If you Google “Investment Banking interview questions,” chances are you will find a ton of resources that can make the whole process seem rather intimidating. Make no mistake, breaking in is by no means easy. But it is very possible and achievable if you are organised and well prepared.
Interview questions can vary a great deal and tend to be on your story, fit, recent deals, current affairs and technical questions. Our focus here is to take you through some important technical questions that come up frequently in Investment Banking interviews. These are equally relevant if you are interviewing for positions in Equity Research, Private Equity or Asset Management.
Q- What are the 3 main financial statements?
The main financial statements are balance sheet, profit & loss statement and cash flow
- A balance sheet provides a summary of assets, liabilities and shareholders’ equity. It indicates the financial position of the company at a point in time.
- Income or P&L provides information about incomes and expenses. It indicates the financial performance of the company over a period of time.
- Cash flow focuses on the movement of cash i.e. cash inflows & outflows.
Q- Creditors have decreased by 20 and Debtors have increased by 20. What’s the impact on cash flows?
An increase in liabilities is a cash inflow and vice versa. Increase in assets is a cash outflow and vice versa. When creditors or current liabilities decrease by 20, it results in a cash outflow of 20. Similarly when debtors or current assets increase by 20, it results in a cash outflow of 20. Therefore the overall impact is an outflow of 40.
Q- Receivables should be shorter or longer?
Shorter the better. A company can manage cash flows better when it is able to realised cash from sale of goods or services faster.
Q- Why is EBIT used for calculating ROCE?
- A company can be financed by both debt and equity. Capital employed is the sum of both debt and equity capital.
- As a general rule, there should be consistency between numerator and denominator. Any profit metric that is after interest, belongs only to equity shareholders by default. Therefore, when the denominator has capital employed, it is important to ensure that the numerator has a profit metric that is attributable to both debt and equity holders.
- Return on Capital Employed or ROCE is calculated by dividing EBIT and average capital employed
Q- Why is net income used to calculate ROE?
Just as ROCE measures the return for all providers of capital, return on equity or RoE measures the return for equity investors only. As a result, RoE is calculated by dividing net income by average shareholders’ equity.
Q- A company is highly levered, what does it mean? What is better, high or low leverage?
Leverage is defined as assets over equity. A higher ratio implies that the equity base is low which means that assets are financed by liabilities. If assets are mostly financed by liabilities like debt, then leverage can be a risky proposition.
In an economic expansion, RoE can be high due to a low equity base. But in a contraction, RoE can be low or negative due to higher interest expense and lower operational efficiency.
Q- What is the difference between depreciation and impairment?
Depreciation is a reduction in value of an asset over a period of time due to natural wear and tear. Impairment is a sudden and irreversible loss in value of an asset.
Q-What is an operating lease and a finance lease?
A lease is a contractual agreement between a lessor and a lessee. The lessor is the owner of the asset, while a lessee is the user or tenant of the asset. A lease gives the lessee the right to use a specific property or asset, for a specific duration, in return for lease payments.
A lease can be classified as a finance lease or an operating lease.
For a lease to be classified as a finance lease, the following conditions should be satisfied:
- Lease term should be for a major part of the asset’s economic life, even if title is not transferred
- At inception of the lease, present value of minimum lease payments amounts to at least 90% of leased asset’s fair value
- The lease transfers ownership of the asset to the lessee by the end of the lease term
Leases that are not finance leases are operating leases. An operating lease is usually for a shorter term compared to the useful life of the asset being leased
Q- Name an industry where leases are widely used?
Companies across sectors usually tend to have a mix of finance and operating leases. But in the airlines and retail sectors, the use of operating leases is particularly prominent.
Q- A company with positive EBITDA over the last 10 years recently went bankrupt. How could this happen?
EBITDA is a measure of operating profit which is based on accruals accounting. It is not a substitute for cash flows. If a company fails to convert revenue or profit generation into cash flows then it is bound to fail. More specific reasons for failure could be:
- High capex
- High interest expense, debt burden
- Negative working capital (longer receivables)
- Cash crunch or liquidity issues
Q- How do you value a business? What are the main company valuation techniques?
There are various ways to value a company and the most commonly used approaches are:
- Trading comparables, a relative valuation methodology based on current market prices of publicly traded peers which determines whether the company is undervalued or overvalued.
