ubs redbook

GENERALLY ACCESSIBLE

October 2008

UBS MBA Investment Banking Recruiting Guide

2008 - 2009

[Jacqueline M. Dinella] [printed: October 30, 2008 9:22 PM] [saved: October 27, 2008 2:59 PM] S:\Global Sourcing\Fall2008-Spring2009\MBA\IBD\Recruiting Guide\UBS MBA Recruiting GuideFINAL 10_27_08.doc

Table of Contents

SECTION 1 UBS Overview _____________________________________________________________________________________ 1

SECTION 2 Internship Timeline ______________________________________________________________________________ 14

SECTION 3 Overview of Investment Banking_______________________________________________________________ 17

SECTION 4 Interview Preparation ___________________________________________________________________________ 24

SECTION 5 UBS Technical Reference Guide _________________________________________________________________ 35


1

SECTION 1

UBS Overview


2

UBS—One of the World’s Leading Financial Firms

UBS creates added value for clients by drawing on the combined resources and expertise of all its businesses

Investment Banking and Securities

Institutional and Wholesale Intermediary Asset Management Worldwide

Wealth Management International & Switzerland, Wealth Management US and Business Banking Switzerland

UBS is a leading global wealth manager, a leading global investment banking and securities firm, and one of the largest global asset managers. In Switzerland, UBS is the market leader in retail and commercial banking. UBS is present in all major financial centers worldwide, with more than 80,000 employees across 50 countries. UBS has CHF 44,283 million equity attributable to UBS shareholders*, long-term credit ratings of AA-/Aa2/AA-(Fitch, Moody’s and S&P respectively)*, and invested assets of CHF 2,763 billion*.

Global Wealth Management & Business Banking

Global Asset Management

Investment Bank

*For the quarter ended 30 June 2008


3

UBS—Metrics to Measure a Firm UBS— a global financial services powerhouse

Assets Under Management Credit Rating

Company AUM

(US$bn)

UBS 2,787

Citigroup 1,707

Merrill Lynch 2 1,637

Deutsche Bank 1,407

Credit Suisse 1,394

JP Morgan 1,187

Goldman Sachs 895

Morgan Stanley 749

Bank of America 2 643

Company

Moody’s/ S&P

Deutsche Bank Aa1/AA-

UBS Aa2/AA-

JP Morgan Aa2/AA-

Credit Suisse Aa2/A+

Bank of America 2 Aa2/A+

Citigroup Aa3/AA-

Goldman Sachs Aa3/AA-

Morgan Stanley A1/A+

Merrill Lynch 2 A2/A+

Tier 1 Capital Ratio Credit Default Swap Rate—5yr Company Tier 1 ratio (%)

Morgan Stanley 12.7

UBS 11.6

Goldman Sachs 11.6

Credit Suisse 10.2

Citigroup 9.3

Deutsche Bank 9.3

JPMorgan 9.1

*Bank of America 7.5

Company CDS

Morgan Stanley 480

Goldman Sachs 257

*Merrill Lynch 164

Citigroup 164

UBS 120

Credit Suisse 114

Bank of America 2 105

Deutsche Bank 100

JP Morgan 93

Source: Assets Under Management and Tier 1 capital ratio as from Q2 2008 company filings; Credit Ratings and Credit Default Swap rate as at 20 October 2008 (Goldman Sachs and Morgan Stanley Tier 1 Capital Ratio as of 3Q2008—Aug 2008)

Notes: 1 Pro forma 2 BAC has announced it has agreed to acquire Merrill. Deal is expected to close in Q1 2009

Backed by its scope and scale it is recognized as being among the best capitalized banks in the sector

UBS has consistently been rated as a top investment bank

The market recognizes UBS’s financial strength

UBS has one of the strongest Tier 1 capital ratio among its peers

Over US$2 trillion in assetsunder management1

Largest wealth manager in the world

Nearly 150 years experiencein private banking

One of the largest global institutional asset managers

More than 80,000 employeesin 50 countries


4

Q3 Remaining Leveraged Loan and Real Estate Exposure

73

6459

36 35 3532

4

(5.0)

15.0

35.0

55.0

75.0

Citi Deutsche

Bank

Merrill Lynch Morgan

Stanley

Goldman

Sachs

Credit Suisse JP Morgan UBS

Leverage Loans Residential CMBS

Source: CEO Mgmt Office and Public Documents Note: Deutsche Bank and Credit Suisse exposure as of Q2 as they have not yet reported


5

Clients Look to their Trusted M&A Advisor During Volatile Times

Rank Mkt Share Rank Mkt Share Rank Mkt Share Rank Mkt ShareM&A 6 5.8 4 6.1 4 7.1 3 7.2

FY 2007FY 2006 YTD 2008FY 2005

Notable 2008 M&A Transactions

US$10.0 bn, Advisor for Constellation Energy on their sale to MidAmerican Energy Holding Company, a Berkshire Hathaway subsidiary. UBS capital commitment of US$ 1.0 bn

GB£15.3 bn, Advisor, Bookrunner, and Sponsor to Lloycs TSB Group PLC on the revised terms for their acquisition of HBOS PLC, their capital raise of GB£ 5.5bn with the support of HM Treasury

US$6.5 bn, Advisor for Eli Lilly and finance arranger for cash offer for IMCLONE Systems, Inc. UBS made an undisclosed capital commitment to Eli Lilly.

GB£ 20.0 bn & GB£12.2 bn, Advisor, Bookrunner, and Sponsor to RBS’ on their rights issuance with HM Treasury and Bookrunner on their fully underwritten issuance where UBS made a capital commitment of GB£ 2.4 billion.

US$6.0 bn, Advisor for International Paper on acquisition of Weyerhauser and lead arranger of debt financing. UBS capital commitment of US$ 1.2 bn to Baa3 rated International Paper.

EUR 11.9bn, Advisor and joint mandated lead arranger of debt financing to INA Schaeffler KG on its tender offer for all outstanding shares of Continental AG. UBS capital commitment of US$ 1.6 bn.

US$4.4 bn, Advisor on Cadbury Schweppes PLC’s demerger of Dr. Pepper Snapple Group and lead arranger of debt financing. UBS capital commitment of USD 880 m to Baa2 rated Cadbury Schweppes PLC.

US$35.9 bn, Exclusive advisor and joint lead financing arranger for Gas Natural’s acquisition of Union Fenosa. UBS capital commitment of US$3.1 bn.

US$2.9 bn, Lead financial advisor to Vodafone on its 45% owned US affiliate Verizon Wireless’ acquisition of Alltel. UBS capital commitment of US$ 1.2 bn.

US$2.3 bn, Exclusive advisor and exclusive financing arranger for Illinois Tool Works acquisition of Enodis plc. UBS capital commitment of US$2.6 bn.

US$4.1 bn Advisor for Reed Elsevier and lead finance arranger for recommended cash offer for Choicepoint Inc. UBS capital commitment of US$ 1.5 bn to Baa1 rated Reed Elsevier.

US$6.7 bn, Lead advisor to Invitrogen Corp. on its acquisition of Applied Biosystems, creating the second largest pure-play life sciences company in the world. UBS capital commitment of US$795m.

US$3.9 bn, Exclusive advisor on Grey Wolf Inc’s merger of equals with Basic Energy Services, Inc. and lead arranger of debt financing. UBS capital commitment of US$ 462m.

US$20.5 bn, Lead advisor to Allied Waste Industries, Inc. in its definitive merger agreement with Republic Services, Inc

US$18.6 bn, Sole financial advisor to St.George Bank Limited on merger offer from Westpac Banking.


6

UBS: The Equity Underwriter of Choice in Q3 2008 In recent volatile markets issuers turned to UBS for equity advice and execution expertise

Q3 US All-Equity Rankings

Q3 UBS Bookrun Transactions

Company App Value

($mm) Deals Mkt

Share

1 UBS 4,389 18 17.5

2 JP Morgan 3,520 19 14.1 3 Goldman Sachs 3,316 12 13.2 4 Merrill Lynch 2,066 14 8.2 5 Banc of America 2,012 14 8.0 6 Credit Suisse 1,578 13 6.3 7 Citi 1,572 14 6.3 8 Morgan Stanley 1,533 9 6.2 9 Barclays Capital 1,417 6 5.7 10 Wachovia 704 7 2.8

Source: Dealogic; ranked by apportioned volume Dataset excludes self-led issuance and transactions less than $20 million in proceeds

$215mm Block Office/Healthcare REIT September 30, 2008

$45mm Block Industrials September 24, 2008

$78mm Follow-on Triple Net Lease REIT September 24, 2008

$205mm Follow-on Healthcare REIT September 23, 2008

$98mm Block Healthcare REIT September 15, 2008

$149mm Follow-on Energy MLP September 11, 2008

$427mm Follow-on Shopping Center REIT September 9, 2008

$386mm Follow-on Healthcare REIT September 4, 2008

$267mm Follow-on Energy MLP September 4, 2008

$958mm Concurrent Equity/Convertible Industrials August 7, 2008

$2.9bn Concurrent Equity/Convertible Insurance July 29, 2008

$550mm Convertible Media July 28, 2008

$500mm IPO Solar July 23, 2008

$1.4bn Follow-on Energy July 23, 2008

$811mm Follow-on Finance/Media July 15, 2008

$1.6bn Follow-on Energy July 9, 2008


7

UBS: The Block Underwriter of Choice in 2008 UBS has bookrun more bought deals than any other underwriter in 2008

2008 YTD US Block Trade Issuance Rankings

2008 YTD UBS Block Trade Transactions

Company Deals App Value

($mm)

1 UBS 8 1,005 2 Morgan Stanley 7 820 3 Goldman Sachs 6 1,218 4 Merrill Lynch 4 545 5 Barclays Capital 4 789 6 Deutsche Bank 2 181 7 Credit Suisse 2 438 8 Citi 2 219 9 Canaccord Adams Inc 2 100 10 JPMorgan 1 151

Source: Dealogic; ranked by number of deals

Note: Dataset excludes transactions less than $20 million in proceeds

$215 million Office/Healthcare REIT September 30, 2008

$45 million Industrials September 24, 2008

$98 million Healthcare REIT September 15, 2008

$196 million Healthcare REIT June 30, 2008

$163 million Airlines June 19, 2008

$86 million Energy May 15, 2008

$51 million Industrials March 18, 2008

$194 million Healthcare REIT January 28, 2008


8

UBS: The Top-Ranked Trader of Equities in the US In the midst of unprecedented volatility, clients turned to UBS for their superior trading platform. This resulted in increased market share and a No. 1 ranking

2008 US Trading Rankings

January 1 to September 12, 2008 September 15 to September 30, 2008

Rank Company Mkt. Share (%)

1 Morgan Stanley 14.2 2 UBS 13.6 3 Merrill Lynch 13.3 4 Credit Suisse 8.6 5 Deutsche Bank 8.1 6 Citi 7.2 7 Barclays Capital (Lehman) 6.8 8 JP Morgan 6.0 9 RBC Capital 3.3 10 Goldman Sachs 3.0


1 UBS 19.7 2 Merrill Lynch 12.1 3 Morgan Stanley 11.4 4 Credit Suisse 10.6 5 Citi 9.0 6 Deutsche Bank 6.9 7 JP Morgan 6.4 8 Goldman Sachs 4.2 9 RBC Capital 3.6 10 Banc of America 3.0


1 UBS 14.8 2 Morgan Stanley 13.5 3 Merrill Lynch 9.2 4 Credit Suisse 7.6 5 Citi 7.3 6 Barclays Capital (Lehman) 7.2 7 JP Morgan 5.8 8 Goldman Sachs 4.6 9 RBC Capital 4.6 10 Banc of America 3.8


1 UBS 16.3 2 Morgan Stanley 13.2 3 Credit Suisse 9.2 4 Merrill Lynch 9.0 5 Citi 7.3 6 JP Morgan 7.1 7 Goldman Sachs 5.3 8 Deutsche Bank 5.2 9 Banc of America 4.5 10 RBC Capital 3.1

Source: Autex


9

H1 2008 Performance

* BAC has announced it has agreed to acquire Merrill Lynch. Deal is expected to close in Q1 2009

(1,057)

(224)

449

554

1,082

1,145

1,355

(1,314)

(1,750) (1,250) (750) (250) 250 750 1,250 1,750

DB

C

CS

MS

MER*

GS

JPM

UBS

US$ in millions

UBS maintained or increased its market position ranking in the majority of regions in H1 2008 from FY 2007

21BRIC

11Australia

79Japan

41Asia ex Japan

11APAC

13EMEA

32LatAm

89North America

88AMERICAS

55GLOBAL

H1 2008FY 2007

UBS Market Share (Rank)

21BRIC

11Australia

79Japan

41Asia ex Japan

11APAC

13EMEA

32LatAm

89North America

88AMERICAS

55GLOBAL

H1 2008FY 2007

UBS Market Share (Rank)

Source: Dealogic as of 30 June 2008

Consistent and measured achievements

H1 2008 financial performance - net of leveraged loan write-downs


10

IBD Q2 2008 Performance Fastest quarter over quarter growth over any IBD

44% 44% 81% 64% 27% 3% -11% -1% 18%

370

800

424 386 317 195367 240 352

542

616

424 432338

217

298330

237

823

269

302220

367

511210 288 209

0

400

800

1,200

1,600

2,000

JPM GS UBS C MER* DB MS LEH* CS

US$

in m

illion

s

M&A Advisory Equity Underwriting Debt Underwriting

1,735 1,685

1,1501,038 1,022

923 875 858798

44% 44% 81% 64% 27% 3% -11% -1% 18%

370

800

424 386 317 195367 240 352

542

616

424 432338

217

298330

237

823

269

302220

367

511210 288 209

0

400

800

1,200

1,600

2,000


US$

in m

illion

s


44% 44% 81% 64% 27% 3% -11% -1% 18%

370

800

424 386 317 195367 240 352

542

616

424 432338

217

298330

237

823

269

302220

367

511210 288 209

0

400

800

1,200

1,600

2,000


US$

in m

illion

s


370

800

424 386 317 195367 240 352

542

616

424 432338

217

298330

237

823

269

302220

367

511210 288 209

0

400

800

1,200

1,600

2,000


US$

in m

illion

s


1,735 1,685

1,1501,038 1,022

923 875 858798

*LEH no longer in market, BAC has announced it has agreed to acquire Merrill Lynch. Deal is expected to close in Q1 2009


11

What Do Investment Bankers Do?

