Accounting - "Talking" (copy/test)

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1. Walk me through the 3 financial statements & how they generally work

   Not measured yet
   • There are three statements: the Income Statement for profitability over a period, the Balance Sheet for a snapshot of resources and funding at a point in time, and the Cash Flow Statement for liquidity — how cash moves●●○○○
   • The Income Statement runs from Revenue, less COGS to gross profit, less operating expenses, then interest and taxes, down to Net Income●●○○○
   • The Balance Sheet lists Assets on one side and Liabilities plus Shareholders' Equity on the other, and the two sides must always balance: Assets = Liabilities + Equity●●●○○
   • Assets are the resources the company controls, while Liabilities and Equity are the funding sources — like debt, payables, retained earnings, and paid-in capital — that paid for them●●●○○
   • The Cash Flow Statement starts with Net Income and adjusts for non-cash items like D&A and changes in working capital in the operating section●●●○○
   • The investing section captures capital expenditures and asset sales; the financing section captures debt raised or repaid, equity issued, and dividends●●●○○
   • The bottom line of the Cash Flow Statement is the net change in cash, which explains the movement in the cash balance on the Balance Sheet●●●○○
   • Net Income links the statements: it flows into retained earnings on the Balance Sheet and sits at the top of the Cash Flow Statement, so a change in one ripples through all three●●●●○

2. How do the three statements link together?

   Not measured yet
   • The three statements link in four ways.●●●●○
   • Net Income from the Income Statement flows into Retained Earnings within Shareholders' Equity on the Balance Sheet, after any dividends are paid.●○○○○
   • Net Income is the starting line of the Cash Flow Statement.●○○○○
   • Changes in short-term Balance Sheet items — receivables, inventory, payables — appear as working capital adjustments in the CFS operating section.●○○○○
   • A build-up in receivables is cash not yet collected, so it is subtracted from operating cash flow — direction matters in working capital.●●●●○
   • The CFS investing and financing activities drive Balance Sheet items: CapEx increases PP&E net of depreciation, debt raised or repaid changes the debt balance, and equity issuance or dividends change Shareholders' Equity.●●○○○
   • Ending cash equals beginning cash plus the net change in cash from the three CFS sections, and that ending cash is the cash line reported on the Balance Sheet — that is how the statements tie back together.●●○○○
   • Net Income and operating cash flow differ because accrual items with no cash effect — receivables, payables, and non-cash charges — are added back or subtracted in the CFS operating section.●●●○○

3. Walk me through the income statement

   Not measured yet
   • The income statement measures profitability over a period and is walked top to bottom through a series of subtotals●○○○○
   • Revenue is the top line — everything the company earned from selling its goods or services — and subtracting Cost of Goods Sold, the direct costs of producing what was sold, gives Gross Profit●●●○○
   • Gross Profit shows how profitable the core product is before any overhead●●●○○
   • Gross profit less operating expenses — SG&A like sales, marketing, and administrative costs plus depreciation and amortization — gives EBIT, the operating profit●●●○○
   • One line up, adding D&A back to EBIT gives EBITDA, a proxy for cash operating earnings that removes the non-cash depreciation charge●●●○○
   • Below EBIT, subtract interest expense — the cost of debt — and then apply taxes to pre-tax income: Net Income equals pre-tax income times one minus the tax rate●●●○○
   • Net Income is the bottom line of the income statement●○○○○
   • Net Income flows into retained earnings on the balance sheet and into the top of the cash flow statement●●○○○

4. Give me more details on assets, liabilities, and equity

   Not measured yet
   • Assets, liabilities, and equity are the three building blocks of the balance sheet, tied together by the accounting equation Assets = Liabilities + Equity.●○○○○
   • Assets are resources the company controls that are expected to bring positive monetary benefits, i.e. future cash inflows — directly, like cash and receivables, or indirectly, like inventory to be sold or PP&E that supports production.●●○○○
   • Liabilities are unsettled obligations to outside parties that represent future cash outflows, such as paying down debt and settling payables.●○○○○
   • Liabilities are also an external source of capital — lenders and suppliers effectively help fund the company's assets.●●●●○
   • Equity is the owners' claim: capital invested by shareholders plus internally generated retained earnings, which are profits kept rather than paid out as dividends.●○○○○
   • Equity is a residual — whatever is left of the assets after liabilities are settled — which is why it's called net assets.●●○○○

5. Walk me through the cash flow statement

   Not measured yet
   • The cash flow statement tracks the actual movement of cash over a period and, under the indirect method, is built in three sections: operating, investing, and financing●●●○○
   • Operating activities start with Net Income from the income statement, add back non-cash charges like D&A, and adjust for changes in operating working capital●●●●○
   • Working capital direction matters: rising receivables or inventory use cash, rising payables provides cash●●●○○
   • Investing activities are mainly CapEx — cash spent on PP&E — plus asset sale proceeds●●●○○
   • Financing activities include cash raised from issuing debt or equity and cash returned via debt repayment, share buybacks, or dividends●●○○○
   • Adding the net change in cash to the beginning cash balance gives ending cash, which ties to the balance sheet●●●○○

6. Which statement is most important?

   Not measured yet
   • The cash flow statement is the most important statement because it tracks actual cash moving in and out of the business●●○○○
   • The cash flow statement shows the company's real liquidity and financial health — whether the company can actually pay its bills●●●●○
   • Net income is built on accruals: accrual accounting books revenue when earned, so reported profit can sit in accounts receivable rather than arriving as cash●●●●○
   • If those receivables never convert to cash, the reported profit is meaningless — a company can be profitable on paper with revenue mostly tied up in receivables, which is a warning sign on earnings quality●●●○○
   • The cash flow statement cuts through accrual distortions because cash flow is a direct measure — it records cash in versus cash out — so it is harder to manipulate than accrual-based net income●●●●○
   • The cash flow statement tells you whether the business can survive, because claims on the company — debt service, payroll, investment — are all paid in cash, not in reported earnings●●●●○
   • The cash flow statement tells you whether the business can service its debt●●●○○
   • The cash flow statement tells you whether the business can invest●●●○○

7. Why GAAP is important?

   Not measured yet
   • GAAP is the standardized set of accounting rules governing how US companies prepare their financial statements●●●○○
   • Every company follows the same rules — for example on revenue recognition and expense matching — so the numbers are prepared on a consistent, comparable basis●●●○○
   • GAAP keeps financials fair by stopping a company from presenting results in whatever flattering way it prefers, so statements give an honest rather than managed picture●●○○○
   • Because financial documents are prepared on a comparable basis, investors can pick up the statements of any two companies and evaluate and compare them directly, without untangling each firm's idiosyncratic accounting choices●●●○○
   • Comparable, trustworthy numbers are what let capital markets price companies and allocate capital efficiently●●○○○
   • The discipline runs inside the company too: reporting consistently under GAAP over time gives management genuine insight into its own practices and performance●●●○○

8. Explain the conservatism principle in accrual accounting

   Not measured yet
   • Conservatism says that when two accounting treatments are acceptable, you pick the one least likely to overstate the company's financial position●○○○○
   • Revenue and assets are recognized only with verifiable evidence of occurrence — you never anticipate gains●●○○○
   • Probable losses and liabilities are recorded as soon as they are reasonably estimable, even before they are certain●●○○○
   • Probable losses and liabilities must be estimable with sufficient reliability — an estimate must be reasonably quantifiable, not merely mentioned as a possibility, before the loss is booked●●●●○
   • The result is a deliberate downward bias: better to understate revenue and assets than risk overstating them●●○○○
   • The rationale is that statement users are hurt far more by rosy numbers that prove wrong than by conservative ones●●●○○
   • Conservatism does not mean deliberately understating everything: the asymmetry is that it only biases toward caution where outcomes are uncertain, not for certain or verifiable amounts●●●●○
   • Examples include writing inventory down to lower of cost or market and booking probable litigation liabilities early●●●○○
   • Applying conservatism to a specific item requires that the loss or liability already exist or be probable, not that it merely could occur in the future●●●●○

