. How do you evaluate a company credit wise if we are planning to give the company a $500 million loan?

If the company has public debt we would use its debt rating in order to come up with an evaluation of the credit worthiness of the entire company. Alternatively, if the company has no credit rating we can use the index of creditworthiness created by Edward Altman, the so-called Altman Z-score (we would of course also use it for companies that have public debt credit ratings as an addition measure of creditworthiness). We can use the Altmans Z-score or the credit ratings. If no credit ratings, then you benchmark to a company w/ credit ratings. Altmans score is computed as follows: Companies with a Z-score of less than 1.20 are expected to go bankrupt. Companies with a score between 1.20 and 2.90 are likely to either recover or decline in terms of their creditworthiness. Companies w/ score above 2.90 are considered unlikely to go bankrupt. 2. What is leverage? A number of definitions are available. The most common definition of leverage is market leverage defined as the ration Book Debt/(Book Debt + Market Equity). Market equity is computed as the product of share price and total number of shares outstanding. We also oftentimes use a measure called book leverage. This is defined as the ratio of Book Debt/Total Assets. 3. What are the main characteristics of options? See the lecture note on option valuation for a self-contained description of options. In a nutshell, options are rights without any obligations to trade particular securities, such as stocks, currencies, commodities, as well as other derivatives such as futures at a pre-specified date in the future. American options can be exercised anytime during the life-time of the security, while European option can be exercised only at maturity. 4. What are the main characteristics of bonds? The main characteristics of a bond are: its maturity, its duration, its callability, its convertibility, its collateral (if secured), and its interest rates. The latter include the yield to maturity (or promised yield), the coupon rate and the current yield. a. Bond maturity: the length of time till bonds expiration (unlike equity, most of the fixed income securities have finite life). It is different from duration. b. Duration: this is a measure of the interest rate sensitivity, incorporating the timing and maturity of a bond, . Notice that . PV(CFt) is the present value of the payment made at time t, V is the value of the bond. In a sense, this is an average where the weights are the percentage of the value of the bond paid during that period. It measures interest rate sensitivity, since changes in the interest rates impact payments in the future by more than payments that occur sooner. Bonds with longer duration are more sensitive to interest rate changes as compared to bonds with lower duration. The same relationship is not necessarily true for maturity, i.e. zero-coupon bonds with shorter maturity may be more impacted by interest rate change as compared to longer-maturity bonds with coupon payments. c. Callability: this is the feature of the bond that allows the bond issuer to redeem it before maturity. When interest rates fall, corporations would often call their bonds. The price at which the bond can be called is pre-specified in the bond contract. The call price is also beneficial for investors, since it is usually greater than the bonds face value (implying a premium added to the bond).

d. Convertibility: this is the option imbedded in the bond to convert the bond into a stock. Conversion takes place at pre-specified dates & prices contingent on particular conditions occurring. Usually convertible bonds are not secured, and they offer lower interest rate as compared to non-convertible bonds. e. Secured vs. unsecured bonds: when the bond is backed by collateral it is considered secured. Unsecured bonds are also known as debentures. f. Coupon rate: if the bond is paying coupons then the rate of coupon payments as percent from the face is known as the coupon (or interest) rate. g. Current yield: this is the annual interest payment divided by the market price. h. Yield-to-maturity: YTM is the implied rate of return on the bond that would equate its PV to the current bond price: . Finally, oftentimes bonds would contain debt covenants, i.e. provisions aimed at restricting the investment & financing activity of the borrower. These are included in order to offset the adverse selection incentives that a borrower may have (e.g. the borrower may have agreed to use the debt proceeds to fund a low-risk project, however once the funds are in her possession she might decide to utilize them for a high-risk project). 5. What are the main characteristics of hedging? Hedging is a financial transaction geared to offset the risk of a real asset. In essence, the purpose of hedging is to self-insure against future adverse outcomes. There are many approaches that could be used to achieve this insurance effect. One could use forward contracts, futures contracts, swaps, options, or portfolios of the above derivatives. Often times hedges could be achieved by having natural offsets: for example, a foreign affiliate of a US multinational would often borrow local currency so as to offset the currency risk of the local market operation (if the currency devalues, then that would lower sales revenues in US$, yet though it would also lower the value of the foreign currency debt in terms of US$). Hedging extends beyond the realm of real assets: we oftentimes hedge stock market portfolios in class we saw that combining a stock with a long put on it creates the so-called protected put position for the investor, where you have no downside risk, but only upside potential. 6. If you had to choose to help company gain funds would you buy equity or give them a loan and what would you take into consideration before doing it? The choice between equity & debt is based on the benefits of each. Debt comes w/ the following benefits: a. Interest tax shields: unlike equity payments such as dividends and stock repurchases, the payments to debt-holders (interest due) are considered as business expenses and as such are tax-deductible. This tax subsidy may generate preference for debt. In reality though, interest income is taxed at the individual taxpayer level just like equity income is taxed at the personal income level. Thus the relevant computation of the tax-shields of debt need to take into consideration not only the corporate tax rates, but also the personal tax rates on debt and equity payments. On a related note, if the firm has already substantial non-interest tax shields, such as accelerated depreciation, high pension plan contributions, tax sheltering (e.g. company owned life insurance), etc, these would lower the use of interest tax shields, and thus would make debt issuance