Intermediary

Investment Bankers

Principal

Research

BrokersCapital Markets

Sales& Trading

♦ Equity♦ Debt♦ Risk Management♦ FX/Commodities

Advisory

♦ Mergers & Acquisitions

♦ Corporate Finance♦ Restructuring

♦ Capital

♦ Risk Assumption

♦ Proprietary Trading

Corporations

Governments

Financial Institutions

Private Equity Sponsors

Clients(…need capital)

Retail InvestorsIndividuals

Investor Clients(…have capital)

Institutional Investors

Mutual fundsPension fundsHedge funds

Analysts

Intermediary

Investment Bankers

Principal

Research

BrokersCapital Markets

Sales& Trading

♦ Equity♦ Debt♦ Risk Management♦ FX/Commodities

Advisory

♦ Mergers & Acquisitions

♦ Corporate Finance♦ Restructuring

♦ Capital

♦ Risk Assumption

♦ Proprietary Trading

Corporations

Governments

Financial Institutions

Private Equity Sponsors

Clients(…need capital)

Retail InvestorsIndividuals

Investor Clients(…have capital)





Analysts


12

Client Groups

IBD Serves the Following Primary Client Groups GIG and Financial Institutions Represent the Largest Super Sectors

Sovereigns / Agencies

Banks / Financial Intermediaries

Asset Managers

Hedge Funds

Corporates

Financial Sponsors

Insurance Companies

General Partners (GPs)

Sovereigns / Agencies

Banks / Financial Intermediaries

Asset Managers

Hedge Funds

Corporates

Financial Sponsors

Insurance Companies

General Partners (GPs)

Revenues by Super Sector (2007)

GIG24%

FIG19%

REL&L12%

Tele.2%

Health.11%

Tech.7%

Util.5%

Energy5%

Other Sectors

5%

Media4%

CP&R3%

PFG2% Infra.

1%

`


13

IBD—An Established Franchise in the US With revenues doubling and over 200 additional bankers since 2002, UBS has built a world class IBD franchise in the US

Solid Business Model ♦ UBS franchise in the US has the size and expertise to compete across all products and sectors

♦ Continuing to build on the momentum to achieve the goal of Top 5 position

Strong US Presence ♦ Over 900 bankers and 14 global heads based in the US

♦ Major offices in New York, Chicago, Los Angeles, San Francisco and Houston

Unrivaled Global Capabilities

♦ No. 1 franchise in APAC is well positioned to take advantage of expected growth in China and other emerging countries

♦ A solid EMEA franchise with ambitions to be No. 1


14

SECTION 2

Internship Timeline


15

First Semester Recommended Investment Banking Recruiting Timeline Item Goal Date of Completion

Meet with career services counselors and MBA2s if you have general concerns

♦ Determine if investment banking is for you

♦ Start to focus your search

♦ Help you get started

September to November

Read the Wall Street Journal ♦ Be able to speak intelligently about current events in the finance industry

♦ Spot key deals and which banks are involved

♦ Understand general trends over time

Every day!

Spending an hour/day is key (but realistically this will get difficult to do; the closer to corporate presentations/ interviews the more important this will be)

Attend investment banking club events

♦ Understand what is happening in the market

♦ Gain valuable information pertaining to recruiting

♦ Help assist you in your investment banking job search

Every week

Go to these events as much as you can; they can only help

Watch CNBC; check up on the market ♦ Understand what is happening in the market

♦ Understand current trends

Daily

Follow an industry (research, magazines or reports);

CNBC and websites are useful sources of info for following happenings and trends in certain industries

♦ Have a current understanding of a particular industry and be able to speak intelligently about your industry with bankers

♦ Understand the market

♦ Help narrow down an area of interest

Start this ASAP as well

Designate a period of time each week

General research/information gathering about investment banking

♦ Determine if investment banking is for you

♦ Determine areas of interest in investment banking

ASAP

For informationals or corporate presentations (i.e. anytime you have set up a meeting or will be speaking in depth with bankers)

Form investment banking groups ♦ Help divide up the research of the banks

♦ Broaden your understanding by speaking with other people

♦ Gain exposure to all areas

♦ Prepare for closed list interviews

♦ Save you time in the process

Have groups formed ASAP

(be sure to get people seriously interested in investment banking that will put the time into a group)

Corporate presentations

♦ Make some contacts/establish some connections

♦ Gather information/obtain corporate materials handed out at events

♦ Get a feel for the bank

September to November

Note: The above are only suggestions to assist you in your job search


16

First Semester Recommended Investment Banking Recruiting Timeline Item Goal Date of Completion

Corporate events ♦ Attend those designated specifically towards areas of interest

♦ Make some contacts/get your name out there

♦ Get a feel for the bank

All fall and recruiting season

Put together a strong resume; includes reviewing with a career counselor, peers and those in the industry

♦ Attend career services events and workshops

♦ Have a resume that is focused on investment banking

♦ Know how to tailor a specific resume in investment banking terms

♦ Have a working resume ASAP; it is better to have a decent resume in case bankers or anyone needs to see something before your “official” resume is posted

Start putting this together ASAP, but gather information from club and career services events to help you.

DO NOT WAIT UNTIL THE LAST MINUTE

(The resume deadline sneaks up quickly)

The bulk of this work should be done during October

Resumes completed ♦ Have a strong working resume for investment banking events

♦ Have one main resume which you will always use (not great to have floating copies of former resumes going out to the banks)

October/November

Specific bank analysis; industry information

♦ Be able to speak intelligently to bankers about their specific bank

Before informational interviews

Set up and prepare for informationals ♦ Help make contacts for closed lists

♦ Understand the bank better

♦ Demonstrate what a good candidate you are

♦ Show interest and do your homework

Usually time period of mid-to-late October to Winter Break

Some banks make lists earlier than others

(Start with junior bankers first)

Send out resumes and cover letters ♦ GET ON CLOSED LISTS SO YOU CAN INTERVIEW Usually around Thanksgiving; allow sufficient time, it takes longer than you think to come up with good cover letters and gather all of the addresses

Pay attention to club and career services reminders as the semester progresses

Complete informationals; attend remaining recruiting events

♦ Help make contacts for closed lists

♦ Meet more people and get your name out there

By closed list deadlines (usually before Winter Break is the very last chance to visit—check each bank’s deadlines so you don’t miss out!)

Note: The above are only suggestions to assist you in your job search


17

SECTION 3

Overview of Investment Banking


18

Overview of Investment Banking

Purpose

♦ Raise capital through issuance of securities – equity and debt – specialized securities and derivatives

♦ Advise companies in M&A and restructuring

♦ Provide valuation and strategic advisory

Skill Set

♦ Motivated

♦ Team player

♦ Quantitative

♦ Personable

♦ Flexible

♦ Articulate

♦ Aggressive

♦ Deal oriented

♦ Willing to take initiative

♦ Handle stress well

♦ Professionalism

♦ Responsible

Positives/Drawbacks

Positives Drawbacks

♦ Exposure/network

♦ Magnitude/notoriety of deals

♦ Responsibility

♦ Skill and knowledge base development

♦ Compensation

♦ Long hours

♦ Work-life balance

♦ Stress environment

♦ Intensity

♦ Focus on detail


19

Product and Sector Teams

Products Sectors

ECMG

FSLF M&A

ECMG

FSLF M&A

Healthcare Infrastructure Power

GIG Real Estate FIG

Consumer & Retail

EnergyTMT

Healthcare Infrastructure Power

GIG Real Estate FIG

Consumer & Retail

EnergyTMT


20

Product/Sector Interaction

Product Strengths Sector Strengths

♦ Product Expertise

♦ Global Product Liaison

♦ Execution Experience

♦ Specialized Resources

♦ Sector Knowledge

♦ Client Management Skills

♦ Global Coverage

♦ Specialized Resources

♦ While there is an emphasis on execution of transactions in the product groups and an emphasis on marketing and client management in the sector groups, there is a high degree of overlap

– At the end of the day, all investment bankers work for the client

– Specialization maximizes efficiency and service for clients


21

The Associate/Associate Director Role

Responsibilities Qualities

♦ Technical Analysis

♦ Team Management

♦ Logistics/Processing

♦ Whatever it takes

♦ Leadership

♦ Teamwork

♦ Communication

♦ Dedication

♦ Professionalism

♦ Little things can mean a lot and poor execution can mask good skills

– attention to detail

– formatting

– professionalism

– timeliness

♦ Communication is the key to good teamwork and efficiency

– ask questions if you don’t know

– understand what expectations are (timing/deliverable)

– let people know your limitations

♦ Treat your Associate/AD years as an investment (more experiences = more personal capital)

– seek out work

– try to vary the people and types of projects you work with or on

– get included in as many client calls or meetings as possible


22

The Associate/Associate Director in a Team The Associate is an integral part of the deal team

♦ You are an integral member of the team

– team is organized by skills, responsibilities and experience

– you need to work closely with the Analyst and the person above you

– you will be in a position where you represent the bank

– you have support, use it wisely to maximize your own leverage

♦ You will have to develop a management style

– support staff can help you a lot or a little, so treat them with respect

– you will need to train Analysts, summer interns and new Associates

– you will need to build relationships and understand motivations

– you need to take advantage of the bigger “Team”

♦ Working with Junior Resources

– learn to do what you ask them to do

– take time to teach them

♦ Understand who the contact people are in different areas of the bank

– use contacts in different groups amongst your class

– you will be the decision maker in certain circumstances

– help each other as a team of Associates/ADs in your group (“Fresh Eyes”)


23

Being an Associate—A Few Tips

♦ What makes a good Associate?

– professionalism (interaction with clients and co-workers)

– timeliness (know deadlines and meet them, time management, parallel processing)

– technical skills (accounting, finance and spreadsheet skills)

– accuracy (every possible research source examined, no typos, careful numbers work)

– learning to eyeball the output every time you print it out, and to spot unreasonable numbers at a glance

– judgment (what makes sense for the client and for the firm)

– good attitude and a strong work ethic

– think like a project manager (anticipate work that needs to be accomplished and be proactive)

♦ Questions:

– do not be afraid to ask well thought-out questions

– for general questions ask peers; for specific project oriented questions, ask the immediate supervisors and your team

– if no one is around to ask, use your best judgment and footnote your assumption


24

SECTION 4

Interview Preparation


25

Developing Your Story: Key Pieces of Advice

Pick relevant time frames

Have different length versions of your story, but be sure to include the most important points or themes in each version

Your story should flow with your resume, but you should not be re-hashing your resume

Don't read off of your resume or pause to refer to it when interviewing

Keep your story consistent

Your story should always answer "why banking?"

If you mention it or list it on your resume, it’s fair game

Practice, practice, practice!


26

Developing Your Story: Key Pieces of Advice Some key questions that you may encounter, which translate into ……… “tell me your story”:

So, tell me about yourself…

I haven't had time to read your resume, fill me in…

Tell me why banking?

Walk me through your resume…

What did you do before business school?

What do you want me to know about you and your background?

You are a career-switcher. What makes you want to do banking?

You have never done banking before. Why now?

You have done XYZ before, what makes you think you can do banking?


27

Interview Questions—Big Picture Must-Practice Items

Why do you want to do investment banking? – challenge, visibility, opportunity to work with the best

What skills does Investment Banking require? What in your background shows you can do it? – intelligence, initiative, communication skills, attention to detail, teamwork

What do investment banks do? – investment banks act as financial advisors on a range of issues including M&A, restructuring and

capital raising activities. Once a course of action is decided the bank then executes the strategy by underwriting securities, etc

In which industry/product do you wish to focus?


28

Interview Questions—General Theory

What is working capital?

Define Beta; what are the limitations of Beta?

Show how to lever and unlever Beta

What is CAPM; what are the assumptions of CAPM?

Define reward to risk ratio

Write formula for WACC

Define Sharpe ratio

Draw the yield curve

Define duration

Show how convexity impacts a bond’s price to yield relationship

Explain the theory behind Black-Scholes

Discuss different accounting treatments for different securities (e.g. available-for-sale)

What is a carve-out, spin-off and split-off?

What is accretion and dilution? — Give an example

Go over a cash flow statement

What are some liquidity/leverage ratios?

How do you go from NI to cash flow? FCF and FCFE?

How do you value a company?

If you know a company’s P/E, what is its ROE?

Where do deferred tax liabilities come from? — Give an example


29

Sample Interview Questions—Investment Banking Fit What three adjectives would your peers, superiors and subordinates use to describe you?

What is the greatest risk we face in hiring you?

What are your greatest team and personal achievements?

Describe your leadership style

Describe a team situation you were in where things did not work out

Why did you choose your MBA program?

What other business schools did you apply to and why?

Do your grades reflect your abilities?

Why do you want to be an investment banker?

Why do you want to work for UBS?

What differentiates you from all the other highly qualified candidates we are looking at today?

What other types of jobs are you interviewing for and why?

What other investment banks are you interviewing with? If you got offers from all of them, where would you go?

