Detailed technical interview question
Hey guys,
first post here, so be gentle ;-).
I had an IBD interview today and kind of missed the technical questions. My interview partner, however, did not really explain me the answers afterwards, so I am turning to you.
It's mostly about getting from equity to enterprise value und what kind of adjustments one must perform:
1) Why is cash subtracted from debt?
I argued that you could inflate EV by issuing new debt in exchange for cash if the EV was not corrected for the cash you get.
My interview partner was not fully satisfied. He said the reason is that cash is not part of the operating assets - so operating assets are just OA=equity+debt ?
2) Why are minority interests added to EV?
From my understanding, minority interests do not belong to the corporation and can not be used to buy assets - unlike regular debt. So why add them?
3) Why and when are pension obligations added to EV?
It is money actually owned by the employees which the company can not put at use for itself to buy for example assets- unlike debt.
My interview partner partially agreed, saying that in some countries it is a completely seperate account that can not be included, but most of the time it will. Why and when is it, and when exactly is it not included.
4) How would you treat leases?
I have no idea on that one. (Finance) leases are usually capitalized so assets will increase and liablities do as well. So if leases are not part of regular liabilities, I guess you should add them too. Is that correct?
These are the major questions I was unable to instantly answer correcty, so if someone could help me, that will be highly appreciated.
I'll try!
1) Cash is subtracted from debt because the assumption is that all cash will be used to pay debt so there will be less debt equaling the cash amount.
2) Minority interest means the company owns a good portion of another entity (i think it's 20-49%), so the company's equity must include the portion of income they own in the other entity (or losses).
3) Pension obligations are considered liabilities and they are usually not on the balance sheet but they need to be paid so they are treated as debt.
4) Capital leases are capitalized while operating leases are not so they are off balance sheet like pension obligations which you need to add. For example, leases are like rent expense. If you have to pay $100 of rent expense to operate every year that will be your obligation and usually you will have to include the present value of all the lease payments you plan to make in the future.
Hope this helps. Sorry if I'm not too clear, I'm in a hurry.
Correct me if I'm wrong!
It's above 50% but not 100%. Within this range you have to report the full income of the subsidiary, and so your EV has to take into account buying out the portion in the subsidiary that you don't own.
Wrong, wrong, wrong, it's the portion of subsidaries that is owned by third-parties in the company we are analyzing.
You are right! I was looking at it from the minority owner side, which isn't necessarily wrong, just not right for that question.
But thanks for correcting - that's how this forum helps people - everyone contributing something they know.
bossman nailed the first 3, can't comment on the 4th. One thing you might want to add as a real world example for pensions is the big trouble Ford, Chrysler, GM etc got into regarding their pension obligations.
My take on #4. Financial leases are more comparable to mortgages. The company's interest payments (note I said "payments" not "expenses") include two components: 1) interest expense and 2) repayment of the capital lease obligation (just like a mortgage payment includes both interest for the cost of borrowing and repayment of the mortgage). So by the time a person has paid off a mortgage, he/she has paid off both the interest due and the principal amount.
Also, financial leases, unlike other leases, are treated as if the lessee will take ownership of the asset by the end of the lease. So it is capitalized (i.e., goes on the balance sheet) of the lessee, and the lessee has to expense depreciation.
When thinking about the financial statements, it's useful to think about what happens at time t and what happens at time t+1 (the end of the accounting period).
At time t, the company rents the capital asset. $100 (for example) is entered as an asset under PP&E and an equivalent $100 is entered as a liability as a "capital lease obligation."
At time t+1, the company must expense any depreciation associated with the asset, as well as interest (remember this interest expense is only one component of the total interest payment). Let's say depreciation is $10 and interest expense is $20. Multiply that by 1-tax rate (assume the tax is 40%) and we get an $18 decrease in net income.
Still at time t+1. On the cash flow statement, we have the $18 decrease in net income. Add back the $10 noncash expense of depreciation and we now have a net cash outflow of $8 (i.e., -8). Now, we include the repayment of a portion of the principal of the capital lease obligation. Let's say that $15. So we have a net change in cash of -$23.
Still at time t+1. Back to the balance sheet, we have the decrease in cash of $23 under assets. Also, the increase in accumulated depreciation of $10 (aka, a $10 decrease in net PP&E). Add those up and we have a total decrease in assets of $33. On the liabilities side, we have a decrease in the original $100 capital lease obligation of $15 (from the repayment of the principal we did on the SCF) as well as the $18 decrease in net income (under the equity section) for a total decrease in liabilities and shareholders' equity of $33.
So we're balanced. We've expensed depreciation, interest, as well as paid down a portion of the outstanding capital lease obligation.
Here is a good source for explanation and methods of handling operating leases:
http://www.elfaonline.org/cvweb_elfa/Product_Downloads/EFEB07FW.pdf
You can also get in to EBITDA/debt vs. EBITDAR/adjusted debt in certain industries that have large operating leases (retail comes to mind).
Yeah, operating leases are off the balance sheet. Just an expense.
Thanks for the quick answers! 1) This might be the case for an acquisition, but when I generally value a company this is probably not the real solution. I believe there is a more theory-based answer. 2): According to http://www.investopedia.com/terms/m/minorityinterest.asp#axzz1ch9nN4mb what you described is the meaning of the term minority interest in a general business sense, the accounting treatment is explained in 2 (the minority interests in the BS are the stakes of other companies in our subisidaries). I see why it is a liability, I just don't get why it increases Enterprise value. 3) Ok, only don't know why it increases the value of our company 4) Good clarification!
Thank you for the quick advice so far. Does anyone have further answers?
Enterprise value in simple terms is the value of the company's assets, which are funded with equity and debt! So assume you have 50% equity and 50% debt. In this case, equity holders have claim on half of the assets and debt holders have claim on the other half. In addition, you have minority owners that have some interest in company's subsidiaries that have claim on the company's income and thus on the company's assets. Employees with unfunded pensions will have claim on the assets as well and so will lease holders. So the compilation of claims should equal total assets, hence total enterprise value.
Was that clearer?
That was clearer, thanks a lot guys!
When a company owns over 50+% of another company/entity, they have to include 100% of that entity onto their books (I think this is because of GAAP). So, we add minority interest to Enterprise Value to have an apples to apples comparison. Say you run a comp analysis and you use EV/EBITDA and EV/EBIT, EBITDA and EBIT already have that minority interest included. That way, the EV portion and EBITDA portion will be consistent.
That's my understanding, please correct me if I'm wrong.
are these the questions that will be asked right out of undergrad?
Yes, I'm in my third semester right now interviewing for a couple of off-cycle internships this winter.
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