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Why don't you depreciate land?

Depreciation = useful life - land has indefinite -> (not depreciable)

5 key points5 connections
R1R2R3R4R5K1Depreciation is the syste…definitionDepreciation is the systematic allocation of an asset's cost over its finite useful life, and it applies only to assets that wear out or are used up over a bounded periodK2Land is an exception to t…causalLand is an exception to the depreciation principle: it does not wear out, get consumed, or lose its ability to generate economic benefit, so its useful life is indefiniteK3Because land has no finit…causalBecause land has no finite useful life, there is no period over which to allocate its cost, so land is not depreciatedK4Land stays on the balance…contrastLand stays on the balance sheet at historical cost indefinitelyK5Anything built on land, s…exampleAnything built on land, such as buildings or parking lots, has a finite life and is depreciated, even though the land underneath is not
  • applies withinholds only in the other’s scope
  • causesone step produces another
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
R1K1K2applies within
The land exception only makes sense inside the rule that depreciation requires a finite useful life.
R2K2K3causes
Land's indefinite life is what removes any allocation period, so the no-depreciation conclusion follows from it.
R3K2K5requires
You must hold that land itself has indefinite life before you can isolate the finite-lived structure as depreciable.
R4K2K3confused with
Learners conflate the reason (indefinite life) with the conclusion (no allocation period), stating one when asked the other.
R5K3K4causes
No allocation period means the cost is never expensed, so it sits at historical cost forever.

Can companies amortize goodwill?

Public companies = no (indefinite life, like land). Instead, tested for impairment. However, privately held companies may elect to amortize goodwill/over 15 years for tax.

9 key points4 connections
R1R2R3R4K1Goodwill is the excess of…definitionGoodwill is the excess of the purchase price over the fair value of an acquisition's identifiable net assetsK2Goodwill represents the v…definitionGoodwill represents the value of things like brand, workforce, and synergies that cannot be separately identifiedK3Under US GAAP, public com…contrastUnder US GAAP, public companies do not amortize goodwillK4Goodwill is treated as ha…causalGoodwill is treated as having an indefinite life, the same logic that makes land non-depreciableK5Instead of amortizing, pu…mechanismInstead of amortizing, public companies must test goodwill for impairment, at least annually, with no option to amortize insteadK6The impairment test check…mechanismThe impairment test checks whether the fair value of the reporting unit exceeds its carrying valueK7A shortfall in the impair…mechanismA shortfall in the impairment test triggers a write-down through an impairment chargeK8Privately held companies …conditionPrivately held companies may elect to amortize goodwill rather than impair itK9For tax purposes, goodwil…exampleFor tax purposes, goodwill acquired in an asset purchase is amortized straight-line over 15 years under Section 197
  • causesone step produces another
  • confused withlearners mix these two up
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  • precedesmust be said in this order
R1K3K5causes
If public companies did amortize goodwill, the mandatory-impairment-only regime would collapse, so the no-amortization rule drives the impairment requirement.
R2K3K8confused with
Learners collapse the private-company amortization election into the public-company rule, swapping the two regimes.
R3K4K3requires
The no-amortization conclusion only follows once goodwill is granted indefinite life, so stating KLP 2 needs KLP 3's result in hand.
R4K5K6precedes
You cannot state the impairment test's fair-value-versus-carrying-value comparison without first having the mandatory annual-testing requirement it operationalizes.

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

Income Statement - Profitability. (Revenue -> NI) Balance Sheet - Resources (Assets) & Sources of Funding (Liabilities & Equity). A = L+E Cash Flow Statement - Liquidity, starting with NI and adjusting for non-cash adjustments + investing & financing cash flow to get the free cash flow.

9 key points5 connections
R1R2R3R4R5K1The three statements are …definitionThe three statements are the income statement, the balance sheet, and the cash flow statement, collectively capturing profitability, resources, and liquidityK2The income statement cove…mechanismThe income statement covers a period such as a quarter or a year, flowing revenue down through costs and expenses to net incomeK3The balance sheet is a po…mechanismThe balance sheet is a point-in-time snapshot showing assets like cash, inventory, and PP&E, funded by liabilities and shareholder equityK4Assets = Liabilities + Eq…causalAssets = Liabilities + Equity must always tieK5The cash flow statement c…mechanismThe cash flow statement covers the same period as the income statement and starts with net income, adding back non-cash charges like depreciation and adjusting for working capital changes to get cash from operationsK6The investing section sub…mechanismThe investing section subtracts capital expenditures and asset purchases; the financing section shows debt raises or repayments, buybacks, and dividendsK7The cash flow statement e…causalThe cash flow statement ends with the net change in cash, which added to beginning cash gives ending cash — the balance sheet's cash lineK8Free cash flow — roughly …contrastFree cash flow — roughly operating cash flow minus capex — is a derived valuation metric, not the cash flow statement's ending lineK9Net income flows into ret…causalNet income flows into retained earnings on the balance sheet
  • precedesmust be said in this order
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  • confused withlearners mix these two up
R1K2K5precedes
The cash flow statement's operating section starts from net income, which the income statement produces.
R2K5K6precedes
You cannot reach the investing and financing sections without first computing cash from operations.
R3K7K4requires
Ending cash from the cash flow statement is the balance sheet cash line, so the balance depends on it.
R4K7K8confused with
Learners conflate the cash flow statement's ending net change in cash with free cash flow.
R5K9K4requires
Retained earnings from net income is the mechanism that keeps assets equal to liabilities plus equity.

How do the three statements link together?

1) Net Income (IS) -> Retained Earnings, Shareholder Equity on Balance Sheet & top of Cash Flow Statement. 2) Changes to Short-term assets & liabilities in BS = working capital on Cash Flow Statement. HOW CFS IS AFFECTED: Investing & Financing activities from CFS affect Balance Sheet items such as PPE, Debt and Shareholder Equity. Finally, The change in cash (FCF) from the cash flow statement plus beginning cash balance = ending cash balance on Balance Sheet. **HARD - NEEDS GOOD STRUCTURE**

8 key points4 connections
R1R2R3R4K1Net income from the incom…mechanismNet income from the income statement flows into retained earnings within shareholder equity on the balance sheet, so income statement profit raises balance sheet equityK2Net income is the first l…mechanismNet income is the first line item of the cash flow statement's operating section, so it drives the cash flow statement's starting figureK3Changes in short-term bal…mechanismChanges in short-term balance sheet items like receivables, inventory, and payables appear as working capital adjustments in the operating section of the cash flow statementK4Investing section flows c…mechanismInvesting section flows change asset balances like PP&E — capex builds it up while depreciation wears it downK5Financing section flows c…mechanismFinancing section flows change debt and equity balances through issuance, repayment, dividends, and buybacksK6The change in cash plus b…causalThe change in cash plus beginning cash equals ending cash on the cash flow statementK7The cash flow statement's…causalThe cash flow statement's ending cash is the cash line reported on the balance sheetK8A model whose links are c…causalA model whose links are correct ties out — the balance sheet balances — so a non-balancing balance sheet signals a broken link
  • causesone step produces another
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R1K1K2causes
Counterfactual: if net income bypassed equity and went straight to cash, it would no longer be the cash flow statement's operating starting figure.
R2K2K3precedes
The working-capital adjustment only makes sense as a reconciliation of the net income starting figure, so net income must be consumed first.
R3K3K7causes
Counterfactual: if working-capital changes were ignored in operations, ending cash would differ and no longer match the balance sheet cash line.
R4K7K8requires
Counterfactual: if the cash flow ending cash were a separate plug not tied to the balance sheet cash line, the model would not tie out.

How does a $10 increase in Stock-Based Compensation (SBC) affect the 3 financial statements (assume 40% tax rate)?

IS: $10 increase in OpEx, so $6 post-tax decrease to NI CFS: Since non-cash, is $10 add-back ($4 increase) BS: - Assets - Cash increases by $4. - L&E - Retained Earnings = -6, but Shareholder Equity (excluding R/E) is $10, so Equity (and consequently L&E) up by $4

9 key points4 connections
R1R2R3R4K1SBC is a non-cash expense…definitionSBC is a non-cash expense: it is paid in shares rather than cash, so it hits the income statement without any cash outflowK2The offset to the SBC exp…definitionThe offset to the SBC expense is an increase in additional paid-in capitalK3On the income statement, …quantitativeOn the income statement, operating expenses rise $10 and pre-tax income falls $10K4At a 40% tax rate, the $1…quantitativeAt a 40% tax rate, the $10 drop in pre-tax income cuts taxes by $4 and net income by $6K5On the cash flow statemen…quantitativeOn the cash flow statement, the $6 lower net income is combined with a $10 non-cash add-back for the full SBC expense, so cash rises a net $4K6On the balance sheet asse…quantitativeOn the balance sheet asset side, cash is up $4K7On the liabilities and eq…quantitativeOn the liabilities and equity side, retained earnings falls $6K8On the liabilities and eq…quantitativeOn the liabilities and equity side, the $10 SBC grant adds $10 to paid-in capital, so equity rises a net $4K9Assets up $4 equals equit…quantitativeAssets up $4 equals equity up $4, so the balance sheet balances
  • causesone step produces another
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R1K1K2causes
If SBC were a cash expense, the offsetting credit would be cash, not paid-in capital.
R2K2K8requires
The equity-side +$10 APIC figure cannot exist unless the SBC offset was booked to paid-in capital.
R3K5K6precedes
The $4 cash increase on the balance sheet is derived from the CFS net change, so it consumes KLP 4.
R4K8K9precedes
You cannot verify assets up $4 equals equity up $4 until APIC +$10 and RE -$6 are netted.

How does principal repayment affect the 3 statements?

Only CFS and BS - the cash decrease is equal to the liability decrease

7 key points4 connections
R1R2R3R4K1Principal repayment is pa…definitionPrincipal repayment is paying back the borrowed amount of a loan, distinct from interest, which is the cost of borrowing.K2The income statement is u…contrastThe income statement is unaffected because repaying principal is not an expense — only interest hits the P&L.K3On the cash flow statemen…mechanismOn the cash flow statement, the repayment is a cash outflow in financing activities.K4That financing outflow re…causalThat financing outflow reduces the net change in cash and lowers the ending cash balance.K5On the balance sheet, cas…quantitativeOn the balance sheet, cash — an asset — falls by the amount repaid, and the debt liability falls by that same amount.K6The balance sheet still b…causalThe balance sheet still balances and equity is untouched.K7Net effect: only the CFS …quantitativeNet effect: only the CFS and BS are affected, with the cash decrease exactly equaling the liability decrease.
  • applies withinholds only in the other’s scope
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R1K1K2applies within
The income-statement treatment only holds because principal is distinct from interest, which is the P&L expense.
R2K2K7precedes
The net effect that only CFS and BS are affected consumes the prior result that principal repayment does not hit the income statement.
R3K4K5causes
If the financing outflow did not lower the ending cash balance, the cash asset would not fall, so the balance sheet change would not occur.
R4K5K6requires
Concluding equity is untouched and the balance sheet still balances presupposes that cash and the liability fall by equal amounts.

What is trapped cash?

Overseas money in int'l companies that stays offshore to prevent repatriation taxes

8 key points5 connections
R1R2R3R4R5K1Trapped cash is foreign e…definitionTrapped cash is foreign earnings an international company keeps offshore to avoid repatriation taxesK2Under a worldwide tax sys…mechanismUnder a worldwide tax system, home-country tax is deferred until the cash is brought backK3Repatriating trapped cash…mechanismRepatriating trapped cash would trigger the US corporate tax rate on those earningsK4The cash sits on the bala…contrastThe cash sits on the balance sheet but cannot fund domestic operations, dividends, or buybacksK5In valuation, reported ca…causalIn valuation, reported cash overstates usable cash, so analysts exclude or discount trapped cash when computing net debtK6The 2017 US shift to a te…conditionThe 2017 US shift to a territorial tax system largely eliminated this problem, though the term persists for cash locked offshore elsewhereK7Trapped cash is a valuati…contrastTrapped cash is a valuation and capital-allocation problem for the parentK8Trapped cash does not mea…contrastTrapped cash does not mean the foreign subsidiary itself is distressed
  • causesone step produces another
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R1K1K3causes
If repatriation were tax-free, there would be no tax trigger, so the deferral motive vanishes.
R2K1K8confused with
Learners equate trapped cash with a distressed foreign subsidiary, treating parent-level lock-up as subsidiary failure.
R3K3K5causes
Only because repatriation triggers tax does reported cash overstate usable cash for net debt.
R4K5K4applies within
The 'cannot fund domestic operations' claim only matters inside the valuation context of unusable cash.
R5K6K1causes
The 2017 territorial shift removed the US deferral motive, so the classic definition no longer holds there.

What are intercompany investments and investment securities? How do they show up on the 3 statements?

