Draw for me the relationship between WACC and “use of leverage” and

explain it to me.2

Like for the graph used to show the CAPM relation, we use in the X-axis the D/E ration and on the Y-axis the WACC.

Debt Total Capital

WACC = * Cost of Debt * (1-Tax Rate) + Equity

Total Capital * Cost of Equity

The graph in shows the impact of capital structure on a company’s WACC. When there is no debt in the capital structure, WACC is equal to the cost of equity. As the proportion of debt in the capital structure increases, WACC gradually decreases due to the tax deductibility of interest expense. WACC continues to decrease up to the point where the optimal capital structure is reached. The optimal point is the financing mix that minimizes WACC, thereby maximizing a company’s theoretical value (lower discount rate, higher EV).

Once this threshold is surpassed, the cost of potential financial distress (i.e., the negative effects of an over-leveraged capital structure, including the increased probability of insolvency) begins to override the tax advantages of debt. As a

2

For the answer we refer to the following book: Joshua Rosenbaum and Joshua Pearl, Investment Banking, Wiley Finance

result, both debt and equity investors demand a higher yield for their increased risk, thereby driving WACC upward beyond the optimal capital structure threshold

20. How do you do a public comparable valuation3_?

Comparable companies provide a market benchmark against which a banker can establish valuation for a private company or analyze the value of a public company at a given point in time. The foundation for trading comps is built upon the premise that similar companies provide a highly relevant reference point for valuing a given target as they share key business and financial characteristics, performance drivers, and risks. Therefore, the banker can establish valuation parameters for the target by determining its relative positioning among peer companies.

The core of this analysis involves selecting a universe of comparable companies for the target (“comparables universe”). These peer companies are benchmarked against one another and the target based on various financial statistics and ratios. Trading multiples are then calculated for the universe, which serve as the basis for

3

For the answer we refer to the following book: Joshua Rosenbaum and Joshua Pearl, Investment Banking, Wiley Finance

extrapolating a valuation range for the target. This valuation range is calculated by applying the selected multiples to the target’s relevant financial statistics.

Comparable companies analysis is designed to reflect “current” valuation based on prevailing market conditions and sentiment. Market-trading levels may be subject to periods of irrational investor sentiment that cause valuation to differ on a constant basis. Furthermore, no two companies are exactly the same, so assigning a valuation based on the trading characteristics of similar companies may fail to accurately capture a given company’s true value.

As a result, trading comps should be used in conjunction with other valuation methodologies. A material disconnect between the derived valuation ranges from the various methodologies might be an indication that key assumptions or calculations need to be revisited. Therefore, when performing trading comps (or any other valuation/financial analysis exercise), it is imperative to diligently footnote key sources and assumptions both for review and defense of conclusions. To perform a public comparable valuation, perform these 5 steps:

• Step I. Select the Universe of Comparable Companies: look at companies with similar operations (products/services, customers/clients, distribution and geography) and financial aspects (size, profitability, growth profile, ROI, Credit Profile). You can screen for comparable companies from:

o Previous analysis of other bankers such as fairness opinions and equity reports.

o Proxy statement and 10-K o Industry reports

o Screen by SIC or NAICS code using databases such as Capital IQ, Factset, Thomson, Bloomberg.

• Step II. Locate the Necessary Financial Information (both historical and future) to calculate key financial statistics, ratios, and multiples for the selected comparable companies:

o Latest 10-K and 10-Q in order to get the historical financials (mainly for Revenues, EBITDA, EBIT, Net Income, Diluted Shares Out, Net Financial Position, Minorities).

o Equity research or IBES estimates for the future three years. o Market information, such as share price and dividends.

• Step III. Spread Key Statistics, Ratios, and Trading Multiples: Calculate the key financial statistics and ratios, such as:

o Enterprise Value and Equity Value.

o Key financial data such as Revenue, Gross Profit, EBITDA, EBIT and Net Income.

o Calculate key trading multiples such as P/E, EV/EBITDA, EV/EBIT, EV/Revenue.

• Step IV. Benchmark the Comparable Companies: analyze and compare each of the comparable companies with one another and the target. The ultimate objective is to determine the target’s relative ranking so as to frame valuation accordingly.

• Step V. Determine Valuation: the trading multiples for the comparable companies serve as the basis for deriving an appropriate valuation range for the target. The banker typically begins by using the means and medians, min and max, of the most relevant multiple for the sector (e.g., EV/EBITDA or P/E) to extrapolate a defensible range of multiples.

21. What are the main key trading multiples?4

While various sectors may employ specialized or sector-specific valuation multiples, the most generic and widely used multiples employ a measure of market valuation in the numerator (e.g., enterprise value, equity value) and a universal measure of financial performance in the denominator (e.g., EBITDA, net income). For enterprise value multiples, the denominator employs a financial statistic that flows to both debt and equity holders, such as sales, EBITDA, and EBIT. For equity value (or share price) multiples, the denominator must be a financial statistic that flows only to equity holders, such as net income (or diluted EPS). Among these multiples, EV/EBITDA and P/E are the most common.

4

For the answer we refer to the following book: Joshua Rosenbaum and Joshua Pearl, Investment Banking, Wiley Finance

• Equity Value Multiples: equity multiples compare the value of common shares to the earnings available to common shareholders. Use equity multiples to calculate the value of a company’s equity:

o Price Earnings Ratio / Equity Value to Net Income: The P/E multiple gives investors an idea of how much the market is paying for a company’s earning power. P/E ratios are typically based on forward-year EPS (and, to a lesser extent, LTM EPS) as investors are focused on future growth. Companies with higher P/Es than their peers tend to have higher earnings growth expectations in earnings. While the P/E ratio is broadly used and accepted, it has certain limitations because by using earnings it is influenced by the company’s capital structure (interests), differences in accounting policies (depreciation and taxes) and one-off expenses.

P/E Ratio = Price of Stock / Earnings per Share

o Enterprise Value to Revenue Multiple: EV/sales is also used as a valuation metric. Sales may provide an indication of size, but it does not necessarily translate into profitability or cash flow generation, both of which are key value drivers. In certain sectors, however, as well as for companies with little or no earnings, EV/sales may be relied upon as a meaningful reference point for valuation.

Enterprise Value / Revenue

o Enterprise Value to EBITDA or EBIT Multiple: EV/EBITDA serves as a valuation standard for most sectors. It is independent of capital structure and taxes, as well as any distortions that may arise from differences in D&A among different companies. For example, one company may have spent heavily on new machinery and equipment in recent years, resulting in increased D&A for the current and future years, while another company may have deferred its capital spending until a future period. In the interim, this situation would produce disparities in EBIT margins between the two companies that would not be reflected in EBITDA margins. For the reasons outlined above, as well as potential discrepancies due to acquisition-related amortization, EV/EBIT is less commonly used.

Enterprise Value / EBITDA Enterprise Value / EBIT