- Transaction comps, a relative valuation methodology based on precedent transactions which determines how much an acquiror has paid for a target company.
- Discounted Cash Flow or DCF gives intrinsic value and involves forecasting cash flows a business is expected to generate in the future and then discounting these to present terms at an appropriate discount rate.
Valuation can be a subjective exercise and using different methodologies can give a broad valuation range
Q- What are trading compsor comparable company analysis?
Trading comps are a multiples based valuation methodology. First, trading multiples are calculated for a particular company, then these are compared to multiples of industry peers to determine whether the company is over valued or under valued. Therefore, this is a relative valuation methodology
Q- What is Equity value?
Equity value represents the market value of shareholders’ equity and is calculated by multiplying a company’s share price by its fully diluted shares outstanding
Q- What is Enterprise Value or EV?
Equity value measures the value of a company attributable to share holders. But a company may also have debt investors, bondholders or other debt providers. Debt is an important component of the overall capital structure.
Enterprise value or EV represents the value of a company from the perspective of all capital providers and is calculated by adding market cap and net debt. Since EV represents the value of the business for both equity and debt holders, it is also referred to as firm value or aggregate value
Q- What is the treatment of preferred stock in company valuation?
Holders of preferred stock have a fixed claim on the business. Preference dividends must be paid out before anything is paid out to equity shareholders. As a result, preference shares are considered senior to ordinary shares. For valuation purposes, Analysts tend to treat preferred stock as debt. This means that preferred stock is added to EV like other debt items.
Q- Why are earnings normalized?
To get an accurate picture of underlying performance, financials are typically normalised for stock based compensation, impairment , amortisation and other non recurring, exceptional or one time items by Analysts and company management alike.
At the operating profit level i.e EBIT, expenses are simply added back and incomes are subtracted. To adjust at the earnings or net income level, adjustments are the same as at the operating profit level, but post taxes.
Q- What is EBITDA and why is it popular?
EBITDA stands for earnings before interest, taxes, depreciation & amortization and is perhaps the most widely used metric to gauge a company’s performance. It is popular because:
- It’s easy to understand, interpret and compare
- Is not impacted by capital structure, depreciation and taxation which makes it possible to make comparisons
Q- For a growing business, do you expect valuation multiples to increase or decrease as you go into the future?
For a growing business, valuation multiples decrease into the future. Take the case of a P/E multiple. The numerator which is a company’s share price is always as of today and is therefore fixed. But as EPS in the denominator increases with time, multiples will get smaller.
Q- Do you expect transaction multiples to be higher than trading multiples? Why?
Target shareholders need an incentive to sell. Acquirer provides this incentive by offering a control premium to target shareholders which is significantly higher than the current market price which is used in trading comps. As a result, transaction comps are higher than trading comps.
Q- Would potential buyers prefer to evaluate a deal on EV/Sales or EV/EBITDA?
Sales or revenue in itself does not indicate anything about profitability. EBITDA is a better measure of profitability, therefore buyers are more likely to focus on EV/EBITDA
Q- What are synergies? Can you provide a few examples?
Synergies are benefits that are expected to occur as a result of the combination of two businesses. The most common types of synergies are:
Revenue synergies refer to higher sales growth opportunities created by the combination of two companies. An acquiror may be able to sell the target’s products through its own distribution network without cannibalising existing sales. In addition, there may be other opportuities to cross sell due to which the combined entity will have higher revenues and market share.
- Cost synergies: These are costs savings that are expected to result from the combination of two businesses. Savings can come from staff reduction and layoffs, better supply chain management, lower marketing spend, cutting down on overlapping functions such as HQ among others.
- Capex synergies : The acquiror can utilize target’s machinery/plants/R&D to ramp production/sales, rather than invest in new fixed assets.
- Tax synergies : If there are unutlilised net operating losses at the target company, the acquiror may be able to utlise these and reduce its overall tax bill.
Q- What role do synergies play in valuation?
Synergies reduce the overall cost of acquisition for the buyer. NPV of synergies are subtracted from Enterprise Value.
Discounted Cash Flow or DCF
Q- What is DCF? Its main components?
