Investment Banking - Technical Interview
Questions
A company has had a positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen? - ANS - 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.
\A company makes $100 cash purchase of equipment on Dec. 31. How does this
impact the three financial statements this year and next year? - ANS - 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? - ANS - 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.
\Balance Sheet - ANS - 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
\Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS - 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.
\Explain the concept of synergies and provide some examples. - ANS - 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.
\How can we calculate Cost of Equity WITHOUT using CAPM? - ANS - 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.
\How do the 3 statements link together? - ANS - 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
\How do we use the Treasury Stock Method to calculate diluted shares? - ANS - 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.
\How do you account for converitble bonds in the Enterprise Value formula? -
ANS - 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 fully diluted shares? - ANS - 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
Questions
A company has had a positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen? - ANS - 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.
\A company makes $100 cash purchase of equipment on Dec. 31. How does this
impact the three financial statements this year and next year? - ANS - 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? - ANS - 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.
\Balance Sheet - ANS - 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
\Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS - 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.
\Explain the concept of synergies and provide some examples. - ANS - 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.
\How can we calculate Cost of Equity WITHOUT using CAPM? - ANS - 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.
\How do the 3 statements link together? - ANS - 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
\How do we use the Treasury Stock Method to calculate diluted shares? - ANS - 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.
\How do you account for converitble bonds in the Enterprise Value formula? -
ANS - 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 fully diluted shares? - ANS - 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
