciation 300 Depreciation increases by $200
Operating Income / EBIT $450 Operating Income / EBIT $250 EBIT decreases by $200
Tax Expense 180 Tax Expense 100 Tax decreases by $80
Net Income $270 Net Income $150 Net income decreases by $120

BALANCE SHEET BALANCE SHEET

ASSETS ASSETS
Cash $1,370 Cash $450 Cash decreases by $920
Accounts Receivable - Accounts Receivable -
Inventory - Inventory -
Total Current Assets $1,370 Total Current Assets $450 Current assets decrease by $920

Gross PP&E 300 Gross PP&E 1,300 Gross PP&E increases by $1,000
Less: Accumulated Depreciation 100 Less: Accumulated Depreciation 300 Accumulated depreciation increases by $200
Net PP&E $200 Net PP&E $1,000 Net PP&E increases by $800

Total Assets $1,570 Total Assets $1,450 Total assets decrease by $120

LIABILITIES LIABILITIES
Accounts Payable - Accounts Payable -
Accrued Expenses - Accrued Expenses -
Total Current Liabilities $0 Total Current Liabilities $0

Long Term Debt 1,300 Long Term Debt 1,300

SHAREHOLDERS' EQUITY SHAREHOLDERS' EQUITY

Retained Earnings 270 Retained Earnings 150 Retained earnings decreases by $120 since net income
Other - Other - goes to retained earnings
Total Shareholders' Equity $270 Total Shareholders' Equity $150 Shareholders' equity decreases by $120

Total Liabilities & Equity $1,570 Total Liabilities & Equity $1,450 Total liabilities & equity decrease by $120

CASH FLOW STATEMENT CASH FLOW STATEMENT

Net Income $270 Net Income $150 Net income decreases by $120
Depreciation & amortization increases by
Depreciation & Amortization 100 Depreciation & Amortization 300 $200
Cash Flow from Operations $370 Cash Flow from Operations $450 Cash flow from operations increases by $80

Purchase of Car - Purchase of Car (1,000) Capex increases by $1,000 because of purchase of car
Cash Flow from Investing $0 Cash Flow from Investing ($1,000) Cash Flow from investing decreases by $1,000
Cash Flow from Financing - Cash Flow from Financing -

Total Cash Flow $370 Total Cash Flow ($550) Ending cash flow decreases by $920

Beginning Cash 1,000 Beginning Cash 1,000

Change in Cash 370 Change in Cash (550) Change in cash decreases by $920
Ending Cash $1,370 Ending Cash $450 Ending cash decreases by $920 and goes to balance sheet
If you add $100 of payment in kind (PIK) interest expense in the income
statement with a 40% tax rate, how does it affect the income statement
and how does the balance sheet balance?

This is a slightly more advanced question than the previous one.

Payment in kind (PIK) is interest expense on certain types of debt that is not paid in cash
but is added to the principal amount of the debt. Generally, a company receives a PIK
loan for a certain period of time, at the end of which it becomes cash pay.

Income statement. PIK is an interest expense even though we are not paying in cash,
therefore, earnings before tax (EBT) declines by $100. Assuming a tax rate of 40%, net
income declines by $60.
Cash flow statement. Net income decreases by $60, therefore, cash flow, which starts
with net income, decreases by $60. Since PIK interest expense is a non-cash expense,
$100 of PIK interest expense is added back to the cash flow statement under cash flow
from operations, thus, cash flow from operations increases by $40. In cash flow from
financing, even though the principal debt balance has increased from the prior year by
$100 due to the PIK debt, there is no change in cash flow from financing as the increase
was due to the PIK debt and no cash came to the company. The ending cash balance
increases by $40 as a result of $40 increase in cash flow from operations. This $40 then
goes to the assets side of the balance sheet under cash.

Balance sheet. The $60 reduction in net income causes retained earnings to decrease
by $60. On the liability side, the debt increases by $100 because of the increase in the
principal amount of debt due to the addition of PIK interest, thus, the net change in
liabilities plus shareholders’ equity in the balance sheet is an increase of −$60 + $100 =
$40. Cash goes up by $40 as described earlier from the cash flow statement, therefore,
assets increase by $40. Since assets = liabilities + shareholders’ equity, the balance sheet
balances as assets and liabilities + shareholders’ equity both increase by $40.

Table 1.3: Effect of $100 Increase in PIK interest Expense on the Financial Statements
(in $)
XYZCo Summary Financial Statement for the fiscal year ended December 31, 2015
CURRENT SCENARIO $100 INCREASE IN PIK INTEREST EXPENSE
INCOME STATEMENT INCOME STATEMENT
Revenue $1,000 Revenue $1,000
COGS 200 COGS 200
Gross Profit $800 Gross Profit $800
SG&A 250 SG&A 250
Operating Income / EBIT $550 Operating Income / EBIT $550
PIK Interest Expense - PIK Interest Expense 100 PIK interest expense increases by $100
Tax Expense 220 Tax Expense 180 Tax decreases by $40 because PIK interest expense is tax deductible
Net Income $330 Net Income $270 Net income decreases by $60

BALANCE SHEET BALANCE SHEET

ASSETS ASSETS
 Cash $1,330 Cash $1,370 Cash increases by $40
Accounts Receivable - Accounts Receivable -
Inventory - Inventory -
Total Current Assets $1,330 Total Current Assets $1,370 Current assets increase by $40

Gross PP&E 300 Gross PP&E 300

Less: Accumulated Depreciation - Less: Accumulated Depreciation -
Net PP&E $300 Net PP&E $300

Total Assets $1,630 Total Assets $1,670 Total assets increase by $40

LIABILITIES LIABILITIES
Accounts Payable - Accounts Payable -
Accrued Expenses - Accrued Expenses -
Total Current Liabilities $0 Total Current Liabilities $0

Long Term Debt 1,300 Long Term Debt 1,400 Long term debt increases by $100 - PIK interest expense is added to th

SHAREHOLDERS' EQUITY SHAREHOLDERS' EQUITY

Retained Earnings 330 Retained Earnings 270 Retained earnings decreases by $60 since net income
Other - Other - goes to retained earnings
Total Shareholders' Equity $330 Total Shareholders' Equity $270 Shareholders' equity decreases by $60

Total Liabilities & Equity $1,630 Total Liabilities & Equity $1,670 Total liabilities & equity decrease by $40

CASH FLOW STATEMENT CASH FLOW STATEMENT

Net Income $330 Net Income $270 Net income decreases by $60
PIK Interest - PIK Interest 100 PIK interest is a non-cash expense
Cash Flow from Operations $330 Cash Flow from Operations $370 Cash flow from operations increases by $40
Cash Flow from Investing - Cash Flow from Investing -
Cash Flow from Financing - Cash Flow from Financing -

Total Cash Flow $330 Total Cash Flow $370 Ending cash flow increases by $40

Beginning Cash 1,000 Beginning Cash 1,000

Change in Cash 330 Change in Cash 370 Change in cash increases by $40
Ending Cash $1,330 Ending Cash $1,370 Ending cash increases by $40 and goes to balance sheet

A company issues an additional $100 of debt at the beginning of the year.

Interest is charged at 10%, half in cash and half as PIK. The tax rate is 40%.
How will this affect the three financial statements of this company at the
beginning of the year, and after one year?
This question is similar to the previous one on PIK interest, but in this instance, you will need to
keep track of multiple interest payments and tax shields and their effects on the cash flow
statement when answering this question.
Year 0:
Income statement. No change.
Cash flow statement. Cash flow from financing increases by $100 due to debt issuance,
therefore, the ending cash balance increases by $100.
Balance sheet. Cash increases by $100 from the cash flow statement and liabilities increase by
$100 from debt issuance.
Table 1.4: Effect of Issuing $100 of Additional Debt on the Financial Statements at
Year 0
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2015
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income - Assets

Operating Expenses
Operating Income / EBIT
PIK Interest Expense
EBT
Tax
- PIK Interest Expense - Change in Cash $100
- Cash Flow from Operations - Net Change in Assets $100
-
- Cash Flow from Investing - Liabilities
Change in Long Term Debt 100
- Net Change in Liabilities $100
Issue of Long Term Debt 100
Cash Flow from Financing $100 Shareholders' Equity
Retained Earnings -
Net Change in Shareholders' Equity -

Net Change in Net Income - Net Change in Ending Cash $100 Net Change in Liabilities & Shareholders' Equity $100

Year 1:
Income statement. One year of interest on $100 of debt at 10% creates an expense of $10. After
factoring in a tax shield of 40%, net income decreases by $6.
Cash flow statement. Change in net income flows to the cash flow statement, but since only half
of the interest charged was paid out in cash, with the other half being paid-in-kind, we must add
back half of the total interest of $10, i.e., $5 of PIK interest. The net change in cash is a decrease
of $1.
Balance sheet. The net change in cash of $1 flows to the balance sheet, leading to a net decrease
in assets of $1. PIK interest is added to the outstanding principal balance of debt, increasing
liabilities by $5. Since net income decreased by $6, liabilities and shareholders’ equity decrease
by $1and the balance sheet balances.
Table 1.5: Effect of $100 of Additional Debt on the Financial Statements at Year 1
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2016
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($6) Assets

 Operating Expenses - PIK Interest Expense 5 Change in Cash ($1)
Operating Income / EBIT - Cash Flow from Operations ($1) Net Change in Assets ($1)
Interest Expense (10)
EBT ($10) Cash Flow from Investing - Liabilities
Tax Rate 40% Change in Long Term Debt 5
Foregone Tax 4 Net Change in Liabilities $5
Issue of Long Term Debt -
Cash Flow from Financing - Shareholders' Equity
Retained Earnings (6)
Net Change in Shareholders' Equity ($6)

Net Change in Net Income ($6) Net Change in Ending Cash ($1) Net Change in Liabilities & Shareholders' Equity ($1)

A company repurchases outstanding long-term debt before its maturity date

at $110. The outstanding debt has a fair value of $100, equal to its face value
of $100. What is its effect on the three financial statements?
Income statement. Repurchasing a piece of debt at a value greater than the principal represents a
loss on the repurchase. This is otherwise known as a make-whole premium, where the company
must pay a premium to repurchase the debt before its maturity date in order to compensate the
bondholder for the present value of all future interest payments forgone through an early
repurchase. A $10 loss on the repurchase decreases net income by $6 after accounting for the 40%
tax shield.
Cash flow statement. Decrease in net income of $6 flows to the cash flow statement. Since the
$10 loss on repurchase is not related to regular operations, it is added back to the operating section
of the cash flow section. The company spent $110 on buying back debt, leading to an outflow of
$110 in cash flow from financing. Change in cash position for the year is a decrease of $106.
Balance sheet. The change in cash flows to the balance sheet, leading to a net decrease in assets
of $106. The book value of the principal amount of the debt decreases by $100 since it has been
paid back, while retained earnings decrease by $6 due to the decrease in net income. The net
decrease in liabilities and shareholders’ equity of $106 is equal to the change in cash.
Table 1.6: Effect of Repurchase of Outstanding Debt of $100 on Financial Statements
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2015
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($6) Assets

Operating Expenses - Loss on Debt Repurchase 10 Change in Cash ($106)
Operating Income / EBIT - Net Change in Assets ($106)
Loss on Debt Repurchase (10) Cash Flow from Operations $4
EBT ($10) Liabilities
Tax Rate 40% Cash Flow from Investing - Change in Long Term Debt (100)
Foregone Tax 4 Net Change in Liabilities ($100)
Repurchase of Debt (110)
Cash Flow from Financing ($110) Shareholders' Equity
 Retained Earnings (6)
Net Change in Shareholders' Equity ($6)

Net Change in Net Income ($6) Net Change in Ending Cash ($106) Net Change in Liabilities & Shareholders' Equity ($106)

What happens with accrued rent payable increases by $10? Assume a 50%
tax rate.
An accrued expense is created when a company has incurred an expense, but has not yet paid back
its creditor. In this example, we use rent expense. The answer to this question involves similar
steps to dealing with an increase in generic accounts payable, except that the names of the accounts
may differ.
Income statement. An increase in rent expense incurred shows up on the income statement as an
expense and will decrease pre-tax income by $10. After tax, net income decreases by $5.
Cash flow statement. The decrease in net income of $5 flows to the cash flow statement. Since
the $10 of rent expense is a non-cash expense because the company has not yet paid it out, it is
added back to cash flow from operations. The change in the cash position is an increase of $5.
Balance sheet. Cash increases by $5 from the cash flow statement. The expense that has not been
paid off creates an accrued rent payable liability account of $10. Since net income has decreased
by $5, retained earnings will also decrease by $5. Hence, assets increase by $5 and liabilities and
shareholders’ equity also increase by $5.
Table 1.7: Effect of Increase in Accrued Rent Payable by $10 on the Financial Statements
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2015
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($5) Assets

Rent Expense (10) Change in Accrued Rent 10 Change in Cash $5
Operating Income / EBIT ($10) Cash Flow from Operations $5 Net Change in Assets $5
Interest Expense -
EBT ($10) Liabilities
Tax Rate 50% Cash Flow from Investing - Change in Accrued Rent 10
Foregone Tax 5 Net Change in Liabilities $10

Cash Flow from Financing - Shareholders' Equity

Retained Earnings (5)
Net Change in Shareholders' Equity ($5)

Net Change in Net Income ($5) Net Change in Ending Cash $5 Net Change in Liabilities & Shareholders' Equity $5

What happens when the accrued liability in the previous question is paid off?
Income statement. There are no changes to the income statement, as rent was already expensed
at the beginning of the year.
Cash flow statement. A decrease in a current liability represents a decrease in cash similar to the
company using cash to pay back a current debt. The cash position at the end of the year decreases
by $10.
Balance sheet. Cash decreases by $10. The elimination of the accrued rent payable account
decreases liabilities by $10 and hence the balance sheet balances.
Table 1.8: Effect of Paying off the Accrued Rent Liability on the Financial Statements
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2016
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income - Assets

Rent Expense - Change in Accrued Rent (10) Change in Cash ($10)
Operating Income / EBIT - Cash Flow from Operations ($10) Net Change in Assets ($10)
Interest Expense -
EBT - Liabilities
Tax Rate 50% Cash Flow from Investing - Change in Accrued Rent (10)
Foregone Tax - Net Change in Liabilities ($10)

Cash Flow from Financing - Shareholders' Equity

Retained Earnings -
Net Change in Shareholders' Equity -

Net Change in Net Income - Net Change in Ending Cash ($10) Net Change in Liabilities & Shareholders' Equity ($10)

INCREASE IN PREPAID EXPENSE (INSURANCE) — PART 1

A prepaid expense account is created when payments are made in advance by the company for
services rendered in the future. A common example of this is prepaid insurance, where the
insurance premium is paid in advance by the company for coverage for a certain period.
Coverage is generally for a period of one year, in which case the prepaid expense is classified as
a current asset, but it may exceed one year in certain cases. While prepaid expenses are initially
recorded as assets, their value is expensed over time as and when the benefit is received. Thus,
prepaid expenses often feature in multi-step accounting questions in interviews.

What happens when the company buys a one-year insurance policy at a cost
of $1,200?
Assuming that no time has passed since the purchase of the insurance policy:
Income statement. No change to the income statement. Prepaid accounts only create an expense
when the expenses are incurred, and not when the accrual account is created.
Cash flow statement. The creation of a new current asset, i.e., prepaid insurance, means that when
we are calculating changes in net working capital in the cash flow statement, an increase in current
assets is a decrease in cash. As a result, cash flow from operations and overall cash decreases by
$1,200.
Balance sheet. Cash decreases by $1,200. Prepaid insurance, which is a current asset, increases
by $1,200.
Table 1.9: Effect of Buying a One-year Insurance Policy at a cost of $1,200 on the Financial
Statements
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2015
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income - Assets

Operating Expenses - Change in Prepaid Insurance ($1,200) Change in Cash ($1,200)
Operating Income / EBIT - Cash Flow from Operations ($1,200) Prepaid Insurance 1,200
Interest Expense - Net Change in Assets -
EBT - Liabilities
Tax Rate 50% Cash Flow from Investing - Change in Liabilities -
Foregone Tax - Net Change in Liabilities -

Cash Flow from Financing - Shareholders' Equity

Retained Earnings -
Net Change in Shareholders' Equity -

Net Change in Net Income - Net Change in Ending Cash ($1,200) Net Change in Liabilities & Shareholders' Equity -

INCREASE IN PREPAID EXPENSE (INSURANCE) — PART 2

After one month, what impact will prepaid insurance have on all three
financial statements, assuming a tax rate of 50%?
Income statement. Given that the initial value of the prepaid insurance account is $1,200 and that
the policy is for one year, it is fair to assume that the value of the benefits received by the company
each month is $1,200 / 12 months = $100. Since one month has passed, the company must expense
$100, the value of the benefits received. After the tax shield is taken into account, net income
decreases by $50.
Cash flow statement. Net income flows from the income statement to the cash flow statement.
Since the insurance expense of $100 charged on the income statement is a non-cash expense, it is
added back for a net increase of $50 in the cash position.
Balance sheet. Cash increases by $50. Since the company has reaped the benefits of the prepaid
insurance for one month, the prepaid insurance asset accordingly decreases in value by $100, and
we have a net decrease in assets of $50. Since net income decreased by $50, retained earnings also
decrease by $50.
Table 1.10: Effect of Prepaid Insurance after 1 Month on the Financial Statements
(in $)
ABCCo Summary of Changes in Financial Statement for the fiscal month ended January 31, 2016
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($50) Assets

Insurance Expense (100) Change in Prepaid Insurance 100 Change in Cash $50
Operating Income / EBIT ($100) Cash Flow from Operations $50 Prepaid Insurance (100)
Interest Expense - Net Change in Assets ($50)
EBT ($100) Liabilities
Tax Rate 50% Cash Flow from Investing - Change in Liabilities -
Foregone Tax 50 Net Change in Liabilities -

Cash Flow from Financing - Shareholders' Equity

Retained Earnings (50)
Net Change in Shareholders' Equity ($50)

Net Change in Net Income ($50) Net Change in Ending Cash $50 Net Change in Liabilities & Shareholders' Equity ($50)

FARMLAND ACQUISITION — PART 1

An agricultural company buys a piece of farmland that houses a grain

processing plant for 50% debt and 50% cash. The land is valued at $900, while
the plant is valued at $100. The company has a depreciation rate of 10%, an
interest rate of 10% and a tax rate of 50%. How does this affect all three
financial statements at the time of purchase?

In answering this question, you should follow the conventional process of dealing with the income
statement first, followed by the cash flow statement and then the balance sheet. Interviewers
sometimes split accounting questions into multiple parts of increasing complexity in order to gauge
the extent of the candidate’s grasp of accounting.

At Year 0, i.e., the moment when the farmland and plant are signed over, the following occurs:

Income statement. There is no change in the income statement. A purchase of an asset is

considered a capex and does not affect any lines on the income statement.
Cash flow statement. Because we spent $900 on the farmland and $100 on the grain processing
plant, cash flow from investing decreases by $1000. However, since 50% of what we paid was
financed through debt, cash flow from financing increases by $500 ($1000 PP&E × 50% = $500),
leading to a net decrease in our cash position of $500.
Balance sheet. The net decrease in cash of $500 flows from the cash flow statement to the balance
sheet. The addition of new farmland and a grain plant increases PP&E by $1000, leading to a net
change of $500 on the assets side of the balance sheet. On the liabilities side, since we took on
debt of $500, long-term debt increases by $500, and both sides balance.
Table 1.11: Effect of Purchase of Farmland and Processing Plant on the Financial Statements at
Year 0
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2015
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income - Assets

Operating Expenses - Non-Cash Expenses - Change in Cash ($500)
Operating Income / EBIT - Cash Flow from Operations - Purchase of Farmland $900
Interest Expense - Purchase of Processing Plant $100
EBT - Purchase of Farmland ($900) Net Change in Assets $500
Tax Rate - Purchase of Processing Plant ($100) Liabilities
Foregone Tax - Cash Flow from Investing ($1,000) Long Term Debt $500
Net Change in Liabilities $500
Long Term Debt $500 Shareholders' Equity
Cash Flow from Financing $500 Retained Earnings -
Net Change in Shareholders' Equity -

Net Change in Net Income - Net Change in Ending Cash ($500) Net Change in Liabilities & Shareholders' Equity $500

FARMLAND ACQUISITION — PART 2

If the candidate has answered the above question correctly, the interviewer is likely to ask a follow-
up question that involves a greater degree of complexity, such as the one below.

Fast forward one year and explain how interest and depreciation affect the
three financial statements.
Income statement. Some students may be inclined to calculate depreciation by multiplying the
value of the assets acquired, i.e., $1000 by a 10% depreciation rate. However, one could argue that
land is not depreciated because it is assumed to have an unlimited useful life. Other long-lived
assets such as land improvements, buildings and equipment have limited useful lives, thus, the cost
of those assets must be allocated to those limited accounting periods. Since land’s life is not
limited, there is no need to allocate the cost of land to any accounting period.

We arrive at a depreciation expense of $10 by multiplying the 10% depreciation rate by the asset
value of the plant, i.e., $100, and an interest expense of $50 by multiplying the 10% interest rate
by the debt book value of $500. Both of these expenses reduce pre-tax income, leading to a
decrease of $60. A tax rate of 50% leads to a decrease in net income of $30.

Cash flow statement. A decrease in net income of $30 flows to the top line of the cash flow
statement. Since depreciation is a non-cash charge, it should be added back to cash flow from
operations, leading to a net decrease in the cash position of $20 for the year.

Balance sheet. The net decrease in cash of $20 flows to the assets side of the balance sheet. Since
$10 of depreciation occurred during the period, accumulated depreciation goes up by $10 and net
assets go down by $10, leading to a net decrease of $30 on the assets side. On the liabilities side,
since net income has decreased by $30, retained earnings in shareholders’ equity also decreases
by $30.

Table 1.12: Effect of Purchase of Farmland and Processing Plant after Year 1
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2016
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($30) Assets

Depreciation (10) Depreciation Expense 10 Change in Cash ($20)
Operating Income / EBIT ($10) Cash Flow from Operations ($20) Farmland -
Interest Expense (50) Processing Plant (10)
EBT ($60) Purchase of Farmland - Net Change in Assets ($30)
Tax Rate 50% Purchase of Processing Plant - Liabilities
Foregone Tax 30 Cash Flow from Investing - Long Term Debt -
Net Change in Liabilities -
Shareholders' Equity
Cash Flow from Financing - Retained Earnings (30)
Net Change in Shareholders' Equity ($30)

Net Change in Net Income ($30) Net Change in Ending Cash ($20) Net Change in Liabilities & Shareholders' Equity ($30)

Farmland Acquisition Part 3

FARMLAND ACQUISITION — PART 3

There is a third and final part to this question although it is rarely asked. Most interviewers tend
to reserve it for candidates who have been able to answer the first two parts of the question with
ease.

At the end of Year 2, a hurricane hits the East coast and destroys the grain
processing plant and makes the farmland infertile. As a result, the company
defaults on its debt. How will this impact the three statements?

Income statement. We are now at the end of Year 2, after two years of interest and depreciation.
We arrive at a depreciation expense of $10 for the Year 2 by multiplying the 10% depreciation
rate by the asset value of the plant, i.e., $100, and an interest expense of $50 by multiplying the
10% interest rate by the debt book value of $500. As a result, the book value of the grain processing
plant is not $100, but $80, i.e., $100 – 2 years x $10, and must be written down, creating a non-
cash expense on the income statement. Since the farmland is now infertile, it must also be written
down. Both of these create expenses of $980 against pre-tax income. By contrast, a write-down of
$500 in debt creates a negative expense, and actually adds to pre-tax income. The net effect is a
decrease in pre-tax income of $540 and a decrease in net income of $270 after taking into account
a 50% tax shield.
Cash flow statement. The decrease in net income of $270 flows to the top line of the cash flow
statement. Depreciation of $10 is added back to the cash flow statement. Since the PP&E and debt
write-downs are non-cash charges, their effects on net income must be reversed. The PP&E write-
down is added, i.e., $900 and $80 for the land and plant, respectively, and the debt write-down of
$500 is subtracted, leading to a net increase of $220 in the cash position.

Balance sheet. The net increase in cash of $220 flows to the assets side of the balance sheet. Since
$10 of depreciation occurred during the period, accumulated depreciation goes up by $10 and net
assets or the processing plant goes down by $10. The land and plant write-downs decrease their
respective accounts by a total book value of $980 for a total reduction of the assets by $990. This
leads to a net change on the assets side of negative $770. The debt write-down decreases debt by
$500, while the decrease in net income of $270 resulting in retained earnings going down by $260
and a net change of $770 in the liabilities and shareholders’ equity side.

Table 1.13: Effect of Hurricane Destroying the Farmland and Processing Plant at the End of
Year 2 on the Financial Statement
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2017
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($270) Assets

Operating Expenses (10) Depreciation Expense 10 Change in Cash $220
Operating Income / EBIT ($10) Farmland Write down 900 Farmland (900)
Interest Expense (50) Processing Plant Write down 80 Processing Plant (90)
Farmland Write down (900) Long Term Debt Write-off (500) Net Change in Assets ($770)
Processing Plant Write down (80) Cash Flow from Operations $220 Liabilities
Long Term Debt Write-off 500 Long Term Debt (500)
EBT ($540) Cash Flow from Investing - Net Change in Liabilities (500)
Tax Rate 50% Shareholders' Equity
Foregone Tax 270 Retained Earnings (270)
Cash Flow from Financing - Net Change in Shareholders' Equity ($270)

Net Change in Net Income ($270) Net Change in Ending Cash $220 Net Change in Liabilities & Shareholders' Equity ($770)

The company writes down an asset by $8, but the asset write-down is not tax-
deductible. What effect will this have on all three financial statements?
Income statement. The PP&E write-down decreases pre-tax income by $8. Assuming a 50% tax
rate, the company’s books will still record a tax shield, leading to a decrease in net income of $4.
However, since the asset write-down is not tax-deductible, the company will have book taxes that
are less than its actual taxes payable. As per the definition of a deferred tax liability, the asset-
write-down results in the company paying less tax on its books than what is due to the government.
Cash flow statement. The decrease in net income of $4 flows to the cash flow statement. Since
the PP&E write-down is a non-cash charge, it is added back to the cash flow statement. The
deferred tax liability of $4 is also added back, as per the change in net working capital rules. The
net change in the cash position is an increase of $8.

Balance sheet. The increase in cash of $8 flows to the balance sheet. Since $8 of PP&E was written
down, assets decrease by $8, leading to no net change on the assets side. The $4 tax liability that
was created and the decrease in net income of $4 affect retained earnings and cancel each other
out.

Table 1.14: Effect of Write-Down of a Non-tax Deductible Asset on the Financial Statements
(in $)
ABCCo Summary of Changes in Financial Statements for the fiscal year ended December 31, 2015
INCOME STATEMENT CASH FLOW STATEMENT BALANCE SHEET

Gross Profit - Net Income ($4) Assets

Operating Expenses - Deferred Tax Liability 4 Change in Cash $8
Operating Income / EBIT - PP&E Write down 8 PP&E (8)
Interest Expense - Cash Flow from Operations $8 Net Change in Assets -
PP&E Write down (8)
Tax Rate 50% Liabilities
Foregone Tax 4 Deferred Tax Liability 4
Net Change in Net Income (4) Cash Flow from Investing - Net Change in Liabilities 4
Shareholders' Equity
TAX EFFECTS Retained Earnings (4)
Gross Tax Liability 8 Cash Flow from Financing - Net Change in Shareholders' Equity ($4)
Taxes Paid (4)
Net Deferred Tax Liability $4 Net Change in Ending Cash $8 Net Change in Liabilities & Shareholders' Equity -

The questions below relate to more advanced accounting terms including deferred taxes and
goodwill.

What is a deferred tax asset or liability (future income tax asset or liability)?

A deferred tax asset or liability is the sum of accumulated temporary differences multiplied by the
tax rate.

What are temporary differences? Tax laws often differ from the recognition and measurement
requirements of the U.S. or Canadian GAAP. These differences result in temporary differences.
For example, under tax laws, depreciation can be expensed using the reducing balance method vs.
the straight line method for book purposes. The total depreciation amount under both methods will
be the same while the expense recognized in a particular period will be different. Temporary
differences are essentially timing differences between the years in which transactions affect
taxable income and the years in which they enter into the determination of pretax financial income
in the financial statements or book income.