9. Why is fair value accounting used?

   Not measured yet
   • Fair value accounting records assets and liabilities at their current market value rather than their historical cost●○○○○
   • Fair value accounting keeps the balance sheet figures current, instead of showing values that are years out of date●○○○○
   • Fair value accounting marks illiquid securities to market rather than carrying them at stale values●●●○○
   • Without marking, a deteriorating security sits at its old value and the loss stays invisible to investors●●●●○
   • Hidden losses eventually get recognized in sudden write-downs, and a wave of them can collapse confidence and the market●●●○○
   • Marking to market makes value declines surface gradually and visibly while they are small●●●●○
   • The 2008 crisis showed that unmarked losses can accumulate unseen and then trigger sudden write-downs when finally recognized●●●●○
   • Fair value accounting reflects current market prices so that asset values stay comparable across firms and periods●○○○○

10. Why know difference between IFRS & US GAAP?

    Not measured yet
    • IFRS and US GAAP are the two dominant accounting frameworks — IFRS is used by most countries internationally, while US GAAP governs US-listed companies●●○○○
    • IFRS bans LIFO for inventory, allows capitalization of development costs that US GAAP expenses, permits reversal of impairment losses, and is generally more principles-based where US GAAP is more rules-based●●●○○
    • Knowledge of framework differences matters because the same company can look different under IFRS than under US GAAP●●○○○
    • In cross-border M&A, acquirer and target statements reported under different frameworks cannot be compared until converted to a common basis, because you cannot honestly compare margins, asset values, or earnings until you know which adjustments the conversion requires●●●●○
    • For a multinational and its subsidiaries, parent and subsidiary statements reported under different frameworks cannot be consolidated or compared until converted to a common basis●●●●○
    • Framework differences matter most when statements cross accounting borders, so an analyst must know the framework behind reported numbers to interpret them correctly●●○○○
    • The relevance of knowing IFRS vs US GAAP keeps growing due to globalization, as investors increasingly seek geographic diversification of their portfolios and more analysis crosses accounting borders●●●○○

11. Above vs Below the Line

    Not measured yet
    • Above vs below the line is an income statement distinction, with the 'line' drawn at operating income●●●○○
    • Above the line are the operating items: revenue, cost of goods sold, and operating expenses that produce operating income●●●○○
    • Above-the-line items are core and recurring — they drive the business's taxable operating results●●●●○
    • Below the line are the non-operating items: interest income and expense, gains or losses on asset sales, and taxes●●●○○
    • The split matters because it separates recurring operating performance from financing costs and one-off items●○○○○
    • Analysts read above the line to judge the core business's recurring operating performance●●●○○
    • Analysts read below the line to see how financing costs and non-core, one-off events change what reaches net income●●●○○

12. How can a profitable firm go bankrupt?

    Not measured yet
    • Profit is an accounting measure — revenue exceeds expenses on an accrual income statement●○○○○
    • Bankruptcy is triggered by failing to pay debts as they come due, which is a cash question, not an earnings question●●●○○
    • Revenue is booked on accrual when earned, so the income statement can show revenue from a sale for which the customer has not yet paid any cash●●●●●
    • If the firm is ineffective at collecting from customers, cash inflows lag while payroll, suppliers, interest, and debt principal come due on fixed dates●●●●●
    • The firm has no cash on the dates its payments fall due●●○○○
    • Missing a scheduled payment on debt principal or interest lets creditors demand immediate repayment or force involuntary bankruptcy, which is what actually converts a profitable-on-paper firm into a bankrupt one●●○○○

13. What is the difference between EBIT and operating profit?

    Not measured yet
    • EBIT is earnings before interest and taxes.●○○○○
    • Operating profit is revenue minus COGS and operating expenses.●●○○○
    • In most companies, EBIT and operating profit are the same number.●○○○○
    • Operating profit is constructed strictly top-down from the core business, so it contains only core operating items.●●●○○
    • EBIT is usually derived bottom-up from net income by adding back interest and taxes.●●●●●
    • The bottom-up EBIT derivation can sweep in non-operating items like a loss on the sale of equipment, so EBIT can be distorted by non-core items the add-back catches.●●●○○
    • When EBIT and operating profit diverge, operating profit is the stricter, cleaner measure of core performance.●●○○○

14. What is a DTL?

    Not measured yet
    • A DTL stands for deferred tax liability, a balance sheet item representing income taxes the company will owe in future periods●○○○○
    • A deferred tax liability arises when the income tax expense reported on the income statement is lower than the cash taxes actually paid to the tax authority in the same period●●●●○
    • The gap between book tax expense and cash taxes comes from temporary differences between financial accounting rules and tax rules●●○○○
    • A deferred tax liability means the company defers part of its tax bill rather than avoiding it●●○○○
    • The classic example is depreciation: a company uses straight-line depreciation on its books but accelerated depreciation for tax purposes●●●○○
    • In the early years of an accelerated-depreciation asset, the reported tax expense and the cash taxes paid diverge, and the difference is booked as a deferred tax liability●●●●○
    • The deferred tax liability reverses over time as the depreciation schedules cross, and the company pays the previously deferred taxes in later periods●●○○○

15. What are some ratios used to perform credit analyses?

    Not measured yet
    • Credit analysis uses ratios to judge a borrower's ability to service and repay debt.●○○○○
    • Liquidity ratios — current, quick, and cash — measure whether short-term assets cover near-term obligations.●●○○○
    • Leverage ratios — debt-to-EBITDA, debt-to-assets, debt-to-equity — measure how heavily the company is financed with debt.●●○○○
    • Coverage ratios — times interest earned, EBITDA interest coverage, debt service coverage, fixed charge coverage — measure the cushion of earnings or cash flow over required debt payments.●●○○○
    • Profitability ratios — gross, operating, and net margins, plus ROE, ROA, and ROIC — measure whether the business generates returns strong enough to support its debt over time.●○○○○
    • Credit ratios are grouped into four families: liquidity, leverage, coverage, and profitability.●●●●○

16. How would share issuance affect EPS?

    Not measured yet
    • EPS equals net income divided by shares outstanding, usually the weighted-average diluted share count.●●○○○
    • Issuing new shares increases the number of shares in the EPS denominator, without adding to net income at the moment of issuance.●●●○○
    • Because the share count rises while earnings stay the same, the same net income is spread over more shares.●●●●○
    • Share issuance decreases EPS by increasing the denominator while the numerator is unchanged.●●●○○
    • The reduction in EPS caused by spreading unchanged earnings over more shares is called dilution, which is why share issuance is described as dilutive.●●○○○

17. If a company continuously incurs goodwill impairment, what can you take away?

    Not measured yet
    • Goodwill is the premium paid above the fair value of an acquisition's net assets; once booked it sits on the balance sheet unchanged unless impaired.●●●○○
    • An impairment means the acquired business's expected future cash flows no longer support the price paid, so management writes the premium down.●●○○○
    • A single impairment can be bad luck — genuinely unforeseen circumstances such as a market shock or a regulatory change can hit any deal.●●●●●
    • Continuous impairments are a pattern, and a pattern points to the buyer: the company systematically overpaid at acquisition rather than suffering one unlucky deal.●●●●○
    • The pattern suggests the company never correctly understood how the acquired company would contribute to its operations, and management keeps justifying prices the businesses cannot deliver.●●●●○
    • Continuous impairments flag a due diligence and capital allocation problem.●○○○○
    • Continuous impairments say more about the buyer's deal judgment than about the acquired business.●●○○○

18. **How do finance and operating leases work? ****How does it affect equity value/EV?

