Interview Help - Some questions?

1) You use leverage. If you used all equity you would not make a profit. 2) If receivables go up, it is a use of cash, which would decrease FCF. Also, A/R turnover would decrease and A/R days would increase. 3) Drawbacks to WACC is that various industries use different capital structures and it is not comparing apples to apples if companies have a different d/e mix. This is why you unlever betas.

1)b,a,c,d in that order. This is the order of the waterfall 2)Only security that would have precedent over Trade debt is Senior Secured debt (asset-based), or the government.

Good luck.

Monkey would you mind just elaborating a little on #3? I understand why it wouldn't be a consistent comparison but I don't quite see how you've factored in unlevered (asset) beta. I understand that you'd have unlevered cash flows and using an unlevered beta, so I assume you'd be ignoring the effect of leverage in your finding, but I've never seen unlevered beta used outside of APV.

thanks, very helpful

na I got it, I was actually just editting my post when I saw this. It's the same concept as unlevering comp beta's when finding your own beta, to avoid the different D/E mixes. I'd never actually thought of the same project being discounted differently like that, so thanks I appreciate the response.

1) You use leverage. If you used all equity you would not make a profit.

Just to humor a noob high school kid, could someone explain how leverage lets you make a profit in #1? Does it mean you would have deleveraged by the time you sold?

1) You could pay dividends with the operating profits. I believe using leverage is the "better" answer though.

~~~~~~~~~~~ CompBanker

I dont understand how leverage could be used for number 1... if you're not making a profit from the beginning how could leverage be of any use to gain a profit

For 1), when you purchase a company with leverage (debt), you use the acquisition's cash flows to pay off the interest/partially pay down the principal and continue to do that for a number of years until the principal is reduced and you've increased your equity holding in the company (as you've been reducing your debt holding while paying down the principal). At this point, when you sell the company, while you're selling for the same price that you bought, you're going to be gaining the increased equity position that you've claimed over time as profit. Does that help?

actually, most of the above answers are incorrect, though there's probably a good chance that most interviewers don't even know the correct answers when they ask these kind of questions.

(1) You buy an investment for $100m, you sell it for $100m, how would you make a profit?

this question is a bit vague. if the question is you buy and sell the equity of a company for $100m, the only way to make money is to have some sort of distribution during the period in which you hold the investment (e.g. dividends from distributing excess cash flow, dividends from asset sales, or something like a management fee). if the question is you buy and sell an investment for an implied enterprise value of $100m, then the above posters would be correct that leverage + retiring debt would allow you a profit.

(2) What would happen to net change in working capital if receivables went up?

yes, it is a use of cash but that doesn't answer the question. the very simple answer is work cap increases if receivables increase because nwc = current assets (excluding excess cash) less current liabilities (excluding current debt). increasing AR (an asset), increases current assets, thus increases NWC.

(3) What are the drawbacks of using WACC in valuing companies

this question is also vague. using WACC implies using a DCF to value a company, which is a bigger drawback than simply WACC. the drawbacks to DCF are that the inputs are so difficult (impossible) to state with a high degree of confidence. these inputs are the projects of free cash flow, the projection of terminal value and yes, the calculation of WACC. Specifically regarding WACC, the biggest drawback is probably the CAPM doesn't work in practice. But other drawbacks include the fact that nobody really knows what the appropriate Equity Risk Premium to use. That different companies have different capital structures isn't a drawback because the theoretically capital structure to use when calculating WACC is the optimal capital structure, not the actual capital structure. Of course, indeed a drawback is that you have to estimate the "optimal" capital structure, usually based on your comps.

(1) What security has more priority in the capital stack? a. Senior Subordinated Debt b. Trade Debt c. Junior Preferred Equity d. 90% Common Equity Holder (2) What type of security would have even more seniority?

this question is actually quite challenging, as posed. clearly (a) and (b) have higher priority than (c) which has higher priority than (d). however, both (a) and (b) are unsecured and therefore have the same level of priority (known as being pari passu) as per bankruptcy law. however, if (a) is senior to other junior subordinated debt in the capital structure (which would also be unsecured) then (a) would be contractually entitled to receive a higher percentage recovery than the trade credit because the senior sub would receive part or all of the junior sub debt's share. the answer to question 2 would be anything secured (e.g. bank debt). or in the case of Chrysler, the union employees.

hope this helps.

For 1), assuming you're buying/selling with equity, I assume you need to explicitly state that the dividend distribution is a higher % than the discount rate in order for the investment to be worthwhile (positive NPV)?

SpaceMonkey, it depends on if you're talking about nominal terms or present value terms. A single distribution of $1 is still a profit. Heck, given the way people have fared in the market over the last couple of years, a breakeven investment doesn't sound so bad to me!

~~~~~~~~~~~ CompBanker