The purpose of this article Investment Banking Questions and Answers is simply to help you learn about the investment banking interview topics. As a fresher in this field, I am sure you may have had jitters as to what and how to prepare for your first step in this finance world. There could be unlimited number of questions that can be asked on investment banking topics and since it is difficult to cover all of them here, we would be discussing a few of them which are important.
While reading through this write up, I would suggest you actively keep answering the questions yourself before checking the correct answer. This will help you develop the habit of brainstorming and answering these questions in a structured way. Please consider this as a first draft of the article. I will keep on regularly updating this with more questions and answers based on your feedback.
The interview nowadays does not have the typical questions being asked which include the basics on financial concepts. The interviewers want the candidates to think and avoid theories which everyone usually knows. Also since these questions are technical ones there would always be a correct answer, so in case you find yourself not knowing a particular answer, don’t try and fake one. It is always better to confess that you don’t know.
The following are the question and answers on investment banking topics we are going to touch upon in this article;
- Corporate Finance
- Enterprise value/Equity value
- Merger and Acquisitions (M&A)
- Initial Public Offering (IPO)
Tell me about the three most important financial statements and what is their significance
- The three main financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. Speaking about their significance, the income statement provides with the revenue and expenses of a company and shows the final net income that it has made over a period of time.
- The balance sheet signifies the assets of a company such as plant, property & equipment, cash, inventory and other resources. Similarly, it reports the liabilities which includes the Shareholders equity, debt and accounts payable. The balance sheet is such that the assets would always equal the Liabilities plus shareholders equity.
- Lastly, there is the cash flow statement which reports the net change in Cash. It gives the cash flow from the operating, investing and financing activities of the company.
Incase you have the chance to evaluate the financial viability of the company which statement would you choose and why?
- It would be the cash flow statement. The reason being that it provides a true picture of how much cash the business is generating in actual terms.
- The cash flows are hence the main thing you actually pay attention to while you are analyzing the overall financial health of the business.
Let’s say that the depreciation expense goes up by $100. How would this affect the financial statements?
- Income Statement: With the depreciation expense decreasing Operating Income would decline by $100 and assuming a 40% tax rate, Net Income would go down by $60.
- Cash Flow Statement: The Net Income at the top of the cash flow statement goes down by $60, but the $100 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $40. With no further changes, the overall Net Change in Cash goes up by $40.
- Balance Sheet: On the asset side because of the depreciation the Plants, Property & Equipment goes down by $100, and Cash is up by $40 from the changes on the Cash Flow Statement.
Imagine a situation where a customer pays for a mobile phone with a credit card. What would this look like under cash-based vs. accrual accounting?
- In case of cash based accounting the revenue would not be accounted for until the company charges the customer’s credit card, obtains an authorization and deposits the funds in its bank account.
- After this this entry would be showed as revenue in the income statement and also as cash in the balance sheet.
- As against in accrual accounting, it would be shown as Revenue right away. But it would yet not appear as Cash in the Balance Sheet, rather it will be shown as Accounts Receivable.
- Only after the amount is deposited in the company’s bank account, it would be reported as cash.
What is the formula for calculating the Weighted Average Cost of Capital (WACC)?
- WACC = Cost of Equity * Proportion of Equity + Cost of debt * Proportion of debt (1-tax rate). Where, The cost of equity calculated using the Capital Asset Pricing Model (CAPM).
- The formula is Cost of Equity = Risk free rate + Beta* Equity risk premium
- Cost of Debt = The risk-free rate is basically the yield of a 10-year or 20-year US Treasury
- Beta is calculated based on how risky are the comparable companies and equity
- Risk Premium is the percent by which stocks are expected to out-perform “risk-less” assets.
- The proportion is basically the percentage of how much of the company’s capital structure is taken up by each of the components.
There are two companies P and Q which are exactly the same, but one P has debt whereas Q doesn’t have any. In this case, which of the two companies would have a higher WACC?
- In this scenario company Q would have a higher WACC, because debt is less expensive than equity.
The interviewer at this juncture might ask you the reasons why debt is considered to be less expensive?
- The answer is as follows; Interest on debt is tax-deductible (hence the (1 – Tax Rate) multiplication in the WACC formula).
- Debt holders would be paid first in a liquidation or bankruptcy.