Walk me through your resume explaining why you made the choices you did in the past

Tell us about three of your strengths and three of your weaknesses

What electives have you taken outside of finance and accounting?

What is your favorite class and why?

Are you well-rounded?

How do you know you will be able to handle the hours required of an investment banker?

Describe what you learned in class this morning

Do you consider yourself a risk-taker?

How well do you work under pressure?


30

Sample Interview Questions—Other General Questions

What type of a company would be a good candidate for an LBO?

Name two common ways companies can manage their earnings?

How does Net Income flow into the Balance Sheet, Income Statement and Statement of Cash Flows?

Describe how to value a privately held company

Describe three valuation methods – Discounted Cash Flow – Comparable Company or Multiple Valuation – Comparable Transaction Valuation

What is a stock that you follow?

What is the difference between commercial and investment banking?

Do you think the market is efficient?

How would you describe the cost of capital to a non-finance person?

What is CAPM?

Define Beta for a layman

What kind of financial modeling have you done in the past?

Suppose your client had significant excess cash on the balance sheet. How would you recommend its use?

Have you ever worked with a difficult team?

If I had $1 million today, how should I invest?

What question would you like to ask our CEO?


31

Sample Interview Questions—Other General Questions

Where did the Dow, S&P and NASDAQ close yesterday?

What is the Fed Funds rate?

What is the discount rate?

How often does the Fed meet?

What is the 10-year Treasury bond yield?

What does the yield curve look like?

What is the $/Yen exchange rate?

Where do you see the markets in a year?

What did the markets do last week and why?

What have the markets been doing this week and why?

What are three major news items related to the industry in which you are interested? What is the most interesting article you read in the WSJ of late?

What was in the Journal today?

What business publications do you read? What interesting articles have you recently read in those publications?

What activities have you participated in college and business school?

What multiples are used in the industry in which you are interested?

Tell me about a recent IPO you followed

Describe a recent M&A transaction you read about—what were the reasons they merged?


32

Interview Strategy

Things to mention during the interview:

Mention the names of other bankers with whom you have met and done informationals

Names of all other banks with which you are in final rounds or have gotten offers

Tell your story of why you want to do investment banking

Drop names of prominent deals the bank has done

Show that you have done your homework and know the bank’s strengths

Skills/Qualities to demonstrate you have:

Academic excellence

Relevant business experience

Demonstrated leadership experience

Demonstrated work ethic

Interviewing skills

Computer competency

Analytical skills

Problem solving/modeling

Perceived client relationship skills

Know why you want to be a banker (story)

Know why you want to be at that bank


33

Keep Yourself Informed During the Process Bloomberg Terminal Cheat Sheet

Keep up with Deals & Key Calendars Market News

Type functions below <GO> Type functions below <GO>

MA M&A deals database TOP Today’s top business/finance news

MA LEAG M&A league tables TOP STK Top stock market news

NIM Bond new issue monitor TOP DEAL Global deals

– Click on LEAG for league tables BBNI News by industry

ECDR Equity new issue monitor NI MNA M&A news

– Click on LEAG for league tables NI CNI New corporate bond issue news

FOMC Federal reserve announcements/news NI INI IPO news


34

Keep Yourself Informed During the Process

Company Analysis Others (Take a Break!)

Type <Ticker><Equity><Go> and run functions below Type functions below <GO>

DES Company description

DINE Restaurant information

CN Headlines BSP Main sports news

CACS Corporate action calendar POSH Classifieds

HP Daily stock prices BSPE Baseball News

GP Price Graph

MGMT Management and board


35

SECTION 5

UBS Technical Reference Guide


36

Necessary Tools—Information is Everything Most things have been done—ask other bankers before recreating the wheel

Public Filings (US) Additional Company Information and Estimates On-Line Databases Other Databases Others

Annual Report Investext/Multext (research reports) ILX Dun & Bradstreet New Articles—Library (Lexis/Nexis)

10-K (20-F—foreign filers) S&P Tear Sheet FactSet One Source The Wall Street Journal, The New York Times, The Financial Times, Business Week, Forbes, etc.

10-Q (6-K—foreign filers) Value Line Bloomberg OneSource Private Management Files

Proxy I/B/E/S Datastream Spectrum Colleagues

13-D/14D-1 First Call SDC Technimetrics

Registration Statement/Prospectus (S-1, F-1)

Zack’s Spectrum Securities Data

8-K Nelson’s Equidesk

Moody’s Company Reports Bondesk

UBS research Amadata

Bondware

M&A Desk

Reuters


37

Corporate Valuation—The Core of Corporate Finance Overview

♦ As schematically expressed, investment banks typically employ at least two of the methodologies below to arrive at a range of value for a company. This manual will outline these techniques in greater detail

Sample Valuation Analytics

Discounted Cash Flow Analysis

Comparable Company Analysis

Estimated Company Value Range

- Up Analysis Leveraged Acquisition Analysis

Leveraged Acquisition (LBO) or Recapitalization


Comparable Company Analysis

Precedent Transactions Analysis

Estimated Company Value Range

BreakUp Analysis


38

Valuation Methodologies Overview Method Description Pros Cons Comments

Comparable Companies Analysis

♦ Compare the trading and operating performance of the Company to that of its peers

♦ Specifically, determine how the market has capitalized the earnings and cash flows of similar companies. Also, analyze other parameters such as book value, leverage and margins. Compare these ratios to the Company’s performance and/or use them to impute a market value for the Company

♦ Market efficiency ensures that trading values reflect industry trends, business risk, market growth, etc.

♦ Values obtained are a reliable indicator of the value of the Company for a minority investment

♦ Useful technique for assessing vulnerability; when fundamental vs market value is large, vulnerability is high

♦ Always comparing apples to oranges. Truly comparable companies are rare for which differences are hard to account

♦ Thinly traded, small capitalization and poorly followed stocks may not fully reflect fundamental value

♦ Many people feel that the stock market is “emotional” and that sometimes it fluctuates irrationally

♦ The unaffected trading level does not include a control premium or synergy value associated with strategic acquisitions

♦ Explaining value gaps between the Company and its comparables can involve extensive hand-waving

♦ The market is not always an efficient one; small capitalization and thinly traded stocks may not trade actively and the share price therefore may not reflect financial value It is important to select truly comparable companies to reflect accurate comparability


♦ Determine the value offered in past acquisitions of similar companies

♦ Specifically, determine the pricing of past deals as compared to the target’s financial performance and unaffected market value

♦ Recent comparable transactions can reflect supply and demand for salable assets

♦ Realistic in the sense that past transactions were successfully completed at certain premiums. Indicates a range of plausibility for premiums offered

♦ Trends such as consolidating acquisitions, foreign purchasers or financial purchases may become clear

♦ Past transactions are rarely directly comparable—always comparing apples to oranges

♦ Public data on past transactions can be nonexistent or misleading

♦ Values obtained often vary over a wide range and thus are of limited usefulness

♦ Interpretation of the data requires familiarity with the industry and the properties involved

♦ Analysis is typically based on historical data, not forward looking data

♦ It is important to understand terms and logistics of transactions (e.g., unsolicited transactions tend to occur at higher multiples)


39



♦ Discount unleveraged, after-

tax projected free cash flow

at Company’s weighted

average cost of capital to

obtain an economic present

value of assets. Subtract

outstanding debt from the

present value of assets to get

present value of equity

♦ Several discount rates and

operating scenarios are used

to estimate the uncertainty of

the values obtained

♦ Theoretically the most sound

method if one is very

confident in the projections

and assumptions

♦ Not influenced by

temperamental market

conditions or

non-economic factors

♦ Present values obtained are

sensitive to assumptions

and methodology

♦ Values obtained can vary over

a wide range and thus be of

limited usefulness

♦ Involves forecasting future

performance, which is

inherently subjective

♦ DCF value should be adjusted

for non-operating items such

as environmental liabilities

and the value of excess assets

♦ Need realistic five- to ten-year

projected financial statements

♦ Sales growth rate, margins,

terminal multiples and discount

rates are key to value

Leveraged Acquisition (LBO) or Recapitalization Analysis

♦ Model the Company’s

financial performance under

an initially highly leveraged

capital structure

♦ Assume transaction occurs in

today’s borrowing

environment and determine

maximum initial debt the

Company can realistically repay

in a timely manner

♦ Several operating and

business environment

scenarios are used to estimate

the uncertainty in

values obtained

♦ Will help determine realizable

financial bidder value that any

strategic bidder will have

to exceed

♦ LBO value is realistic, in the

sense that it can be achieved

by a well-defined process

♦ Standalone LBO will

underestimate strategic sale

value by ignoring synergies

with acquirer. Financial buyers

tend to pay lower multiples as

they are in for the shorter

term than are strategic buyers.

However, markets change and

financial buyers can be

competitive with strategic

buyers

♦ Value obtained is sensitive to

projections and aggressiveness

of operating assumptions (but

less so than DCF methodology)

♦ LBO value only meaningful for

companies which could

operate under high

financial leverage

♦ Need realistic ten-year

projected financial statements

♦ Equity can be closely held

(private LBO) or publicly

traded (recap/public LBO)

♦ Sales growth rate, margins,

exit multiples and discount

rates are key to value


40


Break-Up Analysis ♦ Valuation of the Company is

based on valuation of

individual segments using

multiples from comparable

companies and precedent

transactions analysis and DCF

and LBO analyses

♦ After valuing the individual

segments, one must add and

subtract non-operating values

and liabilities such as cash,

debt, environmental liabilities,

pension surplus/(deficit), etc.

to arrive at an

Enterprise Value

♦ This methodology provides a

perspective on what the

multi-segment Company

could be worth if the market

value of the stock accurately

reflected the break-up value

♦ Useful technique for targeting

undervalued companies that

may receive a “conglomerate

discount”

♦ Slight variations in multiples

can vary the break-up value

making an undervalued

property fully-valued or

overvalued or vice versa

♦ Application of multiples

requires familiarity with

industry and

businesses involved


41

Enterprise Value vs Equity Value

Definitions

Equity Value

♦ On a trading basis, Equity Value or Market Value is defined as:

– Latest Shares Outstanding x Current Market Price

♦ The latest shares outstanding should be taken from the cover page of the latest Form 10-K or Form 10-Q (20-F, 6-K, Annual Report or Interim Statement for non-US companies), whichever is more recent DO NOT USE SHARES OUTSTANDING FROM BLOOMBERG. THESE FIGURES ARE OFTEN WRONG

– be sure to check whether there has been any kind of stock split or other change in the number of shares (e.g., secondary offering, stock dividend, acquisition for stock, etc.) since the latest filing

♦ On a transaction basis, Equity Value is defined as:

– Latest Shares Outstanding x Offer Price

+ Shares for Options1, Warrants1, SARs2, etc. x (Offer Price Average Exercise Price)

+ Shares for Convertible Debt x Offer Price3

+ Shares for Convertible Preferred Stock x Offer Price3

= Equity Value

Enterprise Value4

In addition to Equity Value, Enterprise Value includes all other sources of capital utilized by the company. Enterprise Value is used in ratios that measure the return to all sources of capital (e.g., Enterprise Value/EBITDA, Enterprise Value/EBIT, etc.)

1 Only if offer price exceeds average exercise price 2 SAR = Stock Appreciation Rights 3 Only if offer price exceeds conversion price 4 Also referred to as Firm Value, Adjusted Market Capitalization and Aggregate Value


42

Enterprise Value vs Equity Value Enterprise Value is defined as: Equity Value

+ Short-Term Debt and Long-Term Debt + Capital Lease Obligations + Preferred Stock at Liquidation Value5 + Out-of-the-Money Convertible Debt + Out-of-the-Money Convertible Preferred Stock + Minority Interest (at market value, if publicly traded) – Cash and Cash Equivalents6 = Enterprise Value

Net Income to Common

♦ Net Income to Common represents the earnings available to common shareholders after interest expense, taxes and preferred dividends. Net Income should always be taken before extraordinary items and adjusted for non-recurring items on an after-tax basis (See discussion on page 13)

EBIT

♦ EBIT (“Earnings Before Interest {interest expense less interest income} and Taxes”) represents the earnings stream (operating income) available to all investors, including debt holders and preferred shareholders. In a typical income statement, it is defined as:

Gross profit – SG&A – Depreciation and Amortization7 – Any other recurring operating expenses/(income)8 = EBIT

5 All preferred stock which is not included in Equity Value 6 Used as a proxy for excess cash, which is cash over and above that needed to run the business on a daily basis 7 Often included in part or in whole in the Cost of Goods Sold. When calculating EBIT using this method, use Depreciation and Amortization from the Income

Statement (if available) since a portion of the Depreciation & Amortization may already be included in COGS. Do not use Depreciation & Amortization from the Statement of Cash Flows. However, when calculating EBITDA (see next page), you should use Depreciation & Amortization from the Cash Flow Statement and add it back to EBIT

8 Note that other income/expense below the operating income line should be included assuming that it is both recurring and non-financial. Check the notes to the financial statements!


