Technical Questions
What makes a good LBO candidate?
Motivated & competent management to run the company after the buyout
Steady, predictable cash flows
Must be company with low requirements for CapEx and R&D. Cash flow must be used primarily to service & retire debt
Financial sponsor should have an exit strategy (e.g. Sell business to another financial or strategic buyer; IPO)
Good niche in the market for their product lines
Work force must be flexible and willing to participate, especially since focus after LBO will be more on debt repayment than expansion
No skeletons (e.g. litigation or unresolved environmental concerns)
Valuable technology already in place with no need for future CapEx
Untapped assets: real estate, exclusive licenses, contracts, patents, etc.
New company should have ability & willingness to cut costs
What are some exit strategies for an LBO?
Initial Public Offering (IPO)
Spin-offs; break up assets
Sell to strategic buyer
Sell to another financial buyer
Management Buyout
What criteria would you use to help a client make an acquisition?
Financial Criteria:
EPS accretion/dilution
Does it create shareholder value? (NPV > 0)
Sources of cash for the acquisition
Strategic Criteria:
Growth in market share
Industry consolidation / economies of scale
vertical integration
Technological or intellectual property acquisition
Regulatory & Political Change e.g. media & telecom (Telecom Reform Act of 1996); financial services (Glass-Stegall Act)
Back to “Sample Interview Questions”
What are the different sources of synergies in M&A?
Revenue synergies
Access to new markets, geographies and customers
Ability to cross-sell products
Vertical integration
Network effects
Cost synergies
Economies of scale
Economies of Scope
Cost efficiencies across value chain (e.g. consolidation of manufacturing plants, savings in distribution/overlapping channels, eliminating duplicative human resources)
What tactics do companies use to fight a hostile takeover bid?
Poison pill
Golden parachutes
White knight
Pac Man
Sell prime assets to become a less attractive company
Take on additional debt to become a less attractive company
What are the advantages and disadvantages to raising equity vs. debt?
Equity
-Pros: In a strong market, a company may be able to receive a premium on its equity.
-Cons: The expected return on equity is higher (at least 12%-15%) making it more expensive than debt
Debt
-Pros: Interest on debt is tax deductible, reducing it’s cost
-Cons: The company’s debt is less marketable if it’s already highly leveraged. Additionally, the interest payment on the debt make it more difficult for it to be cash flow positive.
The M&A Process
-Buy-side: Investment bank represents a client looking to purchase a company. Buy-side engagements are riskier for an investment bank because the bank receives a success fee only if the client outbids all of the other potential buyers.
-Sell-side: Investment bank represents a client who wants to sell all or part of their business. Sell-side engagements are typically more certain than buy-side engagements.
Discounted Cash Flow (DCF)
Discounted Cash Flow is probably the valuation method most tested in investment banking interviews. That’s probably because a DCF valuation is the most thorough method. In short, a DCF valuation results in an intrinsic value of a company, based not on the market but on a company’s cash flows.
In order to complete a DCF, you need the following:
-Historical income statement, balance sheet and cash flow statement.
-Financial projections from management and/or industry experts
DCF Methodology (high level)
1.Discount unlevered Free Cash Flow (FCF) @ Weighted Average Cost of Capital (WACC)
2.Typical starting point for calculating unlevered FCF is EBIT
3.Calculate terminal value; remember to discount to present
4.Add PV of FCF and Terminal Value to arrive at the Enterprise Value
5.Subtract net debt to get Equity Value
6.Divide equity value by shares outstanding to get equity value per share
Unlevered Free Cash Flow
The term unlevered means before the effect of debt. Simply, it means that interest is NOT subtracted in your FCF calculation. Levered FCF means that interest is subtracted.
