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M&A > Week 4 > Flashcards

Week 4 Flashcards

1
Q

What are 2 methods of estimating the cost of debt?

A
  1. Look up yield to maturity on a plain vanilla bond outstanding from the firm
    * Limitations:
    * Few firms have long term plain vanilla bonds
    * If they do, typically not liquid/traded
  2. Look up firm rating and estimate default spread based on rating
    * Limitations:
    * Different bonds from same firm may have different ratings
    * Data typically only available for big, listed firms
    * Solution: generate a synthetic rating
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2
Q

How to use a synthetic rating?

A
  • πΌπ‘›π‘‘π‘’π‘Ÿπ‘’π‘ π‘‘ π‘π‘œπ‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘Ÿπ‘Žπ‘‘π‘–π‘œ = 𝐸𝐡𝐼𝑇 πΌπ‘›π‘‘π‘’π‘Ÿπ‘’π‘ π‘‘ 𝑒π‘₯𝑝𝑒𝑛𝑠𝑒𝑠
  • Take synthetic rating belonging to interest coverage ratio (website Damodaran provides conversion tables)
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3
Q

When it is more problematic to use synthetic ratings (3 reasons)?

A
  • Smaller companies
  • Markets with higher interest rates than the US and comparable markets
  • Companies in markets that hardly rely on debt
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4
Q

Name and explain the 3 different expenditures

A

Operating expenses
* Generate benefits in the current period (e.g. labor, material)

Capital expenses
* Generate benefits over multiple periods (e.g. building, equipment)

Financial expenses
* Measure cost of non-equity finance (e.g. interest), and are independent of operations

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5
Q

How to adjust debt for operating leases?

A
  • 𝐷𝑒𝑏𝑑 π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ π‘œπ‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” π‘™π‘’π‘Žπ‘ π‘’π‘  = 𝑃𝑉(π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” π‘™π‘’π‘Žπ‘ π‘’ π‘π‘œπ‘šπ‘šπ‘–π‘‘π‘šπ‘’π‘›π‘‘π‘ )
  • Discount at the pre-tax cost of debt

When you convert operating leases into debt, you also create an asset to counter it of exactly the same value

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6
Q

How to adjust operating earnings for leases?

A
  • 𝐴𝑑𝑗𝑒𝑠𝑑𝑒𝑑 π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” πΌπ‘›π‘π‘œπ‘šπ‘’ = π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” πΌπ‘›π‘π‘œπ‘šπ‘’ +π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” πΏπ‘’π‘Žπ‘ π‘’ 𝐸π‘₯𝑝𝑒𝑛𝑠𝑒𝑠 βˆ’ π·π‘’π‘π‘Ÿπ‘’π‘π‘–π‘Žπ‘‘π‘–π‘œπ‘› πΏπ‘’π‘Žπ‘ π‘’π‘‘ 𝐴𝑠𝑠𝑒𝑑

Approximately equal to:
* 𝐴𝑑𝑗𝑒𝑠𝑑𝑒𝑑 π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” πΌπ‘›π‘π‘œπ‘šπ‘’ = π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” πΌπ‘›π‘π‘œπ‘šπ‘’ + 𝑃𝑉 π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” π‘™π‘’π‘Žπ‘ π‘’ π‘π‘œπ‘šπ‘šπ‘–π‘‘π‘šπ‘’π‘›π‘‘π‘  Γ—π‘ƒπ‘Ÿπ‘’ βˆ’π‘‘π‘Žπ‘₯ π‘–π‘›π‘‘π‘’π‘Ÿπ‘’π‘ π‘‘ π‘Ÿπ‘Žπ‘‘π‘’ π‘œπ‘› 𝑑𝑒𝑏𝑑

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7
Q

How to adjust NetCapEx for R&D?