43

Enterprise Value vs Equity Value

EBITDA

♦ EBITDA (“Earnings Before Interest, Taxes, Depreciation and Amortization”) represents the pre-tax operating cash flow available to all investors. Defined as:

EBIT (as defined above)

+ Depreciation and Amortization (taken from Statement of Cash Flows)

= EBITDA

Equity Value vs Enterprise Value Multiples

Equity Value (or Market Value) Multiples

♦ Certain flows or values apply to equity holders only—these include net income and book value of equity. Since each of these values is after debt and preferred financing is taken into account, multiples of these flows or values should be based on the value of the equity only

♦ Therefore, the only relevant ratios are:

– Equity Value to: Net Income to Common Shareholders, Book Value and Cash Flow (defined on page 21)

Enterprise Value (“EV”) Multiples

♦ Other flows apply to all capital providers (i.e., debt and equity), and therefore Enterprise Value should be used

♦ Relevant ratios are:

– Enterprise Value to: Sales, EBITDA and EBIT

♦ Also use Enterprise Value as the numerator for industry specific measures (e.g., EV/mineral production, EV/retail sales space, EV/R&D)


44

Treatment of Unusual and Non-Recurring Items Top-Down Comparative Example Definition

Bottom-Up Comparative Example

Notes: 1 $600 * (1-tax rate) = $600 *(0.6) = $360

2 Net Income to Common Shareholders (after Preferred Dividends, which, unlike interest expense, are not tax-deductible like interest expense)

(US$mm) Reported Adjusted

Revenues 1,000 1,000 COGS (500) (500) SG&A (300) (300) + Gain on Sale of Equipment 600 0 EBITDA 800 200 % Margin 80 2 – Depreciation & Amortization (100) (100) EBIT 700 100 % Margin 70 10 Interest Expense (50) (50) 650 50 Taxes @ 40% (260) (20) Net Income 390 30 Preferred Dividends (5) (5)

Net Income To Common Shareholders 385 25 Weighted Average Shares Outstanding (mm) 25 25 E.P.S. 15.40 1.00

(US$mm) EBITDA EBIT Net Income

Reported Results 800 700 390 Pre-Tax Gain on Sale (600) (600) – Post-Tax Gain on Sale (@ 40%) – – (360)1 200 100 30 Preferred Dividends (5) Net Income to Common Shareholders 252 Weighted Average Shares Outstanding (mm) 25 E.P.S. 1.00

♦ Unusual and non-recurring items often are included in a company’s EBITDA, EBIT

and net income and must be removed (adjusted for) in order to assess “normal”

operating performance. These items include gains on sale of assets, restructuring

charges, losses on plant closings, writedown of assets, legal settlements, etc.

Methodology ♦ These non-recurring items are sometimes detailed in the financial statements, but

can always be found in notes to the financial statements and in the “Management’s Discussion and Analysis” section. It is important that these sections of the annual report are carefully read in order to find these adjustments

♦ Often, these items are found in the notes to the financial statements, under “other income/expense” and are only shown on a pre-tax basis. If the after-tax basis is not shown, one must calculate the after-tax effect on net income assuming the marginal tax rate, which varies by country

♦ You should first check the tax footnote in the Annual Report or 10-K (20-F) for an effective tax rate, making sure to exclude non-recurring tax effects like very large NOLs. For US companies one can use 40%, which includes the federal tax rate of 35% and a state and local tax rate of about 5%. The marginal federal corporate tax rates at December 31, 2006 as defined in Ernst & Young’s “Worldwide Corporate Tax Guide and Directory” were:

♦ Note that marginal corporate tax rates should ideally include federal, state and local taxes, although multi-state and multi-national companies complicate this issue. Consult local offices for their input on what tax rate to use. Although the tax rates above are as of December 31, 2006, some have changed and you should double-check them

% % %

Brazil 33.0 Japan 37.5 Switzerland 20.0

Colombia 35.0 Mexico 34.0 UK 33.0

France 33.3 Netherlands 35.0 USA 35.0

Germany 45.0 South Africa 35.0

Hong Kong 16.5 Sweden 28.0


45

Stock Splits

Definition

♦ Corporations often declare stock splits in order to reduce the trading price of their stock and enhance liquidity. While most splits are 2-for-1 (i.e., a shareholder receives one additional share for each share he already holds), corporations also split their stock 3-for-1, 3-for-2, etc. In addition, a corporation may effect a reverse stock split in order to consolidate its shareholder base (i.e., a shareholder receives one share for every three shares he already holds). When a stock splits, the stock price will adjust to reflect a proportional decrease or increase in price depending upon the direction of the split (i.e., if a $60 stock splits 3-for-2, the post-split share price will be $40 per share or if a $40 stock reverse splits 1-for-2, the post-split share price will be $80 per share). It should be noted that the market value of all trading shares will remain the same. Furthermore, high growth, cash constrained companies will occasionally declare stock dividends, which also increase the number of shares outstanding. Be sure to note the effective date of these transactions, as the stock price will not be adjusted until that time

♦ It is imperative to watch carefully for stock splits. Since there is a time lag for when public documents are released, the stock price that appears on ILX or Bloomberg may reflect a split that occurred since the public documents were issued. This would result in incorrect calculations of EPS, Equity Value and Enterprise Value and hence improper valuation multiples

Methodology

♦ One should always check the company’s headlines and earnings announcements on ILX and Bloomberg for stock splits that have occurred since the date of the latest public document. You can also check for stock splits on Bloomberg by typing the company’s ticker symbol, pressing the <<Equity>> key, typing “DVD” and then pressing the green <<Go>> key. The row with white colored text will indicate the relevant dates relating to the stock splits


46

Calculating Last Twelve Months (“LTM” or “Trailing”/”TTM”)

Concept

♦ Markets are dynamic and absorb information instantaneously, and therefore income statement data must reflect the last twelve months (“LTM”) for which publicly reported information is available. Note that typically only US companies and foreign issuers with American Depository Receipts (“ADRs”) report quarterly

Calculation

♦ LTM relates to the Income Statement and Statement of Cash Flows which represent a “flow” over a period of time, as opposed to the Balance Sheet which represents a “stock” (or “snapshot”) at a point in time. Thus, LTM figures are calculated as: 12-month period + most recent period–corresponding prior year period. For example, to calculate the trailing twelve months’ sales for XYZ Corporation (with a 12/31/07 year end) for the period ending 6/30/08 take the 2007 annual sales, add the sales for the six months ended 6/30/08 and subtract the sales for the six months ended 6/30/07. Schematically

Last Fiscal Year (“LFY”) Q1 and Q2 2007 Q3 and Q4 2007

(Subtract) ↑

Last Quarters (“LQs”) Q1 and Q2 2008

(Add) ↑

Last Twelve Months Q3 and Q4 2007 Q1 and Q2 2008

♦ When calculating LTM E.P.S., use the above methodology only and do not divide LTM Net Income by a calculation of LTM weighted average shares outstanding


47

Compound Annual Growth Rate (“CAGR”)

Definition

♦ A value that simplifies the observed data into one number that will, it is hoped, describe it to others in an accurate and meaningful way

Methodology

♦ The formula used to estimate the constant annual percentage rate is:

– ((Xn/X1)(1/(n-1))-1) x 100%

– where: X1 ... Xn = observations for n values

♦ For example, if XYZ Corporation has produced earnings per share as follows

Year Period Actual E.P.S. (US$)

2003 1 2.00

2004 2 2.70

2005 3 3.13

2006 4 3.71

2007 5 4.88

♦ We can calculate the Company’s CAGR in % of growth/year as follows:

– (($4.88/$2.00)(1/4)-1) x 100% = 25%

♦ That is, each year we estimate, on average, that XYZ’s E.P.S. grows by 25% from that of the previous year

♦ When growth rates are used in exhibits and memos, they should be clearly identified as “n-year compound annual growth rates”


48

Comparable Companies

Definition

♦ The comparable companies analysis (“Comps”) typically consists of a comparison of several companies’ operating and trading statistics. The exact ratios and range analyzed will vary from project to project

♦ Comps are good for valuing companies in virtually any given industry. Almost all of our valuation presentations include comparables—usually one set for each sizable segment of the valuation target. Comps serve as the primary measure of value when analyzing a public offering

♦ Use of comps will give you a TRADING VALUE. You will need to add a “control premium” to obtain an ACQUISITION VALUE

Concept

♦ A comparable peer group should embody the same business and financial attributes such that their public trading values represent a reasonable proxy for those of the company under consideration

♦ Relevant attributes include:

– industry group

– business mix (products, markets served, distribution channels, etc.) and respective weight of each product

– geographic location

– operations (production processes, critical inputs/components)

– size (revenues, assets, market capitalization)

– financial parameters (leverage, historical and future growth rates, margins, dividend yield)


49

Comparable Companies Analysis

Methodology

♦ The first step in putting together a comparables exhibit is to identify companies that are considered comparable. An SIC code run from the library and on FactSet are the main sources for a search. Research reports, the proxy statement, the 10-K and Bloomberg may also list comparable companies. You want to identify “pure plays” or those companies that closely resemble the company (or segment of a company) that you are evaluating

♦ Once you have the output from the SIC code run and FactSet search, read Value Line, S&P Tear Sheet descriptions and/or Moody’s Company Reports to pinpoint those companies that are most similar. These publications also have industry groupings that may be helpful in identifying comparables. Finally, run your list of comparables by another member of your team or industry analyst for a final check

♦ The median values for the comparables chosen are always included in the exhibit. Mean values must be used carefully because skewed or outlying data can result in misleading values. Thus, outliners are often excluded from the mean calculation

♦ It is critical to be attentive to how particular industries trade. Some trade based on EBITDA multiples (i.e., most manufacturing companies), some trade on Price/Earnings or Price/Book multiples (i.e., financial institutions) and some trade on industry specific statistics (i.e., cellular companies trade on a “per pop” basis and paging companies trade on a “per subscriber” basis)

♦ Using the appropriate multiple for the industry and even the individual company to be valued will more accurately reflect the true value of the enterprise


50

Comparable Companies Analysis Also known as “trading comps” or “equity comps”

Assumptions and Footnotes

♦ Reported information is almost never complete enough to meet all inputs for your analysis

♦ Read the Notes to the Financial Statements; answers are often found there

♦ Check with bankers on your deal team or in your industry group; methodologies may differ

♦ Do not be afraid to make assumptions for which there are reasonable foundations

♦ Footnote all company-specific assumptions accordingly:

– sources of assumptions and estimates

– methodologies used for calculations

– adjustments for non-recurring items and marginal tax rate, if appropriate

♦ Footnote all global definitions where applicable, including:

– inclusion of minority interests in net debt

– treatment of preferred stock

♦ Mark your source material with a highlighter and post its so that inputs are easily located and checked LEAVE AN AUDIT TRAIL AND MAKE NOTES OF ALL SOURCES, ASSUMPTIONS AND CALCULATIONS

UBS has constructed a custom-designed Excel model that downloads trading and operating data from FactSet. This model should NEVER be shown to clients or more senior bankers unless it is hand-checked and/or explicitly requested. Moreover, it should be used to “sanity check” your work or provide “quick and dirty” analysis


51

Basics of Trading Comps Inputs to the Comparables Outputs to the Comparables

Item Source

Latest Indicated Annual Dividend

On Bloomberg under Current News; look for the latest dividend declaration headline. Look at the article to get the most recent dividend and annualize it (e.g., multiply by 4 for quarterly dividends). Alternatively, go to the same screen as the stock split screen; see page 14 under “Methodology”

Common Shares Outstanding

On the front page of the 10-Q or 10-K near the bottom. Make adjustments for subsequent events, if any (e.g., share repurchase, stock split, etc.)

Long-Term (“LT”) Debt LT debt plus redeemable preferred stock plus capital lease obligations (if any). Other types of preferred stock are not considered LT debt

Short-Term (“ST”) Debt Under current liabilities, “short-term borrowings” or “bank notes”, plus “current maturities of LT debt”, “accrued interest” 1, if any

Minority Interest Minority interest at market value if publicly traded Preferred Stock Preferred Stock at liquidation value, not included in LT Debt. Book Value Common Shareholders’ Equity from the latest balance sheet. Net Interest Expense 2 Interest expense less interest income both from income statement D,D&A (D&A) Depreciation, Depletion and Amortization (Depreciation and

Amortization) is found on the Statement of Cash Flows (some 10-Qs may not disclose this)

EBIT Earnings before Net Interest Expense and Taxes EBITDA EBIT plus D,D&A. Net Income Net Income to Common Shareholders E.P.S. Primary before extraordinary items. Watch for stock splits: if Net

Income/Shares Outstanding differs from E.P.S. by more than 5%, try to find out why. Remember that some discrepancy is normal, because total shares outstanding does not usually equal weighted average shares outstanding

Cash Flow from Operations per Share Estimates

Cash Flow per Share is equal to Net Income + D,D&A + Deferred Taxes (from Statement of Cash Flows) + Other Non-Cash Charges divided by Shares Outstanding. Research reports or Value Line (in library

E.P.S. Estimates From First Call, I/B/E/S, FactSet, Bloomberg or research reports

Item Source

Equity Value Stock Price × Common Shares Outstanding

Enterprise Value Equity Value + LT Debt + ST Debt + Minority Interest + Preferred Stock (not included in LT Debt) – (Cash + Cash Equivalents)

Price/Earnings Price/E.P.S.

Price/Cash Flow Stock Price/Cash Flow per Share

Dividend Yield Dividends per Share/Stock Price Price/Book Equity Value/Book Value % Payout Dividends per Share/E.P.S. (last 12 months) Interest Coverage 2 EBIT/Interest Expense Enterprise Value/Sales) 3 Enterprise Value/Sales Enterprise Value/EBITDA 3 Enterprise Value/EBITDA Enterprise Value/EBIT 3 Enterprise Value/EBIT

Notes: 1 Accrued Interest is sometimes detailed on the balance sheet or in the Accrued Liabilities footnote 2 For an Interest Coverage ratio, i.e., EBITDA/Interest or EBIT/Interest, be sure to add Capitalized Interest to your Net Interest Expense and subtract it from EBITDA.