    Not measured yet
    • At inception a lease is capitalized as a right-of-use asset equal to the present value of future lease payments, with a matching lease liability.●●●○○
    • Under IFRS every lease is treated like a finance lease: the right-of-use asset is depreciated straight-line over the lease term, and each payment is split into interest expense and principal paydown.●●○○○
    • US GAAP finance leases are treated exactly the same way as IFRS leases — straight-line depreciation on the asset plus interest and principal on the liability.●●●○○
    • US GAAP operating leases set the right-of-use asset's depreciation equal to the liability's principal paydown, so the two pieces net to a constant single lease expense.●●●●○
    • Because straight-line depreciation and the liability's amortization don't track each other, the liability balance will not equal the asset balance.●●●○○
    • In the US, depreciation happening to equal principal paydown makes the mismatch harmless, but in other regimes where they diverge it can be problematic.●●●○○
    • Because the expense is split into interest and depreciation, EBITDA no longer bears the lease cost, so the liability is added as debt-like in the equity-to-EV bridge.●●●○○
    • Depreciation is added back as non-cash, but the liability itself must also be added to EV — adding only one side creates a mismatch.●●●○○
    • In a DCF the simplest treatment keeps leases out of the capital structure, with the lease payment as a normal operating expense in FCF — unlike the income statement treatment where it is split.●●●○○

19. What is restricted cash?

    Not measured yet
    • Restricted cash is cash the company holds but cannot use for general purposes because it is earmarked for a specific use.●○○○○
    • Typical examples include escrow accounts, debt service or collateral requirements, acquisition reserves, and lender-required compensating balances.●●●●○
    • Restricted cash is presented separately from unrestricted cash, classified as current or non-current based on when the restriction expires.●●●●○

20. Why are some assets exempt from the historical cost principle?

    Not measured yet
    • The historical cost principle records assets at the price the company originally paid for them.●●●○○
    • Some assets are exempt because their current market price reflects their true economic value better than the old purchase price.●●●○○
    • Some assets are exempt because the cash they are expected to be realized for reflects their true economic value better than the old purchase price.●●●○○
    • Once market prices move, the original cost no longer tells users what the asset is actually worth, so the exemption preserves relevance.●●●○○
    • The exemption applies only where those values are reliably observable, so the balance sheet stays both relevant and objective.●●●●○
    • Marketable securities are carried at fair value.●●●○○
    • Derivatives are carried at fair value.●●●○○
    • Assets held for sale are carried at fair value.●●●○○
    • These assets are carried at fair value because they will be realized at market prices.●●●●○

21. Why are intangible assets not in the balance sheet?

    Not measured yet
    • Intangible assets are non-physical resources such as brand value, patents, and customer relationships●○○○○
    • Internally generated intangibles have no arm's-length transaction to establish value, so any value management asserts would be a subjective guess with no independent evidence for auditors to verify●●●●●
    • Accounting standards require an asset's value to be reliably measurable, and internally generated intangibles fail that test, so they are expensed as they are created rather than capitalized●●●○○
    • Goodwill and identifiable intangibles obtained through M&A appear on the balance sheet, while internally built equivalents do not●●●●○
    • For acquired intangibles, the purchase price is an observable, third-party-verified value●●●○○
    • The payoff: balance sheets understate companies rich in internally created IP, so their market value often far exceeds book value●●●○○

22. Why do we use the historical cost principle?

    Not measured yet
    • The historical cost principle records assets at their original purchase price●○○○○
    • The original price is objective and verifiable through invoices and contracts●●○○○
    • Current valuations are not objectively verifiable in the way original purchase prices are, because a current value is an estimate someone has to make, not a recorded transaction price●●●○○
    • Revaluing assets every period would make earnings and equity swing with market prices, exposing the financial statements to constant price volatility●●○○○
    • Those market price movements have nothing to do with how the business actually performed, so the reported numbers would reflect speculation rather than the company's actual operations●●●●○
    • Historical cost is conservative: gains are recognized reluctantly — assets aren't marked up on optimistic forecasts●●●○○
    • Losses are recognized promptly: values are written down as soon as impairment is evident●●●●○
    • The trade-off is relevance: in inflationary times the balance sheet can understate what assets are actually worth today●●●○○
    • We accept this loss of relevance in exchange for reliable, stable, verifiable numbers●●○○○

23. What are non-recurring items? What do we generally do with them?

    Not measured yet
    • Non-recurring items are one-off charges or gains not expected to repeat as part of running the business●●○○○
    • Common examples include restructuring charges and inventory write-downs, plus impairments, litigation settlements, and asset sale gains or losses●●○○○
    • Non-recurring items distort a single period's reported earnings, making the underlying business look better or worse than it really performed in that period●●○○○
    • A one-time gain inflates a single period's earnings above the level the core business can sustain●●●○○
    • A one-time charge depresses a single period's earnings below the level the core business can sustain●●●○○
    • When comparing companies, analysts add non-recurring items back to get normalized earnings, because they aren't part of core operations and don't reflect sustainable earnings power●○○○○
    • Analysts add back non-recurring items rather than carrying them forward, because only core operations generate earnings that will persist into future periods●●●○○
    • Caution: if costs labeled one-off recur every year, they are really core costs and should not be added back●●●○○

24. What is the difference between organic vs inorganic growth?

    Not measured yet
    • Both terms describe where a company's growth comes from: organic growth is generated from within the company's own operations, while inorganic growth comes from external M&A transactions — buying other companies. The key difference is the source of the growth, internal operations versus external transactions.●●●○○
    • Organic growth examples: boosting internal efficiency, expanding business operations into new regions or capacity, and improving the product mix toward higher-margin offerings.●●●○○
    • Inorganic growth adds the acquired companies' revenue, market share, or capabilities.●●●○○
    • The source difference drives the trade-off between organic and inorganic growth: organic growth is slower, but the company controls it fully and carries no integration risk and no price paid for someone else's business.●●○○○
    • Inorganic growth is much faster — an acquisition instantly adds revenue and market share — but it carries integration risk, valuation risk on the price paid, and potential culture clashes.●●●●○
    • Organic growth is typically viewed as higher quality and more sustainable, while inorganic growth only creates value if the integration succeeds.●●●○○

25. How does CapEx & depreciation shift for mature vs new companies?

    Not measured yet
    • CapEx is cash spent on long-lived assets, and depreciation spreads each asset's cost over its useful life.●●○○○
    • New companies show high CapEx because they're building out capacity, but low depreciation because their asset base is young.●●●○○
    • Mature companies' CapEx falls to maintenance level, just enough to sustain existing capacity rather than expand it.●●●○○
    • Mature companies carry a large asset base accumulated over years of past investment, so their ongoing depreciation charge stays high even after growth CapEx stops.●●●●●
    • In mature companies, CapEx at or below depreciation makes reported earnings roughly approximate free cash flow.●●●○○
    • In mature companies with CapEx below depreciation, free cash flow exceeds reported earnings because the non-cash depreciation add-back exceeds cash reinvestment.●●●○○
    • Growth companies have a high CapEx-to-depreciation ratio — CapEx well above depreciation — because reinvestment outruns the depreciation on their still-young asset base.●●●○○
    • Growth companies look cash-poor and free-cash-flow negative despite reported profits, because heavy reinvestment absorbs the earnings that mature companies convert to cash.●●●○○

