Investment banking interview questions, with suggested answers
MBAs are a useful people, if for no other reason than the help they can provide to the investment bankers of future. Below are a collection of real questions that were asked of investment banking candidates at the MBA level, along with suggested answers that they later put together. If you find yourself on a 'superday' interview at a big bank, you can bet that you'll be asked at least of few of these questions. Disagree with an answer? Let us know in the comments below.
Explain an LBO (leveraged buyout) to my grandmother, who knows nothing about finance
An LBO is a transaction in which a party purchases a business and brings it private. The transaction is funded using a large portion of debt. Three main characteristics of LBOs – 1) high debt, which is intended to be paid down, 2) incentives, managers are given greater stake in business, 3) private ownership, many LBOs go public again once debt has been paid down.
If a company was looking to raise debt or equity, what are the 3 most important questions to ask?
1) Whether they will generate enough cash flows to cover interest obligations. How many multiples in excess of current interest payments is their operations generating in cash flow?
2) What is their current capital structure and can they bring on more debt and leverage the company further without being too levered versus industry and peers so that their credit rating and stock price isn’t negatively impacted.
3) What is the current equity value? If the stock price is appropriately valued or has a potentially high value, then equity might be better.
How does FED change the interest rates?
The FED can adjust the Federal Funds Rate which is the interbank overnight rate at which the FED lends money. The lower the Federal Funds Rate, the lower real interest rates. The FED can also adjust the money supply through the purchase or sale of government bonds, whereby affecting inflationary expectations which will adjust nominal interest rates.
What would be the difference between the interest coverage rate of a senior board vs. junior debt?
Interest coverage rate is operating income divided by interest expense (EBIT/interest). This basically measures how much leadway a company has between its earnings and interest payments (a hurdle they must keep jumping to avoid default).
In event of bankruptcy, the senior debt would have to be paid before the junior. However, when using the interest coverage ratio to analyze a company’s ability to keep up with their debt payments, I would look at the EBIT divided by ALL forms of debt as a failure to make payments for any form of debt results in default.
How does Net Income flow into the Balance Sheet, Income Statement and Statement of Cash Flows?
The Net Income on the bottom line of the income statement gets added into the retained earnings on the balance sheet. The net income from the income statement is also the starting line of the statement of cash flows.
How do you value a company?
There are five common valuation methodologies.
- Trading Range (the range the stock has been trading in during the past 52‐weeks). If we trust the market we should assume this is a reasonable place to start our analysis.
- Discounted Cash Flow (DCF), also called Intrinsic Value, seeks to find a present value of all future cash flows of the firm that are available to stakeholders. This can be done using WACC (weighted average cost of capital) or APV (adjusted present value).
- Public Comparables looks at peer companies to determine how the market values companies in the same or similar businesses using multiples including P/E and EV/EBITDA.
- Acquisition Comparables, also called Deal Comps or Precedent Transactions, looks to see how much acquirers recently paid for similar businesses.
- Asset Value, also called liquidation or breakup value, examines what you can sell the company’s assets for (including real estate).
In addition, valuation can be framed through:
- Leveraged Buyout looks at what a financial sponsor could pay considering a target IRR (internal rate of return) and the debt capacity of the firm.
- Merger Consequences Analysis is actually an affordability analysis (what can an acquirer pay) rather than an analysis of the value of a target.
Describe how to value a privately held company
Valuation for a private company is the same as the valuation of a public company with some complications, particularly as it relates to DCF (discounted cash flow). Because a private company has no publicly traded equity, a beta cannot be directly computed.
To find the cost of equity (KE)
1. Estimate the total value of the private company based on comparables (use average EV/EBITDA)
2. Deduct the value of the debt to get estimated “market” value of equityor internal use only
3. Get the average levered beta from the comparables and unlever it
4. Re-lever the beta for the private company based on the target D/E (debt-to-equity) ratio
5. Calculate Ke based on CAPM (capital asset pricing model)
To find the cost of debt (Kd)
1. Some privately held companies have publicly traded debt – so look up trading yields to estimate Kd
2. Alternatively, estimate what the credit rating of the company would be based on comparables (look at credit statistics)
3. For estimated credit ratings, use current market yields for similarly rated companies to determine Kd
Then calculate WACC as normal and DCF as normal
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Suppose your client had significant excess cash on the balance sheet. How would you recommend its use?