Intercompany: Stock Investment/Investment in Security (<20, unrealized gains) Equity Investments (20-50, marked-to-market as unrealized gains. dividend reduces share, like NCI, NI increases) Consolidation (>50%, other share is NCI in stockholders' equity) Securities: 1) Trading (initial cost, unrealized = shown in IS) 2) AFS (initial, unrealized = equity) 3) HTM (historical, dividend = revenue)

9 key points6 connections
R1R2R3R4R5R6K1Intercompany investments …definitionIntercompany investments are stakes one company holds in another, either as equity ownership or as debt securities.K2The accounting treatment …conditionThe accounting treatment for an intercompany investment depends on the ownership level and the intent behind holding it.K3Below 20% ownership the s…definitionBelow 20% ownership the stake is passive and sits on the balance sheet as an investment in securities, with no consolidation and no equity-method income.K4Between 20% and 50% owner…conditionBetween 20% and 50% ownership the parent has significant influence over the investee, so the equity method applies rather than fair-value accounting.K5Under the equity method, …mechanismUnder the equity method, the investor's share of the target's net income flows into the investor's own net income and increases the investment balance.K6Under the equity method, …causalUnder the equity method, dividends received reduce the investment balance rather than adding to income.K7Above 50% ownership the p…definitionAbove 50% ownership the parent controls the target and consolidates it line by line, with the unowned portion presented as noncontrolling interest within stockholders' equity.K8Investment securities are…definitionInvestment securities are typically the under-20% passive holdings, classified by intent: trading securities for short-term price moves, available-for-sale securities for possible future sale, and held-to-maturity securities intended to be held to the end and carried at historical cost.K9Unrealized gains and loss…contrastUnrealized gains and losses on trading securities flow through the income statement, while unrealized gains and losses on available-for-sale securities bypass the income statement and sit in equity via OCI until realized; for held-to-maturity securities the coupon or dividend is recognized as revenue on the income statement.
  • causesone step produces another
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  • confused withlearners mix these two up
R1K2K3causes
Ownership level and intent determine which accounting bucket applies, so the 20% threshold treatment follows from the classification premise.
R2K3K8applies within
The under-20% passive bucket is exactly the domain where investment-security classifications by intent operate.
R3K3K7precedes
The consolidation threshold above 50% is only meaningful once the sub-20% non-consolidation baseline is established.
R4K4K5requires
The equity-method income pickup cannot be stated without first establishing that significant influence triggers the equity method.
R5K5K6confused with
Both describe equity-method effects on the investment account, but income pickup increases it while dividends decrease it.
R6K8K9causes
Classifying a security as trading, AFS, or HTM determines where its unrealized gains and losses land on the statements.

If a company incurs $100 in PIK interest, how does it affect 3 statements (assuming 40% tax rate)

IS: $100 expense, $60 post-tax CFS: $-60 + 100 (non-cash adjustment), +$40 BS: Assets - Cash +$40, Liabilities = $100 Equity = -60 (R/E)

9 key points9 connections
R1R2R3R4R5R6R7R8R9K1PIK interest is an expens…definitionPIK interest is an expense that accrues onto the debt balance instead of being paid in cash during the period, so it is recognized now but settled later.K2The income statement show…quantitativeThe income statement shows the full $100 as interest expense, and at a 40% tax rate net income falls by $60.K3The $100 of interest expe…quantitativeThe $100 of interest expense reduces taxes by $40.K4On the cash flow statemen…mechanismOn the cash flow statement you start from the -$60 net income and add back the $100 of accrued PIK as a non-cash adjustment.K5Cash is up $40 at the bot…quantitativeCash is up $40 at the bottom of the cash flow statement.K6On the balance sheet, cas…quantitativeOn the balance sheet, cash rises $40.K7The debt balance increase…quantitativeThe debt balance increases $100 from the PIK accrual to principal.K8Equity falls $60 through …causalEquity falls $60 through retained earnings.K9The balance sheet balance…causalThe balance sheet balances because assets rise $40 while liabilities rise $100 and equity falls $60.
  • requiresthe second is only true if the first is
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R1K1K4requires
The add-back of $100 as a non-cash adjustment only works because PIK accrues to debt rather than being paid in cash.
R2K1K7causes
Because PIK is settled later, the $100 accrues to principal and the debt balance rises.
R3K1K2applies within
The full $100 hitting the income statement as interest expense presupposes PIK is recognized now even though settled later.
R4K2K8confused with
Learners mix the income statement's $60 net income decline with the balance sheet's $60 equity decline through retained earnings.
R5K3K5causes
The $40 tax reduction is the sole reason cash rises $40 despite no cash interest payment.
R6K4K5precedes
Deriving cash up $40 consumes the -$60 net income plus $100 add-back already computed on the cash flow statement.
R7K5K6confused with
Learners conflate the cash flow statement's bottom-line cash change with the balance sheet's cash line, treating them as interchangeable.
R8K6K9requires
The balancing claim needs the asset side's $40 cash increase already established from the cash flow statement.
R9K7K9requires
Stating the balance sheet balances with liabilities up $100 requires already knowing the debt increased $100.

What is OID (original issue discount) in debt?

Allows investors to only pay less if they take on debt first (original issuers)

9 key points4 connections
R1R2R3R4K1Original issue discount m…definitionOriginal issue discount means the debt is issued below its face value, with the discount being the gap between the issue price and par.K2Original investors pay le…mechanismOriginal investors pay less up front than the par amount they are repaid at maturity.K3Investors might pay $90 f…quantitativeInvestors might pay $90 for a bond and receive the full $100 at maturity.K4The $10 gap is the origin…causalThe $10 gap is the original investors' compensation for taking on credit risk early.K5The issuer initially reco…definitionThe issuer initially records the debt on the balance sheet at the discounted issue price, not par.K6Over the life of the loan…mechanismOver the life of the loan the discount is accreted back up toward par.K7That accretion is recogni…mechanismThat accretion is recognized as additional interest expense even though no cash is paid on that piece.K8On the cash flow statemen…causalOn the cash flow statement the accretion is added back as a non-cash adjustment.K9OID is common in high-yie…exampleOID is common in high-yield and convertible debt, letting the issuer attract early investors without committing to a high cash coupon up front.
  • applies withinholds only in the other’s scope
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R1K4K1applies within
Calling the gap compensation for credit risk only holds when the discount exists as issue-price-below-par.
R2K5K6causes
Recording debt at the discounted price creates the carrying gap that must later be accreted upward to par.
R3K6K7requires
Accretion toward par is the mechanism that produces the additional non-cash interest expense.
R4K7K8causes
Because the accretion is a non-cash expense, it must be added back on the cash flow statement.

How to estimate share price (given current + projected growht rate) & calculate share count (given basic outstanding, issued and repurchased + share price)

Share price - Current * (1 + growth rate) Share count - Outstanding + Issued/Price - Repurchase/Price

9 key points6 connections
R1R2R3R4R5R6K1To estimate the projected…quantitativeTo estimate the projected share price, compound the current market price by the expected growth rate: projected price = current price × (1 + g).K2The growth rate is assume…exampleThe growth rate is assumed to apply uniformly, so a $50 stock with 10% expected growth projects to $55.K3The projected share price…contrastThe projected share price and the adjusted share count are two separate calculations.K4The share count starts fr…definitionThe share count starts from basic shares outstanding — the shares already issued and existing today.K5Shares issued during the …mechanismShares issued during the period are added to the count; the number added equals the dollar amount issued divided by the share price.K6Repurchased shares are su…mechanismRepurchased shares are subtracted from the count; the number subtracted equals the dollar amount spent on buybacks divided by the share price.K7Repurchased shares are re…mechanismRepurchased shares are retired at the market price.K8The adjusted share count …causalThe adjusted share count = basic shares outstanding + shares issued − shares repurchased.K9The adjusted share count …causalThe adjusted share count is the denominator used downstream for per-share metrics such as EPS or equity value per share.
  • requiresthe second is only true if the first is
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R1K1K4requires
Share-count division needs a share price, which only KLP0 supplies.
R2K1K5applies within
Dollar-to-shares division presupposes the same share price KLP0 projects.
R3K2K4requires
Adjusting a count needs a share price assumption; growth uniform supplies one.
R4K3K7confused with
Retiring buybacks at market price is mistaken for the two-calculations claim.
R5K6K7confused with
Learners conflate subtracting buyback shares with the retirement-at-market-price fact.
R6K8K9precedes
The denominator claim consumes the adjusted count result.

How do you calculate EPS with P/E?

They are inverses (share price/EPS = P/E)

6 key points4 connections
R1R2R3R4K1The P/E ratio relates a c…definitionThe P/E ratio relates a company's market price per share to its earnings per share.K2The P/E formula is P/E = …quantitativeThe P/E formula is P/E = share price ÷ EPS.K3P/E and EPS are inverses …quantitativeP/E and EPS are inverses of each other.K4To get EPS from a P/E, yo…quantitativeTo get EPS from a P/E, you divide the share price by the P/E multiple.K5For example, a $50 stock …exampleFor example, a $50 stock trading at 20x P/E implies EPS of $50 ÷ 20 = $2.50.K6Given any two of price, E…conditionGiven any two of price, EPS, or the P/E multiple, the third is fixed by the same identity.
  • precedesmust be said in this order
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R1K2K4precedes
Rearranging P/E = price ÷ EPS into EPS = price ÷ P/E consumes the formula, so [3] derives from [1].
R2K2K5applies within
The numeric example only holds under the P/E = price ÷ EPS identity that [1] fixes.
R3K3K4causes
If P/E and EPS were not inverse-linked, dividing price by the multiple would not yield EPS.
R4K4K5confused with
The rule and the worked example are stated interchangeably, so a learner swaps the method for the instance.

What is difference between defined contribution & benefit retirement plans?

1) Contribution = Contribute periodically expense stated 2) Defined Benefit = estimate on how much to satisfy post-retirement benefits and give an amount close to it. If higher, than DTA. If lower, DTL.

9 key points4 connections
R1R2R3R4K1A defined contribution pl…definitionA defined contribution plan is one where the employer contributes a fixed amount periodically.K2For a defined contributio…definitionFor a defined contribution plan, the recorded expense is simply that stated contribution.K3A 401(k) match is the cla…exampleA 401(k) match is the classic example of a defined contribution plan.K4In a defined contribution…contrastIn a defined contribution plan the employee bears the investment risk.K5In a defined contribution…mechanismIn a defined contribution plan, retirement value depends on how the account performs.K6A defined benefit plan is…definitionA defined benefit plan is the opposite: the employer promises a specific retirement benefit.K7The defined benefit expen…mechanismThe defined benefit expense estimate uses actuarial assumptions like discount rate, mortality, and expected returns.K8Under defined benefit acc…conditionUnder defined benefit accounting, if the estimate is higher it creates a deferred tax asset; if lower, a deferred tax liability.K9Funded status is a separa…mechanismFunded status is a separate balance-sheet item: if the obligation exceeds plan assets the plan is underfunded and shows a net liability, and if assets exceed the obligation the plan shows a net asset.
  • causesone step produces another
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R1K1K4causes
If the employer contribution were not fixed but renegotiable, the employee would no longer bear the investment risk
R2K1K5requires
Retirement value depending on account performance only makes sense if contributions are fixed, not benefit-promised
R3K5K6confused with
Account-performance dependence in DC is easily swapped with the employer's promised benefit in DB
R4K7K9precedes
Computing the DB obligation from actuarial assumptions must come before comparing it to plan assets for funded status

What are some ways to inflate earnings?

LIFO -> FIFO Refusal to write-down impaired assets Deferral of R&D/CapEx Capitalizing normal expenses Aggressive Revenue Recognition Policies

9 key points4 connections
R1R2R3R4K1Inflating earnings means …definitionInflating earnings means raising reported net income without any real underlying improvement in the businessK2One way is switching from…mechanismOne way is switching from LIFO to FIFO: in rising prices, FIFO draws on older, cheaper inventory layers than LIFO wouldK3Because those older inven…causalBecause those older inventory layers are cheaper, the switch lowers reported COGSK4Lower reported COGS from …causalLower reported COGS from the LIFO-to-FIFO switch raises net incomeK5Another way is refusing t…mechanismAnother way is refusing to write down impaired assets when carrying value exceeds recoverable valueK6Another way is deferring …mechanismAnother way is deferring R&D or CapEx — skipping the spending boosts this period's earnings at the expense of future periodsK7Another way is capitalizi…mechanismAnother way is capitalizing normal operating expenses, moving them to the balance sheet and depreciating them slowly instead of expensing nowK8Another way is aggressive…mechanismAnother way is aggressive revenue recognition: booking revenue before it is earnedK9Aggressive revenue recogn…exampleAggressive revenue recognition includes channel stuffing, bill-and-hold, or optimistic percentage-of-completion estimates on long-term contracts
  • causesone step produces another
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R1K2K3causes
If inventory layers were not cheaper in rising prices, the LIFO-to-FIFO switch would not lower COGS.
R2K3K4causes
You cannot claim net income rises until you already have the lower-COGS result in hand.
R3K6K1applies within
Deferring R&D only inflates earnings if reported net income has not genuinely improved.
R4K9K8applies within
Channel stuffing and bill-and-hold are concrete instances of the aggressive-revenue-recognition category.