26. What is working capital?

    Not measured yet
    • Working capital is defined as current assets minus current liabilities●●●●○
    • Working capital measures short-term liquidity — whether the company can cover obligations coming due within a year●●○○○
    • Current assets include items like cash, accounts receivable, and inventory●●●●●
    • Current liabilities include accounts payable, accruals, and short-term debt●●●○○
    • Positive working capital signals the company can pay near-term obligations without new financing; negative can signal liquidity strain●○○○○
    • Negative working capital isn't always bad — businesses that collect from customers before paying suppliers can run efficiently that way●●●○○

27. Why are effective & marginal tax rates often different? Can you give specific examples on why they might differ?

    Not measured yet
    • The effective tax rate is total tax expense divided by pre-tax accounting income, so it reflects the company's specific tax situation rather than the statutory rate●●○○○
    • The marginal rate is simply the statutory rate applied to the next dollar of income, and it governs decisions about incremental income●●○○○
    • Deductions and credits like R&D credits, interest deductibility, and accelerated depreciation pull the effective rate below the statutory rate●●●○○
    • Income taxed at preferential rates, like long-term capital gains, lowers the effective rate●●○○○
    • Non-deductible expenses such as fines and certain meals and entertainment cause the effective rate to exceed the marginal statutory rate●●●●○
    • Timing differences like deferred taxes can make the effective rate in a given year diverge from the long-run rate●●●○○
    • Income earned across jurisdictions at different statutory rates blends into a single effective rate●●●○○
    • The effective rate is what the company actually bears, so the gap between the marginal and effective rates maps the company's specific tax advantages and disadvantages●●●○○

28. What are some ways/metrics to compare companies?

    Not measured yet
    • There are six main lenses for comparing companies: location, growth, size, profitability and revenue, debt and capital structure, and industry-specific metrics●●○○○
    • Location is a comparison lens because regulatory environments differ by geography●●●●○
    • Location matters because economic exposure differs by geography●●●○○
    • Location matters because growth potential differs by geography●●●○○
    • The second lens is growth metrics, including historical revenue growth and projected revenue growth●●○○○
    • The third lens is size, measured by equity value and enterprise value, which tells you whether you're comparing a large-cap against a small-cap●○○○○
    • The fourth lens is profitability and revenue metrics, including gross margin, EBITDA margin, net margin, and absolute revenue●○○○○
    • The fifth lens is debt and capital structure, measured by leverage ratios such as debt-to-EBITDA and interest coverage●○○○○
    • The sixth lens is industry-specific metrics, such as LTV and CAC for B2C SaaS and same-store sales for retail●○○○○

29. Walk me through a DCF

    Not measured yet
    • A DCF values a company as the present value of the cash flows it will generate in the future●●●○○
    • DCF step 1 is projecting unlevered free cash flow — cash flow before financing, available to all capital providers — over an explicit 5-10 year forecast period●●●○○
    • Projected UFCF is built from revenue, EBIT, taxes, D&A, working capital changes, and capex●●●○○
    • DCF step 2 is calculating terminal value, which captures the value of all cash flows beyond the explicit forecast period●●○○○
    • Terminal value can be estimated by the perpetuity growth method, applying a long-run growth rate to the final-year cash flow●●○○○
    • Terminal value can also be estimated by the exit multiple method, applying a multiple to the final year's metric (e.g., EBITDA)●●●●○
    • DCF step 3 discounts both the forecast-period cash flows and the terminal value to present value using the weighted average cost of capital●●○○○
    • DCF step 4 goes from enterprise value to equity value by subtracting net debt and other senior claims and adding back non-operating assets like excess cash●●●○○
    • The final DCF steps divide equity value by diluted shares to get intrinsic value per share, then flex key assumptions in a sensitivity analysis to produce a range of implied values rather than a single number●●○○○

30. Conceptually, what does the discount rate represent?

    Not measured yet
    • The discount rate is the return an investor requires on an investment given its risk profile.●●○○○
    • The discount rate represents the opportunity cost of investing in a given asset versus an alternative of similar risk.●●●○○
    • The discount rate embeds the time value of money: a dollar today can earn a return, so future dollars are worth less today.●●○○○
    • The discount rate embeds a risk premium: riskier cash flows demand more compensation for the chance they don't materialize.●●●●○
    • A higher discount rate is applied to cash flows that are riskier.●●●○○
    • A higher discount rate makes future cash flows worth less in present value terms.●●●○○
    • In a DCF, unlevered free cash flows are discounted at the weighted average cost of capital because that rate reflects the blended required returns of both debt and equity providers.●●●○○

31. What is the difference between Unlevered & Levered DCF? What are the discount rates used for?

    Not measured yet
    • Unlevered DCF discounts free cash flow before any financing effects, so it values the whole firm and lands on enterprise value.●●○○○
    • Unlevered free cash flow excludes interest expense and debt repayments because it represents cash available to all capital providers.●●●○○
    • Because unlevered FCF belongs to the whole capital structure, it is discounted at WACC, the blended cost of debt and equity.●●○○○
    • From the unlevered DCF's enterprise value, you subtract net debt to bridge to equity value.●●●○○
    • Levered DCF discounts cash flows after interest expense and mandatory debt repayments, so it lands directly on equity value with no net debt bridge.●○○○○
    • Levered free cash flow is available only to shareholders, so the correct discount rate is the cost of equity alone — pairing it with WACC would double-count debt.●●○○○
    • The deciding difference is perspective: unlevered values the firm via enterprise value and backs into equity, levered values equity directly.●●○○○

32. How do you determine the risk-free rate?

    Not measured yet
    • The risk-free rate is the return on an investment with zero default risk, and it anchors every other rate in the DCF.●○○○○
    • Theoretically the risk-free rate is the yield to maturity of default-free government bonds, not a single universal number.●●●○○
    • Each discounted cash flow should in theory use a government bond whose maturity matches that cash flow's duration — the rate is horizon-specific, not one rate for the whole valuation.●●○○○
    • A year-3 cash flow is discounted at the 3-year default-free rate, and so on.●●●●○
    • Matched-maturity rates are unusable in practice because long-dated government bonds trade thinly.●●●●○
    • Practitioners therefore default to the 10-year Treasury yield as the proxy risk-free rate, since that market is the deepest and most liquid benchmark.●●●○○
    • That 10-year Treasury yield is the number plugged into CAPM as the risk-free rate, i.e. the rate that actually enters the cost of equity.●○○○○

33. What effect does a low interest-rate environment have on DCF valuations?

    Not measured yet
    • A DCF valuation is the present value of future cash flows after stripping out the return investors demand for time and risk.●●○○○
    • The risk-free rate is a direct input into WACC through the CAPM-built cost of equity, so it moves the entire discount rate.●●●○○
    • In a low-rate environment the risk-free rate falls, pulling WACC and other discount rates down.●●●○○
    • Holding the cash-flow forecast unchanged, a lower discount rate mechanically raises the DCF valuation; the increase is a discounting effect, not an assumption that the low-rate environment also changes projected cash flows.●●○○○
    • A lower discount rate raises the discount factor applied to each future cash flow, so less value is stripped away in discounting.●●●●○
    • Because the terminal value dominates a DCF and is discounted hardest, lower rates lift valuation most where terminal value weights are large.●●●○○

34. Define the equity risk premium used in the CAPM formula.

    Not measured yet
    • The equity risk premium is the additional return investors demand for holding stocks instead of risk-free government securities.●○○○○
    • In the CAPM formula, the equity risk premium is the market's expected return minus the risk-free rate.●●●○○
    • That market equity risk premium spread is then scaled by the stock's beta to produce the stock-specific risk premium added on top of the risk-free rate.●●○○○
    • The equity risk premium is the price of taking on equity risk: it is the extra compensation investors require for bearing nondiversifiable market risk.●●○○○
    • The equity risk premium exists because shareholders are residual claimants who are paid last, so they must be paid extra to accept equity risk.●●●○○
    • The equity risk premium is measured from broad market history rather than from any single company — it is a market-wide figure.●●●○○
    • Historically the equity risk premium has run around 4 to 6 percent, and that 4–6% range is what practitioners typically plug into CAPM when building a cost of equity.●●●○○

