Finance Exam Cheat Sheet

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Western University *

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3303

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Finance

Date

Feb 20, 2024

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Uploaded by CommodoreIbex2179

FINANCE FRAMEWORK Context - Role - Who are we? What tools do we have? What are our incentives? - Investor  Socially responsible investing, Investment bank  Susceptible to stability of equity market and is concerned with customer relationships. May want a higher purchase price. - Board wants to maximize shareholder value and avoid conflict of interest - CFO wants a bonus/keep his job Issue, Objective and Timing - Acquisition (EV), IPO (V e - Value per share) , or stock recommendation) - List all alternatives : Buy, sell, hold, buy it at a later date, look into better companies Criteria- Maximize shareholder value, Optimal capital structure, unlocking value in target company (M&A), raising optimal amount of capital (IPO), timing, growth, risk - What is our risk profile? What is our time horizon? Analysis of Shareholder Preferences ? Exit Plan External Size-Up Economy  PEST Political - Tax benefits? Any changes? (Ex. International operations may improve tax rate) - Political risks ? SEC/Competition Bureau regulations? Can political risk be quantified into CAPM? Economic - If [economic variable] changes, it may impact the [characteristic]/financial position of the company - R eal GDP growth – Worsening economy  greater market risk  higher WACC  lower valuation - Business Cycle? Expansion or Recession (increases cost of capital) - I nterest rate - Low interest rates  investors want lower return  lower WACC  higher valuation Social - Aging population? Size of target demographic declining or growing? Effect on revenues or valuation? - Reputational risk  Social responsibility (e.g. cigarette company) Technology - Is there change in consumer trends? Does this affect our product or revenue? - Innovation risk  higher WACC  lower valuation Industry - Growth: Is there overall growth in the industry? Will this affect terminal value? - Profitability: Is the industry profitable? What are margins like? High margins  increase valuation? - Size: Is the industry large? Is there a lot of demand? Is it a defensive or discretionary item? - Fragmented/Consolidated: Is the industry fragmented (lots of competition) or consolidated? - Key Competitors: What are our competitors doing? What are their strategies? Market shares? - Intensity of competition, Threat of entrants (Effects on Market share/revenue) o Barriers to entry  High  defensible free cash flows  higher valuation) - Threat of substitute, Power of supplier (low power = lower discount rate) and Power of customer : low power  high pricing power  higher FCF  higher firm value - Bidder Reaction: What might be their reaction to our bid? Other potential bidder reactions Competition:  Threat of substitutes  Threat of new entrants - Barriers to entry  Fragmented vs. consolidated  Market power, price points

Consumers:  Price sensitivity  Consumer’s needs/wants Distribution:  Negotiating power in supply chain  Retailer/wholesaler margins Key Success Factors Internal Size-Up  Public or private? Public  share price vs Private  TEV  How easy is it to issue shares or raise debt? Is there demand for shares? Marketing:  Target Market, buyer behavior, brand recognition, & demand risk  4P’s Price Product Placement Promotion  Competitive advantage *IPO/acquisition is a good way to market company Operations:  Manufacturing and distribution  Ability to meet demand/capacity  High growth needs cash  Inventory control, Working capital requirements, inventory control  Supply reliability/risk  Wholesaler/distributor power Management:  Experience, leadership, culture  Managerial issues (ethics, ownership, control) Strategy:  Short and long term strategy  Business model  Why do they need M&A/IPO?  Ownership “Fit Analysis” (for M and A) - Why merge/acquire the firm? Inorganic vs organic growth succeeds in this industry? - What are the key strengths and potential risks of acquiring this company - Does the deal make sense? Ie KSFs  scale, innovation etc - Complementarity: is company A strong where company B is week? - Tally up strengths and weaknesses Financial Size-Up FIRST STEP: Decide if CASH is excess or not Check by: looking at WC  if this # is similar in size to cash, then assuming its in WC Calculating WC: (AR+INV-AP) or WC/Sales or (CA- cash)-(CL)  if this is negative, no sense, include cash “I considered both definitions, neither jumped out so I chose…”

