Finance is a very interesting domain. There are many aspiring students that go through years of education in Finance to obtain jobs in Investment Banking,...
We talked about capital budgeting and the basics of NPV and DCF in an earlier post. Here we will explore in detail the concepts used...
In any M&A or investment deal, Due Diligence (DD) and Reporting are the final steps. While they are relatively mundane, it is extremely essential to...
Budgeting is always a tricky issue. In most companies, there are always two budgets for a project or a department – bottoms-up and top-down. Bottoms-up...
There are many reasons why companies engage in M&A. For...
Getting a loan can feel a lot like navigating a...
Finance is a very interesting domain. There are many aspiring students that go through years of education in Finance to obtain jobs in Investment Banking, Private Equity and M&A. As you can imagine, those are some of the best paying sectors.
There is a perception of Finance that we want to break. It is perceived that Finance is extremely analytical and only involves numbers and models. While that is mostly true, there are multiple dimensions to finance. And in today’s world, those are highly relevant. Let us look at some of the key traits required in Finance today
Finance is not just math, it requires people skills too. Consider the role of an analyst in a Venture Capital industry. When you deal with investments in VC, you are required to be creative. Information is not available at first sight. Financial analysts in VC have to engage directly with startups and scaleups, in addition to their financial modelling job profile.
The concept of creative accounting is becoming mainstream today, unfortunately. Creative accounting is the process of designing financial statements and categorizing metrics such that the net result, i.e. profits, are as positive as they can be. In some case, creative accounting has bordered on illegal and cost companies millions of dollars in lawsuits. Financial analysts have to be aware of this and raise potential red flags.
By presentation, we don’t just mean designing a kickass PowerPoint and communicating it to stakeholders. Financial analysts and managers often have to present to a non-financial audience, meaning that they have be crisp, concise and simple enough whilst presenting facts. This required significant communication skills.
Creativity is crucial in finance. We will use the case of deal structuring in this case. Beyond financial modeling skills, structuring a deal requires an ability to grasp tons of concepts and bring them all together to create the ideal structure. This is a different kind of creativity, though, and can be learned and assimilated.
Finance and accounting are sectors that are constantly disrupted by technology. And yet, in most companies, analysts use outdated tools. As the years pass by this will change and finance professionals need to be aware of technological changes happening in the sector.
So, as you can see, finance is like every other function when it comes to skill development. Job descriptions for finance professionals seem to be evolving, with more skills required from such professionals. Best to be prepared!
We talked about capital budgeting and the basics of NPV and DCF in an earlier post. Here we will explore in detail the concepts used in capital budgeting, something that is essential for every investment analyst and manager alike.
The sub-categories of capital budgeting include Net Present Value (NPV), Internal Rate of Return (IRR), Accounting rate of return (ARR), Payback period and Discounted Payback period. Most of us have heard of NPV and IRR. In any project manager role, these two are crucial to evaluate the feasibility of a project.
NPV is the sum of all discounted cashflows of an entity. To calculate NPV, you first need to ascertain the period that you are estimating cashflows for. Once you have that and the cashflows in hand, each cashflow is discounted by a discount factor. The discount factor is the rate by which the value of money depreciates on a periodic basis.
NPV of an entity is the deciding value of the entity. IF NPV is lesser than zero, the entity is assumed to generate a loss on investment. An NPV greater than zero generates a positive return on investment. While NPV is the best way to assume the profitability of a project, it is not a variable for which you can set a target.
And that is where IRR comes in. IRR Is defined as the discount rate at which NPV is zero. In other words, it is an indicator of a project’s return. Most companies use an IRR target to determine if a project is worth pursuing. While IRR is a great indicator to use when cashflows are predictable and te time horizon is small, it has its limitations.
Accounting rate of return is another factor that is used commonly. Simply put, it is the sum of all annual net income divided by initial investment. ARR is a simple metric, and avoids time value discounting of money. It is used in comparison of projects and judge basic profitability of a project to an investor.
Payback, as the term suggests, is the timeframe that it takes to recover an investment. Sometimes, there is a balancing act that is done between IRR and payback. Projects with higher profitability potential but longer payback periods are sometimes traded off for lower-profitability but shorter-tenure projects.
And finally, discounted payback is simply applying the time value of discounting to payback. In this case, you compare the initial investment to the sum of discounted cashflows to determine when you recoup the outlay.
There are many reasons why companies engage in M&A. For some, the decision is purely financial and intended to increase revenues and profits. But for most, the decision is purely strategic. In short, companies pursue M&A for increase in capabilities, diversification or expansion of market share.
When a company grows to a certain level and requires more than just organic means to grow further, both financially and otherwise, M&A’s are required. In today’s shareholder-centric society where companies are compelled to appease their shareholders each quarter due to the constraint of quarterly reporting formalities, M&A’s is like a cheat code to companies. It helps them to accelerate growth.