35. Explain the concept of beta.

    Not measured yet
    • Beta measures a stock's systematic risk — the portion of risk that cannot be diversified away — relative to the broader market.●○○○○
    • It is the slope of the linear regression of the security's returns against market returns — how the stock co-moves with the market.●●●○○
    • A beta of 1.0 means the stock's returns are expected to be consistent with overall market returns.●●●○○
    • With a beta of 1.0, a 10% market rise implies a roughly 10% return on the stock.●●●○○
    • A beta above 1.0 amplifies market moves — a beta of 1.5 turns a 10% market move into roughly a 15% stock move.●●○○○
    • A beta between 0 and 1 means the stock moves with the market but less than proportionally.●●○○○
    • A negative beta means the stock moves inversely to the market, rising when the market falls.●●●○○
    • Beta covers only systematic risk because firm-specific risk can be diversified away, and investors aren't paid for risk they can eliminate.●●○○○

36. What is the difference between systematic risk and unsystematic risk?

    Not measured yet
    • Systematic risk is market-wide risk — rates, recessions, macro shocks — that moves every security together●●○○○
    • Because systematic risk is undiversifiable, it is priced: the market compensates investors with a risk premium in expected returns only for this component of a security's volatility●●○○○
    • Systematic risk cannot be diversified away because no portfolio of stocks escapes market-wide movements●●○○○
    • Unsystematic risk is company- or industry-specific, like a product recall or a key executive leaving●○○○○
    • Unsystematic risk is diversifiable: in a large portfolio, idiosyncratic bad events at one holding are offset by idiosyncratic good events at others, so its contribution to portfolio volatility shrinks toward zero●●○○○
    • Because unsystematic risk can be eliminated for free by holding a diversified portfolio, the market pays no extra expected return for bearing it●●●○○
    • Total volatility decomposes into a priced systematic component and an unpriced unsystematic component: an investor holding only one stock bears both, but a diversified investor bears only the systematic part●●●○○

37. ** (THINK) Does a higher beta lead to a lower or higher valuation?

    Not measured yet
    • Beta measures a stock's sensitivity to movements in the overall market, with a beta of 1 moving with the market and a beta above 1 being more volatile than the market●○○○○
    • A higher beta means the stock is riskier, so equity holders demand a higher return to hold it●●●○○
    • In CAPM, the cost of equity equals the risk-free rate plus beta times the equity risk premium, so a higher beta directly raises the discount rate●●●○○
    • A beta of 1.5 loads you with 1.5 times the market's equity risk premium, pushing the discount rate up●●●●○
    • Because the same stream of cash flows is discounted at a higher rate, each future cash flow is worth less in present value terms, so a higher beta leads to a lower valuation●○○○○

38. ** (THINK ON SPOT) What types of sectors have higher/lower beta?

    Not measured yet
    • Beta measures how much a stock moves with the overall market.●○○○○
    • The deciding factor is cyclicality of demand — how much revenues fall in a recession determines whether beta sits above or below 1.●●●●○
    • Low-beta sectors are the defensive ones — consumer staples and healthcare.●○○○○
    • Defensive demand persists through a recession: people keep buying groceries and prescription drugs in any economy, so those revenues stay stable.●●●●○
    • High-beta sectors are the cyclical ones — autos, restaurants, discretionary retail.●●●●○
    • Cyclical demand is deferrable: in a downturn consumers postpone cars, eating out, and discretionary purchases, so revenues swing hard with the market.●●●○○

39. ** (CONCEPT) What is industry beta? What is the benefit of using an industry beta?

    Not measured yet
    • Industry beta estimates a company's beta from its peer group's betas rather than the company's own stock history●●○○○
    • Industry beta is computed by unlevering each comparable company's beta to strip out that comparable's capital structure, taking the median of those unlevered betas as the industry unlevered beta, and then relevering that median unlevered beta at the target company's own debt-to-equity ratio●●●○○
    • A single company's regression beta is estimated from its own historical stock returns, so it can be distorted by that company's idiosyncratic events●●●○○
    • A single company's regression beta typically has a large standard error, making it an imprecise estimate of the company's true systematic risk●●●●○
    • Averaging across a peer group's betas reduces the idiosyncratic noise carried by any one company's regression beta, giving a more stable estimate of the target's beta●●○○○
    • Private companies have no traded stock, so they have no observable own-stock beta●●●●○
    • An industry-derived beta gives private companies a defensible discount-rate input where none exists directly●●○○○

40. ** (HARD) What are the flaws of regression beta?

    Not measured yet
    • Regression beta comes from regressing a stock's historical returns against a market index — the slope is the beta●●●○○
    • It is backward-looking: it is built entirely on past returns and assumes the historical relationship with the market persists●●○○○
    • If the business has changed, the historical relationship may no longer describe the company's true risk●●●●○
    • It has a large standard error, so the estimate is imprecise and sensitive to the index and time window chosen●○○○○
    • Company-specific events like lawsuits or restructurings create deviations the regression cannot explain, polluting the estimate●●○○○
    • It assumes capital structure is constant because it embeds historical debt-to-equity ratios●●●○○
    • A company whose leverage has changed or plans to change has a historical beta that is wrong for forecasting●●○○○

41. ** (SEMI HARD THINK ON SPOT) What is the impact of leverage on the beta of a company?

    Not measured yet
    • Unlevered beta captures only the business risk of the underlying assets, so it is untouched by capital structure.●●○○○
    • Debt creates fixed interest and principal obligations that must be paid regardless of how the business performs.●●●●○
    • Because creditors take their fixed payments first, the residual variability of cash flows falls entirely on equity holders — on a shrinking equity cushion as debt grows.●●●○○
    • The more debt, the more of the company's total volatility is concentrated in the equity, so levered beta rises with leverage.●●○○○
    • Mechanically, levered beta = unlevered beta × [1 + (1 − tax rate) × D/E]; this applies to the levered beta specifically, not to unlevered beta, which stays fixed as capital structure changes.●●●●○
    • As the debt-to-equity ratio rises, the multiplier [1 + (1 − tax rate) × D/E] grows, so levered beta rises monotonically with leverage.●●○○○
    • The higher levered beta feeds into the CAPM, raising the cost of equity — investors demand more return to hold a more levered company's shares.●●○○○

42. ** (HARD - THINK OF DIFFERENT COMPANIES) What is the relationship between beta & the amount of leverage used?

    Not measured yet
    • Beta measures how volatile a company's equity is relative to the market — its systematic risk.●●●○○
    • Mature companies have stable, predictable cash flows and earnings, which shows up as a low beta.●●●●○
    • Stable, predictable cash flows are exactly what lenders want, so mature firms can borrow more, and more cheaply — low beta goes with high leverage.●●○○○
    • High-beta companies — young growth or cyclical firms — have uncertain cash flows, so lenders see them as risky borrowers.●●●○○
    • For high-beta firms, debt comes expensive with restrictive terms, and lenders won't extend much of it anyway.●●○○○
    • Layering fixed debt obligations onto already-volatile cash flows would amplify swings in equity returns, raising levered beta and the cost of equity.●●●○○
    • The relationship is broadly inverse: low-beta mature sectors like utilities and staples carry the most debt, high-beta growth sectors the least.●●○○○

43. ** (HARD - CONCEPT) Which is typically higher, cost of debt or cost of equity? Why?