For example, we buy a car for $5,000 and use straight-line depreciation over five years for book
purposes but use reducing balance for tax purposes at a depreciation rate of 25%. Let us assume a
corporate tax rate of 40%.
Table 1.15: Deferred Tax Asset and Liability Using Book and Tax Depreciation Methods
Particulars Year1 Year 2 Year 3 Year 4 Year 5 Total

Book Value $4,000 = $3,000 = $4,000 - $2,000 = $1,000 = $0 =

$5,000 - 1,000 $1,000 $3,000 - $1,000 $2,000 - $1,000 $1,000 - $1,000
Accounting Depreciation $5,000/5 = $5,000/5 = $1,000 $5,000/5 = $5,000/5 = $5,000/5 = $5,000
$1,000 $1,000 $1,000 $1,000
Tax Value $3,750 = $5,000 - $2,813 = $3,750 - $2,110 = $1,582 = $0 =
$1,250 $937 $2,813 - $703 $2,110 - $528 $1,528 - $1,582
Tax Depreciation $5,000 x 25% = $3,750 x 25% = $2,813 x 25% = $2,110 x 25% = $1,582 x 25% = $5,000
$1,250 $937 $703 $528 $396 + $1,187

Temporary Difference = $250 = $1,250 - $187 = ($110) = ($582) = $0 =

+ Accumulated Tax Difference $1,000 +$250 + $187 - $110 - $582
− Accumulated Accounting +$937 + 703 + $528 + $1,583
Difference − $1,000 − $1,000 − $1,000 − $1,000
Deferred tax liability/(asset) = $100 $75 ($44) ($233) $0
Temporary Difference
× Tax Rate (40%)

Deferred Tax Liabilities arise when an expense is deducted first for tax and recognized later for
accounting or when revenue is recognized first for accounting and included in taxable income later.
In our example, in Year 1 and Year 2, the company has a deferred tax liability of $100 and $75,
respectively, for accounting purposes since the company has recorded more tax depreciation than
accounting depreciation in its books and will claim less tax depreciation in total than accounting
depreciation in its books in the future.

Deferred Tax Assets arise when an expense is recognized first for accounting and deducted later
for tax purposes. In our example, in Year 3, the company has deferred tax assets of $44 for
accounting purposes since the company has more accounting depreciation than tax depreciation
recorded in its books and will claim more tax depreciation in total than accounting depreciation in
its books in the future.

What is goodwill and how is it calculated?

Goodwill is the excess of equity purchase price over the fair value of the identifiable net assets
acquired in a business combination. Goodwill can be defined as:

Goodwill = Equity Purchase Price Paid for the Company Including Premium
Less: Fair Market Value of Identifiable Net Assets
(Assets – Liabilities) of the Target

Goodwill = Equity Purchase Price Paid for the Company Including Premium – Fair
Market Value of Identifiable Net Assets (Assets – Liabilities) of the Target or Fair
Market Value of Equity of the Target

Acquirers generally pay more than the fair market value of a company’s identifiable net assets for
many reasons, including: i) synergies they might get from buying the target, ii) unreported assets
the target may have on the balance sheet including customer loyalty, and iii) assets off-balance
sheet due to accounting standards.

Let us explain some of the key terms described above. In accounting, the book value of equity is
the original cost of the company’s common stock adjusted for inflows and outflows such as
retained earnings, dividends and stock buybacks. It appears as shareholders’ equity on a company’s
balance sheet in its annual reports, Form 10-K and Form 10-Q. It is defined as:

Book Value of Equity = Book value of assets

Less: Book value of liabilities

The fair market value of equity is the book value of assets and liabilities revalued to fair market
value, generally at the time of a business combination. For example, land, which is generally
shown on the books at cost and is not depreciated or appreciated, may undergo a significant
adjustment from its book value to its fair market value.

Fair Market Value of Equity = Fair Market Value of Assets

Less: Fair Market Value of Liabilities

The market value of equity is the total market value of all the company’s outstanding shares. It
includes the premium paid to buy the shares of the company acquired. It can be defined as:

Market Value of Equity = Fully Diluted Shares Outstanding

Times Share Price (including premium if any)
for a public company or Equity Value for
a private company

Please note that in calculating goodwill, we take the equity purchase price paid for the company
and not its enterprise value, which is the total value of the company. Intangible assets can be
identifiable or unidentifiable assets. Identifiable assets include patents, copyrights and trademarks,
which have a limited life and can be acquired separately. Unidentifiable assets include goodwill,
which has an unlimited life and cannot be acquired separately.
What is the accounting treatment of goodwill?

US GAAP and Canadian GAAP no longer allow goodwill to be amortized as an operating expense.
Goodwill is shown as an intangible asset on the balance sheet and is tested once a
year for impairment. If it is found impaired, it is written down to its impaired value and a loss is
shown on the income statement. The loss does not affect the cash flow of the company. If no
impairment is found, goodwill can remain on a company’s balance sheet indefinitely. Goodwill
cannot be written up on the balance sheet.
Although a write-down of goodwill does not affect cash flow, it could indicate that the acquirer
overpaid for the acquisition. An article in the Wall Street Journal observed that, in 2012, “U.S.
companies slashed the value of their past acquisitions by $51 billion because the deals didn’t pan
out as expected … Hewlett-Packard Co. took a $13.7 billion write-down due to the diminishing
value of its 2011 acquisition of software firm Autonomy … Microsoft Corp. took a $6.2 billion
write-down largely on its 2007 purchase of online-advertising company aQuantive”.1

What is negative goodwill? How is it accounted for?

Negative goodwill arises when the price paid for equity is less than the fair value of a company’s
identifiable net assets. Negative goodwill generally occurs after a distressed sale. Under the current
U.S. and Canadian GAAP, negative goodwill is recorded as income. The gains are not supported
by any current cash inflow, therefore, they are both nonrecurring and non-cash in nature. On the
balance sheet side, the acquired net assets under the current standards will be carried at fair value.

The financial statements of companies operating in certain sectors are different from the more
typical financial statements of, say, a manufacturing or services company. Candidates
interviewing for a job in a particular industry may be asked a question related to the financial
statements of that industry, therefore, they must understand the basic financial statements of that
industry and how they differ from regular financial statements. The following questions relate to
these differences.

Walk me through the income statement and balance sheet for a bank
and explain how it differs from an income statement and balance sheet
for a manufacturing company?
The financial statements of a bank are significantly different from those of companies operating
in other industries. It is critical to understand and articulate these differences if you are
interviewing for a job in the banking sector.
It is important to note that a bank’s primary business activity is providing loans to its customer
base, from which it earns interest income, whereas companies in other industries derive revenues
from selling products or services. Accordingly, a bank’s principal source of earnings is interest
income, not revenue from the sale of goods or services. The sample income statements of a bank
and a non-bank company below in Table 1.16 highlight the key variances between them.
Table 1.16: Sample Income statement of a manufacturing company and a banking company

1
Chasan, Emily and Murphy, Maxwell. “Companies Get More Wiggle Room on Soured Deals,” Wall Street Journal, Nov. 11,
2013, http://www.wsj.com/articles/SB10001424052702304868404579191940788875848.
 (in millions of $)
PQR Bank, Summary Income Statement for the
(in millions of $) fiscal year ended December 31, 2015
ABCCo Summary of Income Statement for the PARTICULARS AMOUNT
fiscal year ended December 31, 2015 Revenue
PARTICULARS AMOUNT Interest Revenue $750

Revenue $750 Interest Expense (150)

COGS (150) Net Interest Revenue $600

Gross Profit $600

Commission and Fees 100

Operating Expenses Administration and Other Fiduciary Fees 100

SG&A 250 Realized Gain on Sale of Investment 50

Depreciation & Amortization 50 Insurance Premiums 25

R&D 150 Other Non-Interest Income 25

Other Operating Expenses 50 Total Non-Interest Revenue $300

Total Operating Expenses $500

Total Revenue, net of Interest Expense $900
EBIT 100
Interest Expense 15 Operating Expenses, net of Interest Expense
Interest Income (5) Provision for Credit Losses 80
EBT $110 Compensation & Benefits 250
Provision for Income Tax Expense (30) Premises and Equipment 50

Net Income $80 Technology / Communication 70

Advertising & Marketing 200
Other Operating Expenses 130
Total Operating Expenses, net of Interest Expense $780

EBT 120
Provision for Income Tax Expense (40)
Net Income $80

Interest Income vs Sales. As highlighted in the sample income statements above, a key difference
between a bank and non-bank company is the source of revenues, with the banks’ principal revenue
source being interest income. Its primary business activity is to provide loans to its customer base,
ranging from residential, car and personal loans to individual borrowers to working capital funding
and acquisition finance for large corporations. The bank charges interest on these loans, which
forms the basis of its revenue stream. By contrast, a manufacturing company’s interest income
would be recorded under operating income in its income statement.
Interest Expense vs Cost of Goods Sold (COGS). A bank’s interest expense is the interest it pays
on its sources of capital to conduct its lending activity. Sources of funding for banks include both
customer deposits, such as certificates of deposits and savings accounts, and external debt.
Net Interest Income (NII). Banks typically make money from the spread between the interest
income they earn and the interest expense they pay, which is called net interest income (NII).
Accordingly, NII divided by the bank’s earning assets is its net interest margin (NIM). NIM is an
important indicator of a bank’s profitability, similar to gross margin in the case of non-financial
companies.
Non-Interest Income. A bank’s non-interest income can be derived from a wide range of
activities, such as M&A fees and securities trading for large investment banking units and deposit
and transaction fees, insufficient funds fees and monthly account service charges for more
traditional commercial banking franchises.
Non-Interest Expenses. A bank’s non-interest expenses are similar to those of non-finance
companies and include compensation expenses, professional fees and marketing costs. Provision
expense is the provision a bank makes for credit losses on delinquent and bad debt for the period.
It is an estimate banks make based on historical data and is treated as an expense in the income
statement.
Sample balance sheets for a bank and a non-bank company are given below:

Table 1.17: Sample Balance Sheet of a manufacturing company and a banking company

(in millions of $)
PQR Bank, Summary Balance Sheet for the
fiscal year ended December 31, 2015
PARTICULARS AMOUNT
Assets
Cash and Deposits with Banks $250
Federal Funds sold and Securities borrowed 1,500
Brokerage Receivables 300
Trading Account Assets 3,000
Investments 2,500
Loans, net of unearned income 4,000
Intangible Assets 250
Other Assets 800
Total Assets $12,600

Liabilities
(in millions of $) Total Deposits 10,000
ABCCo Summary of Balance Sheet for the Federal Funds purchased and Securities loaned 500
fiscal year ended December 31, 2015 Brokerage Payables 350
PARTICULARS AMOUNT Trading Account Liabilities 250
Assets Short-term Borrowings 350
PP&E $3,150 Long Term Debt 400

Less: Depreciation (150) Other Liabilities 100

PP&E, net of Depreciation $3,000 Total Liabilities $11,950

Intangible Assets 800

Inventories 400 Shareholders' Equity
Cash & Cash Equivalents 200 Common Stock 200
Accounts Receivables 300 Retained Earnings 500
Prepaid Expenses 100 Treasury Stock (50)
Other Assets 100 Total Shareholders' Equity $650

Total Assets $4,900

Total Liabilities and Shareholders' Equity $12,600

Liabilities
Accounts Payable 500
Accrued Expenses 300
Short Term Borrowings 1500
Long Term Borrowings 2000
Total Liabilities $4,300

Shareholders' Equity
Common Stock 200
Retained Earnings 400
Total Shareholders' Equity $600

Total Liabilities and Shareholders' Equity $4,900

We can observe the following key differences between the balance sheets:
Assets. Unlike manufacturing companies where inventory is a major asset, loans are a bank’s
primary asset. Some of the key assets of banks include:
Net loans. Once a bank issues a loan to its customers, whether individual consumers,
corporations or government agencies, it becomes an asset on the balance sheet as the money is
owed to the bank. Loans are generally shown net of provision for loan losses on a bank’s
balance sheet.
Banks normally hold a significant level of financial securities, including government bonds,
corporate bonds, derivative contracts and equity securities. The majority of these securities are
held for a relatively short period and reflect the bank’s trading activities.
Property, plant and equipment. A bank’s PP&E is similar to non-bank companies but
generally forms a much smaller percentage of its total assets and is less important.
Liabilities. As noted earlier, customer deposits are an important part of a bank’s funding
platform because they allow it to carry out its business activities. When a customer deposits
funds at a bank, a liability is created on the bank’s balance sheet, as it is required to repay those
funds at some point in the future.

What are some of the unique characteristics of the financial statements

of an insurance company?

Consider the following income statements of XYZ Company to ABC Insurance and
compare the two.
Table 1.18: Sample Income Statement of a manufacturing company and an insurance company

(in millions of $)
(in millions of $)
ABCCo Summary of Income Statement for the
DEF Insurance Co, Summary Income Statement for the
fiscal year ended December 31, 2015
fiscal year ended December 31, 2015
PARTICULARS AMOUNT
PARTICULARS AMOUNT
Revenue $750
Revenue
COGS (150)
Property & Casualty Insurance Premium $1,600
Gross Profit $600
Life Insurance Premium 200
Policy Charges 100
Operating Expenses
Net Investment Income 300
SG&A 250
Other Revenues 100
Depreciation & Amortization 50
Total Revenue $2,300
R&D 150
Other Operating Expenses 50
Benefits & Expenses
Total Operating Expenses $500
Incurred Property & Casualty Loss 1100
Life Insurance Benefits 100
EBIT 100
Other Benefits & Claims 100
Interest Expense 15
Amortization of Deferred Policy Acquisition Costs 300
Interest Income (5)
Other Expenses 500
EBT $110
Total Benefits & Expenses $2,100
Provision for Income Tax Expense (30)
Net Income $80
EBT 200
Provision for Income Tax Expense (60)
Net Income $140

As we can see from the two statements, insurance companies are more similar to
manufacturing companies than banks. Nevertheless, there are a few points worth noting:

Premiums. A large portion of an insurance company’s revenues comes from the

premiums it writes for its customers. Note, however, that premiums are equal to
policyholder benefits and claims. It is not uncommon for insurance companies to break
even or make a small loss on their underwriting business, only to become profitable
through their investing activities. Warren Buffet is a good example of this.

Net investment income. Like banks, insurance companies collect huge amounts of
money from their customers. This money (premiums) will not be needed until the future
(if at all), and thus the insurance company can create a “float” and use this for its
investing activities. Regulations limit the types of asset classes insurance companies can
become exposed to, and most insurance companies are required to hold the majority of
their float in fixed income government or high grade corporate bonds. This is the reason
insurance earnings are so sensitive to interest rates.
Interest credited to account balances. Many policyholders have accounts with
insurance companies that promise to deliver a small interest payment on deposits. This
is a typical expense for insurance companies. There may also be other similar expenses
such as policyholder dividend payments, etc.

Long-term securities. As noted earlier, insurance companies hold a large amount of

their assets in long-term fixed income securities. The requirements set by regulators for
asset allocation vary slightly between life insurance companies and property and
casualty companies, but it is sufficient to know that both invest heavily in fixed income
assets.

Future policy benefits. This is a large long-term liability for insurance companies. They
reflect the future obligations the insurance company will have with respect to the current
policies that are written.

Deferred policy acquisition costs. When an insurance company sells a new premium,
it must pay a commission to the dealer on the whole value of the premium. Due to the
matching principle in accounting, the expense is only realized on the income statement
once the revenue associated with it is received. Because policies can last for several
years, this expense can be compared to a prepaid expense.
Table 1.19: Sample Balance Sheet of a manufacturing company and an insurance company

(in millions of $)
(in millions of $)
DEF Insurance Co, Summary Balance Sheet for the
ABCCo Summary of Balance Sheet for the
fiscal year ended December 31, 2015
fiscal year ended December 31, 2015
PARTICULARS AMOUNT
PARTICULARS AMOUNT
Assets
Assets
Investments $7,500
PP&E $3,150
Cash & Cash Equivalents 50
Less: Depreciation (150)
Accrued Investment Income 100
PP&E, net of Depreciation $3,000
Premiums, Insurance & Other Receivables 400
Intangible Assets 800
Deferred Policy Acquisition Costs 500
Inventories 400
Reinsurance Recoverables 500
Cash & Cash Equivalents 200
Goodwill 200
Accounts Receivables 300
Other Assets 750
Prepaid Expenses 100
Total Assets $10,000
Other Assets 100
Total Assets $4,900
Liabilities
Property & Casualty Loss Expense Reserves 1,800
Liabilities
Future Policy Benefits & Claims 3,000
Accounts Payable 500
Unearned Premium 750
Accrued Expenses 300
Short & Long Term Debt 3,500
Short Term Borrowings 1500
Other Liabilities 800
Long Term Borrowings 2000
Total Liabilities $9,850
Total Liabilities $4,300

Shareholders' Equity
Shareholders' Equity
Common Stock 50
Common Stock 200
Retained Earnings 100
Retained Earnings 400
Total Shareholders' Equity $150
Total Shareholders' Equity $600

Total Liabilities and Shareholders' Equity $10,000

Total Liabilities and Shareholders' Equity $4,900
Chapter 14: TEV and Comparable
Company Valuation Q&A
“It’s far better to buy a wonderful company at a fair price than a fair company
at a wonderful price”
– Warren Buffet

An understanding of valuation is important for almost all types of finance jobs, including
jobs in investment banking, buy and sell side research, asset management and alternate
asset management, such as hedge funds and private equity. The ability to value
companies is a critical skill that will lead to a successful career in these areas. Interview
questions on valuation test the candidates:

• Familiarity with the key concepts including total enterprise value (TEV) and
equity value
• Knowledge of advanced concepts that impact valuation, including non-
controlling interest, fully diluted shares outstanding and treatment of
convertible debt
• Understanding of key valuation methods including comparable company,
precedent transactions, discounted cash flow (DCF) and leveraged buyout
(LBO) analysis
• Ability to link the different valuation methodologies together and
understanding of the valuation methods used by various finance professionals.
For example, equity research analysts focus on comparable companies and DCF
whereas investment bankers will use comparable companies, precedent
transactions, DCF and LBO analysis
• Insight into the unique valuation methods and metrics used in various
industries. For example, financial institutions use price to book value and not
enterprise value metrics

The following questions focus on the interviewee’s familiarity with key concepts in
valuation including enterprise value and equity value

What are some of the reasons we value companies?

Investment bankers, companies, venture capitalists, research analysts and various other
parties conduct valuations for a number of reasons, which are summarized in Table 1.1.

Table 1.1: Examples of Valuation used by Various Professions

 Venture Capital Start-up company wants to raise capital for growth
purposes, and both the venture capitalist and the
company perform a valuation
Leveraged Buyout PE firm wants to acquire a public or private company and
the PE firm and the company perform a valuation
Equity Research Research analysts value public companies and provide a
recommendation on whether to buy, sell or hold the stock
Initial Public Offering Private company needs to determine the value of the
company in order to go public
Debt Offerings Lender values the assets given as collateral by the
borrower for a secured debt offering
Mergers and Acquisition: Company X wants to acquire a business and
Acquisitions place a value on the target;
Divestiture: Company X wants to sell a division that is
non-core to its operations
Restructurings Company X is in distress and wants to value the
company, so that it knows what it is worth to its various
stakeholders, i.e., debt, preferred and equity

What is enterprise value and how is it different from equity value?

Enterprise value (EV) is the total value of the operations of a company that is available
to debt, preferred and equity shareholders or the capital providers of a company. For a
public company, EV means the value of the company as it is trading in the market. It is
also known as the total enterprise value, firm value or aggregate value of a company. It
is defined as:

Total Enterprise Value (TEV) = Equity Value

Add: Debt
Add: Preferred Stock
Add: Noncontrolling Interest
Subtract: Cash and cash equivalents

While the above definition will suffice for most interviews, we can refine it further for
those who are already working in finance jobs:

Total Enterprise Value (TEV) = Equity Value

Add: Debt
Add: Preferred Stock
Add: Noncontrolling Interest
Add: Unfunded Pension and Other
Liabilities
Add: Off Balance Sheet Obligations
Subtract: Investments in Associated
 Companies
Subtract: Cash and cash equivalents
Equity value is the value available to equity holders once other providers of capital,
such as debtholders, and other liabilities have been repaid. For public companies:

Equity Value (Market Capitalization) = Share price × Diluted

Shares Outstanding

For private companies, we can calculate the enterprise value using different valuation
methods and then subtract debt and add cash to get equity value.

Debt includes all interest bearing liabilities and should be taken at market value (if
available, or else at book value).

Debt = Short − term debt

Add: Long − term debt
Add: Capitalized Leases

Market value of debt is used to calculate TEV and if the debt is not distressed and market
prices are not easily available, in practice, we take the book value of debt.

Short-term debt has a maturity of less than one year and comprises short-term debt, the
current portion of long-term debt, commercial paper and other interest bearing
obligations included in the current liabilities section of a company’s balance sheet.

Preferred stock is generally taken at its market value or liquidation value which is the
amount the company will need to pay its preferred stockholders if the preferred is not
convertible to common stock.

Excess cash is subtracted to calculate TEV. Excess cash is defined as the cash a
company has beyond the minimum cash it needs for working capital purposes. Since it
is difficult to determine the minimum cash required for working capital, we generally
subtract all the cash in the balance sheet in our calculation of TEV.

Capital leases are a form of borrowing since a company has acquired all the economic
interest in the leased asset with an obligation to make the lease payments.

Unfunded pension liability and other deemed debt liabilities such as environmental
provisions are added to TEV since similar to debt, it is a claim on the company’s assets.

Investments in associated companies are equity interests representing a 20-49%

ownership interest in another company by the parent company. It is shown as an asset
in the parent company balance sheet. Market value of the investment is subtracted while
calculating TEV.

Off-balance sheet commitments include operating lease commitments in industries such

as retailers and airlines. Operating lease payments in future years can be converted to
debt by discounting the payments, in most cases, with the pre-tax cost of the company’s
debt. Some analysts also use a multiple of current rent ranging from 6x-8x current rent,
depending on the industry.

Why is cash subtracted when calculating the enterprise value of a

company?

When we buy a company, we need to pay all the stakeholders, including debtholders
and equity holders, and we get to keep the company’s cash. For example, Company A
has the following:

(in $)
Company A
Share Outstanding 1,000.0
Stock Price $10.0
Market Capitalization $10,000.0
Debt $1,000.0
Cash $500.0

If we buy the company, we need to pay the equity holders and debtholders, which will
be $10,000 + $1,000 = $11,000 and we get $500 in cash. Therefore, we effectively paid
$10,500 for the company, which is its TEV.

A different way to explain this is that cash can be used to pay the debt, thus, if we
restructure the capital structure, Company A will have a market capitalization = $10,000,
Debt = $500 and Cash = $0. The company’s value to all stakeholders will be $10,500,
i.e., equity value + debt – cash.

Another explanation is that the company’s cash is already included in the market price
of its shares. This is described more fully in the answer to the next question.

The interviewer may ask the above question in another way as given below.

If a company with excess cash on its balance sheet distributes all of the
cash as dividends to its shareholders, will that not increase the
company’s enterprise value?

No. Theoretically, a dividend will have no impact on the EV of the company. For
example, if Company A has the following:
 (in $)
Company A
Share Outstanding 1,000.0
Stock Price $10.0
Market Capitalization $10,000.0
Debt $1,000.0
Cash $500.0

TEV is $10,000 + $1000 − $500 = $10,500. If Company A gives its shareholders a

dividend of $500, it would seem that the TEV should go up to $11,000, i.e., $10,000 +
$1,000, but that is not the case.

Since the cash is already factored in the stock price of Company A, its market
capitalization will fall by the amount of dividend given, that is, $9,500. TEV will be
$9500 + $1,000 = $10,500, which is the same as before. Shareholders of the firm will
get $9,500 + $500 = $10,000, which is the same value without the dividend.

What is noncontrolling or minority interest and why is it added to

calculate total enterprise value?

Noncontrolling interest, sometimes referred to as minority interest,1 is the part of a

company’s subsidiary that is not owned by the parent company, but is owned by other
investors. It is shown in the balance sheet as a separate line item under the liabilities and
equity section of the consolidated balance sheet. In the income statement, it is subtracted
from the consolidated net income and shown separately as part of the profit attributable
to minority shareholders.

When a company owns more than 50% but less than 100% of another company, the
parent company has to consolidate the other company in its books and reflect 100% of
the subsidiary’s assets and liabilities and 100% of its income in its books. For example,
if Company A owns 80% of company B, it will consolidate all of Company B’s
financials in its books. It will show 100% of Company B’s assets, liabilities and income
in its books. The 20% of Company B that Company A does not own is shown separately
as noncontrolling interest in the equity section of the consolidated balance sheet. It is
also shown separately as noncontrolling interest in the consolidated income statement.

Let’s say Company A acquires Company B and their balance sheets are as follows:

1 In December 2007, FASB Statement No. 160 suggested changing name from minority interest to noncontrolling
interest.
 (in $) (in $)
Company A Company B
Assets $20,000.0 Assets $10,000.0
Liabilities $10,000.0 Liabilities $5,000.0
Shareholders Shareholders
Equity $10,000.0 Equity $5,000.0

The combined balance sheet will be:

(in $)
Company Combined
Assets $30,000.0
Liabilities $15,000.0
Shareholders Equity $14,000.0
Non controlling Interest $1,000.0

Noncontrolling interest is the 20% of Company B not owned by Company A. Assets =

Liabilities + Shareholders equity + Noncontrolling interest

In the income statement, Company A’s net income is $10,000 and Company B’s net
income is $5,000, thus, the consolidated net income will be $15,000. The noncontrolling
interest of 20% in Company B, which is $1,000, will be shown as a separate line item
and net income after noncontrolling interest will be $14,000.

To calculate TEV, we add the balance sheet noncontrolling interest in the enterprise
value formula as it represents a claim on the assets of the company—it is a liability, like
debt. For example, if someone were to acquire the company, they would also need to
pay off this liability.

We can also see why noncontrolling interest is added back while doing comparable
company metrics such as TEV/EBITDA. For example, if Company A owns 80% of
Company B, when we take EBITDA from the consolidated income statement, it
accounts for 100% of the consolidated companies due to the accounting rule described
above. The market value of the equity value included in TEV accounts for the fact that
Company A owns 80% of Company B. Hence, the numerator, which is TEV, is
accounting for 80% of Company B and the denominator, which is EBITDA, is
accounting for 100% of Company B. To make an apples-to-apples comparison of this
valuation multiple to account for either 100% or 80% of TEV and EBITDA of Company
B in both numerator and denominator, we need to adjust either the EBITDA or the TEV.

Rather than adjusting the consolidated EBITDA to show 80% of Company B since
sometimes EBITDA for Company B is not broken out in the consolidated financial
statements, we can add the noncontrolling interest to the TEV. By doing so, we will be
showing 100% of the Company B in both the numerator, which is TEV, and the
denominator, which is EBITDA.
Can the enterprise value of a company be negative?

Yes, TEV of a company can be negative in certain scenarios. A negative TEV means
that the company has more cash than the market value of its equity and debt. For
example, a company has 10 million shares outstanding with a stock price of $10, $50
million of debt and $200 million of cash. Its TEV would be -$50 million. This implies
that someone could buy the company’s shares and debt and get the $200 million of cash.
In normal situations, this would not be possible in efficient markets and there typically
would be a reason for that to happen.

One of the reasons could be that the company is about to go bankrupt as we saw in the
technology bust in 2001-2003 when a number of companies had negative TEV. The
business models of these companies were not viable and these companies were burning
cash quickly. If someone would have bought the shares and debt of these companies,
they would have had to incur substantial liquidation costs and may not have got all the
cash on the balance sheet.

Secondly, we see financial institutions such as banks may have negative TEV. TEV is
not an appropriate measure for banks since it is very difficult to classify what is debt for
these companies since customer deposits could also be taken as debt.

We need to be careful that while calculating TEV, we are taking all the debt including
off balance sheet obligations into account. Also, since a public company files Form 10-
K and Form 10-Q on a quarterly basis and we get the cash and debt number from these
filings, the current market value may be at a later date and the company may have used
its cash or paid down its debt in the interim period.

Explain fully diluted market capitalization.

The fully diluted shares of a company include the basic shares outstanding plus the
potential dilutive effect of any securities, including stock options given to employees,
warrants, convertible debt and convertible preferred stock.

Market Capitalization = Share Price × Basic Shares Outstanding

Fully Diluted Market Capitalization = Share Price × Number of Fully

Diluted Shares Outstanding

Basic shares outstanding represent the number of common shares that are outstanding at
the time of the company’s last reporting date and can be found in the front page of the
company’s most recent annual or quarterly reports, i.e., Form 10-K or 10-Q for U.S.
companies. We should also check the company’s press releases to find out if it has issued
any additional shares after the last reporting date or done a large share buyback.
We use the treasury stock method to calculate the dilutive effect of employee stock
options. Options converted into shares using the treasury stock method will be added to
the basic shares outstanding to get the fully diluted shares of the company. Information
on employee stock options can be found in the notes to the financial statements in the
company’s Form 10-K; these details are generally not broken out in the quarterly or
other filings of the company.

