Investment Banking Technical Interview
Questions
A company has had positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen? - ANS - 1. The company is spending too much
on Capital Expenditures - these are not reflected at all in EBITDA, but it could still
be cash-flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3. The company's debt all matures on one date and it is unable to refinance it due
to a "credit crunch" - and it runs out of cash completely when paying back the
debt.
4. It has significant one-time charges (from litigation, for example) and those are
high enough to bankrupt the company.
\A company with a higher P/E acquires one with a lower P/E - is this accretive or
dilutive? - ANS - You can't tell unless you also know that it's an all-stock deal. If
it's an all-cash or all-debt deal, the P/E multiples of the buyer and seller don't
matter because no stock is being issued. Sure, generally getting more earnings
for less is good and is more likely to be accretive but there's no hard-and-fast rule
unless it's an all-stock deal.
\A stock is trading at $5 and another stock is trading at $50. Which has greater
growth potential? - ANS - It depends. The stock with the higher growth potential
is most likely the stock with the lower market cap,
so if the $5 stock has 1 billion shares outstanding and the $50 stock has 10,000
shares outstanding, the $50 stock would most likely have higher growth potential.
\All else equal, how would one company prefer to pay for another? - ANS - Since
cash is the cheapest source of capital, it would be the preferred way to purchase
another company if the purchaser had sufficient cash. If a company feels its stock
price is inflated, it would prefer to use that to pay for the acquisition. Really
depends on the acquisition, companies, and market.
\Are most mergers stock swaps or cash transactions and why? - ANS - In strong
markets many mergers are stock swaps mainly because the prices of company
stock are so high, but also because the current owners may desire stock in the
new company as they anticipate further growth in a strong market
\As the proportion of debt in the capital structure increases, WACC does what? -
ANS - WACC decreases due to the tax deductibility of interest expense
\Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS -
First, the Liabilities & Shareholders' Equities side is adjusted - the new debt is
,added on, and the Shareholders' Equity is replaced by however much equity the
private equity firm is contributing.
On the Assets side, Cash is adjusted for any cash used to finance the
transaction, and then Goodwill & Other Intangibles are used as a "plug" to make
the Balance Sheet balance.
\Can you name two companies that you think should merge? - ANS - This is
another question testing your awareness of what is going on in the markets.
There is no right or wrong answer to this question, just have in mind two
companies that you believe would benefit from merging, and have a well
formulated rationale for a the merger (think synergies, gain foothold in a new
market, consolidation of operations, or brand recognition).
\Company XYZ released increased quarterly earnings yesterday, but their stock
price still dropped. Why? - ANS - First, the entire market or the industry to which
XYZ belongs could have been down on the day, which had more of an impact
than the company's positive earnings. More likely, however, is that the increased
earnings figures they reported were not as high as the Wall Street analysts'
estimates.
\Describe a company's typical capital structure. - ANS - A company's capital
structure is composed of several layers of both debt and equity. Debt can be
senior (i.e. bank loans), mezzanine, then subordinated where senior is paid off
first in the event of a bankruptcy, then mezzanine then subordinated. Equity is
either preferred or common stock. Preferred stock combines some features of
both debt and equity: it can appreciate in value, and also pays out a consistent
dividend but it has very little or no rights in a bankruptcy. Common stock is
traded on the exchanges, if the company is public. In the event of bankruptcy,
common stockholders have the least claim to assets in the event of liquidation,
and therefore they bear the highest level of risk and earn the highest return on
investment.
\Difference between Cost of goods sold (COGS) and Selling, general, and
administrative (SG&A)? - ANS - Cost of goods sold is the expense most directly
involved in creating revenue. Costs involved in operating the business are SG&A.
This category includes marketing, salaries, utility bills, technology expenses and
other general costs associated with running a business.
\From the three main financial statements, if you had to choose two to analyze a
company, which would you choose and why? - ANS - If I had to choose two
financial statements, I would choose the Balance Sheet and the Income
Statement. As long as I had the Balance Sheets from the beginning and end of the
period, as well as the end of period Income Statement, I would be able to generate
a Cash Flow Statement.
,\How are the three financial statements connected? - ANS - The bottom line of the
Income Statement is Net Income. Net income links to both the Balance Sheet and
Cash Flow statement.