First, you must define what you think is significant excess cash. For companies that are in cyclical industries, paying out large amounts of cash might leave the company unprepared for a subsequent market downturn. Once you have established that your client does indeed have excess cash on the books, there are a few tried and tested uses for excess cash.
- Invest in positive net present value (NPV) projects (acquisitions, CapEx, R&D)
- Return money to shareholders in the form of share repurchases, dividends, and debt repayments
- Must take into account Kd, Ke, WACC, and tax considerations
Why might two companies have a different cost of equity?
They have different betas. The beta of a stock measures that stock’s sensitivity to movements in the overall stock market. More volatile stocks have a beta higher than one; less volatile stocks have a beta less than one.
In an all-stock transaction, a company with a lower P/E is buying a company with a higher P/E. What is the effect of this transaction? What happens if you use debt/cash to make part of the above transaction? Why?
The point of this question is to get you to say whether the acquisition is accretive or dilutive. Generally, companies do not want dilutive acquisitions since they destroy shareholder value. The combined company’s ratio will have a higher P/E than the acquirer originally did (but lower than the seller, obviously). However, since more shares will have to be issued by the lower P/E company (than would have been needed if the acquirer had a higher P/E ratio), the combined company will have a lower EPS (dilutive acquisition). Typically, the company with the higher growth rate and growth potential commands a higher P/E . The opposite is true for companies with lower P/E ratios. If you throw in debt/cash, fewer shares will be needed for the acquisition, thus the transaction will be less dilutive, and potentially accretive.
If a company changes its method of inventory valuation from LIFO to FIFO in an inflationary environment, what is the impact on the three financial statements?
If a company changes its method of inventory valuation from LIFO (last in, first out) to FIFO (first in, first out) in an inflationary environment, it means that the cost of goods sold (COGS) will fall, since goods purchased earlier are being charged to COGS and ending balance of inventory will rise since recently purchased goods will now be reflected in ending inventory. This means that income will rise in the I/S, and value of assets will increase in the B/S.
Of the three main valuation methods (DCF, Public comparables and transaction comparables), rank them in terms of which gives you the highest price. Which one typically yields the highest valuation?
Simple answer – it depends. Depends on discount rate in DCF model, depends on the comparable companies used, depends on whether the market is hot/cold and the companies are overvalued/undervalued for no good reason. Generally, however, transaction comps would give the highest valuation, since a transaction value would include a premium for shareholders over the actual value. The second highest valuation would probably be the DCF, since there are a lot more assumptions that are involved (growth rate, discount rate, terminal value, tax rates, etc), but it can also be the most accurate depending on how good the assumptions are.
If you had to pick one statement to look at (balance sheet, cash flow, income statement), which one would it be and way?
No right answer – can go with whichever one you like. Each has its advantages: income statement – shows the profitability of a company, trends in sales/expenses, margins, etc; balance sheet is a great way to see what items make up the company’s assets and who the company needs to pay back for those assets. Personally, I would go with the cash flow statement. At the end of the day, cash is king. A company that has positive income but very little cash is in deep trouble. Cash flows are used for DCF models, not net income. The cash flow statement allows observing important performance metrics from both income statements and balance sheets such as net income, depreciation, sources and uses of funds, changes in assets and liabilities.
Name two common ways companies can manage their earnings?
1) Changing accounting practices under GAAP (e.g. switching between S‐L Depreciation and Double Declining Balance; changing between LIFO and FIFO; etc…).
2) “Big bath” (taking negative hits in an already bad year and basically just writing the year off) or “Cookie Jar Accounting” (reducing top‐line revenues in good years and keeping them on reserve for bad years).
What type of a company would be a good candidate for an LBO?