Increase in capabilities
Take the case of a pharmaceutical company with the intention to develop a new type of drug. It lacks certain skills and knowledge to develop this drug, and decided to acquire a smaller rival that offers those. This way, the acquirer increases its capabilities and subsequently, its revenues and margins. While one may argue that the expense could have been avoided by the acquirer internally developing the drug, there is also the issue of time and development cost.
Diversification is a strategy used to expand product and client segments. Think of Kellogg’s acquisition of RXBAR, or British American Tobacco’s (BAT) acquisition of Reynolds American. Those are examples of diversification. In the case of BAT, the Reynolds’ acquisition gave them control of the Newport menthol cigarette brand and reach the African-American client segment in the US. Diversification-driven M&A’s are extremely common in the US.
Expansion of market share
This is quite straightforward. When a company acquires a rival or even an overseas firm, it expands market share. They are also called horizontal mergers and result in greater synergies if properly executed. Such synergies enable cost reductions and higher margins. The best, and most recent, example is the acquisition of Starwood hotels by Marriott, that was done to combat the rising threat of Airbnb to the traditional hotel industry.
Economies of scale
Companies also merge to realize economies of scale, which is extremely important to be sustainable. If a company is unable to reach a position where its marginal revenue (MR) is greater than its marginal cost (MC), it has few choices other than to be part of yet another company in its industry.
The rationale behind an M&A deal is crucial and companies have to fully size up the reasons for carrying out this process. It also helps to have such a solid rationale when sourcing for deals.
Getting a loan can feel a lot like navigating a financial minefield, to get the best loan for your needs you need to move carefully and weigh up all your options. Checking professional comparison websites and information sites like this resource guide are a must!
It might sound easy to do but many people make mistakes when it comes to getting a loan, it’s a lot easier to get or do something wrong than many people realise. But we can help, below I’ve outlined my very own resource guide into some of the most common mistakes loan seekers make.
When you know what the mistakes are, avoiding them yourself will be a lot easier. So, read on to find out how you can avoid the pitfalls and get the best loan for your needs by ensuring you don’t make any of the common mistakes that plague loan seekers.
Not Getting The Right Type of Loan
Loans are not a one-size fits all financing option, they come in many different forms, so you should make sure you get the right type of loan for your needs. Title loans, for example, are a great alternative to the more popular payday loan.
But because many people don’t take the time to research their options they can end up with a worse deal. So, make sure you look at all your options first, before getting a payday loan with high-interest rates why not consider the benefits of a title loan instead? If you own a vehicle this is a viable alternative.
You could also consider talking to your bank and applying for an overdraft with them. That’s just a few of the possibilities instead of rushing into what seems like the fastest way to get money, you should instead think about the long-term and consider your options carefully to ensure you get the best loan for your needs.
Not Taking Interest Rates Into Account
The interest payments are an essential part of many types of loan, especially the more short-term ones. However, many people fail to take them into account when getting a loan especially first-time loan seekers.
But this can be a very costly mistake, so you need to remember to add the interest rates to your monthly repayments. This way you can work out what you can actually afford to take out and repay, so make sure you remember to research the interest rates.
Not Thinking About Your Credit Score
Just like interest rates another important part of many loans is your credit score. You might not realise it but for the majority of loans, your credit score will be the overriding factor on whether you get accepted or not. If your credit score is to low then you could easily miss out on your perfect loan.
Which is why it’s important you keep tabs on your credit score when seeking a loan, you might also want to consider raising it before you try to apply for a loan in the first place. If you can afford to take some extra time to boost your credit score first then it could ensure you have more options in the future when it comes to applying for a loan.
If you have a poor credit score your options for a loan will be very limited not to mention expensive. So, don’t forget about your credit score and always try to keep it as high as you can, if you’re likely to apply for a loan in the near future.
Not Researching The Loan Provider
Loans are very complicated but millions of people a year apply for them, but how many of those millions of people actually think about the group or business providing the loan? I’ am sure some do but not all of the people applying for a loan will, which isn’t good news when you consider the risks involved.
You should research any loan provider very carefully before even beginning the application process for a loan. Yes, this will take extra time, but it will help ensure you are dealing with a professional lender.
The majority of loan providers are professional, experienced lenders but there are still poor-quality lenders out there as well as the potential for scams and con-artists. So, ensure you research any loan provider you are thinking of using thoroughly, so you can ensure they have a positive reputation for providing a high-quality service.
Not Reading The Fine Print
Reading the fine print is essential for almost anything and this is especially true when it comes to loans. All loans offer an element of risk, so you should make sure you read the fine print, so you know exactly what you are getting into when applying for a loan.