    Not measured yet
    • Cost of debt is the return lenders require on the money they've lent; cost of equity is the return shareholders require for holding the stock.●●○○○
    • Cost of equity is typically higher than cost of debt for essentially every company.●○○○○
    • Equity holders are last in line in bankruptcy, paid only after every creditor is satisfied, and often recover little or nothing.●●●●○
    • Debt holders sit senior with contractual, legally owed payments, so their downside is far more limited.●●●●○
    • Limited downside is why lenders accept a much lower required return.●●○○○
    • Interest payments are tax-deductible, and the effective after-tax cost of debt is the stated rate times one minus the tax rate.●●●○○
    • Dividends enjoy no such tax deduction, so equity gets no tax subsidy.●●●○○
    • Equity investors bear more risk and receive no tax subsidy, so they demand a higher required return.●○○○○

44. ** If Cost of Equity is higher than Debt, why not only use debt?

    Not measured yet
    • WACC is the blended required return across a company's debt and equity financing.●●○○○
    • Debt is the cheaper dollar at low levels: interest is tax-deductible and lenders take less risk than shareholders.●●○○○
    • Substituting debt for equity initially lowers WACC, since each cheap debt dollar replaces an expensive equity dollar.●●○○○
    • As leverage climbs, the probability of financial distress and bankruptcy rises.●●●○○
    • Lenders reprice that risk by demanding higher interest rates, so the cost of debt itself rises with leverage.●●○○○
    • Debt's cheapness was never a property of debt itself, only of debt at moderate levels; past a point the cost of debt can exceed the cost of equity.●●○○○
    • Plotting WACC against the percentage of debt in the capital structure yields the 'WACC smile': it falls at first, bottoms out at the optimal capital structure, then rises again as distress costs take over.●●●●○
    • Financing with only debt doesn't minimize your cost of capital — it lands you on the wrong side of the smile, with a worse, not cheaper, cost of capital.●○○○○

45. ** (WEIRD) What is the difference between IRR and WACC?

    Not measured yet
    • IRR is the projected return of a specific project — the discount rate at which its NPV is exactly zero.●●○○○
    • Mechanically, IRR is the implied rate the initial investment compounds at to reproduce the project's cash flows and exit value.●●●○○
    • WACC is the blended required return of all capital providers, weighting cost of debt and cost of equity by their shares of the capital structure.●●○○○
    • WACC is the minimum return the company's debt and equity investors collectively need to fund the business.●●●●○
    • IRR is a property of one project's cash flows; WACC is a property of the company's overall financing, set by the market.●●○○○
    • WACC acts as the hurdle: if a project's IRR exceeds WACC it creates value and is accepted; below WACC it destroys value.●●○○○

46. ** (THINK ON FEET) Which would have more of an impact on a DCF, discount rate or sales growth rate? Why?

    Not measured yet
    • A DCF values a company as the present value of projected free cash flows plus terminal value, discounted at the WACC●●●○○
    • Sales growth enters the DCF only through the revenue line, one driver among many — margins, taxes, capex, working capital — that shape free cash flow●●○○○
    • A change in sales growth only affects cash flows from the year it takes hold onward, before any discounting●●●○○
    • The discount rate is applied to every forecasted cash flow and to the terminal value●●○○○
    • Because discount factors compound as (1+WACC)^t, a small change in the rate compounds across the whole forecast●●●○○
    • Terminal value is typically more than half the valuation, so it is highly sensitive to the discount rate●●●○○
    • A 1% change in the discount rate moves the valuation more than a 1% change in sales growth, so the discount rate has the greater impact●●○○○

47. ** What is the argument against using the exit multiples approach in a DCF?

    Not measured yet
    • An exit multiple prices the terminal value by applying a market multiple from comparables to the final year's projected metric.●●●○○
    • A DCF is meant to be an intrinsic valuation built purely on the company's own cash flows, independent of market pricing.●●●●○
    • An exit multiple imports relative, market-based valuation into the terminal value instead of intrinsic fundamentals.●●●●○
    • Because a large share of value sits in the terminal value, the resulting valuation moves with market sentiment, defeating the DCF's purpose.●●●○○
    • In practice exit multiples are still used because they are easier to discuss and defend than perpetuity growth assumptions.●○○○○

48. ** What is the purpose of the mid-year convention? When would mid-year be inappropriate?

    Not measured yet
    • The mid-year convention discounts each year's cash flow at the midpoint of the year rather than at year-end.●●●●○
    • Year-end discounting assumes all cash arrives on the final day, which misrepresents companies that generate cash steadily all year.●●●●○
    • Discounting at t minus 0.5 reflects the realistic timing of steadily earned cash.●●●○○
    • Mid-year convention discounts cash less than year-end convention, so it increases the valuation.●●●●○
    • Mid-year is inappropriate for highly seasonal companies whose cash is concentrated in part of the year, such as a winter clothing brand like Canada Goose.●●●○○
    • Mid-year convention is inappropriate for a company whose cash flows do not arrive steadily throughout the year.●●○○○
    • The exit multiple is struck on full year-end values, so applying it alongside a mid-year convention is inconsistent.●●●●○

49. How would raising additional debt impact a DCF analysis?

    Not measured yet
    • Theoretically, raising debt has no impact on a DCF because the model discounts unlevered free cash flow, which is unaffected by financing choices.●●●●○
    • Unlevered free cash flow is measured before financing effects, so the DCF is capital-structure neutral by construction.●●●○○
    • More debt makes lenders riskier-positioned, so the cost of debt rises.●●●●○
    • Debt's senior claim makes the equity residual riskier, so the cost of equity also rises with leverage.●●●●○
    • When both costs of capital rise, the blended WACC increases.●●●●○
    • A higher WACC discounts each cash flow more heavily, lowering the present value of projections and terminal value, so the valuation falls.●●●○○

50. ** (THINK) Imagine that 2 companies had the same leverage ratio (with the same FCF & profit margins). Are their default risks the same?

    Not measured yet
    • No: identical leverage ratios do not mean identical default risk, because the traditional ratio omits a key balance sheet item.●●●○○
    • Ratios like debt/EBITDA are gross measures that compare total debt to earnings and ignore cash on the balance sheet.●●●●○
    • Cash can pay down debt and cover interest through a downturn, acting as a cushion the gross ratio cannot see.●●●●○
    • The company holding more cash is better positioned to finance the same debt load.●●●○○
    • The company holding more cash is better positioned to service the same debt load, so its default risk is lower.●●●○○
    • For this reason analysts also use net debt/EBITDA, which nets cash against debt before dividing by EBITDA.●●●○○

51. **When is a DCF inappropriate?

    Not measured yet
    • A DCF is inappropriate when you lack the financial statements needed to build the cash flow line.●●●●○
    • A DCF is inappropriate when the company is not expected to generate positive cash flows in the foreseeable future.●●●●○
    • Building unlevered free cash flow requires the full statement set: EBIT to reach NOPAT, plus depreciation, capex, and the change in working capital to bridge to actual cash.●●●●●
    • With only revenue and EBIT, you cannot construct a credible FCF line.●●●●○
    • With only revenue and EBIT in hand, public comparables are easier to implement because they work directly off those metrics.●●●○○
    • With no positive cash flows, near-term values discount to negative, and the terminal value — which carries most of the valuation — rests on cash flows that do not exist.●●●○○
    • The no-positive-cash-flow case is typical for early-stage or heavily loss-making companies.●●○○○
    • In such cases you would reach for approaches built on future profitability or revenue multiples instead.●○○○○

52. If 80% of a DCF valuation comes from the terminal value, what should be done?

    Not measured yet
    • Heavy terminal value dependence means most of the valuation rests on the least observable assumptions●○○○○
    • A short forecast period forces too much value into the terminal calculation before the company reaches steady state●●●○○
    • Extending the forecast until growth and margins normalize shifts value into explicitly modeled cash flows●●●●○
    • The perpetuity growth rate must reflect a stable mature company, typically no higher than long-run nominal GDP growth or inflation●●●○○
    • An exit multiple must be justified by where comparable companies actually trade at maturity, not just carried over from the entry multiple●●●●○
    • Back out the implied growth rate from the multiple, or implied multiple from the growth rate, and test whether either is defensible●●●●○
    • If the cross-checks hold, an 80% terminal value can be legitimate for a stable, mature business; if not, fix the assumptions before presenting the number●●○○○

53. **(CONCEPT) For forecasting purposes, do you use effective or marginal tax rate?