Capitalized Interest, if available, can be found in the Management’s Discussion and Analysis section or in the notes (P,P,&E) to the financial statements 3 The idea here is that since EBIT, EBITDA and Sales are not affected by the company’s choice of capital structure (as are cash flow, net earnings and book value),

the appropriate multiples use total capital (i.e., equity and debt), and not just equity capital


52

Selected Trading Statistics The objective of this exhibit is to assess the value of a company relative to its peer group by comparing various equity trading multiples

The exhibit is broken into the following parts:

♦ Closing Price:

– use a recent closing stock price from Bloomberg, FactSet or ILX and be sure to note the date of this quote in the exhibit. Prices for all companies should (normally) be as of the same date

♦ LTM P/E (Last Twelve Months):

– if the fiscal year is the most recent period, simply divide the current stock price by the last fiscal year’s E.P.S.

– if one or more form 10-Qs have been filed since the end of the fiscal year, compute the LTM P/E (see page 15)

♦ Projected P/E:

– get estimates from First Call or I/B/E/S (make sure you determine whether E.P.S. are on a fully-diluted or primary basis and footnote this) for the next 2 fiscal years (i.e., if your LTM date is as of March 31, 2008 and your fiscal year-end is December 31, 2008, get the December 31, 2008 and December 31, 2009 estimates). The First Call estimates can be obtained from FactSet or from the First Call computer (typically located on the trading floor); online I/B/E/S estimates are available on FactSet

– be sure to use the median (not the mean) I/B/E/S estimates to avoid skewed data values

– if the second year estimates are unavailable, you should look up the Median Estimated 5-Year Growth Rate for the company in the I/B/E/S section of FactSet. Use this growth rate and apply it to the last estimate you have. For example, if your last estimate is $1.50 and you have a Median Estimated 5 Year Growth Rate of 20%, then the next fiscal year’s estimate would be $1.80 ($1.50 x 1.20 = $1.80)


53

Selected Trading Statistics

Calendarize Earnings Estimates as Needed (and Footnote This), i.e.:

June 2008 + June 2009

2 = December 2008

or

May 2008 x 5⁄12 + May 2009 x 7⁄12 = December 2008

♦ Trading Statistics:

– Enterprise Value/Sales

– Enterprise Value/EBITDA

– Enterprise Value/EBIT

♦ EBITDA, EBIT and Net Margins:

– exclude any extraordinary items and one-time occurrences (e.g., restructuring charges) from all earnings numbers

– divide EBITDA, EBIT and Net Income by total revenues. Use the most recent financial statements for these figures (i.e., LTM calculation) and also look at forecasted figures


54


♦ EBIT/Assets:

– use same EBIT value as above

– to calculate average assets, add beginning period assets to ending period assets (both from the periods for which the EBIT applies) and divide by 2 (watch out for equity issues and acquisitions). Use the asset value at the most recent balance sheet available

♦ Return on Equity:

– use net income

– divide by average Stockholders’ Equity. Sum beginning and ending period equity and divide by 2 to get average Stockholders’ Equity (watch out for equity issues and acquisitions). Use the Stockholders’ Equity value at the most recent balance sheet available

♦ Price/Book Value:

– book value of common equity per share (sum of equity accounts on most recent balance sheets) divided into the most recent stock price. Be sure to exclude Book Value of Preferred if it is reported with the Shareholders’ Equity

♦ Price/Cash Flow:

– Cash Flow refers to Operating Cash Flow, OR Net Income plus Depreciation, Depletion and Amortization plus Deferred Taxes and other Non-Cash Charges

– Cash Flow Projections can be taken from research reports whereas latest 12 months cash flow should be calculated from the latest financial statements


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♦ Additional statistics may include:

– inventory turnover: ratio of COGS to inventory or annual sales to inventory, which shows how many times the inventory of a firm is sold and replaced during an accounting period

– interest coverage (fixed charge coverage): ratio of profits before payment of interest on bonds and other contractual long-term debt. It indicates how many times interest charges have been earned by the corporation on a pre-tax basis

– total debt/EBITDA: (ST Debt + LT Debt + Redeemable Preferred Stock)/EBITDA. This statistic measures how many times debt covers EBITDA

– capital expenditures/revenues

– working capital/revenues

– days payable: the number of days between when the company receives goods and/or services and when it pays for them

– days receivable: the number of days between when the company provides goods and/or services and when it receives payment for them


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Definition

Today, XYZ announced the sale of its Danco subsidiary to LBO

Partners for $135 million, including the assumption of

debt and other liabilities.

Today, IBM announced the sale of its printed circuit board

operations for $80 million, plus $100 million of assumed debt.

Today, XYZ announced the sale of its Danco subsidiary to LBO

Partners for $135 million, including the assumption of

debt and other liabilities.

Today, IBM announced the sale of its printed circuit board

operations for $80 million, plus $100 million of assumed debt.

♦ The precedent transactions exhibit contains information about selected M&A transactions in the same industry as the company (or segment of a company) that you are evaluating, thereby allowing a value to be imputed to the company under consideration. The purpose is similar to that of the comparables trading statistics except that by looking at prior acquisitions, you can get a sense of the premium that is paid to gain control of the target company (i.e., control premium). This is another way to assess the value of the company from a potential buyer’s perspective

Methodology

♦ Unlike the DCF analysis, this technique does not focus on the operating assumptions of the current or prospective owner. Rather, such multiples represent an index of recent market prices paid by other acquirers and accepted by other sellers. From a potential seller’s viewpoint, the multiples suggest a target price range at which other buyers have been willing to buy. Conversely, for potential buyers, the multiples suggest price ranges that are acceptable to sellers

♦ However, because each acquisition is unique and buyers and sellers typically do not know all the factors and motives that went into the formulation of another acquisition price, acquisition multiples often suggest a wide range of values and must be used with care. Moreover, because the acquisition market is not continuous in time, the fact that a particular multiple was paid in the past does not necessarily mean that it still applies today. Unlike the stock market, there is no current P/E benchmark other than the most recent industry transaction which may be several months or even years old. Furthermore, many transactions occur at the subsidiary or division level for which no trading valuations exist

♦ Precedent transactions analysis is based on historical, not forward looking, data. In reality, transactions are valued using forward looking data which are not disclosed to the public at the time of the acquisition


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♦ Prices paid as a multiple of net earnings and/or operating profit (EBITDA and EBIT) are typically the most useful for a broad range of industrial companies. An important requirement for such multiples to be meaningful is that the accounting principles underlying earnings be comparable across the sample of transactions

♦ The output for precedent transaction analysis is largely similar to that of comparable companies with one difference:

– Equity Value—Equity value should be calculated based on the fully-diluted number of shares outstanding because convertible securities and options will typically come “in-the-money” in an M&A transaction. Note that management options, not to be confused with publicly-traded options, typically vest in change of control transactions

– Enterprise Value—Since a majority of M&A transactions are done at the division and subsidiary level, financial data is sometimes difficult to procure. If no debt is assumed, Equity Value and Enterprise Value will be equal

Warrants and Options

♦ Warrants, options and similar securities are considered common stock equivalents at all times unless conversion of these securities proves antidilutive (i.e., E.P.S. is actually increased after accounting for these securities. This occurs if the market price of the stock is lower than the exercise price of the option). As a result, both primary and fully-diluted E.P.S. should reflect the dilution that would result from exercise or conversion of these securities

♦ The amount of dilution reflected in E.P.S. data should be computed by application of the “treasury stock” method. Under this method, E.P.S. is calculated as if the warrants and options were exercised at the beginning of the reporting period (or, if later, at the time of issuance) and as if the funds obtained by the exercise were used to purchase common stock at a market price


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Precedent Transactions Analysis Shares for E.P.S. purposes = Shares Outstanding + Incremental Shares

= Number of Options – Number of Options x Exercise Price Incremental Shares

Market Price of Stock

For primary shares outstanding, use the average market price during the period as the denominator.

To calculate fully-diluted shares outstanding, substitute the closing market price of the stock (for the period in question) for the market price if the closing price is higher.

If the closing market price is higher, the number of shares repurchased will be smaller and therefore more shares will be left outstanding. This results in a more diluted E.P.S.

As a practical matter, we typically use the current stock price for both calculations for the sake of simplicity, unless the stock price has changed dramatically over the period in question.

Treasury Stock Method Example

(US$)

Net Income 5,000,000

Shares Outstanding 2,000,000

Shares for Warrants and Options 200,000

Exercise Price per Share 20

Average Market Price per Share 25

Closing Market Price per Share 30

Primary E.P.S.

200,000 – 200,000 x $20 = 40,000 incremental shares

$25

$5,000,000 Primary E.P.S.

= 2,000,000 + 40,000

= $2.45


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Fully-Diluted E.P.S.

200,000 x $20 = 66,667 incremental shares 200,000 –

$30

$5,000,000 = $2.42 Fully-Diluted E.P.S. =

2,000,000 + 66,667

Sources: Securities Data Company (“SDC”)—SDC provides a comprehensive M&A and corporate finance database that can be used to screen for and download information related to M&A transactions. This data is frequently inaccurate and must be checked. Nevertheless, an SDC screen should only be used to identify transactions. Analysis should always be done using official documentation and filings

You must order the relevant merger proxies and public filings available at the time of acquisition to accurately reflect the purchase price and other operating data

“Precedent Transactions Book”—a book of completed precedent transaction lists is being compiled and will be kept in the library. You should submit to the library for inclusion to this compilation any Precedent Transactions Analyses you have performed

Note: The number of shares assumed to be repurchased using option proceeds cannot exceed 20% of outstanding stock (400,000 limit in our example, versus 160,000 shares assumed to be repurchased for the Primary calculation). The additional option proceeds should be assumed to retire short-term debt first, then long-term debt, and finally, to be invested in government securities


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Discounted Cash Flow (DCF)

Definition

♦ Discounted Cash Flow is one method of valuing a company, business segment or project. The DCF value represents the present value of unlevered, after-tax cash flows to all providers of capital using the weighted average cost of capital (WACC) as the discount rate

Methodology

The DCF method entails estimating the free cash flow available to debt and equity investors (i.e., the annual cash flows generated by the business, and the terminal value of the business at the end of the time horizon) and discounting these flows back to the present using the weighted average cost of capital as the discount rate to arrive at a present value of the assets

♦ Pros and pitfalls:

– the DCF is not tied to historical accounting values; it is forward-looking

– it recognizes the time value of money

– it allows an expected operating strategy to be incorporated into the model

– pay particular attention to the generation of cash flows and the assumptions you use. Since there is a great deal of subjectivity in making assumptions, a poorly constructed set of assumptions may yield inaccurate or unmeaningful results. Make sure that the cash flow assumptions and calculations are reasonable

– check to see how much of the total value comes from the terminal value. If the terminal value represents significantly more than 50–60% of the total value, then the DCF value is less reliable since much of the value is driven by your assumptions about how much the business is worth in the future

– be careful about inflation forecasts. Discount current dollar cash flows at nominal discount rates and constant dollar cash flows at real discount rates

– DCF valuations are based on assumptions. Use several scenarios about the future to create bounds on the target’s value


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Free Cash Flow (FCF)

Definition

♦ Cash flow generated by all assets

♦ Unlevered; “free from financing considerations”

♦ Accrual to all providers of capital

Calculation

EBITDA

– Depreciation

= EBITA

– Notional Taxes 1

= After-tax EBITA

+ Depreciation

– Investment in Working Capital ((Current Assets-Cash)-(Current Liabilities-STD))

– Capital Expenditures

= Free Cash Flow

Alternatively

Net Income 2

+ Deferred Taxes and other Non-Cash Charges (e.g., depreciation, amortization and deferred taxes) 3

+ After-tax Interest Expense

– Investment in Working Capital

– Capital Expenditures 4

= Free Cash Flow

Notes: 1 At the company’s effective tax rate, typically 35% 2 Net Income before preferred dividends, equity income and minority interest 3 Note that goodwill amortization is only deductible for tax purposes under limited circumstances in the US 4 Capital expenditures will fluctuate from year to year. It is assumed that in the terminal year, capital expenditures equals the depreciation, depletion and

amortization charge. On average, capital expenditure is likely to be higher than in the terminal year


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♦ Contrasted with Cash Flow from Operations (which consists of Net Income plus Depreciation and Amortization plus Deferred Taxes and Non-Cash charges)

Methodology

Income Statement

♦ Project growth in Net Sales:

– base assumptions on:

– research reports

– client forecasts (if available)

– industry trends

– percent growth is usually an input; aggregate sales is derived from this input

♦ Estimate the following by percent of sales:

– cost of Goods Sold (COGS)

– selling, General and Administrative (SG&A) Expenses

♦ Determine Interest Expense based on the notes to the most recent form 10-K. Refer to the debt schedule and calculate the weighted average interest rate. If no debt schedule is available, then compute Interest Expense as a percent of average Long-Term Debt:

– average LTD outstanding = (Beginning LTD + Ending LTD)/2

– note that his interest expense calculation will cause a CIRC in Excel; therefore, you need to iterate the model several times. Remember that the amount of interest will have no impact on a DCF’s value since the analysis is done on an unlevered basis

♦ Assess tax rate based on the marginal tax rate (federal, state and local) and current tax regulation


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♦ Net Income from the income statement 9

♦ Depreciation:

– beginning Property, Plant and Equipment (PP&E) plus ½ Capital Expenditures divided by average asset life

– also express as % of PP&E

– note: This depreciation calculation will cause a CIRC in Excel. Therefore, you need to iterate the model several times

– excludes owned property because it is not depreciable (leased property is)

– average asset life = PP&E divided by depreciation expense

♦ Deferred Taxes:

– some percentage of depreciation based on historical relationship

♦ After-tax interest expense:

– interest expense x (l–t) where t = marginal tax rate

– note: Interest Expense should be net of interest income (i.e., gross interest expense minus interest income) because interest income is not a function of operations (excluding financial institutions)

♦ Capital Expenditures (CapEx):

– the expenditures necessary to maintain the required capital intensity (see PP&E analysis under selected balance sheet items)