IF CASH IS EXCESS: take it out of TEV to find equity value, add it back to equity to find TEV and take it out of debt to find NET DEBT IF CASH IS WC: do NOT take it out or add it to any values, NOT included in net debt therefore JUST debt 2 Years of ratios Types of comparisons: 1) Across financial statements, 2) Industry, 3) Trend YoY Key ratios  IPO: Sales growth, gross margin, net income margin, interest coverage, D/E, and ROE  M&A Bidder: Emphasis on capital structure and financing ratios - D/E, D/EBITDA, interest coverage, etc. (capital structure and financing ratios)  M&A Target: Emphasis on performance via growth and margins - Sales growth, net income growth, gross profit margin, net income margin, ROE, ROA (growth and margin ratios)  Examine stock prices - Bidder: High stock prices implies that we can buy with equity - Target: High stock price implies company is currently overvalued and the buyer’s control premium offered would shrink Mergers and Acquisitions  Perform internal Size-Up for bidder and target company Potential Fit:  How would shareholders react  Advantages and disadvantages of acquisition  Potential synergies  Fit with corporate strategy  Integration challenges Synergies  Synergies – Additional value created by the combo of two entities into one, through increased revenues or reduced costs Revenues Synergies: Resulting from cross-selling and up-selling opportunities Cost Synergies: Reduction in costs; employee layoff + operating efficiency Implications  Link to growth, discount rate, valuation, acquisition decision, IPO decision  Where are current interest rates ? Low interest rates  investors demand lower return  lower WACC  higher valuation  Is the economy expected to worsen? Worsening economy  greater market risk  higher WACC  lower valuation  Does the firm operate in a high technology environment? Innovation risk  higher WACC  lower valuation  How predictable are the firm’s revenues? Predictable revenues  steadier free cash flows  higher valuation  Are there significant barriers to entry? High barriers to entry  defensible free cash flows  higher valuation Relative Valuation/Multiples Methods FIRST STEP: Set criteria for comparable companies:  Link criteria to growth and risk  Eliminate only a few outlier firms  generate all, then exclude: leave in minimum 6  “I will consider growth, risk, debt, size, bus model, cap structure, mkt cp, but I will be focusing on”  Private companies don’t have MV of equity  Capital structure should not be used as screen

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 Eli mate backward looking multiples that don’t follow proper direction (getting smaller) Business Profile Financial Profile Sector, geographies Products and services Customers and end Markets Distribution Channels Geography (tax rate) Size (market Cap) Profitability (Margins) Growth Profile Return on Investment Capital structure ie debt levels Multiply by denominator , EBITA is better than EBIT because companies could have different depreciations based on their hard investment policies or their acquisition policies, accounting policies, cap st. etc. Price/Earnings method Step 1: Calculate P/E for comparable firms P/E = Price Per Share / Earnings per share OR Market Capitalization / Net Income Step 2: Multiply To find My Enterprise Value (TEV)- Comparable P/E x your (net income + v debt – cash) To find My implied Price per Share = Price per share / Earnings per Share x My earnings per Share To find My Value of Equity = Price / EPS x My Earnings (net income) PROS: takes into account cap structure  good if similar bc captures growth & risk of the company -accounts for risk by capturing debt burdens through interest ie would weigh more with more debt CONS: dependent on capital structure and accounting principles (assumes the exact comparability) -doesn’t give an accurate indication of performance itself Enterprise Value to EBITDA or EBIT Approach Step 1: TEV/EBITDA for comparable firms  Add depreciation to EBIT if EBITDA not given TEV = MV equity + MV Debt - EXCESS Cash TEV / EBITDA = EV/EBITDA Multiple Step 2: Multiple your company’s EBITDA by TEV/EBITDA TEV = EV / EBITDA multiple x our EBITDA Step 3: Solve for equity Value MV equity = TEV – MV Debt + EXCESS Cash Step 4: Find Price Per share Price per Share = MV equity /Outstanding shares Finds EV: comparable EV/EBITDA x your EBITDA - EE/EBITDA- best multiple, levels investment and capital structure playing field - EBITDA: best bc assess op performance (efficiency measure) takes into account costs but is capital structure neutral  good for business models that are not cap intesntive - EV/EBIT levels the capital structure playing field but not investment - Looks at firm as potential acquirer would because it takes into account debt - Low ratio indicated company may be undervalued - EV/EBITDA and P/E difference suggests variance in CS, use of debt to amplify returns Other Multiple approaches  Price to Cash Flow: P = P/CF multiples x CF 1  Price to Revenue: P = P/Rev multiples x REV 1  Revenue multiple can be used if company is not making profit When to use Multiples Approach:

 When there are positive earnings  Comparable operate in similar geographies (same tax rates)  Similar capital structures  Similar depreciation and amortization account rules  Earnings/income more indicative of value than cash flow FORWARD VS BACKWARD LOOKING -Forward looking used for target but con is that it is based on a forecast/guess -Backward looking numbers are more tangible -COMMENT ON PATTERN: forward looking should be getting smaller bc denominator (earnings, EBIT) should be increasing/growing  if going in the wrong direction, remove BACKWARDS bc assuming that something was unusual in the past that they are correcting for the future  concerning for strength of model though Comparable Transaction Approach  Ratio-based valuation : Look at ratios to price paid in transaction by target financials (Earnings, EBITDA, sales etc.)  Premium Paid Analysis : Look at premiums in recent merger transactions (price paid to recent stock price)  May need to convert price paid into a multiple  Analyze transaction - Recency - Business structure - Market timing/economic cycles - Control premiums/ownership % required - Financial vs. strategic acquisition BETAS -public companies will have betas -unlever with comp’s D/E, relever with OUR D/E -assess’s the business’ risk in relation to the market  can depend on industry ie education doesn’t fluctuate with the market therefore lower beta Betas of comparable companies and take average:  If given target's beta , unlever and relever at TARGET Cap Structure  If given industry beta , unlever and relever... say why chose industry  If given comps , narrow down comps and choose then unlever and relever  Unlever and relever beta when firm wants to achieve a new capital structure or when using comparable firms’ beta (to negate the effects of debt)  DO NOT RELEVER IF NO DEBT IN CAP STRUCTURE  Levered Beta / Equity Beta – includes debt  Unlevered / Asset Beta – Only includes assets B U = B L / [1 + (1-T) x D/E)] Relever Beta using own capital structure:  Use levered beta in CAPM calculation B L = B U x (1 + 1(1 – T) x D/E)  Cost of Equity should be between 8 – 14% Valuation

 Looking for Enterprise value if valuing division of company WACC  Weighted Average Cost of Capital (WACC) – weighted average of the cost to a firm of all the forms of long-term financing, including debt, preferred shared, and common shares - The lower the WACC, the higher the firm value - k C = W e x k e + W d x k d x (1 – t) + W p x k p - W e = Weight of equity k e = Cost of equity - W d = Weight of debt k d = Cost of debt t = Tax rate - W p = Weight of preferreds k p = Cost of preferreds Step 1: Capital Structure 1. Target capital structure 2. Market Value - Equity: Share price x # shares outstanding - Debt: Divide price of bond by face value ($100), multiply by book value on balance sheet 3. Book Value - Two criteria for including line items: i) permanent ii) interest-bearing - Includes: Short-term obligations, Long-term Debt, Other Long-term Liabilities, Preferred Shares, Current portion on LT debt, Common equity, Retained Earnings  Weights of target company Step 2a: Cost of Equity 1. Capital Asset Pricing Model (CAPM) - Relates cost of equity for an individual asset to that asset’s beta K e = r f + B x (RP) which is (r m - r f ) - K e = Required rate of return on equity - r f = Risk-free rate (Current yield on government bonds, usually 10 yr: average length of project) - Using 30 years is more conservative bc  higher r  higher WACC  lower value - MRP = Expected market risk premium, assume 5-7% historical average if not given - E/V  always market value of equity Step 2b: Cost of Debt  Current YTM on outstanding long-term debt  Use credit rating, comps, or spread  Coupon on outstanding bonds if recently issued  Spread over treasuries given a credit rating (S&P, Moody’s, Fitch)  Market yield on comparable company long-term debt  Taking interest paid and dividing it by the principal amount of loan  Worst case: Interest expense/ Avg. debt outstanding (affected by debt repayment)  WEIGHT: use target weight of debt Step 2c: Cost of preferred K P = Dividend / Price Step 3: Calculate WACC Implications:  High WACC: high cost of raising capital for projects, going public via IPO decreases WACC, M&A may decrease WACC depending on capital structure  Low WACC: Low cost of raising capital for projects, M&A may increase WACC depending on capital structure Discounted Cash Flow Approaches(DCF) Free Cash Flows to the Firm Model (FCFF)