If the company has other potentially dilutive securities, e.g., convertible preferred stock
or convertible debt, we need to account for those as well in our fully diluted share count.

How is convertible debt treated while calculating fully diluted shares

outstanding?

Convertible debt is debt that can be converted into equity shares. If the convertible debt
is not in-the-money, i.e., the conversion or exercise price is higher than the current stock
price, then it is treated as debt, whereas if it is in-the-money, i.e., if the exercise price is
lower than the current stock price, we treat it as equity and take it out of debt so as not
to count it twice.

For example, Company A has $1,000 of convertible debt that can be converted into 20
shares at a price of $50. There can be two scenarios:

Company A’s stock price is $40. The convertible debt is not in-the-money and we will
take the $1,000 as debt.

Company A’s stock price is $60. In this case, the convertible debt is in-the-money,
therefore, even if debtholders have not converted it yet, for our calculations we will
assume that they will do so. In this scenario, we will take the convertible debt as equity,
so the equity value will go up by $1,000/$50 = 20 shares * $60 = $1,200. Also, the debt
of the company will be reduced by $1,000.

The following questions highlight the various valuation methods, including comparable
company, precedent transactions, DCF and leveraged buyout analysis, and test the
interviewee’s ability to link the valuation methodologies together.

What are the common valuation methodologies used to determine the

value of a company?

We generally use four valuation methods to value a company. These are (i) comparable
company analysis, (ii) precedent transaction analysis, (iii) discounted cash flow analysis,
and (iv) leveraged buyout analysis. Other valuation methods could include sum-of-the-
parts analysis and liquidation analysis, which are generally used in the event of a
bankruptcy and are not among the standard valuation methods. We have briefly
described the methods below:
Comparable company analysis. This method answers the question, “What is the value
of the company compared to other similar companies trading in the market?” It reflects
the market’s perception of the company’s value relative to a peer group of publicly
traded companies.

The target company we are valuing could be a public or private company. It could be a
standalone company or a subsidiary, but the comparable companies will only be public
companies. This implied valuation does not reflect any premium for control, i.e., no
change in ownership. One of the challenges of this method is that it is often difficult to
identify relevant comparable companies and to adjust for differences in their underlying
businesses, capital structure and accounting regimes. Ideally, companies that are nearly
identical should be compared. Some factors for determining appropriate comparable
companies include similar size, industry, business model, margins, growth rates,
accounting standards and geographical market. Financials may require appropriate
adjustments to ensure a like-for-like comparison.

Precedent transactions analysis. This method answers the question, “How much will
the company sell for relative to other similar companies that have already been sold in
the market recently?” It is a key valuation benchmark when a change of control is
assumed.

It values a company that is being sold based on how similar businesses were sold. The
target company we are valuing could be a public or private company. The precedent
transactions analyzed can be public and private companies and include acquisitions and
divestitures of assets and subsidiaries. Similar to comparable companies, one of the
challenges is finding relevant recent transactions as well as valuation multiples for these
transactions, especially for private companies. This method provides information on
how the transactions were completed, i.e., cash, stock or a combination of both and on
the relevant transaction multiples and premiums paid. It is usually limited to transactions
that have closed and also announced but have not closed. Transactions that were
announced and then withdrawn are normally excluded.

Discounted cash flow analysis. This method answers the question: “What is the value
of the company based on its projected future cash flows?” The DCF model values a
company or business based on the net present value (NPV) of its future cash flows.

Volatility in market conditions has a limited impact on this method, and it is most
appropriate for companies that have predictable annual free cash flows. DCF valuations
are highly sensitive to underlying assumptions about free cash flows, including growth
rates and margins, discount rate or weighted average cost of capital (WACC) and
terminal value calculations.

Leveraged buyout analysis. This method answers the question, “How much can a
private equity player pay for the company and still achieve their required internal rate
of return (IRR)?” It establishes the maximum price payable by the private equity firm to
acquire a company and still meet their specified IRR targets.
Sum-of-the-parts analysis. This method answers the question, “How do I value my
company’s individual business units to arrive at a value for the whole company?” For
diversified companies that have multiple business units, such as General Electric,
separate valuation methods may be appropriate for the different business units which are
then added to arrive at the value of the whole company. We generally use market-based
comparable company multiples analysis although we can also do a DCF valuation using
the appropriate WACC and perpetuity growth rates for each subsidiary in order to reflect
differences in business models and risk.

Liquidation analysis. This method answers the question, “What would be the value of
the company if it were to liquidate today and sell off all its assets and pay off its
liabilities?” It is used for companies on the brink of bankruptcy or those that have already
filed for bankruptcy. It can also be used for solvent companies if stakeholders want to
find out whether the returns generated from the business are greater than the returns they
could get from investing the proceeds of a liquidation of the business.

Which of the valuation methods, i.e., comparable companies, precedent

transactions, DCF and LBO analysis should give the highest value and which
one should give the lowest value?

This question gauges how well the candidate understands the four common valuation methods as
well as the pros and cons of each method. There is no one right answer to this question. If asked
to rank the methods, precedent transactions would give the highest valuation, followed by DCF,
leveraged buyout and comparable company analysis in descending order, but it is important to note
that the valuation will depend on a number of factors such as market conditions and the
assumptions made in the valuation models.

Investment bankers usually summarize the valuation methods and key data points graphically and
show them together in a football field valuation graph. This allows the client and the banker to
review the valuation methods and enables the banker to determine the appropriate valuation for
the company. The football field valuation can be shown on a TEV and/or on a per share basis. The
following are generally shown on a football field graph:

The 52-week high/low is the range of the highest and lowest price at which the stock has traded
over the past year from the date of the valuation. We add the debt and subtract cash as of the
valuation date to show the stock prices in terms of enterprise value.

Equity research estimates are the range of the target prices that equity research analysts have on
the stock as of their recent reports on or prior to the valuation date. Data sources such as Thomson
One or S&P Capital IQ can provide this information. We should note that the majority of equity
research analysts have a buy rating on a company and are generally bullish on the stock price of
the company.
Total enterprise value is the current market valuation of the company available to all its
stakeholders as it is trading in the market today. Since we calculate TEV as it is on the valuation
date, it is one number and not a range of values.

Comparable company analysis is the implied valuation of the company based on other similar
publicly traded companies. The common valuation metrics are TEV/revenues, TEV/EBITDA and
price/earnings (P/E) ratio, and we calculate last twelve months (LTM), one-year forward and two-
year forward multiples. On the football field, we show the metrics most relevant to the company
being valued based on the industry the company is in and its stage of growth.

A comparable company valuation can be higher or lower than the current market valuation of the
company depending on whether the company being valued is overvalued or undervalued compared
to its peers in the market. It will be lower than a precedent transaction valuation since it does not
include the control premium. It is typically similar to a DCF valuation but may also be lower or
higher depending on the assumptions made in the DCF valuation. Even though an LBO valuation
does not take into account synergies, it is generally higher than a comparable company valuation
since PE firms are acquiring the company and need to pay a premium. However, the actual result
will depend on the market conditions and cost of capital for the PE firm.

Precedent transactions analysis is the implied valuation of the company based on other similar
public and private sale transactions that have closed recently. The common valuation metrics
calculated and shown on the football field are TEV/revenue and TEV/EBITDA, and we calculate
LTM multiples. The precedent transactions methodology will give the highest valuation since
precedent transactions include the control premium. If the precedent transaction valuation is lower
than the comparable company valuation, it could be due to the fact that the sale transactions were
older and the stock market has moved up in the last year or two. In this case, we need to adjust the
transactions to current market conditions. It may also be the case that the transactions we have
used are not similar to the company being valued and the comparable companies in terms of
industry, business model, profitability, size, growth rates and geography. A precedent transaction
valuation will generally be higher than a DCF valuation but this will depend on the assumptions
we made in the DCF analysis. Sometimes, a DCF valuation can be higher than a precedent
transaction valuation.

A DCF valuation of a company is based on the company’s cash flows in the future and is not
market dependent as compared to precedent transaction and comparable company valuation
methods. A DCF valuation is highly sensitive to the free cash flow projections, WACC and
terminal growth rate or multiple chosen and hence can vary substantially depending on the
assumptions we make regarding these components. A DCF valuation will be lower than a
precedent transaction valuation since DCF does not include the control premium. It is similar to
the comparable company valuation, but since assumptions made while doing a DCF valuation are
generally optimistic, it usually comes out higher. In an M&A transaction, we show the DCF
valuation with potential revenue and cost synergies to the acquirer, and because of this, it can be
higher or lower than the precedent transaction valuation and higher than the comparable companies
valuation.
An LBO valuation of the company is based on what a PE firm can pay to buy the company and
get the IRRs it wants. It is typically the floor valuation since it does not include synergies and
hence gives the minimum price that strategic buyers need to pay to acquire the company. It would
generally be lower than a precedent transaction valuation and higher than a comparable company
valuation but this really depends on market conditions. In 2006 and early 2007, debt was cheap
and companies were getting high levels of leverage, with the result that PE firms were able to pay
more for a company than even strategic acquirers. Sometimes, when the debt markets are not in
favor of PE firms and the cost of capital is very high, this valuation can be lower than a comparable
company valuation and even the current market valuation of the company. If it falls below the
current market valuation, it tells bankers that the market conditions are not favorable to PE firms
and these firms cannot even pay the current market value of the company.

Table 1.2 is an example of a football field valuation graph showing the various valuation
methodologies and some of the key data points discussed above.

Table 1.2: Football Field Valuation Graph

Current TEV: $1,050

52 Week High / Low $890 $1,450

Broker Estimates $1,150 $1,550

Trading P / NTM EPS $1,040 $1,310

Trading EV / NTM EBITDA $1,000 $1,400

Trading EV / LTM EBITDA $990 $1,350

Transaction EV / LTM EBITDA $1,170 $1,530

DCF incl. Synergies $1,250 $1,750

DCF excl. Synergies $1,200 $1,550

LBO $1,150 $1,500

$800 $1,000 $1,200 $1,400 $1,600 $1,800

The following questions relate to the common valuation multiples used to value companies as well
as the unique valuation metrics used for different industries.

What are the common valuation metrics used to value companies?

We generally use enterprise value (EV) and equity value multiples to value companies. To
calculate the multiple, we need the EV or equity value in the numerator and revenues, earnings or
book value of the company in the denominator. We calculate LTM, one-year forward and two-
year forward multiples and then, depending on the company’s stage of growth, decide which
multiple(s) and year(s) would be appropriate for the company. While calculating the LTM and
projected multiples, the EV or equity value stays constant for a valuation date but the revenues or
earnings will change. LTM are the most recent actual numbers of a company, whereas forward
multiples are based on projected numbers for the company. Multiples are generally useful for
comparison purposes across companies in the same industry. We have briefly discussed EV
multiples below:

The EV/revenue multiple is generally used for companies that have negative EBIT or EBITDA
such as start-up technology and distressed companies. It is less prone to accounting manipulations
than EBIT or EBITDA. Revenue multiples are less volatile as earnings for many companies,
including cyclical companies, may fluctuate from year to year due to numerous reasons. The
drawback of the revenue multiple is that it does not take costs into account, and a company might
show excellent revenue growth but may not be profitable.

The EV/EBITDA multiple is generally the most common enterprise value multiple used since it
takes into account the costs of a company. An EV/LTM EBITDA multiple of 6.0x means that an
acquirer is willing to pay six times a company’s LTM EBITDA to buy the company. It does not
take the capital structure of the company into account since it is calculated before interest expense
has been paid to debtholders. Hence, we can compare companies with different capital structures
in the same industry. Further, it does not take into account depreciation expense, which is a non-
cash expense, and therefore enables us to compare companies that use different depreciation
methods, i.e., straight line or declining balance, as well as companies that own their assets
compared to companies that might lease assets.

The EV/EBIT multiple is similar to TEV/EBITDA in terms of being capital structure

neutral except that depreciation and amortization expense is subtracted to get EBIT.
Thus, this multiple captures the impact of capital expenditures and is used in industries
where it is important to include capital expenditures. Further, some people argue that
even though depreciation is a non-cash charge, it is an expense that should be considered
as assets will need to be replaced at some point and hence should be subtracted to get
EBIT.

The next three multiples discussed below are common equity value multiples:

Price/earnings ratio is the most common equity multiple used by sell-side and buy-side analysts.
It is simple to calculate and takes into account the effect of capital structure, depreciation and
amortization, and taxes. A high price/earnings (P/E) ratio could indicate that the stock is
overvalued. It could also be a signal that earnings may increase in the future, a factor that the
current multiple has taken into account. A low PE ratio might signal that the stock is undervalued.
It could also indicate that the company is not doing well and is not a suitable investment. The P/E
ratio is helpful for comparing companies with a similar capital structure. One of the drawbacks of
the P/E ratio is that the way in which a company or capital structure is financed might have an
effect on its P/E ratio. For example, if a company issues equity and gets cash, its enterprise value
will stay the same but its earnings per share will go down and its P/E ratio will go up. It is because
of this drawback that enterprise value multiples, which exclude the effect of capital structure, are
more commonly used.

The price/earnings to growth (PEG) ratio is helpful for comparing companies with different
growth rates, a factor that is not captured by P/E ratio. For example, company A might have a P/E
ratio of 20x and company B a P/E ratio of 10x, and it may appear as though company B is
undervalued compared to company A. However, if the growth rate of company A is double that of
company B, it may not be undervalued. PEG ratio is defined as the P/E ratio divided by the earnings
per share (EPS) growth rate. Generally, we calculate the trailing P/E multiple and take the five-
year long-term projected EPS growth rate of the company from data sources such as Thompson
One and S&P Capital IQ. When comparing companies with different PEG ratios, it is important
to ensure that all the companies use the same metrics, i.e., trailing or forward P/E for the numerator
and one-year forward or five-year average growth rates for the denominator. If a company has a
very high growth rate, we need to consider that it may be riskier and the risk may not be captured
by the PEG ratio. We also need to verify that the company’s EPS growth is coming from organic
growth or increasing margins and not just from putting more debt on its balance sheet.

The price/book value per share can be calculated market value per share divided by the book
equity value per share from the company’s latest balance sheet. It can also be defined as the market
capitalization divided by the total shareholders’ equity on the balance sheet. It indicates how much
equity shareholders are paying for the net assets of the company. Book value may not be
representative of a company’s actual value, especially in industries such as pharmaceuticals and
consumer products where the companies may have intangible assets such as market share and
brand name. It can be used for capital intensive businesses but not for services-based firms that
have very few assets on their books.

Can a company have a higher TEV/EBITDA multiple than TEV/Revenue

multiple? Also, can the P/E multiple of a company be the same as TEV/EBITDA
multiple?

A company will have a higher TEV/EBITDA multiple than TEV/Revenue. The reason for that is
that revenues are higher for a company than the EBITDA and the enterprise value is the same so
the multiple for EBITDA will be higher. For example, if a company’s revenue is $1,000 and
EBITDA is $400 and enterprise value is $4,000 the TEV/Revenue multiple will be 4x and
TEV/EBITDA multiple will be 10x.

Generally, the P/E multiple would be higher than TEV/EBITDA since earnings are lower than
EBITDA by a higher percentage as compared to equity value to enterprise value. The P/E multiple
is based on the equity value of the company and the TEV/EBITDA multiple is based on the
enterprise value of the company. It could be possible that both of them are the same, for example,
if enterprise value is $2,000 and EBITDA is $200 and equity value is $1,000 and net income is
$100, the TEV/EBITDA multiple would be 10x and the P/E multiple will also be 10x.

Company A and company B are trading at a P/E multiple of 20x but company
A is trading at a TEV/EBITDA multiple of 15x and company B is trading at a
TEV/EBITDA multiple of 12x. Is it because company A has higher debt?

You cannot conclusively say that the reason company A has higher EBITDA multiple is because
of higher debt. If the two companies had the same EBITDA and equity value, then company A
enterprise value is higher than company B and it could be because of higher debt. But it could also
be that company A has the same or even less debt than company B but less cash than company B.
It could be that company A has more preferred stock than company B or more unfunded pension
obligations than company B which makes its enterprise value higher.

For example, let us say company A and B equity value, EBITDA and net income is $2,000, $200
and $100 respectively. The enterprise value of company A is $3,000 and the enterprise value of
company B is $2,400. The PE ratio of A and B is 10x. TEV/EBITDA of company A is 15x and
TEV/EBITDA of company B is 12x. It could be that company A and B have debt of $2,000 but
company A has cash of $1,000 and hence EV of $3,000 while company B has cash of $1,600
which makes it enterprise value $2,400.

If one company A is trading at a P/E ratio of 15x and another company B is

trading at a P/E ratio of 10x, can we say that company A is overvalued and
company B is undervalued and we should buy company B?

If both the companies were identical, i.e., they were in the same industry and geography, had
similar margins, growth rates and enterprise value, we could have said that company B is
undervalued.

Company A and B may be in different industries and we will need to compare them to the
comparable companies in that industry to see if they are undervalued or overvalued. For example,
if comparable companies in the industry are trading at 20x and company A is similar to the
comparable companies, since company A is trading at 15x, then it may be undervalued.

Further, we will need to do a stand-alone valuation like discounted cash flow analysis and we may
see that company B has lower growth rates, margins and a high cost of capital and hence a lower
valuation and stock price. Our analysis may conclude that company B should trade at 8x and since
it is trading at 10x, it is overvalued and not undervalued.

An automobile (or an airline company) is trading at a P/E multiple of 4x

compared to the average historical P/E of 6x in these industries. Is the stock
undervalued?

It may seem that a company that is trading at a 4x P/E is cheap compared to the average industry
P/E of 6x. Automobile and airline companies are cyclical companies, and if they are trading at a
low P/E, it could mean that their earnings are very high as the company may be at the top of the
economic cycle when the economy is doing well and most likely will fall in the future. The P/E
ratio of these companies will increase at the bottom of the economic cycle when their earnings are
depressed. Hence, more investigation would be needed to see if the company is undervalued or not
as there might be some company specific factors also that might be impacting the valuation such
as lower margins and growth rates than the industry and weak management team.

What are the metrics used in valuing companies in the oil and gas
industry?

If you are interviewing for a specific sector or have previously worked in a particular industry, you
may be asked to highlight the multiples used in that industry. Some industries apply specific sector
multiples different from those discussed above, and it is important to be aware of them.

The financial institutions sector includes investment banks, commercial banks, insurance
companies and investment companies. Debt is generally difficult to ascertain for companies in this
sector since customer deposits are also debt, and hence it may not be appropriate to use EV
multiples. EBITDA is also not used, since interest income is part of revenues and interest expense
is a cost, unlike most other sectors where interest expense is shown below the operating income
line. Thus, equity multiples rather than EV multiples are used for valuing companies in this sector.
Multiples include price or equity value/book value per share and equity value/net asset value
(NAV) per share.

Some sectors and industries use specific multiples as described below.

Valuation Multiples in Certain Industries

• Retail: EV/EBITDAR (Earnings before Interest, Taxes, Depreciation, Amortization and

Rent Expense)
• Financial Institutions – Price or Equity Value/Book Value per share and Equity Value /
Net Asset Value (NAV) per share, Price to Book Value, P/E Ratio
• Oil and Gas and Natural Resources: EV/EBITDAX (Earnings before Interest, Taxes,
Depreciation, Depletion, Amortization and Exploration Expense)
• Metals and Mining: EV/Reserves, EV/Production/Capacity (in units)
• Real Estate: EV/Square Footage, Equity Value/Funds from Operations (“FFO”)
• Telecommunications: EV/Access Lines or Fiber Miles

Is it better to value a company using a revenue or EBITDA multiple? When

would you use a revenue multiple?

It is better to use the EBITDA multiple since EBITDA captures the operating costs of the company.
Revenue multiples are used if the company has negative EBITDA, which is the case with loss
making companies and start-ups. Most start-ups in the technology sector can be valued using
revenue multiples.

Revenue multiples can also be used if the EBITDA margin is not steady. When a company is in
the growth stage, its EBITDA margin is generally low since the company spends more on sales
and marketing expenses and its fixed costs are high. As a company matures, its EBITDA margin
becomes stable. Consumer goods companies that have been in existence for a long time will be
valued using EBITDA since they will generally have steady EBITDA margins.

Should we use EV/EBITDA or market capitalization/EBITDA when valuing

companies? What about EV/earnings or market capitalization/earnings?

Value multiples generally have two inputs. In the numerator, we could have the EV or equity value,
and in the denominator we can have a measure of revenues, EBITDA, EBIT or net income.

We would use EV/EBITDA or EV/EBIT rather than market capitalization/EBITDA or market

capitalization/EBIT in valuing a company. EV is available to all the stakeholders of the company,
namely equity, debt and preferred, whereas market capitalization is available only to equity
holders. EBITDA or EBIT is also available to all the stakeholders of a company since it is
calculated before interest has been subtracted. Hence, both the numerator and denominator are
available to all the stakeholders. This measure is independent of capital structure and is helpful in
evaluating companies in the same industry with different capital structures.

We use the ratio market capitalization/net income, since market cap is available to equity holders
and net income is also available to equity holders since interest has been subtracted. Market
capitalization/net income is equal to the P/E ratio as described below:

Market Capitalization = Shares Outstanding × Share Price

Net Income = Shares Outstanding × Earning Per Share (EPS)

Market Capitalization Share Price P

= = E ratio
Net Income EPS
Chapter 15: Financial Modeling
Questions
Financial modeling is a critical skill for most finance positions including investment
banking, equity research, asset management, corporate banking, alternate asset
management positions such as hedge funds and private equity and corporate finance
roles in corporations. Interviewers focus on the following when asking questions on
financial modeling:
• Knowledge of financial modeling and excel demonstrated through professional
work experience in the past or in school
• Understanding of income statement, balance sheet and cash flow through
accounting questions discussed earlier as well as the ability to project the three
financial statements
• Advanced financial modeling concepts for a particular model. For example, an
interviewer could ask you to walk them through how you built a three statement
model, leveraged buyout model as well as an accretion dilution mergers and
acquisitions model

The following questions below focus on knowledge of financial modeling including

understanding the three financial statements

Why do we build a financial model?

A financial model consists of an assumptions worksheet comprising the key drivers of

the model. It also consists of a model worksheet which would include the historical and
projected income statement, balance sheet and cash flow statement. A financial model
enables us to conduct sensitivity analysis by changing assumptions and seeing the effect
on net income, EBITDA or any other relevant metric. A financial model is used by
various stakeholders as summarized in Exhibit 1.1.

Exhibit 1.1: Uses of Financial Model

Bank Evaluating whether a company can pay interest and

principal on time on a loan being offered
Chief Financial Decide whether to invest in a plant and see the effect of
Officer that decision on the three statements
Entrepreneur When his company runs out of cash and how they can
raise the cash from various constituents
Investment banker Value the company for various purposes including an
initial public offering, recapitalization or a mergers and
acquisitions transaction
Equity Research Analyst Provide a recommendation on a stock by various
methods including discounted cash flow analysis

1
How would you project revenues for a public or private company?

Companies need to project their revenues and ensure that their actual results are close to
the projected numbers. It depends on a number of factors including the industry and the
type of company. It is difficult to project revenues for early stage companies as well as
companies where the revenue may be dependent on successful completion of an event,
for example, an FDA approval of a drug for a biotech company. The following would
be helpful in projecting revenues for a company:

Historical revenue growth rates Analyze whether there is a declining trend or if we

should use an average. Average may not be appropriate for a high growth company since
when its revenues increase, the revenue growth rate is likely to decline in future years.
Acquisitions or divestitures in earlier years may make historical data not comparable, so
we would need to adjust for those events

Management guidance for public companies If a public company has given guidance
on revenues which is typically for the next two years, then it would be helpful in
projecting the revenues. For private companies, discussion and input from management
on customer contracts, sales pipeline and other indicators would be helpful in making
revenue estimations

Equity research reports for public companies We can take one analyst we deem
appropriate or an average of all the analysts’ projections, which we can get from data
sources like Thomson Reuters. Initiating research reports i.e., the first time an analyst
launches coverage on a company or detailed equity reports will break down the analyst’s
assumptions on the company model

Industry outlook Growth rate of the industry including end user demand of the
company product and market share of the company is helpful in making projections. We
need to sanity check these assumptions for example, if end user demand is growing 5%,
how are you projecting 20% growth for the company? Or if we project revenues to be
$1 billion in 3 years and the total market is $2 billion, is it realistic that the company can
capture 50% of the market?

Competitors in the industry Competitive advantages of the company compared to

peers which could in turn describe why your company is growing faster or slower than
the competition

Macroeconomic factors GDP growth of the country if it is a domestic business, and

inflation

How would you project the following when you are building an
integrated cash flow model: COGS, SG&A, Capex, Gross PP&E,
Retained Earnings?

2
There are various ways you can project a number of the items mentioned above and it
also depends on the industry and the type of company (cyclical business, etc.) but in
general, the following would be good ways to project the data:

Cost of goods sold (COGS) Historical margin data and trends Why are the margins
increasing or declining? Has the company changed its mix of products or services over
time, which affected its margins? Non-recurring items should be excluded from the
historical data. Management guidance for public companies, if available, and input and
discussions with management for private companies should be incorporated. Generally,
management will give guidance on revenues and EPS and not specifically for COGS

Equity research reports Generally, initiating research reports (the first time an analyst
launches coverage on a company) or detailed reports will break down the analyst’s
assumptions on the company model

Competitors in the industry Competitive advantages of the company compared to

others. COGS include both fixed costs such as factory overhead and variable costs such
as raw materials. If a company had more fixed costs in COGS, as revenues increase,
COGS as a percentage of revenues will decrease

Selling, general and administrative expenses (“SG&A”) It is similar to projecting

COGS. Selling expenses are both variable and fixed with salesman commission as an
example of variable cost and advertising expenses an examples of fixed selling costs.
G&A expenses are primarily fixed expenses. You can break SG&A into two parts.
Selling expenses can be projected based on revenues while G&A expenses can be
projected based on a growth rate such as inflation

Capital expenditures (“Capex”) Capex is generally two types. Maintenance Capex is

required to sustain a base level of growth. Expansion Capex is required to add capacity
and can include large one-time outlays. Though Capex will increase with additional
revenues, the fixed component of Capex will make it increase in a different proportion

Gross property, plant and equipment (“PP&E”) Gross PP&E on the balance sheet
can be projected as last year’s Gross PP&E plus this year’s Capex minus the sale of
assets this year

Retained earnings This year’s retained earnings can be projected as last year’s retained
earnings plus net income after dividends or minus net losses for the year

What are a revolving credit facility and a term loan? How are they
different?

A revolver or revolving line of credit facility is a type of loan where the borrower can

3
draw the loan and repay it at any time at the option of the borrower. It is secured by the
borrowing company’s accounts receivable and inventory. It provides liquidity and
enables a company to get its cash flow earlier for working capital purposes that having
to wait for its receivables to be paid or for inventory to sell and become accounts
receivable. Companies take on a revolver when they cannot obtain an unsecured loan in
addition to the company’s cash flow to service their working capital. Revolvers are given
for a period of one to three years or longer.

Term loans are loans generally given by banks for one to ten years in duration. They are
generally secured by the fixed assets of the borrower and are used to finance the longer
term needs of the company such as purchase of capital assets. They have a fixed payment
schedule over the period of the loan which includes interest and a part of the total loan
balance which has not yet been paid called principal. Interest is calculated on the unpaid
balance of the loan. Mortgages and certain student loans are also examples of term loans
in the U.S.

The key differences between a revolver and term loan are:

Security Revolvers are secured by current assets such as accounts receivable and
inventory whereas term loans are secured by fixed assets of the company such as
property, plant and equipment

Use of funds Revolvers are used to finance working capital needs of the company
whereas term loans are used to finance longer term needs of the company such as capital
expansion

Loan balance Revolver loan balance can fluctuate on a daily basis. Once the company
has taken a revolver, it can borrow, repay and then borrow again over the period of the
loan. Term loan balances are fixed for a period that could be a few months to several
years and the company cannot borrow again once it has paid down the term loan

What is the difference between a term loan and unsecured debt or

bonds?

We have summarized the key differences between term loans and unsecured debt below
in Exhibit 1.2.