In terms of the balance sheet, net income flows into stockholder's equity via
retained earnings. Retained earnings is equal to the previous period's retained
earnings plus net income from this period minus dividends (from this period).
In terms of the cash flow statement, Net Income is the first line as it is used to
calculate cash flows from operations. Also, any non-cash expenses or non-cash
income from the Income Statement (i.e., depreciation and amortization) flow into
the Cash Flow Statement and adjust net income to arrive at cash flow from
operations.
Any balance sheet items that have a cash impact (i.e., working capital, financing,
PP&E, etc.) are linked to the cash flow statement since it is either a source or use
of cash. The net change in cash at the bottom of cash flow statement and cash
from the previous period's balance sheet comprise cash for the current period.
\How can a company raise its stock price? - ANS - Any positive news about the
company can potentially raise the stock price.
1. A company can repurchase stock, which lowers the number of shares
outstanding and therefore increases the value per share.
2. It can improve operations to produce higher earnings, causing its EPS to be
higher than anticipated by industry analysts, which will send a positive signal to
the market
3. It can announce a change to its organizational structure such as cost-cutting or
consolidation, which would lead to increased earnings
4. It can announce an accretive merger or an acquisition that will increase
earnings per share
\How could a firm increase the returns on an LBO acquisition? (4 ways) - ANS - 1.
Increase the sale price when the firm monetizes its investment.
2. The firm could negotiate a lower purchase price, which would have a similar
effect to raising the selling price.
3. Finally, the private equity firm could increase the amount of leverage or debt on
the deal. The higher the leverage, the higher the return, all else equal.
4. In modeling the returns, you could increase your projections for the acquired
company's earnings and cash flows.
\How do you apply the 3 valuation methodologies to actually get a value for the
company you're looking at? - ANS - Sometimes this simple fact gets lost in
discussion of Valuation methodologies. 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.
Example: If the median EBITDA multiple from your set of Precedent Transactions
is 8x and your company's EBITDA is $500 million, the implied Enterprise Value
would be $4 billion
\How do you calculate a company's terminal value? - ANS - 1. Exit Multiple
approach--> Assign a valuation multiple (such as EV/EBITDA) to the final year's
FCF.
2. Perpetuity Method-->Multiply final year's free cash flow by 1 plus the growth
rate (inflation or GDP rate) divided by the WACC minus the growth rate
\How do you calculate the number of fully diluted shares? In what context would
you need to calculate number of fully diluted shares? - ANS - Treasury stock
method. Finding the number of current shares outstanding, adding the number of
options and warrants that are currently "in the money," and then subtracting the
number of shares that could be repurchased using the proceeds from exercising
the options and warrants.
Used when calculating Equity Value.
\How do you determine which valuation methodology to use? - ANS - Usually the
best valuations are a combination of a few of the methodologies. But if one
seems more accurate than the others than it could be weighted more heavily.
\How do you do comparable company analysis? (5) - ANS - 1. Select the Universe
of Comparable Companies (find companies with similar business and financial
characteristics)
2. Locate the necessary financial information via SEC files, equity research
reports, and press releases.
3. Calculate the key statistics, ratios, then trading multiples for the comparable
universe. I.E. Size (Equity value, Entreprise value, Net Income), Profitability
(Gross Profit Margin, EBITDA, EBIT), Growth Profile, Return on Investment, Credit
Profile (Leverage ratios, credit ratings, coverage ratio). Use that information to
calculate relevant trading multiples such as P/E, EV/EBITDA, EV/EBIT, EV/Sales.
4. Benchmark the Comparable Companies. Lay out the financial statistics and
ratios alongside those of the target and see the similarities and differences.
5. Determine Valuation. Use the medians for the relevant trading multiples such
as EV/EBITDA as the basis for extrapolating an initial range. Narrow down the
range by selecting the multiples of the closest comparables (2 to 3 companies).
The apply the chosen range to the target's relevant financial statistics to produce
an implied valuation.
