Investment Banking - Technical Interview Questions

Income Statement

1. Sales Revenue

2. COGS

Gross Profit

3. Operating Expenses (SG&A)

Operating Income (EBITDA)

4. Depreciation

EBIT

5. Interest

6. Taxes

Net Income

Why is the Income Statement not affected by changes in Inventory?

The expense is only recorded when the goods associated with it are sold (COGS)

Statement of Cash Flows

1. Net Income

2. Operating Activities

Depreciation

Changes to AR, Liabilities, Inventories, Other

Total Cash Flow from Operating Activities

3. Investing Activities

Capital Expenditures

Investments/Other

Total Cash Flow from Investing Activities

4. Financing Activities

Dividends

Borrowings

Sale of Stocks/Other

Total Cash Flow from Financing Activities

Change in Cash and Cash Equivalents

Balance Sheet

1. Assets

Current Assets (Cash, AR, Inventory, etc)

Long-term Assets (PP&E, Amortization, etc.)

2. Liabilities

Current Liabilities (AP, etc.)

Long-term Liabilities (Debt, Minority Interest)

3. Shareholder Equity

Assets = Liabilities + Shareholder Equity

How do the 3 statements link together?

Net income from Income Statement flows into Shareholders' Equity on the Balance Sheet and into the top line of the Cash Flow Statement

Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement

Cash Flow investing and financing activities affect Balance Sheet items such as PP&E and Shareholders' Equity

If a company incurs $10 (pretax) of depreciation, how does this affect the three financial statements?

1. Income Statement: Depreciation is an expense, so EBIT declines by $10. Assuming a 40% tax rate, net income declines by $6.

2. Cash Flow Statement: Net income decreases by $6 and depreciation increases by $10, meaning that cash flow from operations increased by $4.

3. Balance Sheet: Since cumulative depreciation increased by $10, Net PP&E decreases by $10 (asset). Since cash flow increased by $4 on cf statement, cash increases by $4 (asset). The $6 reduction of net income causes retained earnings to decrease by $6.

If depreciation is a non-cash expense, why does it affect the cash balance?

It is tax-deductable. Since taxes are a cash expense, depreciation affects cash by reducing the amount of taxes you pay.

Where does depreciation usually show up on the Income Statement?

It could be a separate line item.

It could be embedded in COGS or Operating Expenses

A company makes $100 cash purchase of equipment on Dec. 31. How does this impact the three financial statements this year and next year?

Year 1

Assume FY ends Dec. 31. Why? No depreciation for the first year.

IS: Capital expenditure so no affect on net income, i.e. no change on IS.

CFS: No change in net income = no change in cash flow from operations; however, $100 increase in capex ($100 use of cash in cash flow from investing activities) = $100 use of cash.

BS: Cash down $100, PP&E up $100.

Year 2

Assume straight line depreciation over 5 years with 40% tax rate.

IS: $20 of depreciation = $12 reduction in net income.

CFS: Net income down $12 and depreciation up $20 = Net effect is cash up $8.

BS: Cash (asset) up $8 and PP&E (asset) down $20. Retained earnings down $12 to balance.

A company makes $100 debt purchase of equipment on Dec. 31. How does this impact the three financial statements this year and next year?

Year 1

IS: No depreciation and no interest expense.

CFS: No change to net income = no change to cash flow from operations. $100 increase in capex = $100 use of cash in cash flow from investing activities. Increase in cash flow from financing section = increase of debt of $100. Net effect on cash = 0.

BS: No change to cash (asset), PP&E (asset) up $100 and debt (liability) up $100 to balance.

Year 2

Assume straight line depreciation over 5 years with 40% tax rate. Assume a 10% interest rate on debt and no debt amortization.

IS: $20 depreciation + $10 of interest expense = $18 reduction in net income ($30 * (1-40%)).

CFS: Net income down $18 and depreciation up $20 = Net effect of cash up $2.

BS: Cash (asset) up $2, PP&E (asset) down $20, Retained Earnings down $18.

If cash collected is not recorded as revenue, what happens to it?

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.

Over time the Deferred Revenue balance turns into real revenue on the Income Statement

What is the difference between cash-based and accrual accounting?

Cash-based recognizes revenue and expenses when cash is actually received or paid out

Accrual accounting recognizes revenue when collection is reasonably certain and recognizes expenses when they are incurred rather than when they are paid out in cash

How do you decide when to capitalize rather than expense a purchase?