9 Before preferred dividends, equity income and minority interest


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Free Cash Flow (FCF) ♦ Investment in Working Capital (WC):

– difference between beginning and ending WC (see WC analysis under Selected Balance Sheet Items below) – exclude Cash and Cash Equivalents – exclude Short-Term Debt (STD)

Selected Balance Sheet Items

♦ Working Capital excluding cash and cash equivalents and STD: – estimate WC as a percent of sales: WC = (Current Assets–Cash and Cash Equivalents)–(Current Liabilities–STD) – possible to squeeze cash from WC by operating more efficiently – the three major components of working capital are: inventories, receivables and payables – inventories are calculated based on “turns”. The equation is:

Inventories

Cost of Goods Sold x 365

– receivables are based on days outstanding. The equation is:

Receivables

Sales x 365

– payables are also based on days. The equation is:

Payables

Cost of Goods Sold x 365

– “other current assets” should be calculated as a percentage of sales and “other current liabilities” as a percentage of COGS

♦ Property, Plant and Equipment (PP&E): – project by capital intensity/efficiency: sales divided by (PP&E)

Beginning PP&E known

– Depreciation known

+ CapEx solved for

= Ending PP&E known


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Free Cash Flow (FCF) ♦ Capitalization: STD, LTD and Equity:

– project STD as a percentage of LTD

– equity for each year can be calculated directly

Beginning equity known

+ Net Income to Common Shareholders known

+ /– Stock issue/buyback known

– Common dividends know by % payout

= Ending equity solved for

– debt projected by debt to equity ratio

– know LTD/Equity ratio and equity, solve for LTD

– if appropriate, LTD can be paid down with free cash flow

Discounted Cash Flow Tables

♦ Examines sensitivity of present value to:

– discount rate (the weighted average cost of capital or WACC)

– terminal perpetual growth rate or terminal multiple

♦ Elements:

– 1st year FCF

– present value of FCF years 2 through 10

– present value of terminal value

– add other assets not accounted for by free cash flows (e.g., cash, option proceeds, pension surplus)

– subtract liabilities not accounted for by free cash flows (e.g., STD, LTD, pension deficit)

♦ To obtain an equity value per share, divide by the fully-diluted number of shares—(i.e., include options and convertible securities which would be advantageous to exercise)


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Forecasting Terminal Value: Two Methods

Perpetual Growth

♦ Implicit assumption: the firm will be owned forever

♦ Digression—dividend discount model

– states that you can value a stock by taking the present value of the dividend in perpetuity Expected Stock Value = Div

r

– where Div = a dividend to be received one period from now

– r = discount rate

– If the dividend is expected to grow forever at the same rate, the formula is modified to read: Expected Stock Value = Div

r-g

– where g = perpetual growth of the dividend

Perpetual Growth Formula:

Terminal Value = FCFn * (1 + g)

(r-g)

– where FCFn = free cash flow in period “n”

– g = perpetual growth rate

– r = weighted average cost of capital


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♦ Implications of the perpetual growth formula:

– FCFn * (1 + g) means you have converted the period “n” FCF into the period “n + 1” FCF (i.e., FCFn + 1)

– /(r–g)—means you have taken the present value of a perpetuity of FCF starting at period “n + 1” and growing at “g”

– the formula assumes that you receive the first FCF one year from now. (“now” being the middle of period “n” since all FCFs are assumed to occur at mid-period), so the “present value” of this perpetuity is at time “n–0.5”

– you can make a variety of assumptions about when the cash flows are received

Terminal Multiple

♦ Implicit assumption: the firm will be sold at the end of period “n”

♦ Use a multiple of any relevant figure: Book Value, Net Income, Cash Flow from Operations, EBIT, EBITDA, Sales, etc.

– note: Terminal Value should be an Enterprise Value; NOT ALL multiples produce an Enterprise Value (e.g., P/Es)

– LITMUS TEST: Has interest been subtracted before you arrive at this figure?

– if yes: the multiple gives an EQUITY Value

– if no: the multiple gives an ENTERPRISE Value

Multiple of Value Produced

Book Value Equity

Net Income Equity

Cash Flow from Operations (as defined on page 21 and page 24) Equity

Net Sales Enterprise

EBITDA Enterprise

EBIT Enterprise

♦ Since the firm is sold at the end of the period of projected FCFs, the terminal multiple value is at time “n”


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Reality Check: Imputing a Perpetual Growth Rate or a Terminal Multiple

♦ To equate the terminal values produced by the perpetual growth method and by the terminal multiple method, grow the terminal value generated by the perpetual growth method by half a period (i.e., multiply the terminal value by

5.0)^1( r+ )

Equity Multiple Example:

TV = FCFn * (1 + g) * (1 + r)^0.5 = P/En * Nin + TDn

(r-g)

Where

TV = unlevered terminal value

FCFn = free cash flow of period “n”

g = perpetual growth rate of free cash flow

r = weighted average cost of capital

P/En = terminal P/E multiple

NIn = net income of period “n”

TDn = total debt of period “n”, including preferred stock

Solve for the Implied Terminal P/E Ratio:

P/En = FCFn * (1 + g) * (1 + r)^0.5–TDn * (r–g)

NIn * (r–g)

Solve for the Implied Perpetual Growth Rate:

g = (P/En * NIn + TDn) * r–FCFn * (1 + r)^0.5

(P/En * NIn + TDn) + FCFn * (1 + r)^0.5


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Forecasting Terminal Value: Two Methods ♦ Asset multiple example—with an asset multiple, the formula is the same as with an equity multiple, but total debt =

zero (TDn = 0): TV = FCFn * (1 + g) * (1 + r)^0.5 = A/EBITn * EBITn

EBITn + (r–g)

– where A/EBITn = asset value to EBIT multiple

Solve for the Implied A/EBIT Ratio:

A/EBITn = FCFn * (1 + g) * (1 + r)^0.5

EBITn + (r–g)

Solve for the Implied Perpetual Growth Rate:

g = (A/EBITn * EBITn) * r–FCFn * (1 + r)^0.5

(A/EBITn * EBITn) + FCFn * (1+ r)^0.5

♦ One fallacy of the DCF analysis is that the two methods (i.e., the terminal method and the perpetual method) do not always concur. Determining the growth rate is somewhat subjective and the analysis is highly sensitive to it. The terminal multiple is also somewhat subjective as it requires an estimate of future trading multiples, which may very well be different from current multiples. The analysis is highly sensitive to this as well and oftentimes results in a total present value heavily weighted toward the terminal value, rather than the stream of cash flows

♦ Notwithstanding the above mentioned text, it is often useful to determine the enterprise value via both methods so that you can compare the two results and their implied multiples of current operating results. For example, if the terminal method results in a total present value of 8x Year 1 EBITDA and the perpetual method results in 5x Year 1 EBITDA, both analyses and their respective assumptions deserve further review

♦ In addition, you should also compare the terminal multiple implied by the perpetual growth rate and vice versa. If, for example, you are using the perpetual method and the implied terminal multiple is 3x EBITDA (and your industry trades at 9x EBITDA), chances are your perpetual growth rate is too low. Similarly, if you are using the terminal method and the implied perpetual growth rate is 11%, chances are your terminal multiple is too high. It should be noted that this is not necessarily always the case and sometimes one particular method might be irrelevant to that particular company. They should be checked nevertheless, and you should consult someone else on your team to determine appropriate measures


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Calculating WACC

Weighted Average Cost of Capital (WACC)

♦ To determine the WACC of a company, one must ascertain the costs of the various sources of capital for the company, with a given capital structure. The after-tax costs of the various sources are then averaged to arrive at an appropriate discount rate to value unlevered cash flows

♦ We incorporate three basic sources of capital into our methodology

– debt

– preferred Equity

– common Equity

♦ Since the cost of each financing source is partly a function of the mix between the various sources of capital, you may need to calculate the WACC and its individual cost components at various capitalization structures

♦ As a practical matter, you should determine the credit rating of the company at the targeted capital structure(s), and seek rate views based on those credit ratings

♦ Where to find cost of debt:

– check the footnote referring to debt to see what the Company is currently paying

– consult a banker in debt capital markets for a 10-year maturity all-in new issue rate at the credit rating corresponding to the targeted capital structure. As part of this process, you should look at the yield on new issues of comparable companies since the cost of debt is a function of the risks associated with a given business/industry

– if the company has public debt outstanding and you do not intend to change its capital structure, find the debt rating in Moody’s, the S&P handbook or on Bloomberg


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Calculating WACC

♦ Where to find cost of preferred equity:

– check to see if there is any outstanding in the market

– consult a banker in equity capital markets to determine the rate at which the company could raise similar preferred stock today

♦ Calculating the cost of common equity:

– use the Capital Asset Pricing Model (CAPM)

– cost of Equity = Risk-free Rate + (Predicted Beta * Equity Risk Premium)

♦ The risk-free rate can be taken as the interest rate on a generic 10-year government note. You can obtain this generic ten-year rate on Bloomberg by typing “GT20”, pressing the <<Govt>> key, and then pressing the green <<Go>> key

– justification comes from the observation that the cash flow pattern of a 10-year bond roughly approximates the cash flow pattern of a typical ten-year DCF analysis

Equity Risk Premium: The “equity risk premium” refers to the premium demanded by equity investors on shares which have an “average” degree of market-related risk and an “average” level of leverage (i.e., debt/equity ratio). UBS makes the assumption that the historical risk premium is a good proxy for the expected risk premium. Our methodology calculates the relevant risk premium as the mean of excess returns of common stocks versus long-term government bonds. Data for this calculation is taken typically from the Ibbotson and Sinquefield study, Stock, Bonds, Bills and Inflation. You should consult with senior members of your team over what market risk premium to use and why.


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Calculating WACC

♦ Obtain the predicted (not historical) Beta (b) from FactSet. If you are working with a public company and do not intend to change its capital structure, simply obtain the predicted Beta from Barra and use it in the CAPM formula above. If you do intend to alter the capital structure or when valuing private companies or a segment of companies, you will need to calculate an average or median Beta of comparable companies to get a more accurate measure of the risk associated with a given business

♦ Betas and equity risk premium data are normally available only for major stock markets. It may still be possible to use this data when the target business is in a different country, although the equity risk premium might be higher for a developing economy or an emerging stock market than for, say, the NYSE or London Stock Exchange

♦ Beta reflects the assumed level of gearing. Betas obtained from FactSet, Datastream, Value Line and most other sources are “geared betas” which reflect the actual level of gearing for the company concerned. Within normal gearing ranges, Beta can be adjusted to reflect assumed gearing levels different from the actual gearing level

♦ The problem with taking an average of the published Betas is that a stock or Beta is a function of a company’s capital structure. Betas will be higher for more highly leveraged companies. Thus, we use a formula to unlever all Betas to get an unlevered Beta for each comparable company

♦ “Levered Beta”—calculated assuming firm’s current leverage: total debt/adjusted market capitalization. Obtain predicted levered Betas for your company and/or comparable companies from FactSet

♦ Unlever the predicted Beta(s) to arrive at an unlevered Beta for your company or each comparable company:


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Calculating WACC

Unlevered Beta = Levered Beta

1 + ((1–t) x (Debt/Common)) + Pfd/Common

Where

Beta = predicted Beta (from FactSet or Barra Rosenburg)

t = marginal tax rate

Debt = market value of total debt

Common = market value of common equity

Pfd = market value of preferred equity

♦ Note: It is more technically correct to use the average market values of debt, preferred equity and common equity from the period over which the predicted beta was calculated. However, we typically use the most recent values since they are usually not significantly different and since it is much easier to do so

♦ Calculate the mean or median unlevered Beta from your sample and relever the mean or median unlevered Beta with different capitalization structures to examine various scenarios

– relevered Beta = Unlevered Beta * [l + ((l-t) * (Debt/Common)) + Pfd/Common]

– use the relevered Beta as the “predicted Beta” in the CAPM formula

– the Debt, Equity and Capitalization values used should represent the “target” capital structure (the capital structure that includes planned debt and equity financings)


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Calculating WACC

Weighted Average Cost of Capital

♦ Note: Always use MARKET VALUE of common equity and preferred stock

WACC = Ke x E + Kd (1–t) x TD + Kpx Pfd

TD + E + Pfd TD + E + Pfd TD + E + Pfd

Where Ke = Risk Free Rate + (Levered Beta x Market Risk Premium)

Kd = 10-year all-in cost of borrowing for a new issue (actuals or comparables)

Kp = Estimated cost of preferred stock (same type as existing)


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DCF Analysis Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is critical

The following points should be considered

♦ The risk-free rate should normally be 2-6% above the assumed general long-term rate of inflation

♦ The currency used for projections should be the same as the currency on which the WACC is based

♦ The assumptions about capital structure (i.e., proportions of debt, equity and preferred) and tax rates should be reviewed carefully if the company will pay little or no tax under those assumptions

♦ If management provides a discount rate, the underlying assumptions should be checked. Is it after-tax? Is it a return on equity or a return on capital? For what currency is it calculated? Is it a hurdle rate?