Capitalized vs Expensed

Capitalized = long-term. Expensed = used in that time period

9 key points5 connections
R1R2R3R4R5K1Capitalizing means record…definitionCapitalizing means recording a cost as a long-term asset on the balance sheet because it benefits multiple periodsK2Expensing means the cost …definitionExpensing means the cost is fully used in the current period and hits the income statement immediatelyK3Capitalized costs are spr…mechanismCapitalized costs are spread over their useful life through depreciation; expensed costs hit earnings all at onceK4A capitalized cost raises…causalA capitalized cost raises current net income, while expensing the same cost immediately lowers itK5Capitalizing a $1 million…exampleCapitalizing a $1 million asset with a ten-year life records $100,000 of depreciation per year instead of a full $1 million earnings chargeK6If you capitalize a $1 mi…contrastIf you capitalize a $1 million piece of equipment, nothing hits earnings today; if you expense it, the full $1 million hits earnings in the current periodK7The practical difference …contrastThe practical difference between capitalizing and expensing is timingK8The judgment call that de…conditionThe judgment call that decides which treatment to use is whether the benefit extends beyond the current period; an asset with a useful life over a year that will produce future economic benefit gets capitalizedK9Routine costs consumed no…exampleRoutine costs consumed now — salaries, rent, ordinary maintenance — get expensed
  • causesone step produces another
  • precedesmust be said in this order
  • requiresthe second is only true if the first is
R1K2K4causes
Expensing hitting the income statement immediately produces the lower current net income result.
R2K3K5precedes
The annual $100,000 depreciation figure is computed by applying the spreading principle to the asset's cost and life.
R3K4K6requires
The claim that the full $1M hits earnings today when expensed depends on expensing immediately lowering current net income.
R4K6K7precedes
The concrete $1M timing example supplies the timing-difference conclusion between capitalizing and expensing.
R5K8K9causes
The useful-life benefit judgment drives routine consumed costs like salaries and rent into the expensed category.

What happens when share price = up by 10%?

Nothing (BS is historical value)

9 key points6 connections
R1R2R3R4R5R6K1The balance sheet records…definitionThe balance sheet records assets and liabilities at historical cost, not at current market valueK2A 10% share price increas…mechanismA 10% share price increase is a market-value event that occurs in the stock market; the company's own financial statements contain no market-value remeasurement trigger for itK3The company receives no c…causalThe company receives no cash and records no gain from a share price increase, because the price change happens in trades between shareholders rather than between the company and an investorK4Nothing on the balance sh…causalNothing on the balance sheet changes — assets, liabilities, and book equity all stay at their historical valuesK5The income statement is u…causalThe income statement is unaffected, because the price gain went to shareholders trading shares, not to the company as revenue or cashK6Only market-based measure…contrastOnly market-based measures move: market cap rises 10%, and ratios like P/E and market-to-book shift while book value stays the sameK7Book equity differs from …contrastBook equity differs from market cap, so a 10% rise in market cap does not by itself imply any change in reported shareholders' equityK8The exception: if the com…conditionThe exception: if the company itself transacts at the market price — issuing shares, buying back stock, or using stock in a deal — the price enters the accountingK9When the company does tra…conditionWhen the company does transact at the market price, the effect is limited to the transaction itself (cash received or paid, shares issued or repurchased), not a remeasurement of existing assets or liabilities to market
  • causesone step produces another
  • confused withlearners mix these two up
  • precedesmust be said in this order
R1K2K6causes
If a share price rise were instead a book remeasurement event, market-only measures like market cap would not be the sole movers.
R2K3K5causes
If the company received cash from the price rise, the income statement would record revenue, so [4] needs [2].
R3K6K7confused with
Both concern market-versus-book movement, so a learner may state the ratio-shift point while meaning the book-equity-separation point.
R4K7K8precedes
You cannot derive the company-transaction exception without first having the book-versus-market-cap distinction that [6] establishes.
R5K8K9precedes
Recognizing the transaction exception must come before bounding its effect to the transaction, since [8] specifies what [7] opens up.
R6K8K9confused with
The exception's trigger and its scope are easily conflated: stating when the price enters accounting versus how far it reaches.

Retention ratio vs Dividend Ratio

RETENTION: Money kept (NI-Dividends)/NI DIVIDEND: Dividend/NI

9 key points5 connections
R1R2R3R4R5K1The retention ratio is th…definitionThe retention ratio is the share of net income a company keeps in the business.K2The dividend ratio — usua…definitionThe dividend ratio — usually called the payout ratio — is the share of net income paid out as dividends.K3Retention ratio is calcul…quantitativeRetention ratio is calculated as net income minus dividends, divided by net income.K4The dividend ratio, usual…quantitativeThe dividend ratio, usually called the payout ratio, is dividends divided by net income.K5If a company earns $100 a…exampleIf a company earns $100 and pays $30 in dividends, it retains $70, so the retention ratio is 70%.K6In that same example, the…exampleIn that same example, the payout ratio is 30%.K7Because every dollar of n…causalBecause every dollar of net income is either paid out or kept, the two ratios always sum to 100%.K8The payout ratio tells yo…definitionThe payout ratio tells you how much cash the company returns to shareholders and how sustainable the dividend is.K9The retention ratio feeds…mechanismThe retention ratio feeds directly into growth: a company's sustainable growth rate is its retention ratio times its return on equity.
  • confused withlearners mix these two up
  • precedesmust be said in this order
  • requiresthe second is only true if the first is
  • applies withinholds only in the other’s scope
R1K2K4confused with
Both name the dividend ratio, so a learner may state the formula while missing that it is the same concept.
R2K3K5precedes
You cannot produce the 70% figure without first having the retention formula from net income minus dividends.
R3K7K5requires
The 70% retention figure in the example is only derivable because retention and payout exhaust net income.
R4K7K6requires
The 30% payout figure depends on the complementarity principle that the two ratios partition net income.
R5K9K1applies within
The growth link only holds under the definition of retention as the share of income kept in the business.

When adjusting for non-recurring expenses, are litigation expenses always adjusted?

No - sometimes is discretionary. Pharma, for example, may choose not to (often has litigation)

6 key points6 connections
R1R2R3R4R5R6K1Adjusting for non-recurri…definitionAdjusting for non-recurring expenses means removing one-time charges to arrive at normalized, recurring earnings - i.e., what the company generates in a typical yearK2Litigation expenses are n…contrastLitigation expenses are not automatically adjusted out; whether a given expense qualifies as non-recurring is a judgment call, and litigation is a classic gray areaK3For many companies, litig…conditionFor many companies, litigation genuinely is a recurring cost of doing business rather than a one-off chargeK4The test to apply is freq…mechanismThe test to apply is frequency and linkage to the core business: a charge that shows up every year is effectively operating even if lumpyK5Pharma companies face lit…examplePharma companies face litigation constantly, so analysts often choose to leave litigation expenses in rather than adjust for themK6Adding back an expense th…causalAdding back an expense that actually recurs overstates normalized earnings - it overstates what the company really earns in a normal year and flatters the company
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
  • causesone step produces another
  • applies withinholds only in the other’s scope
  • precedesmust be said in this order
R1K2K6confused with
Learners conflate the judgment call about whether to adjust with the warned consequence of wrongly adjusting.
R2K3K2requires
The judgment call that litigation isn't auto-adjusted depends on the premise that litigation can genuinely be recurring.
R3K4K2causes
Having the frequency-and-linkage test is what makes litigation's non-recurring status a judgment call rather than automatic.
R4K5K4applies within
The pharma litigation example is a concrete application that only makes sense under the frequency-and-linkage test.
R5K5K3precedes
Stating pharma faces constant litigation and analysts leave it in consumes the prior result that litigation can be recurring.
R6K6K3requires
Overstating normalized earnings by adding back a recurring item only matters because litigation often genuinely recurs.

What is the cash conversion cycle? What are the 3 parts of it? What do they mean?

CCC -> DIH (Inv/COGS), DSO (A/R, Rev), DPO (A/P / COGS) DIH - how long it takes for inventory to be turned into cash DSO - how long it takes to get A/R into cash DPO - how long it takes to pay off payables CCC - how long it takes to go from Inv -> Cash (from purchase to selling)

9 key points7 connections
R1R2R3R4R5R6R7K1The cash conversion cycle…definitionThe cash conversion cycle measures how long it takes a company to go from purchasing inventory to collecting cash from selling it, i.e. how many days cash is tied up in the operating cycleK2Days Inventory Held = Inv…definitionDays Inventory Held = Inventory / COGSK3Days Inventory Held is th…definitionDays Inventory Held is the part of the cycle measuring how long inventory sits before it is sold, i.e. how long it takes inventory to be turned into cashK4Days Sales Outstanding = …definitionDays Sales Outstanding = Accounts Receivable / RevenueK5Days Sales Outstanding is…definitionDays Sales Outstanding is the part of the cycle measuring how long it takes the company to collect cash from customers after making a saleK6Days Payable Outstanding …definitionDays Payable Outstanding = Accounts Payable / COGSK7Days Payable Outstanding …definitionDays Payable Outstanding is the part of the cycle measuring how long the company takes to pay its own suppliersK8The cycle is made up of e…definitionThe cycle is made up of exactly three parts combined as DIH + DSO - DPO: the company buys inventory, waits for it to sell, waits for customers to pay, but meanwhile delays paying its own suppliers, which offsets part of that timeK9A shorter cycle is bettercausalA shorter cycle is better
  • applies withinholds only in the other’s scope
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
R1K1K8applies within
The DIH+DSO-DPO combination only holds under the framing that CCC measures days cash is tied in the operating cycle.
R2K2K3confused with
Learners conflate DIH's directional meaning with its formula, stating the narrative when asked for the ratio.
R3K4K5confused with
Learners swap DSO's meaning with its AR/Revenue formula, giving the interpretation when the calculation is asked.
R4K6K7confused with
Learners conflate DPO's supplier-payment meaning with its AP/COGS formula, offering one in place of the other.
R5K8K2requires
You cannot state the DIH+DSO-DPO formula without already having DIH's Inventory/COGS definition in hand.
R6K8K4requires
The DSO term in the formula presumes DSO is defined as Accounts Receivable over Revenue.
R7K8K6requires
The DPO term in the formula presumes DPO is defined as Accounts Payable over COGS.

What ratios do you look at to assess working capital efficiency?

DIH, DSO, DPO

8 key points5 connections
R1R2R3R4R5K1Working capital efficienc…definitionWorking capital efficiency is how quickly a company moves cash through its operating cycleK2Days Inventory Held is In…definitionDays Inventory Held is Inventory divided by COGS and measures how fast inventory turns into salesK3Days Sales Outstanding is…definitionDays Sales Outstanding is Accounts Receivable divided by Revenue and measures how quickly the company collects from customersK4Days Payable Outstanding …definitionDays Payable Outstanding is Accounts Payable divided by COGS and measures how long the company takes to pay suppliersK5The three ratios roll up …causalThe three ratios roll up into the cash conversion cycle, DIH plus DSO minus DPOK6The cash conversion cycle…definitionThe cash conversion cycle is the net number of days cash is tied upK7Higher DSO or DIH ties up…contrastHigher DSO or DIH ties up cash longer, while higher DPO helpsK8Higher DPO helps because …causalHigher DPO helps because suppliers effectively provide free financing
  • applies withinholds only in the other’s scope
  • confused withlearners mix these two up
  • precedesmust be said in this order
  • requiresthe second is only true if the first is
R1K2K1applies within
DIH measures inventory-to-sales speed only if efficiency is defined as cash moving through the operating cycle.
R2K3K4confused with
DSO and DPO share the days-outstanding form but flip who owes whom, so learners swap them.
R3K5K6precedes
You cannot state the CCC as net days tied up without first rolling DIH, DSO, DPO into a single figure.
R4K6K7precedes
Claiming higher DSO or DIH ties up cash presumes CCC already established as days cash tied up.
R5K7K8requires
Higher DPO helping only holds if suppliers give free financing; otherwise longer payment hurts.

What are the working capital line items (8) ?

Assets: A/R, Inventory, Prepaid Expenses, Other current assets Liabilities: A/P, Deferred Revenue, Accrued Expenses, Other Liabilities

8 key points8 connections
R1R2R3R4R5R6R7R8K1Working capital line item…definitionWorking capital line items are the current assets and current liabilities that turn over in the operating cycle, excluding cash and debt/financing items.K2There are exactly eight w…quantitativeThere are exactly eight working capital line items in total.K3The four working capital …quantitativeThe four working capital asset items are Accounts Receivable, Inventory, Prepaid Expenses, and Other Current Assets.K4The four working capital …quantitativeThe four working capital liability items are Accounts Payable, Deferred Revenue, Accrued Expenses, and Other Current Liabilities.K5Cash is excluded from the…conditionCash is excluded from the working capital asset line items, so it is not one of the eight.K6Debt is excluded from the…conditionDebt is excluded from the working capital liability line items, so short-term borrowings and similar financing items are not among the eight.K7Accounts Receivable and I…contrastAccounts Receivable and Inventory are the two operating-asset line items explicitly named as working capital assets, distinct from Prepaid Expenses and Other Current Assets.K8Accounts Payable and Defe…contrastAccounts Payable and Deferred Revenue are the two operating-liability line items explicitly named as working capital liabilities, distinct from Accrued Expenses and Other Current Liabilities.
  • applies withinholds only in the other’s scope
  • precedesmust be said in this order
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
R1K1K3applies within
The four-asset list only makes sense inside a working-capital definition that already excludes cash and financing items.
R2K1K4applies within
Naming four working-capital liabilities presupposes the definition that strips out debt and financing liabilities.
R3K3K2precedes
You cannot assert exactly eight items until the four assets are enumerated and counted.
R4K3K4confused with
Learners swap the asset quartet and liability quartet, putting Accounts Payable or Deferred Revenue among assets.
R5K4K2precedes
The count of eight is derived only after the four liability items are enumerated alongside the four assets.
R6K5K3requires
The specific four-asset composition requires cash be excluded, otherwise the asset list would have five entries.
R7K6K4requires
The four-liability composition requires debt be excluded, otherwise financing items would inflate the liability list.
R8K7K8confused with
The two operating-asset names and two operating-liability names are easily transposed across the balance sheet sides.