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FCFF = NOPAT + D&A – CAPX – Increase in WC FCFF = NOPAT – Increase in NPP&E – Increase in WC  Approach of estimating the equity value of a firm based on a projection of free cash flows - Measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment Step 1: Calculate WACC k C = W e x k e + W d x k d x (1 – t) + W p x k p Step 2: Calculate FCFF for each period FCFF = EBIT x (1 – Tax Rate) + non-cash expenses (depreciation, amortization) – capital expenditures – net changes to working capital EBIT- Earnings before Interest and Tax EBITDA- Earnings before Interest Tax Depreciation and Amortization o EBIT: EBITDA + depreciation, Revenue – operation expenses, Revenue x operating margin o Non-cash expenses: Depreciation schedule, as % of sales, Net PPE n – (Net PPE n+1 – Capital Exp n+1 ), CAPEX – Change in NPPE - Pick one and justify - Change in PPE= CAPX - DEP o Capex: if not provided look at difference in assets year to year, or assume a % of revenue o Working Capital: Changes in WC = WC 0 – WC 1 , % of sales - WC = Current Assets [(AR+Inv. + Prepaid X + (Cash if needed for daily ops)] – Non-interest bearing Current Liabilities (AP/Deferred Rev./Accrued Expenses) - If include cash, assume there’s no excess cash Step 3: Discount each FCFF back to the present using WACC as discount rate PV FCFF = FCFF / (1 + K c ) n Step 4: Terminal Value TV = FCFF n x (1+g) / K c – g N is last period before TV PV calc Growth  Analysts forecast of growth  GDP growth 2 – 4%  MAX SUST. GR. RATE: WACC *((Increase in NetPP&E – Increase in WC)/NOPAT) Present value of Terminal Value: PV TV = TV / (1 + K c ) n Step 5: Firm Value  Add Present Value of FCFF and with present value of Terminal Value  Don’t include PV FCFF discount period 0 Total Enterprise Value= PV of TVn + PV FCFF (Years 1 to n)s Step 6: Value of equity and share price Value of equity = Firm Value - Net Debt Net Debt = Debt – EXCESS Cash - Debt is Interest-bearing and permanent debt - Cash is non-operating cash - Say if cash is going to operating activities rather than paying off debt

Share price = Value of equity / # of Shares Outstanding  If company has set life span, then don’t do terminal value Sensitivity  Perform sensitivity on share price for WACC, growth rate, sales growth, EBITDA Margins, Exit Multiple, Capex - WACC and growth are common sensitivities b/c risk (WACC)and growth drive value of a company  Choose range for valuation from DCF Valuation Summary Table  Draw implications about different valuation ranges  Discounted cash flow analysis suggested an _____ value of _____ to _____  Comparable EV/EBITDA multiples suggested an _____ value of _____ to _____  Comparable P/E multiples suggested an _____ value of _____ to _____ Analysis of Valuation Methods FCFF Pros Cons - Uses time value of money principles and focuses on cash flows - Incorporates growth and risk over many years - Removes affects of different accounting principles - Only as good as assumptions made - Assuming constant capital structure, cost of capital, and growth rate - Assumptions about capex, working capital changes, EBIT, tax rate, growth rate Price-Earnings Method

Pros Cons - Forward looking - Based on market place -takes into account growth and risk - Assuming comparable firms are fairly priced in market place - Focuses on earnings rather than cash flow  Earnings can be affected by accounting methods - Does not take capital structure into account - Only a 1-year snapshot When to use: - Positive earnings - Comparables are in similar geographies (Equivalent tax rates) - Similar capital structure, or capital structure are an important feature - Similar depreciation and amortization accounting rules - Earnings/income more indicative of value than cash flow Enterprise Value to EBITDA Pros Cons - Mitigates problems in P/E multiple - More cash flow oriented; less issues with accounting methods - Minimizes distortions from differences in capital structure and fixed assets b/c using EBITDA - Based on a one-year snapshot Recommendation & Action Plan IPO Decision  Whether or not IPO should occur - Use of capital from IPO  Price per share - Explanation of chosen valuation - Discuss/evaluate valuation approaches  Competitive/strategic implication - Ownership - Timing Reasons for an IPO Advantages:  Enlarging and diversifying equity base  Enabling cheaper access to capital  Increasing exposure, prestige, public image; establishes credibility  Attracting and retaining better management and employees through liquid equity participation  Facilitating acquisitions  Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc. Disadvantages:  Legal, accounting, marketing costs  Requirement to disclose financial and business information  Competitors, suppliers, customers  Risk that required funding will not be raised  Loss of control and stronger agency problems due to new shareholders