\How do you do market value/market capitalization valuation? Can you do it for
private companies? - ANS - No, market value of equity is only available for
publicly traded companies. It is calculated by
Questions
A company has had positive EBITDA for the past 10 years, but it recently went
bankrupt. How could this happen? - ANS - 1. The company is spending too much
on Capital Expenditures - these are not reflected at all in EBITDA, but it could still
be cash-flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3. The company's debt all matures on one date and it is unable to refinance it due
to a "credit crunch" - and it runs out of cash completely when paying back the
debt.
4. It has significant one-time charges (from litigation, for example) and those are
high enough to bankrupt the company.
\A company with a higher P/E acquires one with a lower P/E - is this accretive or
dilutive? - ANS - You can't tell unless you also know that it's an all-stock deal. If
it's an all-cash or all-debt deal, the P/E multiples of the buyer and seller don't
matter because no stock is being issued. Sure, generally getting more earnings
for less is good and is more likely to be accretive but there's no hard-and-fast rule
unless it's an all-stock deal.
\A stock is trading at $5 and another stock is trading at $50. Which has greater
growth potential? - ANS - It depends. The stock with the higher growth potential
is most likely the stock with the lower market cap,
so if the $5 stock has 1 billion shares outstanding and the $50 stock has 10,000
shares outstanding, the $50 stock would most likely have higher growth potential.
\All else equal, how would one company prefer to pay for another? - ANS - Since
cash is the cheapest source of capital, it would be the preferred way to purchase
another company if the purchaser had sufficient cash. If a company feels its stock
price is inflated, it would prefer to use that to pay for the acquisition. Really
depends on the acquisition, companies, and market.
\Are most mergers stock swaps or cash transactions and why? - ANS - In strong
markets many mergers are stock swaps mainly because the prices of company
stock are so high, but also because the current owners may desire stock in the
new company as they anticipate further growth in a strong market
\As the proportion of debt in the capital structure increases, WACC does what? -
ANS - WACC decreases due to the tax deductibility of interest expense
\Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS -
First, the Liabilities & Shareholders' Equities side is adjusted - the new debt is
,added on, and the Shareholders' Equity is replaced by however much equity the
private equity firm is contributing.
On the Assets side, Cash is adjusted for any cash used to finance the
transaction, and then Goodwill & Other Intangibles are used as a "plug" to make
the Balance Sheet balance.
\Can you name two companies that you think should merge? - ANS - This is
another question testing your awareness of what is going on in the markets.
There is no right or wrong answer to this question, just have in mind two
companies that you believe would benefit from merging, and have a well
formulated rationale for a the merger (think synergies, gain foothold in a new
market, consolidation of operations, or brand recognition).
\Company XYZ released increased quarterly earnings yesterday, but their stock
price still dropped. Why? - ANS - First, the entire market or the industry to which
XYZ belongs could have been down on the day, which had more of an impact
than the company's positive earnings. More likely, however, is that the increased
earnings figures they reported were not as high as the Wall Street analysts'
estimates.
\Describe a company's typical capital structure. - ANS - A company's capital
structure is composed of several layers of both debt and equity. Debt can be
senior (i.e. bank loans), mezzanine, then subordinated where senior is paid off
first in the event of a bankruptcy, then mezzanine then subordinated. Equity is
either preferred or common stock. Preferred stock combines some features of
both debt and equity: it can appreciate in value, and also pays out a consistent
dividend but it has very little or no rights in a bankruptcy. Common stock is
traded on the exchanges, if the company is public. In the event of bankruptcy,
common stockholders have the least claim to assets in the event of liquidation,
and therefore they bear the highest level of risk and earn the highest return on
investment.
\Difference between Cost of goods sold (COGS) and Selling, general, and
administrative (SG&A)? - ANS - Cost of goods sold is the expense most directly
involved in creating revenue. Costs involved in operating the business are SG&A.
This category includes marketing, salaries, utility bills, technology expenses and
other general costs associated with running a business.
\From the three main financial statements, if you had to choose two to analyze a
company, which would you choose and why? - ANS - If I had to choose two
financial statements, I would choose the Balance Sheet and the Income
Statement. As long as I had the Balance Sheets from the beginning and end of the
period, as well as the end of period Income Statement, I would be able to generate
a Cash Flow Statement.