**What is ROA & ROE? If 50/50 D-to-E and 10% ROA, what is the ROE?

ROA: NI/Asset AVG, is how efficient a company utilize its assets to generate earnings. ROE: NI/Equity AVG, is how efficient a company utilizes the capital shareholders contribute to generate earnings. $10/50 = 20%

7 key points4 connections
R1R2R3R4K1ROA is net income divided…definitionROA is net income divided by average total assets, measuring how efficiently a company uses its assets to generate earningsK2ROE is net income divided…definitionROE is net income divided by average shareholders' equity, measuring how efficiently the company uses the capital shareholders contributed to generate earningsK3A 50/50 debt-to-equity mi…conditionA 50/50 debt-to-equity mix means assets are funded half by debt and half by equityK4On $100 of assets, $50 is…quantitativeOn $100 of assets, $50 is debt and $50 is equityK5A 10% ROA means net incom…quantitativeA 10% ROA means net income of $10 on $100 of assetsK6ROE is $10 of net income …quantitativeROE is $10 of net income over $50 of equity, or 20%K7Equity multiplier = asset…mechanismEquity multiplier = assets / equity = $100 / $50 = 2, so ROE = ROA × equity multiplier = 10% × 2 = 20%
  • causesone step produces another
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • confused withlearners mix these two up
R1K3K4causes
A 50/50 ratio only yields the $50/$50 split because total assets are normalized to $100.
R2K4K5requires
Net income of $10 from 10% ROA only follows once $100 of total assets is established.
R3K5K6precedes
ROE as $10/$50 cannot be computed until the $10 net income from ROA is in hand.
R4K6K7confused with
Both yield 20% ROE, so learners often cite the multiplier method while mis-deriving the income/equity division.

**What is ROIC? How do you calculate it?

Assesses how efficient a company is at capital allocation. Is >> WACC, is efficient. NOPAT/Invested Capital

9 key points4 connections
R1R2R3R4K1ROIC (return on invested …definitionROIC (return on invested capital) measures how efficiently a company converts capital invested in the business into after-tax operating profitK2ROIC is the core test of …definitionROIC is the core test of whether management is a good allocator of capitalK3ROIC is calculated as NOP…quantitativeROIC is calculated as NOPAT (net operating profit after tax) divided by invested capitalK4NOPAT is operating income…mechanismNOPAT is operating income times (1 − tax rate), which isolates operating profitability from financing decisionsK5Invested capital is debt …quantitativeInvested capital is debt plus equity, or equivalently total assets minus non-interest-bearing liabilities like payables and accrualsK6ROIC matters because of t…mechanismROIC matters because of the comparison to WACC, the blended cost of the debt and equity funding the businessK7WACC is the hurdle rate t…causalWACC is the hurdle rate that ROIC must clearK8If ROIC exceeds WACC, eac…causalIf ROIC exceeds WACC, each reinvested dollar earns more than it costs, so management is allocating capital efficiently and creating valueK9If ROIC is below WACC, th…causalIf ROIC is below WACC, the company destroys value with every dollar it reinvests, no matter how fast revenue grows
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • confused withlearners mix these two up
R1K3K4requires
Without defining NOPAT as operating income times (1 − tax rate), the numerator in ROIC cannot be computed.
R2K5K3requires
ROIC cannot be calculated without knowing what goes in the denominator, invested capital.
R3K6K7precedes
WACC as the hurdle rate cannot be stated without first introducing WACC as the blended cost of funding.
R4K8K9confused with
Both compare ROIC to WACC but state opposite value-creation conclusions, so learners swap the conditions.

What are the quick & current ratios?

Current: Short-term obligations (Current Assets/Liabilities) Quick: Liquid Assets (cash, A/R, short-term investments)/Current Liabilities Can be misleading if A/R is uncollectible or short-term asset is illiquid

9 key points4 connections
R1R2R3R4K1The current and quick rat…definitionThe current and quick ratios are liquidity ratios measuring whether a company can cover obligations due within a yearK2Current ratio = current a…quantitativeCurrent ratio = current assets / current liabilitiesK3A current ratio above 1 m…conditionA current ratio above 1 means short-term assets exceed short-term obligationsK4Quick ratio = (cash + acc…quantitativeQuick ratio = (cash + accounts receivable + short-term investments) / current liabilities — it excludes inventory and prepaidsK5The quick ratio is the st…contrastThe quick ratio is the stricter testK6Inventory and prepaids ar…causalInventory and prepaids are excluded from the quick ratio because they often can't be converted to cash quickly or without discountingK7Both ratios can be mislea…conditionBoth ratios can be misleading: receivables in the numerator may be uncollectibleK8Both ratios can be mislea…conditionBoth ratios can be misleading: short-term investments can be illiquid in practiceK9Because of those caveats,…mechanismBecause of those caveats, you'd supplement the ratios with receivables aging or the cash conversion cycle
  • precedesmust be said in this order
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
R1K1K3precedes
Interpreting above 1 as sufficient coverage consumes the definition that ratios test one-year obligations.
R2K2K7confused with
A learner substituting formula correctness for numerator quality states the ratio yet misses uncollectible receivables.
R3K4K6requires
You cannot justify which assets the quick ratio drops without the convertibility criterion.
R4K5K4requires
Calling the quick ratio stricter presupposes its formula excludes less-liquid current assets.

**What are the asset, inventory, receivables, accounts payable turnovers? What do they mean?

Asset = Rev/Avg Asset Inv = COGS/Inv Receivables = Rev/AR A/P = COGS/AP

9 key points5 connections
R1R2R3R4R5K1Turnover ratios are activ…definitionTurnover ratios are activity ratios measuring how efficiently the company converts balance sheet items into sales, expressed as times per yearK2Asset turnover = revenue …quantitativeAsset turnover = revenue for the period divided by average total assets over the period — dollars of sales generated per dollar of assetsK3Inventory turnover = COGS…quantitativeInventory turnover = COGS for the period divided by average inventory over the period — how many times a year the company sells through its stockK4Inventory turnover uses C…mechanismInventory turnover uses COGS rather than revenue because inventory is carried on the books at costK5Receivables turnover = re…quantitativeReceivables turnover = revenue for the period divided by average accounts receivable over the period — how quickly customers pay their billsK6A/P turnover measures the…contrastA/P turnover measures the rate at which the company pays its suppliers, and a lower payables turnover indicates the company is stretching payment terms to hold onto cash longerK7Each turnover converts to…mechanismEach turnover converts to a days metric by dividing 365 by the ratio — DSO, DIO, DPOK8DSO, DIO, and DPO combine…causalDSO, DIO, and DPO combine into the cash conversion cycle — the days a dollar is tied up between paying suppliers and collecting from customersK9Higher isn't always bette…contrastHigher isn't always better: faster inventory and collections are good, but a lower payables turnover can actually help cash flow
  • applies withinholds only in the other’s scope
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
  • precedesmust be said in this order
R1K2K1applies within
The asset turnover formula is only meaningful under KLP0's framing of turnover ratios as sales-conversion activity measures.
R2K4K3requires
Inventory turnover's denominator must be a cost-based stock measure, so its COGS-based definition depends on KLP3 being true.
R3K5K6confused with
Receivables and payables turnover both use revenue-style and balance-sheet inputs, and learners easily swap the customer-collection idea with supplier-payment stretching.
R4K7K8precedes
The cash conversion cycle can only be stated after each turnover has been converted into its days form via 365 divided by the ratio.
R5K9K8applies within
The cash conversion cycle interpretation only holds when higher collections/inventory velocity and lower payables turnover are valued as cash-flow-favorable.

**What is the DSCR & FCCR? How to calculate? When are they used?

Debt Service Coverage Ratio - measures creditworthiness, whether a company can pay off their debt obligations. Usually used in distressed scenarios. - Formula: (EBITDA-CapEx)/(Mandatory Principal Repayment + Interest Expense) - Often must be 1.25/1.5x or higher (used in Rx & Real Estate) Fixed Charge Coverage Ratio - Assesses whether a company's earnings can over its fixed charges - Formula: (EBIT + Lease Charges)/(Lease Charges + Interest Expenses) - Often must be 1.25x/1.5x or higher. Note: Lease Charges is on top & bottom (since you're measuring cash before you pay vs how much you actually pay)

9 key points6 connections
R1R2R3R4R5R6K1DSCR measures whether a c…definitionDSCR measures whether a company's cash flow can cover its debt service, making it a core creditworthiness test.K2DSCR matters most in dist…conditionDSCR matters most in distressed or highly leveraged situations, where the question is whether the borrower can keep paying.K3DSCR equals EBITDA minus …quantitativeDSCR equals EBITDA minus CapEx, divided by mandatory principal repayments plus interest expense.K4CapEx is subtracted from …mechanismCapEx is subtracted from EBITDA because cash must first cover reinvestment before it can service debt.K5Lenders typically require…conditionLenders typically require DSCR of at least 1.25x to 1.5x, so cash flow covers debt service with a cushion.K6DSCR thresholds are stand…exampleDSCR thresholds are standard covenants in restructuring and real estate lending.K7FCCR measures whether ear…definitionFCCR measures whether earnings cover all fixed charges — including lease obligations — not just interest and principal.K8FCCR equals EBIT plus lea…quantitativeFCCR equals EBIT plus lease expense, over lease expense plus interest expense, and also generally needs to clear 1.25x to 1.5x.K9Lease expense sits in bot…mechanismLease expense sits in both the numerator and denominator of FCCR because you compare cash available before paying fixed charges to the charges themselves.
  • applies withinholds only in the other’s scope
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • confused withlearners mix these two up
R1K2K1applies within
DSCR as a core creditworthiness test only bites in distressed or highly leveraged cases, not healthy borrowers.
R2K3K4requires
The formula subtracting CapEx from EBITDA only holds if the cash-first-for-reinvestment rationale explains why CapEx sits in the numerator.
R3K3K5precedes
Interpreting the 1.25x minimum as a cushion requires already knowing the numerator is cash available after CapEx.
R4K6K5requires
DSCR thresholds being standard covenants presupposes the specific 1.25x-1.5x cushion level lenders actually require.
R5K7K8precedes
You cannot state the FCCR formula placing lease expense in both numerator and denominator without first having defined FCCR as covering all fixed charges.
R6K7K8confused with
Learners conflate FCCR's formula with DSCR's fixed-charge coverage concept, swapping which charges enter each ratio.

How does share repurchases affect the 3 statements?

IS: No effect CFS: Financing Cash Outflow BS: Decrease in cash = decrease in equity

9 key points4 connections
R1R2R3R4K1On the income statement, …contrastOn the income statement, there is no effect from a share repurchase.K2Net income is unchanged b…mechanismNet income is unchanged because a buyback is not revenue, an expense, or a tax item.K3On the cash flow statemen…mechanismOn the cash flow statement, the repurchase is a financing cash outflow, not an operating or investing cash flow.K4The repurchase is like a …exampleThe repurchase is like a dividend or debt repayment.K5On the balance sheet, cas…quantitativeOn the balance sheet, cash falls by the repurchase amount on the asset side.K6Shareholders' equity fall…quantitativeShareholders' equity falls by the same amount as the cash outflow.K7The repurchased shares ar…mechanismThe repurchased shares are held as treasury stock, which reduces equity.K8Assets and equity shrink …mechanismAssets and equity shrink together, so the balance sheet stays balanced.K9Shares outstanding drop w…causalShares outstanding drop while net income is unchanged, so EPS rises.
  • applies withinholds only in the other’s scope
  • causesone step produces another
  • requiresthe second is only true if the first is
R1K3K4applies within
Classifying the buyback as financing only holds because it parallels dividends and debt repayment, not operations.
R2K6K8causes
If equity fell by less than cash, assets would shrink without matching equity and the sheet would unbalance.
R3K7K6causes
If repurchased shares were not treasury stock, nothing would reduce equity by the cash amount.
R4K9K2requires
EPS rising needs unchanged net income in the numerator; if buyback cut net income, EPS could fall.

When can a company capitalize software development costs under accrual accounting?

