QUESTION: 

Walk me through an LBO analysis!

ANSWER GIVEN:

First, we need to make some transaction assumptions.  What is the purchase price and how will the deal be financed?  With this information, we can create a table of Sources and Uses (where Sources equals Uses).  Uses reflects the amount of money required to effectuate the transaction, including the equity purchase price, any existing debt being refinanced and any transaction fees.  The Sources tells us from where the money is coming, including the new debt, any existing cash that will be used, as well as the equity contributed by the private equity firm.

Typically, the amount of debt is assumed based on the state of the capital markets and other factors, and the amount of equity is the difference between the Uses (total funding required) and all of the other sources of funding.

The next step is to change the existing balance sheet of the company to reflect the transaction and the new capital structure.  This is known as constructing the “proforma” balance sheet.  In addition to the changes to debt and equity, intangible assets such as goodwill and capitalized financing fees will likely be created.

The third, and typically most substantial step is to create an integrated cash flow model for the company.  In other words, to project the company’s income statement, balance sheet and cash flow statement for a period of time (say, five years).  The balance sheet must be projected based on the newly created proforma balance sheet.  Debt and interest must be projected based on the post-transaction debt.

Once the functioning model is created, we can make assumptions about the private equity firm’s exit from its investment.  For example, a typical assumption is that the company is sold after five years at the same implied EBITDA multiple at which the company was purchased.  Projecting a sale value for the company allows us to also calculate the value of the private equity firm’s equity stake which we can then use to analyze its internal rate of return (IRR).  Absent dividends or additional equity infusions, the IRR equals the average annual compounded rate at which the PE firm’s original equity investment grows (to its value at the exit).

While the private equity firm’s IRR is usually the most important piece of information that comes out of an LBO analysis, the analysis also has other uses.  By assuming the PE firm’s required IRR (amongst other things), we can back into a purchase price for the company, thus using the analysis for valuation purposes.  In addition, we can utilize the LBO model to analyze the trend of credit statistics (such as the leverage ratio and interest coverage ratio) which is especially important from a lender’s perspective.

QUESTION:

What factors can lead to the dilution of EPS in an acquisition?

ANSWER GIVEN:

A number of factors can cause an acquisition to be dilutive to the acquiror’s earnings per share (EPS), including: (1) the target has negative net income, (2) the target’s Price/Earnings ratio is greater than the acquiror’s, (3) the transaction creates a significant amount of intangible assets that must be amortized going forward, (4) increased interest expense due to new debt used to finance the transaction, (5) decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction and (6) low or negative synergies.

QUESTION:

If you are in a business that wants to preserve cash, what type of inventory accounting method would you use (LIFO or FIFO) in a time of rising prices, and why?

ANSWER GIVEN:

You would use LIFO because that would give you a higher cost of goods sold and would, thus, lower your pre-tax income and reduce the amount of taxes owed.  The sales prices would be the same anyway in order for this question to be reasonable so the determining factor is COGS.

QUESTION:

What is Minority Interest and why do we add it in the Enterprise Value formula?

ANSWER GIVEN:

When a company owns more than 50% of another company, U.S. 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 since the parent company does not 100% of the sub, the parent company will have a line item called minority interest on its income statement reflecting 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).  By doing 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. One might ask, instead of adding minority interest to Enterprise Value, why don’t we just subtract the portion of sales or EBITDA that the parent does NOT own.  In theory, this would indeed work and may in fact 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:

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

ANSWER GIVEN:

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, subtract Capex and add/subtract and decrease/increase in working capital. Next, you want to determine the appropriate discount rate for the cashflows, the WACC. The cost of debt is determined using the current yields on the company's existing debt issues (where bonds are trading) and tax affecting them. The cost of equity is generally determined by CAPM (ie risk-free rate plus 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 PV of the terminal value  Next, you would determine the PV of the free cash flows for the given period (dividing the cashflows 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:

Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?

ANSWER GIVEN:

Enterprise Value (EV) equals the value of the operations of the company attributable to all providers of capital.  That is to say, because EV incorporates all of both debt and equity, it is NOT dependant on the choice of capital structure (i.e. the percentage of debt and equity).  If we use EV in the numerator of our valuation metric, to be consistent (apples to apples) we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA.  These such metrics are also not dependant on capital structure because they do not include interest expense.  Operating metrics such as earnings do include interest and so are considered leveraged or capital structure dependant metrics.  Therefore EV/Earnings is an apples to oranges comparison and is considered inconsistent.  Similarly Price/EBITDA is inconsistent because Price (or equity value) is dependant on capital structure (levered) while EBITDA is unlevered.  Again, apples to oranges.  Price/Earnings is fine (apples to apples) because they are both levered.

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We cannot guarantee the authenticity of these questions nor the accuracy of the answers: they are what one candidate claims to have been asked by Goldman Sachs and have not been verified by the bank