less attractive. b. Disciplining role for management (i.e. the management pre-commits itself to pay a fixed interest coupon instead of plowing back corporate resources in oftentimes value-destroying projects). c. Financial Flexibility (CFOs do value the financial flexibility of unused debt capacity since it helps them smooth-out the volatility of demand & supply in the product market of their firms). d. Debt is not information sensitive: unlike equity, debt is not information sensitive. Thus, when there exists high asymmetry of information between corporate managers and outside investors, debt might be the preferred financing choice, since equity will be too costly to issue. To see that, imagine the following situation: a manager has a project that has PV of $1billion. This value is obtained based on her private information for the quality of the project. Market participants do not possess this insider information. Thus they value the firm at the ongoing rate for such projects, which is $800million. If the manager caters for the interests of shareholder, she clearly would not issue equity, and would prefer to finance it with debt debt holders would be willing to provide financing as long as they deem the chances of the firm become insolvent sufficiently low. The costs of the debt include: a. Bankruptcy costs (i.e. the deadweight loss resulting from the sale/ liquidation of the assets of a bankrupt firm) b. Debt overhang: high levels of outstanding debt from prior periods could lead to very conservative investment policy on the side of corporate managers. Overly conservative investment policy is not desirable for shareholders, since it comes at a cost the company would skip some positive NPV (i.e. value-enhancing) projects since they may lead to additional business risk, undesirable in the circumstances of too high leverage (simply, even if the firm is successful, most of the operating cash flow would be used to pay for existing debt). Taking the above considerations, one would decide on whether to issue debt or equity. If the advantages of issuing debt are higher than the disadvantages to issuing debt, the company shall go ahead and issue debt. 7. Walk me through a DCF? Discuss two ways you could value a company. Let us take the example of the Free Cash Flow to the Firm (FCFF) approach of valuation. We start by computing the operating profit. We compute it by subtracting the costs of goods sold from the sales of the firm. Next, we deduct depreciation to obtain the after tax profit and tax due to obtain the net income. We add back to net income the depreciation, subtract the capital expenditure, subtract increases in net working capital and subtract increases in other assets. Note: we do not subtract interest expense from the pre-tax income. This is because the benefit of the tax shield is already accounted for in the tax-adjusted WACC formula. (Notice that I have given you in class the Au Bon Pain example, where we added the interest tax shield back to the free cash flow that is an alternative to value the company, but notice then that you cannot use the taxadjusted WACC formula, because you would be double-counting the interest tax shields). An alternative way to value the equity of the company is to apply the Free Cash Flow to Equity (FCFE) approach. The difference from the above is that we would discount the equity cash flows at the equity cost of capital. In that case, we would