2 possibilities: 1) App development stage (internal use) 2) Stage when "technologically feasibility" = reached (can be marketed) NOTE: All development costs are recognizes like a fixed asset purchase and capitalized/amortized over useful life

9 key points5 connections
R1R2R3R4R5K1Under accrual accounting,…definitionUnder accrual accounting, software development costs are generally expensed as R&D as they are incurred.K2Broader rule: there are t…conditionBroader rule: there are two specific situations in which software development costs get capitalized rather than expensed as R&D; in all other cases they are expensed as incurred.K3First situation: for soft…conditionFirst situation: for software a company builds for its own internal use, costs can be capitalized once the project reaches the application development stage.K4The application developme…definitionThe application development stage means actual coding and configuration of the software; upfront planning, design, and other preliminary activities are not part of it.K5Second situation: for sof…conditionSecond situation: for software the company intends to sell or market, costs can be capitalized only once technological feasibility has been established — that is, the details of the design and the plan are complete enough to determine whether the product can actually be built and brought to market. Technological feasibility is not reached merely because coding has begun.K6Technological feasibility…definitionTechnological feasibility means design and planning are complete enough that the product can actually be built and brought to market.K7Before either trigger poi…contrastBefore either trigger point — the start of the application development stage for internal-use software, or the establishment of technological feasibility for software to be sold — costs flow through the income statement as expenses.K8Once capitalized, the cos…mechanismOnce capitalized, the costs sit on the balance sheet like a fixed asset purchase, and are amortized over the software's useful life.K9Amortizing the capitalize…causalAmortizing the capitalized costs spreads them across future periods, shifting expense off the current income statement and flattering near-term profit.
  • applies withinholds only in the other’s scope
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
  • causesone step produces another
R1K3K4applies within
Capitalizing internal-use costs at the application development stage only holds under KLP3's definition of that stage as coding, excluding planning and design.
R2K3K5confused with
Learners conflate the internal-use trigger (application development stage) with the sold-software trigger (technological feasibility), applying the wrong test.
R3K5K6requires
KLP4's capitalization trigger for software to be sold cannot hold without KLP5's definition of technological feasibility as completed design and planning.
R4K7K2requires
Stating that pre-trigger costs are expensed consumes KLP1's prior result that only two situations permit capitalization.
R5K8K9causes
KLP7's capitalization as a balance-sheet asset drives KLP8's amortization spreading expense across future periods, flattering near-term profit.

You buy a factory for $10M at the start of the year. It has a 10-year useful life. Then you sell it in the beginning of year 2 for $5M. Record the changes in the 3 statements in year 1 & year 2 assuming a 50% tax rate.

YEAR 1: IS: $1M Depreciation, so negative $500K to NI CFS: Operating is up $500K (1M adjustment), but investing is down $10M. In total, down 9.5M BS: Cash is down $9.5M, offset by $9M increase assets ($1M depreciation) & Equity is down $500K YEAR 2: IS: Loss on Sale of Equipment ($4M) -> negative $2M to NI CFS: $2M non-adjustment in CFS + $5M for investing, so +$7M in total BS: Cash up $7M but Assets down $9M. Offset by Equity, which is down $2M

9 key points8 connections
R1R2R3R4R5R6R7R8K1A factory purchase is a c…definitionA factory purchase is a capital expenditure, so the $10M purchase never touches the income statement at acquisition; it is a $10M investing outflow on the year 1 cash flow statement.K2Over year 1 the factory d…quantitativeOver year 1 the factory depreciates $1M straight-line ($10M cost over a 10-year life), cutting pre-tax income by $1M and net income by $500K at the 50% tax rate.K3Year 1 cash flow statemen…mechanismYear 1 cash flow statement starts from the -$500K net income and adds back the $1M of non-cash depreciation, leaving operating cash flow +$500K thanks to the tax shield.K4Year 1 investing cash flo…quantitativeYear 1 investing cash flow is down $10M for the purchase, so total cash falls $9.5M.K5Year 1 balance sheet: cas…quantitativeYear 1 balance sheet: cash down $9.5M and PP&E up $9M net of depreciation, so total assets and retained earnings (equity) are each down $500K and the sheet balances.K6Year 2: the sale happens …quantitativeYear 2: the sale happens at the start of the year, so no depreciation is recorded, and selling for $5M against the $9M book value creates a $4M loss.K7Year 2: the $4M loss redu…mechanismYear 2: the $4M loss reduces net income by $2M after the 50% tax rate and is added back as non-cash, so operating cash flow is +$2M, and the $5M proceeds sit in investing — total cash up $7M.K8Year 2 balance sheet: cas…quantitativeYear 2 balance sheet: cash up $7M against PP&E down $9M, so assets and equity both fall $2M and the sheet balances.K9Netted across both years,…causalNetted across both years, cash and equity are each down $2.5M — we paid $10M, got back $5M, and the tax shields recovered part of the loss.
  • causesone step produces another
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
R1K2K3causes
The add-back amount equals the depreciation charge, so a different depreciation directly changes operating cash flow.
R2K2K5causes
Year 1 retained earnings fall by net income, which the depreciation charge determines.
R3K3K5requires
The cash change on the year 1 balance sheet comes directly from operating plus investing cash flow.
R4K3K7confused with
Both add back a non-cash item to reach operating cash flow, but from depreciation versus a loss.
R5K5K8confused with
Both are balance-sheet balance checks differing only by year and by depreciation versus disposal.
R6K6K7causes
The size of the loss fixes the tax shield add-back and thus year 2 operating cash flow.
R7K6K8requires
Year 2 balance sheet needs the $9M book value and $5M proceeds from the sale-loss point.
R8K7K8requires
Year 2 balance sheet cash movement equals the year 2 total cash flow figure.

What is the difference between Levered FCF & Unlevered FCF?

Unlevered FCF represents cash flow from core operations after OpEx & Investments. UFCF: EBIT* (1-Tax) +D&A-NWC Changes-CapEx LFCF: Cash from Operations - CapEx - Debt Principal Payments

8 key points4 connections
R1R2R3R4K1Unlevered FCF is the cash…definitionUnlevered FCF is the cash from core operations available to all capital providers — debt and equity holders — before any financing effects.K2UFCF equals EBIT times (1…quantitativeUFCF equals EBIT times (1 minus tax) plus D&A, minus the change in net working capital, minus CapEx.K3Unlevered FCF is not redu…conditionUnlevered FCF is not reduced by interest expense or any debt service, because it is computed before financing flows.K4Levered FCF is the cash r…definitionLevered FCF is the cash remaining for equity holders after financing — cash from operations minus CapEx minus debt principal repayments.K5Interest isn't subtracted…mechanismInterest isn't subtracted separately in the levered formula because it has already been deducted inside cash from operations under US GAAP.K6Levered FCF is reduced by…contrastLevered FCF is reduced by mandatory debt service, so higher leverage lowers levered FCF even when operating cash flow is unchanged.K7You discount unlevered FC…causalYou discount unlevered FCF at WACC to get enterprise value, and levered FCF at the cost of equity to get equity value.K8Because the two measures …contrastBecause the two measures use different discount rates and different claimholders, substituting one for the other in a DCF yields the wrong value.
  • requiresthe second is only true if the first is
  • causesone step produces another
R1K1K2requires
You cannot state the EBIT-based build-up without first knowing UFCF is pre-financing cash to all capital providers.
R2K2K5causes
Starting the levered build from CFO automatically embeds interest, explaining why it is not subtracted again.
R3K6K3causes
Because mandatory debt service lowers LFCF, one infers UFCF must exclude debt service to stay leverage-neutral.
R4K7K8causes
Different discount rates and claimholders are what make substituting one FCF measure for the other value-wrong.

If a company has no debt, what is its WACC? How is CoE calculated?

CoE = CAPM, so Risk Free Rate + Levered Beta * ERP

8 key points5 connections
R1R2R3R4R5K1WACC is the blended requi…definitionWACC is the blended required return on all capital, weighting each source's cost by its share of the capital structure.K2With no debt, equity is 1…quantitativeWith no debt, equity is 100% of the capital structure.K3Because the debt weight i…causalBecause the debt weight is 0%, the weighted average has only one nonzero term, so WACC equals the cost of equity.K4Cost of equity is calcula…quantitativeCost of equity is calculated with CAPM: the risk-free rate plus levered beta times the equity risk premium.K5The risk-free rate compen…definitionThe risk-free rate compensates investors for the time value of money, and in practice is the 10-year Treasury yield.K6Beta measures how sensiti…mechanismBeta measures how sensitive the stock is to movements in the overall market.K7Levered beta is used beca…mechanismLevered beta is used because it reflects the risk of the company as it is actually financed — all equity in this case.K8The equity risk premium i…definitionThe equity risk premium is the extra return the market pays above the risk-free rate for bearing systematic risk.
  • causesone step produces another
  • applies withinholds only in the other’s scope
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
R1K2K3causes
If equity were only 60% of capital, the weighted average would retain a debt term and WACC would not equal CoE.
R2K2K7applies within
Levered beta reflects the all-equity financing only because debt is zero; with debt, levered beta would differ from asset beta.
R3K4K5requires
CAPM cannot be stated without the risk-free rate input that compensates for time value of money.
R4K4K6requires
CAPM's levered beta input cannot be applied without already knowing beta measures market sensitivity.
R5K6K7confused with
Learners routinely swap raw beta, the market-sensitivity measure, with levered beta adjusted for the firm's financing.

If a company had a 0% chance of defaulting, what would be its CoD, CoE, and WACC?

CoD = Risk-free rate (theoretically 0% since US gov bonds still have a chance like 0.01% of defaulting - since no risk then you shouldn't have to get compensated). CoE = Risk-free rate (since beta = 0, uncorrelated with market, again should be 0%) Thus, WACC = 0%

7 key points4 connections
R1R2R3R4K1Cost of capital is the re…definitionCost of capital is the return investors demand to compensate for risk — remove the risk and you remove the required compensation.K2Lenders charge a spread o…mechanismLenders charge a spread over Treasuries almost entirely to price default risk.K3With zero chance of defau…causalWith zero chance of default there is no credit loss to compensate, so no default-risk spread is required on the debt.K4Since even Treasuries car…quantitativeSince even Treasuries carry a sliver of default risk, a truly riskless asset deserves no risk compensation at all, so the cost of debt is 0%.K5Under CAPM, the cost of e…definitionUnder CAPM, the cost of equity is the risk-free rate plus beta times the equity risk premium.K6The company's cash flows …quantitativeThe company's cash flows are uncorrelated with the market, so its beta is zero, and the equity risk premium term vanishes; the cost of equity is therefore 0%.K7WACC is the weighted aver…quantitativeWACC is the weighted average of the cost of debt and the cost of equity, so with both at 0% the WACC is 0%.
  • causesone step produces another
  • requiresthe second is only true if the first is
  • applies withinholds only in the other’s scope
R1K3K4causes
Removing the default-risk spread on debt is what drives the cost of debt down to zero.
R2K4K7requires
The zero WACC conclusion consumes the cost of debt being 0% as one of its two inputs.
R3K5K6applies within
The beta-zero equity conclusion only holds inside the CAPM framework the equity cost is defined by.
R4K6K7requires
WACC averaging to zero cannot be stated without first establishing the cost of equity equals zero.

**What is the formula to go from Unlevered -> Levered Beta?

Unlevered = Levered/(1+D/E * (1-Tax)), Levered= Unlevered * (1+Tax Rate * D/E)

6 key points5 connections
R1R2R3R4R5K1Levered (equity) beta ref…definitionLevered (equity) beta reflects the company's business risk plus the extra risk added by its capital structure.K2Unlevered (asset) beta st…definitionUnlevered (asset) beta strips out leverage to isolate pure business risk.K3The relevering formula is…quantitativeThe relevering formula is: levered beta = unlevered beta × [1 + (1 − tax rate) × (D/E)].K4Unlevering is the inverse…quantitativeUnlevering is the inverse operation: unlevered beta = levered beta / [1 + (1 − tax) × D/E].K5The (1 − tax) term exists…causalThe (1 − tax) term exists because interest is tax-deductible.K6The interest tax shield d…mechanismThe interest tax shield dampens how much extra risk each dollar of leverage piles onto equity.
  • confused withlearners mix these two up
  • applies withinholds only in the other’s scope
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • causesone step produces another
R1K1K2confused with
Levered and unlevered beta are routinely swapped, since both are called beta and differ only by capital structure.
R2K2K3applies within
The relevering formula is meaningful only because unlevered beta was defined as removing leverage; the equation bridges these two defined quantities.
R3K3K6requires
The formula's validity assumes the tax shield dampens leverage risk; without that mechanism the equation would have a different form.
R4K4K3precedes
Deriving the unlevering formula consumes the relevering formula by algebraic inversion, so you need the lemma before the corollary.
R5K5K3causes
The tax-deductibility of interest is precisely what puts (1 − tax) into the relevering multiplier.

How do you estimate Cost of Debt?

If public, just use the yield on debt (avg interest expense/avg debt). If no public debt, create a synthetic/estimated rating of their debt & use the market credit spread (which you add to risk-free rate) to calculate yield

6 key points5 connections
R1R2R3R4R5K1Cost of debt is the effec…definitionCost of debt is the effective yield a company pays on its borrowed funds — the return its lenders requireK2If the company's debt is …mechanismIf the company's debt is publicly traded, use the market yield on that debt directly as the cost of debtK3In practice, because corp…quantitativeIn practice, because corporate bonds often are not liquidly traded, proxy the yield on the debt as average interest expense divided by average total debtK4If there is no public deb…conditionIf there is no public debt, build a synthetic rating by benchmarking the company's credit metrics — its leverage and interest coverage ratios — against those of rated peersK5For the synthetic (or act…mechanismFor the synthetic (or actual) rating, take the market credit spread investors demand for bonds of that rating and add it to the risk-free rateK6The sum of the credit spr…quantitativeThe sum of the credit spread and the risk-free rate is the estimated yield on the debt, i.e. the estimated cost of debt
  • precedesmust be said in this order
  • confused withlearners mix these two up
  • causesone step produces another
R1K2K3precedes
The illiquidity fallback proxy only makes sense once you know the market-yield route exists but fails.
R2K2K4confused with
Both pick the cost of debt, but one uses traded market yield while the other builds a synthetic rating.
R3K3K4confused with
Both are fallbacks when no clean market yield exists, but one proxies via expense/debt and the other via peer ratings.
R4K4K5precedes
You cannot add a credit spread without first deriving the rating that selects which spread applies.
R5K5K6causes
If spread plus risk-free rate did not compose the yield, the final cost-of-debt sum would be undefined.