    Not measured yet
    • The marginal rate is the rate on the next dollar of income, essentially the statutory rate, while the effective rate is average taxes paid divided by pre-tax income●●●○○
    • The tax rate flows into free cash flow and the terminal value, so the choice is effectively an assumption about taxes paid in perpetuity●●○○○
    • The marginal rate is forward-looking and theoretically right in the long run●●●○○
    • In the long run temporary items wash out and incremental income is taxed at the statutory rate●●●●○
    • Near term, companies pay below the statutory rate due to credits and permanent differences, so the marginal rate over-estimates early cash taxes and understates free cash flow●●●●●
    • The effective rate is the historical average of taxes actually paid, making it the more accurate assumption for the first forecast years●●●○○
    • Persistently paying below the statutory rate keeps building deferred tax assets and liabilities, so the effective rate is not sustainable in perpetuity●●●●○
    • The standard approach starts at the effective rate in early years and normalizes toward the marginal rate as the forecast approaches the terminal period●●●○○

54. How does a DDM differ from a DCF? Why don't we use the DDM model/ what are the disadvantages of using the DDM?

    Not measured yet
    • The DDM values equity as the present value of future dividends, discounted at the cost of equity because dividends belong only to shareholders.●●●○○
    • A DCF discounts unlevered free cash flow at WACC to get enterprise value, while the DDM uses dividends at cost of equity to get equity value directly.●●●●○
    • The DDM is highly sensitive to its dividend growth rate, payout ratio, and required rate of return, so small assumption changes swing the valuation.●●○○○
    • The DDM ignores share buybacks, which many companies now favor as their primary return of capital, understating total shareholder returns.●●●●○
    • A high dividend payout ratio can reflect a poorly run company with no reinvestment opportunities, so high dividends do not signal quality.●●●○○
    • High-growth companies pay little or no dividends, leaving little cash flow for the model to discount.●●●○○
    • If the dividend growth rate exceeds the required return, the DDM formula breaks and produces an undefined or negative value.●●●●○
    • The DDM cannot value companies that pay no dividends at all.●●●○○
    • The DDM relies on a single, rigid dividend policy and cannot adapt when a company changes its payout or reinvestment strategy.●●●○○

55. **How does a lower tax rate impact DCF valuations?

    Not measured yet
    • Taxes affect a DCF in two places: through the unlevered free cash flows and through the WACC discount rate.●●○○○
    • A lower tax rate raises NOPAT, so every year's unlevered free cash flow is higher and the present value of the cash flows rises.●●●●○
    • The cost of debt in WACC is the after-tax rate, rate times (1 − t), so a lower tax rate shrinks the interest tax shield and raises the after-tax cost of debt.●●●●○
    • Levered beta equals unlevered beta times one plus (1 − t) times debt over equity, so a lower tax rate raises levered beta and therefore the cost of equity.●●●●○
    • Both the higher after-tax cost of debt and the higher cost of equity push WACC up, discounting the cash flows more heavily and lowering value.●●●○○
    • The net effect on valuation is ambiguous — higher FCF pushes value up while higher WACC pushes it down, with the FCF effect usually dominating.●●○○○

56. **Is it better to have $100M more in revenue or have a $100M lower in OpEx? Why?

    Not measured yet
    • Net income is revenue minus all expenses, so each $100M helps the bottom line only to the extent it survives the income statement.●●●○○
    • Extra revenue brings incremental COGS and operating expenses with it, so $100M of revenue raises net income only by the incremental margin.●●●●●
    • For this year's earnings, the $100M revenue increase is offset by the incremental costs it requires, so it is not a dollar-for-dollar gain.●●●○○
    • For immediate net income, the $100M OpEx reduction beats the $100M revenue increase.●●●●○
    • Extra revenue is recurring, so it can recur in future years rather than being a one-time benefit.●●●○○
    • Because recurring revenue can support a revenue multiple in valuation, extra revenue can lift enterprise value by more than the same $100M of OpEx savings.●●●●○
    • If the question is long-term value rather than this year's earnings, the $100M revenue increase can be worth more than the $100M OpEx reduction.●●●○○

57. A company holds Trading securities that rise from $50 to $100 (40% tax rate). What is the immediate effect on pre-tax income and the 3 balance sheet more broadly?

    Not measured yet
    • Trading securities are marked to market through earnings, so unrealized gains hit the income statement in the period they occur.●○○○○
    • Pre-tax income rises by $30 from the unrealized gain.●●●●○
    • The $50 unrealized gain is non-cash; on the cash flow statement the full $50 is backed out of net income as a non-cash adjustment.●●●○○
    • Because the gain is taxed at the 40% rate, the company pays $20 of tax on a gain it has not yet collected in cash, so cash is down $20.●●●●○
    • On the balance sheet, trading securities are up $50 and cash is down $20, so total assets are up $30 net.●●●○○
    • On the balance sheet, no liability account changes: the unrealized gain and the related tax payable do not create or alter any liability.●●●○○
    • Equity is up $30 through retained earnings (the $50 gain net of the $20 tax), which is what makes the balance sheet balance: assets +$30 equal equity +$30.●●○○○

58. Company A owns 80% of Company B and consolidates it. B earns $200M of net income. On A's income statement, the 20% A does not own is

    Not measured yet
    • A parent owning more than 50% consolidates the subsidiary and reports 100% of its results on its own income statement.●●●○○
    • Company A's income statement therefore includes the full $200M of Company B's net income.●●●○○
    • The 20% A does not own — $40M — is deducted as 'Net Income Attributable to Noncontrolling Interests.'●●○○○
    • After the deduction, $160M of consolidated net income is attributable to A's own shareholders.●●●●○
    • The NCI line prevents the parent from claiming as its own earnings that actually belong to outside shareholders.●●○○○

59. Versus an operating lease with the same economics, a finance (capital) lease will generally make a company's EBITDA

    Not measured yet
    • With an operating lease, the entire lease payment is recorded as a single rent expense inside operating costs, so the full lease cost reduces EBITDA.●●●●○
    • With a finance lease, the same economic cost splits into two components: depreciation on the leased asset, which is inside EBITDA, and interest on the lease liability, which sits below EBIT alongside other financing items and never touches EBITDA.●●●○○
    • Because a finance lease pushes the cost into depreciation and interest rather than rent expense, EBITDA is higher than under an economically identical operating lease.●●●○○
    • A finance lease treats the lessee as having bought the asset, so the company books the leased asset and a matching lease liability on the balance sheet.●●●●○
    • Over the life of the lease, the two treatments expense roughly the same total, leaving EBIT and net income similar; the difference is which line the cost lands in.●●●○○

60. How does a gain in trading securities affect the 3 statements? What about AFS? What about HTM? How do they differ?

    Not measured yet
    • The trading, AFS, and HTM classifications determine where a security's unrealized gains and losses are reported.●●○○○
    • Trading securities are marked to fair value each period, and unrealized gains flow through the income statement like realized ones.●●●●○
    • A trading gain raises net income and retained earnings on the balance sheet, with a non-cash add-back on the cash flow statement.●●●○○
    • AFS unrealized gains bypass the income statement and go to OCI, moving accumulated OCI inside stockholders' equity only.●●●●○
    • When an AFS security is sold, the gain moves out of OCI and onto the income statement as realized income.●●●○○
    • HTM securities are carried at amortized cost, so unrealized gains are ignored on all three statements.●●●○○
    • HTM income — in practice interest, per the card the investment income — does hit the income statement each period.●●●○○
    • The key difference is the income statement: trading hits it immediately, AFS only when realized, HTM only through its income stream.●●●○○