Exhibit 1.2: Differences between Term Loan and Unsecured Debt

Term Loans Unsecured Debt

Security Secured (first priority of
receiving claim in
bankruptcy filing), lower
interest rate than unsecured
debt. Generally floating
Unsecured, don’t have collateral.
Higher interest rate than term loan
and fixed coupon rate. Lower priority
in terms of satisfaction in bankruptcy

4
 interest rate loan filing than secured loan
Maturity Shorter maturity than Longer term maturities (e.g., 7, 10, 15
unsecured. Generally given and 30 years)
by banks for 5-7 years
Principal Terms loans get amortized. Bullet repayment at maturity so bonds
Repayment That is, the principal amount do not get amortized
gets paid/reduced every year
as per agreement between
borrower and bank

How do you model the revolver paydown or drawdown in the model?

What is the circular reference in the model?

The revolver is the account used to integrate the income statement, balance sheet and
cash flow statement. Mechanically, the way the model works is as follows:

• If cash flow produced during the period (before any revolver paydown or
drawdown) + the beginning cash balance is greater than 0, then any excess cash
is used to paydown the revolver balance. The amount of the paydown is the
minimum of the beginning revolver balance or the cash flow + the beginning
cash balance
• If cash flow produced during the period (before any revolver paydown or
drawdown) + the beginning cash balance is less than 0, the cash deficit will be
funded by a drawdown on the revolver. The amount of the drawdown is the
amount of the cash flow deficit in this model

In reality, there is a revolver availability based on a borrowing base formula calculated

as a % of eligible accounts receivable + eligible inventory. For the purposes of modeling
the revolver, the cash flow produced during the period = cash flow from operations +
cash flow from investing activities + cash flow from all financing activities except the
revolver

As the calculation of the revolver drawdown/paydown, revolver ending balance, and

interest expense is a circular reference, you need to set your computer to the proper
setting
• On the “Tools” bar, go to “Options”, and “Calculation”, and click “Iterations”
• We have intentionally told Excel not to mention the circular reference by doing
the above step
• Circular reference is when one number is dependent on another number in the
formula (e.g., A1 = A1 + A2)

5
Chapter 16: Discounted Cash Flow
Analysis Q&A
“To properly value a business, you should ideally take all the flows of money
that will be distributed between now and judgment day and discount them at
the appropriate discount rate. That’s what valuing businesses is all about.
Part of the equation is how confident you can be about these cash flows
occurring. Some businesses are easier to predict than others. We try to look
at businesses that are predictable.”
– Warren Buffett
Discounted cash flow (DCF) questions are important for almost all types of finance jobs.
These include investment banking, buy and sell side research, asset management and
alternate asset management jobs such as hedge funds and private equity. A typical
interview will likely involve questions on valuing a company using the DCF valuation
method, with a specific focus on the following:

• Knowledge of the DCF valuation method and ability to explain the method in
a concise way
• Understanding of the important components of DCF including unlevered free
cash flow, weighted average cost of capital and terminal value
• Understanding of the challenges of the DCF valuation method and its pros and
cons
• Practical application of the DCF valuation method for various types of
companies and scenarios such as cyclical companies and negative earnings

The questions below are intended to test the interviewee’s knowledge of DCF and its
key components, including unlevered free cash flow, weighted average cost of capital
and terminal value

Walk me through a discounted cash flow analysis.

This is a very common question in finance job interviews. DCF analysis values a
company or business based on the “net present value” (NPV) of the company’s future
cash flows. When answering this question, it is recommended that you describe the steps
in the analysis in a concise manner, as given below. When you have done so, ask the
interviewer if he or she would like you to explain the steps in greater detail. In order to
perform a DCF analysis, the following steps need to be completed:
 Step 1: Calculate and Calculate and then project the unlevered free cash flows to infinity
project unlevered free since we assume that the company is a going concern. 1 However,
cash flow since we cannot project the cash flows to infinity, we project free cash
flows for a period of five or 10 years, or until the company reaches a
steady state of growth.
Step 2: Determine the Weighted average cost of capital or (WACC) is a weighted average
WACC after-tax cost or required rate of return for different sources of capital
for a company, i.e., debt, preferred and equity.
Step 3: Calculate the Terminal value is the value of the company at the end of the projection
terminal value period, which could be Year 5 or Year 10 or when the company
reaches a steady state of growth. For example, if we project free cash
flows for five years, the terminal value is the value of the company at
the end of Year 5 or the value of the cash flows from Year 6 to infinity
at the end of Year 5.
Step 4: Calculate the Calculate the present value of the projected free cash flows and the
present value of the terminal value at the appropriate discount rate, i.e., WACC. Add the
cash flows and add present value of all the cash flows to get the enterprise value of the
them to get the company.
enterprise value of
the company

Step 5: Calculate Since enterprise value = equity value + debt + preferred – cash, equity
stock price for a value = enterprise value – debt – preferred + cash. Divide equity value
public company by the fully diluted shares outstanding to get the stock price of the
company.

How do you calculate the unlevered free cash flow of a company?

Unlevered free cash flow represents the cash flows available to all capital providers or
stakeholders, i.e., debt, preferred and equity holders, after operating and investing
activities have been accounted for. It values the company as a whole before interest
payments on the debt have been made and hence is independent of the capital structure.
We predict the unlevered cash flows for five to 10 years since predicting cash flow
beyond 10 years would be challenging for most companies and predicting cash flow for
less than five years would be too short a horizon to be useful. Unlevered free cash flow
equals:

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑜𝑟 𝐸𝐵𝐼𝑇

𝐿𝑒𝑠𝑠: 𝑇𝑎𝑥𝑒𝑠
𝐿𝑒𝑠𝑠: 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒/(𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒) 𝑖𝑛 𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
Add: Depreciation and Amortization and Other Non-Cash Expenses

1 The going concern principle assumes that the company will remain in business for the foreseeable future.
We start from EBIT because we want the unlevered free cash flow, and EBIT is
calculated before interest expense is subtracted; therefore, it is available to all
stakeholders, namely debt, preferred and equity holders. The value of the company we
will get when we start from EBIT will be the enterprise value of the company.

Tax rate is the company’s marginal tax rate. In the U.S., we assume it to be 35% or 40%.
Change in the working capital is the increase or decrease in working capital from the
prior year. An increase in working capital is a reduction of cash flow and a decrease in
working capital is the reverse. Capital expenditure is subtracted as it is a use of cash.
Depreciation and amortization are added since they are non-cash charges.
What taxes do you take into account in calculating free cash flows?

The marginal tax rate is the tax rate on the next dollar or incremental amount of income.
It is calculated by dividing the additional taxes by the income involved. The effective
tax rate is calculated by dividing the actual total tax that a company pays by its total
income. It is generally lower than the marginal tax rate since a company can claim
certain deductions and tax credits and also because the tax structure is tiered with initial
income being taxed at a lower rate. We use marginal taxes in DCF analysis since we
assume that the company will not be able to get the deductions and tax credits in the
future. We can subtract effective taxes for a few years if we know that a company can
get those deductions and credits, but it is not advisable to assume those deductions or
credits in perpetuity.

In DCF, we tax operating income or EBIT and not earnings before tax. We do not use
actual taxes paid since they are calculated after interest expense has been subtracted and
reflect the savings on taxes because of interest expense. In our cost of capital or WACC
calculation, we take the tax savings into account since the cost of debt is after tax. If we
increase our numerator, i.e., the cash flows, for the same reason, we would be double
counting the tax benefits.

Why do we subtract the increase in working capital and add the

decrease in working capital when calculating free cash flow?
When calculating the free cash flow for DCF purposes, we calculate the net working
capital, which highlights the cash a company requires to finance its ongoing operations.
It is defined as:

Current Assets less Cash and Marketable Securities

NWC = Minus
Current Liabilities less Short-term Interest Bearing Debt

o NWC = Net working capital

We subtract cash and marketable securities since they earn a return as opposed to other
current assets such as inventory and accounts receivable, which do not earn a return.
Also, debt which includes short-term debt and the short-term portion of long-term debt
is taken out of the equation since we will include it to calculate the cost of capital for the
company and do not need to show it twice.

Companies that manage working capital well can decrease their net working capital and
increase their free cash flow. Companies that can reduce their inventory or collect their
receivables more quickly, and hence decrease their receivables will be able to generate
more cash, which can be used to grow the business and enable balance sheet flexibility.
We need to be careful here because decreasing net working capital is not always in the
best interest of the company since too little inventory can affect its operations. Also,
delaying payments to suppliers can signal that the company is not doing well and may
be in distress.

How do you calculate the terminal value of a company?

There are two methods for calculating terminal value, namely the Gordon growth model
or the perpetuity growth method and the terminal or exit multiple method.

In the perpetuity growth method, we choose an appropriate rate by which the company
can grow forever after we have projected the company’s cash flow for five years or 10
years or until the company reaches a steady state of growth. The chosen growth rate
should be modest, for example, we can use the average long-term expected rate of GDP
growth or inflation since companies cannot grow at a high growth rate in perpetuity. To
calculate the terminal value, we multiply the previous year’s free cash flow, e.g., Year
5 or 10, by 1 plus the chosen growth rate, and then divide by the discount rate less the
growth rate.

FCFn ∗ (1 + 𝑔)
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
(𝑟 – 𝑔)

o FCFn = free cash flow of the last projection period, typically year 5 or
year 10
o g = perpetual growth rate
o r = discount rate or weighted average cost of capital

The second method, i.e., the terminal multiple or exit multiple method, is the one that is
more often used in investment banking. Here, we take an operating metric such as
EBITDA, EBIT or revenues for the last projected period in our free cash flow forecast,
which could be Year 5 or Year 10, and multiply it by an appropriate valuation multiple
from comparable companies. The most common metric used is EBITDA, and we
typically select the last twelve months (LTM) enterprise value/ EBITDA multiple.

The terminal value is then discounted back along with other cash flows to get the present
value or enterprise value of the company. An example of a DCF where cash flows have
been projected for 5 years is given below:
 FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + TV
PV =
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5

o PV = present value of all the cash flows including terminal value

o FCF1 = free cash flow at year 1
o TV = terminal value at the end of year 5
o r = discount rate or WACC
o (1 + r)1 = discount factor for year 1 cash flows

What are the challenges of using the Gordon growth model or

perpetuity growth method and the terminal or exit multiple method
when calculating terminal value?

Both the Gordon growth model or perpetuity growth method and the terminal multiple
method have drawbacks as they are based on certain assumptions. We need to do a
sensitivity analysis to see how the value of the company will change when we change
the terminal growth rate or the EBITDA multiple.

In the perpetuity growth method, the value of the company is hypersensitive to the
chosen terminal growth rate. It is difficult to predict the growth rate at which the
company is expected to grow to infinity. We generally assume a growth rate of between
2% and 4%, depending on GDP growth, inflation, the company growth’s rate and the
growth of the industry. Further, once we have selected a growth rate, we assume that it
will stay constant in perpetuity, which is not the case. Finally, the equation to calculate
terminal value using the perpetuity growth rate method assumes that the steady growth
rate will be less than the WACC since the equation will not work if that is not the case;
yet this assumption may not always be correct.

For the terminal multiple method, the terminal multiple we get is from comparable
companies, and we know that it is difficult to find suitable comparable companies.
Moreover, the multiple we use is the LTM enterprise value/ EBITDA multiple, and we
apply the LTM multiple in Year 5 or 10 to calculate the terminal value in that year. It is
difficult to predict how much the multiple will change in 5 or 10 years, and hence, in
most cases, we assume the multiple will remain the same. We may need to make an
adjustment to the LTM multiple for a number of reasons, say, for instance, if the current
market has a bullish or bearish sentiment or if the comparable companies are growth
companies and have a high current LTM multiple. Further, since we use a multiple from
comparable companies to calculate terminal value, the terminal multiple method make
the DCF valuation similar to the comparable company relative valuation.

We may want to use the perpetuity growth rate method if the company we are valuing
does not have appropriate comparable companies, or if we expect the terminal multiple
to change significantly over the next five to 10 years. It is advisable to use both methods
and examine the results as a sanity check. For example, at a 3% growth rate, what
terminal multiple do we get? Or if the multiple is 8x, what is the implied growth rate? If
either of the values seem high or low, you can adjust the multiple or growth rates used.
You can use the “goal seek” feature in Excel to perform this sanity check.
When using the terminal or exit multiple method, when will we assume that the
EBITDA multiple for the terminal year may be less than what the company is
currently trading at?

We will assume a lower EV/ EBITDA multiple than their current multiple for the terminal year in
five or 10 years for a growth company. We expect a company’s growth rate to decline as more
competition enters the market, and as the company or the industry in which it operates becomes
more mature. Since growth companies trade at higher multiples than mature companies, as their
growth declines, their multiples will also decline accordingly.

Explain weighted average cost of capital (WACC).

The weighted average cost of capital or (WACC) is the weighted average after-tax cost
or required rate of return for different sources of capital for a company, i.e., debt,
preferred and equity. WACC is the discount rate used in a DCF analysis to present value
projected unlevered free cash flows and terminal value to get the enterprise value of a
company. The WACC formula takes into account the cost of each type of source of
capital weighted by the respective percentage of the sources of capital in the capital
structure of the company:

𝐸 𝑃 𝐷
𝑊𝐴𝐶𝐶 = [𝐾𝐸 ∗ ( )] + [𝐾𝑃 ∗ ( )] + [𝐾𝐷 ∗ ( ) ∗ (1– 𝑇)]
𝐸+𝐷+𝑃 𝐸+𝐷+𝑃 𝐸+𝐷+𝑃

o KE = cost of equity
o KD = cost of debt
o KP = cost of preferred
o E = market value of equity of the subject company
o D = fair market value of debt (we generally assume same as book value
unless distressed) of the subject company
o P = value of preferred
o T = tax rate

The cost of debt is based on the market value of the debt and can be calculated as
explained below. Cost of preferred is higher than debt since it is below debt in the capital
structure, i.e., if a company goes bankrupt, debt gets paid first, then what is left goes to
preferred equity, and finally, the remaining proceeds go to equity holders. Interest on
debt is paid before taxes but preferred dividends are paid from the after-tax profits of
the company. Cost of preferred is calculated by finding the dividend yield on the current
preferred stock of the company. Dividend yield is calculated by the preferred dividend
divided by the market price of the preferred stock. If the market price of the preferred
stock cannot be easily found, we can use the dividend yield of comparable companies.
Cost of equity can be calculated using the capital asset pricing model described in detail
below.
How do you calculate the cost of equity?
The cost of equity is calculated using the capital asset pricing model (CAPM)

𝐶𝐴𝑃𝑀 = 𝑅𝑓 + 𝛽(𝑅𝑚 – 𝑅𝑓 ) + SP

Rf = risk-free rate is the 10-year, 20-year or 30-year rate on a riskless security, for
example, the Treasury bond in the U.S. Investment banks generally use a 10-year yield
on the U.S. Treasury bond. We can use longer-term instruments since we assume that
the company is a going concern and that its cash flows are in perpetuity. 10-year
Treasury bond securities are more liquid than some of the longer dated maturities, and
hence, from a practical view, we use the 10-year rate.

Rm = market rate i.e., the expected return on the market portfolio.

Rm – Rf = market risk premium, i.e., the return above the risk-free rate.

Market risk premium is calculated by taking an arithmetic average of the difference

between the expected market return, i.e., S&P 500 in the U.S., over the risk-free rate for
a particular period. It is usually calculated by taking an average of data points over many
years in order to incorporate a large sample of events, although some people look at
more recent returns over a 10-year period. For example, Ibbotson Associates, a company
specializing in providing products for the investment community, calculates a market
risk premium of 7.1% for the 1926-2007 period. Investment banks use one number to
ensure consistency in valuation work across the bank, and this ranges between 5-7.5%
depending on the time period chosen and the methodology used by the bank.

β = levered beta, and we can get it from Bloomberg, Thomson Reuters or other financial
information providers. Beta is the measure of the volatility or covariance of the return
on a security compared to the market as a whole, i.e., systematic risk. S&P 500 is used
in the U.S. as a proxy for the overall market.

SP = Size premium is based on empirical evidence that smaller companies are riskier
and hence should have a higher cost of equity. Ibbotson provides size premium, which
we can add to the CAPM formula.
How do you calculate the cost of debt?
The cost of debt is the interest rate at which the company can borrow for the long term
today. It is not the cost of debt or interest the company is paying for the debt it has
borrowed in the past and shown on its balance sheet. The cost of debt is calculated on
the market value of the debt and not on its book value. For publicly traded debt, it will
be the weighted average of the current yield on the different types of debt the company
has. Current yield is the annual coupon on the par value of the bond divided by the
current price of the bond. The company’s coupon does not reflect the cost of debt in the
current market conditions.

We use the (1–tax rate) for debt in the WACC formula since interest expense is tax
deductible, hence, the effective cost of debt is K D*(1–T). For debt where market prices
are not easy to find or in the case of private debt, we can take the prices of comparable
public companies with similar ratings to the debt we are trying to value.

The following questions focus on the challenges of the DCF valuation method, its pros
and cons and its practical application for different types of companies and scenarios.

When using the CAPM to calculate WACC, why do you have to unlever
and then relever beta?

We generally unlever and lever the beta for two reasons: (i) to calculate the beta for a
private company and (ii) to change the capital structure of a public company.

Beta is the measure of the volatility or covariance of the return on a security compared
to the market as a whole, i.e., systematic risk. S&P 500 is used in the U.S. as a proxy
for the overall market. A beta of 1 signals that the stock should have an expected return
similar to the market or that a 1% rise in the market translates into a 1% rise in the stock.
A beta of less than 1 signals lower systematic risk or lower volatility than the market.
A stock with a higher beta than 1 signals that it has higher systematic risk and volatility
than the market, which results in a higher cost of equity.

For example, a beta of 1.3 means that the stock is 30% more volatile than the market; in
other words, if the market goes up by 1, the stock will rise by 1.3 and if the market goes
down by 1, the stock will go down by 1.3. Higher beta stocks are more volatile and hence
riskier. Since they carry a higher risk, they also have the potential to provide higher or
lower returns than the market. Stocks in sectors such as utilities, healthcare and
consumer staples have low betas.

In the following example, we calculate the beta of a private company. We need to

calculate the beta to determine the cost of equity for a private company using the CAPM
since private companies do not trade in the stock markets. We obtain the betas of
comparable companies to calculate the beta for a private company. In order to make an
“apples to apples” comparison, leverage needs to be removed from the betas of these
comparable companies; hence, we must first unlever the beta of each of our comparable
companies. Sources such as Bloomberg provide levered betas, so we need to unlever the
beta by using the formula below to make the conversion.

𝛽𝐿
𝛽𝑈 =
(1 + 𝐷(1– 𝑇))
E
o 𝛽𝑈 = unlevered beta
o 𝛽𝐿 = levered beta
o D/E = debt/equity ratio
 o T = marginal tax rate

After unlevering the betas, we can now use the appropriate comparable company beta,
which could be the mean or median of the unlevered betas of the comparable companies.
Since we need a levered beta for the CAPM, we will need to relever the beta again.

𝐷
𝛽𝐿 = 𝛽𝑈 ∗ (1 + ∗ (1– 𝑇))
𝐸

To get the debt and equity of the private company, we use its target capital
structure. After relevering, we can use the levered beta in the CAPM formula to
calculate the cost of equity for the private company.

Which is typically higher, the cost of equity or the cost of debt and why?
What kind of a curve would WACC have if you showed it on a graph?

The cost of equity is higher than the cost of debt. First, debt-holders are paid before
equity holders in the event of liquidation, so the returns equity holders expect should be
higher since they bear greater risk. Debt is less risky than equity since debt holders are
paid interest that is a fixed obligation for the company. Interest is paid before dividends
are given to equity holders and dividends are discretionary. Secondly, interest on the
debt is tax deductible and therefore lowers the cost of debt for the company. Companies
do not get tax benefits from dividends since they are paid after taxes have been
subtracted.

WACC would have an upward sloping curve. When a company will issue debt, it will
lower the overall cost of capital for the company since debt is cheaper than equity. If we
use too much leverage, the financial risk of the shareholders will increase, for example,
the dividend paid to them becomes more volatile as interest needs to be paid prior to any
dividend. Since shareholders risk increases, they would want to be compensated for this
higher risk through a higher return and hence will result in a higher cost of equity and
WACC.

Further, a company taking on too much leverage will also result in it having a greater
probability of default on its debt and hence the possibility of bankruptcy. Both
shareholders and debt-holders will demand a higher return for this increased risk of
bankruptcy that will increase the WACC.

We have summarized the upward sloping curve below in Figure 1.1. As you see, initially
due to cheaper debt, the WACC falls and reaches an optimum point Z where WACC is
the lowest. As debt continues to increase, the cost of equity increases at a higher rate
and ultimately leads to an increase in the cost of debt also.
Figure 1.1 Upward Sloping WACC Curve
What is a negative beta and can we have a negative beta?

A negative beta means that the investment goes up when the markets go down and vice
versa. Yes, we can have a negative beta. Gold is an example of a negative beta over the
short term. Gold is often seen as a hedge against inflation, thus, when there is inflation,
stocks and bonds go down, but gold prices go up. A put option on the stock, which
provides the owner of the put the right but not the obligation to sell the stock by a
predetermined date at a specific price, is another example of a negative beta.

Some stocks, such as gold mining stocks, may have negative betas for some time. We
assume that stock markets will rise over the long term, therefore, if a stock has a negative
beta over a longer period, say, 20 to 30 years, the stock will most likely go bankrupt if
it goes against the market.

What percentage of the value in a DCF comes from the terminal value?

One of the drawbacks of a DCF analysis is that a major part of the value of a company
comes from its terminal value. This is based on multiples from comparable companies
or on a constant growth rate which is difficult to predict in perpetuity. We could get
50%-75% of the total value of a company from its terminal value. If we get a number
higher than 75% of the total value from its terminal value, we may want to consider
projecting the cash flows for a longer period and checking the assumptions we have
made in the DCF model.

We should ensure that the terminal year represents an average year and does not include
any non-recurring items. We should as a sanity check use the terminal value we get using
the perpetuity method to determine the implied equivalent EBITDA exit multiple. We
can compare the multiple to industry multiples and see if those are reasonable and if not
make adjustments to the perpetuity growth rate. Also, if we used the terminal multiple
method to get the terminal value, we can test its reasonableness by determining the
implied perpetuity growth rate. We can see the growth rate we get is according to
industry standards for perpetuity growth rates and if not make adjustments to the
multiple, if required.

What would you sensitize in your DCF at the end of your model? Why do we
do this?

DCF model is based on a number of assumptions. The three critical assumptions are forecasting
free cash flows, WACC or discount rate and the terminal growth rate or terminal multiple used to
calculate terminal value. At the end of the model it is good to see how the EV of the company or
the stock price will change if we change the terminal growth rate and the WACC of the company.
For example, if the model has a WACC of 9% and a terminal growth rate of 3%, we may want to
sensitize the model and see how the EV of the company will change for WACC ranges of 8%-
10% and terminal growth rates of 2%-4%. We can also change the 5 year or 10 year projections.
Generally, when we build projections, we will have a base case scenario that is generally what the
management and the bankers have decided are appropriate projections of the company. We can
also have an upside scenario given that the company grows faster and also a downside scenario
assuming the growth of the free cash flows is slower that the base scenario.

We have provided below an illustrative 5-year DCF model. In the sensitivity table, we have
shown how the EV of the company will change when you change the growth rate and the
discount rate of the company.
Table 1.1: ABCCo Discounted Cash Flow Model

($ in millions except per share data)

Terminal Value
ABCCo Discounted Cash Flow Model

Fiscal Year Ending December 31,

2016P 2017P 2018P 2019P 2020P

Net sales $ 126.0 $ 132.3 $ 138.9 $ 145.9 $ 153.2

EBITDA 69.3 72.8 76.4 80.2 84.2

EBIT 62.2 65.5 68.9 72.6 76.4

2020 Unlevered FCF $ 42.5
Less: Taxes 24.9 26.2 27.6 29.0 30.5
Terminal Growth Rate 3%
Less: Capital Expenditures (8.8) (9.3) (9.7) (10.2) (10.7)
Terminal Value $ 486.7
Less: (increase)/decrease in Working Capital 0.6 (0.4) (0.4) (0.4) (0.4)

Plus: Depreciation and Amortization 7.1 7.3 7.5 7.7 7.9 Discount Period 5.00

Unlevered Free Cash Flow $ 36.2 $ 36.9 $ 38.7 $ 40.6 $ 42.5 Discount Factor 0.57

Discount Period 1.0 2.0 3.0 4.0 5.0

PV of Terminal Value $ 276.2
Discount Factor 0.9 0.8 0.7 0.6 0.6

Present Value of Unlevered Free Cash Flow $ 32.3 $ 29.4 $ 27.5 $ 25.8 $ 24.1

Total Enterprise Value $ 415.4 Terminal Growth Rate

Less: Net Debt 50 2% 2.5% 3.0% 3.5% 4.0%

Equity Value $ 365.4 10% $ 483.3 $ 507.5 $ 535.1 $ 567.1 $604.3

Shares Outstanding (in millions) 20 Discount Rate 11% $ 428.8 $ 447.2 $ 467.8 $ 491.1 $517.8

Value Per Share $ 18.3 12% $ 385.3 $ 399.6 $ 415.4 $ 433.0 $452.9

13% $ 349.7 $ 361.0 $ 373.5 $ 387.2 $402.4

14% $ 320.1 $ 329.2 $ 339.2 $ 350.1 $362.1

DCF Assumptions

Tax Rate 40.0%

Discount rate 12.0%

Terminal Growth Rate 3.0%

Valuation Date 12/31/2015

Can you use a 2%-4% growth rate for calculating terminal value under
the perpetuity growth method if you were using the DCF method to
value an oil well?

You would not use the standard 2%-4% growth rate for calculating the terminal value
of an oil well using the perpetuity growth method as the growth rate of the cash flows
would not continue in perpetuity because of the limited life of the oil well.

How would you do a DCF valuation for a cyclical company?

Cyclical companies are typically in industries that follow economic cycles, such as the
automobile, steel, housing and airline industries. Their profits tend to be more dependent
on the economy than on the characteristics of the company. When the economy is doing
well, these companies post high profits and when the economy is in a recession, their
profits fall. DCF valuation is dependent on a number of assumptions such as the existing
free cash flow, growth in the cash flows, WAAC and terminal value. Further, the
cyclicality of the company makes DCF valuation even more challenging and dependent
on a number of subjective assumptions.

For cyclical companies, the first step would be to see where the company is in its cycle,
i.e., at the top of the cycle when the economy is doing well, at the bottom or at the mid-
point of the cycle. Cyclical companies generally have high fixed costs and hence their
earnings fluctuate significantly depending on the economy and the stage of the cycle
they are in. We estimate a normalized complete cycle, which could range from five to
10 years depending on the industry and company, and project the cash flow for the entire
cycle. Since a significant value of DCF is based on terminal value, we ensure that the
terminal year value we calculate using either the exit multiple method or perpetuity
growth rate is based on normalized earnings. Since average revenues over the cycle may
not work for a company with growing revenues, we can take the revenues of the terminal
year and multiply it by the average operating margins for the cycle to get normalized
operating income.

How would you do a DCF valuation when net income and operating income
are negative for a company?
We should not use negative earnings as the base year to project cash flows when doing
a DCF valuation. We need to understand the reasons for the negative earnings, such as
whether it is due to some temporary issues facing the business or to some permanent,
long-term problems facing the company or the industry. For example, a start-up
company may have more initial costs and generally will have negative earnings for a
few years, or a business could have certain non-recurring, one-time charges.

We need to project the cash flow until the earnings become positive and are normalized,
or the EBIT margin, which is operating income divided by revenues, becomes stable.
Normalized EBIT can be used for calculating terminal value by using the terminal
multiple method or the perpetuity growth method.

How would you treat net operating losses (NOL) in a DCF valuation?
NOL are tax credits that can be used to reduce income. In the U.S., we can carry NOL’s
forward 20 years to reduce taxable income in the future, and also they can be carried
back 2 years to reduce prior year taxes. NOL’s are not included in unlevered free cash
flow since we calculate UFCF using marginal tax rates and not effective tax rates. The
marginal tax rate does not take into account the value of the NOL’s. NOL’s savings are
for a finite amount of time and they are of less risk than the company’s cash flow into
perpetuity and hence it needs to be calculated separately and added to the value of the
enterprise.

We project the NOL’s taking into account their expected utilization based on the net
income of the firm in future years. For calculating the WACC, we need to take into
account the probability that the company will be able to have sufficient net income in
the future to use the NOL’s and hence the greater the probability of utilizing the NOL’s
the lower the WACC.

What are some of the pros and cons of the DCF valuation method?