How are operating & financial leases treated in a DCF?

THE SIMPLE METHOD: GAAP: Operating leases are treated as operating expenses just expensed by the rent expense amount, and it's not treated as debt (so not added back) IFRS: Build a debt amortization/ROU asset depreciation schedule - see how much you're adjusting non-cash vs outflow for debt repayments. HARD METHOD (argued against since not really debt - principal repayments are tax-deductible): Treat Operating Leases as debt - thus, add-back all the changes and exclude from DCF, including it in your WACC at the end

7 key points4 connections
R1R2R3R4K1Under the simple GAAP met…conditionUnder the simple GAAP method, operating lease payments sit in rent expense inside operating income, so unlevered free cash flow already reflects themK2Under simple GAAP, operat…contrastUnder simple GAAP, operating lease obligations are not added to debt and get no WACC adjustment, because doing so would double count the rent already in FCFK3Finance leases are debt-l…contrastFinance leases are debt-like under both frameworks: interest is a financing cost excluded from FCF and the lease liability counts as debtK4Under IFRS 16 all leases …mechanismUnder IFRS 16 all leases are capitalized, so you build a schedule splitting each fixed payment into ROU depreciation and principal repaymentK5In the IFRS schedule, dep…mechanismIn the IFRS schedule, depreciation is a non-cash charge added back to FCF, while the principal repayment is a financing outflow excluded from FCFK6The hard GAAP method trea…contrastThe hard GAAP method treats operating leases as debt: capitalize the obligation, exclude rent from FCF, and include the liability in WACCK7The hard method is argued…causalThe hard method is argued against because the full lease payment is tax-deductible as rent, whereas debt treatment only gives a tax shield on interest, misstating taxes
  • causesone step produces another
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
R1K1K2causes
Because rent already sits in operating income, adding the lease to debt and WACC would double count it.
R2K4K5requires
Splitting each IFRS payment into depreciation and principal is needed before classifying which piece is added back versus financing.
R3K4K5confused with
Both involve the IFRS lease payment schedule, so learners conflate the schedule construction with the FCF classification of its outputs.
R4K6K7causes
Treating operating leases as debt is only coherent if you exclude rent, which then destroys the full rent tax shield.

A company takes on $1000 in operating leases to buy PP&E. How does Equity Value & Enterprise Value change?

Equity Value = unchanged, as it is an off-balance-sheet commitment Enterprise Value = increases. Operating leases is added back if you're using a EBITDAR or revenue multiple that excludes its capital structure effects (similar to how EBIT excludes interest expense from debt). Since ROU is an operating asset, it's included

6 key points5 connections
R1R2R3R4R5K1Taking on an operating le…definitionTaking on an operating lease means committing to fixed rental payments to use an asset instead of buying it outright with financingK2Equity value is unchanged…causalEquity value is unchanged because a lease is an operating commitment, not a financing transaction — no cash is raised from investorsK3Enterprise value increase…causalEnterprise value increases because the lease obligation is added back as a debt-like itemK4The add-back applies when…conditionThe add-back applies when valuing off EBITDAR or revenue multiples, whose metrics exclude the lease expense and therefore its capital-structure-like effectK5By contrast, borrowing to…contrastBy contrast, borrowing to buy the asset would bring in cash and change equity holders' positionK6The ROU asset sits inside…conditionThe ROU asset sits inside enterprise value as a productive operating asset, while equity holders' claim stays untouched
  • causesone step produces another
  • precedesmust be said in this order
  • applies withinholds only in the other’s scope
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
R1K1K3causes
The lease being an operating commitment rather than a financing transaction is what makes the obligation a debt-like add-back to EV.
R2K2K3precedes
You must first establish equity value is untouched by the operating lease before attributing the entire change to enterprise value.
R3K3K4applies within
The EV increase from adding back the lease only holds when using EBITDAR or revenue multiples that exclude lease expense.
R4K3K6confused with
Learners confuse the ROU asset sitting inside EV with the lease obligation being added back as debt-like, mixing asset and liability effects.
R5K5K2requires
The claim that equity value is unchanged depends on contrasting with borrowing, which would bring in cash and alter equity holders' position.

How are operating & financial leases change over time? How does it differ from other types of debts?

Under GAAP (operating) you still pay fixed amount, but difference is that depreciation is same as principal repayment, so the CFS has no adjustments (you just pay the fixed amount). Asset goes down at same speed as liability. Under IFRS, you pay a fixed amount (say $20) for principal repayment & interest expense. Depreciation = straight-line. Thus, asset can go down faster than liability. Use schedule to calculate each separately

9 key points6 connections
R1R2R3R4R5R6K1Each fixed lease payment …mechanismEach fixed lease payment is split between reducing the lease liability and expensing the right-of-use assetK2Under GAAP operating leas…conditionUnder GAAP operating leases, the single lease expense reported each period is a fixed, straight-line amount for the entire lease term, and it is not presented as an interest-plus-depreciation splitK3Because the expense is le…mechanismBecause the expense is level, the ROU asset reduction equals the liability reduction each period — asset and liability decline at the same speedK4So on the cash flow state…mechanismSo on the cash flow statement there are no adjustments under GAAP — the fixed cash payment fully explains the changeK5Under IFRS, the lessee re…mechanismUnder IFRS, the lessee reports a depreciation charge on the ROU asset and a separate interest expense on the lease liability, rather than one level lease expenseK6Under IFRS, depreciation …contrastUnder IFRS, depreciation is straight-line while interest declines as the liability shrinksK7Early in an IFRS lease, i…causalEarly in an IFRS lease, interest is high so principal repayment is small, meaning the liability declines more slowly than the assetK8Unlike the GAAP case, the…contrastUnlike the GAAP case, the IFRS cash flow statement needs a schedule that calculates depreciation, interest, and principal separatelyK9Versus plain debt: debt h…contrastVersus plain debt: debt has no ROU asset, and like IFRS leases its interest declines and principal grows — whereas GAAP operating lease expense stays flat for the whole term
  • requiresthe second is only true if the first is
  • causesone step produces another
  • confused withlearners mix these two up
  • precedesmust be said in this order
  • applies withinholds only in the other’s scope
R1K2K3requires
Equal asset and liability reduction is derived from the level straight-line expense; without that premise the equal-speed claim has no basis.
R2K3K4causes
If ROU and liability declined at different speeds, the cash flow statement would need reconciling adjustments rather than being fully explained by the cash payment.
R3K5K9confused with
Both involve declining interest and growing principal, so learners conflate IFRS lease accounting with plain debt treatment.
R4K6K7precedes
You cannot derive slow liability decline in early IFRS periods without first knowing interest declines while depreciation stays straight-line.
R5K7K8causes
The need for a separate depreciation/interest/principal schedule arises because IFRS liability and asset decline at different rates.
R6K9K2applies within
The flat GAAP operating lease expense that contrasts with debt only holds because GAAP does not split interest and depreciation.

How are leases treated on the balance sheet?

Asset - ROU Asset. Liabilities = equal amount (lease liability)

6 key points7 connections
R1R2R3R4R5R6R7K1Under both GAAP and IFRS …definitionUnder both GAAP and IFRS a lease is capitalized, so the balance sheet picks up a right-of-use asset on the asset side and an offsetting lease liability on the liabilities side.K2The ROU asset represents …definitionThe ROU asset represents the company's right to use the leased asset.K3The lease liability repre…definitionThe lease liability represents the obligation to keep making the remaining lease payments.K4At inception the ROU asse…quantitativeAt inception the ROU asset and lease liability are recorded at the same amount, the present value of the future lease payments, so the balance sheet stays balanced when the lease is signed.K5After inception the liabi…mechanismAfter inception the liability amortizes with an interest component while the ROU asset is depreciated.K6Because the two sides are…causalBecause the two sides are subsequently reduced at different rates, the ROU asset and the lease liability diverge and no longer appear as equal amounts.
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • causesone step produces another
  • applies withinholds only in the other’s scope
R1K2K3confused with
Learners often swap the ROU asset (right to use) with the lease liability (obligation to pay), stating the wrong side of the entry.
R2K4K5requires
You cannot describe the post-inception split into interest and depreciation without first having the inception PV equality as the starting basis.
R3K4K6precedes
The claim that the two amounts stop being equal presupposes they were equal at inception, so the later claim consumes the earlier result.
R4K4K1causes
If the initial ROU asset and liability amounts were not equal, capitalizing the lease would not keep the balance sheet balanced as KLP 0 implies.
R5K5K6causes
Different subsequent reduction rates are the derivation's input; the divergence in carrying amounts is the output you cannot state without it.
R6K5K2applies within
Depreciating the ROU asset only makes sense if the ROU asset is the right to use the asset rather than the underlying asset itself.
R7K6K3applies within
The divergence between the two amounts only holds if the lease liability is the obligation for remaining payments rather than a fixed recorded sum.

How is TV calculated?

1) Perpetuitiy (Gordon Growth) - calculated by assuming perpetual growth after forecast period. It's the (projected cash flow for 1 year after forecast)/r-g 2) Exit Multiple - Calculated by applying a multiple assumption on a metric (usually EBITDA) in terminal year

8 key points5 connections
R1R2R3R4R5K1Terminal value captures a…definitionTerminal value captures all free cash flows beyond the explicit forecast period, so it must be calculated explicitly rather than left out of the valuation.K2The first method is Gordo…definitionThe first method is Gordon Growth: assume the company's cash flows grow at a constant rate g forever after the forecastK3The Gordon Growth TV equa…quantitativeThe Gordon Growth TV equals the projected cash flow for one year after the forecast, divided by r minus gK4The Gordon Growth numerat…mechanismThe Gordon Growth numerator is the terminal-year cash flow grown one more year at (1+g)K5In the Gordon Growth form…definitionIn the Gordon Growth formula, r is the discount rate, usually WACCK6The second method is the …definitionThe second method is the exit multiple: apply an assumed multiple, usually EV/EBITDA, to a metric in the terminal yearK7Under either method the t…mechanismUnder either method the terminal value is a value as of the end of the forecast, so it's discounted back to present using the final-year discount factorK8Gordon Growth is highly s…contrastGordon Growth is highly sensitive to the g and WACC assumptions, so a strong candidate sanity-checks its implied multiple against the exit multiple method
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • applies withinholds only in the other’s scope
R1K1K3requires
Without terminal value capturing post-forecast cash flows, the Gordon Growth formula's purpose is undefined.
R2K2K7requires
Knowing TV is valued at forecast end only matters if a method like Gordon Growth produces that end-of-forecast value.
R3K4K3precedes
You cannot correctly compute the Gordon Growth numerator without first growing the terminal-year cash flow by (1+g).
R4K5K2applies within
The Gordon Growth constant-growth formula only holds when r is the appropriate discount rate, typically WACC.
R5K6K8requires
Sanity-checking the implied multiple in KLP 7 is impossible without the exit multiple method from KLP 5.

How are options, restricted stock, convertible bonds and convertible preferred stock counted in share count/enterprise value?

If strike price is in-the-money, then count the share count and use the treasury stock method (options, convertible bonds & pref. stock). Restricted stock is generally counted (even if unvested under logic that they'll eventually vest)

8 key points7 connections
R1R2R3R4R5R6R7K1Options, restricted stock…definitionOptions, restricted stock, and convertibles are potentially dilutive securities that must be reflected in fully diluted shares before computing equity value and enterprise valueK2Out-of-the-money options …conditionOut-of-the-money options — those whose strike price is above the current share price — are excluded from the diluted share count because exercising them would be anti-dilutiveK3Under the treasury stock …mechanismUnder the treasury stock method, assume all in-the-money options are exercised, the company receives the strike proceeds, and it uses those proceeds to repurchase shares at the current market priceK4Net option dilution equal…quantitativeNet option dilution equals options multiplied by (1 minus strike over price), because the repurchase offsets most of the shares issuedK5Convertible bonds and con…conditionConvertible bonds and convertible preferred stock are counted only when conversion is in-the-moneyK6The most precise treatmen…contrastThe most precise treatment of converts is the if-converted method: add the converted shares and add back the interest or dividends you no longer pay, while a common simplification is to apply the treasury stock approach insteadK7Restricted stock is count…contrastRestricted stock is counted in full even when unvested, because there is no strike to hurdleK8Excluding unvested restri…causalExcluding unvested restricted stock would understate the true fully diluted share count
  • applies withinholds only in the other’s scope
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
  • precedesmust be said in this order
  • causesone step produces another
R1K1K2applies within
Dilution inclusion only makes sense where securities would increase shares; the anti-dilutive exclusion is the boundary condition of that inclusion.
R2K2K4requires
Net option dilution only applies to options that pass the in-the-money screen, so the formula cannot be stated before the exclusion condition is fixed.
R3K2K5confused with
Both are in-the-money screens for dilution, but one governs options and the other governs converts, so learners substitute one screen for the other.
R4K3K4precedes
The net dilution formula is derived by subtracting treasury repurchases from exercised shares, so it consumes the treasury stock method setup.
R5K4K7confused with
Learners often apply the net dilution formula to restricted stock, not realizing restricted stock has no strike and is counted in full.
R6K6K5applies within
If-converted versus treasury-stock treatment only matters once conversion is determined in-the-money, so the conversion test bounds the method choice.
R7K7K8causes
Counting restricted stock in full is what prevents the understatement; without that counting rule the understatement claim has no basis.