Capitalize when the asset has a useful life of over 1 year (this is depreciated for tangible assets and amortized for intangible assets over a certain number of years)

A company has had a positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

1. Excessive capital expenditures (cash-flow neg)

2. Unaffordable high interest expense

3. Credit crunch for loan maturity.

4. Significant one-time charges (from litigation, etc.) that are high enough to bankrupt the company.

Walk me through a DCF analysis.

1. Project free cash flow for a period of time (5 years)

Free Cash Flow = EBIT - Taxes + D&A - CapEx - Change in Working Capital (this measure is unlevered/debt-free bc does not include interest)

2. Project Terminal Value: 2 methods

Method 1: Gordon Growth (Perpetuity Growth) ~ choose a rate at which the company can grow forever, i.e. average long-term expected GDP growth or inflation.

Method 2: Terminal Multiple method ~ multiply the last year's free cash flow by (1 + chosen growth rate)/(discount rate - growth rate) (used more often) ~ typically use EBITDA multiple (LTM basis from company comparable analysis)

You might use GG over Terminal Multiple if you have no good Comparable Companies or if you have reason to believe that multiples will cahnge significantly in the industry several years down the road.

3. Find present value of free cash flows and terminal value by using an a discount rate (aka WACC).

4. Sum up present value of projected cash flows and present value of the terminal value to get DCF value.

Note: Bc we use unlevered cash flows and WACC as our discount rate, the DCF value = Enterprise Value, not Equity Value.

When would you not use a DCF in a valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows or when debt and working capital serve a fundamentally different role.

Why would you not use a DCF for a bank or other financial institution?

Banks use debt differently than other companies and do not re-invest it in the business-they use it to create products instead.

For financial institutions, it's more common to use a dividend discount model for valuation purposes.

What is working capital? How is it used?

Working Capital = Current Assets - Current Liabilities

Positive number => company can pay off its short-term liabilities with its short-term assets.

Tells you whether or not the company is "sound"

What is WACC and how do you calculate it?

WACC = Weighted Average Cost of Capital: used as the discount rate in a DCF analysis to present value projected free cash flows and terminal value.

Represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile.

Reflects the cost of each type of capital (debt, equity, and preferred stock) weighted by the respective percentage of each type of capital in the company's capital structure.

WACC = [Cost of Equity * %Equity (E/E+D+P)] + [Cost of Debt * %Debt (D/E+D+P) * (1-tax rate)] + Cost of Preferred * (%Preferred)

Cost of Equity is the result of the CAPM.

Cost of Debt is the result of prevailing interest rates/yields on debt issued by similar companies.

Cost of Preferred Stock is the result of prevailing dividend yields on preferred stock issued by similar companies.

How do you calculate the cost of equity?

Via CAPM

Cost of Equity = Risk free rate + Beta*Equity Risk Premium

RFR: generally the yield on a 10 or 20 year U.S. Treasury Bond

Beta: levered and represents the riskiness of the company's equity relative to overall equity markets.

Equity Risk Premium: The amount that stocks are expected to outperform the risk free rate over the long-term.

Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a "size premium" and "industry premium"

How can we calculate Cost of Equity WITHOUT using CAPM?

Cost of Equity = (Dividends per Share/Share Price) + Growth Rate of Dividends

*Use where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity in CAPM.

Two companies are exactly the same, but one has debt and one does not-which one will have the higher WACC?

The one without debt will have a higher WACC up to a certain point, because debt is "less expensive" than equity. Why?

Interest on debt is tax-deductible.

Debt is senior to equity.

Interest rates on debt are usually lower than the Cost of Equity.

If you use levered free cash flow, what should you use as the Discount Rate?

You would use the Cost of Equity rather than WACC since we're not concerned with Debt or Preferred Stock in this case-we're calculating Equity Value, not Enterprise Value.

What is Beta?

A measure of the riskiness of a stock relative to the broader market. Beta is calculated as the covariance between a stock's return and the market return divided by the variance of the market return. By definition, the market has a beta of 1.0.

A stock above 1 is perceived to be more risky than the market.

A stock less than 1 is perceived to be less risky.

When using the CAPM for purposes of calculating WACC, why do you have to unlever and then relever Beta?