The DCF method has a number of advantages as outlined below:

• DCF is forward looking and based on a company’s future cash flows in

perpetuity. It is a fundamental valuation methodology as compared to relative
valuation, which projects only a year or two into the future
• Fluctuations in the capital markets have limited impact on a DCF valuation
• It is helpful when there are no suitable comparable companies available for
valuation
• DCF enables you to value an independent company, a division or subsidiary
within a company and synergies in a mergers and acquisitions transaction
• The DCF model enables us to do a sensitivity analysis and see how the value of
the company changes in response to changes in operating metrics and in key
assumptions. These include changes in the free cash flow or revenue growth
rates, costs, capital expenditures, increase and decrease in working capital,
terminal growth rate and WACC
• Since we are considering cash flow in DCF, there is limited impact on the
different accounting approaches to income recognition

DCF has a number of drawbacks, as given below:

• DCF valuation provides the best results when you can forecast cash flows into
the future, and it is challenging to do that beyond a few years
• DCF is extremely sensitive to its assumptions, namely cash flow, terminal
growth rate or terminal multiple and WACC
• Terminal value represents a significant part of the total value of the company
• DCF assumes a constant capital structure, which will not be the case for the
company in the future
Chapter 17: Leveraged Buyout
Q&A
“Look, don't congratulate us when we buy a company, congratulate us
when we sell it. Because any fool can overpay and buy a company, as long
as money will last to buy it”
– Henry Kravis
Leveraged buyout (LBO) questions are important not only for private equity (PE)
positions but also for interviews for investment banking and internal mergers and
acquisitions positions in corporations. The ability to build and interpret an LBO model
is a critical skill that will lead to a successful career in these fields. Interviewers test job
candidates on the following when asking LBO questions:

• Familiarity with how an LBO works, including the major players in the industry
• Ability to build an LBO model and understand the key inputs in the model
including being able to do numerical questions based on their understanding of
the model
• Insight into recent transactions in the industry and the key terms of those
transactions

The questions below explain how an LBO works and what characteristics make a target
attractive to a PE firm.

What is a leveraged buyout?

We can explain an LBO in the three steps mentioned below:

Step 1: Acquisition of the target including financing the transaction An LBO is the
acquisition of a company or a division of a company using a significant amount of debt
to finance the cost of the acquisition. The acquired company can be private or public.
The PE firm tries to take on as much debt as possible because the higher the leverage,
the higher the potential return to the PE firm.

The PE firm arranges the debt from banks and other investors and puts in equity in the
company. The assets of the company being acquired are used as collateral or security
for the debt. The debt is given by banks and other providers of capital to the company
being acquired and is non-recourse to the PE firm, i.e., the lenders cannot go after the
personal assets of the PE firm if the company cannot pay off the debt. The typical ratio
in an LBO is 60%-80% debt and 20%-40% equity. The ratio is dependent on the
company’s cash flow, the industry the company is in, and the state of the debt markets.
Step 2: Operational restructuring The PE firm also implements operational
improvements to the company after the acquisition which enhances returns to the PE
firm.

Step 3: Exit strategy The typical exit strategy in an LBO is an exit in three to five years
via an initial public offering (IPO) or the sale of the company to strategic or other PE
investors.

Major leveraged buyout PE firms include Apollo Global Management, Bain Capital,
Blackstone, The Carlyle Group, Goldman Sachs Private Equity, KKR, Silver Lake
Partners and TPG Capital.

What are some characteristics of a target that make it attractive to a

PE firm?

The characteristics of a good LBO target include:

• Stable and predictable cash flows, which are important for paying interest and
principal payments on debt
• Limited need for ongoing capital expenditures or working capital investments
• Opportunity for the PE firm to pursue expense reductions and improvements in
operational efficiencies to enhance profitability
• Attractive valuation so that the PE firm can buy the company cheaply and sell it
at a higher price when it exits
• Strong market position and competitive advantage, which create barriers to entry
and also make cash flows predictable
• High tangible asset base to use as collateral for the debt
• Balance sheet with little debt so that the PE firm can lever up the company
• Assets available for divestiture, which can be used to reduce the debt
• Growth opportunities, either organic or through acquisitions, that enable growth
to result in high returns for PE firm
• A defined exit strategy, whether it is an IPO or a sale
• Opportunities for synergy with portfolio companies. PE firms have become so
large that they have other companies in their portfolio and can get synergies
similar to the strategic buyers
• Strong management team, given the need to operate under a highly leveraged
scenario; if the management team is not competent, the PE firm will replace it
with its own team

What are some exit strategies for a company that has gone through an LBO?
The PE firm will try and exit its investment through a sale or an IPO. It can also realize
some of its investment by executing a dividend recapitalization. These three scenarios
are summarized below:
Sale PE firms can sell the company to a strategic buyer. They could also sell the
company to another financial buyer who may choose to do another leveraged buyout if
the debt markets are favorable. When a PE firm sells to another PE firm, it is called a
secondary buyout. This could provide the PE firm with an earlier opportunity for a
liquidity event than an IPO if market conditions do not favor an IPO or if there aren’t
many strategic buyers for the company. Breaking up the company into parts and selling
parts of the company to different buyers could be one sale strategy but this may not
constitute a full exit.

Examples of PE sales include Warburg Pincus selling Bausch & Lomb, a maker of
contact lenses, lens care products and surgical devices, to Valeant Pharmaceuticals
International for $8.57 billion in cash in May 2013. In September 2013, PE firms Ares
and the Canada Pension Plan Investment Board acquired Neiman Marcus, a luxury
specialty department store in a secondary buyout from PE firms TPG and Warburg
Pincus for $6 billion.

Initial Public Offering (IPO) results in part of a company’s shares being sold to the
public. PE firms will be able to realize a partial exit through the IPO and in some cases
may be able to sell all their shares in the IPO. Dollar General, the discount retailer, was
purchased in 2007 by a group of private equity investors including KKR and went public
in November 2009. SeaWorld Entertainment, the theme park operator, went public in
April 2013. In late 2009, the PE firm Blackstone acquired SeaWorld from Anheuser-
Busch for about $2.3 billion.

Dividend recapitalization PE firms can change the capital structure of the company by
taking on additional debt to pay themselves a dividend. For example, in two to three
years, the bank may give the company more debt if the company can support that debt.
This could happen if the company pays down some of the initial debt and thereby lowers
its total debt/EBITDA ratio and increases its EBITDA/interest expense ratio. While it
is not a true exit strategy, a dividend recapitalization allows the PE firm to retain full
ownership in the company and increases the PE firm’s internal rate of return (IRR) since
it received cash out earlier from the company.

Examples of dividend recapitalization include car rental company Hertz Corp. raising
debt to pay a $1 billion dividend to PE firms Clayton Dubilier & Rice, Carlyle Group
and the buyout arm of Merrill Lynch in late 2006, just a few months after its $13 billion
buyout. Burger King paid its private equity backers Bain Capital, Goldman Sachs Group
Inc. and TPG Capital a $367 million cash dividend in 2006, a short while before it went
public1.
What are some positive characteristics of leveraged buyouts?

1 Jennifer Rossa, “The Ghost of Dividend Recaps Past,” Private Equity Beat, The Wall Street Journal, 21 Aug. 2009.
There are a number of reasons why leveraged buyouts are useful to companies and
investors:
No distractions of being a public company Since companies are taken private after an
LBO, they do not have to constantly meet short-term quarterly goals, which is important
to the Wall Street investment community and can focus instead on a longer time horizon.
Management is not distracted by regular meetings with equity research analysts and
shareholders.

Tax advantages of debt Interest on debt is tax deductible, and hence a company can
save taxes by increasing debt.

High returns for investors PE firms obtain their capital from pension funds,
endowments and high-net-worth individuals and can generate high returns for these
investors.

Operational improvements to the company Companies that are not well run can
benefit from the expertise of the PE firms in improving their operations.

Liquidity event for founders/owners Owners have a larger pool of potential buyers to
choose from since they can go to strategic investors as well as PE firms.

Help distressed companies become viable businesses PE firms invest in distressed

companies and then restructure the business financially and operationally to transform
them into viable firms.

Companies become disciplined Companies do not spend cash carelessly as they have
substantial debt obligations. PE firm is continuously looking for ways to cut costs and
improve the company profitability.

Management interest is aligned with the company Since the new management team
of the acquired company receives shares and options in the company, their interests are
completely aligned with those of the PE firm and they are incentivized to perform well.

The following questions test the job candidate’s understanding of an LBO model as well
as their ability to do numerical problems related to LBOs.

Explain the steps involved in an LBO analysis.

Table 1.1 outlines the key steps involved in an LBO analysis:

Table 1.1: Key Steps in an LBO Analysis

Step 1: Determine the o Determination of the purchase price typically

purchase price involves a full-scale valuation of the company
including DCF and relative valuation methods such
 as comparable company analysis and precedent
transaction analysis. You will focus more on
precedent transactions than comparable company
multiples since you are buying the company and need
to include the premium paid in other transactions. The
PE firm also conducts due diligence on the company
acquired. This includes accounting, financial and
operational due diligence
o If the company has publicly traded equity, then a
purchase price would be calculated similar to EV is
calculated. Purchase price = Offer price per share *
fully diluted shares + debt + noncontrolling interest +
preferred stock – cash
o For a private company, we can use DCF or a multiple
of EBITDA based on precedent transactions to
calculate the TEV and then subtract debt and add cash
to come to the equity value
Step 2: How will the deal o Create a sources and uses table where sources equal
be financed uses of funds
o Use of funds consists of the amount required to pay
the various stakeholders of the target, including debt
holders and equity holders. It usually equals the
purchase price plus transaction fees, including
financing and investment banking fees required to
close the deal
o Source of funds includes the capital required to
complete the transaction. It consists of different types
of debt such as term loans, secured and unsecured
debt as well as the equity contribution by the PE firm
o The amount of debt that can be obtained is dependent
on many factors including: i) the industry in which the
company operates, ii) the stability of the company’s
cash flows, and iii) the current state of the debt capital
markets. The PE firm needs to put in equity that it
cannot raise from other sources, i.e., Total uses – all
other sources of funding. PE firms would like to put
in a minimum amount of equity in order to maximize
their IRRs
Step 3: Create a pro o Create a pro forma balance sheet of the company as
forma balance sheet of the closing date of the transaction by adjusting the
existing balance sheet of the company to reflect the
LBO transaction, including the new capital structure
o Goodwill will be created. Expense advisory and
financing fees
 Step 4: Create an
integrated cash flow
model for the company
Step 5: Exit strategy for
the PE firm
Step 6: Calculate the
IRRs for PE firms and
other parties
Step 7: Evaluate credit
ratios of the company
o Project the company’s income statement, balance
sheet and cash flow statement for a period of time,
which could be five or 10 years, to reflect the changes
in the financial model due to the leveraged buyout
o We assume that the acquired company will be sold or
taken public through an IPO in three to five years
o We also assume that the acquired company will be
sold at a multiple similar to what it was bought for.
For example, if the company was bought at a 7x LTM
EBITDA multiple, the assumption is that the
company will be sold for 7x LTM EBITDA in five
years. This enables PE firms to analyze the IRRs as a
result of capital structure changes without assuming
an increase in the multiple or the implementation of
cost-cutting and other operational initiatives
o We do a sensitivity analysis on the exit multiple and
the exit period as we do not know what the multiple
will be when the PE firm exits in the future
o The IRR of the PE firm is dependent on various
assumptions such as sale multiple, length of time the
investment is kept and also the amount of equity put
in by the PE firm
o We can also calculate IRRs for other parties including
unsecured lenders who may get warrants in the
transaction
o We look at the important credit ratios such as
debt/EBITDA and EBITDA/interest expense for the
next five years to evaluate if the acquired company
can support the debt used to finance the LBO
transaction

What are the uses of an LBO model?

There are a number of reasons for building an LBO model, including:

Internal rate of return (IRR) The PE firm can analyze its IRR on the transaction. PE
firms target an IRR of approximately 18%-25% on their investments. It also enables
other parties such as unsecured lenders, who may have been given warrants, to calculate
their IRRs.

Optimal capital structure of the company The sources and uses table provides the PE
firm with details on how much equity they need to put in the company to buy the
company. It tells us the amount of capital that can be raised from other sources, including
bank debt, senior bonds, junk bonds and existing cash of the company. Further, the
model determines the various assumptions that are made. These include the amount of
leverage from various providers, interest rates terms and the equity investment by the
PE firm.

Credit analysis A PE firm acquires a company by financing the purchase with as much
debt as the cash flows of the business and the debt markets will support. The LBO model
determines whether the company has sufficient cash flow to pay the principal and
interest components on various types of debt. Credit statistics, including the leverage
ratio and interest coverage ratio, enable us to do this analysis.

Sensitivity analysis An LBO model should have the capability to perform a sensitivity
analysis. Sensitivities could be run on: i) the exit multiple of the investment, e.g., can
you exit at 6x, 7x or 8x LTM EBITDA, ii) the exit time horizon for the investment, e.g.,
three, five or seven years, iii) the interest rate assumptions on the various debts going
forward, iv) the amount of debt you would like to put on the company, and v) changing
the operating assumption projections based on what the PE firm can do to improve the
company operationally, for example, assumptions on revenue growth, cost of goods
sold, and SG&A expenses as a percentage of revenues.

Valuation methodology An LBO analysis is a valuation methodology as it tells us how

much a PE firm can pay to buy the company and still get the IRR it requires. By
assuming the PE firm’s required IRR, among other things, we can back into a maximum
purchase price that the firm can pay for the company. The model is not only built by the
seller and the PE firm, but also by other strategic buyers who would like to know how
much a PE firm would be willing to pay to acquire the company as they prepare their
bids.

What are the features of payment-in-kind interest and its treatment in

the LBO model?

Payment-in-kind (PIK) is interest expense on certain types of debt, which is not paid in
cash but added to the principal amount of the debt as additional debt or securities. For
example, if a company has $1,000 of debt with PIK interest expense at 10%, the interest
expense of $100 for the year will be added to the principal and the debt would become
$1,100 at the end of the year. The interest of $110 is added to the principal amount the
following year, and the debt will become $1,210 the year after that. The interest on PIK
debt is higher than it is on regular cash-pay debt because PIK is primarily beneficial to
the company. Since interest is deferred to the future, the lender would need to account
for the time value of the money and hence get a higher rate of interest. The lender also
bears the greater risk of a default on the loan since it is to be repaid in the future and the
interest on it is being compounded.

PIK is good for companies that need to save cash, especially for LBOs where the
companies have a large amount of debt that require cash payments. However, PIK is
generally not good for companies as they have to pay interest on interest, and the interest
rate on PIK debt is higher than on cash-pay debt. PIK debt can be in kind for a certain
number of years, after which interest is paid in cash for the remaining duration of the
loan. It is also possible to have a PIK toggle feature where interest can be paid in cash
or kind, usually at the option of the borrower. These loans are not offered by banks,
given the risk involved. Hedge funds, private equity funds and other special high yield
and mezzanine funds make PIK loans.

PIK interest expense is taken as an interest expense in the income statement even though
no interest has been paid in cash. In the cash flow statement, PIK interest expense, being
a non-cash charge, is added back to the net income under cash flow from operations. 3

How do you account for advisory and financing fees in an LBO model?

Advisory fees include advisory and legal fees payable to investment bankers, lawyers
and accountants are expensed, i.e., deducted from cash and retained earnings of the pro
forma balance sheet of the company.

Financing fees include fees paid to lenders to arrange the debt used to be capitalized and
amortized over the term of the loan. From December 15, 20154, these fees are expensed
also, i.e., directly deducted from the carrying amount of the debt liability so both the
debt and cash on the balance sheet is reduced by the amount of the fees.

If you buy a company for $100 and sell it for $100 in five years, can you
make a profit?
This question tests the candidate on his knowledge of LBO.

Let us assume a PE firm buys a company for $100 by using 60% debt ($60) and putting
in 40% equity ($40) in the company. Over the next five years, the company pays down
its debt through the cash flows it has generated.

If at the end of five years, the PE firm sells the company for $100, it gets $100 since
the debt has been paid off. Even though the company did not go up in value, the PE
firm makes a profit of $60 ($100 − $40).
A PE firm made 2x on their investment in 5 years and there were no
dividends or any other cash flows in between the periods. What will be
the IRR?

IRR will be 15%.

3 As per the Statement of Financial Accounting Standards No. 95—Statement of Cash Flows, cash flow from
operations includes cash payments to lenders and other creditors in the form of interest. Cash flow from operating
activities in the cash flow statement begins with net income, which already includes interest expense; hence, we
add the PIK since no cash has been paid for PIK interest expense.

4In April 2015, FASB changed the treatment of debt issuance costs starting from December 15, 2015 whereby they
can be directly deducted from the carrying amount of the debt liability.
There are some general rules that can be applied for IRR calculation. However, these
rules will not work if there are cash flows in between the time periods. Dividends, asset
sales and dividend recapitalizations will distort the result. Also, this rule will not work
if the company does an IPO and sells part of the company at the time of IPO and the
remaining shares later over a number of years. The general rules of IRR if your money:

Doubles in 1 year – 100% IRR

Doubles in 2 years – 41% actual IRR – 40% approx. IRR
Doubles in 3 years – 26% actual IRR – 25% approx. IRR
Doubles in 4 years – 19% actual IRR – 20% approx. IRR
Doubles in 5 years – 15% actual IRR – 15% approx. IRR
3 times in 3 years – 44% actual IRR – 45% approx. IRR
3 times in 4 years – 32% actual IRR – 32% approx. IRR
3 times in 5 years – 25% actual IRR – 25% approx. IRR

What is the IRR if a PE firm acquires a company using 50% debt for
$200 million, and then sells the company in two years for $244 million,
assuming no debt is paid down?
Acquisition of company Bought for $200 million with $100 million equity and $100 million
debt.

Sale Company is sold for $244 million, therefore the debt is still $100 million and the PE firm
gets $144 million, i.e., $244 million − $100 million.

The PE firm makes a profit of $44 million in two years, or an IRR of 144/100^(1/2)-1 = 20%.

A PE firm acquires a company for $200 million EBITDA at a multiple of 10x

and finances it with 70% debt and 30% of equity by PE firm. It sells the
company in 5 years at a multiple of 12x EBITDA and the EBITDA is $250
million and has paid down $800 million of the debt. What is the IRR?

Acquisition of company Bought for EBITDA of $200 million * 10x = $2 billion enterprise value
with 70% of 2bn or $1.4 billion financed with debt and the remaining 30% or $600 million with
equity.

Sale of company Sold for EBITDA of $250 * 12x multiple = $3 billion enterprise value. Debt
remaining will be $1,400-$800 i.e., $600 billion and $2.4 billion in equity.

The PE firm made a profit of $2.4 billion minus $600 million (initial equity PE firm put in) or
$1.8 billion in 5 years or 4x their original investment which is an IRR of approximately 32%.
Suppose that a PE firm builds the model and gets an IRR less than their hurdle
rate. What are the drivers in the model they can change, if possible, to increase
their IRR?

The IRR for a PE firm is dependent on a number of factors. The PE firm can change the
following to increase their IRR:

• Purchase price Reduce the purchase price it would pay and hence increase its IRRs
• Sale price Increase the exit multiple so that it can get a higher sale price and
consequently a higher IRR
• Exit period Reduce the time required to sell the company from, say, five years to four
years, which will enhance its IRR
• Ratio of debt and equity Increase the debt on the company and reduce the amount of
equity it has to put in, which will enhance its IRR
• Dividend Pay itself a dividend, which will enhance the IRR
• Changing operating assumptions Operating assumptions in the model can be changed.
For example, revenue growth rates can be increased, margins can be increased, and the
interest rate assumption on the debt going forward can be reduced, all of which will
enhance the IRR

It is important to note that it may not be possible to change some of these assumptions, for
example, it may not be possible to take on more debt.

Candidates should read about a few LBO transactions prior to the interview as highlighted by the
question below. If the candidate is interviewing with an LBO firm, he or she must be
knowledgeable about the firm’s most recent and notable transactions.

Walk me through an LBO transaction?

The interviewer would like to know whether you have been following recent LBO transactions in
the industry. You may want to talk about a company which was recently acquired by a PE firm
such as the Dell LBO in 2013 and has not had an exit yet. You can also speak about a company
which was acquired a few years ago and recently had an exit via an IPO or a sale such as the Hilton
Hotels acquisition by the PE firm Blackstone and that had an IPO in 2013. It would be easier to
select a public target since more information would be available and disclosed as compared to a
private company. In answering this question, you should highlight the following points:

Names of the acquirer and target Mention the names of the acquirer and target in the transaction.
If the acquirer and target are well-known PE firms and companies, it may not be necessary to
describe them in detail. If the company is not well-known, a brief description of its business would
be helpful.

Strategic rationale Explain the PE firm’s rationale for buying the company and its plans for the
company in the future.
Transaction/deal terms Specify the enterprise value of the acquired company. If it is a public
company, you should mention the premium paid to the last closing stock price. Be sure to point
out any important or unique highlights of the deal.

Financing consideration Discuss the various types of financing used, including term loans, senior
debt and unsecured debt and the equity put in by the PE firm.

Valuation and purchase multiples Discuss the valuation methods used, including comparable
companies, precedent transactions, DCF and LBO analysis. Further, mention multiples of any
relevant precedent transactions and comparable companies. If any other information is available
or if you have built a financial model on the company, discuss the assumptions made in the DCF
and LBO analysis.

Holding period Indicate the length of time for which the PE firm held the company, or in the
case of a recent acquisition, your assumption as to how long it plans to hold it. Highlight any key
operational initiatives and divestitures the PE firm has taken or plans to take in the case of a
recent deal. You can also discuss management turnover or new management put in place by the
PE firm.

Exit strategy Describe the PE firm’s exit strategy via sale or IPO as well as any dividend
recapitalization it has done. Also be sure to mention the expected sales price and IRR achieved at
the exit.
Chapter 18: Mergers & Acquisitions
Q&A
“I have never cared what something costs; I care what it’s worth”
– Ari Emanuel
Mergers and acquisitions (M&A) questions are important for many finance jobs
including investment banking, corporate finance jobs in corporations, and alternate asset
management jobs such as hedge funds and private equity. The ability to understand the
M&A process, valuation, and structural complexities is a critical skill which will lead to
a successful career in these jobs. Interviewers generally focus on the following when
asking M&A questions:

• Familiarity with the key concepts in M&A including the importance of M&A,
and process by which companies are sold
• Knowledge of accretion dilution analysis and factors impacting the analysis
• Evaluate if the candidate follows the relevant M&A deals and can walk the
interviewer through a recent transaction preferably in the industry they are
interviewing for, for example, a healthcare deal for a position in the healthcare
industry group of investment banking

The following questions below focus on familiarity with key M&A concepts

Why do companies engage in mergers and acquisitions?

There are many reasons companies pursue M&A including:

• Gain access to new product markets or broaden the spectrum of their product
line
• Enter new geographical markets and increase distribution capabilities
• Enhance brand recognition and gain access to customer relationships of the seller
• Achieve synergies by consolidating operations to lower costs by achieving
economies of scale or gain market share by consolidation
• Buy their way in to prevent competition from entering the industry, i.e., a
defensive merger
• Buy technology or research and development capabilities. Technology
companies acquire to gain access to new technologies which are frequently
changing
• Acquirer views the target as undervalued
• Acquirer’s organic growth is slowing and it needs to grow via acquisitions

Describe a few reasons why companies pursue a partial or complete

sale?

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Some of the points are similar to the question above, but a few reasons why companies
sell could be:
• Market valuations are attractive i.e., this is the appropriate time to sell at the right
price
• Seller has a technology or research and development business and the buyer
could help them grow their business or has the distribution, marketing and other
facilities to access larger markets. Biotech companies are a good example when
they sell to pharmaceutical companies after they have come up with a good drug
or are in the process of coming up with a good drug
• Founder wants to retire and may not have anyone to take over the business
• Company is distressed or is unable to compete as an independent firm and wants
to sell either in liquidation or restructure and sell some/all its assets
• Founding shareholder(s) have grown the business to the maximum they could
and want to sell so they can start another business
• Business may need substantial funds to grow and compete in the industry
• Business is a non-core business. A number of companies like GE acquire
companies all the time but also sell businesses or assets they deem non-core as
they want to focus on products which are core to their strategy
• Companies sell shares partially when they do an initial public offering (IPO) to
the public as they need cash for growth purposes, mergers and acquisitions or
for working capital purposes. When the company sells shares to the public and
not the shareholders, the money comes to the company in an IPO i.e., also called
as primary shares
• Founding shareholders want to fully or partially sell the business. Venture
capitalists exit the business by selling the company or taking the company public
which is a partial sale. Founders sell shares in the IPO as they want to receive
cash for some of their stake in the company. When money comes to the founders
in an IPO, it is called a secondary share sale
• Private equity companies which do leveraged buyouts sell companies to other
private equity firms or strategic players as an exit strategy

If you were the Chief Financial Officer of a company, how would you
go about making a strategy for an M&A transaction?

If I were the CFO of a company, I would do the following steps in the order mentioned
below or do some steps concurrently:

Screen the potential candidates for an acquisition The first step would be to make a
comprehensive list of public and private companies which could be potential acquisition
targets. Investment bankers can also help in this process as well as the internal M&A
teams in corporations. The list will include an overview of the company, summary
financial information, key shareholders and the reasons why the company might be a
good potential target
Determine the strategic rationale for the acquisition M&A usually starts with a

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strategic reason to acquire another company which could include access to distribution
capabilities and access to new product and technologies. The company will also analyze
the status quo implication on the company, i.e., what may happen if the acquisition is
not pursued as well as build vs. buy analysis. Examples of hostile transactions include
Microsoft wanting to acquire Yahoo because it wanted to be a larger player in the online
business and effectively compete with Google and had not been able to get a significant
market share by itself. Also, Kraft bought Cadbury so it could use Cadbury’s distribution
network in emerging countries like India to sell Kraft products.
Valuation of the target and offer price Once you have decided that the company to be
acquired fits in your strategic plan, you would do a valuation of the company to
determine the appropriate price to be paid for the company. Valuation methods include
comparable companies, precedent transactions, DCF and LBO. We would calculate the
revenue and cost synergies we expect in the deal. We will also do an accretion/dilution
analysis if you are a public company to see if the acquisition is accretive or dilutive.
After valuation, we will want to present the price we want to offer for the company
including the premium for a public company.
Management team, board, name of the combined company, cultural and other
issues A number of issues including composition of the new management team and the
board of directors need to be considered. Sometimes the company being acquired has a
different culture and it may be very difficult to integrate the two cultures of the
companies. The acquired company may have a strong brand name which may be kept
by the acquirer. There may be certain overlapping businesses which need to be disposed
of after the acquisition.
Detailed timeline for the closing of the transaction Timeline will include an estimated
time for announcement of the acquisition as well as the closing date for the transaction
which may happen several months after the announcement. Shareholders approvals may
be required to close the deal. If financing for the deal is required, a detailed timeline of
the financing will need to be provided.
Strategy to approach the target A target can be contacted in many ways including an
auction process if they are already up for sale or through a negotiated sale. If the seller
does not want to sell and the acquirer may still want to buy the target, it can make a
hostile offer. Examples of a hostile transaction is when Microsoft tried to buy Yahoo
since Yahoo did not want to sell. Also, Kraft acquiring Cadbury initially was a hostile
deal, as Cadbury did not want to sell but later became friendly.
Form of consideration to be paid by acquirer An acquirer can either pay cash or stock
or a combination of the two to the shareholders of the target. Many issues including
taxes, transfer of risk, as well as the impact on pro forma ownership can impact the
decision. Credit statistics of the acquirer may change and the acquirer credit rating can
be impacted if it issues a lot of debt.
Structure the transaction A number of issues including tax issues of shareholders need
to be considered while structuring the deal. One of the key points will be whether the
transaction is structured as a stock purchase or an asset purchase. Some transactions,
especially growth and early-stage companies are structured with an earn-out provision
where the seller can earn a larger share if some performance criteria is met over a period

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of time. For buyers, an earn-out can offer the owner protection against overpaying for a
company that doesn't end up growing in the way its original owners expected.
Deal protection methods include breakup fees and collars. Breakup fees require the
target and acquirer to make payments to the other if the transaction does not close to
ensure that any one party does not terminate the deal. Typically, it is 1%-5% of the
transaction value. The larger the size of the deal, the smaller the percentage of the
breakup fees. In February 2011, NYSE Euronext and Deutsche Borse each agreed to pay
the other party €250 mm or $337 mm breakup or termination fee should the deal be
spoiled which was approximately 3.4% of the transaction value.
In March 2011, AT&T bought T-Mobile USA for $39 bn and agreed to pay a breakup
fee of $3 bn in cash and another $3 bn in spectrum rights to Deutsche Telekom AG1,
the parent of T-Mobile making it the third largest cash disclosed break-up fee ever after
the Pfizer Wyeth and AOL Time Warner transactions which were more than $4 bn in
breakup fees. The cash fee itself was approx. 7.7% of the deal value, making the AT&T
break-up fees higher the other two transactions as a proportion of deal value. 2 With the
addition of assets and services of a similar value, the companies broke global records
with a 15.4% break-up fee, according to Thomson Reuters Data.
Regulatory approvals Approvals may be needed from regulatory agencies like Federal
Trade Commission in the U.S. who will decide that the acquisition is in the best interests
of the consumer. In March 2011, AT&T said it was buying T-Mobile USA for approx.
$39 bn in cash and stock, a transaction that would combine the second and fourth largest
wireless carrier to become the largest in the U.S. The combination would draw focus of
antitrust regulators and require approvals from the Federal Communications
Commission as well as the Justice Department and at a minimum would require large
divestitures in certain markets to appease regulators.
Market the transaction to various parties including media, investors and other
constituents Generally, PR firms such as Brunswick Group and Financial Dynamics
help companies in this effort which includes communication of post-merger financial
and integration milestones as well as developing scenario plans for various
contingencies.