,\How are the three financial statements connected? - ANS - The bottom line of the
Income Statement is Net Income. Net income links to both the Balance Sheet and
Cash Flow statement.
In terms of the balance sheet, net income flows into stockholder's equity via
retained earnings. Retained earnings is equal to the previous period's retained
earnings plus net income from this period minus dividends (from this period).
In terms of the cash flow statement, Net Income is the first line as it is used to
calculate cash flows from operations. Also, any non-cash expenses or non-cash
income from the Income Statement (i.e., depreciation and amortization) flow into
the Cash Flow Statement and adjust net income to arrive at cash flow from
operations.
Any balance sheet items that have a cash impact (i.e., working capital, financing,
PP&E, etc.) are linked to the cash flow statement since it is either a source or use
of cash. The net change in cash at the bottom of cash flow statement and cash
from the previous period's balance sheet comprise cash for the current period.
\How can a company raise its stock price? - ANS - Any positive news about the
company can potentially raise the stock price.
1. A company can repurchase stock, which lowers the number of shares
outstanding and therefore increases the value per share.
2. It can improve operations to produce higher earnings, causing its EPS to be
higher than anticipated by industry analysts, which will send a positive signal to
the market
3. It can announce a change to its organizational structure such as cost-cutting or
consolidation, which would lead to increased earnings
4. It can announce an accretive merger or an acquisition that will increase
earnings per share
\How could a firm increase the returns on an LBO acquisition? (4 ways) - ANS - 1.
Increase the sale price when the firm monetizes its investment.
2. The firm could negotiate a lower purchase price, which would have a similar
effect to raising the selling price.
3. Finally, the private equity firm could increase the amount of leverage or debt on
the deal. The higher the leverage, the higher the return, all else equal.
4. In modeling the returns, you could increase your projections for the acquired
company's earnings and cash flows.
\How do you apply the 3 valuation methodologies to actually get a value for the
company you're looking at? - ANS - Sometimes this simple fact gets lost in
discussion of Valuation methodologies. 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.
Example: If the median EBITDA multiple from your set of Precedent Transactions
is 8x and your company's EBITDA is $500 million, the implied Enterprise Value
would be $4 billion
\How do you calculate a company's terminal value? - ANS - 1. Exit Multiple
approach--> Assign a valuation multiple (such as EV/EBITDA) to the final year's
FCF.
2. Perpetuity Method-->Multiply final year's free cash flow by 1 plus the growth
rate (inflation or GDP rate) divided by the WACC minus the growth rate
\How do you calculate the number of fully diluted shares? In what context would
you need to calculate number of fully diluted shares? - ANS - Treasury stock
method. Finding the number of current shares outstanding, adding the number of
options and warrants that are currently "in the money," and then subtracting the
number of shares that could be repurchased using the proceeds from exercising
the options and warrants.
Used when calculating Equity Value.
\How do you determine which valuation methodology to use? - ANS - Usually the
best valuations are a combination of a few of the methodologies. But if one
seems more accurate than the others than it could be weighted more heavily.
\How do you do comparable company analysis? (5) - ANS - 1. Select the Universe
of Comparable Companies (find companies with similar business and financial
characteristics)
2. Locate the necessary financial information via SEC files, equity research
reports, and press releases.
3. Calculate the key statistics, ratios, then trading multiples for the comparable
universe. I.E. Size (Equity value, Entreprise value, Net Income), Profitability
(Gross Profit Margin, EBITDA, EBIT), Growth Profile, Return on Investment, Credit
Profile (Leverage ratios, credit ratings, coverage ratio). Use that information to
calculate relevant trading multiples such as P/E, EV/EBITDA, EV/EBIT, EV/Sales.
4. Benchmark the Comparable Companies. Lay out the financial statistics and
ratios alongside those of the target and see the similarities and differences.
5. Determine Valuation. Use the medians for the relevant trading multiples such
as EV/EBITDA as the basis for extrapolating an initial range. Narrow down the
range by selecting the multiples of the closest comparables (2 to 3 companies).
The apply the chosen range to the target's relevant financial statistics to produce
an implied valuation.
\How do you do market value/market capitalization valuation? Can you do it for
private companies? - ANS - No, market value of equity is only available for
publicly traded companies. It is calculated by