We typically get the appropriate Beta from our comparable companies; however, before using an "industry" beta, we must first unlever the Beta of each of our comps.

In general, stocks of companies that have debt are somewhat more risky than stocks of companies without debt. Why? Bc debt increases the risk of bankruptcy and funds are not being used to grow business (limits flexibility).

We must first strip out the impact of debt from the comps' Betas (aka Unlever the beta). After unlevering, we can use the appropriate "industry" Beta (the mean of the comps).

Then we can relever the beta for the appropriate capital structure of the company being valued, and then use the Beta in the CAPM formula.

What is the formula for unlevered beta?

Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) * (Debt/Equity)))

What is the formula for levered beta?

Levered Beta = Unlevered Beta * (1+ ((1-Tax Rate)*(Debt/Equity)))

Which is less expensive capital, debt or equity?

Debt is less expensive (aka cost of debt is lower than the cost of equity). Why?

1. Interest on debt is tax deductible (tax shield)

2. Debt is senior to equity in a firm's capital structure.

What is the difference between enterprise value and equity value?

Enterprise Value: represents the value of the operations of a company attributable to all providers of capital. Also helpful to think of Enterprise value as the takeover value. The main use for enterprise value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA).

Enterprise value = Market cap + Debt + Minority interest + Preferred shares - Total cash and cash equivalents.

Enterprise value = Market cap + Total Debt - Cash and Cash Equivalents

Equity Value: a component of enterprise value and represents only the proportion of value attributable to shareholders.

Why do we look at both Enterprise Value and Equity Value?

Bc Equity Value is the number the public-at-large sees, while Enterprise Value represents the true value of the company.

Why do you subtract cash in the enterprise value formula?

1. Cash is considered a non-operating asset

2. Cash is already implicitly account for within equity value.

This is the amount the takeover company pockets.

What is minority interest and why do we add it in the enterprise value formula?

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance.

So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial performance.

In keeping with the "applet-to-apples" theme, you must add Minority Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

Why do we add Preferred Stock to get to Enterprise Value?

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company's assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

How do you account for converitble bonds in the Enterprise Value formula?

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value

If they're out-of-the-money then you count the face value of the convertibles as part of the company's Debt

How do you calculate the market value of equity?

MVE = Share Price * Number of Fully Diluted Shares Outstanding

What's the difference between Equity Value and Shareholders' Equity?

Equity Value is the market value; this value can never be negative.

Shareholders' Equity is the book value; this could be any value.

For healthy companies, Equity Value usually far exceeds Shareholders' Equity.

What is the difference between basic shares and fully diluted shares?

Basic shares: the number of common shares that are outstanding today.

Fully diluted shares: basic shares + potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt.

How do you calculate fully diluted shares?

FDS = Basic number of shares + Dilutive effect of employee stock options

To calculate the effect of options, we typically use the Treasury Stock Method. The concept of the treasury stock method is that when employees exercise options, the company has to issue the appropriate number of new shares but also receives the exercie price of the options in cash.

How do we use the Treasury Stock Method to calculate diluted shares?

1. Tally the company's issued stock options and weighted average exercise prices (from the company's 10K)

If using for precedent transactions or M&A analysis, we will use all of the options outstanding.

If our calculation is for a minority interest based valuation (comparable companies) we will use options exercisable. Options exercisable are options that have vested while options outstanding takes into account both options that have vested and that have not yet vested.

2. Subtract the exercise price of the options from the current share price (or per share purchase price for an M&A analysis), divide by the share price (or purchase price) and multiply by the number of options outstanding. Repeat for each subset of options reported in the 10K.

3. Aggregate to get the amount of diluted shares. Options where the exercise price is greater than the share price then the options are out of the money and have no dilutive effect.

Walk me through an LBO analysis.

1. Make transaction assumptions: What is the purchase price and how will the deal be financed? Create a table of Sources and Uses (where Sources equals Uses). Uses = amount of money required to effectuate the transaction, i.e. equity purchase price, existing debt being refinanced, and transaction fees. Sources tells us from where the money is coming, i.e. new debt, existing cash that will be used, and equity contributed by private equity firm. Equity = difference between Uses (total funding required) and all of the other sources of funding.

2. Construct "proforma" balance sheet. Change existing balance sheet of company to reflect the transaction and new capital structure; intangible assets, debt, and equity will be changed.