♦ An after-tax discount rate should be used with after-tax cash flows

♦ Sales and costs are generally projected as nominal values (i.e., they include inflation). There are some situations in which it is acceptable to discount real cash flows using a “real” discount rate, but using nominal figures (i.e., which include inflation) is usually more accurate, reduces the possibility of confusion and is often simpler

♦ Preferred stock should be included in the WACC calculation and in the capital structure weightings if it represents a significant part of the capital structure


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LBO

Definition

♦ A leveraged buyout (LBO) is the acquisition of a target company by an investor group, which typically includes the target’s own management. The investor group acquires control of the target, financing its acquisition with a minimal amount of equity capital. The primary financing is in the form of debt collateralized with the assets of the target itself or with the target’s cash flow

♦ The goal of an LBO is to use the target to finance the purchase. The greater the borrowing power of the target, the less equity the investor group requires to make the acquisition. The actual cash outlay of the buying group is minimized—and the potential return on investment increased

♦ In a typical LBO, assuming stable credit markets, equity comprises between 20% and 30% of the purchase price. Under current market conditions, the equity contribution has trended towards 40-50%. The total amount of equity required depends upon the target’s sale price, the borrowing power of the target’s assets, the terms of such borrowing, and the lenders’ equity requirements. The target’s available cash may also be used to finance the purchase price

The Typical LBO Candidate

♦ It is difficult to define the characteristics of an ideal LBO candidate. However, it may be said that the following general guidelines apply

– management. Good management is the single most important factor in any LBO. A motivated and competent management group is needed to run the company after the buyout. In most cases, the best choice is for existing management to take an equity interest in the company. However, new management is sometimes brought in by new investors. As long as the management, new or old, is qualified and has appropriate incentive, the company should have a good chance for success


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LBO

– cash flow is crucial. Cash flows should be healthy, steady and relatively predictable to permit collateralized, secured or unsecured borrowings. Excessive requirements for capital expenditures and research and development must not be critical to the ongoing success of the enterprise: cash flow must be used primarily to service and retire acquisition debt. “CASH IS KING, THE REST IS JUST JOURNAL ENTRIES” is a key concept

– exit strategy. The financial sponsor should have a strategy for exiting the business within an appropriate timeframe, either by selling the business to another financial or strategic buyer or by selling stock to the public through an initial public offering. The exit multiple should be at least the acquisition multiple assuming the financial sponsor has improved profitability

– market niche. Most LBO entities have found a good niche in the market for their product lines. These companies have a steady stream of revenues and a client base that is not overly dependent on a few large customers. Obviously, it helps to have a steady growth pattern, since growth in profitability will accelerate the repayment of the debt. Growth will also greatly enhance the valuation of the company in the event that it decides to make an initial public offering

– work force. Since assets are often redeployed and business plans change after an LBO, the company’s work force must be flexible and willing to participate. The company will often have to focus more on debt repayment than on expansion. Good employee morale is therefore very important. Management should make a concerted effort to minimize turnover by communicating effectively with all its employee groups

– skeletons in the boardroom. Any litigation problems or unresolved environmental concerns can be “deal-breakers” since these problems can make financing difficult to attain

– safety valves. Unrelated or potentially expendable divisions can greatly enhance the attractiveness of a target company, since they may be sold to raise funds for repayment of debt. Recently, banks have decided not to lend to transactions dependent upon asset sales

– technology. State-of-the-art technology helps ensure maximum efficiency and profitability. Also, if the technology is already in place there is less need for significant capital expenditure in the future

– buried treasure. Deal-makers always look for hidden or untapped assets, such as real estate, exclusive licenses, rights, patents, contracts, or franchises from which maximum value may be derived

– costs. The new company should have the capacity and the willingness to cut costs


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LBO

♦ A LBO valuation assumes a certain capital structure, the returns demanded and the constraints imposed by the various providers of finance (equity, mezzanine, debt) and an assumption as to an exit route after a number of years (by flotation or trade sale). By a process of iteration, it establishes the maximum value that can be placed on the business in order for the returns to be achieved and the arithmetic to work

♦ We should bear in mind that LBOs are, by their very nature, structured with relatively high levels of debt. High debt adds to risk, and this is reflected in the returns demanded by investors in LBOs, which is in turn reflected in valuations

♦ The capital structure of LBOs reflects market circumstances. Whenever an LBO valuation is being considered, it is critical to insure our assumptions about viable capital structure are realistic

Financing

♦ Revolving Credit Facility

– Asset Based Lending Facility (“ABL”): maximum financing estimated at 75-90% of receivables and 35-60% of inventory. Need to understand seasonality of working capital needs

♦ Term Loans—”Senior Secured Debt”—typically has a 5–6 year maturity. Sum of Term Loan and Revolving Credit Facility kept at approximately 30% of pro forma capitalization (total debt + total book equity)

♦ Senior or Subordinated Notes—Bonds, typically unsecured with 7–8 year maturity

♦ Subordinated Debentures—typically 12–15 year debt

♦ Zero Coupon Debentures—typically 15–20 year maturity

♦ Common Equity—Goal of Financial Sponsors is to keep equity contribution low to maximize returns. Usually minimum of 30% of capitalization but in current market, more like 40-50%. Often diluted to an extent by options and warrants. Fully-diluted returns should be 20-25%

♦ Preferred Equity—standard or paid-in-kind (“PIK”)

Coverage

♦ EBITDA/Cash Interest—should be 2.0x–2.5x in year 1 and rise to 3.0x–4.0x in five years


79

LBO

♦ EBIT/Cash Interest—should be greater than 2.0x and should rise to over 2.5x within 1–2 years

♦ (EBITDA-CapEx-Change in WC-Cash Taxes)/Cash Interest—should be 1.0x at a minimum. 1.5x-2.0x is more comfortable

♦ Debt paydown—should be less than 5–6 years

♦ Exit horizon—typically 4–6 years


80

Comparison of DCF and LBO Although an LBO valuation and a DCF valuation both take a company’s cash flow projections as their starting point and incorporate a terminal value after a few years, there are some very important differences between them, both in concept and in execution

DCF LBO

Process Discounting to an NPV Extrapolation from assumed requirements as to IRR

Treatment of Debt Usually subsumed in the value of the business as a whole (i.e., discounting total cash flows for the business produces the value for the equity and the debt–Firm Value, from which debt is deducted to obtain Equity Value)

The attribution of different required returns to the different layers of capital—equity, mezzanine, debt—is the essence of this process

Terminal Value A DCF is, in principle, applied to a series of cash flows to infinity. The “terminal” value after a few years is merely shorthand for producing the value of a (growing) perpetuity

The terminal value is a real future exit multiple—either on a flotation or on a trade sale—and is usually assumed to take place within 3–7 years

Resultant Value Unless a hurdle rate of return has been built into the discount factor, it produces a “theoretical” or “absolute” value before taking into account the “profit” requirement of the buyer

Reflects the different “profit” requirements of the providers of capital’s perspective


81

Break-Up Analysis

Definition

♦ The break-up valuation reflects the value of a company’s equity by summing the value of its individual segments on a standalone basis to arrive at the aggregate value, and then making corporate adjustments to determine the enterprise and equity values. In essence, the break-up analysis looks at the company from the perspective of a raider who would finance an acquisition by “breaking up” the company (i.e., selling off each operating segment)

– the theory here is that the parts are worth more than the sum

♦ Methodology

♦ The break-up value exhibit can be structured as a one-page exhibit with both values and comments on a single page or a summary sheet of values and a back-up sheet of footnotes and computations

♦ In valuing a diversified company, the break-up value is composed of individual values for the separate operating segments (generally, based on multiples of EBIT, EBITA or EBITDA) and the other non-operating items, such as cash, debt, environmental liabilities, pension surpluses/deficits, tax credits, etc. The operating segments are valued based on an analysis of what similar companies have received in a precedent transaction or by using trading comps, DCFs or a LBO analysis

1. Segments:

A. Each segment of the company is valued independently in this section. The valuation method used depends largely on the type of company and the available information. Discounted cash flow valuation and analysis of multiples (e.g., premiums paid in precedent transactions, or trading multiples of comparable companies plus an M&A premium) are two commonly used approaches. Confer with a team member to choose the most appropriate valuation technique. Be sure to footnote the chosen method

2. Cash and Equivalents:

A. Include any cash deemed unnecessary to operate the business (i.e., excess cash), plus marketable securities


82

Break-Up Analysis

3. Option Proceeds:

A. Use the most recent financial statements to determine the number of options outstanding. Footnote the date of the balance sheet used

B. If in-the-money, multiply the number of options by the average exercise price (also found in the footnotes)

C. Make sure that the number of shares used to calculate the option proceeds is added to the number of shares outstanding used to calculate the per share data

D. In the “Comments” column, list the number of options outstanding at a given date and the average exercise price of the options

4. Pension Surplus (see footnotes to Annual Report or 10-K):

A. In the event that the calculation yields a negative number, the exhibit entry would be called “Pension Deficit” and the value would be subtracted from the total assets

B. Pension Surplus/(Deficit) is calculated as such:

($) ($)

Plan Assets at Fair Value 522.9 361.2

– Projected Benefit Obligation 361.2 or 522.9

Pension Surplus/(Deficit) 161.7 (161.7)

C. List the date of the financial statements used in calculating the pension surplus


83

Break-Up Analysis 5. Other Assets:

A. Other Assets are usually taken straight from the balance sheet. This typically includes such items as corporate real estate (as opposed to PP&E used by operating division), advances to affiliates and equity investment in unconsolidated subsidiaries. If the market value of Other Assets is known, then use that number rather than the book value

B. Note the date of the balance sheet from which the value of these assets was estimated

6. Other Items include: After-tax Environmental Liabilities, Tax Credits and the net present value of Net Operating Loss Carryforwards

7. Short-Term Debt: from most recent balance sheet

8. Long-Term Debt: from most recent balance sheet

9. Liquidation Value of Preferred Stock: from most recent balance sheet or the notes to the financial statements

10. Minority Interest: from most recent balance sheet or Market Value (if known)

11. Equity Value (or Net Asset Value):

A. Total items 1 through 10, adding and subtracting when appropriate. The result is the pre-tax breakup value of the company’s equity

B. If possible, it is usually desirable to analyze the breakup value on an after-tax basis since in reality, raiders would have to pay taxes if they sold off the individual segments of the company. You will need to determine the tax basis of each segment to figure out the taxes paid by segment and, therefore, the overall after-tax breakup value. The only truly accurate way to determine the tax basis for each business is to obtain this number from the company. However, most of the time you will not have access to this information so you must make an estimate. The process for estimating tax basis will vary by industry and company. The concept is to start with the book value of net assets, subtract out deferred taxes and make further adjustments based on the capital intensity of the business and the length of time the business has been owned by the company. Consult with team members as to what tax basis to use and footnote your assumption for each segment


84

Break-Up Analysis

12. Market Value:

A. Add the number of shares outstanding from the most recent financial statements and the number of options (from #3 above) to determine the total shares outstanding. Footnote the date of this value

B. Multiply this by the recent closing stock price. Note this date also

13. Footnotes:

A. List the number of shares used to calculate the per share numbers. Make sure this number includes the options which are assumed to have been exercised in #3 above (i.e., the number of shares used to calculate option proceeds should be added to the number of shares outstanding to maintain consistency)

B. Other footnotes as needed


85

Break-Up Analysis ♦ An example of a break-up value for XYZ Company is illustrated below

XYZ Company Segment Valuation EBITDA Multiple Value

Segment 1 $110.0 8.0x $880.0 Segment 2 90.0 10.0 900.0 Segment 3 45.0 7.0 315.0 Corporate 1 (12.0) 8.6 (103.2)

TOTAL $233.0 8.6x $1,991.8

XYZ Company Non-Operating Items Cash $30.0 Short-Term Debt (20.0) Long-Term Debt (190.0) Liquidation Value of Preferreds (70.0) Environmental Liabilities (After-tax) (36.0) Net Proceeds from Exercise of Options 100.0 Pension Surplus/(Deficit) 2 40.0 Tax Credits 3 50.0 NPV of NOLs (After-tax) 4 45.0 Total Non-Operating Items (51.0) Aggregate Valuation $1,940.8 Fully-Diluted Shares Outstanding (mm) 125.0 Pre-tax Aggregate Value per Share $15.53 Market Price on June 30, 2008 14.00 Pre-tax Aggregate Premium to Market 10.9% Pre-tax Pre-Corporate Value $2,044.0 Pre-tax Pre-Corporate Value per Share $16.35 Pre-tax Pre-Corporate Premium to Market 16.8%

Notes: 1 Corporate expense valued at weighted average multiple of all three segments 2 Equal to Plan Assets at Fair Value less Projected Benefit Obligation 3 Tax credits are an after-tax figure, dollar for dollar 4 NPV of NOLs is the after-tax discounted NOL cash flows


86

Acquisition Structures

♦ After preparing a set of valuations and deciding on a price for the target, an acquiring company must decide how much of the target to acquire and how to account for it

♦ If an acquirer acquires up to 20% of a target, it is recorded on the acquirer’s books using the Cost Method. For an acquisition of an interest between 20% and 50%, the Equity Method is employed. When an acquisition of over 50% is made, the financial statements of the target are fully consolidated with the acquirer’s financial statements. All of these methods can be accounted for using the purchase method

Suggested Procedure for Determining Appropriate Method

Equity Methodand

One-Line Consolidation

Consolidation Statement

Cost Method

PercentageAcquired

0%

20%

50%

100%

PurchaseMethod

Equity Methodand

One-Line Consolidation

Consolidation Statement

Cost Method

PercentageAcquired

0%

20%

50%

100%

PurchaseMethod


87

Merger Accounting

Purchase Methods

Cost Method

♦ For acquisitions of less than 20% of voting stock

♦ Recognize income upon receipt of dividends

♦ Example:

– Company A purchases a 5% interest in the Common Stock of Company B for $1,000. Company A records this purchase on its books by reducing the cash account by $1,000 and recognizing a $1,000 investment in Company B

– Company B subsequently declares and pays a $2,000 dividend on its common stock. Company A records this action by increasing its cash balance by $100 (5% x $2,000) and recognizing $100 in investment income, of which 70% is excluded from income tax

