Investment Banking Practice Exam
UPDATED ACTUAL QUESTIONS AND
CORRECT ANSWERS
QUESTION: "How much would you pay for a company that generates $100 of cash flow every single
year into eternity?" - CORRECT ANSWER ANSWER: It depends on your Discount Rate, or
"targeted yield."
If your Discount Rate is 10%, meaning you could earn 10% per year in companies with similar
risk/potential return profiles, you would pay $% = $1,000.
But if your Discount Rate is 20%, you would pay $% = $500.
QUESTION: "A company generates $200 of cash flow today, and its cash flow is expected to grow at
4% per year for the long term.
You could earn 10% per year by investing in other, similar companies. How much would you pay for
this company?" - CORRECT ANSWER ANSWER: Company Value = Cash Flow / (Discount
Rate - Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate.
So, this one becomes: $200 / (10% - 4%) = $3,333.
QUESTION: "What might cause a company's Present Value (PV) to increase or decrease?" -
CORRECT ANSWER ANSWER: A company's PV might increase if its expected future cash
flows increase, its expected future cash flows start to grow at a faster rate, or the Discount Rate
decreases (e.g., because the expected returns of similar companies decrease).
The PV might decrease if the opposite happens.
QUESTION: "What does the internal rate of return (IRR) mean?" - CORRECT ANSWER
ANSWER: The IRR is the Discount Rate at which the Net Present Value of an investment, i.e.,
Present Value of Cash Flows - Upfront Price, equals 0.
, You can also think of it as the "effective compounded interest rate on an investment" - so, if you
invest $1,000 today, end up with $2,000 in 5 years, and contribute and earn nothing in between, the
IRR is the interest rate you'd have to earn on that $1,000, compounded each year, to reach $2,000 in 5
years.
QUESTION: "How do the 3 financial statements link together? Assume the Indirect Method for the
Cash Flow Statement." - CORRECT ANSWER ANSWER: To link the statements, make Net
Income at the bottom of the Income Statement the top line of the Cash Flow Statement.
Then, adjust this Net Income number for any non-cash items such as Depreciation & Amortization.
Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may
increase or decrease the company's cash flow depending on how they've changed.
That gets you to Cash Flow from Operations.
Next, reflect investing and financing activities, which may increase or decrease cash flow, and sum up
Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom.
Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net Income to
Retained Earnings within Equity on the Balance Sheet.
Then, link each non-cash adjustment to the appropriate Asset or Liability SUBTRACT links on the
Assets side and ADD links on the L&E side.
Link each CFI and CFF item to the matching item on the Balance Sheet, using the same rule as above.
Check that Assets equals Liabilities + Equity at the end if this is not true, you did something wrong
and need to re-check your work.
QUESTION: "A company runs into financial distress and needs cash immediately. It sells a factory
that's listed at $100 on its Balance Sheet for $80. What happens on the 3 statements, assuming a 40%
tax rate?" - CORRECT ANSWER ANSWER: Income Statement: Record a Loss of $20 on the
Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate.
UPDATED ACTUAL QUESTIONS AND
CORRECT ANSWERS
QUESTION: "How much would you pay for a company that generates $100 of cash flow every single
year into eternity?" - CORRECT ANSWER ANSWER: It depends on your Discount Rate, or
"targeted yield."
If your Discount Rate is 10%, meaning you could earn 10% per year in companies with similar
risk/potential return profiles, you would pay $% = $1,000.
But if your Discount Rate is 20%, you would pay $% = $500.
QUESTION: "A company generates $200 of cash flow today, and its cash flow is expected to grow at
4% per year for the long term.
You could earn 10% per year by investing in other, similar companies. How much would you pay for
this company?" - CORRECT ANSWER ANSWER: Company Value = Cash Flow / (Discount
Rate - Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate.
So, this one becomes: $200 / (10% - 4%) = $3,333.
QUESTION: "What might cause a company's Present Value (PV) to increase or decrease?" -
CORRECT ANSWER ANSWER: A company's PV might increase if its expected future cash
flows increase, its expected future cash flows start to grow at a faster rate, or the Discount Rate
decreases (e.g., because the expected returns of similar companies decrease).
The PV might decrease if the opposite happens.
QUESTION: "What does the internal rate of return (IRR) mean?" - CORRECT ANSWER
ANSWER: The IRR is the Discount Rate at which the Net Present Value of an investment, i.e.,
Present Value of Cash Flows - Upfront Price, equals 0.
, You can also think of it as the "effective compounded interest rate on an investment" - so, if you
invest $1,000 today, end up with $2,000 in 5 years, and contribute and earn nothing in between, the
IRR is the interest rate you'd have to earn on that $1,000, compounded each year, to reach $2,000 in 5
years.
QUESTION: "How do the 3 financial statements link together? Assume the Indirect Method for the
Cash Flow Statement." - CORRECT ANSWER ANSWER: To link the statements, make Net
Income at the bottom of the Income Statement the top line of the Cash Flow Statement.
Then, adjust this Net Income number for any non-cash items such as Depreciation & Amortization.
Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may
increase or decrease the company's cash flow depending on how they've changed.
That gets you to Cash Flow from Operations.
Next, reflect investing and financing activities, which may increase or decrease cash flow, and sum up
Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom.
Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net Income to
Retained Earnings within Equity on the Balance Sheet.
Then, link each non-cash adjustment to the appropriate Asset or Liability SUBTRACT links on the
Assets side and ADD links on the L&E side.
Link each CFI and CFF item to the matching item on the Balance Sheet, using the same rule as above.
Check that Assets equals Liabilities + Equity at the end if this is not true, you did something wrong
and need to re-check your work.
QUESTION: "A company runs into financial distress and needs cash immediately. It sells a factory
that's listed at $100 on its Balance Sheet for $80. What happens on the 3 statements, assuming a 40%
tax rate?" - CORRECT ANSWER ANSWER: Income Statement: Record a Loss of $20 on the
Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate.
