Investment Banking Technical Interview Questions and Answers

Below is the exhaustive list of Investment Banking technical interview questions and answers. If you want to add any additional answers, please do it via comment section. In case you want to add new questions, please contact us through the contact us form or email us.

What are the three financial statements?

The three financial statements are

Income or Profit & Loss Statement – The income statement is a financial statement that shows the profitability. It starts with the revenue line and works its way down to net income after deducting various expenses. The income statement is for a specific time period, such as a quarter, half-year or year.
Balance Sheet – As the name suggests, the balance sheet provides a snapshot or balance data of the company at a given point in time, such as the end of the quarter or year. Here, two sides are built viz Assets and Liabilities. In a business, at the end of a particular period, the total amount of assets and total amount of liabilities must always match.
Cash Flow Statement – The statement of cash flows is a format to show the cashflows in buckets. For Eg. Net change in working capital where the change in current assets and current liabilities are taken into account. Though current assets and liabilities consists of several items, in cash flow we depict it in a format that is easy to analyse. The cash flow statement is a magnified version of the cash account on the balance sheet that accounts for the entire period, reconciling the cash balance at the beginning and end of the period.

The cash flow statement is used to calculate Cashflow from Operations, Cashflow from Investments, and Cashflow from Finance. Net amount of each section is added to get cashflow of that particular period. This cashflow is added to the previous cash balance to get the net cash balance.

How can a company be valued?

There are two different ways of valuing a company i.e. the Intrinsic Value (discounted cash flow valuation – DCF), and the Relative Valuation method (Comparable Transactions).

Discounted Cash Flow (DCF) Method / Intrinsic Value:
Intrinsic Valuation is a method where the projected free cash flows of the company are discounted using a reasonable factor or discounted rate to calculate its present value adjusting for debt or cash in hand.

Relative Valuation method:
This method is used where the comparable transactions are available, which consists of companies in the same industry with comparable operational, growth, risks, and return on capital characteristics. Though identical companies do not exist, one should try to discover as many comparable organisations as possible. The popular metrics of relative valuations are PE Multiple, EBITDA Multiple, Sales Multiple, PAT Multiple, Enterprise Value/EBITDA Multiple.

How to calculate the cost of equity?

Cost of equity can be calculated using either dividend captalisation model or Capital Asset Pricing Model (CAPM). CAPM is widely used model. Following is the formula for Dividend capitalization model and CAPM Model.

Dividend capitalization model

Cost of Equity = DPS/CMV+ GRD

where:

DPS = Dividends per share, for next year

CMV = Current market value of stock

GRD = Growth rate of dividends

b. Capital Asset Pricing Model (CAPM)

CAPM stands for Capital Asset Pricing Model. The CAPM is a method to calculate expected return on equity or cost of equity based on risk free interest rate, market risk premium and volatility in the security.

CAPM Formula-

Cost of equity = Risk free Rate of return + (Beta * Equity Risk Premium)

Where,

Risk Free Rate of Return – Normally, Government’s long term bond rate or treasury return is taken as risk free rate of return

Equity Risk Premium = Market rate of return – Risk free Rate of return

What is higher – the cost of equity or the cost of debt?

Cost of Equity is higher than Cost of Debt. Let’s see the reasons:

1. Normally, Debt is secured and have first charge on the assets while equityholders gets after paying off all debt. Therefore, to cover this gap, equityholders expect a higher rate of return.

2. Debt has predictive and regular payments while equityholders gets dividend & profits only when the business declares profits.

3. Interest expenses on the debt are charged to Profit & Loss account at EBIT level. Thus, providing a saving on the tax. Had the interest expenses are not charged to P & L, the tax liability shall be more. Therefore, it is prudent to mix debt in the capital structure for increasing the business.

What is the formula for Enterprise Value (EV)?

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest – Cash

Equity Value: Market capitalization of a stock (if business is listed on stock exchange), else a comparable market capitalization (if the business is not listed on stock exchange)

What is Beta of a company?

Beta (β) is a measurement of volatility of anything vis a vis its related market. Eg. Beta of a stock is measurement of its volatility of returns in comparison to the stock market as whole.

A higher beta means greater risk (volatility) and higher expected profits / loss for a company. Do not consider risk here as negative results. It could be positive as well. The crux is that beta represents volatility.
Benchmark for beta is 1.0. Everything above 1.0 is more variable / volatile and Beta below 1.0 is less variable & volatile. For more clarity, let’s understand it through an example of stock market. Stock having Beta of 1.2 will see a price increase of 12% when the market increase by 10% in the given period of time, while stocks having beta of 0.7 will see a price increase of 7% when the market moves by 10% in the given period of time.