** For the perpetuity approach for finding TV of a company, how do you determine the long-term growth rate?

Should be around 1-3% (up to 5%). The GDP of the country where the company is based is a good proxy, as it must slow down to less than that (if it was higher, then some day the company would grow larger than the country's whole economy)

6 key points6 connections
R1R2R3R4R5R6K1The terminal growth rate …definitionThe terminal growth rate is the perpetual growth applied to final-year FCF in a growing-perpetuity terminal valueK2A reasonable long-term gr…quantitativeA reasonable long-term growth rate is roughly 1-3%, and you should almost never exceed 5%K3The long-term nominal gro…quantitativeThe long-term nominal growth rate of GDP in the company's home market is a strong benchmark or ceiling for a mature company's perpetuity growth rate; for a developed market such as the U.S. that ceiling is approximately 2-3% per yearK4For an established develo…exampleFor an established developed market, the ceiling on a perpetual growth rate is around historical long-run GDP or inflation growth of about 2-3%, not a higher rateK5If g exceeded long-run GD…causalIf g exceeded long-run GDP growth, the company would eventually grow larger than the entire country's economy — an impossible outcomeK6By the terminal period yo…conditionBy the terminal period you are valuing a mature business, so it should sit at or below GDP growth, not at a growth-stage rate
  • applies withinholds only in the other’s scope
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
  • causesone step produces another
  • precedesmust be said in this order
R1K1K6applies within
The perpetual-growth FCF formula only makes sense once the terminal period is a mature business.
R2K2K4confused with
The 1-3% working range and the 2-3% developed-market ceiling are easily swapped.
R3K4K5confused with
Learners state the 2-3% number as a memorized rule and state the GDP-too-big argument separately.
R4K5K2requires
The 1-3% band is only justified by the GDP ceiling that makes higher growth impossible.
R5K5K4causes
The impossibility of outgrowing the economy forces the 2-3% developed-market ceiling.
R6K5K6precedes
You cannot assert the terminal period is mature enough to sit at GDP growth without the GDP limit.

How do you sanity-check the TV methods with each other?

Implied G: (TV(exit)*WACC-FCF)/ (TV(exit)+FCF) or just WACC - FCF/TV Implied EV/EBITDA multiple = TV (perpetual)/EBITDA

7 key points7 connections
R1R2R3R4R5R6R7K1The two TV methods — grow…definitionThe two TV methods — growing perpetuity and exit multiple — are independent estimates of the same number, so you sanity-check each by backing out the input the other impliesK2From the perpetuity side,…quantitativeFrom the perpetuity side, the implied EV/EBITDA multiple equals the perpetuity TV divided by terminal-year EBITDAK3Ask whether a buyer would…conditionAsk whether a buyer would realistically pay that implied EV/EBITDA multiple — compare it to current trading comps for the company and its peers; if it implies a multiple no buyer would pay, the growth or WACC assumption is offK4From the exit multiple si…quantitativeFrom the exit multiple side, reverse the perpetuity formula: since TV equals FCF next year over (WACC minus g), rearranging gives implied g equals WACC minus next-year FCF over the exit-multiple TVK5The full rearrangement is…quantitativeThe full rearrangement is (TV times WACC minus FCF) over (TV plus FCF); most people quote the shortcut WACC minus FCF over TVK6The implied g should fall…conditionThe implied g should fall in the defensible 1-3% long-term band: if it comes out at 7%, your exit multiple is too aggressive; if it is negative, your multiple may be too conservativeK7The two methods should la…conditionThe two methods should land in the same neighborhood; if the implied inputs (WACC, exit multiple, growth rate) are wildly inconsistent, one of your assumptions is wrong — you go back and fix the wrong assumption rather than averaging blindly
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
  • confused withlearners mix these two up
R1K1K2requires
Backing out the other method's input requires knowing which metric that method produces.
R2K2K3precedes
Judging whether buyers would pay the multiple needs the implied multiple already computed.
R3K2K4confused with
Both back out an input, but one yields an implied multiple and the other an implied growth rate.
R4K3K6confused with
Both are sanity tests, but one checks an implied multiple against comps, the other an implied g against a band.
R5K4K5precedes
The full algebraic rearrangement presupposes the basic reverse-solve for implied g.
R6K5K6precedes
Testing whether implied g lands in 1–3% requires the rearrangement producing that g.
R7K6K7requires
Deciding an assumption is wrong depends on detecting implausible implied inputs like a 7% g.

What are the 10 things to look for when building a comp set for companies?

Profitability, Size/Growth Stage, Presence in Market, Geography, Business Model & Target Customer, Capital Structure, Growth Rate, Margin Profiel, Risks (financial and other)

9 key points5 connections
R1R2R3R4R5K1A comp set is screened fo…definitionA comp set is screened for comparability on the ten dimensions that drive multiples, so peer multiples genuinely reflect the target's valueK2Profitability matters bec…causalProfitability matters because a profitable peer earns a different multiple than a cash-burning oneK3Capital structure matters…causalCapital structure matters because leverage changes equity risk and the comparability of metricsK4Risks — financial and oth…definitionRisks — financial and otherwise — such as customer concentration, regulatory exposure, or cyclicality, must be comparableK5Presence in market is the…definitionPresence in market is the third dimension: market share and competitive positionK6Business model and target…causalBusiness model and target customer is the fifth dimension: subscription versus transactional, B2B versus consumer, because models with recurring revenue trade at structurally different multiplesK7Growth rate is the sevent…quantitativeGrowth rate is the seventh dimension: a peer growing 30% trades on a very different multiple than one growing 3%K8Margin profile is the eig…causalMargin profile is the eighth dimension: the same revenue with very different cost structures means the multiple isn't telling you the same thingK9No peer matches on everyt…causalNo peer matches on everything: you pick matches on the multiple-driving dimensions and adjust for the rest, adding industry classification and end-market exposure as a final screen so you're not comping across sectors that behave differently in a downturn
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
  • applies withinholds only in the other’s scope
R1K1K9requires
If a comp set were not screened for comparability first, the final industry screen would have no selection criteria to work with.
R2K2K7confused with
Profitability and growth both drive multiples, so a learner may cite profit margin when the differentiator is actually growth rate.
R3K3K8requires
You cannot claim the margin-profile comparison is meaningful without first fixing capital structure, since leverage distorts profit margins.
R4K4K5applies within
Market-share comparability only makes sense once risk comparability has established the peers face similar competitive and regulatory conditions.
R5K6K8confused with
Both explain why identical revenue can produce different multiples, so model type and cost structure get swapped.

A company reports $40M in SBC as a non-cash add-back. When projected UFCF in a DCF, how should SBC be treated?

As a real cash expense (no add-back). If it is added, increase diluted share count to reflect the new shares created

7 key points5 connections
R1R2R3R4R5K1Stock-based compensation …definitionStock-based compensation is employee pay delivered in shares rather than cashK2In a DCF, SBC should be t…definitionIn a DCF, SBC should be treated as a real cash expense and deducted from UFCF, with no add-backK3SBC is non-cash in the pe…mechanismSBC is non-cash in the period but is a real economic cost because employees work, the company pays them in equity, and those shares dilute existing shareholdersK4The internally consistent…conditionThe internally consistent alternative is to add the $40M back, as GAAP does on the cash flow statement, but only if you simultaneously increase the diluted share count to reflect the new shares the grants createK5Adding SBC back while lea…causalAdding SBC back while leaving the share count alone is a double count that overstates equity value per shareK6The add-back on the repor…contrastThe add-back on the reported cash flow statement is fine for historical free cash flow because there the dilution is handled separatelyK7In a DCF you are valuing …conditionIn a DCF you are valuing the whole future, so the cost must be captured either in FCF or in the share count, never in neither
  • confused withlearners mix these two up
  • causesone step produces another
  • requiresthe second is only true if the first is
R1K2K5confused with
Deducting SBC and calling the no-add-back double count both claim to fix overstatement, so learners swap the prescription for the diagnosis.
R2K3K2causes
If SBC were not a real economic cost, deducting it from UFCF would be wrong, so 2 drives 1's prescription.
R3K3K4confused with
Learners conflate 'SBC is a real cost' with 'add it back as non-cash', treating the consistency condition as the treatment itself.
R4K4K5causes
The add-back-plus-dilution-share-count route makes leaving share count alone a double count, so 3 grounds 4.
R5K7K2requires
The 'either in FCF or share count, never neither' rule is what forces SBC into UFCF once share count is fixed.

Acquirer A trades at a P/E of 20.0x with a 20% marginal tax rate. Target B trades at a P/E of 12.0x with a 25% marginal tax rate. Acquirer A buys Target B at a 30% premium using a consideration mix of 60% stock and 40% debt. The pretax cost of debt is 8.0%. Ignoring synergies and purchase price allocation (PPA) adjustments, is this transaction accretive or dilutive to Acquirer A's EPS, and by what net yield differential?

You want to compare yield vs WACC after acquisition

7 key points6 connections
R1R2R3R4R5R6K1Accretion or dilution com…definitionAccretion or dilution compares the earnings yield acquired on the target's purchase price against the blended after-tax cost of financing the purchase; if the acquired yield exceeds the financing cost, the deal is accretive to EPS.K2The premium goes into the…quantitativeThe premium goes into the purchase multiple first: 12x times 1.30 is 15.6x, so the yield you're actually buying is 1 / 15.6, about 6.4%.K3The cost of the stock por…quantitativeThe cost of the stock portion is the acquirer's own earnings yield, 1 / 20 = 5%.K4The cost of debt is the 8…quantitativeThe cost of debt is the 8% pretax rate tax-effected at the acquirer's 20% marginal rate: 8% x (1 - 0.20) = 6.4%.K5Blend the two costs by th…quantitativeBlend the two costs by the consideration mix: 60% x 5% + 40% x 6.4% = 3.0% + 2.56% = 5.56%.K6The target's 25% tax rate…causalThe target's 25% tax rate never enters the calculation; with PPA and synergies ignored, target earnings pass through unchanged and only the acquirer's rate, applied to the new interest, matters.K7The acquired yield of abo…contrastThe acquired yield of about 6.4% beats the 5.56% blended cost by about 0.85 percentage points (roughly 85 basis points), so the transaction is accretive to the acquirer's EPS.
  • applies withinholds only in the other’s scope
  • causesone step produces another
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
R1K2K1applies within
The premium-inflated purchase multiple sets which acquired yield feeds the accretion comparison.
R2K2K7causes
The 6.4% acquired yield drives the roughly 85bp accretive conclusion.
R3K3K5requires
The 5.56% blend consumes the acquirer's 5% stock cost as its other input.
R4K4K5requires
The 5.56% blend consumes the tax-effected 6.4% debt cost as one of its two inputs.
R5K4K6confused with
Learners mix up which tax rate applies to debt versus target earnings.
R6K5K7causes
The blended 5.56% cost is the benchmark the acquired yield beats.

What are the 2 values to value if a transaction is accretive or dilutive & find the net yield differential?

1) Yield vs WACC (post-acquisition) - Calculate yield of the target by doing (1/ P/E) -> how much you're earning with respect to market cap of company - % paid in stock * (yield of acquirer) + % paid in debt * (1-tax rate) * (interest rate on debt) 2) EPS (pre and post acquisition) - (New-old EPS)/old EPS*100%

8 key points5 connections
R1R2R3R4R5K1There are two complementa…definitionThere are two complementary ways to test accretion/dilution: compare the acquired yield against the blended financing cost, and compare EPS before versus after the deal.K2Method one starts with th…quantitativeMethod one starts with the target's earnings yield — 1 divided by its P/E — which is the earnings you earn per dollar of its market cap.K3The premium belongs in th…conditionThe premium belongs in this calculation: the yield you're buying is 1 over the target's P/E times (1 + premium), not the target's quoted yield.K4The financing cost blends…quantitativeThe financing cost blends two pieces: percent stock times the acquirer's earnings yield (1 / acquirer P/E), plus percent debt times the interest rate times (1 − tax rate).K5If the acquired yield exc…contrastIf the acquired yield exceeds the blended cost, the deal is accretive; the yield method is a quick screen, not the final word.K6Method two is the direct …definitionMethod two is the direct test: build pro-forma combined net income and the new share count, and compute pro-forma EPS.K7Accretion/dilution is rep…quantitativeAccretion/dilution is reported as (new EPS − old EPS) / old EPS × 100%.K8The EPS method captures t…causalThe EPS method captures the full mechanics — actual shares issued and combined earnings — so it's the number you ultimately report, while the yield method just screens direction.
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
  • precedesmust be said in this order
R1K3K2requires
Premium can't be embedded in the yield unless the raw 1/P yield is first in hand.
R2K5K4requires
The accretive/dilutive verdict needs the blended financing cost the comparison uses.
R3K5K8confused with
Learners swap the quick screen verdict for the final reported EPS number.
R4K6K5precedes
Calling the yield method a screen assumes the pro-forma EPS method exists to supersede it.
R5K7K6requires
The percentage change needs the new and old EPS numbers the pro-forma build produces.

