Investment Banking

Interview Questions
Wall Street Prep

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Acknowledgments
We want to specifically thank the following instructors, without whom this guide would not have been
possible. Your industry knowledge makes this guide unique in its depth and breadth: Jay Patel, Eric Cheung,
Haseeb Chowdhry, Ziv Feldman, Adam McGowan, Silab Mohanty, and Jeff Schmidt.
In addition, this guide draws from the experience of our team of over 50 faculty members, all former
practitioners in investment banking, private equity, and other buy-side firms. All come from various
industry and product backgrounds, and their input has been invaluable throughout the writing process.
And most importantly, we want to thank Justin Kim, who toiled to bring this guide to life, working with our
faculty and clients to make sure that the interview questions not only reflect what interviewees should
expect to face, but that the answers reflect the level of detail expected by interviewers.
Thank you,
Matan Feldman
Founder and Chief Executive Officer,
Wall Street Prep

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Investment Banking
Interview Questions
Wall Street Prep
2021 Edition
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Table of Contents
Introduction..............................................................................................................................................................................
.7 Technical Section Introduction .....................................................................................................................................................................8
Accounting Questions..........................................................................................................................................................
12 Financial Statements & Accrual Concepts .............................................................................................................................................13
Financial Statement Analysis ......................................................................................................................................................................27
Advanced Accounting .....................................................................................................................................................................................35
Valuation Questions .............................................................................................................................................................
44 Corporate Finance Theory............................................................................................................................................................................45
Intrinsic Valuation............................................................................................................................................................................................54
Relative Valuation.............................................................................................................................................................................................65
Mergers & Acquisitions Questions..................................................................................................................................
72 M&A Concepts....................................................................................................................................................................................................73
Accretion/Dilution Modeling ......................................................................................................................................................................81
Leveraged Buyout Questions.............................................................................................................................................
90 Private Equity Investing ................................................................................................................................................................................91
LBO Modeling.................................................................................................................................................................................................. 104
LBO Modeling Tests...................................................................................................................................................................................... 110
Capital Markets
Questions...............................................................................................................................................111 Debt &
Leveraged Finance......................................................................................................................................................................... 112 Equity
Financing............................................................................................................................................................................................ 122 General
Market Knowledge....................................................................................................................................................................... 133 Hedge
Fund Investing Strategies ............................................................................................................................................................ 140 Sales &
Trading............................................................................................................................................................................................... 155 Industry
Specific Questions.............................................................................................................................................165
Industry Specific Section Introduction................................................................................................................................................ 166
Technology, Media & Telecommunications (TMT)......................................................................................................................... 167
Software as a Service (SaaS)..................................................................................................................................................................... 182
Financial Institutions Groups (FIG)....................................................................................................................................................... 191
Healthcare ........................................................................................................................................................................................................ 204
Consumer Products & Retail .................................................................................................................................................................... 217
Financial Restructuring .............................................................................................................................................................................. 227
Real Estate (REIT)......................................................................................................................................................................................... 241
Real Estate Private Equity (REPE)......................................................................................................................................................... 244
Industrials ........................................................................................................................................................................................................ 246
Oil & Gas (O&G).............................................................................................................................................................................................. 257
Behavioral
Questions.........................................................................................................................................................260
Behavioral Section Introduction............................................................................................................................................................. 261
Behavioral Interview Advice .................................................................................................................................................................... 263
Personal Background Questions............................................................................................................................................................. 267
Firm Specific Questions .............................................................................................................................................................................. 274
Past Experiences & Situational Questions.......................................................................................................................................... 278
Elevator Test Questions .............................................................................................................................................................................. 282

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INTRODUCTION

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ACCOUNTING
QUESTIONS

Introduction
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INTRODUCTION

Technical Section Introduction

Dear Reader,
This interview guide was designed with a single goal in mind: To give you the tools to land a job in
investment banking and other related financial services sectors.
There is much material to cover in this guide, so let’s just dive right in. For virtually every technical
interview question, there are some general principles to govern your approach:

Keep Answers Concise

it's reasonable to finish a succinct answer with,
One of the most frequently asked interview
questions for investment banking is, “How “Would you like a little more detail on any of this?”
do you value a company?” I could easily However, while most candidates struggle with keeping
take an hour to explain how to value a answers brief, others have the opposite problem of
company and I would barely scratch the surface. not giving sufficient details.
That's not what we're going for in an interview. The interviewer just needs to understand that
When asked an expansive technical question where you can
you're unsure about the appropriate level of detail, articulate concepts at a high level. In most cases,
answers should be no longer than 2-3 minutes.

As a rough guideline for questions without clear numerical or concrete answers, the answers should last
at least 1 minute. This shows the interviewer you're actually taking the time to think and come up with
thoughtful responses.
For example, answering the question, “Walk me through the cash flow statement,” by saying, “You start
with net income, and then make non-cash adjustments to net income to arrive at cash for the year” would
not be enough to show your understanding.

Avoid Rambling into Tangents

it as meaning that further explanation is required on
The longer your response goes on, the
risk of being asked to elaborate on a topic your end.
you don't fully understand increases in To be able to wait patiently after giving your initial
tandem. That being said, don't extend answer shows that you
beyond your comfort zone and keep answers short The more tangents in your answer, the more
to avoid giving the interviewer extra reasons to probe likely a
deeper. difficult counter point could be
Upon responding to a question, a momentary pause brought up.
from the interviewer is normal, so don't misconstrue

recognized the concept the interviewer was testing for, and have confidence that an adequate response
was provided.

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INTRODUCTION

Handle Difficult Questions Effectively

It's a near certainty that you'll be asked a question to which you don't know the answer.
Just remember to remain calm and not let the interviewer see you sweat. Firms want to hire individuals
who are presentable to clients, so remaining calm while under pressure is essential.
The most important thing is that if the interview takes a turn in the wrong direction: don't fall into
a downward spiral because it's rarely as bad as you might think.
There are three types of approach you can take when you're unsure how to answer a question:

If you kind of know something related to what is being asked

First and foremost: avoid guessing. Instead, look for a way to describe the parts of the
question you understand and then be upfront about where you're unsure.

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For example, if you're unsure how to answer: "How would you value a bank?" You might say,
"Well, I know that banks are different from traditional companies in that their main source of
revenue comes from interest on loans, but I don't think I understand bank valuation that
well and this is definitely something I plan to look into after this interview."

If you think you

know the
subject matter
but don't
understand the
question
When a question is asked in an unclear or vague manner, you'll want to reformulate the
question back to the interviewer for some clarification.

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For example, if an interviewer asks: "Is EBITDA usually lower or higher than cash flow?"
You could begin by asking, "Just to confirm I'm understanding the question correctly, are
you defining cash flow here as unlevered free cash flows or as operating cash flows?"

If you just flat

out don't know
the answer
In
this
situation, it's preferable to say, "Honestly, I would need to think about that more and would rather

not guess because I don't think I'll be able to give a sufficient answer." 3
Here, it's necessary to come off as humble as you don't want to appear indifferent to the fact
that you don't know the answer. An important part of damage control is using the opportunity
to show the interviewer your professionalism under stress. While not a technical skill, this is a
key interpersonal skill that firms look for.

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INTRODUCTION

Prioritize Based on the Specific Role

How you allocate your time while preparing for interviews is more important than how many hours you spent.
For this reason, decide which career path you're most interested in recruiting for and then ensure that
your time is being spent in the right places.
The table below, which uses “Harvey Balls” (a favorite in investment banking pitch books), provides an
overview of which sections of this guide to focus on based on the specific role you're pursuing:

Suppose you're interviewing for an investment banking role. Questions about leveraged buyouts will come
up far less than if you were interviewing for private equity – just keep in mind that any question is fair
game.
But if you do get asked about LBOs, it'll most likely be a simple question such as, “What is the basic intuition
behind an LBO?” as opposed to, “Walk me through how to model a dividend recap.”
This interview guide has been organized such that each subsection within a major topic starts with the most
frequently asked questions. If you're focusing on a career path that doesn't go deep into a section, you should
at least go through the most frequently asked questions for that section.

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ACCOUNTING
QUESTIONS
Accounting
Questions

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ACCOUNTING
QUESTIONS
and ensuring all financials are presented on a fair,
consistent basis – the interests of investors and
lenders are protected.
Financial Statements & Accrual
What are the main sections of a 10-K?
Concepts
What is the primary purpose of US GAAP?
In the US, the Securities and Exchange Commission
("SEC") authorizes the Financial Accounting
Standards Board ("FASB") to determine the set of
accounting rules followed by publicly traded
companies.
Under FASB, financial statements are required to be
prepared in accordance with US Generally Accepted
Accounting Principles ("US GAAP").
Watch Video → Basic Accounting
Through the standardization of financial reporting

In a 10-K, you'll find the three core financial statements, which are the income statement, cash flow
statement, and balance sheet. There'll also be a statement of shareholders’ equity, a statement of
comprehensive income, and supplementary data and disclosures to accompany the financials.
Main Sections of a 10-K

Business Overview Overview of the company’s business divisions, strategy, product or service
offerings, seasonality, geographical footprint, and key risks.

Management’s Discussion Commentary and summarized analysis of the company’s fiscal year result
& Analysis ("MD&A") from the perspective of the management team.

Financial Statements The “Core 3”: Income Statement, Balance Sheet, Cash Flow
Statement The “Other 2”: Statement of Comprehensive Income,
Statement of Shareholders’ Equity

Notes Supplementary disclosures to the financial statements that provide

more details about a company’s recent financial performance.

What is the difference between the 10-K and 10-Q?

10-K: A 10-K is the annual report required to be filed with the SEC for any public company in the U.S. The
report is comprehensive and includes a full overview of the business operations, commentary on recent
performance by management, risk factors, disclosures on changes in accounting policies – and most
importantly, the three core financial statements with supplementary data.
10-Q: A 10-Q refers to the quarterly report required to be filed with the SEC. Compared to the 10-K, this
report is far more condensed in length and depth, with the focus being on the quarterly financials with
brief sections for MD&A and supplementary disclosures.
Additional Differences: A few more differences are 10-Ks are required to be audited by an independent
accounting firm, but 10-Qs are only reviewed by CPAs and left unaudited. 10-Ks must also be filed ~60-90
days after the fiscal year ends, whereas 10-Qs must be submitted ~40-45 days after the quarter ends.
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ACCOUNTING snapshot of a company's resources (assets) and
QUESTIONS sources of funding (liabilities and shareholders'
equity) at a specific point in time, such as the end of
a quarter or fiscal year.
Walk me through the three financial
statements.
1. Income Statement ("IS"): The income statement
shows a company's profitability over a specified
period, typically quarterly and annually. The
beginning line item is revenue and upon deducting
various costs and expenses, the ending line item is
net income.
Watch Video → The 3 Financial Statements
2. Balance Sheet ("BS"): The balance sheet is a

3. Cash Flow Statement ("CFS"): Under the indirect approach, the starting line item is net income, which
will be adjusted for non-cash items such as D&A and changes in working capital to arrive at cash from
operations. Cash from investing and financing activities are then added to cash from operations to arrive at
the net change in cash, which represents the actual cash inflows/(outflows) in a given period.
Walk me through the income statement.
The income statement shows a company’s below lists the major income and expense
accrual-based profitability over a specified time components of the income statement:
period and facilitates the analysis of its historical Watch Video → The Income Statement
growth and operational performance. The table

Income Statement Typical Components

Net Revenue (or Sales) The income statement begins with revenue (often called the “top line"), which
represents the total value of all sales of goods and delivery of services
throughout a specified period.

Less: Cost of Goods Sold COGS represents the costs directly tied to producing revenue, such as the
costs of materials and direct labor.

Gross Profit Revenues – Cost of Goods Sold = Gross Profit

Less: Selling, General Operating expenses that are not directly associated with the good or
& Administrative service being sold (e.g., payroll, wages, overhead, advertising, and
("SG&A") marketing).

Less: Research & R&D refers to developing new products or procedures to improve their
Development ("R&D") existing product/service offering mix.
EBITDA Gross Profit – SG&A – R&D = EBITDA
EBITDA stands for: Earnings Before Interest, Taxes,
Depreciation & Amortization.

Less: Depreciation & D&A is a non-cash expense that estimates the annual reduction in the value
Amortization ("D&A") of fixed and intangible assets

Operating Income EBITDA – D&A = Operating Income (or EBIT)

("EBIT") EBIT stands for: Earnings Before Interest and Taxes.

Less: Interest Expense, Interest expense from debt, net of interest income generated from
net investments.

Pre-Tax Income ("EBT") EBIT – Interest Expense, net = Pre-Tax Income (or “Earnings Before Tax”)

Less: Tax Expense Tax liability recorded by a company for book purposes.

Net Income EBT – Tax Expense = Net Income (referred to as the “bottom line”)

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ACCOUNTING
QUESTIONS

Apple Inc. | Historical Income Statement (Snapshot from Financial Statement Modeling Course)

Apple Income Statement 2016A 2017A 2018A 2019A ($ in millions) 9/30/16 9/30/17 9/29/18 12/31/19

Revenue $215,639 $229,234 $265,595 $260,174 Less: Cost of Revenue (131,376) (141,048) (163,756) (161,782)
Gross Profit $84,263 $88,186 $101,839 $98,392 Less: Research & Development (R&D) (10,045) (11,581) (14,236)
(16,217) Less: Selling, General & Administrative (SG&A) (14,194) (15,261) (16,705) (18,245) Operating Income
(EBIT) $60,024 $61,344 $70,898 $63,930 Plus: Interest Income 3,999 5,201 5,686 4,961 Less: Interest Expense
(1,456) (2,323) (3,240) (3,576) Less: Other Expense, net (1,195) (133) (441) 422 Pre-Tax Income (EBT) $61,372
$64,089 $72,903 $65,737 Less: Taxes (15,685) (15,738) (13,372) (10,481) Net Income $45,687 $48,351 $59,531
$55,256

Walk me through the balance sheet.

The balance sheet shows a company’s assets, liabilities, and equity sections at a
specific point in time. The fundamental accounting equation is: Assets = Liabilities
+ Shareholders’ Equity. The assets belonging to a company must have been funded
somehow, so assets will always be equal to the sum of liabilities and equity.
cash itself, along with marketable securities,
Assets Section: Assets are organized in the order
of liquidity, with “Current Assets” being assets that accounts receivable, prepaid expenses,
can be converted into cash within a year, such as Watch Video → Balance Sheet

and inventories. “Long-Term Assets” include property, plant, and equipment (PP&E), intangible
assets, goodwill, and long-term investments.
Liabilities Section: Liabilities are listed in the order of how close they're to coming due. “Current
Liabilities” include accounts payable, accrued expenses, and short-term debt, while “Long-Term
Liabilities” include items such as long-term debt, deferred revenue, and deferred income taxes.
Shareholders’ Equity Section: The equity section consists of common stock, additional paid-in capital
(APIC), treasury stock, and retained earnings.
Could you give further context on what assets, liabilities, and equity each represent? Assets:
Assets are resources with economic value that can be sold for money or bring positive monetary benefits in
the future. For example, cash and marketable securities are a store of monetary value that can be invested to
earn interest/returns, accounts receivable are payments due from customers, and PP&E is used to generate
cash flows in the future – all representing inflows of cash.
Liabilities: Liabilities are unsettled obligations to another party in the future and represent the external
sources of capital from third-parties, which help fund the company's assets (e.g., debt capital, payments
owed to suppliers/vendors). Unlike assets, liabilities represent future outflows of cash.
Equity: Equity is the capital invested in the business and represents the internal sources of capital that
helped fund its assets. The providers of capital could range from being self-funded to outside institutional
investors. In addition, the accumulated net profits over time will be shown here as "Retained Earnings."

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ACCOUNTING
QUESTIONS

What are the typical line items you might find on the balance sheet?
Assets Section

Current Assets (Listed in Order of Liquidity)

Cash & Cash Equivalents This line item includes cash itself and highly liquid, cash-like investments,
such as commercial paper and short-term government bonds.

Marketable Securities Marketable securities are short-term debt or equity securities held by
the company that can be liquidated to cash relatively quickly.

Accounts Receivable A/R refers to payments owed to a business by its customers for products
and services already delivered to them (i.e., an "IOU" from the customer).

Inventories Inventories are raw materials, unfinished goods, and finished goods waiting
to be sold and the direct costs associated with producing those goods.

Prepaid Expenses Prepaid expenses are payments made in advance for goods or services
expected to be provided on a later date, such as utilities, insurance, and rent.

Non-Current Assets

Property, Plant & Fixed assets such as land, buildings, vehicles, and machinery used
Equipment ("PP&E") to manufacture or provide the company’s services and products.

Intangible Assets Intangible assets are non-physical, acquired assets such as patents,
trademarks, and intellectual property ("IP").

Goodwill An intangible asset created to capture the excess of the purchase price over
the fair market value ("FMV") of an acquired asset.

Liabilities Section
Current Liabilities (Listed in Order of Liquidity)

Accounts Payable A/P represents unpaid bills to suppliers and vendors for
services/products already received but were paid for on credit.

Accrued Expenses Accrued expenses are incurred expenses such as employee compensation
or utilities that have not been paid, often due to the invoice not being
received.

Short-Term Debt Debt payments coming due within twelve months, with the current portion
of long-term debt also included.

Non-Current Liabilities

Deferred Revenue Unearned revenue received in advance for goods or services not yet delivered
to the customer (can be either current or non-current).

Deferred Taxes Tax expense recognized under GAAP but not yet paid because of
temporary timing differences between book and tax accounting.

Long-Term Debt Long-term debt is any debt capital with a maturity exceeding twelve months.

Lease Obligations Leases are long-term contractual agreements, allowing a company to

lease PP&E for a specific time period in exchange for regular payments.

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ACCOUNTING
QUESTIONS
Shareholders’ Equity

Common Stock Common stock represents a share of ownership in a company and can be issued
when raising capital from outside investors in exchange for equity.

Additional Paid-In APIC represents the amount received in excess over the par value from the
Capital ("APIC") sale of preferred or common stock.

Preferred Stock Preferred stock is a form of equity often considered a hybrid investment,
as it has features of both common stock and debt.

Treasury Stock Refers to shares that had been previously issued but were repurchased by
the company in a share buyback and are no longer available to be traded.

Retained Earnings (or Represents the cumulative amount of earnings since the company was
Accumulated Deficit) formed, less any dividends paid out.

Other Comprehensive OCI consists of foreign currency translation adjustments and unrealized
Income ("OCI") gains or losses on available for sale securities.

Apple Inc. | Historical Balance Sheet (Snapshot from Financial Statement Modeling Course)

Apple Balance Sheet 2017A 2018A 2019A ($ in millions) 9/30/17 9/29/18 12/31/19

Cash & Cash Equivalents $20,289 $25,913 $48,844 Marketable Securities (Short-Term and Long-Term) 248,606
211,187 157,054 Accounts Receivable, net 17,874 23,186 22,926 Inventories 4,855 3,956 4,106 Other Current
Assets 31,735 37,896 35,230 Property, Plant & Equipment, net 33,783 41,304 37,378 Other Non-Current Assets
18,177 22,283 32,978 Total Assets $375,319 $365,725 $338,516

Accounts Payable $44,242 $55,888 $46,236 Other Current Liabilities 30,551 33,327 37,720 Deferred Revenue
10,384 5,966 5,522 Commercial Paper 11,977 11,964 5,980 Long-Term Debt (Including Current Portion) 103,703
102,519 102,067 Other Non-Current Liabilities 40,415 48,914 50,503 Total Liabilities $241,272 $258,578
$248,028

Common Stock & APIC $35,867 $40,201 $45,174 Retained Earnings 98,330 70,400 45,898 Other Comprehensive
Income (OCI) (150) (3,454) (584) Total Shareholders' Equity $134,047 $107,147 $90,488

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ACCOUNTING non-cash expenses such as depreciation &
QUESTIONS amortization and stock based compensation, and
then makes adjustments for changes in working
capital.
Walk me through the cash flow statement.
There are two methods by which cash flow
statements are organized: Direct and Indirect.
The more common approach is the indirect method,
whereby the cash flow statement is broken out into
three sections:
1. Cash from Operations: The cash from operations
section starts with net income and adds back Watch Video → The Cash Flow Statement

2. Cash from Investing: Next, the cash from investing section accounts for capital expenditures (typically
the largest outflow), followed by any business acquisitions or divestitures.
3. Cash from Financing: In the third section, cash from financing shows the net cash impact of raising
capital from issuances of equity or debt, net of cash used for share repurchases, and repayments of
debt. The cash outflows from the payout of dividends to shareholders will be reflected here as well.
Together, the sum of the three sections will be the net change in cash for the period. This figure will then
be added to the beginning-of-period cash balance to arrive at the ending cash balance.
How are the three financial statements connected?
IS ↔ CFS: The cash flow statement is connected to the income statement through
net income, as net income is the starting line on the cash flow statement.
CFS ↔ BS: Next, the cash flow statement is addition, the ending cash balance from the bottom
linked to the balance sheet because it tracks the of the cash flow statement will flow to the
changes in the balance sheet’s working capital balance sheet as the cash balance for the current
(current assets and liabilities). The impact from period.
capital expenditures (PP&E), debt or equity
issuances, and share buybacks (treasury stock) Watch Video → 3 Fiancial
are also reflected on the balance sheet. In Statements Connections
IS ↔ BS: The income statement is connected to the balance sheet through retained earnings. Net income
minus dividends issued during the period will be added to the prior period's retained earnings balance to
calculate the current period’s retained earnings. Interest expense on the income statement is also
calculated off the beginning and ending debt balances on the balance sheet, and PP&E on the balance
sheet is reduced by depreciation, which is an expense on the income statement.
If you have a balance sheet and must choose between the income statement or cash flow
statement, which would you pick?
Assuming that I would be given both the beginning and end of period balance sheets, I would choose the
income statement since I could reconcile the cash flow statement using the balance sheet’s
year-over-year changes along with the income statement.
Which is more important, the income statement or the cash flow statement? The income statement
and cash flow statement are both necessary, and any in-depth analysis would require using both. However,
the cash flow statement is arguably more important because it reconciles net income, the accrual-based
bottom line on the income statement, to what is actually occurring to cash.
This means the actual movement of cash during the period is reflected on the cash flow statement. Thus, the
cash flow statement brings attention to liquidity-related issues and investments and financing activities
that don't show up on the accrual-based income statement.