A

Research and development expenses:

𝐴𝑑𝑗𝑒𝑠𝑑𝑒𝑑 𝑁𝑒𝑑 πΆπ‘Žπ‘π‘–π‘‘π‘Žπ‘™ 𝐸π‘₯π‘π‘’π‘›π‘‘π‘–π‘‘π‘’π‘Ÿπ‘’π‘  = 𝑁𝑒𝑑 πΆπ‘Žπ‘π‘–π‘‘π‘Žπ‘™ 𝐸π‘₯π‘π‘’π‘›π‘‘π‘–π‘‘π‘’π‘Ÿπ‘’π‘  + πΆπ‘’π‘Ÿπ‘Ÿπ‘’π‘›π‘‘ π‘¦π‘’π‘Žπ‘Ÿβ€™π‘  𝑅&𝐷 βˆ’π΄π‘šπ‘œπ‘Ÿπ‘‘π‘–π‘§π‘Žπ‘‘π‘–π‘œπ‘› π‘œπ‘“ π‘…π‘’π‘ π‘’π‘Žπ‘Ÿπ‘β„Ž 𝐴𝑠𝑠𝑒𝑑

Acquisitions of other firms:
𝐴𝑑𝑗𝑒𝑠𝑑𝑒𝑑 𝑁𝑒𝑑 πΆπ‘Žπ‘ 𝐸π‘₯ = π‘π‘’π‘‘πΆπ‘Žπ‘π‘–π‘‘π‘Žπ‘™ 𝐸π‘₯π‘π‘’π‘›π‘‘π‘–π‘‘π‘’π‘Ÿπ‘’π‘  + π΄π‘π‘žπ‘’π‘–π‘ π‘–π‘‘π‘–π‘œπ‘›π‘  π‘œπ‘“ π‘œπ‘‘β„Žπ‘’π‘Ÿ π‘“π‘–π‘Ÿπ‘šπ‘  βˆ’ π΄π‘šπ‘œπ‘Ÿπ‘‘π‘–π‘§π‘Žπ‘‘π‘–π‘œπ‘› π‘œπ‘“ π‘ π‘’π‘β„Ž π‘Žπ‘π‘žπ‘’π‘–π‘ π‘–π‘‘π‘–π‘œπ‘›π‘ 

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8
Q

Which valuation to use when? (Firm versus Equity)

A

Use Equity Valuation
* For firms which have stable leverage, whether high or not
* If equity (stock) is being valued

Use Firm Valuation
* For firms which expect to change leverage over time (e.g. acquisition, LBO)
* For firms for which you have partial information on leverage (e.g. interest expenses are missing)
* In all other cases, where you are more interested in valuing the firm than the equity

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9
Q

When to use DDM and when FCFF?

A

Dividend Discount Model
* Firms which pay dividends (and repurchase stock) close to Free Cash Flow to Equity
* For firms where FCFE are difficult to estimate (Example: Banks and Financial Service companies)

Use the FCFE Model
* For firms which pay dividends which are significantly higher or lower than the Free Cash Flow to Equity.
* For firms where dividends are not available (Example: Private Companies, IPOs)

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10
Q

When to use Stable / 2 stage / 3 stage growth?

A

Stable growth: Growth pattern
* Firm is large and growing at a rate close to or less than growth rate of the economy
* Firm is constrained by regulation from growing at rate faster than the economy
* Firm has the characteristics of a stable firm (average risk & reinvestment rates)

2-Stage growth:
* Firm is large & growing at a moderate rate (≀ Overall growth rate + 10%)
* Firm has a single product & barriers to entry with a finite life (e.g. patents)

3-Stage (or n-stage) growth:
* Firm is small and growing at a very high rate (> Overall growth rate + 10%)
* Firm has significant barriers to entry into the business
* Firm has firm characteristics that are very different from the norm

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11
Q

What are the 3 steps of valuation as a bridge?

A
  1. Survey the landscape
  2. Create a narrative for the future
  3. Check the narrative against history, economic first principles & common sense
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12
Q

What are the 3 ingredients of a runaway story?

A
  1. Charismatic, likeable Narrator: The narrator of the business story is someone that you want to see succeed, either because you like the narrator or because
  2. he/she will be a good role model. Telling a story about disrupting a much business, where you dislike status the quo: The status quo in the business that the story is disrupting is
  3. dissatisfying (to everyone involved)> With a societal benefit as bonus: And if the story holds, society and humanity will benefit.
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13
Q

What is the formula of a meltdown story?

A

Untrustworthy storyteller + Story at war with numbers + Bad business model

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M&A (6 decks)

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