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 Dilution of shares? Stakeholders  Determine how important ownership is to the existing shareholders for IPOs  How does this decision affect shareholders of both companies? Action Plan  Underwriting fee: 1% to 8% of share issuance Risks and Contingency:  Our role and how that can affect the timeline and power of our decision Potential Risks:  Required funding is not raised (lack of demand)  Loss of control  Incorrect timing (bad signal  we think our company is overvalued therefore issuing debt etc) Mergers & Acquisitions Decision  Whether or not M&A should occur  Price to pay for acquisition of target company: WE ALWAYS PAY THE EQUITY VALUE bc we assume we are TAKING ON THE EXISTING DEBT - Walk away price - Discuss/evaluate valuation approaches Reasons for M&A  Efficiency  Synergistic gains  Information  Undervalued assets  Agency Problems  entrenched management  Market power  just want to be the biggest  Keep up with consolidation in the industry  everyone else is doing it  Defense  potential cost if competitor gets it (also reason for premium) Why should I pay a premium?  Competitive/strategic implications  Synergies  % of synergies that will be realized  Personal outlook different than market outlook  Control premium (20-30%)  premium for getting control of company Stakeholders  Determine how important ownership is to the acquirer and the seller  How does this decision affect shareholders of both companies?  Who has controlling interest in the merged company and where does it reside? Action Plan Bidding strategy  Range of values, Starting offer, walkaway price  Relate to valuation  If buying, set price celling, if selling set price floor  Could price of company be driven up by competing bids?  Discuss control premium that must be paid Financing the transaction  Cash cheapest, then debt, then equity  FRICTO for debt and equity  Calculate key ratios (EPS, interest coverage, debt vs. equity, Return on equity)  COMPARE ONE KEY RATIO BEFORE AND AFTER  How much debt can we take on and how much equity can be issued? o Cash: Cheapest option, need enough for operations, low working capital gap, not seasonal o Debt: Low interest rates, high interest coverage

o Equity: High stock prices, high EPS  Capital of target AND bidder can be used to finance acquisition - Alignment w/ target capital structure Consolidated Balance Sheet:  Combine major line items (Cash, debt, equity, to find total amount for acquisition)  Remove deferred taxes and equity of target company (Wiped out by transaction cost)  Goodwill is plug Consolidated Balance Sheet Bidder Target Combined Assets Cash Goodwill Liabilities Deferred Taxes Transaction Cost Total equity Total Liabilities + equity Key Ratios: Interest Coverage = EBIT/ Interest exp. = EBIT Bidder + EBITE Target / Int exp Bidder + Int exp Target + Int exp New Debt  Int exp New Debt = New debt x Cost of Debt EPS = Net Income / Shares Outstanding = Net Income / (Current # shares + Additional # Shares) = Net Income / (Current # Shares + (Cost of acquisition / Price per share)) Risk and Contingencies  Our role and how that can affect the timeline and power of our decision  Potential risks + contingencies: o Synergies may not be realized o Proposed bid fails and company can’t acquire target company  Can increase shareholder value by conducting share buyback or issuing more dividends  Discuss the catalysts for realizing the implied values Ratios Liquidity Ratios Current Ratio Total Current Assets / Total Current Liabilities Times short term assets can cover short term debts; Benchmark 2:1; insolvency = too low; too high  inefficient use of capital Acid Test Ratio (Cash + Marketable Securities + Accounts Receivable) / Total Current Liabilities Ability to meet-short term payments using most liquid assets (not inventory); Benchmark 1:1 Working Capital Total Current Assets – Total Current Liabilities Higher is safe b/c better chance of paying off ST debt; High  Money better spent elsewhere, Low  Money tied up in working capital Working Capital Turnover Sales/Working Capital Depletion of working capital to the generation of sales over a given period Fixed Asset Turnover Ratio Net Sales / Net PPE company's ability to generate net sales from fixed-asset investments Efficiency Ratios Age of Receivables Accounts Receivable / (revenue/365) How long customers take to pay us - Too low  Credit policies too tight and scaring off business