Post-acquisition integration strategy Quite a few M&A deals are unsuccessful as the
two companies could not integrate properly and the synergies planned prior to the
acquisition do not materialize. Detailed plans with specific steps for integration as well
as the team to oversee the process need to be defined and agreed upon.
The following questions below focus on familiarity with accretion dilution analysis and
key factors which impact the analysis.

What is an accretion/dilution analysis and why is it important?

An accretion/dilution analysis is primarily done by the acquirer prior to the deal to see

1 AT&T Fires Back at DOJ, WSJ Article dated September 10, 2011.
2 Source: Dealogic and WSJ Article dated March 22, 2011.

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how shareholder value will be affected by the transaction. It is used by public companies
to analyze the impact on the acquirer’s earnings per share (EPS) due to the acquisition
of another company. If the acquirer’s or combined company’s EPS increases after the
acquisition compared to the EPS of the acquirer prior to the acquisition, the transaction
is considered accretive. If the acquirer’s or combined company’s EPS decreases after
the acquisition compared to the EPS before the acquisition, the deal is considered
dilutive.

Companies are concerned with accretion or dilution before making their acquisition
decision as it can affect the acquirer’s stock price. Generally, companies will like to
make accretive acquisitions, as accretive transactions assume that the company’s stock
price will increase. As many public companies trade on P/E multiples, any dilution to
EPS could result in a subsequent drop in the stock price and vice versa.

For example, let us assume that the current share price of the acquirer is $10 and its EPS
is $1. Therefore, its P/E ratio is 10.0x or the company trades at 10x earnings. If a 20%
EPS accretion occurs, i.e., EPS increases to $1.20, and if the market assumes that the
P/E ratio of the acquirer remains the same as before, if the acquisition is of a company
related to the acquirer, i.e., if the P/E ratio remains at 10.0x, the stock price will increase
to $12. In reality, the stock price does not always go up because the market may not like
the acquisition for a number of reasons. One of the reasons could be that the market does
not believe that the combined company will be able to achieve the synergies highlighted
by the acquisition and hence the stock price may even go down even though the
acquisition was thought to be accretive before the deal.
How do you do an accretion/dilution analysis?

An accretion/dilution analysis can be done in the ten steps outlined below:

Step 1: Collect market data which will include the names and stock tickers of the
acquirer and the target, their share prices on the date prior to the deal, fully diluted shares
outstanding and the premium offered to the target.

Step 2: Calculate the purchase price or enterprise value of the target by first
calculating the equity value at the offer price and then adding debt, preferred and
noncontrolling interest, if any and subtracting cash. This enables us to see the use of
funds or how much does the acquirer need to purchase the target. The acquirer will
require the purchase price plus the transaction fees it needs to pay bankers, lawyers and
other parties to close the deal.

Step 3: Determine financing and assumptions for the deal Source of funds or the
amount the acquirer needs to finance the deal will come from either or a combination of
cash on the acquirer’s balance sheet, taking on additional debt and by issuing new shares.
If the acquirer uses its existing cash, it will lose interest it was earning on the cash. We
can estimate the interest income acquirer was earning from the financial documents filed
such as Form 10-K. Interest on new debt can be assumed from the acquirer’s market
cost of debt adjusted for the estimated leverage of the new company.

5
Step 4: Calculate exchange ratio For the portion of the deal financed with stock, the
acquirer will need to issue new shares which is determined generally by the total amount
financed by shares divided by the last closing price of the acquirer prior on the date the
deal is announced. Exchange ratio, i.e., the number of new shares given by the acquirer
for each share of the target acquired is determined by the number of new shares issued
divided by the number of existing shares of the target.

Step 5: Combine and project the acquirer and target income statements
We combine the income statement of the buyer and target and then project the income
statement based on public filings and equity research reports. Generally, the acquirer
and investors look at projections for the next two years, though you can also project for
a longer period. We take the buyers tax rate to the combined pre-tax income to get the
combined net income of the company and divide by the diluted shares outstanding to get
to the earnings per share. We find the last twelve months and projected two years P/E
ratio for the acquirer and also for the target at the current and offer price.

Step 6: Calculate post-tax synergies which include revenue synergies through

distribution channels, cross-selling of products and increasing prices. Cost synergies
include reducing employee headcount, reducing sales and marketing expenses and
saving costs by combining factories or offices.

Step 7: Calculate goodwill and combine the acquirer and target balance sheet
Goodwill is calculated by taking the purchase price of equity and subtracting the fair
market value of the net assets or equity acquired. The balance sheets are combined and
adjusted for the goodwill, deal financing by subtracting the cash used and adding the
debt or shares issued and by writing off the shareholder equity of the target.

Step 8: Find pro-forma net income by adjusting the combined net income for the
effect of the acquisition The post-tax synergies will increase the combined net income
for the current and projected years. Secondly, we amortize any new intangibles created
in the deal. Thirdly, we will subtract the interest on the new debt taken by the buyer and
the interest income foregone on the cash used to acquire the company. We adjust post-
tax since we are making the adjustment to net income which is post-tax.

Step 9: Calculate pro-forma EPS of combined company which will be calculated by

dividing the pro forma net income of the combined company by the pro forma diluted
shares outstanding of the new company. Pro-forma shares will be the acquirer’s shares
outstanding prior to the acquisition plus the number of shares issued by the acquirer to
finance the purchase of the target, if stock was issued to do the deal

Step 10: Evaluate if the deal is accretive or dilutive Compare pro forma EPS to EPS
of acquirer before the acquisition. If the EPS of the combined company is more than the
EPS of the acquirer prior to the acquisition, then the acquisition is accretive and if the
EPS of the combined company is less then the EPS of the acquirer, then it is dilutive.

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What may cause dilution in the acquirer’s EPS?

There are a number of reasons which can cause dilution:

• If the target has a higher P/E multiple than the acquirer, dilution will occur
assuming the acquirer issues mostly new stock for the acquisition, as opposed to
using cash
• If the acquirer borrows cash to fund a cash purchase of the target, the increase in
interest expense from the new debt may cause dilution as well as if the acquirer
uses cash from its balance sheet, the opportunity cost of interest income lost due
to the cash used to pay for the target may cause dilution
• If there is a large amount of new amortizable intangibles that arise from the
transaction, the increase in amortization expense on the income statement can
cause dilution
• Low or negative synergies as a result of the acquisition
• If the acquirer overpays for the target company
• Target company has negative net income

Will the deal be accretive if company A with P/E ratio of 20x buys
company B with a P/E ratio of 10x in an all-stock transaction?
Generally, not accounting for synergies and other adjustments, if the P/E of
the acquiring company is higher than the P/E of the target and if it is an all stock
transaction, then the deal will be accretive to the acquirer’s EPS. The acquirer has to pay
less for each dollar of earnings than the market is valuing its own earnings. Acquirer
will have to issue proportionally less shares in the transaction as it is paying with a
higher valued currency.

Another way to make the evaluation is by examining how much you get as a percentage
of how much you invest. For example, the yield for company A is 1/20 or 5%. Hence,
you would receive $1 of earnings for investing $20. Company B has a yield of 1/10 or
10% or you would receive $1 of earnings for investing $10. The acquirer company A’s
cost of acquisition is less than the seller company B’s yield and therefore, the acquisition
will be accretive.

What is the general rule by which you can tell whether an acquisition
is accretive or dilutive?
Not factoring in synergies and other adjustments, the cost to the acquirer to do the
acquisition would be the weighted average cost of how it financed the deal. It would
include the cash it used to pay for the acquisition plus any additional debt it raised and
any additional stock it issued.

Weighted average cost of acquisition for the buyer = cost of cash * % of cash used +
cost of debt * % of debt used + cost of stock * % of stock used

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Cost of cash = foregone interest rate on cash * (1-acquirer’s tax rate)
Cost of debt = interest rate on new debt * (1-acquirer’s tax rate)
Cost of stock = net income divided by equity value or 1/P/E multiple of the acquirer

We can calculate the yield of the target, i.e., how much will you get for every dollar
invested in the target by net income of the target divided by the equity purchase price
including the premium paid. This can also be written as 1 divided by P/E ratio of the
target since P/E ratio is defined as market capitalization divided by net income.

If the buyer is paying less than what the target is yielding, the deal will be accretive. We
compare the weighted average cost of acquisition of the buyer to the yield of the seller
and make the general rule:

Accretive = if the weighted average cost of the acquisition is less than the target yield
Dilutive = if the weighted average cost of the acquisition is more than the target yield
Neutral = if the weighted average cost of the acquisition is equal to the target yield

What is the cheapest form of financing for an acquirer in an

acquisition?
Though cost is only one factor in determining financing, generally acquirers’ own cash
would be the cheapest form of financing. The interest income a company earns on its
cash is typically low and also would be lower than what it will pay lenders for the debt
it has on its balance sheet. The company may not be able to use all its cash to fund the
deal, for example, its cash may be restricted or overseas and locked up. Further, the
company may need the cash for major capital expenditures or to pay down debt which
might be maturing.

Debt will be more expensive than cash but most likely cheaper than equity. It would
depend on the type of acquirer and its current leverage ratios and if they have capacity
to add additional leverage without causing financial distress or substantial higher interest
rates. Debt may also limit the flexibility and increase cost of raising additional debt in
the future for the acquirer.

Stock will most likely be the most expensive. An exception could be when the acquirer
is trading at a very high P/E ratio. For example, lets say acquirer is trading at a P/E ratio
of 80x. Its pre-tax cost of stock will be 1/80 or 1.25% which could be the lowest among
all the choices. Also, companies have flexibility to issue stock, though the acquirer will
be careful to ensure that the additional stock will not lead to loss of control of the
combined company.
What are synergies in an M&A transaction?
Synergies mean that the sum of the value of the acquirer and the target as a combined
company is greater than the two companies valued apart. The amount of projected
synergies justifies most mergers and acquisitions. The different types of synergies are:

8
Cost synergies include the ability to cut costs of the combined companies due to the
consolidation of operations including closing one corporate headquarters, closing stores
that overlap, reducing back office and information technology expenses, economies of
scale in terms of buying products, laying off people in the management team and
reducing advertising expenses of the combined company

Revenue synergies include the ability to sell more products and services or raise prices
due to the acquisition or merger. For example, increasing sales due to cross-marketing
of products or expanding into a new area where only one company existed prior to the
acquisition. Generally, cost synergies are easier to predict than revenue synergies.

Financial synergies could include reducing the cost of capital, for e.g., a large company
buys a smaller company and the smaller company can now borrow at a lower rate at
which the larger company can borrow.

Many mergers and acquisitions do not work and a big part of their failure is the inability
to realize the synergies that the acquiring company had predicted it would be able to
achieve prior to the acquisition.

What are the primary types of consideration for a target’s equity in an

M&A transaction?

The primary types of consideration by an acquirer for a target’s equity are all-cash,
stock-for-stock, and cash/stock mix. How the acquiring company finances its cash could
be through cash on its balance sheet or through a debt and/or equity offering. A number
of factors will be evaluated to decide the appropriate consideration including:

• Transfer of risk In a cash transaction, the risk that the expected synergies for
which the premium on the target’s current stock price was paid for will not
materialize is borne by the acquired company shareholders. In a stock deal, the
risk is shared with the acquirer and target in the ratio of the stock held in the new
company
• Accretion dilution impact of giving stock or cash will be considered by the
acquirer
• Cost of debt Buyers may like to issue debt given its lower cost relative to equity.
Amount of debt is impacted by how much debt can the acquiring company obtain
from their lenders and also higher debt can impact the credit rating of the buyer.
Some companies do not like excessive debt on their balance sheet
• Pro forma ownership Some founders may not want to give lot of stock away as
it impacts their ownership of the combined company
• Timing of the deal Cash deals are generally faster to complete than stock
transactions
• Valuation Equity can be used by buyers if they believe that their equity is
overvalued. Equity dilutes existing shareholders and is generally more expensive
than debt

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 • Seller preferences are also important as some shareholders may prefer cash over
stock as payment due to the guaranteed value of cash
• Tax issues play a role in shareholders’ preferences. Cash consideration usually
is taxable for shareholders. Stock is generally not taxable if structured properly
until the shares are eventually sold
• Upside potential Some shareholders may take stock to participate in the upside
potential of the combined companies if they believe in the stock of the acquirer
What are the different types of buyers in an M&A transaction?

Table 1.1 below provides details on the strategic and financial buyers in an M&A deal.

Table 1.1: Strategic and financial buyers in an M&A deal

Strategic Financial
Strategic buyers include a corporation Financial buyers are looking to acquire a
looking to acquire another company for company mainly as a financial
strategic business reasons investment
Strategic buyers look for synergies and Financial buyers are mainly private
growth. For example, a competitor or a equity funds looking to do a leveraged
company in the same industry that wants to buyout of the company
move into a new region. Purchasing an
existing company in a new region may be
more cost effective than starting new
operations themselves
Generally, strategic buyers have an However, if the debt markets are in their
advantage over financial buyers as they can favor, financial buyers can afford to pay
get synergies from the transaction and hence a higher valuation than the strategic
can afford to pay a higher price. They could buyers due to their ability to highly
also benefit from a lower cost of capital and leverage the company. The LBO boom in
a lower return threshold than a private 2006 and 2007 led to 9 out of the 10
equity firm largest LBOs ever at that time because of
the favorable debt markets whereby debt
was cheap and available
Examples of strategic buyers are the Examples of private equity or financial
acquisition by Mars of Wrigley for $23 buyers are Carlyle, Clayton Dubilier &
billion, Hewlett-Packard Company buying Rice and Merrill Lynch buying Hertz;
EDS for $13 billion, and Belgium’s InBev and Bain and Thomas H. Lee buying
agreeing to purchase Anheuser-Busch Clear Channel Communications
Companies Inc. for $55 billion
What kind of strategic alternatives review will a banker do for a
company considering a sale or part of its business?
A banker will look at various alternatives outlined below including sale of all or part of
the business, an initial public offering, recapitalization of the capital structure and

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continuation of the status quo. Table 1.2 below details the various alternatives.

Table 1.2: Various alternatives for company considering sale

Sale of all or part of Bankers may advise the company to sell the whole
the business company or parts of the business which are non-core
to the operations.
Initial public offering Generally, bankers will advise a company to go for an
IPO is they feel the company is ready to be a public
company in terms of quarterly reporting requirements
and managing expectations on a regular basis of
investors and research analysts and other
stakeholders, and have a strong management team
with public market experience.
Recapitalization of Sometimes a company is not doing well because they
the capital structure have a lot of debt or their capital structure is not
optimal for the company to operate. Bankers can
suggest a recapitalization of the capital structure, for
example, convert debt into equity.
Continuation of the Continue with the current state of the business.
status quo Bankers may advise selling the company when the
market conditions improve or when business is
attractive to buyers.

What is the typical auction process for a sale of the company and the
advantages and disadvantages of each process?

Auctions can be broad or targeted. In a broad auction, the seller contacts many potential
buyers including both financial and strategic buyers. Table 1.3 below highlights the
advantages and disadvantages of broad and targeted sale.

Table 1.3: Broad and targeted auction process

Advantages of Broad Auction
• Makes the process competitive
and limits potential buyers’
negotiating leverage
• Maximizes the probability of
achieving the highest possible
price for the seller as all
possible bidders have been
approached
• Board of Directors are
comfortable that they have
Disadvantages of Broad Auction
• Difficult to preserve confidentiality
• Unsuccessful outcome can create the
perception of tainted asset
• Some prospective bidders may decline
to participate in broad auctions –
Warren Buffett generally does not like
auctions
• Business disruptions can take place
• Industry competitors may participate

11
 satisfied their duties to their to gain confidential information
shareholders to maximize
value

Advantages of Targeted Auction Disadvantages of Targeted Auction

• Higher likelihood of
preserving confidentiality
• Reduces business disruption
• Maintains perception of
competitive dynamics
• Reduces the potential of a
failed auction as seller signals
that he is looking for a partner.
Generally, targeted auctions
involve few targeted buyers
that have been identified as
having a strong strategic fit and
financial capacity
• Potentially excludes non-obvious but
credible buyers
• Potential to leave money on the table
if certain buyers are excluded
• Lesser degree of competition
• May afford buyers more leverage in
negotiations
• Provides less market data on which
Board of Directors can rely to satisfy
itself that value has been maximized

What is a negotiated sale and what are the advantages and

disadvantages of a negotiated sale?

A negotiated sale involves a direct dialogue with a single prospective buyer. Table 1.4
details the advantages and disadvantages of a negotiated sale.

Table 1.4: Advantages and disadvantages of a negotiated sale process

Advantages Disadvantages

12
 • Highest degree of confidentiality
• Generally, less disruptive to a business
than an auction; flexible deal timelines
and deadlines
• Minimizes perception of a tainted asset
if the sale does not go through
• May be the only basis on which a
potential buyer will participate in a sale
process
• Limits seller negotiating leverage and
competitive dynamics
• Potential to leave money on the table
if other buyers would have been
willing to pay more
• Still requires significant management
time to satisfy buyer diligence needs
• Depending on the buyer, it may
require sharing of sensitive
information with the competitor
without certainty of transaction close
• Provides less market data on which
the target’s Board of Directors can
rely to satisfy itself that value has
been maximized

What is the difference between a stock purchase and an asset purchase

in an M&A transaction?

In a stock vs. asset purchase, generally, the buyer prefers to buy assets and the seller
prefers to sell shares. Table 1.5 below details the difference between a stock and asset
purchase in an M&A deal.

Table 1.5: Difference between stock and asset purchase in an M&A deal
Stock Purchase Asset Purchase
What do you • Acquire 100% of a • You acquire only certain
get? company’s shares as well assets of a company and
as all its assets and assume only certain
liabilities both on and liabilities
off-balance sheet • Buyer assumes only
• Buyer assumes all certain liabilities and can
liabilities of the acquired choose what he is getting
entity so it is generally preferred
by the buyer
Tax Basis for Buyer inherits existing tax Buyer can step-up the value of
Buyers basis in acquired assets with assets for tax purposes and
no additional depreciation take incremental depreciation
for tax purposes expense

13
 Tax Basis for Given that shareholders buy Seller’s basis in assets tends
Sellers and sell regularly in publicly to be lower than selling
listed companies, the shareholders’ basis in shares,
average tax basis in shares which may result in
can be relatively high incremental tax
Treatment of Buyer acquires all the tax Buyer will not acquire any tax
Tax Losses losses of the acquired entity losses of the acquirer

Company A has 100 shares outstanding and a stock price of $10 and
net income of $50. Company A acquires company B for $500 million
equity purchase price and the net income for company B is $50 million.
If the deal is financed by all debt and the cost of debt is 10% and the
tax rate is 40% for both companies, is it accretive or dilutive not
factoring in synergies and other adjustments?

Company A has a market capitalization of $1,000 million and net income of $50 and
therefore a P/E ratio of 20x. Its yield is 1 divided by P/E ratio or $50/$1,000, i.e., 5%.
P/E ratio of company B is $500/$50 or 10x and yield is $50/$500 or 1/10 or 10%.

Cost of the acquisition for company A is 10%*(1-.4) or 6% and it is less than the target
yield of 10%. Therefore, the deal will be accretive.

If company A paid for company B by issuing new shares, would it be

accretive or dilutive in the question above?

Company A P/E ratio of 20x is greater than company B P/E ratio of 10x and since it is
an all stock deal, it would be accretive when a higher P/E ratio company buys a company
with a lower P/E ratio. Also, the yield of company A is 5% and it is buying a company
with a higher yield of 10%, hence it will be accretive.

We can also see this numerically. Company A has an earning per share (EPS) of $0.5,
i.e., net income divided by shares outstanding. Company A will issue $500/$10 = 50
new shares to acquire company B. The total shares outstanding after the acquisition will
be 100 shares of company A plus 50 new shares issued, i.e., 150. Net income of the
combined company will be $100 million. Combined company EPS will be $100/150 or
$0.667. We see that the combined company EPS is higher than the standalone EPS of
company A. Hence, the deal is accretive.
Walk me through an M&A transaction?

The interviewer would like to know whether you follow recent M&A transactions in the industry.
To answer this question, it is generally recommended that you pick a recent transaction preferably
done by the bank you are interviewing with. It is generally easier to talk about a public transaction

14
since information is readily available. A number of sources can be useful while preparing for this
question including proxy statements3, press release by the company, research reports as well as
company filings such as Form 8-K4. While answering this question, the following points can be
highlighted:

Names of the acquirer and target Mention the names of the acquirer and target in the
transaction. If the acquirer and target are well known companies or PE firms, it may not
be necessary to describe them in detail. If the company is not well known, a brief
description of what their business is would be helpful.

Hostile or friendly deal Mention if the deal is hostile or a friendly transaction. Most
transactions are friendly.

Announced and closing date of the transaction Day the deal was announced as well
as closing date or expected closing date if the deal has not yet closed yet.

Strategic rationale Explain rationale as to why the acquirer bought the company and
their plans for the company in the future.

Transaction/deal terms Highlight the enterprise value of the company acquired. If it is

a public company, you should mention the premium paid to the last closing stock price.
Any key and unique highlights of the deal should be mentioned which could be
regulatory hurdles or shareholders not wanting to do the deal.

Financing consideration How the acquirer is paying for the target, i.e., cash, stock or
a combination of the two. If cash, how are they raising the cash which could be a
combination of cash on the balance sheet and financing through debt and equity.

Synergies Cost and revenue synergies expected from the transaction can be disclosed.

Valuation and purchase multiples Discuss the valuation methods used including
comparable companies, precedent transactions, DCF and LBO analysis. Further,
mention multiples of any relevant precedent transactions and comparable companies. In
case information is available or you did your own model on the company, discuss
assumptions made in the DCF and LBO analysis.

Deal structuring This could include break-up fees, tax issues or any structuring points
peculiar to the deal.

Advisors on the transactions Mention the investment banks who advised on the
transaction.

3 Proxy statement detailing the M&A transaction is sent to target shareholders so they can vote on the transaction. A majority of
shareholders need to vote for the transaction. A buyer must seek shareholder approval if it is issuing more than 20% of its shares
as consideration in the M&A transaction.
4 Form 8-K needs to be filed within four business days by public companies to the Securities and Exchange Commission

regarding certain material corporate events such as entry of a material definitive agreement.

15
We have outlined below a recent M&A transaction and the key details of that
transactions.
Transaction Merck’s acquisition of Sigma-Aldrich5 announced on September 22, 2014

Names of the acquirer and target Merck is acquiring Sigma-Aldrich, a St Louis, MO

based life sciences and high technology company listed on Nasdaq with operations in
37 countries and sales of $2.7 billion in 2013.

Hostile or friendly deal Friendly transaction.

Announced and closing date of the transaction Announced date was September 22,
2014 and closing is expected by middle of 2015 subject to regulatory approvals.

Strategic rationale Sigma helps fill in a lot of the missing pieces for Merck. Many of
Merck's products are used to manufacture pharmaceuticals, whereas Sigma-Aldrich's
products are commonly used in the earlier stages of drug discovery and development.
The combined company would be able to offer customers products that span the drug
development life-cycle, from discovery to production.

Transaction/deal terms It is an all cash transaction and has an implied enterprise value
of $16.495 billion and equity value of $17.0 billion. This represented a multiple of 19.8x
LTM EBITDA for the 12 months ended June 30, 2014 and 2014E P/E multiple of 32.2x.
The agreed price represents a 37% premium to the latest closing price of $102.37 on
September 19, 2014, and a 36% premium to the one-month volume weighted average
closing price.

Financing consideration The deal is expected to be financed through cash on Merck’s

balance sheet and up to $15.6 billion of debt financing. Bridge financing was secured
and the final financing structure will consist of cash, bank loans and bonds. Investment
grade rating of Merck will be maintained after the transaction.

Synergies Merck expects annual synergies of about 260 million euros or $340 million.
These should be fully achieved within three years after closing. Synergies will come
from consolidating manufacturing footprint, streamlining administrative functions and
infrastructure, saving on U.S. public company costs as well as optimizing sales and
marketing and R&D portfolio. Merck also expects integration costs of about 400 million
euros spread over 2015 to 2018.

Valuation and purchase multiples Comparable companies, precedent transaction and

DCF were used to value the company. Equity research price targets, 52 week high and
low stock prices and premiums paid for public targets over $1bn over the last 25 years
were also considered.

5Source: Press release by Merck dated September 22, 2014 and proxy statement filed with SEC by Sigma Aldrich on November
3, 2014.

16
Comparable companies include Agilent Technologies Inc., Bruker Corporation,
PerkinElmer, Inc., Pall Corporation, Qiagen N.V., Techne Corporation, Thermo Fisher
Scientific, Inc. and Waters Corporation. Comparable companies were trading at
TEV/EBITDA 2014E multiple of 12.5x-16.0x and TEV/EBITDA 2015E multiple of
11.5x-14.5x and P/E 2014E of 4.35x and P/E 2015E of 4.73x. This gives an implied
valuation of Sigma Aldrich of $77-$117 per share.

Precedent transactions include Thermo Fisher acquiring Life Technologies in 2013,

Merck acquiring Milipore in 2010, Invitrogen acquiring Applied Biosystems in 2008,
Thermo Electron acquiring Fisher Scientific in 2006 and General Electric acquiring
Amersham in 2003. The range of TEV/LTM EBITDA multiple of the comparable
transactions is 12.7x-16.8x which provides an implied share price for Sigma Aldrich
based on its LTM EBITDA of $834 million of $92-$120.

DCF analysis implies a stock price of $110-$150. Free cash flow for 10 years and
estimate compound annual organic sales growth of 6% from 2014-2018 and then
revenue growth decreasing to 3% from 2018 to 2024. Terminal value is calculated as of
December 31, 2024 using perpetuity growth method and perpetual growth rates of 2%-
3%. Discount rate is assumed to be 7.1%-8.1%.

Premiums paid for public targets over $1 billion were also calculated and for all cash
deal the premium was 8% for 25 years to June 2014, 29% for all stock deals for 25 years
to June 2014 and 35% for all deals for 25 years to June 2014. Mean premiums for year
to date to June 30 transactions were in the range of 27%-32%. Taking a premium range
of 25%-40%, we get a closing price per share as of September 19, 2014 of $128-$143
per share.

Deal structuring Break-up fees payable by Merck would be $934,383,000 whereas

break-up fees paid by Sigma Aldrich would be two-tiered with 318,540,000 payable if
they accept another acquisition proposal within 30 days of the merger agreement and
$552,135,000 in other circumstances. Sigma Aldrich would not solicit any acquisition
proposal from other parties but will be allowed to accept unsolicited proposals from
parties after the merger agreement and prior to the shareholder vote.

Advisors on the transactions Investment banks that advised Merck on the transaction
were Guggenheim and J.P. Morgan. Sigma-Aldrich was advised by Morgan Stanley.

