Corporate Finance Guide

Steps and Rules of Thumb for Corporate Finance Exam

1. Read case and look at exhibits

2. Read questions 

3. Performance

Return on Equity = Net Income / Shareholders’ Equity

To determine underlying factors, break down:

ROE = (net income/sales) x (sales/assets) x (assets/equity)

net profit margin x asset turnover x financial lev

Which one increased the most? What it means:

More profitable More efficient More levered

(Not as good)

ROIC = (EBIT(1-t))/(Debt+Equity)

= (1-t) x EBIT/SALES x SALES/CAPITAL

(Op Profit Mgn) (Turnover)

4. Valuation

a. FCF – look for amortization, other current assets, accrued expenses, and deferred taxes. When projecting the first year – for change in cash, don’t forget to take necessary cash for year 0! (not the actual BS number)

b. Optimal Capital Structure: what is right D/E ratio?

c. Variability – determines OPMrwc. How volatile is the OPM? Answer this question by projecting future directions of prices\sales and costs. Look at past performance also. Usually take lowest positive OPM and subtract 2%-6%.

d. Vulnerability – if company in distress, what will the customers\competitors\creditors\investors will do?

i. Sales Use the most recent Annual Sales #

x OPMrealisticworstcasescenario Take lowest observed OPM and take haircut

= EBITrealisticworstcasescenario This gives you EBIT in theoretical worst case scenario

÷ h (coverage ratio 1,2 or 3) Diego Rule  make it 2 (gives you enough leeway)

= Imax This gives you max interest your company can support

Divide last EBIT # (one corresponding to sales # above) by Imax above.

This will give you the EBIT / I coverage ratio.

Use this as primary means to determine appropriate bond rating (AAA, AA, A, BBB, BB, B, etc…)

After selecting appropriate bond rating, find interest rate associated with rating.

This gives you…

÷ rDebt This number will also be used in WACC

= Target Debt Level (D*) This is your target debt...