- Too higher  customers not paying in time, should tighten credit policies Age of Payables Accounts Payable / (purchases/365) How long it takes to pay suppliers - Too low  get more short-term cash by taking longer to pay - Too high  May get bad reputation and have credit privileges cut off Age of Inventory Inventories / (COGS / 365) How long inventory is in stock - too low  Stock outs may be arising - too high  Excess inventory (tied up cash) Working Capital Gap A/R + Inv – A/P Days cash is strapped in AR and Inv before suppliers can be paid Difference between collecting payments and making payments for inventory - Want smaller gap to have cash on hand - negative is good Vertical Analysis COGS to Sales COGS / Sales Relative cost of inputs. Lower the lower the costs Gross Profit Margin ( Gross Profit )/ Sales Gross profit earned on sales. Higher the higher the cut received on each sale. Operating margin ( Operating Income )/ Sales ower the lower the expenses relative to sales. Profit Margin ( Net Income )/ Sales Higher the more profitable each sale. Financial Leverage Debt Capacity Total Liabilities / Total Assets What % of the business is financed through debt? Lower is safer Debt to Equity Total Liabilities / Total Equity Times of debt for every dollar of equity - Lower is safer; too high  too leveraged; too low  inefficient equity use Net Worth to Total Assets Total Equity / Total Assets What % of business do assets own? Higher is better; Too low  Too much debt; too high  underleveraged which reduces ROE Interest Coverage EBIT / Interest on LT Loan Times a company can meet interest payments; lenders want to know loan charges can be covered; higher is better; Benchmark = 2 - 1.5 is minimum - 2.5 is warning Profitability Return on Equity Net Income (Loss) / Common Equity Maximum return available to shareholders; higher means satisfied Return on Assets Net Income / Total Assets What returns are being generated on fixed assets; higher means good use Growth Profit Growth Profit (Year 2) – Profit (year 1) / Profit (Year 1) Efficiency of operations relative to previous period Sales Growth Sales y2 – sales y1 / sales y1 Growth of overall activity - Should be proportional to profit Asset Growth Asset y2 – asset y1 / asset y1 Changes in level of resources owned

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- Should be proportional to profit + sales ROE Decomposition (Dupont Formula) Return on Equity = Return on Sales x Asset Turnover x Leverage Net inc/equity = (Net inc/sales) x (sales/assets) x (assets/equity) Profit (good) efficiency(good) leverage(bad) Price-Earnings Method Price-Earnings Ratio (P/E) Price per share/ Earnings per share Market cap / Net Income Values a company relative to its earnings per share indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. Earnings per Share (EPS) Net Income / Outstanding Shares Portion of a company’s profit allocated to each outstanding share of common stock Valuation share price Price per share / Earnings per Share x My earnings per Share EV/EBITDA Method Enterprise Value (EV) or (TEV) MV equity + MV Debt - Cash Economic measure reflecting the market value of a whole business TEV/EBITDA Multiple EV/EBITDA Valuation enterprise value EV / EBITDA multiple x EBITDA Market Value of Equity MV equity = TEV – MV Debt + Cash WACC WACC W e x k e + W d x k d x (1 – t) + W p x k p overall required return for a firm - cost of raising capital CAPM (Ke) r f + B x RP model that describes the relationship between risk and expected return - Says investor must be compensated for TV of money and risk Unlevered beta B U = B L / [1 + (1-T) x D/E)] Compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta of a company without any debt. Unlevering a beta removes the financial effects from leverage Levered Beta B L = B U x (1 + 1(1 – T) x D/E) measure of the volatility , or systematic risk , of a security or a portfolio in comparison to the market as a whole Market Risk Premium Assume 5% if not given difference between the expected return on a market portfolio and the risk-free rate Risk free rate Current yield on government bonds interest an investor would expect from an absolutely risk-free investment over a specified period of time FCFF

