Question:

Briefly walk through a discounted cash flow analysis (including WACC).

Answer:

First, you want to calculate free cash flow for a certain period of time (generally five or ten years). To calculate free cash flow, start with after-tax EBIT and then add back D&A (depreciation and amortisation), subtract Capex and add/subtract the decrease/increase in working capital.

Next, you want to determine the appropriate discount rate for the cash flows, the WACC. The cost of debt is determined using the current yields on the company's existing debt issues (where bonds are trading) and the tax rate affecting them. The cost of equity is generally determined by the capital asset pricing model (CAPM) (ie. the risk-free rate plus the company's beta multiplied by the equity risk premium). WACC=D/(D+E)*(1-T)*Kd + E/(D+E)*Ke

Next, you would calculate a terminal value for the firm either using a multiple of EBITDA or a perpetuity growth rate on the firm's free cash flow.

- Multiple Method - Multiply the final year's EBITDA by an appropriate EBITDA multiple for the firm (based on comparables)

- Perpetuity Growth Method - multiply the final year's free cash flow by (1+growth rate) and divide that by (r-g).

You would next calculate the present value (PV) of the terminal value.

Next, you would determine the PV of the free cash flows for the given period (dividing the cash flows by WACC).

Finally, you would add the PV of the terminal value to the PV of the free cash flow to determine the value of the firm.

Question:

What is the formula for enterprise value?

Answer:

The formula for enterprise value is: market value of equity (MVE) + debt + preferred stock + minority interest – cash.

Question:

What is minority interest and why do we add it in the enterprise value formula?

Answer:

When a company owns more than 50% of another company, US accounting rules state that the parent company has to consolidate its books.

In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the “sub”) on its own financial statements.  But if the parent company does not own 100% of the sub, the parent company will have a line item called minority interest on its income statement. This will reflect the portion of the sub’s net income that the parent is not entitled to (the percentage that it does not own).  The parent company’s balance sheet will also contain a line item called minority interest which reflects the percentage of the sub’s book value of equity that the parent does NOT own.  It is the balance sheet minority interest figure that we add in the Enterprise Value formula.

Now, keep in mind that the main use for Enterprise Value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.)  When we take, say, sales or EBITDA from the parent company’s financial statements, these figures - due to the accounting consolidation - will contain 100% of the sub’s sales or EBITDA, even though the parent does not own 100%.  In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest).  Because we do this, both the numerator and denominator of our valuation metric account for 100% of the sub, and we have a consistent (apples to apples) metric.

You might wonder why - instead of adding minority interest to Enterprise Value, we don't just subtract the portion of sales or EBITDA that the parent does NOT own.  In theory, this would indeed work and may be more accurate.  However, typically we do not have enough information about the sub to do such an adjustment (minority owned subs are rarely, if ever, public companies).  Moreover, even if we had the financial information of the sub, this method is clearly more time consuming.

Question:

Which will place a higher value on the company, equity comparables (trading comps) or M&A comparables (transaction comps) and why?

Answer:

M&A comparables will be higher due to a control premium that must be paid and synergies expected to be derived from the deal.

Question:

A companymakes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year?

Answer:

First Year:

Let’s assume that the company’s fiscal year ends Dec. 31.  The relevance of the purchase date is that we will assume no depreciation the first year.

Income Statement:  A purchase of equipment is considered a capital expenditure which does not impact earnings.  Further, since we are assuming no depreciation, there is no impact on net income, thus no impact to the income statement.

Cash Flow Statement:  No change to net income so no change to cash flow from operations.  However, we’ve got a $100 increase in capex so thereis a $100 use of cash in cash flow from investing activities.  No change in cash flow from financing (since this is a cash purchase) so the net effect is a use of cash of $100.

Balance Sheet:  Cash (asset) down $100 and PP&E (asset) up $100 so no change to the left side of the balance sheet and no change to the right side.  We are balanced.

Second Year:

Here, let’s assume straight line depreciation over 5 years and a 40% tax rate.

Income Statement:  Just like the previous question:  $20 of depreciation, which results in a $12 reduction to net income.

Cash Flow Statement:  Net income down $12 and depreciation up $20.

No change to cash flow from investing or financing activities.  Net effect is cash up $8.

Balance Sheet:  Cash (asset) up $8 and PP&E (asset) down $20 so left side of balance sheet down $12.

Retained earnings (shareholders’ equity) down $12 and again, we are balanced.

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