Investment Banking interview question#1 - Accounting

QUESTION Bob’s furniture bought 25% stake in Phil’s lumberyard. Bob paid $1,000,000 for the investment. Next year Phil’s lumberyard had a massive loss of $8,000,000. How would Bob’s furniture report this loss?

ANSWER As Bob’s furniture had 25% stake. Thus it was between 20 and 50% rule, so Bob’s furniture would use equity method accounting to report his investment. As per this rule Bob’s furniture is supposed to report any proportional profit or loss arising from Phil’s lumberyard’s business operations. As Phil’s lumberyard had $8,000,000 of loss thus Bob’s furniture needed to report $8,000,000 x 0.25 = $2,000,000 loss. But as Bob’s total investment was $1,000,000 so he will just report $1,000,000 loss and show the investment to Phil’s lumberyard as zero. Thus Bob’s furniture still needs to account for the remaining $1,000,000 loss. The company will keep track of it separately. If Next year Phil’s lumberyard reports a profit of $6,000,000 then Bob’s share would be $6,000,000 x 0.25 = $1,500,000. But Bob would just report profit of $500,000 because the company would first need to account for that extra $1,000,000 loss.

Investment Valuation Quiz question # 1

QUESTION We have 3 businesses. Following are their details. BUSINESS-A : Free cash flow of $1,000 million , expected to grow at 5% for next 50 years. Zero terminal value BUSINESS-B : Free cash flow of $1,000 million , expected to grow at 7% for next 50 years. Zero terminal value BUSINESS-C : Free cash flow of $1,000 million , expected to grow at 20% for next 5 years , 10 % growth for next years-6 thru 10 and 5% growth years 11 thru 20. Its then expected to wind down at the end of Year-20 with terminal value of $10,000 million. BUSINESS-A is selling for $20,000 million, BUSINESS-B is selling for $22,000 million, and BUSINESS-C is selling for $35,000 million. Which one would you invest in? Assume a discount rate of 8% for all three businesses.

ANSWER In order to answer the question we would need to find the present value of the future cash flows for all the three businesses. BUSINESS-A : Present value of future cash flows is $24,195 million. BUSINESS-B : Present value of future cash flow is $34,897 million BUSINESS-C : Present value of future cash flow is $33,646 million. (Includes $10 billion of terminal value in Year-20 , whose present value is $1.7 billion) Let us calculate the expected return for each business. Its done by using the following formula : {(Present value of future cash flows) – (Cost of investment)} / Cost of Investment BUSINESS- A : {$24,195 - $20,000} / $20,000 = 20.98% BUSINESS- B : {$34,897 - $22,000} / $22,000 = 58.63% BUSINESS- C : {$33,646 - $35,000} / $35,000 = -3.87% Thus the answer is ‘B’ because it’s expected return is the highest amongst the three. In the above example at first glance BUSINESS-C might seem more valuable because of high returns in the initial years and a high terminal value , but it did not come out true. Following are basic valuation lessons we can learn from this exercise 1. It’s common for investors to stress on the immediate growth rate while valuing investments. But what is more important is the overall expected life of the business, because that can make large difference as to how much cash the business is going to generate in its lifetime. 2. After certain point the effect of terminal value on the total value is very minimal. The $10 billion Terminal value for BUSINESS-C was just 5% of total value, because the present value of the terminal value for Year-20 was just $1.7 billion. 3. Even slight difference in growth rate can make large difference if carried on for long time. BUSINESS-B ‘s value is $10 billion higher than that of BUSINESS-A because its growth rate was 7% compared to that of BUSINESS-A’s 5%.