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ACCOUNTING cash flow to reinvest into its operations and meet its
QUESTIONS debt obligations comes first. At the end of the day,
"cash is king."

If you had to pick between either the income

statement or cash flow statement to analyze a
company, which would you pick?
In most cases, the cash flow statement would be
chosen since the cash flow statement reflects a
company's true liquidity and is not prone to the same
discretionary accounting conventions used in accrual
Watch Video → Cash Flow
accounting. Whether you're an equity investor or
Statement Review
lender, a company's ability to generate sufficient free

Although one factor that could switch the answer is the company's profitability. For an unprofitable company,
the income statement can be used to value the company based on a revenue multiple. The cash flow
statement becomes less useful for valuation purposes if the company's net income, cash from operations, and
free cash flow are all negative.
Why is the income statement insufficient to assess the liquidity of a company? The income
statement can be misleading in the portrayal of a company’s health from a liquidity and solvency
standpoint.
For example, a company can consistently show positive Financial reporting under accrual accounting is also
net income yet struggle to collect sales made on credit. imperfect in the sense that it often relies on
The company's inability to retrieve payments from management discretion. This "wiggle room" for
customers would not be reflected on its income managerial discretion in reporting decisions increases
statement. the risk of earnings management and the misleading
depiction of a company's actual operational management's
performance. discretion, making the income statement less
Accrual accounting often relies on reliable.

The solution to the shortcomings of the income statement is the cash flow statement, which reconciles net
income based on the real cash inflows/(outflows) to understand the true cash impact from operations,
investing, and financing activities during the period.
What are some discretionary management decisions that could inflate earnings? Using excess
useful life assumptions for new capital expenditures to reduce the annual depreciation Switching from LIFO
to FIFO if inventory costs are expected to increase, resulting in higher net income Refusing to write-down
impaired assets to avoid the impairment loss, which would reduce net income Changing policies for costs to
be capitalized rather than expensed (e.g., capitalized software costs) Repurchasing shares to decrease its
share count and artificially increase earnings per share ("EPS") Deferral of capex or R&D to the next period
to show more profitability and cash flow in the current period More aggressive revenue recognition policies
in which the obligations of the buyer become less stringent
Tell me about the revenue recognition and matching principle used in accrual accounting.
Revenue Recognition Principle: Revenue is recorded in the same period the good or service was delivered
(and therefore "earned"), whether or not cash was collected from the customer. Matching Principle: The
expenses associated with the production/delivery of a good or service must be recorded in the same period
as when the revenue was earned.
How does accrual accounting differ from cash-basis accounting?
Accrual Accounting: For accrual accounting, revenue recognition is based on when it's earned and the
expenses associated with that revenue are incurred in the same period.

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ACCOUNTING
QUESTIONS

Cash-Basis Accounting: Under cash-basis accounting, revenues and expenses are recognized once cash is
received or spent, regardless of whether the product or service was delivered to the customer.
What is the difference between cost of goods sold and operating expenses? Cost of Goods Sold:
COGS represents the direct costs associated with the production of the goods sold or the delivery of services
to generate revenue. Examples include direct material and labor costs. Operating Expenses: Operating
expenses such as SG&A and R&D are not directly associated with the production of goods or services offered.
Often called indirect costs, examples include rent, payroll, wages, commissions, meal and travel expenses,
advertising, and marketing expenses.
When do you capitalize vs. expense items under accrual accounting?
The factor that determines whether an item gets capitalized as an asset or gets expensed in the period
incurred is its useful life (i.e., estimated timing of benefits).
Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for more than one
year need to be capitalized and expensed over time. For example, PP&E such as a building can provide
benefits for 15+ years and is therefore depreciated over its useful life.
Expensed: In contrast, when the benefits received are short-term, the related expenses should be incurred
in the same period. For example, inventory cycles out fairly quickly within a year and employee wages
should be expensed when the employee's services were provided.
If depreciation is a non-cash expense, how does it affect net income?
While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax
deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has
already occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase.
Do companies prefer straight-line or accelerated depreciation?
For GAAP reporting purposes, most companies prefer straight-line depreciation because lower depreciation
will be recorded in the earlier years of the asset’s useful life than under accelerated depreciation. As a
result, companies using straight-line depreciation will show higher net income and EPS in the initial years.
Eventually, the accelerated approach will show lower depreciation into an asset's life than the straight-line
method. However, companies still prefer straight-line depreciation because of the timing, as many
companies are focused more on near-term earnings.
If the company is constantly acquiring new assets, the “flip” won’t occur until the company significantly
scales back capital expenditures.
What is the relationship between depreciation and the salvage value assumption? Most
companies will use a salvage value assumption in which the remaining value of the asset is zero by the end
of the useful life. The difference between the cost of the asset and residual value is known as the total
depreciable amount. If the salvage value is assumed to be zero, the depreciation expense each year will be
higher and the tax benefits from depreciation will be fully maximized.

Straight Line Annual Depreciation = (Asset Historical Cost − Salvage Value)

Useful Life Assumption
Do companies depreciate land?
While classified as a long-term asset on the balance sheet, land is assumed to have an indefinite useful
life under accrual accounting, and therefore depreciation is prohibited.

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ACCOUNTING
QUESTIONS

How would a $10 increase in depreciation flow through the financial statements? The depreciation
expense will be embedded within either the cost of goods sold or the operating expenses line item on the
income statement.
IS: When depreciation increases by $10, EBIT would while cash will be up by $3 on the assets side. On the
decrease by $10. Assuming a 30% tax rate, net income L&E side, the $7 reduction in net income flows through
will decline by $7. retained earnings. The balance sheet remains in
CFS: At the top of the cash flow statement, net income balance as both sides went down by $7.
has decreased by $7, but the $10 depreciation will be The key takeaway is depreciation, despite being a
added back since it's a non-cash expense. The net non-cash
impact on the ending cash balance will be a positive $3 expense, reduces
increase. taxable income and has a positive impact on the
BS: PP&E will decrease by $10 from the depreciation, ending cash.

A company acquired a machine for $5 million and has since generated $3 million in accumulated
depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value
of that PP&E on the balance sheet?
The short answer is $2 million. Except for certain liquid financial assets that can be written up to reflect
their fair market value ("FMV"), companies must carry the value of assets at their net historical cost.
Under IFRS, the revaluation of PP&E to fair value is permitted. Even though permitted, it's not widely used
and thus not even well known in the US. Don't voluntarily bring this up in an interview on your own.
What is the difference between growth and maintenance capex?
Growth Capex: The discretionary spending of a business to facilitate new growth plans, acquire more
customers, and expand geographically. Throughout periods of economic expansion, growth capex tends
to increase across most industries (and the reverse during an economic contraction).
Maintenance Capex: The required expenditures for the business to continue operating in its current state
(e.g., repair broken equipment).
Which types of intangible assets are amortized?
Amortization is based on the same accounting concept as depreciation, except it applies to intangible assets
rather than fixed tangible assets such as PP&E. Intangible assets include customer lists, copyrights,
trademarks, and patents, which all have a finite life and are thus amortized over their useful life.
What is goodwill and how is it created? Read More → Goodwill: Differences Between GAAP and
Goodwill represents an intangible asset that captures the Tax Accounting Can companies amortize goodwill?
excess of the purchase price over the fair market value
of an acquired business's net assets. Goodwill is the excess premium paid over the fair
Suppose an acquirer buys a company for a $500 million value, and is
purchase price with a fair market value of $450 million. created to "plug" this gap for the balance sheet to
In this hypothetical scenario, goodwill of $50 million remain in balance.
would be recognized on the acquirer’s balance sheet.

Under GAAP, public companies are prohibited from amortizing goodwill as it's assumed to have an
indefinite life, similar to land. Instead, goodwill must be tested annually for impairment.
However, privately held companies may elect to amortize goodwill and under some circumstances,
goodwill can be amortized over 15 years for tax reporting purposes.

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ACCOUNTING
QUESTIONS

What is the “going concern” assumption used in accrual accounting?

In accrual accounting, companies are assumed to continue operating into the foreseeable future and remain
in existence indefinitely. The assumption has broad valuation implications, given the expectation of
continued cash flow generation from the assets belonging to a company, as opposed to being liquidated.
liabilities). As a result, the risk of a company's revenue or
Explain the reasoning behind the principle of
asset values being overstated and expenses or liabilities
conservatism in accrual accounting.
being understated is minimized.
The conservatism principle requires thorough
verification and use of caution by accountants when Why are most assets recorded at their historical
preparing financial statements, which leads to a cost under accrual accounting?
downward measurement bias in their estimates. For any revenue or expense to be
Central to accounting conservatism is the belief that it's recognized, there must be evidence of
better to understate revenue or the value of assets than occurrence with a measurable monetary amount.
to overstate it (and the reverse for expenses and
The historical cost principle states that an asset's value on the balance sheet must reflect the initial purchase
price, not the current market value. This guideline represents the most consistent measurement method
since there's no need for constant revaluations and markups, thereby reducing market volatility.
What role did fair-value accounting have in the subprime mortgage crisis?
In the worst-case scenario, sudden drops in asset values could cause a domino effect in the market. An
example was the subprime mortgage crisis, in which the meltdown's catalyst is considered to be FAS-157. This
mark-to market accounting rule mandated financial institutions to update their pricing of illiquid securities.
Soon after, write-downs in financial derivatives, most notably credit default swaps ("CDS") and
mortgage-backed securities ("MBS"), ensued from commercial banks, and it was all downhill from there.
Why are the values of a company's intangible assets not reflected on its balance sheet? The
objectivity principle of accrual accounting states that only verifiable, unbiased data can be used in financial
filings, as opposed to subjective measures. For this reason, internally developed intangible assets such as
branding, trademarks, and intellectual property will have no value recorded on the balance sheet because they
cannot be accurately quantified and recorded.
Companies are not permitted to assign values to these intangible assets unless the value is readily
observable in the market via acquisition. Since there's a confirmable purchase price, a portion of the excess
amount paid can be allocated towards the rights of owning the intangible assets and recorded on the closing
balance sheet.
If the share price of a company increases by 10%, what is the balance sheet
impact? There would no change on the balance sheet as shareholders’ equity reflects the
book value of equity. Equity value, also known as the "market capitalization," represents the
value of a company’s equity based on supply and demand in the open market. In
contrast, the book value of equity is the initial historical amount shown on the balance
sheet for accounting purposes. This represents the Book Value of Equity = Total Assets – Total Liabilities
company's residual value belonging to equity
Watch Video →
shareholders once all of its assets are liquidated and
Book v Market Value
liabilities are paid off.

The equity value recorded on the books will be significantly understated from the market value in most cases.

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ACCOUNTING
QUESTIONS

For example, the book value of Apple’s common stock is only ~$51 billion as of its latest 10-K filing for
FY 2020, whereas its market value of equity is over $2 trillion as of this guide's publishing date.
Do accounts receivable get captured on the income statement?
There is no accounts receivable line item on the income statement, but it gets captured, if only partially,
indirectly in revenue. Under accrual accounting, revenue is recognized during the period it was earned,
whether or not cash was received.
The two other financial statements would be more useful to understand what is happening to the accounts
receivable balance since the cash flow statement will reconcile revenue to cash revenue, while the
absolute balance of accounts receivable can be observed on the balance sheet.
Why are increases in accounts receivable a cash reduction on the cash flow statement? Since the
cash flow statement begins with net income and net income captures all of a company’s revenue (not just
cash revenue), an increase in accounts receivable means that more customers paid on credit during the
period.
Thus, a downward adjustment must be made to net income to arrive at the ending cash balance. Although
the revenue has been earned under accrual accounting standards, the customers have yet to make the due
cash payments and this amount will be sitting as receivables on the balance sheet.
What is deferred revenue?
Deferred revenue (or "unearned" revenue) is a liability that represents cash payments
collected from customers for products or services not yet provided. Some examples are
gift cards, service agreements, or implied rights to future software upgrades associated
with a product sold. In all the examples listed, the $500 might allocate $480 of the
cash payment was received upfront and the benefit to Watch Video → Deferred Revenue
the customer will be delivered on a later date.
For instance, a company that sells a smartphone for

sale to the phone and the remaining $20 to the value of the customer’s right to future software upgrades.
Here, the company would collect $500 in cash, but only $480 would be recognized as revenue. The remaining
$20 will stay recognized as deferred revenue until the software upgrades are provided.
Why is deferred revenue classified as a liability while accounts receivable is an asset? Deferred
Revenue: For deferred revenue, the company received payments upfront and has unfulfilled obligations to
the customers that paid in advance, hence its classification as a liability. Accounts Receivable: A/R is an
asset because the company has already delivered the goods/services and all that remains is the collection of
payments from the customers that paid on credit.
Why are increases in accounts payable shown as an increase in cash flow?
An increase in accounts payable would mean the company has been delaying payments to its suppliers or
vendors, and the cash is currently still in the company's possession. The due payments will eventually be
made, but the cash belongs to the company for the time being and is not restricted from being used. Thus, an
increase in accounts payable is reflected as an inflow of cash on the cash flow statement.
Which section of the cash flow statement captures interest expense?
The cash flow statement doesn't directly capture interest expense. However, interest expense is recognized on
the income statement and then gets indirectly captured in the cash from operations section since net income
is the starting line item on the cash flow statement.

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ACCOUNTING
QUESTIONS

What happens to the three financial statements if a company initiates a dividend? IS: When a
company initiates a dividend, there'll be no changes to the income statement. However, a line below net
income will state the dividend per share ("DPS") to show the amount paid. CFS: On the cash flow
statement, the cash from financing section will decrease by the dividend payout amount and lower the
ending cash balance at the bottom.
BS: The cash balance will decline by the dividend amount on the balance sheet, and the offsetting entry
will be a decrease in retained earnings since dividends come directly out of retained earnings.
Do inventories get captured on the income statement?
There is no inventory line item on the income statement, but it gets indirectly captured, if only partially, in cost
of goods sold (or operating expenses). For a specific period, regardless of whether the associated inventory
was purchased during the same period, COGS may reflect a portion of the inventory used up.
The two other financial statements would be more useful for assessing inventory as the cash flow statement
shows the year-over-year changes in inventory, while the balance sheet shows the beginning and
end-of-period inventory balances.
How should an increase in inventory get handled on the cash flow statement? An increase in
inventory reflects a use of cash and should thus be reflected as an outflow on the cash from operations
section of the cash flow statement. The inventory balance increasing from the prior period implies the
amount of inventory purchased exceeded the amount expensed on the income statement.
What is the difference between LIFO and FIFO, and what are the implications on net income?
FIFO and LIFO are two inventory accounting methods to estimate the value of inventory sold in a
period.
First In, First Out ("FIFO"): Under FIFO accounting, the goods that were purchased earlier would be the
first ones to be recognized and expensed on the income statement.
Last In, First Out ("LIFO"): Alternatively, LIFO assumes that the most recently purchased inventories are
recorded as the first ones to be sold first.
The impact on net income would depend on how inventory costs have changed over time:
First In, First Out (FIFO) Last In, First Out (LIFO)

Rising If inventory costs have been rising, If inventory costs have been rising, then COGS
Invento lower COGS would be recorded for the period will be higher under LIFO
ry under FIFO. because the recent, pricier purchases
Costs Since the less expensive inventory are assumed to be sold first.
(🡩) was recognized, net income will be Thus, the result would be lower net income for
higher in the current period. the period.

Decreasi If inventory costs have been If inventory costs have been dropping, then
ng dropping, COGS would be COGS would be lower under LIFO.
Inventor higher under FIFO, since older Thereby, net income for the period will be
y Costs inventory costs are more higher since the cheaper inventory costs
(🡫) expensive. were recognized.
The ending result would be lower net
income for the period.

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ACCOUNTING
QUESTIONS

What is the average cost method of inventory accounting?

Besides FIFO and LIFO, the average cost method is the third most widely used inventory accounting
method. Under this method, the assigned inventory costs are based on a weighted average, in which the
total costs of production in a period are summed up and divided by the total number of items produced.
Each product cost is treated equally and inventory costs are spread out evenly, disregarding the date of
purchase or production. Thus, this method is viewed as a simplistic compromise between the two other
methods, but would be improper to use if the products sold are each unique with significant variance in the
cost to manufacture and the sale price (i.e., more applicable for high-volume, identical batches of
inventory).
How do you calculate retained earnings for the current period?
Retained earnings represent the total cumulative amount of net income held onto by a company since
inception after accounting for any dividends paid out to its common and preferred shareholders.
Current Period Retained Earnings = Prior Retained Earnings + Net Income –Dividends What
does the retention ratio represent and how is it related to the dividend payout ratio? The retention
ratio represents the proportion of net income retained by the company, net of any dividends paid out to
shareholders. The inverse of the retention ratio is the dividend payout ratio, which measures the proportion of
net income paid out as dividends to investors.

Retention Ratio = (Net Income − Dividends)

Net Income Dividend Payout Ratio = Dividends Paid
Net Income
What are the two ways to calculate earnings per share (EPS)?
1. Basic EPS: Determines a company's earnings on a per-share basis, but allocable to only the basic shares
outstanding (otherwise known as "common shares").

Basic EPS = (Net Income − Dividends on Preferred Stock)

Basic Weighted Average Shares Outstanding
2. Diluted EPS: Compares a company's earnings relative to its shares outstanding on a per-share basis but
considers the impact of potentially dilutive securities such as options, warrants, and convertible securities.
If an option is "in-the-money," the option holder can become a common shareholder at their choosing.
Thus, diluted EPS is a more accurate depiction of ownership value per share. Diluted EPS = (Net Income −
Dividends on Preferred Stock)
Diluted Weighted Average Shares Outstanding
Read More → Forecasting Shares Outstanding and Earnings Per Share (EPS)
Where can you find the financial reports of public companies?
In the US, public companies are required to report periodic filings with the SEC, including an annual report
(10- K) and three quarterly (10-Q) reports each year. These reports are available for free through SEC EDGAR.
In other countries, reporting requirements will vary, but most countries will require at least an annual
report, while some will require an interim filing (i.e., a report in the middle of the company’s fiscal year).
Only a few countries make company filings easily accessible through a central database, forcing analysts to
rely on expensive financial data providers or dig through company websites manually to collect data.
The closest database to EDGAR in breadth and ease of use is Canada’s SEDAR database. In the United
Kingdom, the closest EDGAR equivalent is Companies House, where private companies must also report their
financials.
Read More → Bloomberg vs. Capital IQ vs. FactSet vs. Thomson Reuters Eikon

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ACCOUNTING
QUESTIONS

What is a proxy statement?

The proxy statement, formally known as "Form 14A," is required to be filed before a shareholder meeting
to solicit shareholder votes. The document must disclose all relevant details regarding the matter for
shareholders to make an informed decision.
In addition, the board of directors' compensation and other notable announcements such as changes to
the company’s articles of incorporation are included.
What is an 8-K and when is it required to be filed?
An 8-K is a required filing with the SEC when a company undergoes a materially significant event and must
disclose the details. Often called the "current report," 8-Ks are usually filed within four days of the event.
The information contained within the report should be of high importance and pertinent to shareholders.
Events that would trigger this filing would include previously unannounced plans for a new acquisition,
disposal of assets, bankruptcy, a tender offer, the resignation of a senior-level manager or member of the
board of directors, or disclosure that the company is under SEC investigation for alleged wrongdoing.
Why has understanding the differences between US GAAP and IFRS financial reporting become
increasingly important?
For public companies in the US, the reporting rules and guidelines are set by the Financial Accounting
Standards Board (FASB) and referred to as US Generally Accepted Accounting Principles (US GAAP). The
International Accounting Standards Board (IASB) oversees the International Financial Reporting
Standards (IFRS), which is followed by over 144 countries.
Understanding the differences between US GAAP and IFRS has become more important because:
Continuation of Globalization: Globalization is the gradual convergence of economies in different
countries. The widespread adoption of IFRS has placed pressure on the US to adopt IFRS to have a
single set of accounting standards and rules used worldwide, but it seems unlikely in the near-term.
Geographic Diversification of Investments: In recent years, investment firms have been broadening
their investments' geographic scope to consider more opportunities overseas. Nowadays,
institutional investors are more open to making investments in emerging markets due to the
prevalence of opportunities and as a strategy to re-risk their overall portfolio.
Cross-Border M&A Activity: Cross-border mergers and acquisitions ("M&A") have emerged as a strategy
for multinational companies to enter new markets, extend their reach to new potential customers, and
diversify their revenue sources.

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ACCOUNTING
QUESTIONS
Financial Statement Analysis
What are some of the most common margins used to measure profitability?
Profitability Margins

Gross Margin The percentage of revenue remaining after

Gross Margin = Gross Profit

subtracting just COGS, the direct costs associated
with the company's revenue generation (e.g., direct
Revenue
materials, direct labor).

Operating Margin The percentage of profitability after subtracting

operating expenses from gross profit. This Operating Margin = EBIT
Revenue
measure is useful for comparisons due to being
independent of capital structure and taxes.

Net Profit Margin The percentage of accrual profitability

remaining after all expenses have been Net Profit Margin = Net
Incom
subtracted. Unlike operating margin, this
e
measure is impacted by capital structure and
Reven
taxes. ue

EBITDA Margin The most widely used profit margin for

benchmarking due to being independent of EBITDA Margin = EBITDA
Revenue
capital structure and taxes, in addition to
adjusted for non cash expenses (D&A) and
non-recurring items.

What do the phrases “above the line” and “below the line” mean?
The expression "the line" is in reference to operating income, which represents the point that divides
normal, ongoing business operations from non-operational line items.
“Above the Line”: If a profitability metric is "above the line," it reflects a company's operational
performance before non-operational items such as interest and taxes. Financing-related activities are an
example of such non-operational items, as decisions on how to fund a company are discretionary (debt
vs. equity). For example, a metric such as earnings before interest, taxes, depreciation and amortization
("EBITDA") is considered “above the line." Hence, its widespread usage for comparative purposes since
operational performance is portrayed while being independent of capital structure and taxes.
“Below the Line”: In contrast, profitability metrics "below the line" have adjusted operating income for
non-operating income and expenses, which are items classified as discretionary and unrelated to the
core operations of a business. An example would be net income, since interest expense, non-operating
income/(expenses), and taxes have all been accounted for in its ending value.
Is EBITDA a good proxy for operating cash flow?
While EBITDA does add back D&A, typically the largest EBITDA” metric does add-back SBC. These non-cash and
non-cash expense, it doesn't capture the full cash impact any non recurring adjustments must be properly
of capital expenditures ("capex") or working capital accounted for to assess a company's past operational
changes during the period. performance and to accurately forecast its future cash
flows.
EBITDA also doesn't adjust for stock-based
compensation, although an increasingly used “adjusted Read More → EBITDA vs. Cash Flows from Operations vs.
Free Cash Flow
Despite the criticism regarding its
drawbacks, EBITDA remains the most widely used
proxy for operating cash flow in practice.