17
Chapter 19: Markets and Current
Events Q&A
“One of the funny things about the stock market is that every time one person
buys, another sells, and both think they are astute”
– William Feather
Knowledge of the markets including stock indexes, commodities, interest rates, foreign exchange
rates is important for sales and trading, private wealth and asset management interviews. Questions
testing the candidate’s knowledge on markets can be asked for other finance interviews also.
Recruiters would like to test that the candidate has a genuine interest in finance and reads the
financial newspapers and follows key indices such as the Dow Jones Industrial Average (DJIA)
and S&P 500, commodities including oil and gold, foreign exchange rates and interest rates. In a
finance interview, markets and current events questions will test the candidate’s

• Interest in the stock, debt, commodities and foreign exchange markets and strong interest in
finance by reading the financial newspaper such as Wall Street Journal and the Financial
Times as well as finance publications such as Bloomberg Business Week and Fortune
• Understanding of the key factors that move stocks, debt, commodities and foreign exchange
markets including interest rates, company and industry performance, inflation, supply and
demand and political and economic stability
• Ability to have a view on the markets, interest rates, commodity prices and speak about them
intelligently and concisely. Even the leading experts in the world get their predictions wrong,
but it is important that candidates have a view substantiated by data and market factors for
finance interviews

For questions where you need to predict the future, it is important to follow the major stock indices,
interest rates and currency rates compared to other major currencies in the country you are
interviewing for. For example, for stocks in U.S., the major indices would be the DJIA, S&P 500
and the Nasdaq Composite. It would be helpful to also follow the major indices of the world, i.e.,
in the U.S., Canada, U.K., BRIC (Brazil, Russia, India and China) and Japan. Make sure you know
the current levels of the index and the history of the indices as it is easier to have view on the future
when you know the history and demonstrates that you follow the markets. Have an opinion whether
the index will go up, down or stay relatively flat. If you have 3 positive points and one con, address
them up-front but summarize with a concise view.

Where is the Dow today and where do you think it will be in the next 12 months?

1
 25 Year Dow Jones Industrial Average

20000
Dow Jones Stock Index

15000

10000

5000

0
7/1/1992
5/1/1993
3/1/1994
1/1/1995
11/1/1995
9/1/1996
7/1/1997
5/1/1998
3/1/1999
1/1/2000
11/1/2000
9/1/2001
7/1/2002
5/1/2003
3/1/2004
1/1/2005
11/1/2005
9/1/2006
7/1/2007
5/1/2008
3/1/2009
1/1/2010
11/1/2010
9/1/2011
7/1/2012
5/1/2013
3/1/2014
1/1/2015
11/1/2015
9/1/2016
7/1/2017
Year

Source: Thomson Reuters. Data is for the period July 1, 1992 to July 1, 2017. Chart represents month end closing
prices for the Dow Jones Industrial Average and does not include intra-day high and low prices. Dow reached intra-
day high of 21,535 on June 20, 2017.

Many factors can lead to a discrepancy in the supply and demand of stocks which drive changes
in prices. This results in higher or lower investor sentiment about the value of share prices in the
future. These include interest rates, the performance of industries and companies in the market,
economic and regulatory issues, government performance data and technological improvements,
wars, conflicts and natural disasters. For example, low interest rates make stocks attractive since
companies expand by borrowing money and their cost of debt is low, hence allowing companies
to have higher profits and pay larger dividends and thus increase its share price. Also, the
alternative investments to stocks such as government treasuries and bonds are not that attractive
when interest rates are low. Below is a suggested way to answer the question. We are assuming
the date when the question was asked is June 1, 2017.

Answer: The Dow today is at 21,114 and is up about 13.6% since President Trump was elected
on November 9, 2016 when it was 18,590 in the last eight months. It has had the second longest
bull run in the history of the Dow for over eight years since it bottomed out at 6,547 on March 9,
2009 and is up 222.5% since that close.

I think the Dow will be up a further 15% to around 24,300 one year from now for the following
reasons. I believe the proposed Republican Party tax reforms would be approved and implemented
this year and that would reduce corporate and personal taxes. That is expected to increase the
earnings of S&P 500 companies by over 15% and also result in increased consumer and corporate
spending. Further, the tax reform provides for giving a temporary relief on repatriated profits for
U.S. companies that were holding cash abroad. That is expected to bring back $2 trillion to the
U.S. and a part of that would go in the stock market.

2
Global economy should remain strong for the latter part of 2017 and in 2018 as both the developed
and emerging economies will continue to show strong growth. Continental Europe has been
showing continued strength and the pessimism regarding China being unwarranted with the growth
rising back above 6.5% and expected to for this year. U.S. growth seems to be heading higher and
if the tax reform goes through, it will lead to higher GDP growth. Further, unemployment rate is
at 4.4% in the U.S. and I believe will come down below 4% in a year which would be the lowest
in 17 years. It can also fall below 3.8% in 2018 which would be the lowest rate in 50 years and
help fuel the strong economy and higher stock market. Further, advanced economies are able to
hold off on increasing interest rates while emerging economies will continue to cut interest rates
due to lower inflation.

There are many risks that can lead to a smaller increase in the Dow but I feel these risks have a
low probability of happening over the next twelve months. These risks include political risks such
as the U.S. tax reform not going through, economic risks such as a slowdown in China due to the
escalating corporate debt or recession in the U.S. and geopolitical risks such as escalation in the
U.S. North Korea conflict. Other risks include a big cybersecurity or terrorist attack and trade war
between U.S. and China and cancellation of the NAFTA agreement by the U.S. which could slow
down the growth and negatively impact the stock markets.

Note: You do not have to be exact in the numbers you give, for example, the Dow is at around
21,100 or 21,000 today will also be okay. You need to show that you follow the markets and know
the history. The DJIA index has gone up at a compound annual growth rate of 6.6% over the last
50 years (not including inflation and assuming no dividends were reinvested) from 786 on
December 31, 1966 to 19,762 on December 30, 2016 which also includes many years when the
Dow had negative returns.

What is the shape of the yield curve for U.S. Treasuries? What does it tell us?

The yield curve is a line graph that shows the relationship between short-and long-term interest
rates of fixed income securities. The yield curve for U.S. Treasury is considered the market
benchmark though you can have yield curves for any fixed income security such as investment
grade, high yield and municipal bonds. Investors use the yield curve to forecast interest rates and
also to price bonds. Since U.S. Treasury securities are perceived to have no credit risk, other fixed
income securities are priced based on the U.S. Treasuries. For example, a higher quality one-year
corporate bond is priced 0.75% higher than the one-year U.S. Treasuries bond. Yield curves are
also a reliable leading indicator of economic activity and are used to predict recessions or an
economic upturn. The different types of yield curves are described below:

Normal yield curve or upward sloping yield curve is when the yield on the longer-dated bonds is
higher than the yield on the shorter-dated bonds. It implies that the economy will grow in the future
and the strong growth will lead to higher inflation and interest rates. This occurs when central
banks, i.e., the Federal Reserve in the U.S. is easing monetary policy, increasing the supply of
money and availability of credit in the economy. We have shown below the yield curve for the
U.S. Treasury on June 30, 2017 which is a normal yield curve. Data can be found on the U.S.
Department of the Treasury website. For the interviews, you should know the current shape of the

3
yield curve by looking at the rates on the website. As we can see from the graph below, the longest-
maturity, i.e., 30-year Treasury bond bears greater investment risk with having money tied up for
a longer period of time and hence offers the highest return.

Normal US Treasury Yield Curve

2.84%
3.00% 2.61%
Treasury Yield Interest Rates %

2.31%
2.50% 2.14%
1.89%
2.00% 1.55%
1.38%
1.50% 1.14% 1.24%
1.03%
0.84%
1.00%
0.50%
0.00%
1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
Time to Maturity

Data as of June 30, 2017 can be found in the U.S. Department of the Treasury website www.treasury.gov under
Resource Center, Data and Charts Center, Interest Rate Statistics and Daily Treasury Yield Curve Data.

Inverted yield curve is when the yield on the longer-dated bonds is lower than the yield on the
shorter-dated bonds. It indicates that investors think the economy is slowing or will decline in the
future and will lead to lower inflation and interest rates. An inverted yield curve can signal that the
economy can enter into a recession. For example, if investors expect falling equity prices and
decreasing interest rates, they will try to lock their capital into longer-term Treasuries. If many
investors do that, it will lead to increase in the prices of longer-term Treasuries and will cause
yields to fall. The investors will also not prefer to buy shorter-term Treasuries which will cause
Treasury prices to fall and yields to rise.

Inverted Treasury Yield Curve

3.0%
Treasury Yield Interest Rates %

2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
Time Period

Sample data used for illustration purposes.

4
Flat yield curve A flat yield curve happens when there is not much difference between the short-
term and the long-term rates. It can occur in anticipation of slowing economic growth. The curve
may flatten when short-term interest rates rise on the expectation of Federal Reserve increasing
interest rates. It can also flatten when inflation is less of a concern. Since investors demand higher
long-term rates because of inflation, if the concern of inflation is not there, the premium between
short-term and long-term rates shrinks.

Humped yield is very rare and occurs when the rates on the medium-term fixed income securities
are more than the rates on the short-term and long-term securities. A humped curve may indicate
a period of uncertainty in the economy or transition of yield curve from inverted to normal or from
normal to inverted.

Steepening yield curve happens when the spread or gap between the short-term and long-term
rates widens. Generally, we take the spread between the 2-year and 10-year Treasury bond. It
means that investors expect rising inflation, higher interest rates and stronger economic growth.
The investors demand higher yield because of higher inflation and interest rates which can hurt
bond yields.

Answer: As of June 30, 2017, the yield curve was normal or upward sloping with the 3-month
Treasury bill yielding 1.03% and the 30-year Treasury bond yielding 2.84%. Investors were
expecting strong economic growth which would result in increase in interest rates by the Federal
Reserve and also higher inflation. At the end of June 2017, inflation was at 1.7% below the Federal
Reserve target of 2% and it was expected to increase to the target rate of 2%.

Where is the 10-Treasury yield and where do you think it will be in a year from
now?

U.S. 10 Year Treasury Note Rates for Last 40 Years

16.00%
Constant Maturity Rate %

14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
30 7

30 9

30 1

30 3

30 5

30 7

30 9

30 1

30 3

30 5

30 7

30 9

30 1

30 3

30 5

30 7

30 9

30 1

30 3

30 5

7
6/ 97

6/ 97

6/ 98

6/ 98

6/ 98

6/ 98

6/ 98

6/ 99

6/ 99

6/ 99

6/ 99

6/ 99

6/ 00

6/ 00

6/ 00

6/ 00

6/ 00

6/ 01

6/ 01

6/ 01
01
/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/2

/2

/2

/2

/2

/2

/2

/2

/2
30
6/

Time Period

Source: Board of Governors of the Federal Reserve System (US)- https://fred.stlouisfed.org/series/DGS10. Data is of
the period June 30, 1977 to June 30, 2017.

5
The 10-year U.S. Treasury note yield is the most widely tracked rate and one of the most popular
debt instruments in the world. Its yield is used to benchmark other important interest rates such as
mortgage rates and automobile loans. The 10-year U.S. Treasury yield has been as high as 15.84%
on September 30, 1981 and then hit an all-time low of 1.37% on July 5, 2016.

The federal funds rate is the interest rate at which depository institutions such as banks lend reserve
balances to other depository institutions overnight. The federal funds target rate is determined by
a meeting of the Federal Open Market Committee (FOMC). The federal funds rate impacts short-
term borrowings such as bank prime rate, the LIBOR, credit card loans and adjustable mortgages
and interest on Treasury bills. During the financial crisis, the FOMC reduced the federal funds rate
from 5.25% to 0.25% or effectively zero on December 16, 2008 by cutting the rate over 10 times
in a period of approximately one year. After keeping the rate at 0.25% for 7 years, the FOMC
increased it on December 15, 2015 to 0.5% and then 3 more times to 1.5% on June 14, 2017. The
FOMC signaled it will raise the rates to 2% in 2018, 2.5% in 2019 and 3% in 2020.

Answer: The 10-year Treasury note as of June 30, 2017 was at 2.31%. It has risen from its all-
time low of 1.37% as of July 5, 2016. I believe that in one year it would be around 3% given that
there is a fear about rising inflation. Further, since the economy is doing well, rates can be higher.
The Federal Reserve is also expected to trim the holdings of Treasuries it purchased through
quantitative easing. This will increase the supply of Treasury notes and result in upward pressure
on the yield. Though the fed funds rate is more directly correlated to the short-term borrowings,
since the FOMC plans to do more increases in 2017 and 2018, I think it is likely that long-term
Treasuries such as 10-year bond will also rise. On the other side, I think Treasuries will not increase
further than 3% since central bank purchases from other countries will continue since U.S. yields
are much higher than comparable yields in developed economies of Europe and Japan.

The increase in Treasury yields will result in new mortgages and refinancing existing mortgages
becoming more expensive and can lead to a slowdown in the housing market and hence the
economy. Higher rates will lead to a fall in stock prices since higher rates of borrowing for
individuals and corporates will slow down economic growth and hence profits. With higher rates,
alternate to stocks such as bonds become more attractive and hence investors might shift some
money from stocks to bonds. Also, bond investments will take a hit since as rates rise, the value
of the existing bonds fall and can cause losses for investors.

Where is the Euro against the US dollar and where do you think it will be in the
next 12 months?

6
 Euro / USD Foreign Exchange Rate
1.6
1.5
Exchange Rate

1.4
1.3
1.2
1.1
1
0.9
0.8
1/1/1992
11/1/1992
9/1/1993
7/1/1994
5/1/1995
3/1/1996
1/1/1997
11/1/1997
9/1/1998
7/1/1999
5/1/2000
3/1/2001
1/1/2002
11/1/2002
9/1/2003
7/1/2004
5/1/2005
3/1/2006
1/1/2007
11/1/2007
9/1/2008
7/1/2009
5/1/2010
3/1/2011
1/1/2012
11/1/2012
9/1/2013
7/1/2014
5/1/2015
3/1/2016
1/1/2017
Time Period

Source: Thomson Reuters. Data is for the period July 1, 1992 to July 1, 2017. Chart represents month end closing
prices for the Euro/USD Foreign Exchange Rates and does not include intra-day high and low prices.

The foreign exchange market in the world is the largest and most liquid financial market with over
$4 trillion daily traded by banks, corporations, investment funds and retail investors. The
currencies that trade the most are the U.S. dollar, Euro, Japanese Yen, British Pound, Canadian
Dollar and Swiss Franc. The exchange rate between two countries is dependent on many factors:

Inflation If one country experiences a higher inflation than another country, the currency of the
country having higher inflation should decline. For example, if the inflation in U.K. is higher than
U.S., goods in the U.K will become more expensive and exports less competitive and hence
demand for the pound will reduce.

Interest rates If interest rates in the U.S. rises faster than other countries, it will make foreign
investors want to invest in the U.S. to get higher returns. The capital inflows will result in driving
up the value of the U.S. dollar.

Current account balances In general, current account deficits will result in long-term currency
depreciation and vice-versa. If a country’s consumers developed an enormous appetite for foreign
products, the current account balance will probably deteriorate and the currency will also
depreciate as it bids up the foreign currency required to buy the products.

Political and economic stability will cause investors to lose confidence and invest money in other
stable countries and depreciate the currency of the country having instability. Investors will not
want to invest or own securities in a country which has a lot of government debt and the risk of
default of that debt is high.

The Euro is the official currency of the European Union and 19 of the 28 member states known as
the eurozone use the Euro. The Euro was introduced in 1999 at an exchange rate of $1.18 and
depreciated continuously over the next two years to trade below the U.S. dollar at $0.83, i.e., 0.83
U.S. dollars buy one Euro on October 2000. It has traded above the U.S. dollar since 2002 peaking
at around $1.60 in 2008.

7
Answer: On June 30, 2017, the Euro Dollar exchange rate was $1.14 i.e., $1.14 U.S. dollars buys
1 Euro. It had risen from $1.05 at the beginning of the year though it was down from $1.37 on
June 30, 2014 over the last three years. We think the Euro will stay around the $1.15 for the next
one year. The positives for Euro were a pro-Euro government formed in France in May 2017 and
the anticipation of pro-Euro government being formed in Germany later in early 2018 which would
further lead to European integration and even higher growth across the Euro region. This would
lead to more unhedged inflows into the Eurozone. Unhedged inflows mean that international
investors have a positive view of the currency in future years and invest in Europe without
protecting themselves against a fall in the currency. If investors protect themselves, they sell the
EUR/USD rate at the same time they buy it and hence one transaction counteracts the other and
hence prevents currency appreciation. The negatives for Euro are the political instability in Italy
with elections due in early 2018 and an anti-Euro sentiment in the country.

What is the price of gold and where do you think it will be in the next 12
months?

Gold Price in US$ for the Last 40 Years

2000
1800
1600
1400
1200
Price

1000
800
600
400
200
0
1/ 77

1/ 79

1/ 81

1/ 83

1/ 85

1/ 87

1/ 89

1/ 91

1/ 93

1/ 95

1/ 97

1/ 99

1/ 01

1/ 03

1/ 05

1/ 07

1/ 09

1/ 11

1/ 13

1/ 15
17
19

19

19

19

19

19

19

19

19

19

19

19

20

20

20

20

20

20

20

20

20
3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/

3/
1/

Time Period

Source: ICE Benchmark Administration Limited (IBA) - https://fred.stlouisfed.org/series/GOLDAMGBD228NLBM.

Prices are as of London AM fix. Data is for the period January 3, 1977 to June 3, 2017. Chart represents month end
closing prices for Gold and does not include intra-day high and low prices. Gold reached a high of 1,895 on September
25, 2011.

Factors described below can impact the price of gold:

Supply and demand Increase in the demand for gold can lead to increase in prices. According to
the World Gold Council, in 2016, 47% of the demand for gold came from jewelry with China and
India accounting for approximately 60% of the demand. 24% of the demand came from
institutional and private investors through direct purchases of bars and coins and 12% from
exchange-traded funds, exchange-traded notes and closed-end funds that trade as shares on the
stock exchange. SPDR Gold Shares (Ticker: GLD), the largest physically backed gold exchange-
traded fund in the world and iShares Gold Trust (Ticker: IAU) on the NYSE are examples of large

8
exchange-traded funds.

9% of the demand came from net purchases by central banks to diversify their portfolios, especially
away from dollar-denominated assets. U.S. and Germany central banks have close to 70% of their
reserves in gold and many European countries have substantial holdings in gold. An increase in
reserves by these countries or other central banks increasing their gold reserve will increase the
demand for gold. Technological applications such as electronic components such as bonding wire,
decorative and dental applications accounted for 4% of the demand.

In 2016, supply came from gold mining which accounted for 71% of the supply and recycling of
gold which accounted for 29% of the supply. Increase in gold prices leads to increase in recycling
of gold which is the most dynamic element of the gold market supply and helps to balance the gold
market.

Geopolitical and economic stability Gold prices tend to rise and it is viewed as a safe haven
during financial crisis, lack of confidence in governments and acts of war.

Interest rates Higher interest rates can lead to a fall in price since gold does not generate any
income and investors will sell gold and move money into a savings account and treasury bonds.
When interest rates are low, the opportunity cost of holding gold is low compared to other investing
assets. Hence, lower rates increase the demand for gold.

Currency devaluation Gold prices are in U.S. dollar and it generally has an inverse relationship
with the U.S. dollar. When the dollar is falling, the value of other countries’ currencies increases.
This increases their demand for commodities including gold. Further, when dollar value declines,
investors look for alternate ways to store value and gold is one of those sources.

Gold prices hit a record of $850 an ounce in January 1980 and then fell to a low of $252 in August
1999 and it took approximately 28 years for it to break the $850 mark in January 2008. Gold then
hit a record high close to $1,895 on September 5, 2011 before falling to $1,521 at the end of 2011.

Answer: As of June 30, 2017, the price of gold was at $1,242 an ounce. Gold has risen from
$1,151 at the start of 2017 and we expect it to be around $1,300 in a year from now. The reason
for the increase is that we believe emerging market growth is trending strong at above 6%. The
growing wealth among households and rise in disposable wealth will increase the demand for gold.
Since jewelry accounts for over 50% of the demand for gold, this will lead to an increase in the
price of gold.

Further, the geopolitical tension between the U.S. and North Korea and escalation of conflict in
the Middle East is another reason for our increase in gold prices. We believe that gold prices will
not increase beyond $1,300 given that the Federal Reserve is planning to raise interest rates in the
latter part of 2017 and 2018 and the probability of recession is low in the U.S. and globally in 2017
and 2018. Though the Federal Reserves is increasing rates, inflation is also rising, so the real
interest rate, i.e., nominal interest rate minus inflation is low which bodes well for gold.

What is the price of oil and where do you think it will be in the next 12 months?

9
 Crude Oil Prices: West Texas Intermediate for Last 30 Years
160.00
140.00
120.00
100.00
Price

80.00
60.00
40.00
20.00
0.00
7

7
98

98

99

99

99

99

99

00

00

00

00

00

01

01

01

01
/1

/1

/1

/1

/1

/1

/1

/2

/2

/2

/2

/2

/2

/2

/2

/2
/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1

/1
12

12

12

12

12

12

12

12

12

12

12

12

12

12

12

12
Time Period

Source: U.S. Energy Information Administration- https://fred.stlouisfed.org/series/DCOILWTICO. Data is for the

period December 1, 1986 to December 1, 2017. Chart represents month end closing prices for Brent Crude Oil and
does not include intra-day high and low prices.

Brent, WTI and other types of oil The price of oil is the spot price of a barrel of benchmark crude
oil such as West Texas Intermediate (WTI), Brent ICE (Brent), Dubai Crude, Bonny Light and
Western Canadian Select (WCS). Specific gravity, sulfur content in oil and the location of oil in
terms of distance to refineries and tidewater makes the oil prices vary. Brent crude is a sweet light
crude oil since it has low density and low sulfur content. Since its supply is water borne from oil
fields along the coast of Norway and U.K., it is easy to transport to distant locations and is used to
price approximately two-thirds of the crude oil contracts globally. WTI is the main benchmark
used to price oil in the U.S. It is very sweet and light and is extracted from wells in the U.S. and
sent to Cushing, Oklahoma through pipeline where it is stored. It is expensive to ship to other parts
of the world since it is landlocked. `

Many factors impact oil prices including:

The Organization of Petroleum Exporting Countries (OPEC) is a consortium of 14 countries

and is responsible for 40% of the world’s total supplies. It has an impact on world’s oil supplies
since it can affect the price of oil by increasing or decreasing production among member countries.
According to Rystad energy, in November 2015, Angola, Nigeria, Libya and Venezuela had high
costs of producing a barrel of crude oil at $35.40, $31.6, $23.80, and $23.50 per barrel, respectively
compared to Saudi Arabia and Kuwait having costs of $10 and $8.50 per barrel, respectively.
Further, oil accounts for most of the exports and GDP for OPEC countries who are dependent on
oil exports to balance their fiscal budgets. Fuel exports make up 98% of all exports for Venezuela.
In November 2016, OPEC members agreed to cut back production for the first time since the
financial crisis till end of 2018 and were joined by some other non-OPEC members like Russia
which also agreed to cut back production. OPEC’s decision to limit production was to eradicate
excess inventory but in the middle of 2017, inventory was still more than the five-year average.

10
U.S. production and oil supplies While OPEC and certain non-OPEC members were able to cut
production, supplies were strong as U.S. produced oil at a record pace in 2017. In 2018, the U.S.
could become the largest producer of oil in the world.

Government sanctions, threat of war and natural disasters Sanctions by the U.S. against Iran,
escalation of the U.S. tensions with North Korea, unrest in Nigeria and Libya, and terrorist attacks
and military coups in oil producing countries can all lead to increase in prices. Natural disasters
like hurricanes and wildfires can also impact oil prices.

Demand for oil Price of oil dropped in 2014 due to weakness in Europe and China and demand
had picked up significantly in 2016 and early 2017 due to economic growth globally.

Oil futures and market sentiment The price of oil is set in the futures market by two participants.
Hedgers are airlines buying oil futures contracts to protect against a rise in prices, whereas
speculators, who constitute the majority of the oil futures contracts are investors guessing on the
price of oil in the future without taking physical delivery of the product. If there is market sentiment
that future oil demand will increase, both speculators and hedgers will buy oil contracts and lead
to increase in the price of oil.

History of oil prices WTI oil was $26 a barrel in January 1986 and had risen to a high of around
$145 a barrel by June 2008 and then dropped to around $30 at the end of 2008. Oil prices increased
to $103 in January 2012 before dropping again to $26 by February 2016. They have again starting
to go up and were at $45 on June 30, 2017.

Answer: WTI price was at $45.17 on June 30, 2017. It had gone up from a low of around $30 in
February 2016 but down from around $53 in February 2017. I expect oil prices to be around $60
twelve months from now due to strong economic growth globally, major oil producing countries
limiting supply, output disruptions in Venezuela and a weaker dollar. I believe the U.S. dollar
weakening will make make oil which is denominated in dollars more attractive to all other
countries which will increase the demand of oil and hence prices. Further, Venezuela, which has
the highest proven reserves in the world was facing production declines of over 30% due to
macroeconomic issues like hyperinflation, excessive leverage and currency devaluation as well as
problems with its state owned national oil company.

11
Brainteasers and Guesstimates
“guesstimate = better than a guess but not as guaranteed as an estimate"
– A.A. Bell

Disclaimer Please note that the below questions have appeared in many interviews and books but
you can get different brainteasers in the interview. These questions are only included for
instructional purposes. You should practice as many brainteaser and guesstimates as they can as
practice will enable you to answer these questions effectively.

Brainteasers and guesstimates can unnerve the most well-prepared finance candidate. The goal of
the interviewer is to test your analytical capabilities by analyzing a situation and forming a
conclusion and also to see how you can handle pressure or stress. Sales and trading interviews
may involve brainteasers as may other interviews for finance jobs.

Four people, Albert, Bill, Charlie and Derek need to get across a river. The only
way to cross the river is by an old bridge, which holds at most 2 people at a
time. Because it is dark, they can't cross the bridge without a torch, of which
they only have one. So each pair can only walk at the speed of the slower person.
All of them need to get across to the other side as quickly as possible. Albert is
the slowest and takes 10 minutes to cross; Bill takes 5 minutes; Charlie takes 2
minutes; and Derek takes 1 minute. What is the minimum time to get all of
them across to the other side?

• It takes 17 minutes in total. Alternatively, we can send Charlie back first and then Derek
back in the second round, which takes 17 minutes as well

Key point is to realize that the 10-minute person should go with the 5-minute person and this
should not happen in the first crossing, otherwise one of them will have to go back. So Charlie and
Derek should go across first (2 minute); then send Derek back (1minute); Albert and Bill go across
(10 minute); send Charlie back (2minute); Charlie and Derek go across again (2 minute).

There are a total of 9 bicycles and tricycles. If the total number of wheels was
23, how many tricycles were there?

• 5
o Assuming 2 wheels for each cycle, 9 cycles will have 18 wheels. But, there are 23
− 18 = 5 extra wheels
o As bicycles have 2 wheels and tricycles have 3 wheels, there is 1 extra wheel per
tricycle in the park. Thus, the 5 extra wheels belong to 5 tricycles
There are 6 black marbles and 10 white marbles in a box. If we pick up some
marbles from the box, what is the minimum number of marbles we will have
to pick to be certain to find a pair of marbles of the same color?

• 3
o To find a pair, we must pick at least 2 marbles. But, if we pick 2 marbles blindly,
then they may be of different colors. If we pick 3 marbles blindly, then there are
only 2 possibilities: all 3 marbles are of the same color, or 2 marbles are of the same
color and 1 is of a different color
o Both these possibilities guarantee a pair of marbles of the same color. Thus, we
should minimally pick 3 marbles to be certain to find a pair of marbles of the same
color

A teacher has a total of 16 pieces of chalk. When a piece of chalk reduces to 1/4
of its original size, it gets too small for her to hold for writing and hence she
keeps it aside. But your teacher hates wasting things and so when she realizes
that she has enough of these small pieces to join them together and make
another piece of chalk of the same size, she joins them together and uses the
new piece of chalk. If she uses one piece of chalk each day, how many days
would the 16 pieces of chalk last?

• 21 days
o The teacher uses one piece of chalk each day. Hence the total number of days she
uses 16 pieces of chalk is 16. Each piece of chalk leaves a fraction of 1/4 its size so
16 such fractions remain. Since 4 such fractions are joined to give a new chalk,
your teacher combines all the fractions to get 4 chalks which can again be used for
4 days. Hence, she has managed to use 16 pieces of chalk for (16 + 4) days!
o But, what about the leftovers of the pieces of chalk used over the last 4 days? They
can be joined to form yet another piece of chalk which means another day! So your
teacher uses the 16 pieces of chalk for a total of 21 days.

Which number is 3 times the sum of its digits?

• The number is 27, simply because 27 = 3 *(2 + 7).

How does one find this number? Let t be the digit in the tens place and u be the digit in
the units place. Then, the number is 10 t + u, and the sum of its digits is t + u. The
following equation can be readily written:
10 t + u = 3 t + 3 u or
7 t = 2 u.
Thus, t / u = 2 / 7. Since t and u are digits, t must be 2 and u must be 7.
When I add 6 times my age 6 years from now to 7 times my age 7 years from
now, I get 14 times my current age. How old will I be 5 years from now?