It is difficult to define the characteristics of a typical LBO candidate, but the following things are very important:
- Good management (MOST IMPORTANT): could be new or old, but they need to be motivated, competent, qualified, and correctly incentive.If the management is old, you probably want to give them some equity interest in the company as an incentivizing tool. If the management is new, you need to find the right incentives.
- Strong cash flow: cash flow should be healthy, steady, and predictable to allow for easy borrowing from creditors.
- Massive required cash outflows for CapEx and R&D shouldn’t be necessary to the ongoing success of the company.
- Exit strategy: Financial sponsor should have a strategy for exiting the company within an appropriate timeframe by either: selling the company to a strategic or financial buyer or IPOing the company. The exit multiple should be at least the acquisition multiple assuming the sponsor has improved the profitability of the profitability of the portfolio company.
- Market niche: good niche in the markets for their product lines.
- Steady stream of revenues and a client base that is not overly dependent on a few large customers.
- Steady growth pattern, as growth in profitability will accelerate the repayment of debt; growth will also help the valuation of the company if the sponsor is looking to IPO the company.
- Work force: must be flexible and willing to participate, as business plans change and assets are often redeployed after an LBO.
- Skeletons in the boardroom: litigation or environmental concerns could be dealbreakers since these issues could make it difficult to attain financing.
- Technology: state‐of‐the‐art technology helps ensure maximum efficiency and profitability; also decreases need for large CapEx in the future.
- Buried treasure: deal‐makers are always looking for untapped or hidden resources such as, real estate, exclusive licenses, rights, patents, contracts, franchises, etc… from which maximum value has yet to be unleashed.
- Costs: a company must have the capacity and willingness to cut costs.
Define Beta for a layman
Beta tells you how much the price of a given security moves relative to movements in the overall market.
A Beta of 1 means that if the market moves, the stock moves in unison with the market.
A Beta < 1 means that if the market moves a certain amount, the stock will move less than that amount
A Beta >1 means that if the market moves a certain amount, the stock will move more than that amount.
What kind of multiples should I use to do a comparable company analysis on ABC company? How would I calculate them?
Common ratios used to compare equity performance:
- Price / EPS
- Market Value / Net Income
- Market Value / Book Value
- Price to Earnings / Growth Rate (“PEG Ratio”)
Common ratios used to compare enterprise performance:
- Enterprise Value (EV) / EBITDA
- EV / EBIT
- EV / Sales (generally only appropriate for volume driven businesses or those with negative earnings)
How would you evaluate the credit worthiness of a company if you were a bank?
A creditor’s measure of an individual’s or company’s ability to meet debt obligations. Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:
- Limit the borrower’s ability to weaken their balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.
- Allow for monitoring the debt requiring audits and monthly reports
- Allow the lender to decide when he can recall the loan based on specific events or when financial ratios like debt/equity, or interest coverage deteriorate.
Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively.
Visualize the income statement of any company you have audited. Take me through its key line items.
- Revenues: Source of income that arises from the sale of goods and/or services and is recorded when it is earned.
- Expenses: Costs incurred by a business over a specified period of time to generate therevenues earned during that same period of time. Commonly includes COGS and SG&A.
- Net Income: Revenue minus expenses.
How do you value companies in emerging markets other than DCF?
There are three major ways to valuation:
- Comparable Companies
- Precedent Transactions
- DCF Analysis
- Liquidation Valuation – valuing company’s assets assuming they are sold off then subtracting liabilities to determine how much capital an equity investor receives.
- Replacement Value – based on cost of replacing assets.
- LBO Analysis – determine how much a PE firm could pay for a company to hit a target IRR in the range of 20‐25%.
Valuations in emerging markets. How would you value a bond issued by a company in an emerging market?
- Comparable companies and their bonds
- Study economic trends – inflation, GDP growth
- Determine risk and associated risk premium bond purchasers willing to pay in that market
Advise a client how to expand into the consumer market in Mexico. (Valuation issues, whose WACC would you use etc.).
- Use acquirer’s WACC
- Study economic trends – inflation, GDP growth – and government involvement
- Review different industries within the consumer market
- Determine which company/industry has the lowest risk
- Company comparables
- Review debt possibilities
- DCF issues – difficult to project over 10-year period