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ACCOUNTING
QUESTIONS

What are some examples of non-recurring items?

Non-recurring items include legal settlements (gain or loss), restructuring expenses, inventory write-downs,
or asset impairments. Often called "scrubbing" the financials, the act of adjusting for these non-recurring
items is meant to normalize the cash flows and depict a company's true operating performance.
When adjusting for non-recurring expenses, are litigation expenses always added back? Not
necessarily, as whether an expense is non-recurring depends on the industry. In many cases, it's a
discretionary decision on whether an expense is a part of the normal operations of a company. For
example, expenses related to litigation might not be added back for a research and development (R&D)
oriented pharmaceutical company, given the prevalence of lawsuits in the industry.
target right end markets).
What is the difference between organic and
Inorganic Growth: Once the opportunities for organic
inorganic revenue growth? Organic Growth: A
growth have been maximized, a company may turn to
company experiencing organic growth is expanding to inorganic growth, which refers to growth
new markets, enhancing its sales & marketing strategies,
improving its product/service mix, or introducing new Simply put, organic growth is the
products. The focus is on continuously making optimization of a
operational improvements and bringing in revenue (e.g., business from the internal efforts of management
set prices more appropriately post-market research, and their employees.

driven by M&A. Inorganic growth is often considered faster and more convenient than organic growth.
Post-acquisition, a company can benefit from synergies, such as having new customers to sell to,
bundling complementary products, and diversification in revenue.
How does the relationship between depreciation and capex shift as companies mature?
The more a company has spent on capex in recent years, capex is related to routine maintenance capex (e.g.,
the more depreciation the company incurs in the replace equipment, refurbish store layouts).
near-term future. Therefore, when looking at What is working capital?
high-growth companies spending heavily on growth
As a company begins to mature and its growth
capex, their ratio between capex and annual
stagnates, a greater proportion of its total capex will
depreciation will far exceed 1.
shift towards maintenance.
For mature businesses experiencing stagnating or
declining growth, this ratio converges near 1, as the only

The working capital metric measures a company's liquidity and ability to pay off its current obligations using
its current assets. In general, the more current assets a company has relative to its current liabilities, the lower
its liquidity risk. Current liabilities represent payments that a company needs to make within the year (e.g.,
accounts payable, accrued expenses), whereas current assets are resources that can be turned into cash
within the year (e.g., accounts receivable, inventory).
Working Capital = Current Assets − Current Liabilities
Read More → Working Capital: Formulas, Misconceptions and Real Examples
Why are cash and debt excluded in the calculation of net working capital (NWC)? In practice,
cash and other short-term investments (e.g., treasury bills, marketable securities, commercial paper)
and any interest-bearing debt (e.g., loans, revolver, bonds) are excluded when calculating working
capital because they're non-operational and don't directly generate revenue.
Net Working Capital (NWC) = Operating Current Assets − Operating Current Liabilities

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ACCOUNTING
QUESTIONS

Cash & cash equivalents are closer to investing activities since the company can earn a slight return (~0.25%
to 1.5%) through interest income, whereas debt is classified as financing. Neither is operations-related, and
both are thereby excluded in the calculation of NWC.
Read More → Working Capital in Valuation
Is negative working capital a bad signal about a company's health?
Further context would be required, as negative working capital can be positive or negative. For instance,
negative working capital can result from being efficient at collecting revenue, quick inventory turnover,
and delaying payments to suppliers while efficiently investing excess cash into high-yield investments.
However, the opposite could be true, and negative working capital could signify impending liquidity issues.
Imagine a company that has mismanaged its cash and faces a high accounts payable balance coming due
soon, with a low inventory balance that desperately needs replenishing and low levels of AR. This company
would need to find external financing as early as possible to stay afloat.
What does change in net working capital tell you about a company's cash flows? The change in
net working capital is important because it gives you a sense of how much a company's cash flows will
deviate from its accrual-based net income.
Change in Net Working Capital = NWC Prior Period − NWC Current Period
If a company's NWC has increased year-over-year, its operating assets have grown and/or its operating
liabilities have shrunk from the prior year. Since an increase in an operating asset is a cash outflow, it should
be intuitive why an increase in NWC means less cash flow for a company (and vice versa).
What ratios would you look at to assess working capital management efficiency?
Efficiency Ratios

Days Inventory
DIH measures the average number of days it takes

DIH = �Inventory
Held ("DIH")
for a company to sell off its inventory.

COGS � × 365 Days

Companies strive to minimize their DIH and sell
their inventory as soon as possible.

Days Sales DSO represents the average number of days it takes

Outstanding for a company to collect payments made on credit. DSO = � AR
("DSO") Lower DSOs mean less time is needed to retrieve Revenue� × 365 Days
cash from sales made on credit.

Days Payable DPO refers to the average number of days it takes

Outstanding for a company to pay back its suppliers. DPO = � AP
("DPO") Higher DPOs indicate the company has more COGS� × 365 Days
bargaining power over its suppliers.

What is the cash conversion cycle?

The cash conversion cycle ("CCC") measures the number of days it takes a company to convert its inventory
into cash from sales. Therefore, a lower cash conversion cycle is preferred as it implies the company
generates and collects cash in a shorter duration. As a general rule, companies with lower CCCs operate
efficiently, hold more negotiating power over suppliers, and have quicker sales collection cycles.
Cash Conversion Cycle = DIO + DSO –DPO

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ACCOUNTING
QUESTIONS

How would you forecast working capital line items on the balance sheet?
Working Capital Forecast

Accounts
A/R typically grows along with
DSO should be calculated for historical periods
Receivable
revenue and should remain in-line
(DSO = A/R ÷ Revenue x 365)
(A/R)
with historical periods.
Assumptions for DSO in future periods will be
based on historical trends or an average.
DSO often gradually decreases over
time as companies become more
Forecasted A/R can be calculated by (DSO
efficient in payment collection.
assumption ÷ 365) x forecasted revenue.

Inventori Inventory will grow in-line with DIH would be calculated for historical periods
es COGS in most cases. (DIH = Inventory ÷ COGS x 365)
DIH can decrease over time as Historical trends or an average of past
companies become more efficient periods should be used for the DIH
at selling their inventory. assumptions.
Forecasted inventory balance will be equal to
the (DIH assumption ÷ 365) x forecasted
COGS.
Prepaid Prepaid expenses will typically be Historical prepaid expenses would be calculated
Expenses SG&A related, but can grow as a % of SG&A (or revenue).
with revenue if it's unclear. Forecasted prepaid expenses will be equal to
the % assumption x forecasted revenue.

Other Other current assets normally grow Other current assets for past periods would be
Current along with revenue, assuming calculated by dividing past amounts by revenue.
Assets they're tied to operations. Forecasted OCA would be equal to the %
Otherwise, can be straight-lined assumption x forecasted revenue.

Accou A/P will typically grow with COGS, DPO for past periods will be calculated (DPO =
nts especially if the company sells goods A/P ÷ COGS x 365).
Payabl (i.e., inventory payment delays). Historical trends would be followed or an
e DPO can be assumed to gradually average can be taken for the assumption.
(A/P) increase if the company might have Forecasted A/P will be equal to the (DPO
more buyer power in the future. assumption ÷ 365) x COGS.

Accrued Accrued expenses usually relate to Accrued expenses as a percentage of SG&A will
Expenses operating expenses, thus it will first be calculated for historical periods.
grow along with SG&A (or Forecasted accrued expenses will be the %
revenue if it's unclear). SG&A assumption x current period SG&A.

Deferred Deferred revenue is typically Deferred revenue as a % of revenue will be

Revenue forecasted to grow with the calculated for historical periods.
revenue, as it's likely a part of the Forecasted D/R will be equal to the % of
company's business model. revenue assumption x forecasted
revenue.

Other Current liabilities are usually Current liabilities as a % of revenue will be

Current forecasted to grow with calculated for previous periods.
Liabilitie revenue Forecasted OCL will be equal to the % of
s If the driver is unclear, it can be revenue assumption x current period
straight-lined. revenue.

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ACCOUNTING
QUESTIONS

How would you forecast capex and D&A when creating a financial model?
In the simplest approach, D&A can be projected as either a percentage of revenue or capital expenditures,
while capex is forecasted as a percentage of revenue. Re-investments such as capex directly correlate with
revenue growth, thus historical trends, management guidance, and industry norms should be closely
followed.
Alternatively, a depreciation waterfall schedule can be put together, which would require more data from
the company to track the PP&E currently in-use and the remaining useful life of each. In addition,
management plans for future capex spending and the approximate useful life assumptions for each
purchase will be necessary. As a result, depreciation from old and new capex will be separately shown.
For projecting amortization, useful life assumptions would also be required, which can often be found in
a separate footnote in a company's financial reports.
How would you forecast PP&E and intangible assets?
When forecasting PP&E, the end of period balance will be calculated using the roll-forward schedule shown
below. Note, capex will input as a negative, meaning the PP&E balance should increase. Other factors that
could affect the end-of-period PP&E balance are asset sales and write-downs.
PP&E Roll-Forward
EOP PP&E = BOP PP&E + Capex − Depreciation
To forecast intangible assets, management guidance becomes necessary as unlike capex, there's usually no
clear historical pattern that can be followed as these purchases tend to be inconsistent. In most cases, it's
best to rely on management if available, but in the absence of guidance, it's recommended to assume no
purchases.
Intangible Assets Roll-Forward
EOP Intangibles = BOP Intangibles + Intangibles Purchases – Amortization
What is the difference between the current ratio and the quick ratio?
The current ratio and quick ratio are used to assess a company’s near-term liquidity position. The two ratios
are both used to determine if a company can meet its short-term obligations using just its short-term assets
at the present moment.
Current Ratio: A current ratio greater than 1 implies that the company is financially healthy in terms of
liquidity and can meet its short-term obligations.

Current Ratio = Current Assets

Current Liabilities
Quick Ratio: Otherwise known as the acid-test ratio, the quick ratio measures short-term liquidity, but uses
stricter policies on what classifies as a liquid asset. Therefore, it includes only highly liquid assets that
could be converted to cash in less than 90 days with a high degree of certainty.

Quick Ratio = (Cash & Cash Equivalents + AR + Short Term Investments)

Current Liabilities
Give some examples of when the current ratio might be misleading?
The cash balance used includes the minimum cash amount required for working capital needs – meaning
operations could not continue if cash were to dip below this level.
Similarly, the cash balance may contain restricted cash, which is not freely available for use by the business
and is instead held for a specific purpose.
Short-term investments that cannot be liquidated in the markets easily could have been included (i.e., low
liquidity, cannot sell without a substantial discount).
Accounts receivable could include “bad A/R", but management refuses to recognize it as such.

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ACCOUNTING
QUESTIONS

Is it bad if a company has negative retained earnings?

Not necessarily. Retained earnings can turn negative if the company has generated more accounting losses
than profits. For example, this is often the case for startups and early-stage companies investing heavily to
support future growth (e.g., high capex, sales & marketing expenses, R&D spend).
Another component of retained earnings is the payout of dividends and share repurchases, contributing to
lower or even negative retained earnings. In these scenarios, the negative retained earnings mean the
company has returned more capital to shareholders than taken in.
How can a profitable firm go bankrupt?
To be profitable, a company must generate revenues that exceed expenses. However, if the company is
ineffective at collecting cash from customers and allows its receivables to balloon, or if it cannot get favorable
terms from suppliers and must pay cash for all inventories and supplies, the company can suffer from
liquidity problems due to the timing mismatch of cash inflows and outflows.
Profitable companies with these types of working capital issues can usually secure financing, but if
financing suddenly becomes unavailable (e.g., 2008 credit crisis), the company could be forced to declare
bankruptcy.
Alternatively, a profitable company that took on far too much debt in its capital structure and could not
service the interest payments may also default on its debt obligations.
What does return on assets (ROA) and return on equity (ROE) each measure? Return on assets
("ROA") and return on equity ("ROE") are measures of profitability that show how effective a company’s
management team is at utilizing the resources it has on-hand (assets or equity).
Return on Assets: ROA measures asset utilization and how efficiently a company's assets are used to
generate earnings. A high ROA relative to a peer group indicates assets are being used near full capacity,
whereas a low ROA means management may not be deriving the full potential benefit from its assets.
Return on Assets (ROA) = Net Income
(Average of Beginning and Ending Total Assets)
Return on Equity: The ROE ratio gives insight into how efficiently a management team has been using the
capital shareholders have contributed. A higher ROE means management is efficient at using the money
raised from equity financing (and vice versa).
Return on Equity (ROE) = Net Income
(Average of Beginning and Ending Book Value of Equity)
What is the relationship between return on assets (ROA) and return on equity (ROE)? The
relationship between ROA and ROE is tied to the use of leverage. In the absence of debt in the capital
structure, the two metrics would be equal. But if the company were to add debt to its capital structure, its
ROE would rise above its ROA due to increased cash, as total assets would rise while equity decreases.
If a company has a ROA of 10% and a 50/50 debt-to-equity ratio, what is its ROE? Imagine a
company with $100 in total assets. A 10% return on assets (ROA) would imply $10 in net income. Since the
debt-to-equity mix is 50/50, the return on equity (ROE) is $10/$50 = 20%.
When using metrics such as ROA and ROE, why do we use averages for the denominator? The
numerator, usually net income, comes from the income statement. The denominator, either assets or
equity, comes from the balance sheet. The income statement covers a specific period, whereas the
balance sheet is a snapshot at one particular point in time. Thus, the average between the beginning and
ending balance of the denominator is used to adjust for this mismatch in timing.

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ACCOUNTING
QUESTIONS

What are some shortcomings of the ROA and ROE metrics for comparison purposes? A
company's ROA and ROE ratios are benchmarked against competitors in the same industry to assess
management efficiency and track historical trends. However, the ROA and ROE ratios are most useful when
compared to a peer group of companies with similar growth rates, margin profiles, and risks. This
approach would be best suited for established companies operating in mature, low-growth industries with
many comparable companies to accurately track the management team's profitability and efficiency.
What is the return on invested capital (ROIC) metric used to measure?
The return on invested capital ("ROIC") metric is used to assess how efficient a management team is at capital
allocation. A company that generates an ROIC over its cost of capital (WACC) suggests the management team
has been allocating capital efficiently (i.e., investing in profitable projects or investments) and if sustained over
the long-run, this indicates a competitive advantage. ROIC represents one of the most fundamental
assessments of a company: "How much in returns is the company earning for each dollar invested?" Return on
Invested Capital (ROIC) = NOPAT
Invested Capital
Read More → Calculating Return on Invested Capital
What does the asset turnover ratio measure?
The asset turnover ratio is a metric used to understand how efficiently a company uses its assets to generate
sales. The asset turnover ratio answers the question, "How many dollars in revenue does the company
generate per dollar of assets?" The higher the ratio, the better, as this suggests the company is generating more
revenue per dollar of an asset owned. But it has shortfalls in being distorted by capital expenditures and asset
sales. Asset Turnover Ratio = Revenue
(Average of Beginning and Ending Total Assets)
What does inventory turnover measure and how does it differ from days inventory held (DIH)?
The inventory turnover ratio is how often a company has sold and replaced its inventory balance throughout
a specified period (i.e., the number of times inventory was "turned over").

Inventory Turnover = Cost of Goods Sold

(Average of Beginning and Ending Inventory)
In contrast, DIH is the average number of days it takes for a company to turn its inventory into
revenue. What does accounts receivables turnover measure?
Accounts receivable turnover is a metric used to measure the number of times per year that a company can
collect its average accounts receivable from customers. The higher the turnover ratio, the better as it
indicates the company is efficient at collecting its due payments from customers that paid on credit.

Receivables Turnover = Revenue

(Average of Beginning and Ending Accounts Receivables)
What does accounts payables turnover measure and is a higher or lower number preferable?
Accounts payable turnover measures how quickly a company pays its vendors. Generally, longer credit
terms provide a company with more flexibility as it means the company has more cash-on-hand. A higher
A/P turnover means the company pays off its A/P balance quickly, meaning the cash outflows occur faster.

Accounts Payable Turnover = Cost of Goods Sold

(Average Beginning and Ending Accounts Payable)

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ACCOUNTING
QUESTIONS

What are some ratios you would look at to perform credit analysis?
Credit Ratio Purpose Examples
Type

Liquidity Ratios Assesses a company’s ability to meet its Current Ratio

current obligations using its current Quick Ratio
assets. Cash Ratio

Leverage/Solven Compares a company's use of debt to Debt-to-EBITDA

cy Ratios assets, equity, earnings, and total Debt-to-Assets
capitalization to evaluate if its debt Debt-to-Equity
obligations can be met.

Coverage Ratios Measures a company's ability to Times Interest Earned

service interest payments and other EBITDA Interest Coverage
debt-related obligations using a cash Ratio Debt Service Coverage
flow metric. Ratio
Fixed Charge Coverage Ratio

Profitability Conveys a company's ability to Gross, Operating, Net Profit, and

Ratios consistently generate profits, enabling it EBITDA Margins %
to meet its debt obligations. ROE, ROA, and ROIC

What are the two types of credit ratios used to assess a company's default risk?
Credit Ratios

Leverage Ratios Leverage ratios compare the amount of debt

Total Debt/EBITDA
held by a company to a specific cash flow
Senior Debt/EBITDA
metric, most often EBITDA.
Net Debt/EBITDA
Total Debt/Equity
Total Debt/Total Capital

Interest Interest coverage ratios measure a EBIT/Interest Expense

Coverage company’s ability to cover its interest EBITDA/Interest Expense
Ratios payments using its cash flows. The higher EBITDA/Cash Interest Expense
the interest coverage ratio, the better (EBITDA – Capex)/Interest Expense
(ideally, >2.0x).

How do you calculate the debt service coverage ratio (DSCR) and what does it measure? The debt
service coverage ratio (DSCR) is a measure of creditworthiness that tests a company’s ability to pay its
current debt obligations using its current cash flows. As a general rule, a DSCR greater than 1.0 shows the
company is generating sufficient cash flows to pay down its debt. But a DSCR below 1.0 could be a cause of
concern, as it suggests the company might have insufficient cash flows to handle the debt it currently holds.
There are various methods to calculate the DSCR, but one commonly used example is shown

below: DSCR = (EBITDA − Capex)

(Mandatory Principal Repayment + Interest Expense)
How do you calculate the fixed charge coverage ratio (FCCR) and what does it mean? The fixed
charge coverage ratio (FCCR) is used to assess if a company's earnings can cover its fixed charges, which
can include rent, utilities, and interest expense. The higher the ratio, the better the creditworthiness. Fixed
charges can include expenses such as rent or lease payments, and utility bills.

Fixed Charge Coverage Ratio (FCCR) = (EBIT + Lease Charges)

(Lease Charges + Interest Expense)

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ACCOUNTING
QUESTIONS

Advanced Accounting
How would raising capital through share issuances affect earnings per share (EPS)? The impact on
EPS is that the share count increases, which decreases EPS. But there can be an impact on net income,
assuming the share issuances generate cash because there would be higher interest income, which increases
net income and EPS. However, most companies' returns on excess cash are low, so this doesn't offset the
negative dilutive impact on EPS from the increased share count.
Alternatively, share issuances might affect EPS in an acquisition where stock is the form of consideration.
The amount of net income the acquired company generates will be added to the acquirer’s existing net
income, which could have a net positive (accretive) or negative (dilutive) impact on EPS.
How would a share repurchase impact earnings per share (EPS)?
The impact on EPS following a share repurchase is a reduced share count, which increases EPS. However,
there would be an impact on net income, assuming the share repurchase was funded using excess cash. The
interest income that would have otherwise been generated on that cash is no longer available, causing net
income and EPS to decrease.
But the impact would be minor since the returns on excess cash are low, and would not offset the
positive impact the repurchase had on EPS from the reduced share count.
What is the difference between the effective and marginal tax rates?
Effective Tax Rate: The effective tax rate represents the percentage of taxable income corporations must
pay in taxes. For historical periods, the effective tax rate can be backed out by dividing the taxes paid by
the pre-tax income (or earnings before tax).

Effective Tax Rate % = Taxes Paid

Earnings Before Tax
Marginal Tax Rate: The marginal tax rate is the taxation percentage on the last dollar of a company’s
taxable income. The tax expense depends on the statutory tax rate of the governing jurisdiction and the
company's taxable income, as the tax rate adjusts according to the tax bracket in which it falls.
Why is the effective and marginal tax rate often different?
Effective and marginal tax rates differ because the effective tax rate calculation uses pre-tax income from
the accrual-based income statement. Since there's a difference between the taxable income on the income
statement and taxable income shown on the tax filing, the tax rates will nearly always be different. Thus, the
“Tax Provision” line item on the income statement rarely matches the actual cash taxes paid to the IRS.
Read More → Effective vs. Marginal Tax Rates
Could you give specific examples of why the effective and marginal tax rates might differ? Under
GAAP, many companies follow different accounting standards and rules for tax and financial reporting.
Most companies use straight-line depreciation (i.e., equal allocation of the expenditure over the useful life)
for reporting purposes, but the IRS requires accelerated depreciation for tax purposes – meaning, book
depreciation is lower than tax depreciation for earlier periods until the DTLs reverse.
Companies that incurred substantial losses in earlier years could apply tax credits (i.e., NOL carry
forwards) to reduce the amount of taxes due in later periods.
When debt or accounts receivable is determined to be uncollectible (i.e., “Bad Debt” and “Bad AR”), this can
create DTAs and tax differences. The expense can be reflected on the income statement as a write-off but
not be deducted in the tax returns.

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ACCOUNTING but elect to use straight-line depreciation for GAAP
QUESTIONS reporting. This means that for a given depreciable asset,
the amount of depreciation recognized in the earlier
years for tax purposes will be greater than under GAAP.
What are deferred tax liabilities (DTLs)?
Deferred tax liabilities ("DTLs") are created when a
company recognizes a tax expense on its GAAP income
statement that, because of a temporary timing difference
between GAAP and IRS accounting, is not actually paid to
the IRS that period but is expected to be paid in the Temporary timing differences in book and tax
future. accounting lead to the creation of
DTLs are often related to depreciation. Companies can DTAs/DTLs, which will gradually unwind to a
use accelerated depreciation methods for tax purposes balance of zero.