Discounted Cash flow or DCF valuation involves estimating future cash flows a business is expected to generate and then discounting these to present value terms, at a cost of capital that represents the riskiness of underlying cash flows. The main steps involved in preparing a DCF are as follows:
- Estimating and forecasting free cash flows
- Calculating cost of capital
- Estimating terminal value
- Determining value and interpreting results
Q- What is FCFF?
FCFF or free cash flows to the firm is the surplus cash available to both equity and debt providers after meeting all cash flow needs but before any payments to providers of debt. In order to get to FCFF, start with EBIT, then subtract taxes. This gives NOPAT. Then, add back D&A and adjust for changes in working capital. Finally, subtract capex.
FCFF = EBIT * (1- tax rate) + D&A +/- changes in working capital – capex
Q- What is FCFE?
FCFE or free cash flows to equity is the surplus cash available to equity holders after meeting all cash flow needs including financial obligations. In order to get to FCFE, start with net income which is already post interest and taxes. Then, add back D&A and adjust for changes in working capital. Finally, subtract capex and adjust for changes in debt.
FCFE = Net Income+ D&A +/- changes in working capital – capex +/-net borrowings.
Q- What is terminal value?
DCF is prepared on the premise that a business is a going concern. However, it is not possible to prepare a business plan till infinity. That is why most practitioners prepare a 2 stage DCF where stage 1 captures value of cash flows during the forecast period. But the business will continue to generate cash flows even after the forecast period or stage This is captured by terminal value.
Q- How is terminal value calculated?
There are two ways of calculating terminal value. One is the Gordon growth method which assumes that cash flows grow into perpetuity at a constant rate g as the company is in a steady state.
Terminal Value = FCFFTY * (1+g)/ (WACC – g)
The other method of calculating terminal value is the exit multiple method. For FCFF, terminal value can be calculated by multiplying EBITDA in the terminal year with an appropriate EBITDA multiple. If a company is being valued on a standalone or going concern basis then exit multiples can be based on trading comps. If on the other hand, the business is going to be sold at the end of the forecast period, then it makes sense to use transaction comps as exit multiples. For FCFE, PE multiples can be used.
Q- What is typically higher – cost of debt or cost of equity?
Debt represents a fixed claim on a business and is senior to equity in the capital structure. Therefore debt providers have lower risk compared to equity investors whose claim is residual. Lower the risk, lower the expected return for debt providers which means lower cost for the company.
Q- Explain the use of mid-year convention in a DCF?
There is an implicit assumption that all cash flows arise at the end of the year. Reality is that most companies generate cash flows evenly throughout the year. To get around this problem, analysts make a mid-year adjustment when discounting cash flows. By doing so, discounting is lower compared to year end discounting . As a result, value is higher.
Mergers and Acquisitions
Q- What are some of the main drivers for M&A activity (mergers and acquisitions)?
M&A is pursued with the intention of enhancing shareholder value. Main drivers include:
- Access to new geographies
- Economies of scale
- Technology/R&D/ Patents
- Regulations etc
Q- If a buyer has the capacity to offer cash for a target company, why would it choose not to do so?
There can be a number of reasons for a buyer not to use cash for an acquisition:
- Buyers may want to preserve cash balances so there is healthy liquidity in the future.
- Return on treasury is usually greater than cost of debt which is a cheaper source of finance.
- If it’s share price is higher, this will lead to lower dilution.
Q- Why would a strategic acquirer typically be willing to pay more for a target company than a private equity firm?
A strategic acquirer can unlock value of synergies better which will effectively reduce its cost of acquisition. As a result, they are able to offer more for a target compared to private equity investors.
Q- What is a leveraged buyout?
A leveraged buyout or LBO is an acquisition which is financed mostly by debt. The target company’s assets and cashflows are typically used as a collateral for the debt.
Q- What type of companies make for an ideal LBO candidate?
There can be a number of characteristics for the ideal LBO candidate, but the most important is stable cash flow generation. LBO is a debt funded acquisition which in itself is a mandatory repayment. The company should be generating predictable and stable cash flows that are enough not only to meet its own needs but also be able to service debt.
Q- What is a typical IRR that PE firms expect?
Private equity firms make their investment decisions based on IRR. A typical IRR can be anything between 20-30%. PE firms aim to run the business more efficiently than existing management if they are buyout firms. Even if they have a smaller strategic stake, they work hard to deliver growth, scale and efficiencies. This ultimately results in higher exit valuations and by extension, IRR.
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