It serves as a risk indicator and is important to calculate risk premium in Capital Asset Pricing Model (CAPM).

How to calculate beta for a company?

For a listed company, Beta is calculated by regressing the stock return vis a vis the return of the lead index of stock exchange for a given period of time. Regression is a simple statistical method.

For unlisted company, a comparable listed company is identified to calculated the Beta. For a realistic calculation of Beta of a unlisted company, there is a requirement to de-lever and again lever it with the comparable listed company. We will learn on the de-levering and levering further.

Can Beta be negative?

Yes. Negative beta of a stock reflects its movement in the opposite direction of the market. If the stock market is going up the stock will go down and vice versa.

What is a deferred tax asset?

Deferred tax assets are resources that can be utilized for future tax reduction. It typically indicates that a company has overpaid taxes or paid taxes in advance, so it may anticipate recovering those funds in the future.

This typically arises as a result of changes to tax laws that take place in the middle of the financial year or difference in calculation in taxes based on accounting standard and Income tax laws, or when a company experiences a loss during a fiscal year since those losses might be applied to future taxable gains.

What is the difference between a merger and an acquisition?

When two different companies come together to form a new company is termed as merger.

When one company acquires another company, and the former keeps its identity is termed as acquisition. The new company may or may not retain its identity.

What is Discounted Cash Flow / DCF?

DCF stands for Discounted Cash Flow. As the name suggest, the future cash flows of the company are discounted, using a discounted factor, to present day.

DCF is a method use to value a company.

What is Working Capital in business or accounting?

Working Capital is a metric in accounting to understand the day to day financial position in a business. It is measured as current assets minus current liabilities. Items of Current Assets are Inventory, Account receivable, etc. and Current Liabilities are short term loans, any amount payable within one year, etc.

What does Negative Working Capital mean?

Working Capital = Current Assets – Current Liabilities

Thus, negative working capital occurs when current assets is less than current liabilities.

When current assets such as inventory, debtor, prepaid or advance expenses increases, it results in decrease in cashflows. Whereas when current liabilities such as creditors, expenses payable etc. Increases, it results in increase in cashflows.

With this logic, when working capital becomes negative meaning current liabilities being more than current assets, must results in increase in cashflows from operation.

What is the difference between cash-based accounting and accrual accounting?

Cash based accounting

The cash based accounting adapts the method of recording transactions of income & expenses in the books as and when it happens. This method does not recognise accounts receivable or accounts payable

Typically, small businesses uses cash based accounting method as it is simple to maintain the books. It is easy to maintain the accounts without recording the accounts receivable and accounts payable. Thus, a business can easily track the available cash with them at any given point in time.

Also, the books are easy to compute income tax as the transactions are purely recorded on cash received and paid basis. The tax is computed on the difference of the receipt and payment.

Pros of Cash based accounting

Simplest method of accounting
Quickly shows the available cash with the business
Easy for tax computation and payment providing control on the tax payment as it is calculated basis the difference of the receipt & payment of cash

Cons of Cash based accounting

Accounts payable & receivable is not considered that can results in cashflow mismatch in the business, thereby jeopardising the long run sustainability of the business
Difficult to switch to accrual based accounting when the business grows beyond a certain size where it requires to record transactions on accrual basis

Accrual based accounting

In accrual accounting, revenues and expenses are recorded when the transaction happens regardless of the cash is received and paid immediately or not.

If there is revenue and cash is not received, the transaction becomes the part of accounts receivable and when there is expenses and cash is not paid, the transaction becomes the part of accounts payable.

Let’s understand the above through an example.

A manufacturing company buys raw material on 10^th July and pays on 9^th October utilising credit period for 90 days. Here, the expenses is recorded on 10^th July when the transaction happens and goes to account payable. This amount shall be paid on 9^th October when the cash is paid and accounts payable is reduced by the same amount.

The same may happen with accounts receivable when it sells the products to the buyers.