Those temporary timing differences are recognized as DTLs. Since these differences are just temporary –
under both book and tax reporting, the same cumulative depreciation will be recognized over the life of the
asset – at a certain point into the asset’s useful life, an inflection point will be reached where the depreciation
expense for tax reporting will become lower than for GAAP.
What are deferred tax assets (DTAs)?
Deferred tax assets ("DTAs") are created when a company recognizes a tax expense on its GAAP income
statement that, due to a temporary timing difference between GAAP and IRS accounting rules, is lower
than what must be paid to the IRS for that period. These net operating losses ("NOLs") that a company can
carry forward against future income create DTAs.
For example, a company that reported a pre-tax loss of $10 million will not get an immediate tax
refund. Instead, it'll carry forward these losses and apply them against future profits.
However, under GAAP, the tax benefit will be recognized from a presumed future tax refund immediately on
the income statement, and this difference gets captured in DTAs. As the company generates future profits and
uses those NOLs to reduce future tax liabilities, the DTAs gradually reverse.
Another reason for DTAs is the differences between book and tax rules for revenue recognition. Broadly,
tax rules require recognition based on receiving cash, while GAAP adheres rigidly to accrual concepts.
Read More → Financial Concepts: Deferred Taxes
What impact did the COVID-19 Tax Relief have on NOLs?
Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, NOLs that arise beginning in 2018
and through 2020 could be carried back for up to a maximum of five years. The rules for claiming tax losses
were changed to assist individuals and corporations negatively impacted by the pandemic.
For tax years beginning after 2020, the CARES Act would allow NOLs deduction equal to the sum of:
1. All NOL carryovers from pre-2018 tax years
2. The lesser amount between 1) all NOL carryovers from post-2017 tax years or 2) 80% of remaining
taxable income after deducting NOL carryovers from pre-2018 tax years
Previously, NOLs arising in tax years ending after 2017 could not be carried back to earlier tax years and offset
taxable income. NOLs arising in tax years post-2017 could only be carried forward to later years. But the key
benefit was that the NOLs could be carried forward indefinitely until the loss was fully recovered (yet limited
to 80% of the taxable income in a single tax period).

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ACCOUNTING
QUESTIONS

What are the notable takeaways from Joe Biden’s proposed tax plans?
The corporate tax rate will rise from the Trump Era’s Tax Cuts and Jobs Act ("TCJA") rate of 21% to 28%;
estimated to increase the government’s tax revenue from $2 trillion to $3 trillion over the next decade. The
top tax rate for individuals with a taxable income of $400k+ will rise from 37% to 39.6%. A 12.4% payroll
tax will be imposed on those earning $400k+ and to be split evenly between employers and employees.
Minimum tax on corporations with book profits of $100+ million, which would be structured so that
corporations would pay the greater amount between 1) their regular corporate income tax or 2) the
15% minimum tax with net operating loss (NOL) and foreign tax credits allowed.
Does a company truly not incur any costs by paying employees through
stock-based compensation rather than cash?
Stock-based compensation is a non-cash expense that reduces a company’s
taxable income and is added-back on the cash flow statement.
However, SBC incurs an actual cost to the issuer by impact of the new shares, becomes less valuable on
creating additional shares for existing equity a per-share basis to existing shareholders.
owners. The issuing company, due to the dilutive Watch Video → Stock-Based Compensation

Could you define contra-liability, contra-asset, and contra-equity with examples of each?
Contra-Liability: A contra-liability is a liability account that carries a debit balance. While classified as a
liability, it functions closer to an asset by providing benefits to the company. An example would be financing
fees in M&A. The financing fees are amortized over the debt's maturity, which reduces the annual tax burden
and results in tax savings until the end of the term.
Contra-Asset: A contra-asset is an asset that carries a credit balance. An example would be depreciation, as
it reduces the fixed asset’s carrying balance while providing tax benefits to the company. There is often a line
called “Accumulated Depreciation,” which is the contra-asset account reflected on the balance sheet.
Contra-Equity: A contra-equity account has a debit balance and reduces the total amount of equity held by a
company. An example would be treasury stock, which reduces shareholders’ equity. Since treasury stock
reduces the total shareholders' equity, treasury stock is shown as a negative on the balance sheet.
What is an allowance for doubtful accounts on the balance sheet?
Under US GAAP, the allowance for doubtful accounts estimates the percentage of uncollectible accounts
receivable. This line item is considered a contra-asset because it reduces the accounts receivable balance. The
allowance, often called a bad debt reserve, represents management’s estimate of the amount of A/R that
appears unlikely to be paid by customers. In effect, a more realistic value for A/R that'll actually be turning
into cash is shown on the balance sheet, while preventing any sudden decreases in the company's A/R
balance.
What is the difference between a write-down and a write-off?
Write-Downs: In a write-down, an adjustment is made to an asset such as inventory or PP&E that has
become impaired. The asset's fair market value (FMV) has fallen below its book value; hence, its
classification as an impaired asset. Based on the write-down amount deemed appropriate, the value of
the asset is decreased to reflect its true value on the balance sheet. Examples of asset write-downs would
include damages caused by minor fires, accidents, or sudden value deterioration from lower demand.
Write-Offs: Unlike a write-down in which the asset retains some value, a write-off reduces an asset's value
to zero, meaning the asset has been determined to hold no current or future value (and should therefore be
removed from the balance sheet). Examples include uncollectible AR, "bad debt," and stolen inventory.

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ACCOUNTING
QUESTIONS

How would a $100 inventory write-down impact the three financial

statements? IS: The $100 write-down charge will be reflected in the cost of goods line
item.
The expense would decrease EBIT by $100, and net being written down $100. This will be offset by the
income would decline by $70, assuming a 30% tax rate. decrease of $70 in net income that flows through
CFS: The starting line item, net income, will be down The cash impact of the write-down was net positive,
$70, but the $100 write down is an add-back since as the
there's no actual cash outflow from the write-down. Thecompany's taxable income was reduced from the
net impact to the ending cash will be a $30 increase. tax savings.
BS: On the asset side, cash is up $30 due to inventory

retained earnings on the equity section. Both sides of the balance sheet will be down by $70 and remain
in balance.
How does buying a building impact the three financial statements?
IS: Initially, there'll be no impact on the income statement since the purchase of the building is capitalized.
CFS: The PP&E outflow is reflected in the cash from investing section and reduces the cash balance. BS: The
cash balance will go down by the purchase price of the building, with the offsetting entry to the cash
reduction being the increase in PP&E.
Throughout the purchased building's useful life, depreciation is recognized on the income statement,
which reduces net income each year, net of the tax expense saved (since depreciation is tax-deductible).
How does selling a building with a book value of $6 million for $10 million impact the three
financial statements?
IS: If I sell a building for $10 million with a book value of $6 million, a $4 million gain from the sale would
be recognized on the income statement, which will increase my net income by $4 million. CFS: Since the $4
million gain is non-cash, it'll be subtracted from net income in the cash from operations section. In the
investing section, the full cash proceeds of $10 million are captured.
BS: The $6 million book value of the building is removed from assets while cash increases by $10 million,
for a net increase of $4 million to assets. On the L&E side, retained earnings will increase by $4 million
from the net income increase, so the balance sheet remains balanced.
However, the gain on sale will result in higher taxes, which will be recognized on the income statement.
This lowers retained earnings by $1 million and be offset by a $1 million credit to cash on the asset side.
If a company issues $100 million in debt and uses $50 million to purchase new PP&E, walk me
through how the three statements are impacted in the initial year of the purchase and at the end of
year 1. Assume a 5% annual interest rate on the debt, no principal paydown, straight-line
depreciation with a useful life of five years and no residual value, and a 40% tax rate. Initial
Purchase Year (Year 0)
IS: There'll be no changes as neither capex nor issuing debt impact the income statement. CFS: The $50
million outflow of capex will be reflected in the cash from investing section of the cash flow statement, while
the $100 million inflow from the debt issuance will be reflected in the cash from financing section. The ending
cash balance will be up by $50 million.
BS: On the assets side, cash will be up by $50 million and PP&E will increase $50 million from the PP&E
purchase, making the assets side increase by $100 million in total. On the L&E side, debt will be up
$100 million, which will offset the increase in assets and the balance sheet remains in balance.

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ACCOUNTING
QUESTIONS

End of First Year (Year 1)

IS: Since the capex amount was $50 million with a useful life assumption of five years (straight-line to a
residual value of zero), the annual depreciation will be $10 million. Next, the interest expense will be
equal to the $100 million in debt raised multiplied by the 5% annual interest rate, which comes out to $5
million in annual interest expense. The pre-tax income will be down by $15 million and assuming a 40%
tax rate, net income will be down $9 million.
CFS: Net income will be down $9 million, but the non-cash depreciation of $10 million will be added back,
making the ending cash balance increase by $1 million.
BS: On the assets side, cash is up by $1 million and PP&E will decrease by $10 million because of the
depreciation. Since equity is also down $9 million due to net income, both sides will remain in
balance.
For long-term projects, what are the two methods for revenue recognition? 1. Percentage of
Completion Method: In the percentage of completion method, revenue is recognized based on the
percentage of work completed during the period. This method is used far more common since it's in a
company's best interest to record partial revenue once earned. Two conditions must be met to use this
method: the collection of payment must be reasonably assured, and the total project costs with the estimated
completion date are required to be provided.
2. Completed Contract Method: The completed contract method recognizes revenue once the entire
project has been completed. This method is rarely used in the US, as it would result in a company
under reporting revenue that has been earned under the accrual-based system.
If a company has continuously incurred goodwill impairment charges, what do you take away from
seeing this in their financials?
Goodwill on the balance sheet remains unchanged unless it's impaired, meaning the purchaser has
determined that the acquired assets are worth less than initially thought. While goodwill impairment can be
attributed to unforeseeable circumstances, impairments as a common occurrence may raise concerns
regarding the management team’s history of overpaying for assets or their inability to integrate new
acquisitions.
What is restricted cash and could you give me an example?
Restricted cash is cash reserved for a specific purpose and not available for the company to use. On the
balance sheet, the restricted cash will be listed separated from the unrestricted cash, and there'll be an
accompanying disclosure providing the reasoning why this cash cannot be used.
An example of restricted cash would be if a company signed an agreement to receive a line of credit, but the
lender has required the borrower to maintain 10% of the total loan amount at all times (i.e., “bank loan
requirement”). As long as the line of credit is active, the 10% minimum must be preserved to avoid
breaching the lending terms. The company may have a separate bank account to hold the funds, or the
lender may have required the amount to be placed in escrow to ensure compliance.
What is the accounting treatment for finance leases?
Finance leases is an accounting approach that recognizes the present value of all future lease payments as
debt and recognizes the value provided by those future lease obligations as an asset (PP&E) on the lessee’s
balance sheet. Unlike debt, where the principal is defined, companies must estimate the initial finance lease
liability as
the present value of all future lease payments, using a discount rate assumption. For example, a 4-year
lease with $500,000 annual year-end lease payments at an assumed discount rate of 10% will be
recognized.
Similar to debt, leases are long-term obligations to make payments to another party. However, lease
payments rarely include explicit interest payments in the way debt does. Instead, the interest fees are
implied and accounted for in the total lease expense.

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ACCOUNTING
QUESTIONS

Over the finance lease term, the asset is depreciated, while the lease liability accrues interest during the
year and is then reduced by lease payments (similar to principal payments with debt). On the income
statement, depreciation and the implied interest expense reduces net income.
To recap, the balance sheet initially treats the finance lease as a debt-like liability and the underlying asset as
an owned asset. Over the life of the lease, the income statement impact doesn't capture the rent expense as
one might intuitively assume. Instead, finance lease accounting breaks up the lease payments into two
components on the income statement: interest and depreciation expenses – even though a company in
actuality is paying a lease payment that commingles these two items.
What is the accounting treatment for operating leases?
Lease accounting changed significantly in 2019 for both US GAAP and IFRS. IFRS doesn't allow operating
leases at all, so this only applies to US GAAP.
The initial balance sheet impact is the same as finance leases: Initially, the lease is recognized as a liability on
the balance sheet (just like debt) with the corresponding asset as PP&E. The income statement is where the
accounting diverges from finance leases. The income statement is simply reduced by the rent (lease) expense
throughout the lease term. For example, if a 5-year lease calls for the annual lease payment of $500,000, the
annual rent expense will be recognized as a $500,000 operating expense per year. The cash flow statement
will already reflect the lease payment in each period via the net income line, so the lease payment affects the
cash flow statement in cash from operations.
What are the three different types of intercompany investments?
1. Investments in Securities: The investment in securities method is used when a company invests in
another company's equity, but the ownership percentage is less than 20%. These investments are treated
as minor, passive financial investments due to the insignificant influence.
2. Equity Investments Method: When a company owns between 20-50% of another company, this is
considered a significant level of influence. Thus, proper accounting treatment would be the equity
method. Under the equity method, an investment is initially measured at the acquisition price and
recorded as an “Investment in Affiliate” (or “Investment in Associate”) on the assets side. Although a non
controlling stake, this type of ownership is considered influential enough to affect the target's decisions.
3. Consolidation Method: When the parent company has majority control over 50% ownership, the
consolidation method is used. Instead of creating an individual investment asset, the target company’s
balance sheet is consolidated with the acquirer. To reflect that the acquirer owns less than 100% of
the consolidated assets and liabilities, a new equity line titled “Non-Controlling Interests” (NCI) is
created, which captures the value of equity in the consolidated business held by non-controlling
(minority) interests (other third parties).
What are the three sub-classifications of investment securities?
1. Trading Securities: These are debt or equity investments intended to generate short-term profits. The
purchase amount of the security will be recorded at its initial cost on the balance sheet and
periodically marked-to-market until sold. Any unrealized gain/(loss) will be recorded on the income
statement throughout the holding period until the realized gain/(loss) when sold.
2. Available-for-Sale Securities ("AFS"): These are debt or equity securities held for the long-term but sold
before maturity. The investment amount will be recorded at the initial cost on the balance sheet, marked
to-market until the sale, and categorized as either current or non-current. A distinction from trading
securities is how unrealized gains or losses are not be reflected on the income statement, but recorded as
“Accumulated Other Comprehensive Income” on the balance sheet. Once sold, the realized gain/(loss) will
be recognized on the income statement.

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3. Held-to-Maturity Securities ("HTM"): These are long-term investments in debt securities held until the
end of their term. HTM applies only to debt instruments, typically government bonds, certificates of
deposit (CDs), and investment-grade corporate bonds, as they have fixed payment schedules and
maturity dates. HTM securities are low risk, low return holdings since there's a low risk of default, and
the long-term holding horizon helps mitigate many risks. The investment's original cost is recorded on
the balance sheet (reported at amortized cost). However, the value of the investment is not adjusted
following changes in its FMV due to the HTM classification.
Could you name an example of an asset that's exempt from the cost principle rule? Mark-to-market
accounting would record the asset at its current fair market value and then adjust the value to reflect what an
asset would sell for today. There are a few exceptions to the cost principle rule, with one of them being
marketable securities, which are highly liquid and traded on stock exchanges.
What is trapped cash and what benefit does it provide to companies?
Trapped cash refers to the accumulation of cash overseas by multinational companies. While not
illegal, companies keep this cash offshore to avoid certain repatriation taxes if brought back to the US.
For example, Apple held ~$250 billion overseas at one point, mainly in Ireland, which has been known as a
“tax-haven.” While CEO Tim Cook had to defend Apple’s tax practices to Congress, there was no sign of
illegal wrongdoing, and Cook’s counterargument was that Apple paid all required tax payments related to
sales conducted in the US and shifted the narrative towards how Apple is a global company.
During the Trump administration, fixing this issue and incentivizing US companies to bring their operations
back to their home country was a key objective. But even after the tax cuts went into effect, many corporations
retained significant amounts of cash abroad – well short of the predicted $4 trillion expected to be brought
back. For multinational companies with operations in several countries, there's no clear incentive or
obligation why they would have to bring all their cash and operations back to the US.
When can a company capitalize software development costs under accrual accounting? The
capitalization of software development costs involves internally developed software costs being recognized
similar to fixed asset purchases, as opposed to being expensed as incurred in the current period. These
software-related costs can include programmers' compensation, market testing, and various direct or indirect
overhead costs related to bringing the software to the public. To capitalize software development costs, the
software being developed must be eligible based on GAAP's criterion.
Broadly, there are two stages of software development in which a company can capitalize software costs:
1. The application development stage for software intended for internal use such as coding 2. The
stage when the software’s “technological feasibility” has been reached and can be marketed
The accounting treatment of capitalized software costs is like that of certain intangible assets, in which
the software costs are capitalized and amortized over the useful life assumption on the income statement.
Read More → Accounting for Capitalized Software Costs
What is PIK interest?
PIK stands for “Paid-in-Kind.” PIK interest expense is interest charged by a lender that accrues towards the
ending debt balance as opposed to being paid in cash in the current period. While opting for PIK may
conserve cash for the time being from deferring interest payments to a later date, the debt principal due at
maturity increases each year, as well as the accrued interest payment amount.

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ACCOUNTING
QUESTIONS

What is a PIK toggle note?

A PIK toggle note provides the issuer of the debt with the option to defer an interest payment, but the entire
debt balance, including the accrued payments that must be paid by maturity. Loans can come arranged with a
fixed PIK schedule outlined in the lending terms, but certain debt instruments can come with the optionality
to let the issuer decide whether to pay in cash or accrue over to the next period. Therefore, whether interest
expense is paid-in-cash or PIK effectively becomes a discretionary decision.
If a company has incurred $100 in PIK interest, how would the three-statements be impacted?
IS: On the income statement, interest expense will increase by $100, which causes EBIT to decrease by
$100. Assuming a 30% tax rate, net income will decrease by $70.
CFS: On the cash flow statement, net income will be down by $70, but the $100 non-cash PIK interest will
be added back. The ending cash balance will increase by $30.
BS: On the assets side of the balance sheet, cash will be up $30. Then on the liabilities side, the debt balance
will be up $100 (since the PIK accrues to the debt’s ending balance), and net income is down $70.
Therefore, both sides are up by $30, and the balance sheet balances.
What is the purpose of the original issue discount feature of debt?
An original issue discount ("OID") is a feature of debt meant to make the issuance more appealing to
investors as a “deal sweetener.” Typically, the reduction is 1-2% of the debt issuance.
For example, that if there's $100 of debt being raised, you'll issue it so that the lender only has to pay $98
or $99. An OID is modeled similarly to financing fees and amortized over the term of the debt.
Why are circularities created in financial models?
A circularity is introduced into a financial model when a cell, either directly or indirectly, refers to itself.
The most common circularity is created by interest expense and interest income.
For example, interest expense is calculated off the beginning and ending balances of a company's debt
outstanding, which includes the revolver. Furthermore, the revolver drawdown/(paydown) for a given
period is directly impacted by interest expense – thereby, a circular reference is created.
How would you forecast a company's basic and diluted share count?
In general, management teams will publicly announce their plans for future share issuances or a buyback
program. If that's the case, then the number of share issuance and repurchases can be calculated using the
formula shown below:

Estimated Share Price� – � Share Repurchases

Basic Share Count EOP = Basic Share Count BOP +

Estimated Share Price�
� Shares Issued
The estimated share price used above can be approximated using the formula below: Share Price
Estimate = Prior Period Share Price × (1 + Current Period Consensus EPS Growth Rate)
To calculate the impact of dilutive securities, the differences between the basic and diluted share count in
historical periods can be looked at and this amount can be straight-lined into the future. While this
approach has its shortcomings, it serves as a decent proxy for how potentially dilutive securities such as
options, warrants, and convertible debt will impact the diluted share count.

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How can you forecast a company's implied share price using its EPS?
Since the P/E ratio is equal to a company's share price divided by its EPS, a company's implied share price can
be estimated by taking the forecasted EPS figure and then multiplying it by a P/E ratio assumption. The
conservative approach is to use the company's current P/E ratio as of the present day (or a minor
contraction).
This estimated share price can be sanity checked by using the consensus EPS annual growth rate as a proxy
for share price growth. Both approaches implicitly assume a fixed P/E ratio, but this is meant to be an
approximation of where a company could be trading at, rather than a precise share price forecast.
Read More → Forecasting a Company’s Shares Outstanding and Earnings Per Share
What are the two types of pension plans and how does the accounting differ for each? A pension
plan is a contract between an employer and employee, in which the employer agrees to pay cash benefits
to the employee upon retirement.
1. Defined Contribution: The plan is the simpler of the two, as the employer makes specified contributions
into the plan periodically. The accounting treatment of defined contribution plans is fairly
straightforward as a pension expense will be shown on the income statement (typically SG&A).
2. Defined Benefit: The other option involves the employer having to estimate each period how much of a
contribution must be made to satisfy the upcoming defined post-retirement benefits (and thus, there
will be assumptions on expected payments required). For defined benefit plans, the accounting becomes
more complicated since it involves expected values. But the defined benefit plan will recognize a pension
expense in the SG&A with the off-setting balance sheet entry being either a liability if the amount of cash
contribution is smaller than the pension expense recorded on the income statement or an asset as a pre
paid expense if the amount of cash contribution was greater than the pension expense recorded on the
income statement. Both would lead to tax implications since there would be differences between GAAP
and IRS taxes, which creates DTAs/DTLs.
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ACQUISTIONS
QUESTIONS

Valuation Questions
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QUESTIONS

Corporate Finance Theory

Could you explain the concept of present value and how it relates to company
valuations? The present value concept is based on the premise that "a dollar in the present is
worth more than a dollar in the future" due to the time value of money. The reason being money
currently in possession has the potential to earn interest by being invested today.
company will be equal to the sum of the present
Present Value t= 0 = Cash Flow t=1 value of all the future cash flows it generates.
Therefore, a company with a high
t=1
(1 + r)
Watch Video → Present Value Basics
For intrinsic valuation methods, the value of a

valuation would imply it receives high returns on its invested capital by investing in positive net present
value ("NPV") projects consistently while having low risk associated with its cash flows.
What is equity value and how is it calculated?
Often used interchangeably with the term market capitalization (“market cap”), equity value represents a
company's value to its equity shareholders. A company's equity value is calculated by multiplying its
latest closing share price by its total diluted shares outstanding, as shown below:
Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding
How do you calculate the fully diluted number of shares outstanding?
The treasury stock method ("TSM") is used to calculate the fully diluted number of
shares outstanding based on the options, warrants, and other dilutive securities that
are currently “in-the-money” (i.e., profitable to exercise).
The TSM involves summing up the number of neutral, unlike equity value, which is affected by
in-the-money ("ITM") options and warrants and then financing decisions.
adding that figure to the number of basic shares Enterprise value is calculated by taking the company's
outstanding. equity value and adding net debt, preferred stock, and
In the proceeding step, the TSM assumes the proceeds minority interest.
from exercising those dilutive options will go towards Watch Video →
repurchasing stock at the current share price to reduce Diluted Share
the net dilutive impact. Count

What is enterprise value and how do you calculate

it?
Conceptually, enterprise value ("EV") represents the
value of the operations of a company to all stakeholders Equity value represents just the residual value to
including common shareholders, preferred shareholders, equity holders,
and debt lenders. whereas enterprise value pertains to all providers
Thus, enterprise value is considered capital structure of capital.

Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest
How do you calculate equity value from enterprise value?
To get to equity value from enterprise value, you would first subtract net debt, where net debt equals
the company’s gross debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating
assets.
Equity Value = Enterprise Value –Net Debt – Preferred Stock – Minority Interest

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Net Debt = Total Debt – Cash & Equivalents
QUESTIONS
When calculating enterprise value, why do we
add net debt?
Which line items are included in the
calculation of net debt? The calculation of net
debt accounts for all interest-bearing debt, such as
short-term and long-term loans and bonds, as well
as non-equity financial claims such as preferred
stock and non-controlling interests. From this gross
debt amount, cash and other non-operating assets
such as short-term investments and equity Watch Video → Net Debt
investments are subtracted to arrive at net debt.
The underlying idea of net debt is that the cash on a company’s balance sheet could pay down the
outstanding debt if needed. For this reason, cash and cash equivalents are netted against the company’s debt,
and many leverage ratios use net debt rather than the gross amount.
What is the difference between enterprise value and equity value?
Enterprise value represents all stakeholders in a business, including equity
shareholders, debt lenders, and preferred stock owners. Therefore, it's independent
of the capital structure. In addition, enterprise value is closer to the actual value of
the
business since it accounts for all ownership stakes (as largest airlines combined at one point. The points
opposed to just equity owners). being neglected were:
To tie this to a recent example, many investors were Watch Video → Enterprise Value vs Equity Value
astonished that Zoom, a video conferencing platform,
had a higher market capitalization than seven of the

The equity values of the airline companies were temporarily deflated given the travel restrictions, and the
government bailout had not yet been announced.
The airlines are significantly more mature and have far more debt on their balance sheet (i.e., more non
equity stakeholders).
Could a company have a negative net debt balance and have an enterprise value lower than its
equity value?
Yes, negative net debt just means that a company has more cash than debt. For example, both Apple and
Microsoft have massive negative net debt balances because they hoard cash. In these cases, companies
will have enterprise values lower than their equity value.
If it seems counter-intuitive that enterprise value can be lower than equity value, remember that
enterprise value represents the value of a company’s operations, which excludes any non-operating assets.
When you think about it this way, it should come as no surprise that companies with much cash (which is
treated as a non-operating asset) will have a higher equity value than enterprise value.
Can the enterprise value of a company turn negative?
While negative enterprise values are a rare occurrence, it does happen from time to time . A negative
enterprise value means a company has a net cash balance (total cash less total debt) that exceeds its equity
value. Imagine a company with $1,000 in cash, no other assets and $500 in debt and $200 in accounts payable.
There is $300 in equity in this business, while the enterprise value is -$200.
If a company raises $250 million in additional debt, how would its enterprise value change?
Theoretically, there should be no impact as enterprise value is capital structure neutral. The new debt raised
shouldn't impact the enterprise value, as the cash and debt balance would increase and offset the other
entry.

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However, the cost of financing (i.e., through financing fees and interest expense) could negatively impact
the company's profitability and lead to a lower valuation from the higher cost of debt.
Why do we add minority interest to equity value in the calculation of enterprise value? Minority
interest represents the portion of a subsidiary in which the parent company doesn't own. Under US GAAP, if a
company has ownership over 50% of another company but below 100% (called a “minority interest” or
“non-controlling investment”), it must include 100% of the subsidiary’s financials in their financial
statements despite not owning 100%.
When calculating multiples using EV, the numerator will be the consolidated metric, thus minority interest
must be added to enterprise value for the multiple to be compatible (i.e., no mismatch between the
numerator and denominator).
How are convertible bonds and preferred equity with a convertible feature accounted for when
calculating enterprise value?
If the convertible bonds and the preferred equities are “in-the-money” as of the valuation date (i.e., the
current stock price is greater than their strike price), then the treatment will be the same as additional
dilution from equity. However, if they're “out-of-the-money,” they would be treated as a financial liability
(similar to debt).
What are the two main approaches to valuation?
1. Intrinsic Valuation: For an intrinsic valuation, the value of a business is arrived at
by looking at the business's ability to generate cash flows. The discounted cash
flow method is the most common type of intrinsic valuation and is based on the
notion that a business's value equals the present value average or median multiples derived from the peer
of its future free cash flows. 2. Relative Valuation: In group – often EV/EBITDA, P/E, or some other relevant
relative valuation, a business's value is arrived at by
Watch Video → Valuation Methods
looking at comparable companies and applying the

multiple to value the target. This valuation can be done by looking at the multiples of comparable public
companies using their current market values, which is called "trading comps," or by looking at the
multiples of comparable companies recently acquired, which is called "transaction comps."
What are the most common valuation methods used in finance?
Valuation Methods

Comparable Company Analysis

Trading comps value a company based on how similar publicly-traded
("Trading Comps")
companies are currently being valued at by the market.

Comparable Transactions Transaction comps value a company based on the amount buyers paid
Analysis ("Transaction Comps") to acquire similar companies in recent years.

Discounted Cash Flow DCFs value a company based on the premise that its value is a function
Analysis ("DCF") of its projected cash flows, discounted at an appropriate rate that
reflects the risk of those cash flows.

Leveraged Buyout An LBO will look at a potential acquisition target under a highly
Analysis ("LBO") leveraged scenario to determine the maximum purchase price the
firm would be willing to pay.

Liquidation Analysis Liquidation analysis is used for companies under (or near) distress
and values the assets of the company under a hypothetical,
worst-case scenario liquidation.

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QUESTIONS

Among the DCF, comparable companies analysis, and transaction comps, which approach yields
the highest valuation?
Transaction comps analysis often yields the highest valuation because it looks at valuations for companies
that have been acquired, which factor in control premiums. Control premiums can often be quite significant
and as high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the
resulting valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation.
Which of the valuation methodologies is the most variable in terms of output? Because of its
reliance on forward-looking projections and discretionary assumptions, the DCF is the most variable out of
the different valuation methodologies. Relative valuation methodologies such as trading and transaction
comps are based on the actual prices paid for similar companies. While there'll be some discretion involved,
the valuations derived from comps deviate to a lesser extent than DCF models.
Contrast the discounted cash flow (DCF) approach to the trading comps approach.
Advantages Disadvantages

Discounted The DCF values a company based on The DCF suffers from several drawbacks;
Cash Flow the company’s forecasted cash flows. most notably, it's very sensitive to
(DCF) This approach is viewed as the most assumptions.
direct and academically rigorous Forecasting the financial performance of
way to measure value. a company is challenging, especially if
Considered to be independent of the the forecast period is extended.
market and instead based on the Many criticize the use of beta in the
fundamentals of the company. calculation of WACC, as well as how
the terminal value comprises
around three quarters of the implied
valuation.

Trading Comps Trading comps value a company by While the value derived from a comps
looking at how the market analysis is viewed by many as a more
values similar businesses. realistic assessment of how a company
Thus, comps relies much more could expect to be priced, it's vulnerable
heavily on market pricing to to how the market is not always right.
determine the value of a Therefore, a comps analysis is simply
company (i.e., the most recent, pricing, as opposed to a valuation based
actual prices paid in the public on the company’s fundamentals.
markets). Comps make just as many assumptions
In reality, there are very few truly as a DCF, but they are made implicitly (as
comparable companies, so in opposed to being explicitly chosen
effect, it's always an “apples and assumptions like in a DCF).
oranges” comparison.

How can you determine which valuation method to use?

Each valuation method has its shortcomings; therefore, a combination of different valuation techniques
should be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a
more defensible approximation and sanity-check your assumptions.
The DCF and trading comps are often used in concert such that the comps provide a market-based
sanity-check to intrinsic DCF valuation (and vice versa).

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For example, an analyst valuing an acquisition target may look at the past premiums and values paid on
comparable transactions to determine what the acquirer must realistically expect to pay. The analyst may
also value the company using a DCF to help show how far market prices are from intrinsic value estimates.
Another example of when the DCF and comps approaches can be used together is when an investor considers
investing in a business – the analyst may identify investing opportunities where comps-derived market values
for companies are significantly lower than valuations derived using a DCF (although it bears repeating that
the DCF’s sensitivity to assumptions is a frequent criticism).
Would you agree with the statement that relative valuation relies less on the discretionary
assumptions of individuals?
That could be argued as an inaccurate statement. While a comps analysis often yields different valuations
from a DCF, that’s only because of inconsistent implicit assumptions across both approaches. If the implicit
assumptions of the comps analysis were entirely consistent with the explicit
assumptions of the DCF analysis, the valuations using difference is, you're relying on the assumptions used by
both approaches would theoretically be equal. others in the market.
When you apply a peer-derived multiple to value a All valuation methods contain some degree of
business, you're still implicitly making assumptions inherent bias; thus, various methods should be used
about future cash flows, cost of capital, and returns that in conjunction.
you would make explicitly when building a DCF. The

So when you perform relative valuation, you assume the market consensus to be accurate or at least close
to the right value of a company and that those investors in the market are rational.
What does free cash flow (FCF) represent?
Free cash flow ("FCF") represents a company's discretionary cash flow, meaning the cash flow remaining
after accounting for the recurring expenditures to continue operating.
The simplest calculation of FCF is shown below:
Free Cash Flow (FCF) = Cash from Operations – Capex
The cash from investing section, other than capex, and the financing section are excluded because
these activities are optional and discretionary decisions up to management.
Why are periodic acquisitions excluded from the calculation of FCF?
The calculation of free cash flow should include only inflows/(outflows) of cash from the core, recurring
operations. That said, a periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring
and a normal part of operations (i.e., capex is required for a business to continue operating).
Explain the importance of excluding non-operating income/(expenses) for valuations. For both
DCF analysis or comps analysis, the intent is to value the operations of the business, which requires you to
set apart the core operations to normalize the figures.
When performing a DCF analysis, the cash flows projected should be strictly from the business's recurring
operations, which would come from the sale of goods and services provided. A few examples of non operating
income to exclude would be income from investments, dividends, or an asset sale. Each example represents
income that's non-recurring and from a discretionary decision unrelated to the core operations.
When performing comps, the core operations of the target and its comparables are benchmarked. To make
the comparison as close to “apples to apples” as possible, non-core operating income/(expenses) and any
non-recurring items should be excluded.

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QUESTIONS

Define free cash flow yield and compare it to dividend yield and P/E ratios. The free cash flow yield
("FCFY") is calculated as the FCF per share divided by the current share price. For this calculation, FCF will be
defined as cash from operations less capex.

Free Cash Flow Yield (FCFY) = Free Cash Flow Per Share
Current Share Price
Similar to the dividend yield, FCF yield can gauge equity returns relative to a company’s share price. Unlike
dividend yield, however, FCF yield is based on cash generated instead of cash actually distributed. FCF yield
is more useful as a fundamental value measure because many companies don't issue dividends (or an
arbitrary fraction of their FCFs).
If you invert the FCF yield, you'll get share price/FCF per share, which produces a cash flow version of the
P/E ratio. This has the advantage of benchmarking prices against actual cash flows as opposed to accrual
profits. However, it has the disadvantage that cash flows can be volatile, and period-specific swings in
working capital and deferred revenue can have a material impact on the multiple.
since their default risk has decreased. Thus, it's ordinary
Could you define what the capital structure of a
to see leverage ratios increase in proportion with the
company represents? The capital structure is how a
company's maturity.
company funds its ongoing operations and growth plans.
Most companies' capital structure consists of a mixture ofWhy would a company issue equity vs. debt (and
debt and equity, as each source of capital comes with its vice versa)?
advantages and disadvantages. As companies mature The optimal capital structure is the D/E mix that
and build a track record of profitability, they can usually minimizes the cost of capital, while
get debt financing easier and at more favorable rates maximizing the firm value.

Advantages Disadvantages

Equit No required payments, unlike debt, giving Issuing equity dilutes ownership, and equity
y management more flexibility around is a high cost of capital.
repayment. Public equity comes with more regulatory
Dividends to equity shareholders can be requirements, scrutiny from shareholders
issued, but the timing and magnitude are at and equity analysts, and full disclosures of
the board and management’s discretion. their financial statements.
Another advantage of equity is that it gives The management team could lose control over
companies access to a vast investor base their company and be voted out by
and network. shareholders if the company underperforms.
Debt The interest expense on debt is tax Required interest and principal payments that
deductible, unlike dividends to equity introduce the risk of default.
shareholders (although recent tax Loss of flexibility from restrictive debt
reform rules limit the deduction for covenants prevents management
highly levered companies). from
Debt results in no ownership dilution for undertaking a variety of activities such
equity shareholders and has a lower cost as raising more debt, issuing a
of capital. dividend, or making an acquisition.
Increased leverage forces discipline on Less room for errors in decision-making,
management, resulting in risk-averse therefore poor decisions by
decision-making as a side benefit. management come with more severe
consequences.

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What are share buybacks and under which circumstances would they be most appropriate? A
stock repurchase (or buyback program) is when a company uses its cash-on-hand to buy back some of its
shares, either through a tender offer (directly approach shareholders) or in the open market. The repurchase
will be shown as a cash outflow on the cash flow statement and be reflected on in the treasury stock line
items on the balance sheet.
Ideally, the right time for a share repurchase to be done should be when the company believes the market is
undervaluing its shares. The impact is the reduced number of shares in circulation, which immediately leads
to a higher EPS and potentially a higher P/E ratio. The buyback can also be interpreted as a positive signal by
the market that the management is optimistic about future earnings growth.
Why would a company repurchase shares? What would the impact on the share price and financial
statements be?
A company buys back shares primarily to move cash from the company ’s balance sheet to shareholders,
similar to issuing dividends. The primary difference is that instead of shareholders receiving cash as with
dividends, a share repurchase removes shareholders.
The impact on share price is theoretically neutral – as long as shares are priced
correctly, a share buyback shouldn't lead to a change in share price because while
the share count (denominator) is reduced, the equity value is also reduced by the
now
lower company cash balances. That said, share artificially low share prices if investors discount that
buybacks can positively or negatively affect share cash in their valuations. Here, buybacks should lead to
price movement, depending on how the market a higher
perceives the signal.
Watch Video → Share Repurchases
Cash-rich but otherwise risky companies could see

share price, as the upward share price impact of a lower denominator is greater than the downward
share price impact of a lower equity value numerator.
Conversely, if shareholders view the buyback as a signal that the company’s investment prospects are not
great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset
by a lower equity value (due to lower cash, lower perceived growth and investment prospects).
On the financials, the accounting treatment of the $100 million share buyback would be treated as:
Cash is credited by $100 million
Treasury stock is debited by $100 million
Why might a company prefer to repurchase shares over the issuance of a dividend? The so-called
"double taxation" when a company issues a dividend, in which the same income is taxed at the corporate
level (dividends are not tax-deductible) and then again at the shareholder level. Share repurchases will
artificially increase EPS by reducing the number of shares outstanding and can potentially increase the
company's share price.
Many companies increasingly pay employees using stock-based compensation to conserve cash, thus share
buybacks can help counteract the dilutive impact of those shares.
Share buybacks imply a company's management believes their shares are currently undervalued, making
the repurchase a potential positive signal to the market.
Share repurchases can be one-time events unless stated otherwise, whereas dividends are typically meant
to be long-term payouts indicating a transition internally within a company.
Cutting a dividend can be interpreted very negatively by the market, as investors will assume the worst
and expect future profits to decrease (hence, dividends are rarely cut once implemented).

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VALUATION
QUESTIONS

A company with $100 million in net income and a P/E multiple of 15x is considering raising $200
million in debt to pay out a one-time cash dividend. How would you decide if this is a good idea?
If we assume that the P/E multiple stays the same after the dividend and a cost of debt of 5%, the impact
to shareholders is as follows:
Net income drops from $100 million to $90 million [($200 million new borrowing x 5%) = $10 million]
Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15.0 x $90 million)
Although there's a tax impact since interest is mostly deductible, it can be ignored for interviewing
purposes. That’s a $150 million drop in equity value. However, shareholders are immediately getting $200
million. So ignoring any tax impact, there's a net benefit of $50 million ($200 million – $150 million) to
shareholders.
The assumptions we made about taxes, the cost of debt and the multiple staying the same all affect the result.
If any of those variables were different – for example, if the cost of debt was higher – the equity value might be
wiped out in light of this move. A key assumption in getting the answer here was that P/E ratios would remain
the same at 15x. A company’s P/E multiple is a function of its growth prospects, ROE, and cost of equity. Hence,
borrowing more with no compensatory increase in investment or growth raises the cost of equity via a higher
beta, which will pressure the P/E multiple down.
While it appears based on our assumptions that this is a decent idea, it could easily be a bad idea given a
different set of assumptions. It's possible that borrowing for the sake of issuing dividends is
unsustainable indefinitely because eventually, debt levels will rise to a point where the cost of capital and
P/E ratios are adversely affected. Broadly, debt should support investments and activities that will lead to
firm and shareholder value creation rather than extract cash from the business.
When would it be most appropriate for a company to distribute dividends? Companies that
distribute dividends are usually low-growth with fewer profitable projects in their pipeline. Therefore, the
management opts to pay out dividends to signal the company is confident in its long-term profitability and
appeal to a different shareholder base (more specifically, long-term dividend investors).
What is CAGR and how do you calculate it?
The compound annual growth rate ("CAGR") is the rate of return required for an investment to grow from
its beginning balance to its ending balance. Put another way, CAGR is the annualized average growth rate.

CAGR = � Ending Value

1t
Beginning Value� – 1
What is the difference between CAGR and IRR?
The compound annual growth rate (CAGR) and internal rate of return (IRR) are both used to measure the
return on an investment. However, the calculation of CAGR involves only three inputs: the investment’s
beginning and ending value and the number of years. IRR, or the XIRR in Excel to be more specific, can
handle more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of the
multiple cash flows) accounted for, rather than just smoothing out the investment returns.
CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often
for investment decision-making.

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VALUATION
QUESTIONS

How would you evaluate the buy vs. rent decision in NYC?
First, I would have to make assumptions to allow for a proper comparison, such as having enough upfront
capital to make a down payment and the investment period being ten years.
Under the 1st option, I assume I buy and will have to pay the monthly mortgage, real estate tax, and
maintenance fees (which will be offset by some tax deductions on interest and depreciation) during this
investment period. Then, I'll assume that I could sell the property at a price that reflects the historical
growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final
inflow due to a sale, I can calculate my IRR and compare this IRR to the IRR from renting.
For the 2nd option, I would start by estimating the rental cost of comparable properties, factoring in rent
escalations over ten years. Since there's no initial down-payment required, I would put that money to
work elsewhere, such as an investment in the stock market, in which I would assume an annual return
over the ten years consistent with the long-term historical return on the stock market (5-7%). I could
then compute an IRR based on the inflows/(outflows) and compare the two IRRs to make an informed
decision.
I would keep in mind that this comparison is not precisely “apples to apples.” For example, investing in an
NYC property is riskier than investing in the stock market due to the leverage and lower liquidity. NYC
real estate is liquid, but not as liquid as public stocks. If the two IRRs were identical, I would probably go
with renting as it does not appear that I am being compensated for the added risk.
How would you value a painting?
A painting has no intrinsic value, generates no cash flows, and cannot be valued in the traditional sense. The
pricing of the painting is a function of what someone will pay for it in the market, rather than being anchored
by its fundamentals. To determine the approximate price, you would have to analyze comparable
transactions to see the amount others paid to purchase similar paintings in the past.
When would it be appropriate to use a sum-of-the-parts approach to valuing a company? In a
sum-of-the-parts ("SOTP") analysis, each division of a company will have its unique risk/return profile and
need to be broken up to value the entire company more accurately as a whole. Thus, a different discount rate
will value each segment, and there'll be distinct peer groups for the trading and transaction comps. Upon
completing each division's valuation, the ending values would be summed up to arrive at the total value.
An example of when SOTP analysis (or break-up analysis) would be used is when the company being
valued has many operating divisions in unrelated industries, each with differing risk-profiles (e.g.,
conglomerate).
How does valuing a private company differ from valuing a public company? The main difference
between valuing a private and public company is the availability of data. Private companies are not required
to make their financial statements public. If you're provided private company financials, the process is
similar to public companies, except that private company financial disclosures are often less complete,
standardized, and reliable. In addition, private companies are less liquid and should thus be valued lower to
reflect an illiquidity discount (usually ranges between ~10-30%).
What is an illiquidity discount?
The illiquidity discount used when valuing private companies is related to being unable to exit an investment
quickly. Most investors will pay a premium for an otherwise similar asset if there's the optionality to sell their
investment in the market at their discretion. Therefore, a discount should be applied when performing
trading comps since shares in a public company include a premium for being sold in the public markets with
ease (called the "liquidity premium").
Read More → Estimating Illiquidity Discounts

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VALUATION of all unlevered FCFs beyond the initial forecast
QUESTIONS period needs to be calculated – this is called the
terminal value.

