The Ultimate Investment Banking Cheat Sheet II: Actual Interview Questions and Answers
Earlier this month, we posted a cheat sheet of actual interview questions asked of Ivy League MBA students by U.S. investment banks. We had more than we knew what to do with. Below are the remaining, along with suggested answers compiled by the students themselves.
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 to FIFO in an inflationary environment, it means that 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.
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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).
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 finda present value of all future cash flows of the firm that are available to stakeholders. This can be done using WACC or APV.
- 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 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.
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.