- Instinctively, interest rates on debt are usually lower than the Cost of Equity numbers you see.
- As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will.
Describe the ways through which a company is valued
Precedent transaction analysis
- This is when you look at how much others have paid for similar companies to determine how much the company is worth.
- To use this method effectively you need to be extremely familiar with the industry of the company you are valuing as well as the normal premiums paid for such a company.
Comparable Company Analysis
- Comparable company analysis is similar to Precedent Transactions Analysis except you are using the whole company as an assessment unit, not the purchase of a company.
- So to use this method you would also look for out similar companies to the one you are valuing and look at their price to earnings, EBITDA, stock price and any other variables you think would be an pointer of the health of a company.
Discounted Cash Flow Analysis
- This is when you use future cash flow, or what the company will make in the upcoming years, to determine what the company is worth now.
- To calculate DCF you need to work out what the probable or future cash flow is for a company for the next 10 years.
- Then work out how much that would be in today’s terms by “discounting” it at the rate that would give a return on investment.
- Then you add in the terminal value of the company and that will tell you how much the company is worth.
Which are the situations in which we do not use a DCF in the valuation?
- We would not use a DCF in the valuation if the company has an unstable or unpredictable cash flow or when debt and working capital serve a fundamentally different role.
- For example financial institutions like banks do not re-invest debt and working capital forms a major part of their balance sheets- so here we do not use a DCF for such companies.
List the most common multiples used in valuation
These are relative valuation techniques given below-
Briefly explain leveraged buyout?
- A leveraged buyout (LBO) is when a company or investor buys another company using mostly borrowed money, loans or even bonds to be able to make the purchase.
- The assets of the company being acquired are usually used a collateral for those loans.
- Sometimes the ratio of debt to equity in an LBO can be 90-10.
- Any debt percentage higher than that can lead to bankruptcy.
Explain PEG ratio?
- This stands for Price/earnings to growth ratio and takes the P/E ratio and then accounts for how fast the EPS for the company will grow.
- A stock which is growing rapidly will have a higher PEG ratio. A stock that is fine priced will have the same P/E ratio and PEG ratio.
- So if a company’s P/E ratio is 20 and its PEG ratio is also 20 some might argue that the stock is too expensive if another company with the same EPS has a lower P/E ratio, but that also means that it’s growing faster because the PEG rate is 20.
Give the formula for Enterprise Value
- The formula for enterprise value is: market value of equity (MVE) + debt + preferred stock + minority interest – cash.
Why do you think the cash is subtracted in the formula for enterprise value?
- The reason why cash is subtracted is because it is regarded as a non-operating asset and because Equity Value indirectly accounts for it.
Why do we consider both enterprise value and equity value?
- Enterprise value signifies the value of the company that is attributable to all investors, whereas equity value represents the portion available to equity shareholders.
- We consider both because equity value is the number the public at large sees, while enterprise value represents its true value.
What does it signify, if a company has a negative enterprise value?
- The company could have negative enterprise value when the company has extremely large cash balances or an extremely low market capitalization or both.
- This could occur in companies which are on the brink of bankruptcy or Financial institutions such as the banks, which have large cash balances.
Merger & Acquisition (M&A)
Briefly explain the process of a buy-side M&A deal
- Lots of time is spent completing research on the potential acquisition targets and with the company you are representing, go through multiple cycles of selection and filtering.
- Based on the feedback from them narrow down the list and decide which ones are to be further approached.
- Meetings are conducted to gauge the receptivity of potential seller.
- Serious discussions with the seller take place which calls for in depth due diligence and figuring out the offer price.
- Negotiate the price and other key terms of the purchase agreement.
- Announce the M&A deal/transaction.
Briefly explain accretion and dilution analysis
- In order to gauge the impact of an acquisition to the acquirer’s Earnings per share (EPS) and also compare it with the company’s EPS if acquisition would have not been executed accretion and dilution analysis is undertaken.
- In simple words we could say that in the scenario of the new EPS being higher, the transaction will be called “accretive” while the opposite would be called “dilutive.”
Given a situation where a company with a low P/E acquires a company with a high P/E in an all-stock deal, will the deal likely be accretive or dilutive?
- Other things being equal, in a situation where a company with a low P/E acquires a company with a high P/E, the transaction would be dilutive to the acquirer’s Earnings per Share (EPS).
