Finance Exam Cheat Sheet

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School

Western University *

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Course

3303

Subject

Finance

Date

Feb 20, 2024

Type

docx

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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

 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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