Modelling questions

CFA General
#1

Hello. So I had an interview at IB recently where I was asked how I would proceed with bulding a simple model. During my asnwer I started explaining about FCFF and how to find it from EBIT(1-t). When I mentioned that we need to add depreciation back, the interviewer asked: what kind of depreciation - one we find in financial statements or statements that companies prepare for tax purposes, assuming that they are different. The correct answer was the latter but I have no idea why, was it mentioned in the curriculum ? I think it just says depreciation but doesnt mention what kind.

The second question was how would I find required return on equity for Bulgarian company using CAPM. The correct answer was to use US risk free and add the difference in inflation between US and Bulgaria & use S&P500 as market return (as opposed to my answer to use bulgurian stock index). Are these things mentioned in the cirriculum at all ? I have passed two levels and honestly these questions really got me thinking.

Could you recommend any books where such specifics are discussed ?

#2

This is my take on the correct answers that you were given:

  1. Use the tax return depreciation statement because it will 99% of the time be more than what is stated on a company’s financial report to investors. Most companies show straight line depreciation on their statements for presentation but use accelerated or MACRS for taxes. It would increase the amount of depreciation and thus cash available to the firm. I have a feeling this is what the interviewer was trying to say but others will chime in with more experience.

  2. I’m postulating here but because you are using the US rfr adjusted for inflation in Bulgaria the SP500 return as a proxy for market makes more sense because in a sense of the ‘market,’ it’s more encompassing. The beta coefficient will probably be higher as well. Another reason I probably would have said is that Bulgaria is a frontier market with a relatively small capital market so using the SOFIX (just looked it up) returns may not shine the right light on the situation. Though CAPM isn’t that used for these types of markets. Usually it’s a macro / factor based model to derive required return.

#3

Honestly I think the banker was wrong.

Regarding the depreciation I think the correct way would be to add back the depreciation from the financial statements.

In a second step the difference between accounting taxes and paid taxes is corrected by adding back the change in deffered taxes position so that you come to the CF.

At least that’s the way I do it and the way it is shown in valuation literature.

#4

Banker was wrong. Nobody does this. If you are using EBIT from GAAP statements, then you add back the depreciation on the GAAP Statement. He was just being a c#nt.

#5

Not true at all. Deal financials are often restated to eliminate various non-cash GAAP adjustments that just make modeling cumbersome. You will see “Cash EBITDA” and “Cash Taxes” instead of “GAAP EBITDA” and “GAAP Taxes” very often - for example, you’ll add back noncash pension expense and subtract cash pension contribution to get to Cash EBITDA, and you’ll subtract tax depreciation before applying a tax rate to calculate cash taxes.

This makes modeling more transparent, and easier to track all critical components of the cash flows that are used to service the debt. Typically bankers would use these financial metrics restated on a cash basis to define finacial covenants in the credit agreements - for example, Debt/EBITDA leverage ratio is rarely GAAP EBITDA.

Of course you can do it by subtracting GAAP taxes and then change in deferred tax assets/liabilities, so a complete answer could look at and compare both ways. Still, from a banker’s perspective tax depreciation is the right answer!

#6

oh man sounds pretty interesting but really i have no idea. Spent too many months in the caves of BO. Gotta review and keep working and networking. Wish me luck.

Sorry for the random post. Thanks for the lecture Mobius and to the OP good luck to you as well.

#7

From a valuation perspective both ways must yoield to the same result. However, there is no need to use Tax accounts if you can rely for 100% on GAAP to derive the cash flow.

Also in investmet banking the way Mobius describes is not very common, however you see it from time to time.

Best, Oscar

#8

Here’s my take on it. You should either use accounting depreciation and add/subtract deferred taxes, or just use tax depreciation for a direct measure of cash tax. But both depreciation methods should give you the same net FCF over time, but the timing of cash flows will be different. And that difference can be material in some cases for the time value of money.

For the second question, there are multiple approaches for this case. The one you should use should ultimately the one with least speculation in assumptions. Belgium might have a developing capital market and not the best proxy to use. In this case you would use a global index, or a developed one like the US or Germany, and adjust for inflation and interest rates.

#9

Disagree with my mensch Oscar here. First off, keep in mind that valuation is not the only goal when building a cash flow model. In fact, from a banker’s perspective it is not even the primary objective. When you model a leveraged deal, you are interested in a company’s cash flow capacity for servicing the debt, how it varies under a range of scenarios using transparent assumptions, what meaningful covenant levels to set.

Second, from a process and prsentation standpoint, modeling out full GAAP financials would make your input drivers obscure and the output harder to follow. The fact that endind FCFF is identical and you’ll get the same DCF number if you do a valuation (which nobody disputes) is irrelevant.

A good LBO model presentation would roughly follow this structure -

Cash EBITDA

less cash taxes

less increase in WC

less CAPEX

= Cash flow available for debt servicing

less cash interest

less mandatory amortization

= Excess / discretionary cash flow.

That’s easy to follow, easy to model and see the impact on sensitivities, easy to set appropriate covenants. If you are modeling out GAAP financials on the contrary, you’ll have something like this:

GAAP Net income

plus noncash amortization of deferred financing fees

plus noncash PIK interest

plus D&A

plus noncash pension expense

less cash pension contributions

less increase in current assets, net of current liabilities (which includes changes in deferred tax accounts, obscuring true WC requirements)

less CAPEX

less debt amorization

= Net CF before discretionary items.

The end result might be identical, but what the actual f.uck is going on? When you change an assumption and all numbers move, do you have a firm grasp on the sensitivities? What financial metrics would you use to set a meaningful covanant that would give lenders a forewarning once cash flow starts to deteriorate but before the company defaults on its debt service? Can management use accounting gimmicks to avoid breaking the covenant you defined?

#10

Thanks for your input guys! Really insightful discussion

#11

Yes mobius is spot on. Working in project/structured finance as a financier I would typically model CFADS of a project/asset the way he has set out which gives a more accurate representation of an entity’s cash flow coverage of its debt servicing obligations.

I would add that since the OP is starting with GAAP EBIT from which GAPP DA has been deducted then the appropriate adjustment would be adding back GAAP DA but being conscious of the effect on cash taxes paid from using a different depreciation/amortisation basis for tax purposes.