Intrinsic Valuation
Walk me through a DCF.
The most common approach to building a DCF is the
unlevered DCF, which involves the following steps:
1. Forecast Unlevered Free Cash Flows ("FCFF" or
"UFCF"): First, unlevered free cash flows, which
represent cash flows to the firm before the impact of
leverage, should be forecast explicitly for a 5 to 10
year period.
Watch Video → Building a DCF
2. Calculate Terminal Value ("TV"): Next, the value

The two most common approaches for estimating this value are the growth in perpetuity approach
and the exit multiple approach.
3. Discount Stage 1 & 2 CFs to Present Value ("PV"): Since we are valuing the company at the current
date, both the initial forecast period and terminal value need to be discounted to the present using
the weighted average cost of capital ("WACC").
4. Move from Enterprise Value 🡪 Equity Value: To get to equity value from enterprise value, we would
need to subtract net debt and other non-equity claims. For the net debt calculation, we would add the
value of non-operating assets such as cash or investments and subtract debt. Then, we would account
for any other non-equity claims such as minority interest.
5. Price Per Share Calculation: Then, to arrive at the DCF-derived value per share, divide the equity value
by diluted shares outstanding as of the valuation date. For public companies, the equity value per share
that our DCF just calculated can be compared to the current share price.
6. Sensitivity Analysis: Given the DCF’s sensitivity to the assumptions used, the last step is to create
sensitivity tables to see how the assumptions used will impact the implied price per share.
Conceptually, what does the discount rate represent?
The discount rate represents the expected return on an investment based on its risk profile (meaning, the
discount rate is a function of the riskiness of the cash flows). Put another way, the discount rate is the
minimum return threshold of an investment based on comparable investments with similar risks. A higher
discount rate makes a company’s cash flows less valuable, as it implies the investment carries a greater
amount of risk, and therefore should be expected to yield a higher return (and vice versa).
What is the difference between unlevered FCF (FCFF) and levered FCF
(FCFE)? Unlevered FCF: FCFF represents cash flows a company generates from its
core
operations after accounting for all operating expenses and investments. To
calculate FCFF, you start with EBIT, which is an unlevered measure of profit
because it excludes interest and any other payments to lenders. You'll then tax
effect EBIT, add back non-cash items, make FCFF = EBIT × (1 – Tax Rate) + D&A – Changes in
working capital adjustments, and subtract capital NWC – Capex
expenditures to arrive at FCFF. Tax-affected EBIT is Watch Video → Calculating
often referred to as Net Operating Profit After Unlevered Free Cash Flow
Taxes (“NOPAT”) or Earnings Before Interest After
Taxes (“EBIAT”).

Levered FCF: FCFE represents cash flows that remain after payments to lenders since interest expense and
debt paydown are deducted. These are the residual cash flows that belong to equity owners. Instead of
tax-affected EBIT, you start with net income, add back non-cash items, adjust for changes in working capital,
subtract capex, and add cash inflows/(outflows) from new borrowings, net of debt paydowns.

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VALUATION debt and equity capital providers since UFCFs are
QUESTIONS cash flows that belong to debt and equity providers.
Levered DCF: The levered DCF approach, on the
other hand, arrives at equity
FCFE = Cash from Operations – Capex –Debt
Principal Payment
What is the difference between the unlevered
DCF and the levered DCF? Unlevered DCF: The
unlevered DCF discounts the unlevered FCFs to
arrive directly at enterprise value. When you have a
present value, add any non-operating assets such as
cash and subtract any financing-related liabilities
such as debt to get to the equity value. The
appropriate discount rate for the unlevered DCF is
the weighted average cost of capital (WACC) Watch Video → Unlevered vs Levered DCF
because the rate should reflect the riskiness to both

value directly. First, the levered FCFs are forecasted and discounted, which gets you to equity value
directly. The appropriate discount rate on LFCFs is the cost of equity since these cash flows belong solely
to equity owners and should thus reflect the risk of equity capital. If you wanted to get to enterprise value,
you would add back net debt.
The levered and unlevered DCF method should theoretically lead to the same enterprise value and equity
value, but in practice, it's very difficult to get them to be precisely equal.
What is the appropriate cost of capital when doing an unlevered DCF?
When doing an unlevered DCF, the weighted average cost of capital (WACC) is the correct cost of capital to
use because it reflects the cost of capital to all providers of capital.
However, the cost of equity would be the right cost of capital to use for levered DCFs.
What is the formula to calculate the weighted average cost of capital
(WACC)? The weighted average cost of capital (WACC) can be viewed as the
opportunity cost of an investment based on comparable investments with similar
risk profiles.
WACC is calculated by multiplying the equity weight by the cost of equity and adding it
to the debt weight multiplied by the tax-affected cost
of debt. Debt + Equity× Requity� + � Debt
For the equity and debt values, the market values must Watch Video → The WACC Formula
be used rather than the book values.

Debt + Equity× Rdebt (1 – t)�

WACC = � Equity
E/(D + E) and D/(D + E) are the equity and debt weights of the total capital structure
Requity = Cost of Equity
Rdebt = Cost of Debt, and must be tax-affected since interest is tax-deductible
t = Tax Rate %
If a company carries no debt, what is its WACC?
If a company has no debt on its capital structure, its WACC will be equivalent to its cost of equity. Most
mature companies will take on a moderate amount of leverage once their operating performance stabilizes
because they can raise cheaper financing from lenders.
How is the cost of equity calculated?
The cost of equity is most commonly estimated using the capital asset pricing model ("CAPM"), which links
the expected return on a security to its sensitivity to the overall market (most often S&P 500 is used as the
proxy). Cost of Equity (Re) = Risk Free Rate + Beta × Equity Risk Premium

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VALUATION rate for US-based companies.
QUESTIONS

How do you determine the risk-free rate?

The risk-free rate ("Rf") should theoretically reflect
the yield to maturity of default-free government
bonds of equivalent maturity to the duration of each
cash flow being discounted.
However, the lack of liquidity in the longest maturity Watch Video → Cost of Equity
bonds has made the current yield on 10-year US
treasury notes the preferred proxy for the risk-free
What effect does a low-interest-rate environment have on DCF-derived valuations? If the market's
prevailing interest rates are at low levels, valuations based on DCFs will become higher since the discount rate
will be lower from the decreased risk-free rate, all else being equal.
There has been much debate around normalized risk-free rates. Aswath Damodaran has argued against the
usage of normalized rates and has written that “you should be using today’s risk-free rates and risk
premiums, rather than normalized values when valuing companies or making investment assessments.”
Read More → Musings on Markets: Dealing with Low Interest Rates
Define the equity risk premium used in the CAPM formula.
The equity risk premium ("ERP") measures the incremental risk (or excess return) of investing in equities
over risk-free securities. Historically, the ERP has ranged between 4% to 6% based on historical spreads
between the S&P 500 returns over the yields on risk-free bonds.
Equity Risk Premium (ERP) = Expected Market Return − Risk Free Rate
Explain the concept of beta (β).
Beta measures the systematic (i.e., non-diversifiable) risk of a security compared to
the broader market. Said another way, beta equals the covariance between expected
returns on the asset and the market, divided by the variance of expected returns on
the market.
A company with a beta of 1.0 would expect to see β = 0 🡪 No Market Sensitivity
returns consistent with the overall stock market β < 1 🡪 Low Market Sensitivity
returns. If the market has gone up 10%, the β > 1 🡪 High Market Sensitivity
company should see a return of 10%. A company β < 0 🡪 Negative Market Sensitivity
with a beta of 2.0 would expect a return of 20% if What is the difference between systematic risk
the market had gone up 10%. and unsystematic risk?
Beta/Market Sensitivity Relationship Watch Video → Beta Concept

Systematic Risk: Otherwise known as undiversifiable risk (or market risk), this is the risk inherent within
the entire equity market rather than specific to a particular company or industry. This type of risk is
unavoidable and cannot be mitigated through diversification.
Unsystematic Risk: In contrast, unsystematic risk is the company-specific (or industry) risk that can be
reduced through portfolio diversification. The effects of diversification will be more profound when the
portfolio contains investments in different asset classes, industries, and geographies.

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VALUATION
QUESTIONS

Does a higher beta translate into a higher or lower valuation?

A company with a high beta suggests more risk and will exhibit higher volatility than the market (i.e.,
higher sensitivity to market fluctuations). Thus, a higher discount rate will be used by investors to value
the company’s cash flows, which directly leads to a lower valuation, all else being equal.
What type of sectors would have higher or lower betas?
A useful question to ask yourself when assessing beta is: "Would consumers require (or demand) this
product or service during a recession?"
High Beta: A beta of >1 would mean the industry is highly cyclical and be more volatile than the broad
market. For example, the automobile, semiconductors, and construction industry have higher betas
since most consumers only purchase cars and new homes during positive economic growth.
Low Beta: A beta of < 1 suggests the security is less volatile than the broad market. Consumer product
stores that sell necessary, everyday goods such as toiletries and personal hygiene products would have a
low beta. Other sectors with low betas are hospitals/healthcare facilities and utilities, which provide
essential goods and services required by consumers regardless of the prevailing economic climate.
What are the benefits of the industry beta approach?
The industry β approach looks at the β of a comparable peer group to the company
being valued and then applies this peer-group derived beta to the target. The benefits
are that company-specific noise is eliminated, which refers to distorting events that
could cause the correlation shown in its beta to be less accurate.
So the peer-group derived beta is “normalized” valued. The implied assumption is that the
since it takes the average of the unlevered betas of company's business risk will converge with its peer
comparable businesses and then relevers it at the group over the long run.
target capital structure of the company being Watch Video → Industry Beta

This approach also enables one to arrive at an industry-derived beta for private companies that lack
readily observable betas. To perform a DCF analysis for a private company, the industry beta approach
would be required as privately-held companies don't have readily observable betas.
What are the flaws of regression betas?
1. Backward Looking: The standard procedure to estimate the beta is through a regression model that
compares the historical market index returns and company returns, in which the slope of the
regression corresponds to the beta of the stock. However, this past performance (and correlation) may
not be an accurate indicator of the stock's future performance.
2. Large Standard Error: The regression model is sensitive to the assumptions used, such as the index
chosen to be the proxy for the market return. There are also company-specific events that can cause
deviations that are not indicative of a company’s true correlation with the market.
3. Constant Capital Structure: The regression beta reflects the averaged past D/E ratios instead of the
current leverage in the company’s capital structure. The amount of leverage used by a company often
directly relates to its maturity, so this can be argued to be a flawed assumption for forecasting
purposes, especially when considering beta’s relationship with debt.

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VALUATION
QUESTIONS
lower. This is because levered beta is the combined
risk encompassing both business-specific and
What is the impact of leverage on the beta of a financial risk.
company?
If a company’s capital structure has no leverage, its
levered beta (or equity beta) would be equal to its
unlevered beta (or asset beta), reflecting only
business-specific risk. The removal of the risk from In general, the more leverage used in a capital
the debt component of levered beta results in structure, the higher the beta given the increased
unlevered beta. Therefore, the levered beta can either volatility from debt.
be equal to or greater than unlevered beta, but never

The amount of leverage held by a company directly impacts beta as the financial risk increases from the
greater risk of default and bankruptcy (i.e., less margin for error and more volatility if an economic downturn
occurs).
What is the typical relationship between beta and the amount of leverage used? Generally, mature
companies with lower betas will have a higher percentage of debt in their capital structure because they
can easily get cheap financing based on their long-lasting track record of cash flows and profitability, as
well as being non-cyclical and carrying less risk than the broad market.
In comparison, a company with a high beta will be reluctant to use debt or if they do, the terms of the debt
would be less favorable. From a financier's perspective: "Would the lender be comfortable loaning money to
a company that has a higher beta and volatility throughout different economic cycles?"
What are the formulas used to unlever and relever beta?
By unlevering beta for the peer group, each comparable company’s business risk is isolated, and the
distorting effect of leverage is removed.
Calculating raw betas from historical returns and even projected betas is an imprecise measurement of
future beta because of estimation errors (i.e., standard errors create a large potential range for beta). As a
result, it's recommended to use an industry beta.
Since the betas of comparable companies are distorted because of different rates of leverage, we unlever
the betas of these comparable companies:

β Unlevered = β(Levered)
�1 + � Debt

Equity� (1 − t)�
Then, once a median or average unlevered beta is calculated, this beta is relevered at the target
company’s capital structure:

β Levered = β Unlevered × [(1 + (1 − t) � Debt

Equity� ]
Is it possible for an asset to have a negative beta?
Yes, the most commonly cited example is gold, which has an inverse relationship with the market. When
the stock market goes up, the price of gold will often decrease.
However, when the stock market undergoes a correction or enters recession territory, investors flee
towards gold as a safe-haven, and the increase in demand drives up gold prices.
How do you estimate the cost of debt?
The cost of debt is readily observable in the market as the yield on debt with
equivalent risk.
Watch Video →
Cost of Debt
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VALUATION
QUESTIONS

If the company being valued doesn't have publicly traded debt, the cost of debt can be estimated using a
so called “synthetic rating” and default spread based upon its credit rating and interest coverage ratio.
Read More → Ratings, Interest Coverage Ratios & Default Spread
Which is typically higher, the cost of debt or the cost of equity?
The cost of equity is higher than the cost of debt because the cost associated with borrowing debt
(interest expense) is tax-deductible, creating a "tax shield."
The cost of equity is typically higher because, unlike lenders, equity investors are not guaranteed
fixed payments and are last in line at liquidation (i.e., bottom of the capital structure).
Since the cost of equity is higher than the cost of debt, why not finance using only debt? The
required return on the debt will increase with the debt level because a more highly levered business has a
higher default risk. As a result, the “optimal” capital structure for most companies includes a mixture of debt
and equity.
As the proportion of debt in the capital structure stakeholders increases.
increases, WACC gradually decreases due to the Besides the risk of a company becoming overburdened
tax-deductibility of interest expense (i.e., the "tax with leverage, debt also comes
shield" benefits). WACC continues to decrease until the As more debt is
optimal capital structure is reached. incrementally added to the capital
But once this threshold is surpassed, the cost of structure, the risk to all company
potential financial distress offsets the tax advantages of stakeholders
debt, and the WACC will reverse course and begin an increase.
upward trajectory as the risk to all debt and equity

with more constraints (i.e., covenants) that restrict activity and prevent them from exceeding certain
leverage ratios or maintaining a coverage ratio above a certain threshold.
What is the difference between WACC and IRR?
Internal Rate of Return: The IRR is the rate of return on a project’s expenditures. Given a beginning value
and ending value, the IRR is the implied interest rate at which the initial capital investment would have to
grow to reach the ending value. Alternatively, it's defined as the discount rate on a stream of cash flows
leading to a net present value (NPV) of 0.
Weighted Average Cost of Capital: The WACC (or cost of capital) is the average minimum required
internal rate of return for both debt and equity providers of capital. Thus, an IRR that exceeds the WACC
is an often-used criterion for deciding whether a project should be pursued.
Which would have more of an impact on a DCF, the discount rate or sales growth rate? The
discount rate and the sales growth rate will be sensitized in a proper DCF model, but the discount rate's
impact would far exceed that of operational assumptions such as the sales growth rate.
How is the terminal value calculated?
There are two common approaches to calculate the terminal value ("TV"):
1. Growth in Perpetuity Approach: Often called the Gordon Growth method, the
growth in perpetuity approach calculates the terminal value by assuming a
perpetual growth rate on cash flows after the explicit forecast period and then inserting this

assumption into the static perpetuity formula. Terminal Value (TV) = FCFt+1
(r – g)
Watch Video →
Terminal Value 59

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VALUATION
QUESTIONS

2. Exit Multiple Approach: The exit multiple approach calculates the terminal value by applying a multiple
assumption on a financial metric (usually EBITDA) in the terminal year. The multiple reflects the
multiple of a comparable company in a mature state.
Why is it necessary to discount the terminal value back to the present?
Under both approaches, the terminal value represents the present value of the company’s cash flows in the
final year of the 1st stage of the explicit forecast period right before entering the perpetuity stage. The TV
calculated is the present value of a growing perpetuity at the very end of the stage 1 projection of cash
flows.
Thus, this future value must be discounted back to its present value (PV) since the DCF is based on what
a company is worth today, the current date of the valuation.
For the perpetuity approach, how do you determine the long-term growth rate? The long-term
growth rate is the rate that the company will grow into perpetuity. That being said, it should range
somewhere between 1% to 3% (sometimes up to 5%). Often, GDP or the risk-free rate are proxies for g. This
growth rate must reflect the steady-state period when growth has slowed down to a sustainable rate.
A hypothetical question to ask would be: "Can this company grow at X% for the next hundred years?" If
not, then the perpetuity growth rate should be adjusted downward to be more realistic.
How can the terminal value be sanity-checked if the exit multiple approach was used? If the
exit multiples approach was used to calculate the terminal value, it's important to cross-check the
amount by backing out into an implied growth rate to confirm it's reasonable.

Implied g = (Terminal Value × r – FCF Final Year )

(Terminal Value + FCF Final Year )
Likewise, the implied exit multiple can be calculated from the perpetuity growth

rate. Implied TV Exit Multiple = Terminal Value Perpetuity

Method

EBITDA Final Year

What is the argument against using the exit multiple approach in a DCF?
In theory, a DCF is an intrinsic, cash-flow based valuation method independent of the market. By using the exit
multiple approach, relative valuation is being brought into the valuation. However, the exit multiple approach
is widely used in practice due to being easier to discuss and defend in terms of justifying the assumptions
used.
What is the purpose of using a mid-year convention in a DCF model?
By using the mid-year convention, we are treating the projected cash flows as if they're generated at the
midpoint of the given period. Without this mid-year adjustment, the DCF implicitly assumes that all cash
flows are being received at the end of the year. This would be inaccurate since cash flows are generated
steadily throughout the year, depending on the industry.
The compromise is to use a mid-year convention that assumes the CFs are received in the middle of the
year. Since the projected cash flows are received earlier, the implied valuation of the company would
increase because of the earlier received cash flows. For example, if the cash flow you're discounting is Year
5 and the discount factor is 5, the mid-year convention would use a discount factor of 4.5 since we are
assuming half a year has passed before the cash flow is generated.

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VALUATION
QUESTIONS

Could you give me an example of when the mid-year convention might be inappropriate?
While the mid-year convention in a DCF is standard practice, it may be inaccurate for highly seasonal
companies. Many retail companies experience strong seasonal patterns in demand, and sales are
disproportionally received in the 3rd and 4th quarters.
This is particularly the case for retailers that have a niche in winter clothing. For example, the mid-year
convention may be an inappropriate adjustment for Canada Goose, a Canadian company that focuses
primarily on winter clothing. The unadjusted, period-end assumption may be more appropriate in this
scenario.
How would raising additional debt impact a DCF analysis?
The enterprise value based on an unlevered DCF should theoretically remain relatively unchanged since the
DCF is capital structure neutral. But if the debt raised changed the capital structure weights substantially,
the implied valuation could change. As the percentage of debt in the capital structure increases, the cost of
debt increases from the higher default risk (which lowers the implied valuation).
Imagine that two companies have the same total leverage ratio with identical free cash flows and
profit margins. Do both companies have the same amount of default risk?
If one company has significantly more cash on its balance sheet, it'll most likely be better positioned from a
risk perspective. When assessing leverage risk, a company's excess cash should be considered since this cash
could help paydown debt. Hence, many consider cash to be “negative debt” (i.e., the implied assumption of net
debt).
Therefore, one of the main leverage ratios looked at in addition to Total Debt/EBITDA is Net Debt/EBITDA.
All else being equal, the company with a higher excess cash balance and lower Net Debt/EBITDA would be at
lower risk of bankruptcy (and lower cost of debt).
When would a DCF be an inappropriate valuation method?
Practically, when you don't have access to financial statements, a credible DCF analysis
valuation is difficult, and a comps analysis might be more realistic. So if you have a data
point such as revenue or EBIT, a comps analysis is easier to implement.
In addition, DCFs may be unfeasible when the Why is a DCF not used to value early stage
company is not expected to generate positive cash startups?
flows for the foreseeable future. Here, much of the
Watch Video → DCF Strengths and Weaknesses
company ’s value is weighted towards the distant
future, and the DCF becomes less credible.

Although the DCF approach is based upon a company's future cash flows, this method can still be used on
early-stage startups that are cash flow negative. The caveat being, there must be a path towards turning
cash flow positive in the distant future.
DCFs become less reliable for early-stage startups that may not reach a sustainable, stable growth rate for
15+ years as it becomes very difficult to accurately predict the FCFs beyond this period. A DCF valuation is
most credible when looking at mature companies with an established market position, as opposed to
pre-revenue companies that have not yet determined their business model, go-to-market strategy, or target
end-user.
If 80% of a DCF valuation comes from the terminal value, what should be done? The explicit
forecast period may not be long enough (should range from 5 to 10 years). In the final year in the explicit
stage, the company should have reached normalized, stable growth.
Alternatively, the terminal value assumptions may be too aggressive and not reflect stable growth.