subtract interest expense from the pre-tax income. Why? Because interest paid on debt is not cash flow to the equity holders. We would then proceed to discount the cash flows to equity at the cost of equity. The net present value is then considered the value of equity. Yet another way to value the company is to use multiples, such as the P/E ratio, the PEG ratio (computed as the current P/E ratio divided by the expected longterm growth rate in earnings per share), and the M/B ratio. We create a set of comparable companies which belong to the same industry, have similar size, profitability, and leverage, and we use a price multiple for these (e.g. priceearnings) which we then apply for the company which is being valued. If you believe that these price ratios are not appropriate you can then use alternative comparative methods (such as Price-to-Sales, Price-to-Cash flow, or Price-toEBITDA). In particular, to use the multiples, you need an estimate of cash flows (or other flow measure) at the end of the forecasting period and you would need an estimate of the value to cash flow (or other flow measure) for comparable firms (as discussed above). By multiplying the projected cash flow by the ratio for comparable firms you arrive at estimated company value. Remember that when you use multiples, you are making a number of implicit assumptions. You are implicitly assuming estimates of risk premiums and discount rates and following what the market currently implies. In addition, a number of potential problems arise when using multiples. Static multiples. If you assume that the comparable ratio stays constant through time, you can calculate the ratio by dividing price by trailing earnings or cash flow for the comparable firms. To the degree that market ratios change over time, this is an appropriate assumption. Choosing comparable firms. In choosing comparable firms, you want to select firms that are as similar as possible to the firm you are valuing, as discussed above. On the other hand, you dont want to be so selective that you end up with only one comparable firm. Key characteristics to consider when choosing comparable firms include industry, firm size, profitability, capital efficiency, and financial leverage. Negative ratios. Negative ratios, caused by negative earnings or cash flows, are meaningless. Yet dropping negative ratios from your comparable average may bias your terminal value estimate. A better approach is to sum prices and earnings separately across the industry and then take the quotient. Financial leverage. Market ratios among similar firms can vary because of differences in financial leverage. Financial leverage will lower current earnings in exchange for higher future earnings. The expected growth of earnings will be higher and thus so will ratios based on earnings. To correct for differences in leverage, you choose comparables that have similar leverage ratios to your firm. Alternatively, you can calculate ratios based on firm value and cash flow to assets (opposed to equity). 8. How do you estimate terminal value? We can either assume that the company would be liquidated and compute liquidation value, or assume that the company free cash flow would become a perpetuity starting next year and value it as a perpetual cash flow. The assumption of liquidation value vs. perpetual growth should be based on the industry life cycle: for example, mines, oil rigs, etc would have a finite operational life and as such should be valued by assuming a terminal value. Vice versa, food industry projects are oftentimes long-lived and as such should be valued using a perpetual cash flow as the terminal value. When you compute the liquidation value, here is how to do it: 1. Retire the working capital. 2. Retire the fixed assets of the firm. When you retire the fixed assets, notice that

their un-depreciated (or salvage) value could differ from their on-going market value. If the market value is above the salvage value, then we have to tax the difference. If the market value is below the salvage value then we have to add back to the market value the tax shield (basically the tax credit on the capital loss). When you compute a perpetuity continuation value as of the last year of the enterprise, you would need to assume a growth rate for it. A reasonable growth rate is anywhere between the average inflation rate for the preceding years and the sum of the average inflation and the average real GDP growth for the preceding years. The reason we require the rate to be above the average inflation rate is to prevent the value of the perpetuity eventually shrinking in real terms. The reason we require that the perpetuity has a growth rate below that of the economy, is so to prevent the company from eventually becoming the economy. The value of the perpetuity as of the last year of the pro-forma is , where g is the assumed long-term growth rate, CFN is the cash flow in the last year of the proforma, and r is the appropriate discount rate. Notice that the value of the perpetuity is as of year N, i.e. the last year of the pro-forma. Notice further that we grow for one period the coupon payment, CFN, since the perpetuity starts next period, yet we made the assumption of constant perpetual growth starting in year N. [Note: There is an excellent treatment of this topic in the book I have assigned for the class in the Fall 2006, by Aswath Damodaran, Chapter 12. I have posted the chapter online in Blackboard session 3 or 4. There is also a copy of the book in the library.] 9. We are meeting the CEO of Harley Davidson, what type of questions would you like to ask them regarding their business and why? This question has been asked in October 2004. Two months later, the CEO of Harley Davidson Jeff Bluestein announced his retirement. Apparently the rumors in the market were that the CEO intends to do so (and the CEO did retire in April 2005). Thus, this question is designed to check whether you follow the market news. 10. Analyzing Home Depot? How would you value AOL? These are valuation questions tied to current events in the stock market (e.g. what happens with Home Depot vs. AOL at the time the question is asked.) Perhaps the easiest way to address with such questions is to make oneself informed of the stock market events. A simple, yet very efficient way to achieve this goal is to get an inexpensive subscription to the Wall Street Journal, or even, read the titles from Google Finance. Also, try before interviews to check the upcoming earnings releases: these are the likely movers of the stock market, and consequently likely to attract the interviewers attention. 11. Anheuser-Busch Cos. just released a new bond. You are thinking about buying this bond. How would you price the bond? Since we would like to compute the price of the bond, I assume that we are given the promised yield (or yield to maturity) on this bond, YTM. Given these, and assuming that the bond has no special features (such as callability, convertability, etc), the price of the bond will be , where N is the number of years to maturity. 12. Assume you have levered free cash flows, what is the appropriate discount rate to use? A levered free cash flow is the un-levered free cash flow plus the present value of

the interest tax shield. Such cash flow need be discounted at the return on company assets (WACC) where we do not adjust for the tax (this is very important: if we adjust WACC for taxes and have included the tax shield on interest, we would be effectively double-counting the value of the interest tax shield).