Pros of accrual based accounting

Present a complete view of the business
Helps to make better long term decisions
Avoids the necessity of switching to cash based system when the business grows or as required during the tax filing

Cons of accrual based accounting

More complicated than cash based method, thus require a professional service to record and maintain the transactions
Requires a strong system of control to reduce the risk of frauds as it is prone to manipulation because of time difference in the actual transaction and cashflows from the same

Snapshot of difference between Cash based accounting and Accrual based accounting

Cash based accounting	Accrual based accounting
Recognises revenue when cash is received	Recognises revenue when sales happens
Recognises expenses when cash is spent	Recognises expenses when they are billed
Taxes are paid only on money received and not on complete sales	Taxes paid on money also where sale is completed but cash is still to come to business
Mostly used by sole proprietors and small businesses	Used by mid and large businesses

Example of Profits and Taxes on Cash based accounting and Accrual based accounting

A soft toy wholeseller company sells toys to retailers:

Sells toys and raise invoice for $ 10,000 in July
Receives invoice from its suppliers for $ 2,000 in July
Pays invoice bill of $ 500 for the supply in June
Receives $ 2,000 from retailers towards selling of toys

Using cash based accounting method the profit for July is $1,500 ($ 2,000 income and $ 500 expenses)

Using accrual based accounting method the profit for July is $ 8,000 ($ 10,000 income and $ 2,000 expenses).

As you can see the profits from the above two methods are different. Hence, tax computation on above will also be different.

What is Weighted Average Cost of Capital / WACC and how do you calculate it?

Weighted Average Cost of Capital or WACC is the average cost calculated based on the weight of types of funds in a capital structure of a business.

A business is typically funded through equity or both equity & debt. Equity is considered as riskier than debt, therefore cost for equity capital is higher than debt.

Basis above, higher the equity in the total capital higher the weighted average cost of capital and vice versa.

Let’s understand through an example:

When Equity is High in the capital

Type of Fund	% of Total Capital (a)	Cost of Fund (b)	Weighted Average cost of funds (a x b)
Equity	80%	18%	14.4%
Debt	20%	12%	2.4%
Average Cost of Capital			16.8%

When Equity is Low in the capital

Type of Fund	% of Total Capital (a)	Cost of Fund (b)	Weighted Average cost of funds (a x b)
Equity	40%	18%	7.2%
Debt	60%	12%	7.2%
Average Cost of Capital			14.4%

What is the difference between Goodwill and Other Intangible Assets?

Goodwill and Intangible assets are being used interchangeably in the spoken finance world as both are assets and non-physical in nature. However, on the balance sheet both the items are recorded separately.

Goodwill

Goodwill is part of the assets that comes up when merger & acquisition happens and where the price paid is worth more than the fair market value of the net assets i.e assets minus liabilities. Thus, Goodwill is a premium paid over the fair value of assets during the purchase of a company.

Eg. of Goodwill – Brand loyalty, brand reputation, and other non-quantifiable assets

To understand broadly, say a steel manufacturing company was sold for $ 500 million; it had assets worth $510 million and liabilities of $70 million. The sum of $60 million that was paid over and above $ 440 million (the value of the assets minus the liabilities) is the worth of goodwill and is recorded in the books as such.

Intangible Assets

Intangible assets are those that are non-physical but quantifiable. Eg. – Licensing agreement, Software, Trademarks, Copyrights, Patents, website domain names etc.

Key Difference between Goodwill and Intangible Assets

Goodwill	Intangible Assets
Difference between the price paid over the market value of the net assets	Individual assets having its own value
This is an integral part of the business created on account of m&a transaction. Thus can’t be transacted independently	These assets are independent of business and can be transacted separately

What is Acquisition Premium?

Acquisition premium refers to the price paid over the fair market value of the net assets of the target company. Acquisition premium occurs during the merger & acquisition.

Not necessarily, acquisition premium always occurs in m & a. Sometimes, acquisition happens at discounted value where the price paid is less than the net value of the assets.

How to Calculate Acquisition Premium?

For listed company – In simplest form, the difference between the deal price per share and share price on the stock exchange results in the acquisition premium.

For Eg. Is the current share price of the company is Rs. 20 and the deal price is Rs. 25, then Rs. 5 is the acquisition premium.

We also use enterprise value to calculate the premium paid.

For unlisted company – It requires few steps, such as unlevering & levering of Beta, to arrive at enterprise value and fair market value of the net assets

Financial Accounting of Acquisition Premium

In financial accounting, the acquisition premium is termed as Goodwill and recorded on the asset side of the balance sheet.

Reasons for Acquisition Premium

Below are few reasons that an acquiring company may pay a premium:

a. Synergy: The most common motivation for a merger & acquisition is the creation of synergies, where the combined companies are more valuable than the individual company.