How to Calculate Unlevered Free Cash Flow
Line Item Source
EBITDA
IS
-
Depreciation
IS, CFS, footnotes
=
EBITA
IS
-
Taxes (at effective rate)
Footnotes, estimate
=
Net Operating Profit After Taxes (NOPAT)
+
Deprecation
IS, CFS, footnotes
-
Increase in Working Capital Investment
CFS
-
Capital Expenditures
CFS
=
Unlevered Free Cash Flow
Terminal Value
Terminal Value is a lump sum value that captures all FCF generated by the company beyond the annual projection period. When forecasting a company’s earnings, the idea is that during the forecast period, cash flows are not yet steady. During the period, revenues are rising (hopefully) above normal, capital expenditures are being made along with other changes to the company’s operations. However, at a point in time, the company will begin to grow at a constant rate (theoretically). Typically, a forecast period of five years is chosen, but theoretically, the forecast period should be the length of time needed to arrive at a steady cash flow stream.
Once a company reaches a steady state, it would be silly to forecast earnings for each year a hundred into the future. Instead, you can calculate a terminal value which is the value of company beyond the forecast period. This value is calculated, discounted to the present and then added to the present value of the company’s FCF to arrive at an enterprise value.
Example
Let’s say that our forecast period is five years. In this case, we would calculate the company’s FCF for the next five years based on projections made, and discount each year’s cash flow at WACC to the present. Then, we would calculate the terminal value after the fifth year. This represents the terminal value of the enterprise after the fifth year, so it would have to be discounted five years (also at WACC), to the present. Adding the two values together results in an enterprise value.
Methods to Calculate Terminal Value
1. Perpetual Growth Model
FCFn * (1+g) / (r-g)
n = Final year of forecast period
g = Growth rate of company beyond forecast period. This is typically set at the rate of GDP.
r = Discount rate (WACC)
Key Points
-More academically sound method
-Assumes firm will be owned forever
2. Terminal multiple/ exit multiple method
A more common method, this method applies a multiple to the company’s financials to arrive at a terminal value. This method is simple to apply but flawed since it requires applying market-based relative valuation to help determine intrinsic value
Example
A firm with an EBITDA of $100 million is in an industry where the average company trades at 10 times (10x) EBITDA. Thus, the terminal value is $100 million times 10, or $1 billion.
Motivated & competent management to run the company after the buyout
Steady, predictable cash flows
Must be company with low requirements for CapEx and R&D. Cash flow must be used primarily to service & retire debt
Financial sponsor should have an exit strategy (e.g. Sell business to another financial or strategic buyer; IPO)
Good niche in the market for their product lines
Work force must be flexible and willing to participate, especially since focus after LBO will be more on debt repayment than expansion
No skeletons (e.g. litigation or unresolved environmental concerns)
Valuable technology already in place with no need for future CapEx
Untapped assets: real estate, exclusive licenses, contracts, patents, etc.
New company should have ability & willingness to cut costs
What are some exit strategies for an LBO?
Initial Public Offering (IPO)
Spin-offs; break up assets
Sell to strategic buyer
Sell to another financial buyer
Management Buyout
What criteria would you use to help a client make an acquisition?
Financial Criteria:
EPS accretion/dilution
Does it create shareholder value? (NPV > 0)
Sources of cash for the acquisition
Strategic Criteria:
Growth in market share
Industry consolidation / economies of scale
vertical integration
Technological or intellectual property acquisition
Regulatory & Political Change e.g. media & telecom (Telecom Reform Act of 1996); financial services (Glass-Stegall Act)
Back to “Sample Interview Questions”
What are the different sources of synergies in M&A?
Revenue synergies
Access to new markets, geographies and customers
Ability to cross-sell products
Vertical integration
Network effects
Cost synergies
Economies of scale
Economies of Scope
Cost efficiencies across value chain (e.g. consolidation of manufacturing plants, savings in distribution/overlapping channels, eliminating duplicative human resources)
What tactics do companies use to fight a hostile takeover bid?
Poison pill
Golden parachutes
White knight
Pac Man
Sell prime assets to become a less attractive company
Take on additional debt to become a less attractive company
What are the advantages and disadvantages to raising equity vs. debt?
Equity
-Pros: In a strong market, a company may be able to receive a premium on its equity.