Free cash flow for the firm FCFF = EBIT x (1 – Tax Rate) + non-cash expenses (depreciation, amortization) – capital expenditures – net changes to working capital measure of financial performance that expresses the net amount of cash that is generated for the firm Depreciation Depreciation schedule Depreciation as % of sales Depreciation = Net PPE n – (Net PPE n+1 – Capital Exp n+1 ) Depreciation =CAPEX – Change in NPPE Working Capital Total Current Assets – Total Current Liabilities Higher is safer; too higher  Money better spent elsewhere, WC  low return If includes cash, don’t remove cash of net debt Change in working capital WC 0 – WC 1 When more cash is tied up in working capital than the previous year, the increase in working capital is treated as a cost against free cash flow PV of FCFF FCFF / (1 + K c ) n Terminal Value TV = FCFF n x (1+g) / K c – g NOT Preset value of FCFF Anticipated value on a certain date in the future - It is used in multi-stage discounted cash flow analysis and the study of cash flow projections for a several-year period Growth - GDP growth 2 – 3% PV Terminal Value PV TV = TV / (1 + K c ) n Value of Equity / Market Capitalization Firm Value – Net Debt Price per share x Outstanding shares total dollar market value of all of a company's outstanding shares - Indicates company size Net Debt Debt – Cash Permanent + interest-bearing Shows a company's overall debt situation by netting the value of a company's liabilities and debts with its cash Other Dividend payout ratio Dividend per share / EPS = Dividends / Net Income Percentage of earnings paid to shareholders in dividends Terminal Value TV = FCFF / (1+g) / (Kc – g) Represents the value, as of the last year of annual forecasts, of all free cash flows beyond that point in time - Value of a perpetuity of cash flows Present Value PV = FV / (1+kC) t PV of Tax Shield Old tax amount – New tax amount / Divided by interest rate on loan Reduction in taxable income for an individual or corporation achieved through claiming allowable deductions such as mortgage interest , medical expenses , charitable donations , amortization and depreciation FRICTO EQUITY  TIMING & INCOME DEBT  FLEXIBILITY & RISK Flexibility (if favor flexibility- Equity)

 Taking on equity maintains flexibility on future decision making  Higher levels of debt lead to stricter covenants and higher borrowing costs - Difficult to make decisions - More difficult to obtain and higher interest rates  If firm thinks they need debt to fund operations/projects in near future, should issue equity instead to remain flexible  Interest payments from debt reduce cash flow – less flexibility for capital expenditures Risk (If favor low risk, equity)  Interest coverage risk (check int cov) - Holding too much debt increases risk of not being able to pay interest and being forced into default (credit risk) - Liquidity risk (cannot tell asset)  Determine/compare risk by calculating leverage ratios Income (If favor income, fav debt)  Adding debt increases improves earning per share  Income increased b/c of tax shield Control  Debt does not changes ownership structure  Issuing equity dilutes current shareholders; gives rights to new investors - Depends on shareholders (e.g. family owned firm wants control) Taxes  Debt reduces tax on income - Interest expense is tax deductible  Value of company will increase by taking on debt proportional to amount of debt you assume and tax rate - Smaller amount of earnings belong to government PV of Tax Shield = Total Debt x Tax Rate (From income statement) Tax Rate = Old tax amount – New tax amount / Divided by interest rate on loan Other (Market Timing and Signals) Market Timing:  Debt issuance better when interest rates are lower  Equity issuance better when equity market is overvalued / stock prices higher - Demand for equity not always available - Can check this by seeing if our mulitples are in line with the comps Market Signaling:  Capital structure decision send signals to stakeholders i. Issuing shares: management believes their own shares are fairly priced or overvalued ii. Share buyback: management signals that they believe their own shares to be undervalued iii. Increasing dividends: could signal that management believes in the stability of cash flows going forward iv. Issuing debt : signals confidence in ability to meet interest payments, as well as desire for growth Optimal Debt Amount Too Little Debt Too Much Debt - May be foregone investment opportunities - Not utilizing the cheapest form of - Restrictive covenants may limit freedoms of management - Companies that are near bankruptcy will be

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financing, especially considering tax shield - Lower return on equity charged higher cost of financing - Limits opportunities for future debt issuance - Higher bankruptcy costs

Finance Exam Cheat Sheet

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