• Let x be my present age. My age 6 years from now will be x + 6, and 6 times that will be
6 (x + 6). Similarly, my age 7 years from now will be x + 7, and 7 times that will be 7 (x
+ 7). Adding the two gives 14 times my current age. This gives the equation:

6 (x + 6) + 7 (x + 7) = 14 x.

Solving the above equation gives

x = (6 × 6) + (7 × 7) = 85.
Thus, I will be 90 years old 5 years from now
Chapter 21: Stock Pitch
“If stock market experts were so expert, they would be buying stock, not
selling advice”
– Norman Ralph Augustine

Pick a stock you would buy or sell and explain why.

This would be a common interview question asked in finance interviews as it
demonstrates that you follow the markets as well as tests your skills in valuation
analysis. Select any stock you can talk about intelligently based on valuation and any
other analysis you have done. Explain using fundamental analysis or technical analysis
or both. Interviewers are generally looking for fundamental analysis unless it is a sales
and trading role where you can talk about both strategies. Technical analysis involves
selecting stocks based on historical trends and stock movements mainly contained in
charts. Generally, investment banking, asset management and equity research jobs are
looking for answers based on fundamental analysis.

If you are giving a “buy” recommendation, there are two questions to answer. The first
aspect is “whether company X is a great company.” The second question is “whether
company X is a great buy at today’s price” or “what price is company X worthy of
investment? $30, $40, $50 or some other price?”

Explain why company X is an excellent investment at the current price. Company X

may be a great company but it may be overpriced in the stock market and you may
conclude that you want to short the stock instead of buying it. You should explain the
valuation of the stock based on various valuation methodologies including comparable
company and discounted cash flow analysis and by comparing it to the current enterprise
value of the company or its current stock price.

Have a view on company X similar to that of an equity research analyst, i.e., whether
you will buy, hold or sell the stock. There may be some factors that cause you to think
that you should not buy the company. You want to mention those factors also and say
that the positive factors outweigh the cons and hence you have a “buy” recommendation.

Initiating research report, i.e., the first time a research analyst covers a stock will provide
you maximum details on an industry. Focus on that report, and if there are no initiating
reports written recently, go to the valuation section of equity research reports by analysts
on that stock to help you prepare for your interview.

What are the common valuation metrics and what other metrics are
used in valuing companies in different industries?

Enterprise Value (EV) / EBITDA, EV/Revenues, EV/EBIT, Price/Earnings (P/E) Ratio

1
are the most commonly used valuation metrics. Last twelve months (LTM) data and
one- and two-year forward data is generally analyzed. Price/Earnings/Annual EPS
Growth (PEG) ratio, can be used for growth companies. Generally, the EPS growth rate
used is a one-year growth rate or more often a five year EPS growth rate. PEG ratio
allows us to compare the PE ratio of a growth company vs. a company which is not
growing. If we only use P/E ratios, the higher growth company with a higher P/E ratio
may appear overvalued compared to the other company with lower P/E ratio.

Some industries apply specific sector multiples besides the ones discussed above:
• Financial Institutions – Price or Equity Value/Book Value per share and Equity
Value / Net Asset Value (NAV) per share
• Retail – EV/EBITDAR (Earnings before Interest, Taxes, Depreciation,
Amortization and Rent Expense)
• Oil and Gas and Natural Resources – EV/EBITDAX (Earnings before Interest,
Taxes, Depreciation, Depletion, Amortization, and Exploration Expense)
• Metals and Mining – EV/Reserves, EV/Production (in units)
• Real Estate – EV/Square Footage, Equity Value/Funds from Operation (“FFO”)
• Telecommunications – EV/Access Lines or Fiber Miles

10 POINTS IMPACTING PRICE OF A STOCK

We have highlighted below ten factor that have an impact on the stock price. These could be factors
related to the company earnings and news, industry, economic as well as general market sentiment.
You should factor these in your stock pitch.

1. Company strengths, earnings and news

• Company highlights could be its competitiveness compared to the industry,
potential barriers to entry, products and services, operations as well as its strong
management team. Risks include threats and challenges the company can face in
its business
• Company revenues, earnings and profit growth, and expected profits in the future
compared to projections made by the company and equity research analysts. For
example, if the company beats their own estimates and analyst expectations on
revenues and earnings, stock prices go up on the results. Further, if the company
increases its revenues and earnings guidance, stocks move up and vice versa
• Change in dividend policy, news of an anticipated merger or acquisition by another
company, accounting scandals, changes in key members of the management team,
and introduction of a new product or product recall can all have an impact on the
company and stock price

2
2. Industry performance
• Companies in a particular industry may go up or down at the same time due to
performance of the whole industry but sometimes one company in an industry can
benefit because of negative news of a competitor in the same industry
3. Valuation of the company and the market as a whole
• Valuation of the company can be done using various methodologies including
comparable company analysis and discounted cash flow analysis. Company
valuation can also be compared to their historical valuation
• S&P 500 generally represents the market in the U.S. and its current valuation can
be compared to its historical valuation on different metrics such as PE ratios of the
companies or enterprise value to EBITDA multiples. The reasons for higher or
lower valuations in the past can be analyzed, potentially telling us if the market as
a whole is overvalued or not
4. Central bank policy, inflation and interest rates
• Central banks policy on interest rates, for example, lower interest rates that make it
easier for people to borrow, less incentive to invest in fixed income assets such as
bonds as well as lead to investment in riskier assets like stocks. Inflation will lead
to higher prices and thus may lead to slower sales and profits. Central banks may
raise rates to bring down inflation which can lead to lower stock prices.
5. Global growth and stability
• Growth globally will enable U.S. multinational companies to earn higher profits
and hence impact their stock price.
6. Stable political climate and pro-business economic policies
• Stable political climate with pro-business economic policies that can result in
stronger growth in GDP will benefit stocks in long run. Lowering corporate taxes
and having less regulation without an adverse impact on budget and speculative
activities can lead to higher stock prices.
7. Inflows into passive funds
• Higher inflows into mutual funds and exchange-traded funds (ETFs) can lead to
investments in the stock market which are not related directly to company
fundamentals.
8. Alternate sources of investments
• Alternate sources of investments could include fixed income assets such as
corporate and government bonds, real estate, commodities and investments in
foreign equities. Lower interest rates and possibility of higher rates in the future
may lead investors not to invest in fixed income assets.
9. Liquidity, insider purchases and expiration of lock-ups
• Large capitalization stocks are liquid and have lot of trading volume. Some small

3
 capitalization stocks do not trade as much in the market and hence their stock prices
can be affected by small purchases or sales of stock. Insider purchases should also
be monitored as it could be a signal as to how management and other owners feel
about their stock price
• In an IPO, shares of insiders and employees are generally locked up for sale for 180
days and when the lock-up expires or is about to expire, the share price can be
affected since large amount of shares are now available in the market
10. Exchange rates
• The strength of the U.S. dollar makes its products more expensive for foreign
buyers which could impact the earnings of U.S. companies dependent on exports

4
The recommendations and stock profiles in the following pages are intended for
instructional purposes only and are not meant as a recommendation to buy, sell, or
hold individual securities. Buy, sell or hold recommendations are for teaching
purposes only and do not reflect the author’s view on these stocks. Data taken from
public sources including company website and reports has been adjusted or changed
by the author to illustrate a teaching point and is in no way a recommendation related
to the stock.

10 STEPS FOR A STOCK PITCH

The following steps will help you answer a stock pitch interview question:

Step 1: Provide a brief description of the business for the company you have selected
to pitch to the interviewer. The description can be longer if the company is not a well-
known company.

Step 2: Recommendation, current and target price You want to start your answer
with your recommendation, i.e., buy, sell or hold the stock. You want to mention the
current price of the stock and where you see the stock will be in 12 months from now,
i.e., the target price of the stock.

Step 3: 52-week high and low price helps provide the interviewer with some history
of the stock and demonstrates that you follow the stock and markets.

Step 4: Market capitalization, enterprise value and dividend yield Market

capitalization is based on fully diluted shares outstanding. Dividend yield is the dividend
paid for the last four quarters divided by the current price of the stock.

Step 5: Key investment highlights You can provide five to six investment highlights
for the company and the industry. Generally, investment highlights are related to the
economy and the industry, competitive advantages of the company in areas of products,
marketing, customers, finance and operations as well as an opinion on the management
team of the company.

Step 6: Risk factors You can give three to five risk factors for the company. These are
related to the economy and industry, competitors and any other factors that can
negatively impact the company. You will have more risk factors if your recommendation
is to sell the stock.

Step 7: Summary financials Highlight summary financials that will lead to valuation
discussion, for example, revenue growth rate for the last three or five years and
improving or deteriorating EBIT or EBITDA margins.

Step 8: Valuation Include valuation methods you have used to value the stock including
comparable company analysis and DCF. You can also compare the performance of the
company to an index and its historical performance, for example, company X is currently

5
trading at a one-year forward P/E multiple of 20.0x compared to its historical five-year
forward P/E multiple of 22.0x.

For comparable company analysis, mention the comparable public companies you
chose. Be specific as to the multiple you got, for example, TEV/Revenue or P/E and the
year you are talking about, for example, LTM or one-year forward or two-year forward.
Conclude with the implied enterprise value and stock price based on your analysis. For
DCF analysis, highlight the free cash flow or revenue growth rate for five or ten years,
weighted average cost of capital and the terminal growth rate or terminal multiple you
used.

Step 9: Mention catalyst(s) that can lead to an increase or decrease in the stock price
to achieve your target price. Catalysts can include earnings announcements, new product
launches, dividend announcements, new regulations and federal reserve increasing or
decreasing interest rates.

Step 10: Summary At the end, conclude with the key points that led you to the target
price. It should answer both questions, i.e., is the stock a great company and is it a great
company at today’s price.

We have provided a few sample stock pitch profiles in the following pages. Keep the
answer short and go into details on any particular investment positives or negatives in
the follow up questions by the interviewer. To be consistent, the date of valuation for
these companies is January 4, 2010. Most of the data is taken from public sources
including company websites and research reports. Adjustments to the data have been
made to illustrate a teaching point. All charts and stock prices are taken from MSN
Money and Yahoo Finance.

You will see that picking individual stocks is not easy and can lead to substantial gains
and even losses. For example, Research in Motion, now called BlackBerry Limited had
a high stock price of $147.55 on June 19, 2008, and then had fallen to $65.93 on January
4, 2010. While most analysts had a buy rating on the stock at that date, the stock went
down to $59.10 on January 4, 2011. It had a low of $6.04 on November 21, 2013, and
was trading at $11.83 on May 31, 2018. Visa was at $88.14 on January 4, 2010, and had
fallen to $70.60 on January 4, 2011. The company did a 4 for 1 stock split on March 19,
2015, and was trading at $130.72 after the stock split on May 31, 2018, or $522.88 pre-
split to compare with the $88.14 price on January 4, 2010.

6
 Valuation Date: January 4, 2010
Research in Motion
Closing Market Price: $65.93
(RIMM – NASDAQ)
Industry: Communications Equipment and 52-Week High: $88.08 Recommendation
_ Data Networking

Basic Shares Outstanding: 571.0 M

52-Week Low:

Net Debt:
$35.00

-$1.3B
BUY
Target Price: $75
Market Capitalization: $37.6B
Dividend Yield: 0%
Total Enterprise Value: $36.3B

Investment Highlights Business Description

• Strong international growth – approx. 60% of total revenues Research in Motion (“RIM”) designs, manufactures and markets wireless
by 2015 compared to 35% today solutions. Products and services principally include the BlackBerry wireless
platform and the RIM Wireless Handheld.
• Excellent customer experience and support – customers love
to click away with RIM and the brand loyalty and experience
is sticky. RIM is one of the few handset vendors that interacts 52 Week Chart (Daily Close Prices)
directly and provides support to the end user
• Vertical integration – RIM is one of the few companies
offering hardware, software, and related services
• Strong industry growth – smartphone market expected to grow
by 40% in North America and 55% internationally from 2010-
2015
• Strong management team – has not changed significantly
since the start of the company

Investment Risks Summary of Financial Information

• International expansion – could slow down and not be as fast ($ in mm except EPS data) For the fiscal year ended Feb 28
as projected
• Decline in gross margin – average selling prices are declining 2007A 2008A 2009A 2010E 2011E
due to new entrants coming into the market
• Competition – competitors such as Apple and Samsung, Revenues $3,037 $6,009 $11,065 $14,840 $17,248
among others, could take away market share from RIM’s U.S.
business EBITDA 933 1,908 3,050 3,846 4,453
• Technological threat – Apple and Google perceived by users EBIT 807 1,731 2,722 3,252 3,824
to have superior features and better to browse the Internet
EPS 1.10 2.26 3.30 4.38 5.01
Valuation Valuation Metrics and Comparable Companies

• RIM currently trades at 15.05x estimated 2010E earnings in P/E 2010: 15.05x P/E 2011: 13.15x
the range of how Nokia and Motorola are trading in the TEV/2010 Revenue: 2.44x TEV/2011 Revenue: 2.10x
market. Revenue and earnings growth of RIM for the next five TEV/2010 EBITDA: 9.44x TEV/2011 EBITDA: 8.15x
years is approx. 17% compared to 4% and 3% for Motorola Comparable companies may include premium technology companies such
and Nokia respectively. RIM should trade higher than them as Google, Apple, Yahoo, Akamai Technologies, and Amazon.com as well
given its dominant position in the handset market and higher as handset manufacturers including Motorola, Nokia, Ericsson, Samsung,
revenue growth so at $75 price target it would be 17.12x 2010 Palm and LG
EPS estimate Summary
We suggest a BUY recommendation and a price target of $75 based on DCF
• RIMM trades at 15.05x 2010E earnings compared to approx.
and comparable company valuation and the companies strong revenue
22.0x for technology premium companies like Google, Apple,
Yahoo and Amazon. At $75 price target RIM should trade at growth, customer experience, cost advantage as well as strong growth in the
17.12x times 2010E earnings smartphone industry despite the risks to the price target mentioned above
• DCF price of $75 is based on revenue growth of 17% for five
years, WACC of 12% and terminal growth rate of 3.5%

7
 Valuation Date : January 4, 2010
Baidu (BIDU – NASDAQ)
Closing Market Price: $410.03

Industry: Internet Search Engine 52-Week High: $467.68 Recommendation

Basic Shares Outstanding:

Market Capitalization:
35.0M

$14.5B
52-Week Low:

Net Debt:
$115.30

466.0M
BUY
Target Price: $525
Total Enterprise Value: $14.03B Dividend Yield: 0%

Investment Highlights Business Description

• Superior pricing power – compared to Internet peers in China, Baidu (“BIDU) is the number one Internet search provider in China with a
driven by its dominant market share having over 60% of total focus on Chinese web pages, generating a majority of its revenue through
search traffic and its keyword bidding model pay-per-click advertising.
• New online marketing service, Phoenix Nest – Increased
revenues from its large customers, which are the earliest 52 Week Chart (Daily Close Prices)
beneficiaries. Also, expected increase in revenues from
customers who still do not understand the service and will
begin to utilize the platform soon
• Increase in market share – Google, one of Baidu’s main
competitors, may depart from the Chinese market over
disputes with the Chinese government
• Fall in Traffic Acquisition Cost – as a % of total revenue may
fall in the coming quarters due to the impact of Google leaving
China

Investment Risks Summary of Financial Information

• Slower than expected online search spending – due to the ($ in mm except EPS data) For the fiscal year ended Dec 31
economic slowdown, government policy changes, fraudulent 2007A 2008A 2009A 2010E 2011E
clicks, and availability of an alternative more effective
advertising form Revenues $213.6 $465.5 $651.4 $1,032.3 $1,425.1
• Increased competition – from Google, Tencent and Taobao, a
private largest consumer e-commerce company in China EBITDA 102.1 221.4 296.0 458.5 651.0
• Exit of Google – may not quit China given the importance of EBIT 72.7 159.6 235.1 395.6 565.5
Chinese market to Google and may reach a compromise with
the government EPS 2.40 4.39 6.25 9.98 14.54

Valuation Valuation Metrics and Comparable Companies

• A PEG of .95x is at a premium to a peer average PEG of 0.8x. P/E 2010: 41.1x P/E 2011: 28.2x
A premium is justified given Baidu's dominance in online TEV/2010 Revenue: 13.6x TEV/2011 Revenue: 9.8x
search market and higher EPS and revenue growth rate. TEV/2010 EBITDA: 30.6x TEV/2011 EBITDA: 21.6x
Baidu’s 41.1x 10E PE, is at a premium to a peer average of Comparable companies may include China Internet portals Sina, Sohu,
27x 10E P/E given Baidu's strong growth potential compared Tencent, Alibaba and Ctrip which are the core comparables for valuation.
to the peers (forecasted 70% EPS growth in 2010 vs. 45% Other comparables include China online gaming companies such as Shanda,
across the peers) Netease and Changyou
• The implied 52.6x 2010E P/E at a target price of $525 is at a
premium to Baidu's 3-year average P/E of 45x. We believe a Summary
premium is justified given a stronger market position We have a BUY recommendation and a target price of $525 based on our
• DCF yields a comparable standalone value of US$525 using a DCF and comparable company valuation and the companies’ dominant
discount rate of 13%, a terminal growth rate of 4% and a position in China, superior pricing power, and the potential exit of Google
potential upside of $25 in stock price due to higher revenues impacting Baidu positively despite the risks to the target price mentioned
due to the possible exit of Google above

8
 Valuation Date: January 4, 2010
Infosys (INFY – NASDAQ)
Closing Market Price: $56.76

Industry: IT Service Provider 52-Week High: $56.76 Recommendation

Basic Shares Outstanding:

Market Capitalization:
573M

$33.8B
52-Week Low:

Net Debt:
$22.61

-$ 2.4B
HOLD
Target Price: $60
Total Enterprise Value: $31.4B Dividend Yield: 0.76%

Investment Highlights Business Description

• Macro outlook encouraging – the Indian IT services business Infosys is the second-largest IT services company in India providing
model is closely linked to macroeconomic factors, in business consulting, application development and maintenance and
particular, the health of the U.S. economy. We predict a strong engineering services to 571 active clients in 50 countries. Infosys trades in
recovery in the global and U.S. economy in 2H 2010 the U.S. as an ADR where each share is equal to one share trading in the
Indian market
• Strong growth – revival of the demand environment for 52 Week Chart (Daily Close Prices)
offshore vendors. Though budgets for 2010 are likely to be
flat, offshore vendors could benefit disproportionately as their
global clients look for ways to reduce costs
• Excellent client base – diversified client base which includes
large Fortune 500 companies
• Strong management team – excellent project execution skills
and one of the best corporate governance structure among
Indian companies
• Further upside – could come from rupee depreciation, faster-
than-anticipated recovery in project awards; and
acquisitions/large deal wins not assumed in our estimates

Investment Risks Summary of Financial Information

• Rupee appreciation – beyond the levels assumed and adverse (Rs in mm except EPS data) For the fiscal year ended Mar 31
cross-currency movements could affect revenues
2008A 2009A 2010E 2011E 2012E
• Pricing pressures higher than those built into our assumptions
(Rs/US$) 39.97 46.52 47.00 46.00 45.00
• Potential termination of tax benefits under SEZs remains as
yet not clarified under the draft Indian direct tax code Revenues 166,920 216,930 225,275 253,200 302,562
• Strong regulatory action against outsourcing in Infosys’s key EBITDA 52,380 71,950 76,654 82,124 98,786
geographic markets
EPS $1.98 $2.20 $2.24 $2.53 $3.11
Valuation Valuation Metrics and Comparable Companies

• We value Infosys at 1.2x PEG, using FY10-15F EPS CAGR P/E 2010: 25.3x P/E 2011: 22.4x
of 16%, which we believe is representative of medium-term TEV/2010 Revenue: 5.5x TEV/2011 Revenue: 5.7x
expectations and factors in the impact of higher tax rates with TEV/2010 EBITDA: 19.3x TEV/2011 EBITDA: 17.6x
the phase-out of the tax. This is at the higher end of the Comparable companies may include U.S. listed Accenture, Cognizant, Patni
historical 0.8x-1.2x PEG range for the stock, which we believe and Wipro; India-listed HCL, Tech Mahindra, TCS, Mphasis and Mindtree;
is suitable, given improving visibility on demand as well as European-listed Capgemini and Logica Plc; and BPO companies Genpact,
comfort on margin management currently WNS and Convergys
• Infosys is trading at 25.34x 12-month forward P/E, compared
to its historical range of 11x-29x Summary
• Our target price of $60 for Infosys is based on the DCF model. We have a HOLD recommendation and a target price of $60 based on our
We assume revenue and EBIT growth CAGRs of 18% and DCF and comparable company valuation and the companies strong revenue
17%, respectively for 2010E-2020E, terminal growth growth, management team, positive outlook for the outsourcing industry
assumption of 4.5% and WACC of 12.5% though we factor in the risks to the target price mentioned above

9
 Valuation Date: January 4, 2010
Proctor and Gamble (PG – NYSE)
Closing Market Price: $61.12

Industry: Consumer products 52-Week High: $63.74 Recommendation

Basic Shares Outstanding:

Market Capitalization:
53.3B

$199.9B
52-Week Low:

Net Debt:
$43.93

$32.2B
HOLD
Target Price: $65
Total Enterprise Value: $232.1B Dividend Yield: 2.29 %

Investment Highlights Business Description

• New management and strategy are catalysts – new and more Procter & Gamble is the largest personal care and consumer-products
focused CEO and CFO are leading a step change in strategy company in the world. Major brands include Gillette, Pampers, Tide, Ariel,
that should reaccelerate growth, including selectively cutting Pantene, Bounty, Pringles and Charmin, many of which are number one in
prices and expanding lower-tier offerings, aggressively their industry.
pursuing emerging markets’ white space, and simplifying 52 Week Chart (Daily Close Prices)
operations to create a more nimble organization supported by
the strongest innovation pipeline in 30 years
• Cost-cutting opportunity underappreciated – restructuring
savings of at least $500-$600 mm annually are sustainable
over the next few years, as management reigns in its fairly
high overhead costs
• Earnings growth to reaccelerate – management’s new strategy
will drive a re-acceleration to industry-leading earnings
growth of 11-12% over the next few years versus a 1% decline
in 2010
• Upside risks include better than expected currency, better than
expected productivity gains and pricing benefits and
significant growth from robust innovation

Investment Risks Summary of Financial Information

• Continued macro slowdown, retailer destocking, continued ($ in mm except EPS data) For the fiscal year ended Jun 30
slowdown in beauty products
• Further volatility in input costs and short supplies of raw 2008A 2009A 2010E 2011E 2012E
materials, especially resin and petrochemicals
Revenues $83,503 $79,473 $79,254 $81,268 $85,122
• Stronger dollar, escalating competitive battles, especially in
high-growth developing regions and in focus categories such EBITDA 20,249 19,751 19,366 21,022 22,654
as hair coloring, shampoo, oral care, and skin care
EBIT 17,083 16,669 16,527 18,128 19,724
EPS 3.50 3.71 3.68 4.14 4.62
Valuation Valuation Metrics and Comparable Companies

• PG’s has risen approx. 40% off its March 2009 low. The stock P/E 2010: 16.6x P/E 2011: 14.8x
currently trades at a 16.61x next twelve months EPS estimate, TEV/2010 Revenue: 2.5x TEV/2011 Revenue: 2.5x
below its 5-year average of 17.9x and 10 year average of TEV/2010 EBITDA: 10.3x TEV/2011 EBITDA: 9.5x
19.5x. The stock trades at a 4% premium to its peer group and Comparable companies may include Kraft, Kimberly Clark, Clorox,
a 15% premium to the S&P 500, both roughly in line with its PepsiCo, Kellogg, General Mills, Nestle, Coca-Cola, Unilever and Colgate
5-and-10 year averages. Our $65 target price assumes the
stock will trade at 2010E multiple of 17.66x Summary
• Given the company’s relatively stable cash flows, we use a We have a HOLD recommendation and a target price of $65 based on our
DCF analysis to derive our $65 price target. Assumptions DCF and comparable company valuation and the companies’ strong
include 5.2% sales growth and 0.2 points of margin growth reacceleration of revenue and EPS growth, cost-cutting initiatives and
through 2015, discounted at a 9% WACC derived from innovative pipeline of products despite continued macro slowdown and
CAPM which assumes 0.6x beta, 3.5% risk free rate, 12% volatility of input prices and other risks to the target price mentioned above
equity risk premium and 80% equity capital structure, with
1.5% terminal value growth about in-line with inflation and
implying a 8.8x EBITDA exit multiple

10
Visa (V – NYSE) Valuation Date: January 4, 2010

Closing Market Price: $88.14

Industry: Consumer Financial Services 52-Week High: $83.40 Recommendation

Basic Shares Outstanding:

Market Capitalization:
470.2 M

$61.1B
52-Week Low:

Net Debt:
$41.78

-$4.8B
HOLD
Target Price: $90
Total Enterprise Value: $56.2B Dividend Yield: .61%

Investment Highlights Business Description

• Ongoing shift from cash to electronic forms of payment – Visa (“V”) is accepted at more than 29 million merchant outlets and 1.5
electronic purchase transactions at the point of sale has grown million ATMs in more than 200 countries. Visa does not issue cards. Visa
over 70% from 34bn transactions in 2003 to 58bn transactions generates revenue by assessing fees to financial institutions for access to its
in 2008 based on the Nilson Report data global network, for processing transactions, and for providing other
payment-related services. Its primary customers are card issuers e.g.,
• Dominant position in important US debit market – debit financial institutions and merchant acquirers that leverage its global network
volume growth has outpaced credit volume growth by approx. 52 Week Chart (Daily Close Prices)
2:1 margin since 1996
• Increased international debit card usage – represent 34% of
total cards or 589M cards but only approx. 6% of total
quarterly purchase volume or $41B out of $687B
• Strong relationships with top card issuers – diverse base of
customers with top five customers accounting for ~26% of
revenue. No. 1 JPMorgan Chase represents 8% of revenue
• Strong business model – mid-50% operating margins during
FY10 and strong pricing power with most of its customers
• No credit risk – financial institution clients bear this risk, thus
eliminating Visa’s liability on defaults

Investment Risks Summary of Financial Information

• Decline in consumer spending – consumer confidence ($ in mm except EPS data) For the fiscal year ended Sept 30
remains at historically low levels which could impact credit
and debit volumes. 2007A 2008A 2009A 2010E 2011E
• Litigation and Regulation – named in a number of lawsuits Revenues $5,907 $7,424 $8,145 $9,282 $10,624
and potential regulations in the U.S. regarding interchange
fees and other countries could impact V EBITDA 1,833 2,927 3,764 4,643 5,342
• Customer consolidation – larger institutions have greater EBIT 1,673 2,690 3,538 4,342 5,065
pricing power and may lower pricing for V. Large customer
EPS 1.36 2.12 2.79 3.57 4.35
may be acquired by an institution having a relationship with a
competitor
• Decline in consumer spending – consumer confidence
remains at historically low levels which could impact credit
and debit volumes
Valuation Valuation Metrics and Comparable Companies

• Visa shares trade at 24.68x FY10 and 20.26x FY11 estimate P/E 2010: 24.7x P/E 2011: 20.3x
of $4.35. Visa can deliver 18%-20% EPS growth for the next TEV/2010 Revenue: 6.1x TEV/2011 Revenue: 5.3x
two to three years, even if consumer spending remains TEV/2010 EBITDA: 12.1x TEV/2011 EBITDA: 10.5x
subdued. Accordingly, V shares trade at a PEG ratio of Comparable companies include other card processor companies including
approx. 0.9x based on FY11 expectations Master Card Inc., American Express, Discover Financial, Western Union,
• Given Visa’s dominant position, we believe the company Global Payments, Alliance Data Systems, and CME Group
deserves a sizable valuation premium relative to the market.
V currently trades at a 51% premium to the S&P500 on CY10 Summary
estimates (V’s 24.6 vs. the S&P500’s 16.2x). Visa has We have a HOLD recommendation and a target price of $90 based on our
historically traded at a ~25% valuation premium to its closest comparable company valuation and Visa’s strong position in U.S. debit card
peer, MasterCard (“MA”) and currently trades at a 23% market, no credit risk, excellent customer relationships and strong business
premium to MA on a 2010E basis. Visa’s premium valuation model despite the risks to the target price mentioned above including
vs. MA is warranted given its strong position in the domestic
regulatory changes and litigation
debit market, its higher relative profitability as well as its more
conservative balance sheet

11