3. Create integrated cash flow model for the company. Project the company's income statement, balance sheet, and cash flow statement for a period of time (usually 5 years).

4. Make exit assumptions for private equity firm, i.e. sell company after 5 years at same implied EBITDA multiple at which the company was purchased. This allows us to calculate IRR = average annual compounded rate at which the PE firm's original equity investment grows (most important info). IRR allows us to back into a purchase price for the company.

Why do private equity firms use leverage when buying a company?

By using significant amounts of leverage to finance purchase price, the private equity firm reduces the amount of money (equity) that it must contribute to the deal. Reducing equity contributed increases the firm's rate of return upon exiting the investment.

What drivers to the LBO model will increase the return for the private equity firm?

1. Reduce purchase price.

2. Increase the amount of leverage.

3. Increase selling price, i.e. increase selling multiple.

4. Increase the company's growth rate in order to raise operating income/cash flow/EBITDA in projections.

5. Decrease the company's costs in order to raise operating income/cashflow/EBITDA in projections.

What are some characteristics of a company that is a good LBO candidate?

1. Steady cash flows

2. Limited business risk

3. Limited need for ongoing investment

4. Strong working capital

5. Strong management

6. Opportunity for cost reductions

7. High asset base (to use as debt collateral)

What variables impact an LBO model the most?

Purchase and exit multiples have the biggest impact on the returns of a model.

After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margins.

Can you explain how the Balance Sheet is adjusted in an LBO model?

1. Liabilities and Equities side is adjusted.

The new debt is added on, and the Shareholders' Equity is 'wiped out' and replaced by however much equity the private equity firm is contributing.

2. Assets, cash is adjusted for any cash used to finance the transaction, and then Goodwill and Other Intangibles are used as a "plug" to make the balance sheet balance.

How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor valuation" for the company?

You use it to value a company by setting a targeted IRR (25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR.

Called a floor valuation because PE firms almost always pay less for a company than strategic acquirers would.

What is a dividend recapitalization ("dividend recap")

The company takes on new debt solely to pay a special dividend out to the PE firm that bought it.

Walk me through a basic merger model.

1. Make assumptions about the acquisition-the price and whether it was cash, stock or debt or some combination of those.

2. Determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one.

3. Combine Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS

Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller's Pre-Tax Income.

If it's an all stock deal you can use a shortcut to assess whether it is accretive.

But if the deal involves cash, stock, and debt, there's no quick rule-of-thumb you can use.

Walk me through an accretion/dilution analysis.

AKA Quick-and-dirty merger analysis

Purpose is to project the impact of an acquisition to the acquiror's EPS and compare how the new EPS ("proforma EPS") compares to what the company's EPS would have been without the transaction.

1. Project the combined company's net income ("proforma net income") and the combined company's new share count. Proforma net income = Buyer's Project Net Income + Target's Projected Net Income +/- Transaction adjustments. Adjustments included synergies, increased interest expense, decreased interest income, and new intangible asset amortization.

2. Proforma share count = Acquirer's share count + Number of shares to be created and used to finance purchase.

3. EPS = Proforma Net Income/Proforma Shares. If new EPS is higher than old EPS (accretion); if new EPS is lower than old EPS (dilution).

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.

What are the complete effects of an acquisition?

1. Foregone Interest on cash

2. Additional Interest on Debt

3. Additional Shares Outstanding

4. Combined Financial Statements

5. Creation of Goodwill & Other Intangibles

What facts can lead to the dilution of EPS in an acquisition?

1. Target has negative net income.

2. Target's Price/Earnings ratio is greater than the acquirer's.

3. Transaction creates a significant amount of intangible assets that must be amortized going forward.

4. Increased interest expense due to new debt used to finance the transaction.

5. Decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction.

6. Low or negative synergies.

If a company with a low P/E acquires a company with a high P/E in an all stock deal, will the deal likely be accretive or dilutive?

The deal will be dilutive to the acquirer's EPS because the acquirer has to pay more for each dollar of earnings than the market values its own earnings; therefore, the acquirer will have to issue proportionally more shares in the transaction.

Proforma earnings = Acquirer's earnings + Targets Earnings (numerator of EPS) will increase less than the proforma share count (denominator) => decline in EPS.

What is goodwill and how is it calculated?

Goodwill is an intangible asset and reflects the value of a company that is not attributed to its other assets and liabilities.