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QUESTIONS

How would you handle stock options when calculating a company’s share count? The standard
convention for stock options is to include in the dilutive share count any vested (exercisable) options whose
strike price is below the current share price (“in-the-money”). In addition, any option proceeds the company
received from the exercising of those options are assumed to be used by the company to repurchase shares at
the current share price (the treasury stock method).
But certain finance professionals use all outstanding in-the-money options (as opposed to just the vested
in the-money options) to perform the analysis. The logic being that any options that are still unvested will
vest soon, and since they're in-the-money, it's more conservative to include them in the share count.
How would you handle restricted stock in the share count?
Some finance professionals completely ignore restricted stock from the diluted share count because they're
unvested. However, increasingly, unvested restricted stock is included in the diluted share count under the
logic that eventually they'll vest, and it's thus more conservative to count them.
How would you handle convertible preferred stock in the share count?
Convertible preferred stock is assumed to be converted into common stock to calculate diluted shares if
the liquidation value (i.e., the preferred stock's conversion price) is lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years
ago by issuing 10 million preferred shares, each granting the holder the right to collect either $50 per
preferred share (its liquidation value) or to convert it to one share of common stock. Since the current share
price is greater than the liquidation value, we would assume that the preferred stock is converted for
calculating the diluted share count.
When conversion into common stock is assumed to calculate the share count in a valuation, the preferred
stock should be eliminated when calculating net debt to be consistent and avoid double counting.
How would you handle convertible bonds in the share count?
Convertible bonds are assumed to be converted into common stock if the conversion price of the bond is
lower than the current share price.
For example, imagine a company whose current share price is $60 issued raised $500 million several years
ago by issuing a bond convertible into 10 million shares of common stock. Since the current share price is
greater than the conversion price, we assume the bond is converted to calculate diluted shares.
If conversion into common stock is assumed to calculate the share count, the convertible bonds should
be eliminated from the balance sheet when calculating net debt to be consistent (and avoid
double-counting).
How should operating leases be treated in a DCF valuation?
They should be capitalized because leases usually burden the tenant with obligations and penalties that are
far more similar to debt obligations than to a simple expense (i.e., tenants should present the lease obligation
as a liability on their balance sheet as they do for long-term debt). In fact, the option to account for leases as
an operating lease was eliminated starting in 2019 for that reason.
Therefore, when operating leases are significant for a business (retailers and capital-intensive businesses),
the rent expense should be ignored from the free cash flow build-up, and instead, the present value of the
lease obligation should be reflected as part of net debt.
For forecasting purposes, do you use the effective or marginal tax rate?
The choice between whether to use the effective or marginal tax rate boils down to one specific
assumption found in valuation methods such as the DCF: the tax rate assumption used will be the tax rate
paid into

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QUESTIONS

perpetuity. In most cases, the effective tax rate will be lower than the marginal tax rate, mainly because
many companies will defer paying the government.
Hence, line items such as deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are created. If you
use the effective tax rate, you implicitly assume this deferral of taxes to be a recurring line item forever. But
this would be inaccurate since DTAs and DTLs unwind, and the balance eventually becomes zero.
The recommended approach is to look at the historical periods (i.e., past 3-5 years) and base your
near-term tax rate assumptions on the effective tax rate. But by the time the 2nd stage of the DCF is
approaching, the tax rate should be “normalized” and be within close range of the marginal tax rate.
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VALUATION
QUESTIONS

How does a lower tax rate impact the valuation from a DCF?
1. Greater Free Cash Flows: A lower tax rate would result in more net income as fewer taxes have to be
paid to the government, meaning more earnings retention and higher cash flow.
2. Higher Cost of Debt: A lower tax rate results in a higher after-tax cost of debt and a higher re-levered
beta, all else being equal. If the tax rate is reduced, that would mean the after-tax cost of debt would
rise, and the benefit from the tax-deductibility of interest (“tax shield”) would be reduced.
3. Higher Beta: A lower tax rate would result in a higher levered beta, which would cause the cost of equity
and WACC to increase.
While the last two implications suggest a lower valuation, the net impact on the company's valuation would
be specific to the company's fundamentals, and one would have to flow through all the changes in a DCF
model to see if the increased FCF offsets the increased WACC.
How does a dividend discount model (DDM) differ from a discounted cash flow model (DCF)? The
dividend discount model ("DDM") stipulates that the value of a company is a function of the present value of
all its future dividends paid out, whereas the discounted cash flow states a company is worth the sum of the
present value of all the future free cash flows it generates.
The DDM will forecast a company's future dividends based on a dividend per share ("DPS") and growth rate
assumptions – which are then discounted using the cost of equity. For the terminal value calculation, an equity
value based multiple will be used, most commonly P/E. Therefore, the DDM directly calculates the equity
value and then equity value per share (similar to levered DCFs, but different from unlevered DCFs).
What are the major drawbacks of the dividend discount model (DDM)?
Forward-looking valuation methods each have their shortcomings, and the DDM is no exception, given its
sensitivity to assumptions such as the dividend payout ratio, dividend growth rate, and required rate of
return.
But some additional drawbacks that help explain why DDM is used less often include:
The DDM cannot be used on high-growth companies as the denominator would turn negative since the
growth rate would exceed the expected return rate.
The DDM is more suitable for large, mature companies with a consistent track record of paying out
dividends, but even then, it can be very challenging to forecast out the growth rate of dividends paid. Most
companies don't pay out any dividends, especially as share buybacks have become common. The DDM
neglects buybacks, an increasingly important source of returns for shareholders. If the dividend payout
amounts reflected true financial performance, then the output would be similar to the traditional DCF.
However, poorly run companies can still issue large dividends, distorting valuations.

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VALUATION value such as equity value or enterprise value,
QUESTIONS whereas the denominator will be a financial or
operating metric.
Since absolute values cannot be compared, multiples
Relative Valuation are used to standardize a company's value on a
per-unit basis. This enables comparisons in value
What is the purpose of using multiples in
amongst similar companies, which is the premise of
valuation?
relative valuation. For any valuation multiple to be
A valuation multiple is a financial ratio that reflects meaningful, a contextual understanding of the target
how valuable a particular company is in relation to a company, such as its fundamental drivers and general
specific metric. The numerator will be a measure of industry knowledge, is required.
Valuation Multiples
How do you determine what the appropriate
numerator is for a multiple?

Watch Video →

For multiples, the represented stakeholders in the numerator and denominator must match.
If the numerator is enterprise value, metrics such as EBIT, EBITDA, unlevered free cash flow (FCFF), and
revenue multiples can be used since these are all unlevered (i.e., pre-debt) measures of profitability. In
contrast, if the numerator is equity value, metrics such as net income, levered free cash flow (FCFE), and
earning per share (EPS) would be used because these are all levered (i.e., post-debt) measures.
Walk me through the process of “spreading comps.”
Before you can answer the question, you must ask for clarification on whether the interviewer is asking
about trading or transaction comps. The processes for both, however, have many overlapping aspects.
1. Determine Comparable Peer Group: The first step to perform comps is to select the peer group. For
trading comps, the peer group will be composed of publicly traded comparable companies that are
competitors in the same industry or operate within a nearby industry. For transaction comps, the peer
group would include companies recently involved in M&A deals within the same or a similar industry.
2. Collect Relevant Information: The next step involves finding publicly available information that may be
helpful to understand the trends and factors affecting how companies in a particular industry are being (or
were) valued. Most of the insights gathered in this step will be more on the qualitative side and related to
industry research, understanding ongoing developments, and company-specific details.
3. Input Financials: With the industry research completed, you'll then pull the financial data of each
comparable company and then “scrub” the financials for non-recurring items, accounting differences,
financial leverage differences, and business life cycles (cyclicality, seasonality) to ensure consistency
and allow for a fair comparison among the companies. If relevant, you'll also calendarize each peer
group company’s financials to standardize the metrics to ensure comparability.
4. Multiples Calculation: Then, the peer group's valuation multiples will be calculated and benchmarked in
the output sheet. At a minimum, the multiples are shown on a last twelve months (LTM) and the next fiscal
year (NTM) basis, and as a general convention, the minimum, maximum, 25th percentile, 75th percentile, mean
and median will be listed. Using the research collected in previous steps, you'll then attempt to understand
the factors causing the differences and remove any outliers if deemed appropriate.
5. Apply Multiple to Target: In the last step, the target company being valued will have the median (or
mean) multiple applied to the corresponding metric to arrive at its approximate comps-derived value.
Understanding the fundamental drivers used to value companies within a particular industry makes
comps-derived valuations defensible – otherwise, justifying whether the target should be valued on
the higher or lower end of the valuation range will be difficult.

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VALUATION
QUESTIONS

When putting together a peer group for comps, what would some key considerations be?
Operational Profile: These characteristics entail the nature of the business, such as its industry, business
model, products/services sold, and end markets served. In addition, the company’s position within the
market (market leader or market challenger), stage in the life cycle, and seasonality/cyclicality should all be
considered. The importance of selecting the right peer group for a comps-derived valuation cannot be
overstated, and this begins with understanding the target's operational characteristics. Financial Profile: If
the company might be a suitable inclusion to the peer group based on its operational characteristics, its
financial profile would then be considered. Some metrics to gather would be the company's key cash flow
metrics, size in terms of valuation, profitability margins, credit ratios, historical/estimated growth rates, and
return metrics.
Operational Profile Financial Profile

Industry/Sector Size (Enterprise Value, Equity Value)

Product and Service Offerings Margin Profile (Gross Margin, Operating

Margin, EBITDA Margin)

End Markets and Customers Type Historical and Forecasted Growth Rates
(Revenue, EBITDA, EPS)

Distribution Channels Credit Profile (Leverage Ratios, Coverage Ratios)

Cyclicality or Seasonality Return Metrics (ROIC, ROA, ROE)

Should the target company being valued be included in its peer group?
Many professionals exclude the target company being valued from the peer group because the target's
inclusion would skew the multiple towards the target’s current valuation. However, if the intuition behind a
comps analysis is that the market may misprice individual stocks but is correct on the whole, then logic
dictates that the target should be included in its market-based valuation.
What are the primary advantages of the trading comps approach?
Public Filings: Trading comps involves public companies, making data collection far more convenient
since all their reports and filings are easily accessible online.
Less Data Required: Implementation is a key advantage of trading comps, as proper DCFs cannot be built
without detailed financials and supplementary data. But to get a decent trading comps-based valuation,
only a few data points (e.g., EBITDA, revenue, net income) are required, making it easier to value
companies when access to data sets is limited.
Current Valuations: Trading comps reflect up-to-date, current valuations based on investor sentiment as
of the present day, since it's based on the latest prices paid in the public markets.
What are the main disadvantages of performing trading comps?
Putting together a peer group of “pure-play” companies by itself can be a
challenging task, especially if the target is differentiated and has few (or no) direct
competitors.
Even with a well-thought-out, similar peer group, explaining the differences in
valuation can be difficult as the comparison is always judgment, which can be very challenging – plus, the
“apples to oranges.” Understanding valuation gaps market is often emotional and fluctuates irrationally,
between a company and its comparables involves bringing in more external factors to consider.
Watch Video →
Trading Comps Strengths and
Weaknesses

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QUESTIONS

Low trade volume and less followed equities may not reflect their true fundamental value, making them
less useful for trading comps.
To perform transaction comps, how would you compile the data?
When collecting the data to perform transaction comps, you would use deal announcement press releases,
proxy filings, and the merger agreement to learn about the deal terms. You would also use the target
company's filings (annual and quarterly reports) for historical financial data, research reports, and financial
data vendors such as Bloomberg, Capital IQ, or FactSet for historical share price data and estimated earnings
forecasts.
What do transaction comps tell you that trading comps cannot?
Transaction comps can provide insights into control premiums that buyers and sellers
should expect when negotiating a transaction.
In addition, transaction comps can validate potential buyers' existence in the private
markets and if a particular investment strategy has based on a DCF analysis and
been successfully implemented before.
Watch Video →
Let’s say a certain company is valued at a specific price Transaction Comps

confirmed to be within range by trading comps. However, if there are no buyers in the market, the seller
is unlikely to exit at its expected valuation.
In M&A, why is a control premium paid?
A control premium refers to the amount an acquirer paid over the market trading value of the shares being
acquired (usually shown as a percentage). As a practical matter, a control premium is necessary to
incentivize existing shareholders to sell their shares. It's improbable that an acquirer could get a controlling
interest in a target company without first offering a reasonable purpose premium over the current price.
From the perspective of the shareholders of the acquisition target: "What would compel existing
shareholders to give up their ownership if doing so is not profitable?"
Besides incentivizing existing shareholders to sell, what other factors lead to higher control
premiums being paid?
Competitive Deals: In M&A, nearly all acquirers pay a control premium due to the competitive elements of
sale processes. As a general rule, the control premium paid will be higher the more buyers are involved, as
competition directly drives up the price.
Synergies: If there are potential synergies that can be realized by the acquirer and the management team
has high conviction in its occurrence, then the acquirer might be justified in paying a higher premium. Asset
Scarcity: Many acquirers (strategics in the majority of cases) might pay a higher premium if the specific
asset is a centerpiece to their future plans and there are no other acquisition targets in the market that meet
their criteria. Oftentimes, this acquisition could lead to a meaningful competitive advantage for the acquirer
over the rest of the market, making the completion of this acquisition a necessity. Undervalued Target:
The target company might be perceived to be significantly undervalued from the buyer's viewpoint. From
their perspective, the purchase price could be a moderate premium when compared to their own fair value
assessment of the target, whereas to others the buyer paid an unreasonably high premium.
Mismanagement: A mismanaged company coincides with the previous point, as this typically leads to
underperformance. The acquirer will most likely be under the impression that the management should
be replaced, and through operational improvements, a significant amount of value that is currently not
being fully taken advantage of could be derived. Thus, a target acquired for this reason will be
immediately restructured, beginning with the management team being replaced post-closing.

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VALUATION
The transaction context must also be looked at, such as
QUESTIONS
the form of consideration, the type of buyer (financial
or strategic), and the deal's circumstances, which can
Why is transaction comps analysis often more
challenging than trading comps? Performing
comparable acquisition analysis can be challenging
when there has been limited (or no) M&A activity
within the relevant space, or the comparable
transactions were completed a long time ago in a
completely different economic environment. Data
from those prices paid might not reflect current
market trends and investor sentiment.
Watch Video →
The transaction dates place a significant constraint on
Transaction Comps Strengths and
the pool of comparable transactions. Generally, only
Weaknesses
relatively recent transactions (within the last five
years) offer insight into industry valuations.

significantly influence the final purchase price. However, this information about the deal can be challenging
to compile, especially when they involve private companies, as they're not required to disclose all this deal
related information. Most times, even the purchase price paid for a company may not even be announced –
thus, the data found is “spotty” and less straight-forward than trading comps.
When putting together a peer group for transaction comps, what questions would you
ask? What was the transaction rationale from both the buyer and seller's perspective? Was the
acquirer a strategic or a financial buyer?
How competitive was the sale process?
Was the transaction an auction process or negotiated sale?
What were the economic conditions at the time of the deal?
Was the transaction hostile or friendly?
What was the purchase consideration?
If the industry is cyclical (or seasonal), did the transaction close at a high or low point in the cycle?
When valuing a company using multiples, what are the trade-offs of using LTM vs. forward
multiples?
Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA,
EBIT, and EPS forecasts are subjective and especially problematic for smaller public firms, whose guidance is
less reliable and harder to obtain.
That said, LTM suffers from the problem that historical results are often distorted by non-recurring expenses
and income, misrepresenting the company's recurring operating performance. When using LTM results, non
recurring items must be excluded to get a “clean” multiple. In addition, companies are often acquired based
on their future potential, making forward multiples more relevant.
Therefore, both LTM and forward multiples are often presented side-by-side, rather than picking
one. Read More → The Role of Multiples in Valuation
Why might two companies with identical growth and cost of capital trade at different
P/E multiples?
Growth and cost of capital are not the only drivers of value. Another critical component is the return on
invested capital (ROIC). Besides having different ROICs, the two companies could very well just be in
different industries or geographies.
Other reasons may include relative mispricing or inconsistent EPS calculations, often caused by
non-recurring items or different accounting policies.

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Should two identical companies with different leverage ratios trade at different EV/EBITDA
multiples?
You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure
a company’s value and profits independent of its capital structure. Technically, they won't be exactly
equal because enterprise value depends on the cost of capital, so there'll be some variation.
Should two identical companies with different leverage ratios trade at different P/E multiples?
P/E multiples can vary significantly due to leverage differences for otherwise identical companies. All else
being equal, as a company borrows debt, the EPS (denominator) will decline due to higher interest
expense.
The impact on the share price, on the other hand, is hard to predict and depends on how the debt is used:
If the debt proceeds go unused and generate no return, the share price will decline to reflect the incremental
cost of debt with no commensurate growth or investment. In this scenario, the share price and P/E ratio
can be expected to decline.
But if that debt were used to invest and grow the business, the P/E ratio should increase.
Simply put, debt adds more risk to equity investors (given their junior position in the capital structure)
with little potential return, and investors will value the company at a lower P/E.
Which multiples are the most popular in valuation?
Enterprise Value/EBITDA multiples are the most common, followed by EV/EBIT and P/E. There are
several others that are more industry and company-specific. For example, P/B ratios are used to value
financial institutions, EV/Revenue multiples are used to value unprofitable companies, and (EV –
Capex)/EBITDA multiples can be used for capital-intensive industries such as manufacturing or cable
companies.
What are some common enterprise and equity value multiples?
Enterprise Value Multiples: EV/Revenue, EV/EBIT, EV/EBITDA
Equity Value Multiples: Price/Earnings (P/E), Price/Book (P/B), Price/Levered Cash Flows
Read More → What Does an EV/EBITDA Multiple Mean?
Why would it be incorrect to use enterprise value and net income in a multiple? There would be a
mismatch between the represented investor groups in the numerator and denominator. Enterprise value
represents the value of the operations to all stakeholders in a company, meaning the cash flows belonging to
both lenders and equity providers of capital. Net income, however, represents the residual value that flows
just to equity shareholders.
Why might one company trade at a higher multiple than another?
One company may be valued at a higher multiple than another because of superior fundamentals such as
better growth prospects, higher return on invested capital, lower cost of capital (WACC), and more robust cash
flow generation. Investors are forward-looking. Therefore, companies with better growth trajectories and
signs of being well managed with efficient capital allocation are rewarded with higher valuations.
Intuitively, what does the P/E ratio mean?
The price-to-earnings ratio (P/E) is one of the most widely used metrics by investors to determine a
company's relative value against the industry average and its peers. This can then help determine whether the
company is undervalued, fairly valued, or overvalued. The P/E ratio answers: "How much is the market willing
to pay for a dollar of this company’s earnings?"

EPS PE Ratio = Market Capitalization

PE Ratio = Current Share Price

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A company is currently trading at 12.5x EBITDA, is it overvalued?

The answer depends on the company's industry being valued and how its valuation fares compared to the rest
of its peer group. For instance, a software company trading at 12.5x would be near the sector median,
whereas a double-digit multiple in an industry such as Oil & Gas is rare.
We recommend researching various industries and identifying those that consistently receive higher
valuations on average (e.g., software, healthcare) and which ones don't – and then figure out the reason. The
differences can often be related to cyclical trends that are impacting an industry. For example, sub-industries
related to cloud computing, cybersecurity, remote healthcare, gaming, and video streaming services have seen
significant valuation increases since the beginning of the pandemic.
Read More → Enterprise Value Multiples by Sector
What does a high P/E ratio relative to a peer group imply?
If a company has a high P/E ratio in relation to its peer group, this might mean the market is overvaluing
the company. Alternatively, it could mean the company has less earnings than its peer group (or is a
younger company). For this reason, the use of P/E multiples is most useful when the company is mature
and its peer group has a similar capital structure.
A high P/E ratio is almost always a positive sign that the market expects the company’s earnings to grow in
the future and is optimistic about its growth prospects, as well as its current capex (which is causing the
lower earnings) will pay off over time and eventually lead to greater profits.
A company has an EPS of $2.00 that has declined to $1.00 four years later. Assume its share price
has remained the same at $10. Is its current P/E ratio higher or lower than its four year-back
P/E ratio, and how would you interpret this situation?
The company's P/E ratio would be higher. The company's four year-back P/E ratio was 5.0x and its current
P/E ratio is 10.0x. Therefore, its P/E doubled after its EPS declined by $1.00.
One potential interpretation is that the company is now overvalued and shouldn't be trading at a 10.0x
multiple given the deteriorated EPS. Realistically, the market would view a decrease in EPS negatively,
resulting in a lower share price and valuation.
But since the share price didn't change, there are a few possible explanations:
1. The company could have issued more shares to raise capital that had a dilutive impact on EPS. 2. The
company might have made a dilutive acquisition with stock as the main purchase consideration.
In both cases, the cause of the lower EPS is the increase in the denominator. The share price remaining
constant suggests the market reaction to how the company plans to use the newly raised capital or the M&A
deal was positive, otherwise, the share price would've dropped. Similar to how EPS can be artificially
boosted from share buybacks, it can decrease without there being an actual drop in performance. The
issuance of additional shares typically results in the per-share value decreasing from the dilution, but the
$10 share price is the post-dilution share price (meaning, the price was upheld despite the dilution).
When would the use of the PEG ratio be appropriate?
The PEG ratio is used to standardize the P/E ratio and enable comparisons among companies with different
expected long-term growth rates (g). As a broad rule of thumb, a stock is fairly valued when the PEG ratio is
1, undervalued when the PEG ratio is below 1, and overvalued when above 1.
P �
PEG Ratio = � E g

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There are two approaches for the growth rate used:

1. Trailing PEG: In the first option, the growth rate can be based on a company's historical growth. For
example, the LTM growth rate could be used, or the annualized growth rate over the past 3-5 years. 2.
Forward PEG: The other, more commonly used option calculates the growth rate from a 1-3 year
projection based on consensus estimates or an annualized version of those growth rates.
When would you value a business using the P/B ratio?
The P/B ratio can be used when the company's book value captures a substantial part of its real value. An
example would be commercial banks, as most of their assets and liabilities are frequently re-valued and
similar to their actual market values.
When should you value a company using a revenue multiple vs. EBITDA?
Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result,
multiples based on revenue are the only available option to gain some level of insight.
How would you value a pre-revenue early stage internet company?
An internet company with no revenue or negative profitability could be valued using user engagement
metrics such as the subscriber count, monthly active users, daily active users, and website hits. For example,
pre revenue internet startups are often valued using multiples such as EV/DAU or EV/MAU.
Why is calendarization a required step when performing comps analysis?
Calendarization involves aligning the fiscal year ending dates of a group of comparable companies to allow for
a more accurate comparison. The general convention is to adjust the financials so that all the fiscal years end
in December. The reason calendarization is necessary is that cyclicality and seasonality can skew results and
create discrepancies when making comparisons.
If the market matters most when valuing public companies, do we even need a comps analysis?
Why not just use the market cap directly to value the company?
If the market were perfectly efficient, it would price individual equities correctly, rendering a comps analysis
pointless. However, the reasoning for still using a comps analysis for public company valuations is that the
market may be efficient on average, but it can be off when pricing individual companies. Most investors will
agree that the market is relatively efficient. However, investors can be overly emotional and overreact,
creating investment opportunities.
When applying a peer group derived EV/EBITDA multiple onto your target company, what is an
argument for using the group’s median multiple instead of the mean?
The simple reason is: Medians remove the distortive impact of outliers on the peer group multiple. When
using larger peer groups, the median is preferable over the mean because it limits distortions from outliers,
which increases as more companies are included. The mean might be preferable for smaller peer groups with
fewer than five comparable companies and no outliers.