This will also help ensure you know everything you need to about the loan, if there are certain things you can and can’t do like make early repayments or if there are any hidden charges or extra fees included they will all be detailed in the fine print of your loan. So, before you agree to anything make sure you go over the fine print first.
Borrowing Too Much Money
When you apply for a loan you will likely have an amount in mind, however, it’s easy to be tempted by loan providers and consultants. They might even make you rethink your initial plans and take out a larger loan as a result.
But for the majority of people, this will be a mistake that they’ll later regret. The larger your loan is the more you’ll have to repay and the longer it will likely take you, so work out the amount you need first and then do your best to stick to it. The temptation to borrow more is a very real possibility with loans so do your best to avoid it.
So, that’s six of the most common mistakes people can make when applying for a loan. Make sure you avoid them whenever you can and go into any loan application with a clear picture of what you want.
Debt is used in many financial transactions. If you recall your Corporate Finance 101, you know that the basic elements in the capital structure is equity and debt. While most investments involve trading of equity, debt is also used to realize larger ROIs.
Here, we look at the use of debt by Private Equity firms when investing in a company. Private Equity firms invest normally in Small and Medium Enterprises (SMEs) and invest an average ticket of $100M-$300M in the United States. They use significant debt to fund a purchase, using a Leveraged Buy Out (LBO) transaction.
The reason why debt is used is to increase the Return on Investment (ROI). Let us take an example. If the acquisition price is $150M for a company that generates $20M in EBITDA annually, and the PE fund leverages the transaction by 3.5x EBITDA, meaning finances the deal with $70M in debt. The PE fund puts in the remaining $80M and shift the debt to the company purchased.
Thus, by leveraging the transaction, the PE fund naturally creates value by putting in only 50% of the purchase price from its own pocket, instead of paying the entire $150M. Once the future cashflows are used to service the debt, any additional value that the company creates brings about substantial cash-on-cash return to the PE fund. This is referred to as creation of value through deleveraging a company.
While this sounds bad to the company that the fund invests in, it really is not. In a leveraged transaction, the equity provided to a PE fund in return for the investment is lower. As a result, the company receives significant cash from the PE fund and retains enough equity to realize capital gain. Growth companies usually go for PE investments, as such companies value retaining as much equity internally as possible.
This was recently the case with a company operating in Dalton pass, New Mexico, that was acquired by Carlyle group. Despite the fact that Carlyle levered the acquisition with 75% debt, the seller was willing to engage, both due to the minimal equity trade-off and the prestige of being associated with Carlyle.
LBO’s have been the traditional method of PE investments ever since the first PE fund started. Over the years, the amount of debt in a single transaction has reduced due to concerns about effectively servicing the debt. There are also better regulatory restrictions today on how much debt can be loaded on a company.a
In any M&A or investment deal, Due Diligence (DD) and Reporting are the final steps. While they are relatively mundane, it is extremely essential to do these to both reduce your risk and to ensure compliance with law. They are also a vital part of the post-acquisition process.
There is also another key reason why reporting and DD are increasingly relevant today. A Harvard study has pointed out that while the M&A momentum continues to build, there is also a high financial risk involved as 70-90% of deals are financially unsuccessful. In order to reduce this percentage, a through diligence and reporting process goes a long way.
Due diligence reduces the concept of information risk in corporate transactions. Information risk arises from the fact that a lot of information in M&A deals, especially in cases of acquisition where a large proportion of acquired companies are small, private firms, there is a lack of transparency in data. Sellers prefer not to revel all private information, especially those that can result in an unfavorable view by the buyer.
When there is information risk, due diligence is conducted towards the end to verify the claims of the seller. In cases of Merger or Joint Ventures (JVs), both parties conduct due diligence. Due Diligence ends with a comprehensive report detailing all aspects of the parties. These reports are important both for reasons of traceability and legality.
Furthermore, shareholders greatly value and demand these reports. With the amount of risk involved in M&A deals, comprehensive reports go a long way in convincing existing shareholders that the company is fully aware of all risks involved and has taken reasonable steps to mitigate them. Simply put, the added transparency from the reports and processes is crucial to a publicly listed company.
There are, however, limitations to Due Diligence. While each party desires a comprehensive and lengthy process to get as much information as possible from the other party, Due Diligence delays a deal. Usually, M&A deals ae time-consuming and happen when there is a pressing need. Companies also desire to finish the process as soon as possible in order to reap the benefits sooner.
At the end of the day, there is no rule on the period for due diligence. One suggestion that we can give is to start the due diligence and reporting process during the acquisition period, and not to wait till negotiations are reaching an end. That way, you reduce the total timeframe that it takes for an M&A to reach fruition.
M&A is a complex field. It involves various stages from origination, assessment, strategy, budgeting, deal structuring, implementation and post-implementation management. It is perhaps the most complicated project to undertake, and deservedly one of the most lucrative and rewarded ones.