61. A company grants an executive $10M of RSUs at a 40% tax rate. Please describes the immediate accounting that follows

    Not measured yet
    • Stock-based compensation is compensation paid in shares rather than cash.●○○○○
    • The RSUs are fully vested at grant, so there is no vesting schedule to spread the cost over.●●●●●
    • The company recognizes the full $10 million as stock-based compensation expense immediately.●●●●○
    • The offsetting credit goes to additional paid-in capital, not to a cash or liability account.●●○○○
    • No cash leaves the company.●●●○○
    • The $10 million expense cuts pre-tax income by $10 million.●●●○○
    • The expense cuts net income and flows into retained earnings on the balance sheet.●●●○○
    • At a 40% tax rate, the book compensation creates a deductible temporary difference.●●●○○
    • The company records a deferred tax asset of $10 million times 40%, or $4 million, which reduces tax expense in the same period.●●○○○

62. A parent company owns 30% of an "Associate" company, and the stake shows up as an Equity Investment on the parent's Balance Sheet. When moving from the parent's Equity Value to its Enterprise Value to build a clean EV / EBITDA multiple, why do you subtract the value of the Equity Investment?

    Not measured yet
    • The EV bridge adjusts equity value for items outside the core operating enterprise, such as debt, cash, and non-core assets.●○○○○
    • An equity investment in an associate is a stake in a separate business sitting as an asset on the parent's balance sheet.●●●○○
    • Because the parent owns under 50%, the associate is equity-method accounted and none of its EBITDA is consolidated into the parent's EBITDA.●●●●○
    • The associate's performance reaches the parent only as an equity-method income line below EBIT and through shareholders' equity, never through EBITDA.●●●○○
    • Keeping the investment in EV would mean paying for the associate in the numerator while earning none of its EBITDA in the denominator, distorting the multiple.●●●○○
    • Subtracting the investment scrubs the non-core asset out of EV so the numerator matches the EBITDA the parent actually controls.●○○○○

63. How are equity method investments recorded on the parent company on the 3 statements?

    Not measured yet
    • The equity method applies to stakes of roughly 20% to 50%, where the parent has significant influence but not control.●●●○○
    • The investment is initially recorded as a single asset on the parent's balance sheet at cost.●●●○○
    • Each period the parent records its share — percent times the investee's net income — as one equity income line on the income statement.●●●●○
    • The equity income flows into the parent's net income, raising retained earnings and the investment asset's balance sheet value.●●○○○
    • Equity income is non-cash, so the cash flow statement adds it back when reconciling net income to operating cash flow.●●●○○
    • When the investee pays a dividend, the parent's investment asset is reduced by its share of the dividend — the opposite of the income entry.●●●○○
    • The dividend is real cash, so it comes through as a cash inflow on the cash flow statement.●●○○○

64. Suppose a CEO literally finds $100 of cash on the street and deposits it into the company's bank account. Ignoring the strangeness of the scenario, what is the immediate impact on Equity Value, Enterprise Value, and the P / E multiple?

    Not measured yet
    • The $100 of cash is a new company asset that belongs to shareholders, so Equity Value rises by exactly $100●●○○○
    • Enterprise Value is computed as Equity Value plus Debt minus Cash and Cash Equivalents●●○○○
    • The cash raises Equity Value by $100 but also raises the cash subtracted by $100, so the two effects cancel and Enterprise Value is unchanged●●●○○
    • Net Income is unaffected because found cash is not revenue and never touches the income statement●●●○○
    • P/E is Equity Value divided by Net Income, so only its numerator has moved●●○○○
    • With Equity Value up $100 and earnings flat, the P/E multiple rises●●○○○

65. Why does issuing dividends lower the P/E multiple and gaining cash increase the P/E multiple?

    Not measured yet
    • P/E is Market Cap, i.e. Equity Value, divided by total earnings such as Net Income●●●○○
    • Equity Value reflects the assets shareholders own net of liabilities, and cash on the balance sheet is one of those assets●●●●○
    • Gaining cash adds an asset that belongs to shareholders, so Equity Value rises by the amount of cash gained●●●○○
    • A dividend is a distribution that transfers cash out of the company's balance sheet to shareholders, so the cash asset and Equity Value each fall by the dividend amount●●○○○
    • Net Income doesn't change when cash is simply gained, so a higher numerator over a flat denominator raises P/E●●●○○
    • Net Income for the period is not reduced by the dividend paid, so the P/E denominator is unchanged while the numerator falls, lowering P/E●●○○○
    • Earnings are flat in both cases, so the numerator alone moves: cash inflow raises P/E, dividend payout lowers P/E●●●○○

66. How does the consolidation method work? Say you had 80% of the company, how would you record that?

    Not measured yet
    • The consolidation method applies when the parent owns more than 50% of a subsidiary, combining the two companies' financials●●●●○
    • On the balance sheet you record 100% of the subsidiary's assets and liabilities, even when you own only 80%●●●●○
    • The minority portion is captured by multiplying the subsidiary's net assets — assets minus liabilities — by the 20% you don't own●●●●○
    • The minority share of a subsidiary's net assets is recorded as Non-Controlling Interests, a line item under Shareholders' Equity that takes you to Total Consolidated Equity●●●○○
    • On the income statement you consolidate 100% of both companies' net income as if the parent owned everything●●●●○
    • You then subtract the non-owned percentage times the subsidiary's net income — 20% of the sub's earnings here●●●●○
    • That subtraction produces Net Income Attributable to Parent, with the minority interest deduction sitting below the net income line as an allocation rather than an expense●●●○○

67. Why do you add back non-controlling interests when moving from equity to enterprise value?

    Not measured yet
    • Non-controlling interests are the portion of a consolidated subsidiary owned by outside shareholders rather than the parent●●●○○
    • Because the parent controls the subsidiary, its consolidated financials include 100% of the sub's revenue, EBITDA, and net income even at 80% ownership●●●○○
    • The parent's Equity Value only reflects the claims of the parent's own shareholders, not the subsidiary's outside investors●●●●○
    • Minority holders are shareholders of the fully combined company even though they don't hold shares of the parent itself●●●○○
    • Practically, a buyer of the whole business would have to compensate the minority holders too, so leaving NCI out understates Enterprise Value●●●●○
    • Enterprise Value captures the value of the entire business to all investor groups●●●○○
    • Building Enterprise Value from equity value means adding up the claims of all shareholder groups, including the minority's stake●●●○○

68. A company grants an executive $10M of stock options (valued with the Black-Scholes method) at a 40% tax rate. Please describes the immediate accounting that follows & what might happen after

    Not measured yet
    • Stock options are expensed at grant-date fair value, valued here at $10M with Black-Scholes and recognized over the vesting period●●●●○
    • The expense reduces pre-tax income and net income on the income statement, lowering reported EPS●●○○○
    • No cash leaves the company when options are granted or expensed, so the $10M is added back on the cash flow statement●●●○○
    • At a 40% tax rate, the book expense creates a $4M Deferred Tax Asset because book expense is recognized before the tax deduction●●●●○
    • The actual tax deduction and the cash tax savings arrive only when the options are exercised, which is why the benefit is deferred●●●○○
    • At exercise the deduction is based on intrinsic value at that date, so a higher value creates a windfall tax benefit and expired underwater options force a DTA write-down●●●○○