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MERGERS &
ACQUISTIONS
QUESTIONS
Mergers & Acquisitions Questions 72

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MERGERS &
ACQUISTIONS
QUESTIONS
M&A Concepts
Can you define M&A and explain the difference between a merger and an acquisition? Mergers
and acquisitions (M&A) is an umbrella term that refers to the combination of two businesses. To buyers,
M&A serves as an alternative to organic growth, whereas for sellers, M&A provides an opportunity to cash
out or share in the newly formed entity's risk/reward.
The two terms are often used interchangeably but have some minor differences:
Merger: A merger suggests the combination of two similarly sized companies (i.e., "merger of equals"),
where the form of consideration is at least partially with stock, so shareholders from both entities
remain. In most cases, the two companies will operate under a combined name (e.g., ExxonMobil, Kraft
Heinz, Citigroup), whereas sometimes the new combined entity will be renamed.
Acquisition: An acquisition typically implies the target was of smaller-size than the purchaser. The target's
name will usually slowly dissipate over time as the target becomes integrated with the acquirer. In other
cases (e.g., Salesforce's acquisition of Slack, Google's acquisition of Fitbit), the target will operate as a
subsidiary to take advantage of its established branding.
What are some potential reasons that a company might acquire another company?
Value Creation from Revenue and Cost Synergies
Ownership of Technology Assets (IP, Patents, Proprietary Technology)
Talent Acquisitions (New Skilled Employees)
Expansion in Geographic Reach or into New Product/Service Markets
Diversification in Revenue Sources (Less Risk, Lower Cost of Capital)
Reduce Time to Market with New Product Launches
Increased Number of Channels to Sell Products/Services
Market Leadership and Decreased Competition (if Horizontal Integration)
Achieve Supply Chain Efficiencies (if Vertical Integration)
Tax Benefits (if Target has NOLs)
What are the differences among vertical, horizontal, and conglomerate mergers? Vertical
Merger: A vertical merger involves two or more companies that serve different value chain functions.
From the increased control over the supply chain, the combined entity should theoretically eliminate
inefficiencies.
Horizontal Merger: A horizontal merger comprises a merger amongst companies directly competing in
the same (or very similar) market. Thus, following a horizontal merger, competition in the market
decreases (e.g., Sprint & T-Mobile merger). Notable benefits that stem from a horizontal merger are the
increased geographical coverage to sell products/services and an increase in pricing power.
Conglomerate: A conglomerate refers to the combination of multiple business entities operating in
unrelated industries for diversification purposes – an example would be Berkshire Hathaway.
In terms of vertical integration, what is the difference between forward and backward
integration? Backward Integration: When an acquirer moves upstream, it means they're purchasing
suppliers or manufacturers of the product the company sells – this is known as backward integration.
Forward Integration: When an acquirer moves downstream, it means they're purchasing a company that
moves them closer to the end customer such as a distributor or technical support – this is known as forward
integration.

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Describe a recent M&A deal.

For M&A interviews, come prepared to discuss at least one recent transaction in-detail. To understand the
rationale behind an M&A deal and the market’s perception of the proposed (or closed) transaction,
review press releases and articles with commentary on the deal from reliable sources. Also, look at the
current competitive dynamics within the industries relevant to the deal and the ongoing trends that
could further explain why the transaction was completed.
The specific details regarding the deal which should be included in your response include:
Name of Acquirer and Target Company (along with a business profiles of each)
Merger or Acquisition Strategic Rationale (can be found in the Form S-4 or publicly announced)
Approximate Transaction Size, Premium Offered, and Form of Consideration (if publicly disclosed)
Acquirer and Target's Share Price Movement Post-Announcement
Personal Perspective on the Transaction – "In your opinion, was this a good deal?" For an example
of how to review an M&A transaction, see our analysis on the acquisition of LinkedIn. Read More →
Ultimate Guide to M&A + Breakdown of Microsoft’s Acquisition of LinkedIn What are synergies and
why are they important in a deal?
Synergies are the expected cost savings or incremental revenues arising from an acquisition. They're
important because if an acquirer believes synergies can be realized, a higher premium would be paid.
1. Revenue Synergies: Cross-selling, upselling, product bundling, new distribution channels, geographic
expansion, access to new end markets, reduced competition leads to more pricing power 2. Cost
Synergies: Eliminate overlapping workforces (reduce headcount), closure or consolidation of redundant
facilities, streamlined processes, purchasing power over suppliers, tax savings (NOLs)
Why should companies acquired by strategic acquirers expect to fetch higher premiums than those
selling to private equity buyers?
Strategic buyers can often benefit from synergies, which enables them to offer a higher price. However, the
recent trend of financial buyers making add-on acquisitions has enabled them to fare better in auctions
and place higher bids since the platform company can benefit from synergies similar to a strategic buyer.
How do you perform premiums paid analysis in M&A?
Premiums paid analysis is a type of analysis prepared by investment bankers when advising a public target, in
which the average premium paid in comparable transactions serves as a reference point for an active deal.
The presumption being the average of the historical premiums paid in those comparables deals should be a
proxy (or sanity check) for the premium to be received in the current deal.
Read More → Premiums Paid Analysis in M&A
Tell me about the two main types of auction structures in M&A.
1. Broad Auction: In a broad auction, the sell-side bank will reach out to as many prospective buyers as
possible to maximize the number of interested buyers. Since competition directly correlates with the
valuation, the goal is to cast a wide net to intensify an auction's competitiveness and increase the
likelihood of finding the highest possible offer (i.e., removing the risk of “leaving money on the table”)
2. Targeted Auction: In a targeted auction, the sell-side bank (usually under the client's direction) will have
a shortlist of buyers contacted. These contacted buyers may already have a strong strategic fit with the
client or a pre-existing relationship with the seller.
Read More → Sell-Side Process

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What is a negotiated sale?

A negotiated sale involves only a handful of potential buyers and is most appropriate when there's a specific
buyer the seller has in mind. A potential reason for this type of sale approach could be the seller intends to
stay on and strongly values the partnership and growth opportunities.
Under this approach, the speed of close and confidentiality are two distinct benefits. These deals are
negotiated “behind-closed-doors” and generally on friendlier terms based on the best interests of the client.
What are some of the most common reasons that M&A deals fail to create value?
Overpaying/Overestimating Synergies: Nearly all M&A deals involve a premium in the purchase price. Even
if the deal results in positive results, it might not be enough to justify the premium. Overpaying for an asset
goes hand-in-hand with overestimating synergies. Synergies are challenging to achieve in practice and should
be estimated conservatively, but doing so would result in missing out on acquisition opportunities and being
out-bid. An acquirer often has to accept that the expected synergies used to justify the premium paid may not
be met for the sake of completing the deal.
Inadequate Due Diligence: An acquirer will often fail to perform sufficient diligence before acquiring a
company. The decision may have been made while overly-focused on the target's positives and the
potential post-integration benefits while neglecting the risks. A competitive auction with a short
timeline can lead to this type of poor judgment, in which the other buyers become a distraction.
Lack of Strategic Plan: For an M&A deal, when an acquirer becomes fixated on pursuing more resources
and achieving greater scale without an actual strategy, this can lead to synergies not being realized
despite an abundance of resources on-hand and potential growth opportunities.
Poor Execution/Integration: Post-closing, the acquirer's management team may exhibit poor leadership
and an inability to integrate the new acquisition. This poor integration can lead to diminished employee
morale, cultural mismatches, and a noticeable drop in product/service quality. Of all the reasons M&A
deals can fail, cultural compatibility can be the trickiest risk to assess.
Studies have repeatedly shown a high percentage of deals destroy shareholder value. If that's the
case, why do companies still engage in M&A?
Many studies have concluded that most M&A deals its focus shifts towards protecting its existing market
destroy shareholder value. Yet, many companies share as opposed to growth and stealing more
continue to pursue growth through M&A. market share (i.e., the company is now the target
incumbent to steal market share from).
One reason companies choose to engage in M&A is
M&A is often a
that many deals are done out of necessity, meaning
defensive response to structural sector
they were defensive measures taken to protect their
disruption that presents a threat to an existing
market share or to maintain competitive parity. Once
business model.
a company owns a sizeable percentage of a market,

Therefore, the company must always be on the look-out for developing trends or companies that could
someday become a threat, which is closely related to technological adaptation and staying innovative as
industries continuously develop. M&A is a method for companies to fend off outside threats and gain
new technological capabilities.
What is the purpose of a teaser?
A teaser is a one to two-page marketing document that's usually put together by a sell-side banker on behalf of
their client. The teaser is the first marketing document presented to potential buyers and is used to gauge
their initial interest in formally taking part in the sale process. The intent is to generate enough interest for a
buyer to sign an NDA to receive the confidential information memorandum ("CIM").
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The content found in a teaser will be limited, and the name of the company is never revealed in the document
(instead “Project [Placeholder Name]”), and the teaser only provides the basic background/financial
information of the company to hide the identity of the client and protect confidentiality. The information
provided is a brief description of the business operations, investment highlights, and summary financials
(e.g., revenue, operating income, EBITDA over the past two or three years) – just enough details for the buyer
to understand what the business does, assess recent performance and determine whether to proceed or
pass.
What does a confidential information memorandum (CIM) consist of?
A confidential information memorandum ("CIM") provides potential buyers with an in-depth overview of the
business being offered for sale. Once a buyer has executed an NDA, the sell-side investment bank will
distribute the CIM to the private equity firm or strategic buyer for review.
The format of the CIM can range from being a 20 to 50-page document with the specific contents being a
detailed company profile, market overview, industry trends, investment highlights, business segments,
product or service offerings, past summary financials, performance projections (called the “Management
Case”), management biographies, and the transaction details/timing.
Read More → Confidential Information Memorandum (CIM)
What are the typical components found in a letter of intent (LOI)?
Once a buyer has proceeded with the next steps in making a potential acquisition, the next step is to provide
the seller with a formal letter of intent ("LOI"). An LOI is a letter stating the proposed initial terms, including
the purchase price, the form of consideration, and planned financing sources. Usually non-binding, an LOI
represents what a definitive agreement could look like, but there's still room for negotiation and revisions to
be made in submitted LOIs (i.e., this is not a final document).
Read More → Letter of Intent (LOI)
What are “no-shop” provisions in M&A deals?
In most M&A deal agreements, there'll be a dedicated section called the “no solicitation” provision, or more
commonly known as the “no-shop” provision. No-shop provisions protect the buyer and give exclusivity
during negotiations. The sell-side representative is prevented from looking for higher bids and leveraging the
buyer’s current bid with other buyers. Violating the no-shop would trigger a significant breakup fee by the
seller, and an investigation would be made into the sell-side bank to see if they were contacting potential
buyers when legally restricted from doing so. On the other side, a seller can protect themselves using reverse
termination fees ("RTFs"), which allow the seller to collect a fee if the buyer were to walk away from the deal.
Read More → Breakup Fees and Reverse Termination Fees in M&A
What is a material adverse change (MAC), and could you provide some examples? In an M&A
transaction, a material adverse change ("MAC") is a highly negotiated, legal mechanism intended to reduce the
risk of buying and selling parties from the merger agreement date to the deal closure date. MACs are legal
clauses included in virtually all merger agreements that list out the conditions that allow the buyer the right to
walk away from a deal without facing legal repercussions or significant fines.
Common Examples of MACs
Significant Changes in Economic Conditions, Financial Markets, Credit Markets, or Capital Markets
Relevant Changes such as New Regulations, GAAP Standards, Transaction Litigation (e.g., Anti-Trust)
Natural Disasters or Geopolitical Changes (e.g., Outbreak of Hostilities, Risk of War, Acts of Terrorism)
Failure to Meet an Agreed-Upon Revenue, Earnings, or Other Financial Performance Target
Read More → Material Adverse Change: The ABCs of MACs

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Contrast asset sales vs. 338(h)(10) election vs. stock sales.

Sale Type Description Tax Implications

Asset In an asset sale, the seller will sell the In the asset sale, the buyer gets the incremental
Sales assets to the buyer with each asset D&A tax benefits – meaning, the tax basis of
contractually sold. assets is stepped up, which creates tax
Once the buyer holds all the assets, it deductible D&A and future cash tax savings.
controls the business by having But the seller potentially faces double taxation
everything that made the – first on the corporate level and then on the
seller’s equity worth shareholder level.
something.

Stock In a stock sale, the seller gives the In a stock sale, the buyer doesn't get a stepped
Sales buyer shares. up basis in the seller’s assets, which means
Once the buyer holds all the target the buyer cannot benefit from lower future
shares, it controls the business taxes due to incremental deal-related D&A.
from being its new owner. The seller is taxed only at the shareholder level
(as opposed to the corporate level).

338(h)(1 A 338(h)(10) is something both A 338(h)(10) offers the benefits of stock sales
0) buyer and seller can jointly elect to along with the tax savings of an asset sale.
Election do, which gives you the tax Legally, a 338(h)(10) is considered a stock sale
treatment of an asset sale without but treated as an asset sale for tax purposes.
the hassle of actually exchanging The seller is still subject to double-taxation, but
individual assets. the buyer can benefit from the tax advantages of
This applies to acquisitions of the step-up of assets and the NOLs – leading to a
corporate subsidiaries or S-corps, higher purchase price.
and most applicable when the
target has a high amount of NOLs.

Read More → Asset Sale vs. Stock Sale

Contrast a friendly acquisition and hostile takeover attempt.
Friendly Acquisition: A friendly acquisition is when the takeover bid was made with the consent of both
companies’ management teams and boards of directors. The two had previously agreed to come to the
table and negotiated on good terms. The target's board will notify their shareholders of the bid and
decision, and in most cases, the shareholders will follow the lead of the board.
Hostile Takeover: Conversely, a hostile takeover usually comes after a failed friendly negotiation. The
target's management and board of directors have expressed their objection to the acquisition, but the
acquirer has continued pursuing a majority stake by going directly to the shareholders.
What are the two most common ways that hostile takeovers are pursued?
1. Tender Offer: In a tender offer, the acquirer will publicly announce an offer to purchase shares from
existing shareholders for a premium. The intent is to acquire enough voting shares to have a
controlling stake in the target's equity that enables them to push the deal through.
2. Proxy Fight: Alternatively, a proxy fight involves a hostile acquirer attempting to persuade existing
shareholders to vote out the existing management team to take over the company. Convincing existing
shareholders to turn against the existing management team and board of directors to initiate a proxy
fight is the hostile acquirer's objective, as the acquirer needs these shareholders' votes, which it does
by trying to convince the company is being mismanaged.

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How does a tender offer differ from a merger?

When a public company has received a tender offer, an acquirer has offered a takeover bid to purchase some
or all of the company’s shares for a price above the current share price. Often associated with hostile
takeovers, tender offers are announced publicly (i.e., public solicitation) to gain control over a company
without its management team and board of directors' approval. In contrast, a traditional merger would
involve two companies jointly negotiating on an agreement to combine.
Read More → Tender Offer vs. Merger
What are some preventive measures used to block a hostile takeover attempt? Poison Pill
Defense: A poison pill defense is a tactic used by the company being targeted to prevent a hostile takeover
attempt. Poison pills give existing shareholders the option to purchase additional shares at a discounted
price, which dilutes the acquirer's ownership and makes it more difficult for the acquirer to own a majority
stake (i.e., more shares necessary).
Golden Parachute Defense: A golden parachute is when key employees' compensation packages are
adjusted to provide more benefits if they were to be laid off post-takeover. Since the takeover was hostile,
it's improbable the acquirer would keep the existing management team and board, so they would have to
honor the benefits and severance agreements such as continued insurance coverage and pension
benefits that these executives included to fend off the acquirer.
Dead Hand Defense: A dead hand provision is similar to the traditional poison pill defense strategy and
has the same purpose of creating additional dilution to discourage the acquirer. Rather than giving
shareholders the option to purchase new discounted shares, additional shares are automatically issued
to every existing shareholder (excluding the acquirer).
Crown Jewel Defense: The “crown jewels” are defined as a company’s most valuable assets, which most
often include patents, intellectual property (IP), and trade secrets. This defense strategy is based on
creating an agreement where the company’s crown jewels could be sold if the company is taken over. In
effect, this would immediately make the target less valuable and less desirable to the acquirer.
What are some active defense measures to block a hostile takeover attempt? White Knight
Defense: The white knight defense is when a friendly acquirer interrupts the takeover by purchasing the
target. The unfriendly bidder is referred to as the “black knight,” and this tactic is usually done only when the
target is on the verge of being acquired. The target's management and board have accepted it'll give up its
independence and lose majority ownership, but the result is still in their favor. White Squire Defense: A
white squire defense is similar to the white knight defense in that an outside acquirer will step in to buy a
stake in the company to prevent the takeover. The distinction being the target company will not have to give
up majority control over the business as the white squire investor only purchases a partial stake, sized just
large enough to fend off the hostile acquirer.
Acquisition Strategy Defense: Another option the target company can resort to is to make an acquisition.
While the acquisition may not have been necessary and a premium may have to be paid, the end result is
the balance sheet is less attractive post-deal from the lower cash balance (and/or use of debt).
Pac-Man Defense: The Pac-Man defense is when the target attempts to acquire the hostile acquirer. This
retaliation deters the hostile attempt, rather than being intended to acquire the company. The Pac-Mac
defense is employed as a last-resort as having to follow-through on the acquisition is not the end-goal.
Greenmail Defense: Greenmail is when the acquirer gains a substantial voting stake in the target
company and threatens a hostile takeover unless the target repurchases its shares at a significant
premium. Thus, in a greenmail defense, the target will be forced to resist the takeover by repurchasing
its shares at a premium. However, anti-greenmail regulations have made this nearly impossible
nowadays.

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What is a staggered board and how does it fend off hostile takeover attempts? When the board of
directors of a company is organized as a staggered board, each board member is intentionally classified
into distinct classes regarding their term length. A staggered board is used to defend against hostile
takeover attempts as this type of ordering protects the existing board of directors and the management
team’s interests. Since the board is staggered, gaining additional board seats becomes a more complicated
and lengthy process for hostile acquirers (and deters takeover attempts).
What is a divestiture and why would one be completed?
A divestiture is the sale of a business segment (and the assets belonging to the unit). Often, divestitures are
completed once the management has determined that a segment doesn't add enough value to the core
business (e.g., redundant, a distraction from core operations, and non-complementary to other divisions).
The divestiture allows the parent company to cut costs and shift their focus to their core business while
allowing the divested business's operations to become leaner and unlock hidden value potential.
However, sometimes, the rationale behind the divestiture can be related to restructuring (i.e., prevents
falling into insolvency) or regulatory pressure to prevent the existence of a monopoly.
From the viewpoint of investors, a divestiture can arguably be interpreted as a failed strategy in the sense that
this non-core business failed to deliver the expected benefits (e.g., economies of scale) and show that there's a
need for cash for reinvestment or to better position themselves from a liquidity standpoint. Hence, many
divestitures are influenced by activist investors that push for the sale of a non-core business and then request
a capital distribution.
How does an equity carve-out differ from a divestiture?
An equity carve has many similarities to a divestiture and is often referred to as a “partial IPO.” The
mechanism of an equity carve-out is that the parent company will sell a portion of their equity interest in a
subsidiary to public investors. In nearly all cases, the parent company will still retain a substantial equity
stake in the new entity (usually > 50%).
Upon completing the equity carve-out, the subsidiary will be established as a new legal entity with its
separate management team and board of directors. The cash proceeds of the sale to 3rd investors are then
distributed to the parent, the subsidiary, or a combination.
What is a spin-off and why are they completed?
In a spin-off, a parent company will separate a particular division to create an independent entity with new
shares (ownership claims). The existing shareholders will receive those shares in proportion to their original
proportion of ownership in the company (i.e., pro-rata). The decision is up to the shareholders whether to
hold on to those shares or sell them in the open market. The rationale for spin-offs is usually in response to
shareholders' pressure to divest a subsidiary that would be better off as a standalone company.
What is the difference between a subsidiary and an affiliate company?
Subsidiary: A subsidiary is when the parent company remains the majority shareholder (50%+).
Affiliate Company: An affiliate company is when the parent company has only taken a minority stake.
What is a reverse merger and what benefits does it provide?
A reverse merger is when a privately held company undergoes a merger with another company that's already
publicly traded in the markets. The public company can either be an operating company or be an empty
corporate shell. The benefit of reverse mergers is that the public entity can now issue shares without
incurring the costs associated with IPOs.

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What is an S-4 filing and when does it have to be filed?

An S-4 is a required form that must be filed with the SEC prior to a merger and acquisition activity taking
place. Contained in the S-4 will be material information related to the transaction, such as the deal rationale,
negotiated terms, risk factors, pro forma financials, and other related material.
What is the difference between the Schedule 13-D and 13-G filing?
The Schedule 13-D and 13-G are forms intended to disclose publicly when an investor has taken a
significant stake in a company in terms of ownership and voting power. These filings notify other investors
of the influential investor’s stake (i.e., “beneficial owners”).
Schedule 13-D: A Schedule 13-D must be filed when an investor acquires a minimum of 5% of a public
company's total common equity, and over 2% was acquired in the last twelve months. Within ten days of
the triggering acquisition, the Schedule 13-D must be filed. There must be a direct statement in the filing,
answering whether they intend to acquire more of the company’s shares to gain further influence.
Schedule 13-G: A Schedule 13-G can be filed in lieu of the 13-D as long as the investor doesn't intend to take
control of the company. This alternative, short-form version is filed when an investor acquires 5%+ of the
total equity but less than 2% in the last twelve months. Since there appears to be no intent to further
increase their stake on the filing date, the reporting requirements are shorter, less detailed, and depend
on the investor's classification (e.g., institutional investor, passive investor). If the investor's intent is
amended, the 13-D must be filed within ten days of the change.
Can you explain what the “winner’s curse” is in M&A?
The so-called winner’s curse in M&A is the tendency for the winning bidder to have paid far beyond the
target's fair value. While a certain premium is expected during competitive processes, this can often be
elevated to irrational levels. The buyer may later feel buyer’s remorse and receive scrutiny for overpaying,
especially if the acquisition doesn't pan out as expected, which can lead to write-downs of the acquired assets.
Financial buyers also experience greater difficulty meeting their fund's required returns threshold if a higher
multiple was paid.
What is a holdback in M&A?
To help mitigate transaction risks, a holdback mechanism can require a portion of the purchase price of an
acquisition to be placed in escrow to protect the interests of the buyer post-closing until the terms of the
agreement have been satisfied. This provision can be used to ensure the seller follows through on all agreed
upon conditions outlined in the deal agreement and minimize the risk of monetary loss for the buyer. These
funds would be held in escrow and can be released to the buyer if the seller violates the terms.
What type of material is found in an M&A pitchbook?
A pitchbook is a marketing document used by investment banks to pitch potential clients to hire them for
a particular transaction. The pitchbook will differ by each investment bank, but the general M&A
transaction pitchbook will include:
1. Introduction of the Investment Bank and Dedicated Team Members
2. Situational Overview of the Deal and Client Company
3. Prevailing Market and Industry Trends
4. Implied Valuation Range and Combined M&A Model
5. Proposed Deal Strategy Outline and Key Considerations
6. Credentials and Tombstones of Relevant Industry Experience
7. Appendix (DCF Model, Trading Comps, Transaction Comps)
Read More → Investment Banking Pitchbook: Real-World Examples

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