A company has 100 options currently valued @ $1. The strike price is $10. Assume a 40% tax rate. First, walk me through Year 1. (note: must be with flashcard 48)

IS: SBC expense of $100. Post-tax NI goes down by $60. Before calculating CFS, we know that SBC doesn't actually lead to a change in cash. So, we know that a DTA/DTL will be created to offset the remaining difference. CFS: The -$60 in NI has a $100 non-cash adjustment. The positive $40 is offset by a $40 DTA. So, cash stays the same. BS: (assets) DTA = $40. (L&E) APIC = $100, R/E = -$60

9 key points7 connections
R1R2R3R4R5R6R7K1In Year 1, stock-based co…definitionIn Year 1, stock-based compensation is recorded at the fair value of the options granted: 100 options × $1 = $100, and the $10 strike price is irrelevant until exercise.K2On the income statement, …quantitativeOn the income statement, the $100 of SBC flows through operating expenses, and at a 40% tax rate the book tax benefit is $40, so net income falls by $60.K3The company gets no actua…causalThe company gets no actual tax deduction in Year 1; SBC is deductible only when the options are exercised.K4A $40 deferred tax asset …mechanismA $40 deferred tax asset (40% of the $100 book expense) is created to carry the deduction into the future.K5On the cash flow statemen…mechanismOn the cash flow statement, you start with the −$60 net income, add back the full $100 of SBC because it is a non-cash charge, and subtract the $40 build in the DTA.K6The −$60 net income, +$10…quantitativeThe −$60 net income, +$100 SBC add-back, and −$40 DTA build net to zero, so operating cash flow and total cash are unchanged in Year 1 despite the $60 net income drop.K7On the balance sheet, ass…quantitativeOn the balance sheet, assets rise by the $40 deferred tax asset. Separately, APIC rises by the full $100 gross SBC value while retained earnings falls by the $60 after-tax expense.K8The balance sheet balance…causalThe balance sheet balances because the $40 asset increase equals the net $40 equity change made up of $100 APIC less $60 retained earnings.K9The $40 DTA is a deferred…contrastThe $40 DTA is a deferred tax asset, not a current tax receivable, so it does not reduce taxes payable in Year 1.
  • causesone step produces another
  • confused withlearners mix these two up
  • requiresthe second is only true if the first is
  • precedesmust be said in this order
R1K1K2causes
The $100 fair-value expense is what drives the $60 after-tax net income fall at 40%.
R2K2K9confused with
Learners conflate the DTA with an actual current-year tax reduction, wrongly shrinking the $60 net-income hit.
R3K3K4causes
No Year-1 deduction is exactly why the $40 deferred tax asset exists rather than a current tax reduction.
R4K3K5requires
The CF statement's subtract-the-DTA step presupposes no Year-1 cash tax deduction was taken.
R5K4K5precedes
You cannot state the $40 DTA build line on the cash flow statement without first deriving the DTA.
R6K5K6precedes
The net-to-zero cash conclusion consumes the three CF line items before it can be stated.
R7K8K7requires
The balance sheet only balances because APIC rises $100 and retained earnings falls $60 as KLP 6 states.

A company has 100 options currently valued @ $1. The strike price is $10. Assume a 40% tax rate. Walk me through Year 2 in 4 different scenarios: the stock price rises to $10.5 (and is exercised), rises to $14 (and is exercised)

Scenario 1: - Since the value of options at exercise is lower than the original valuation, we must account for the difference. Originally the options were valued at $100, but only worth $50 at the time of exercise. Thus, the IS has a $50*(40% tax rate), or $20 tax expense In CFS, in the OCF the $20 decrease is offset and re-balanced by the write-down of the DTA, leading to a $20 total increase in cash. In the financing CF the exercise leads to $1000 increase from the proceeds from exercise of options. In BS (assets) DTA = -$40, cash = $1020. (L&E) R/E = -$20, (slightly inaccurate) APIC = $1000 -> note it's slightly inaccurate since APIC is additional price paid above par value. If it's a warrant that generates new stock, then it should be "$1000-par value*# of shares" Scenario 2: - Since value of options is now higher, must account for difference. Originally options were valued at $100, but now worth $400. In IS: This is a tax saving. The saving amount is the change in options price * tax rate, so $300*40% = $120 that directly affects tax expense and increases NI by $120. In CFS: OCF: The $120 increase in NI is further increase by $40 by the reversal of the DTA. Thus, operating cash increases by $160 Financing Cash Flow: $1000 increase from proceeds from exercise of options Total: $1160 IN BS: (assets) Cash = $1160, DTA = -$40. (L&E) Equity: R/E = $120, APIC = $1000

9 key points7 connections
R1R2R3R4R5R6R7K1At exercise the company's…definitionAt exercise the company's real tax deduction equals intrinsic value at exercise — ($10.50 − $10) × 100 = $50 in Scenario 1 and ($14 − $10) × 100 = $400 in Scenario 2 — not the Year 1 $100 estimate.K2Exercise generates $1,000…quantitativeExercise generates $1,000 of financing cash inflow from strike × shares — $10 × 100 — independent of the stock price.K3Scenario 1 at $10.50: the…quantitativeScenario 1 at $10.50: the $50 real deduction yields only a $20 tax benefit against the $40 DTA, a $20 shortfall.K4The shortfall is trued up…mechanismThe shortfall is trued up in the income statement as $20 of extra tax expense, so net income falls $20 in the exercise year.K5Scenario 1 cash flow: −$2…quantitativeScenario 1 cash flow: −$20 net income offset by the $40 DTA write-down nets to +$20 operating, plus $1,000 financing — cash rises $1,020.K6Scenario 1 balance sheet:…quantitativeScenario 1 balance sheet: DTA down $40 to zero, cash up $1,020, retained earnings down $20, APIC up $1,000 — assets up $980 matches equity up $980.K7Scenario 2 at $14: the $4…quantitativeScenario 2 at $14: the $400 real deduction yields a $160 tax benefit, a $120 windfall over the $40 DTA that raises net income $120.K8Scenario 2 cash flow: ope…quantitativeScenario 2 cash flow: operating rises $160 ($120 net income plus $40 DTA release) and financing adds $1,000, so total cash rises $1,160.K9In both scenarios the API…mechanismIn both scenarios the APIC credited from exercise is proceeds minus par value — strike × shares less the par value of the shares issued — so the $1,000 APIC figure is slightly overstated by that par amount.
  • causesone step produces another
  • requiresthe second is only true if the first is
  • confused withlearners mix these two up
  • precedesmust be said in this order
R1K1K3causes
The $50 real deduction is what produces the $20 benefit and thus the $20 shortfall against the $40 DTA.
R2K1K7causes
The $400 real deduction drives the $160 benefit and the $120 windfall over the DTA.
R3K2K9requires
The par-value caveat only bites because the $1,000 proceeds are credited to APIC in the first place.
R4K3K4requires
You cannot derive the $20 extra tax expense without first having the $20 shortfall amount from Scenario 1.
R5K3K7confused with
Shortfall and windfall are the symmetric Scenario 1 / Scenario 2 DTA gaps a learner flips by sign.
R6K5K8confused with
Both are cash-flow walkthroughs; learners reuse Scenario 1's +$20 operating logic inside Scenario 2's +$160.
R7K7K8precedes
The $160 operating cash figure is built from the $120 net income that only the $120 windfall establishes.

A company has 100 options currently valued @ $1. The strike price is $10. Assume a 40% tax rate. Walk me through Year 2 in 4 different scenarios (cont..): (3) is not exercised & expires worthless, and (4) the employee quits & forfeits the options

Scenario 3: In IS: The income tax expense (note: directly affects the income tax line item) goes up by the DTA amount ($40). So, in the IS NI is down $40. In CFS the $40 decrease is offset by the DTA reversal. In BS (assets) DTA = -$40, (L&E) R/E = -$40, so it balances Scenario 4: APIC goes down by full amount ($100), OpEx also goes down by $100 (which means NI is up by $60) in IS. In CFS, NI up $60 and a DTA reversal of $40 offset when you go down by $100 from SBC-add back (which is negative) In BS (Assets) DTA is down by $40, (L&E) APIC is down by $100 but R/E is up $60, so it balances

9 key points7 connections
R1R2R3R4R5R6R7K1At grant, the $100 of sto…definitionAt grant, the $100 of stock-based compensation at a 40% rate creates a $40 deferred tax asset.K2Scenario 3: because the c…mechanismScenario 3: because the company will never get the expected tax deduction at exercise, the $40 DTA reverses straight through the income tax line.K3Scenario 3: income tax ex…quantitativeScenario 3: income tax expense rises $40 through the tax line.K4Scenario 3: net income fa…quantitativeScenario 3: net income falls $40 with no change to pre-tax operating income.K5Scenario 3 cash flow: the…quantitativeScenario 3 cash flow: the $40 net income decrease is offset by a $40 non-cash DTA reversal add-back, so cash is unchanged.K6Scenario 3 balance sheet:…quantitativeScenario 3 balance sheet: DTA down $40 and retained earnings down $40, so it still balances.K7Scenario 4: reverting the…mechanismScenario 4: reverting the original SBC entries drops APIC by the full $100 and drops operating expense by $100.K8Scenario 4: unwinding the…quantitativeScenario 4: unwinding the DTA raises tax expense by $40, so net income rises only $60 rather than $100.K9Scenario 4 cash flow: NI …contrastScenario 4 cash flow: NI up $60 plus the $40 DTA reversal offset the negative $100 removal of the SBC add-back, so cash is unchanged.
  • requiresthe second is only true if the first is
  • causesone step produces another
  • confused withlearners mix these two up
R1K1K2requires
The $40 reversal in Scenario 3 consumes the $40 DTA established at grant, so KLP 1 presupposes KLP 0's asset.
R2K2K3causes
DTA reversing through the tax line is what mechanically drives the $40 rise in income tax expense.
R3K3K4causes
Higher tax expense with flat pre-tax income forces net income down by the same $40.
R4K4K8confused with
Scenario 3's $40 NI decrease and Scenario 4's $60 NI increase both stem from the $40 DTA unwind, inviting sign-swap errors.
R5K5K6requires
Scenario 3's balance sheet balance depends on the non-cash add-back already explaining why cash is unchanged.
R6K7K8requires
Net income rising only $60 requires first reverting the $100 SBC expense and DTA entries.
R7K8K9causes
The $60 NI gain plus $40 DTA reversal is what offsets the $100 SBC add-back removal, keeping cash flat.

Mentally tell me what would happen if the target IRR of your investment was 25%, while current revenue growth was 15% while EBITDA margin remained constant with no multiple expansion, what amount of debt will have to be taken to reach the targeted IRR. Feel free to ask any questions

Questions to ask: 1) What is the free cash flow conversion rate? 2) What is the entry/exit multiples? 3) What is the ECF sweep rate (% used to pay off existing debt)? Assuming no free cash flow conversion and same entry/exit, you'd know that 15% is your current IRR, while 25% is your target. So, then you can basically say rev growth is your yield (15%) and target IRR is the CoE (25%). I'd want to know cost of debt and use that to do a weighted average between 25% and my cost of debt to get to 15%, which is basically my WACC.

9 key points7 connections
R1R2R3R4R5R6R7K1With constant EBITDA marg…definitionWith constant EBITDA margins and no multiple expansion, revenue growth is the only value-creation lever, so the unlevered return equals the 15% growth rateK2Clarify the free cash flo…conditionClarify the free cash flow conversion rate firstK3Clarify the entry and exi…conditionClarify the entry and exit multiplesK4Clarify the debt sweep ra…conditionClarify the debt sweep rate — what percent of free cash flow actually pays down existing debt each yearK5With no FCF conversion an…causalWith no FCF conversion and flat multiples, debt paydown and multiple expansion contribute zero, so current IRR is just the 15% revenue growth against a 25% target, and the gap must come from leverageK6Frame the return as a WAC…contrastFrame the return as a WACC blend: 15% is the asset yield, 25% is the cost of equity on the sponsor's check, and cheaper debt pulls the blended return down to what the assets actually earnK7Set up 15% = equity weigh…quantitativeSet up 15% = equity weight x 25% + debt weight x cost of debt, and solve for the two weightsK8Example: at an 8% cost of…exampleExample: at an 8% cost of debt, equity weight is (15-8)/(25-8) = ~41%, so debt is ~59% of the structure, roughly 1.4x equityK9You cannot give a dollar …contrastYou cannot give a dollar debt figure without the entry price; the framework gives the debt-to-equity mix, then you multiply that debt weight by the capital base to size the debt
  • causesone step produces another
  • applies withinholds only in the other’s scope
  • precedesmust be said in this order
  • confused withlearners mix these two up
R1K1K5causes
If revenue growth were not the sole lever, the conclusion that leverage must close the 25% gap would collapse.
R2K2K5applies within
Treating FCF conversion as zero in KLP4 presumes the conversion question was first resolved.
R3K4K5applies within
The zero-debt-paydown conclusion in KLP4 only holds if the debt sweep rate has been clarified as immaterial.
R4K6K7precedes
The WACC blend framings must be established before the equation mixing asset yield and cost of equity can be written.
R5K6K7confused with
The WACC blend narrative and the explicit weighted equation are easily swapped, one stated as the other.
R6K7K8precedes
Solving the weight equation is required before plugging in the 8% cost of debt numeric example.
R7K8K9precedes
The debt-to-equity ratio from the example must be known before converting it to a dollar debt amount.