-Cons: The expected return on equity is higher (at least 12%-15%) making it more expensive than debt
Debt
-Pros: Interest on debt is tax deductible, reducing it’s cost
-Cons: The company’s debt is less marketable if it’s already highly leveraged. Additionally, the interest payment on the debt make it more difficult for it to be cash flow positive.
The M&A Process
-Buy-side: Investment bank represents a client looking to purchase a company. Buy-side engagements are riskier for an investment bank because the bank receives a success fee only if the client outbids all of the other potential buyers.
-Sell-side: Investment bank represents a client who wants to sell all or part of their business. Sell-side engagements are typically more certain than buy-side engagements.
Discounted Cash Flow (DCF)
Discounted Cash Flow is probably the valuation method most tested in investment banking interviews. That’s probably because a DCF valuation is the most thorough method. In short, a DCF valuation results in an intrinsic value of a company, based not on the market but on a company’s cash flows.
In order to complete a DCF, you need the following:
-Historical income statement, balance sheet and cash flow statement.
-Financial projections from management and/or industry experts
DCF Methodology (high level)
1.Discount unlevered Free Cash Flow (FCF) @ Weighted Average Cost of Capital (WACC)
2.Typical starting point for calculating unlevered FCF is EBIT
3.Calculate terminal value; remember to discount to present
4.Add PV of FCF and Terminal Value to arrive at the Enterprise Value
5.Subtract net debt to get Equity Value
6.Divide equity value by shares outstanding to get equity value per share
Unlevered Free Cash Flow
The term unlevered means before the effect of debt. Simply, it means that interest is NOT subtracted in your FCF calculation. Levered FCF means that interest is subtracted.
How to Calculate Unlevered Free Cash Flow
Line Item Source
EBITDA
IS
-
Depreciation
IS, CFS, footnotes
=
EBITA
IS
-
Taxes (at effective rate)
Footnotes, estimate
=
Net Operating Profit After Taxes (NOPAT)
+
Deprecation
IS, CFS, footnotes
-
Increase in Working Capital Investment
CFS
-
Capital Expenditures
CFS
=
Unlevered Free Cash Flow
Terminal Value
Terminal Value is a lump sum value that captures all FCF generated by the company beyond the annual projection period. When forecasting a company’s earnings, the idea is that during the forecast period, cash flows are not yet steady. During the period, revenues are rising (hopefully) above normal, capital expenditures are being made along with other changes to the company’s operations. However, at a point in time, the company will begin to grow at a constant rate (theoretically). Typically, a forecast period of five years is chosen, but theoretically, the forecast period should be the length of time needed to arrive at a steady cash flow stream.
Once a company reaches a steady state, it would be silly to forecast earnings for each year a hundred into the future. Instead, you can calculate a terminal value which is the value of company beyond the forecast period. This value is calculated, discounted to the present and then added to the present value of the company’s FCF to arrive at an enterprise value.
Example
Let’s say that our forecast period is five years. In this case, we would calculate the company’s FCF for the next five years based on projections made, and discount each year’s cash flow at WACC to the present. Then, we would calculate the terminal value after the fifth year. This represents the terminal value of the enterprise after the fifth year, so it would have to be discounted five years (also at WACC), to the present. Adding the two values together results in an enterprise value.
Methods to Calculate Terminal Value
1. Perpetual Growth Model
FCFn * (1+g) / (r-g)
n = Final year of forecast period
g = Growth rate of company beyond forecast period. This is typically set at the rate of GDP.
r = Discount rate (WACC)
Key Points
-More academically sound method
-Assumes firm will be owned forever
2. Terminal multiple/ exit multiple method
A more common method, this method applies a multiple to the company’s financials to arrive at a terminal value. This method is simple to apply but flawed since it requires applying market-based relative valuation to help determine intrinsic value
Example
A firm with an EBITDA of $100 million is in an industry where the average company trades at 10 times (10x) EBITDA. Thus, the terminal value is $100 million times 10, or $1 billion.
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