Perhaps the most difficult and subsequently rewarded professions is deal origination. This is the process of sourcing for deals, meeting people and helping form a relationship. It involves not just financial knowledge, but strategic know-how, networking and significant travel. People that perform this job are people who can easily form relationships and have high Emotional quotient (EQ).
With a number of players – small, medium and large – advising companies on M&A strategies, the process post-origination is not hard to accomplish. However, in mature economies like the United States, finding a bargain is proving to be extremely difficult, especially when the sell-side and capital availability is very strong today. This is why the role of originator is one of the highest paying jobs.
Recently, we advised a client as part of a mining exploration project Roca Honda at Grants Mineral District, New Mexico. In order to make full use of the project, the client required a software that could assess in detail mineral content in ores. As this type of technology was not part of its core expertise, the client desired to acquire a startup or SME that developed such software applications.
We advised them on things to keep in mind when originating a deal. With the world becoming increasingly digital, the first place to source deals is the internet. Websites such as dealmarket.com and Intralinks are great starting spots to check promising deals. Once the deals are identified, originators have to get in touch with sellers and forge relationships. This is perhaps the most difficult stage.
We trained the employees of our client who were tasked with networking and negotiations, on how to handle them. Before you even get to negotiations, the way to win over your seller if by offering the strategic advantage that they would enjoy once they partner with you. Once you manage to convince them on that, then you get to aspects such as price. Surprisingly, price is not the most important aspect in such sourcing negotiations.
At the end of the day, it is important for originators to remember that the negotiating parties are all humans. As much as they are driven by rationality and economics, humans are emotional beings. It is vital that they feel valued in the M&A process and receive intangible benefits in the process. That alone will ensure success in originations.
Valuation is a key component in Corporate Finance in general. It is universally important, whether you are a startup looking to raise seed capital or a large company intending to go public. In today’s world, it defines companies and their prestige.
The first thing to understand about valuation is unlike most financial concepts, valuation is not entirely mathematical and objective. The reason is because valuation is based on future cash flows. You are predicting how your company will perform over the next 10 years. Hence it involves numerous assumptions.
Depending on the level of assumptions involved and the amount of data that is available, you can use different methods for valuation. The standard two methods include market multiples and discounted cash flow (DCF) methodologies. Additionally, there are Leveraged buyout (LBO) valuations.
Less than a decade back, Strathmore Minerals sold assets in Pine Tree-Reno Creek, Wyoming, to NCA Nuclear Inc. for $30M. While we don’t have full details on this, we were informed that NCA Nuclear Inc. used an LBO methodology to value the asset. The reason behind the LBO methodology was that there was significant amount of debt that was used to purchase the asset.
Let us assess when each method is used. Market multiples are used in the comparable method, where you use a multiple on projected EBITDA to derive valuation. They can be used in situations where a minority share of the company is sold or new equity issued, and there is an accurate comparable that is available. Comparable method is used in Equity Capital Markets (ECM) and M&A transactions
The DCF method is usually the most precise methods, and is used when you have an indication of future cashflows and interest rates. It does involve a huge number of assumptions and whatever it brings in terms of precision, it loses in terms of accuracy. The DCF method is used everywhere, provided future data is available.
And finally, LBO valuation is used in acquisition scenarios where a large amount, of the order of 50%-80% of the total price, is used to fund the acquisition. Private equity firms use this extensively in their acquisitions.
Budgeting is always a tricky issue. In most companies, there are always two budgets for a project or a department – bottoms-up and top-down. Bottoms-up budget is obtained by adding each component/task/sub-department and tallying up the projected expenses for each. Top-down budget is allocated by the senior management to a department or project.
In most scenarios, you have to take both these figures and find a middle point. That is the ideal case, and works in companies where the top-down budget is a range rather than a fixed cap. There are however companies where top-down budgets are often caps and you cannot exceed them. In these companies, the employee who has to finalize the budget often faces the most difficult job.
When you are doing capital budgeting for evaluating an investment project, you have to factor in some key variables that are decisive. These include things such as the Net Present Value (NPV), Internal Rate of Return (IRR) and Payback period. These are the main variables that determine where a project is worth embarking on.
During a recent project of ours where we advised one of our clients on an expansion opportunity in Gas Hills, Central Wyoming, there was a question on whether to use the NPV or the IRR as the decisive factor. This was a scenario where the time horizon was more than 15 years, a substantial period of time. The cashflows were also expected to fluctuate significantly between T0 and the payback period. As a result, we prioritized NPV over IRR.
The main reason for this was in cases of longer payback and unpredictable cashflows, IRR is too simplified a metric for evaluating an investment. NPV, however, can be applied to all situations. Furthermore, IRR uses a single discount rate which may not be valid for longer timeframes. Project managers that focus too much on IRR have to understand such limits. We prioritize NPV in most cases.