Flashcards in PE INDUSTRY Deck (19)
If you could grow net income by raising price or volume each by the same amount, which would you grow?
Well between price and volume, I would definitely choose price, especially if the product is demand inelastic, meaning that price isn’t affect how much units you sell. The reason why I would choose price is because every additional dollar of revenue you earn falls straight to the bottom line after taxes. As comparison, for every additional unit you sell, there is a variable cost component associated with it, meaning for every dollar of revenue you earn, not all of that dollar will fall straight to the bottom line. So in terms of increasing margins, I would definitely increase the price first.
Two companies are in the same industry. One has a 10 percent operating margin, one has a 20 percent operating margin. If both have a fixed, mixed, variable cost structure of 50-50 percent, which would you short if sales across the board fell by 10 percent and what would be your thesis?
So if sales fell across the board by 10 percent, the one thing I would care about is the fixed cost of this company. So for the 10 percent margin, uh, the 10 percent margin operating business, the fixed cost would be 45 percent and the 20 percent margin business, the fixed cost would be 40 percent. So I would choose to short the company with the higher fixed cost, meaning the one with the 10 percent operating margin.
Why do you think a CFO would want to raise debts to buy repurchased shares? Give us a couple reasons.
Perhaps debt is very cheap right now, especially in the markets too, and this could also be a way to if they do not have any other uses for that debt, perhaps any – no new acquisition targets, raising debts could actually decrease their cost of capital depending on how low, like how low interest rates can go right now. And also repurchasing debts, repurchasing – re – excuse me – repurchasing shares is always a good way to return capital to your shareholders too, and by decreasing the number of shares in the market, you’re also increasing the equity value of – the equity to all the remaining shareholders.
From a valuation perspective, what are the most important aspects or factors to consider in a merger model?
A merger model comes down to accretion dilution. Is your EPS going to grow or decrease after you acquire this other company? And you can think of it as a trade-off between the net income you will get from buying the company versus whatever you have to pay out. So if it is an all stock deal, it is the P relative P multiples between you and the buyer, uh, between you and the seller. Uh, if it’s an all debt deal, it’s the interest on the debt. And if it’s a cash, it’s the foregone interest on that cash that you could have used to perhaps invest in other instruments or invest in the stock market. And all those factors will be tax-affected by the buyer’s tax rate. And one component that we always think about is synergies within an M&A model, but, uh, oftentimes those are very hard to realize too, but if we do want to consider that, uh, we should also tax-affect it too, and that’s a simple accretion dilution model
So let’s go through a scenario. A company runs into financial distress and needs cash. It sells a factory that is listed at $100 on its balance sheet for $80. What happens on the three statements assuming 40 percent tax?
The asset you sold for $100, but it’s book value is 80, right? So that means you have a $20 gain on sale, which is going to hit the income statement as if it were revenue. Tax affected, that means that you’re going to get additional 12 million in net income. That 12 million is going to flow into the top of the cash flow statement. You’re going to take out the 20, um, from the gain on sale and add back the 100 from the actual, um, sale of the asset. Right, so you’re going to have net 92. Um, that net 92 in cash flows to the top of the balance sheet, um, where you’re going to take out the 80 from PP&E, so then you have net 12 on the asset side, and that ties to the net 12 of – to the 12 of net income that’s going to hit 13.
What indicators would quickly tell you if an M&A deal is accretive or diluted?
The one that stands out to me is PE. If the PE of the target is greater than that of the acquirer, the deal will be accretive to the acquirer.
So given two companies, how would you determine which one to invest in and why?
This is a pretty broad-based question. There are a number of factors you can consider. There’s return on invested capital, which company is able to generate a profit more efficiently. You would also want to look at free cash flow yield. I think that’s important because you’re going to need cash flow generation in order to pay down debt. And then you might actually want to look at the business and see how concentrated are their customer base and their supplier base and what risk might there be in these places? And then when you think about the market, you might also want to understand, you know, uh, what their market share is relative to each other. Some of the other things that we look at are the market landscape and if there are any secular changes in that particular market. We also look at operational opportunity and like where we see, uh, where can we add value to the company if we owned it. Uh, we also kind of think about what the exit strategy is, so like is this is an asset we’d be interested in for strategics? Is it an IPO? Would there be other sponsors? And kind of, uh, trying to inform, uh, our view of the investment.
How do you assess credit risk?
Leverage Ratios (never exceed 4x)
(debt / equity - under 2x)
Interest-coverage ratios (greater than 1 - maintenance - above 3x)
Fixed Charge Coverage Ratio
Look at the industry, growth.
Credit - protection against bankruptcy
Industry and Company perspective
What are the different types of PE firms?
1) (EARLY STAGE) VC (5-10% - preferred equity or warrants)
2) (MID STAGE) Growth Equity (10-30%)
3) (LATE STAGE) LBO (20-50%)
What are the different ways to find the valuation of a company?
(1) Precedent Tran.
(2) Public Comps
How would you spend a million dollars if it were given to you?
I would consider the investment options available to me (1) PE co-invest (2) bonds and (3) equities. I do not want to invest in something I do not understand well. Since I am 25 and won't be retiring for awhile, I want a high rate of return.
(1) 10% PE coinvest - high return, BUT illiquid, investments of employer
(2) 60% diversified stocks - (passive equity funds) - between domestic and international (half and half)
(3) 30% bonds, low-cost, medium-maturity bonds (2-10 years)- uncorrelated with equity - buy a home in 5 years.
Company A has a potential IRR of 23% and Company B has a potential IRR of 30%. What 2 questions would you ask before you decide which one to invest in?
1) How much investment
3) What industry to they operate in?
Walk me through the calculation of Free Cash Flow.
Less: Change in NWC
How do you calculate amortization of intangible assets?
Typically companies will do a FMV of their intangible assets
5% or less (model it)
What are the uses of excess cash flow?
If the borrower has excess cash and the terms of the debt provide for early repayment at the borrower's option, the borrower may use excess cash to periodically repay debt ahead of schedule. This is called "cash sweep."
What makes for a good management team?
(1) Solid MGMT team with experience
(2) A team that has weathered storms
(3) Been through an acquisition before
What 3 questions would you ask a CEO of a company you were looking to invest in?
(1) Market Leader (growth)
(2) Secret Sauce (special patents, proprietary)
(3) Historical performance (where do you see your company growing in the future)
You have two companies with different EV/EBITDA multiples in different industries. What are some reasons why their EBITDA multiples might be different?
(1) Fraud / Skiddish
(2) Market leader
(3) Position of the industry