- The reason for this is that the acquirer will have to shell out more for each rupee of earnings than the, market values its own earnings.
- Therefore in such situation the acquirer would have to issue proportionally more shares in the transaction.
What are synergies and its types?
- Synergies are where the buyer gets more value than out of an acquisition than what the financials would predict.There are basically two types of synergies –
- Revenue synergy: the combined company can cross sell products to new customers or up sell new products to existing customers. Because of the deal it could be possible to expand in new geographies.
- Cost synergies: the combined company could amalgamate buildings and administrative staff and can lay off redundant employees. It could also be in a position to close down redundant stores or locations.
How does Goodwill get created in an acquisition?
- Goodwill is an intangible asset that mostly stays the same over years and is not amortized like other intangibles. It only changes when there is an acquisition.
- Goodwill is basically the valuable assets which are not shown like financial assets on the balance sheet. For example, brand name, customer relationship, intellectual property rights etc.
- Goodwill is basically the subtraction of the book value of a company from its equity purchase price. It signifies the value over the “fair market value” of the seller that the buyer has paid.
Initial Public Offer (IPO)
Briefly describe what would you do if you are working on an IPO for a client?
- First of all we would meet the client and gather all the necessary information such as their financial details, customers and learn about the sector they belong to.
- After this, you would meet other bankers and lawyers the registration statement which would describe the company’s business and market to its investors.
- Next you would receive comments from the SEC and keep revising the document until it is acceptable.
- Now you would spend the coming weeks in organizing road shows where you would present the company to the institutional clients and also convince them to invest in them.
- After raising capital for the clients the company would start trading on the exchange.
What are the benefits of a company getting listed on an exchange?
- It is an important step for a company to achieve liquidity
- There are certain investors who would want to invest only in exchange listed issuers
- It helps the company establish a recognized value for their stock which in turn could also help it use stock for acquisitions rather than cash
What is in a pitch book?
Pitch book depends on the kind of deal the company is pitching for but the common structure would include:
- Bank credentials to prove their expertise in completing similar deals before.
- Summary of company’s options
- Appropriate financial models and valuation
- Investment Banking Charts
- Potential acquisition targets or potential buyers
- Summary and key recommendations
Tell me a company you admire/follow and pitch me a stock
You need to structure your answer for such questions keeping in mind the following;
- Give the name of the stock you have been following and the reason for the same
- Quickly summarize what the company’s business
- Provide a quick overview of the financials to indicate its size and how profitable it is. Also if you can provide with specific details on Revenue, EBITDA multiples, or its P/E multiple
- Provide reasons as to how the stock or their business is more attractive than its rivals.
- You should speak about the trend the stock has had at least in the past 3-5 years.
- You could also talk about the future outlook for the company.
When buying a company why do private equity firms use leverage?
- The private equity firm reduces the amount of equity to the deal by using significant amounts of leverage (debt) to help finance the purchase price.
- By doing this, it will increase the private equity firm’s rate of return substantially when exiting the investment.
What is convexity?
- This is a more accurate measure of the relationship between yield and price changes in bonds in relation to the change in interest rates.
- Duration calculates this as a straight line, when in actuality it is a convex curve, hence the name.
- This is used as a risk calculation because it can tell how a bond yield will respond to interest rate changes.
Define risk-adjusted rate of returns
- When looking at an investment you cannot simply look at the return that is projected.
- If the profit from investment A is greater than the profit from investment B you may immediately want to go with investment A.
- But investment A might have a greater chance of a total loss than investment B so even though the profit may be larger, it is a lot riskier and therefore not necessarily a better investment.
- Adjusted rate of return is when you not only look at the return that an investment may give you, but you also measure the risk of that investment.
- The adjusted rate of return is usually denoted as a number or rating.
- If you are technically minded you may also want to mention the ways that risk is measured: beta, alpha, and the Sharpe ratio, r-squared and standard deviation.
The key to successfully answering these technical questions is to apply the concepts you’re learning and test yourself. Hope this has helped you learn some important question and answers on investment banking topics and brings you steps closer to crack the high profile interviews. All the best
P.S. Kindly note we have only touched upon the technical questions and their types, apart from these you would also have to prepare for the personal questions, why investment banking questions and brain teasers which are usually part of testing the candidates.