Goodwill =Equity purchase price paid for company - Target's book value (i.e. excess purchase price). This can remain on a company's balance sheet indefinitely barring impairment.

Why might one company want to acquire another company?

1. Buyer views the Target as undervalued.

2. Buyer's organic growth has slowed or stalled and needs to grow in other ways in order to satisfy growth expectations.

3. Buyer expects the deal to result in significant synergies.

Which method would a company prefer to use when acquiring another company - cash, stock, or debt?

Cash is "cheaper" and less risk than debt

Generally stock is most expensive

How much debt could a company issue in a merger or acquisition?

Generally you would look at comps/precedent transactions

Debt/EBITDA median

Explain the concept of synergies and provide some examples.

2+2=5

When the sum of the value of the Buyer and the Target as a combined company is greater than the two companies valued apart.

Two types of synergies: cost synergies and revenue synergies. Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations, i.e. closing one corporate headquarters, shutting down redundant stores, etc.

Revenue synergies refer to the ability to sell more products/services or raise prices due to the merger, i.e. cobranding. Economies of scale.

What are the three main valuation methodologies?

1. Comparable company analysis.

2. Precedent transaction analysis.

3. Discount cash flow analysis.

How do you select Comparable Companies/Precedent Transactions?

The 3 main ways to select companies and transactions:

1. Industry classification

2. Financial criteria (Revenue, EBITDA, etc.)

3. Geography

For precedent transactions, you often limit the set based on date and only look at transactions within the past 1-2 years.

Comparable Company Ex.: Oil and gas producers with market caps over $5 billion

Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue.

Of the three main valuation methodologies, which ones are likely to result in higher/lower value?

Precedent transactions methodology is likely to give a higher valuation than Comparable Companies methodology. This is because when companies are purchased, the target's shareholders are typically paid a price that is higher than the target's current stock price (a control premium). Valuing companies based on M&A transactions (a control based baluation methodology) will include this control premium, resulting in a higher valuation than a public market valuation (minority interest based valuation).

DCF will also likely result in a higher valuation than Company comparables analysis because DCF is a control based methodology and because most projections tend to be pretty optimistic.

Whether DCF will be higher than Precedent Transactions is debatable but it is fair to say that DCF valuations tend to be more variable bc DCF is sensitive to a multitude of inputs or assumptions.

What are the flaws with public company comparables?

No company is 100% comparable to another company

The stock market is "emotional"-your multiples might be dramatically higher or lower on certain dates depending on the market's movements

Share prices for small companies with thinly-traded stocks may not reflect their full value

What are some flaws with precedent transactions?

Past transactions are rarely 100% comparable

Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies

How do you use the three main valuation methodologies to conclude value?

You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you're valuing.

What are some other possible valuation methodologies in addition to the main three valuation methods?

Leverage buyout (LBO) analysis - determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range.

Replacement value - Valuing a company based on the cost of replacing its assets

Liquidation value - valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive

What are some common valuation metrics?

Most common is Enterprise Value (EV)/EBITDA

EV/Sales

EV/EBIT

Price to Earnings (P/E)

Price to Book Value (P/BV)

The EV/EBIT, EV/EBITDA, and P/E multiples all measure a company's profitability. What's the difference between them, and when do you use each one?

P/E depends on the company's capital structure. You use P/E for banks, financial institutions, and other companies where interest payments/expenses are critical.

EV/EBIT and EV/EBITDA are capital structure neutral. Use EV/EBIT in industries where D&A is large and where capital expenditures and fixed assets are important. EV/EBITDA is used in industries where fixed assets are less important and where D&A is comparatively smaller.

Why can't you use EV/Earnings or Price/EBITDA as valuation metrics?

EV = value of the operations of the company attributable to all providers of capital (it incorporates all of both debt and equity and is not dependent on the choice of capital structure). If we use EV in the numerator, we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA (to compare apples to apples). Operating Metrics such as earnings do include interest and so are considered leveraged or capital structure dependent.

Similarly, Price/EBITDA is inconsistent because Price (or equity value) is dependent on capital structure while EBITDA is unlevered. Price/Earnings is fine because they are both levered.

How would you judge a company's credit worthiness?

Risk

1. Cash flows

2. Assets (ability to get money back)

3. Type of Investment (new business, extension of business)

4. Type of loan (what is it for)