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Wall Street Prep 2024(A+ GRADED)Questions With 100 % Verified Answers Assets - ANS resources a company uses to operate its business includes cash, A/R, PP&E Liabilities - ANS represents the company's contractual obligations and includes A/P, debt, accrued expenses Shareholder's equity - ANS is the residual the value of the business available to the owners (shareholders) after debts have been paid off Income statement - ANS illustrates the profitability of the company over a specified period of time broad sense: shows revenue-expenses Balance sheet - ANS snapshot of the company economic resources and funding for those resources at a given point in time (A = L + SE) Revenue - ANS "top-line" represents the sale of goods and services it is recorded when earned (even though cash might not have been received at the time of transaction) Expenses - ANS netted against revenue to arrive at net income COGS (directly associate with good production), SG&A (indirectly associated with production), interest expense (expense related to paying debt holders periodic payments), taxes, depreciation expense (non-cash expense accounting for the use of PP&E, often imbedded within COGS and SG&A) Net income - ANS "bottom- line" revenue-expenses the profitability available to common shareholder's after debt payments have been made (interest expense) if the company pays out dividends, we will see a cash outflow for stable, mature plain vanilla companies, there is not a preference for positive or negative cash flow in this section Net change in cash over period = - ANS cash from operating activities plus cash from investing activities plus cash from financing activities Why do capex increase assets (PP&E) while other cash outflows, like paying salary, taxes, etc do not create any asset, and instead create an expense on the income statement that reduces equity via retained earnings? - ANS Capital expenditures are capitalized because of the timing of their estimated benefits - the lemonade stand will benefit the firm for may years. The employee's work, on the other hand, benefits the period in which the wages are generated and only should be expensed then. This is what differentiates an asset from an expense. Walk through a cash flow statement. - ANS Start with net income, go line by line through major adjustments (depreciation, changes in working capital, and deferred taxes) to arrive at cash flow from operating activities Mention capex, asset sales, purchase of intangible assets, and purchase/sale of investment securities to arrive at cash flow from investing activities Mention repurchase/issuance of debt and equity and paying out dividends to arrive at cash flow from financing activities Adding cash flow from ops, investments and financing gets you total change in cash beginning of period cash balance plus change in cash allows you to arrive at end of period cash balance What is working capital? - ANS Working capital is defined as current assets minus current liabilities; it tells the financial statement user how much cash is tied up in the business through items such as receivables and inventories and also how much cash is going to be needed to pay off short term obligations in the next 12 months. Is it possible for a company to show positive cash flows but be in grave trouble? - ANS Absolutely. Two examples involve unsustainable improvements in working capital (a company is selling off inventory and delaying payables), and another example involves lack of revenues going forward.in the pipeline How is it possible for a company to show positive net income but go bankrupt? - ANS Two examples include deterioration of working capital (i.e. increasing accounts receivable, lowering accounts payable), and financial shenanigans. I buy a piece of equipment, walk me through the impact on the 3 financial statements. - ANS Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement) Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement). Why are increases in accounts receivable a cash reduction on the cash flow statement? - ANS Since our cash flow statement starts with net income, an increase in accounts receivable is an adjustment to net income to reflect the fact that the company never actually received those funds. How is the income statement linked to the balance sheet? - ANS Net income flows into retained earnings. What is goodwill? - ANS Goodwill is an asset that captures excess of the purchase price over fair market value of an acquired business. Let's walk through the following example: Acquirer buys Target for $500m in cash. Target has 1 asset: PPE with book value of $100, debt of $50m, and equity of $50m = book value (A-L) of $50m. Acquirer records cash decline of $500 to finance acquisition Acquirer's PP&E increases by $100m Acquirer's debt increases by $50m Acquirer records goodwill of $450m What is a deferred tax liability and why might one be created? - ANS Deferred tax liability is a tax expense amount reported on a company's income statement that is not actually paid to the IRS in that time period, but is expected to be paid in the future. It arises because when a company actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in depreciation expense between book reporting (GAAP) and IRS reporting can lead to differences in income between the two, which ultimately leads to differences in tax expense reported in the financial statements and taxes payable to the IRS. What is a deferred tax asset and why might one be created? - ANS Deferred tax asset arises when a company actually pays more in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in revenue recognition, expense recognition (such as warranty expense), and net operating losses (NOLs) can create deferred tax assets. Walk me through 3 financial statements. - ANS The three financial statements are the income statement, balance sheet, and statement of cash flows. The income statement is a statement that illustrates the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year. Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity. Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating. Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year." How are the financial statements linked together? - ANS The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement. In terms of the balance sheet, net income flows into stockholder's equity via retained earnings. Retained earnings is equal to the previous period's retained earnings plus net income from this period less dividends from this period. In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period. "Why is the cash flow statement important and how does it compare to the income statement?" - ANS The income statement shows a company's accounting-based profitability. It illustrates a company's revenues, expenses, and net income. Income statement accounting uses what is called accrual accounting. Accrual accounting requires that businesses record revenue when earned and expenses when incurred. "Company A has $100 of assets while company B has $200 of assets. Which company should have a higher value?" - ANS On the face of it, we simply don't have enough information to answer this question. We need certain efficiency and profitability ratios to understand how the companies are using assets to generate revenues. You: Given that we only know the total amount of assets for both company A and B and nothing else, it is impossible to say whether A or B is more valuable. Would I be able to ask you some questions about both companies? Interviewer: Sure You: Would you be able to tell me what industry these two companies operate in? Interviewer: They are both consumer products companies. You: Can I assume that both companies have similar expected asset turnover (revenue/assets), leverage, return on asset, re-investment rates and profit margins? Interviewer: Yes, let's assume this is correct. You: Okay, thank you. Based on this information, it appears that we are comparing two companies with similar returns on capital, long term growth rates, and costs of capital. Since these elements are the primary drivers of value for a business, as long as both companies generate returns above their cost of capital, the firm with the larger assets deserves a higher valuation because they are both effectively "converting" their assets into profitability with equal efficiency, given similar risks and expected growth. How do you value a company? - ANS Intrinsic value (DCF): This approach is the more academically respected approach. The DCF says that the value of a productive asset equals the present value of its cash flows. The answer should run along the line of "project free cash flows for 5-20 years, depending on the availability and reliability of information, and then calculate a terminal value. Discount both the free cash flow projections and terminal value by an appropriate cost of capital (weighted average cost of capital for unlevered DCF and cost of equity for levered DCF). In an unlevered DCF (the more common approach) this will yield the company's enterprise value (aka firm and transaction value), from which we need to subtract net debt to arrive at equity value. Divide equity value by diluted shares outstanding to arrive at equity value per share. Relative valuation (Multiples): The second approach involves determining a comparable peer group - companies that are in the same industry with similar operational, growth, risk, and return on capital characteristics. Truly identical companies of course do not exist, but you should attempt to find as close to comparable companies as possible. Calculate appropriate industry multiples. Apply the median of these multiples on the relevant operating metric of the target company to arrive at a valuation. Common multiples are EV/Rev, EV/EBITDA, P/E, P/Book, although some industries place more emphasis on some multiples vs. others, while other industries use different valuation multiples altogether. It is not a bad idea to research an industry or two (the easiest way is to read an industry report by a sell- side analyst) before the interview to anticipate a follow-up question like "tell me about a particular industry you are interested in and the valuation multiples commonly used." What is the appropriate discount rate to use in an unlevered DCF analysis? - ANS Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to think of unlevered cash flows as the company's cash flows as if it had no debt - so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital (both debt and equity). The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate. Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market (see WSP's DCF module for a detailed analysis of calculating the cost of equity). What is typically higher - the cost of debt or the cost of equity? - ANS The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation. How do you calculate the cost of equity? - ANS There are several competing models for estimating the cost of equity, however, the capital asset pricing model (CAPM) is predominantly used on the street. The CAPM links the expected return of a security to its sensitivity the overall market basket (often proxied using the S&P 500). The formula is: Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf ) Risk free rate: The risk free rate should theoretically reflect yield to maturity of a default-free government bonds of equivalent maturity to the duration of each cash flows being discounted. In practice, lack of liquidity in long term bonds have made the current yield on 10-year U.S. Treasury bonds as the preferred proxy for the risk- free rate for US companies. Market risk premium: The market risk premium (rm-rf) represents the excess returns of investing in stocks over the risk free rate. Practitioners often use the historical excess returns method, and compare historical spreads between S&P 500 returns and the yield on 10 year treasury bonds. Beta (β): Beta provides a method to estimate the degree of an asset's systematic (non-diversifiable) risk. Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market. A company whose equity has a beta of 1.0 is "as risky" as the