Balance Sheet Before Purchase After Purchase After Dividend

Cash ($) 7,000.0 6,000.0 6,100.0

Investments 0.0 1,000.0 1,000.0

Total Assets ($) 7,000.0 7,000.0 7,100.0

Current Liabilities ($) 1,000.0 1,000.0 1,010.5

Common Equity 6,000.0 6,000.0 6,089.5

Total Liability and Equity ($) 7,000.0 7,000.0 7,100.0

Income Statement

Investment Income ($) 100.0

Tax Liability 1 (10.5)

Net Income ($) 89.5

Note: 1 The Tax Liability assumes a marginal income tax rate of 35%: Tax Liability = 100 * (1–0.7) * 0.35 = 10.5


88

Merger Accounting

Equity Method

♦ For acquisitions of more than 20% of voting stock (or evidence of influence on target)

♦ Recognize income as proportional interest in the (adjusted) income of the target company

♦ Acquirer may consolidate results into its book financials if it attains more than a 50% voting interest

♦ Acquirer must consolidate results for tax purposes if it attains more than an 80% voting interest

♦ When recognizing income of the target, the acquirer must apply purchase accounting adjustments

♦ Increase value of investment by acquirer’s proportional interest in target income

♦ Reduce the value of the investment in the target to the extent of dividends received

♦ Step-Up vs No Step-Up:

– “step-Up”: increasing the tax basis of the assets acquired to fair market value

– contrasted with “Write-Up”: increasing the book basis of the assets acquired

– why step-up transactions are nearly an extinct species:

– general Utilities doctrine repealed in Tax Reform Act of 1986

– scenarios under which a step-up is still considered:

– large net operating loss carryforwards on target’s books

– target is an S corporation

– acquirer/target can benefit from certain grandfather provisions


89

Merger Accounting ♦ Purchase accounting adjustments:

– revaluing target balance sheet: – goal is to realize the Fair Market Value (FMV) of the assets and liabilities – eliminate existing amortizing goodwill on target’s books (no amortizations since 2001—see below) – eliminate deferred taxes on target’s books – if acquirer steps up its tax basis, then the revalued balance sheet equals FMV – in a no step-up transaction, assets and liabilities are revalued at their fair market values. A deferred tax account

is set up to equal the tax shield foregone (i.e., the deferred tax account for the acquired company is not eliminated)

Net Asset Value = Revalued Assets–Revalued Liabilities Goodwill = Purchase Price–Net Asset Value

– income statement adjustments: – if part of the consideration is cash: – lose opportunity cost of cash – extra interest charges from debt issued

– change in depreciation for revalued NP&E—the after-tax change will be the same under both step-up and no step-up scenarios

– goodwill is no longer amortized – instead, it is periodically (i.e. annually) tested for impairment

– if impairment is found, the impairment is recorded and goodwill is permanently reduced – previously, goodwill was amortized over up to 40 years – the SEC used to recommend 25-year life, but this also depended on the industry

– add back any amortization of old goodwill – amortize debt discount/premium from revalued LTD over the average debt life

– amortization of discount decreases income; amortization of premium increases income – intuition: amortization of debt discount premium effectively adjusts interest expense to current market rates

– if part of the consideration is preferred stock, preferred dividends arise


90

Complex Purchase Accounting Example No. One

Step-up in Tax Basis

Transaction Assumptions:

♦ A acquires B

♦ Each share of B is exchanged for $65 cash

♦ Total transaction size is $4,876, which A raises by issuing $4,841 in long-term debt and using $6 in excess cash plus options proceeds of $29

♦ Step-up tax basis, no recapture liability

♦ Marginal tax rate of 35.2%

Balance Sheets Prior to Merger Adjust B Purchase Price and Combined ($) A B to FMV Comment B as Adjusted Goodwill Adjustment A + B

Assets:

Other Assets 831 1,884 471,29 Land Reval.; Options Proceeds 2,384 (35) 3,180

Net PP&E 1,453 1,499 749 Fair Market Value 2,248 3,701

Goodwill 54 754 (754) Eliminate Old Goodwill – 2,472 2,526

TOTAL ASSETS 2,338 4,137 4,632 9,407

Liabilities and Shareholders’ Equity:

Current Liabilities 756 1,296 1,296 2,052

Long-Term Debt and Minority Interest 298 1,036 (104) Current Rate Revaluation 932 4,841 6,071

Deferred Taxes 232 288 (288) Eliminate Deferred Taxes – 232

Total Liabilities 1,286 2,620 2,228 8,355

Shareholders’ Equity 1,052 1,517 887 Revaluation Adjustment 2,404 (2,404) 1,052

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY 2,338 4,137 4,632 9,407


91

Complex Purchase Accounting Example No. One


♦ A acquires B



♦ Step-up tax basis, no recapture liability


Income Statements

Prior to Merger Purchase

Accounting Combined A B Adjustments Comment A+B Revenues and Interest Income $3,485 $5,659 (.432) Interest on $6 Cash (7.2%) $9,144 Cost of Sales 1,799 4,221 50 Depreciation Increase (15 year life) 6,070 Selling, General and Administrative Expense 998 918 (19) Eliminate Prior Goodwill Amortization (40 years);

No New Goodwill Amortization 1,897

Interest Expense 40 93 4,508 Debt Revaluation (25 years); Interest on $4,841 Debt (10.5%) 645

Income Before Taxes 648 427 532

Income Taxes 281 177 (198) Income Taxes` 187

NET INCOME $367 $250 $345

E.P.S. $2.97 $3.37 Pro Forma E.P.S. $2.78 Dividends per Share 1.13 1.16 Pro Forma Dividends per Share 1.13 Shares Outstanding 124 74 Pro Forma Shares Outstanding 124 Market Assumptions Stock Price per Share $62.00 $58.00 Pro Forma Stock Price per Share $62.00 P/E Ratio 21.0x 17.0x Pro Forma P/E ratio 22.3x Total Market Value $4,588 $4,300 Pro Forma Total Market Value $4,588 Dividend Yield 1.8% 2.0% Pro Forma Dividend Yield 1.8%


92

Complex Purchase Accounting Example No. Two

No Step-up in Tax Basis–Pre-FASB 96


♦ A acquires B



♦ No step-up tax basis


♦ Original tax basis of Net PP&E for B is $873

Balance Sheets Prior to Merger Adjust B Purchase Price and Combined ($) A B to AFMV Comment B as Adjusted Goodwill Adjustment A + B

Assets:


Net PP&E 1,453 1,499 265 AFMV 1,764 3,217


TOTAL ASSETS 2,338 4,137 4,148 9,444

Liabilities and shareholders’ equity:



Deferred Taxes 232 288 (288) Eliminate Deferred Taxes – 232





93

Complex Purchase Accounting Example No. Two


♦ A acquires B



♦ No Step-up tax basis


Income Statements


Accounting Combined A B Adjustments Comment A+B Revenues and Interest Income $3,485 $5,659 (.432) Interest on $6 Cash (7.2%) $9,144 Cost of Sales 1,799 4,221 18 Depreciation Increase (15 year life) 6,038 Selling, General and Administrative Expense 998 918 (19) Eliminate Prior Goodwill Amortization (40 years);

No New Goodwill Amortization 1,897

Interest Expense 40 93 3,508 Debt Revaluation (25 years); Interest on $4,841 debt (10.5%) 644

Income Before Taxes 648 427 565 Income Taxes 281 177 (165) Income Taxes 199 NET INCOME $367 $250 $366 E.P.S. $2.97 $3.37 Pro Forma E.P.S. $2.95 Dividends per Share 1.13 1.16 Pro Forma Dividends per Share $1.13 Shares Outstanding 124 74 Pro Forma Shares Outstanding 124 Market Assumptions Stock Price per Share $62.00 $58.00 Pro Forma Stock Price per Share $62.00 P/E Ratio 21.0x 17.0x Pro Forma P/E Ratio 21.0x Total Market Value $4,588 $4,300 Pro Forma Total Market Value $4,588 Dividend Yield 1.8% 2.0% Pro Forma Dividend Yield 1.8%


94

Complex Purchase Accounting Example No. Three

No Step-up in Tax Basis—(FASB 96)


♦ A acquires B





♦ Original tax basis of Net PP&E for B is $873

Balance Sheets Prior to Merger Adjust B B as Purchase Price and Combined ($) A B to FMV Comment Adjusted Goodwill Adjustment A + B

Assets:


Net PP&E 1,453 1,499 749 AFMV 2,248 3,701


TOTAL ASSETS 2,338 4,137 4,632 10,093

Liabilities and shareholders’ equity:



Deferred Taxes 232 288 (288), 686 Eliminate Deferred Taxes; Current 686 918





95

Complex Purchase Accounting Example No. Three


♦ A acquires B






Accounting Combined A B Adjustments Comment A+B

Revenues and Interest Income 3,485 5,659 (.432) Interest on $6 Cash (7.2%) 9,144

Cost of Sales 1,799 4,221 50 Depreciation Increase (15 year life) 6,070

Selling, General and Administrative Expense 998 918 (19) Eliminate Prior Goodwill Amortization (40 years); No New Goodwill Amortization

1,897

Interest Expense 40 93 4,508 Debt Revaluation (25 years); Interest on $4,841 debt (10.5%) 645


Income Taxes 281 177 (198) Income Taxes 187

NET INCOME 367 250 345

E.P.S. 2.97 3.37 Pro Forma E.P.S. 2.78

Dividends per Share 1.13 1.16 Pro Forma Dividends per Share 1.13

Shares Outstanding 124 74 Pro Forma Shares Outstanding 124

Market Assumptions

Stock Price per Share 62.00 58.00 Pro Forma Stock Price per Share 62.00

P/E Ratio (x) 21.0 17.0 Pro Forma P/E Ratio (x) 22.3x

Total Market Value 4,588 4,300 Pro Forma Total Market Value 4,588

Dividend Yield (%) 1.8 2.0 Pro Forma Dividend Yield (%) 1.8


96

Accretion/Dilution Analysis

♦ In general, executives of acquiring companies are concerned with the effects of an acquisition on the acquiring company’s future earnings. Since stock price valuation is substantially affected by a Company’s Price/Earnings (P/E) ratio, the lower the earnings get as a result of an acquisition the lower the price must get to maintain the P/E ratio. In general, if a lower P/E company acquires a higher P/E company, the transaction is dilutive and vice versa if stock is used as all of or part of the consideration

♦ For this reason, an accretion/dilution analysis is carried out to determine if an acquisition enhances or dilutes earnings per share

♦ The analysis is simple: if the after-tax costs are greater than the after-tax benefits, the transaction will be dilutive, and if the after-tax benefits are greater than the after-tax costs, the transaction will be accretive

♦ Potential accretion resulting from a transaction include:

– EBIT from the acquired company

– synergies/cost savings realized from the transaction

– plant closings

– labor consolidation

– better raw materials pricing

♦ Potential causes of E.P.S. dilution include:

– goodwill amortization: price paid for the equity minus the fair market value of the net assets (i.e., book value of the equity) amortized by up to 40 years

– incremental interest

– stock issuances in stock swaps

– transaction costs


97

Accretion/Dilution Analysis

Accretion/Dilution Example

♦ Assumptions:

– Company A acquires Company B for $100 cash

– book basis is $60

– goodwill created is $40, no amortization

– 100% financed with debt at 10% interest rate

Income Statements

Prior to Merger Merged

A B A+B

Sales ($) 300 120 420

Cost of Goods Sold 100 50 150

Selling, General and Administrative Expense

100 40 140

Interest Expense 20 14 44 1

Goodwill Amortization 0 0 0


Income Taxes 40 8 43

NET INCOME ($) 40 8 43

E.P.S. ($) 1.00 1.00 1.075

Accretion/(Dilution) (%) (7.5)

Note: 1 Equals $20 + $14 + incremental interest expense of $10 (100 * 10%)


98

Analysis of Shareholders

Definition

♦ The analysis of shareholders exhibit provides insight into shareholder composition, identifies large blocks of stock and provides an understanding of insider holdings

Methodology

1. Major Shareholders

A. The most recent proxy statement will disclose any shareholder owning 5% or more of the outstanding stock of each class of equity

2. Institutions

A. Use the fist two sections of Spectrum to identify the major institutional shareholders. This should include funds and 13-F filers. Avoid double counting of institutional and investment companies by including only those fund holdings that do not have a plus mark in front of them

B. List the top ten institutional holdings or as many more companies that hold 1% or more of the outstanding stock

C. Sum the rest of the institutional holdings and note the number of holders this represents

♦ Calculating institutional holdings should be as follows:

Item Number of Institutions Number of Shares

13-F Filings 55 5,323,360

Plus: Fund Holdings 8 108,640

Total Institutional Holdings 63 5,432,000

Less: Top 10 Institutions (10) (3,354,000)

Others 53 2,078,000


99

Analysis of Shareholders

3 Insiders (Directors, Officers, Management)

A. Use the proxy statement to identify the insider and beneficial shareholdings

4 Total Nonpublic Holdings

A. Sum institution and insider holdings

5 Total Public Holdings

A. Plug for the difference between “Total Nonpublic Holdings” and “Total Shares Outstanding”

6 Footnotes

A. (1) and (2) are standard

B. The holdings of each director or officer should be footnoted as per the proxy

Analysis of Shareholdings

Amount %

Institutions 1 5,323,360 35.8

Other Institutions (total of) 108,640 0.7

Total Institutional Holdings 5,432,000 36.5

Insiders 2 1,102,052 7.4

Other Insiders (total of) 826,125 5.6

Total Insider Holdings 1,928,177 13.0

Total Nonpublic Holdings 7,360,177 49.5

Total Public Holdings 7,503,216 50.5

TOTAL SHARES OUTSTANDING 3 14,863,393 100.0

Notes: 1 Based on the latest 13-F filings of investment companies and institutions 2 Based on proxy statement dated _______ 3 Outstanding as of Form 10-Q dated _______