Synergies generally come in two forms, hard synergies and soft synergies.

Hard synergies refer to cost savings from economies of scale, while soft synergies refer to revenue increases from expanded market share, cross-selling, and increased pricing power.

b. Growth: Acquisition is the quicker way to increase the revenue in comparison of setting up from scratch

c. To be competitive: Combined companies may provide pricing strength, negotiating power, control on the supply chain, etc. This might increase the competitive strength.

Unlocking hidden value: A target company could not be performing well or upto its potential for various such as lack of poor management, lack of vision, lack of right human resources, lack of capital, lack of innovation, lack of motivation to expand, etc. An acquiring company believes that it can unlock the potential by providing the required resources.

d. Diversification: In an acquisition, a target company might provide a diversification in the business resulting in reducing concentration of earning thereby reducing risk in cashflows

e. Incentives: Sometimes, government provide incentives to a certain industry. The motivation is to generate positive business value through incentives combined with business cashflows.

f. Unique capabilities: An acquirer might want to gain certain capabilities that it lacks or strengthen its capabilities. For Eg. Research & Development, Patents, technologies etc.

g. Tax considerations: It is a strategic move to acquire a loss making company for a profit making acquirer to lower its tax liabilities.

h. Management’s personal motive: It can be any motive. Management may be personally motivated to maximize the size of their company for greater power or more prestige or anything else.

What is Terminal Value and how do you calculate it?

Two companies are identical, except one has debt and the other does not; which will have the greater WACC?

Describe the basics of the LBO model.

How is the balance sheet adjusted in an LBO model?

What is the difference between high-yield debt and bank debt?

Why would a company refuse to pay 100% cash to another company if it was capable of doing so?

How is GAAP accounting different from tax accounting?

Tell me about major items in Shareholder’s Equity.

What are examples of non-recurring charges that are added back to a company’s EBIT/EBITDA when looking at its financial statements?

What is the difference between capital leases and operating leases?

What % dilution in Equity Value is “too high?”

Explain an IPO valuation for a firm that is about to go public.

Explain the Sum-of-the-Parts analysis.

Why would we use the mid-year convention in a DCF?

What’s the difference between Purchase Accounting and Pooling Accounting in an M&A deal?

Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in M&A deals?

What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?

Explain how a Revolver is used in an LBO model.

How to adjust the Income Statement in an LBO model?

What is EBITDA?

How do you value a company?

How do you calculate terminal value?

How do you do a DCF valuation?

What is Beta, and why would you unlever it?

Which is more expensive: the cost of debt, or the cost of equity?

What are the main factors that cause a need for mergers and acquisitions?

When should a company issue debt instead of equity?

What is net working capital?

What is an IPO?

Explain the process of helping a company complete an M&A from the buy-side.

What is the monetary policy?

Monetary Policy is an economic policy that manages the quantum and growth of money supply in an economy. It is a financial method to achieve broader objective of economic stability through increase in employment and low inflation.

The central bank or similar regulatory organisation is responsible for formulating and managing the monetary policy. Though, the complete banking system is used to manage the monetary policy as the central bank deals with other banks in the economy and not with retail public or corporates. In India, the central bank is Reserve Bank of India. In USA, the central bank is Federal Reserve. Click here to read the list of Central Banks of major countries of the world.

Tools of Monetary Policy

The central bank uses the following tools to implement monetary policies:

Increase or Decrease the Interest Rate: The central bank uses this tool to control the inflation through increase or decrease the money supply in the economy. Let’s understand this. Availability of money to retail public through low cost loan keeps the demand of the goods higher.

The Central Bank increases the interest rate at which it borrows money from the banks to suck out the excess liquidity from the market. The banks will be more interested to park their money with central bank now instead to lend it in the market either to retail or corporates. The banks increases their loan rate to public now. Increase in interest rate deter the retail public to avail loans to buy goods in excesses keeping their expenses in control.

Thus the whole process results in bringing down the demand of the goods and thereby the prices. This leads to lower inflation.

If you want to understand, you need to study the whole concept of why and how the monetary policy works. It is easy!

Change in the reserve requirements: Banks primary business is to lend money and accept deposits. Lending money is a risky business. To keep the depositors money safe with controlled risks, central banks mandates commercial banks to keep certain percentage of the deposits with them as reserves, typically termed as Statutory Liquidity Ratio (SLR) and cash Reserve Ratio (CRR).

By changing the percentage as required, central banks manage the money supply. Increase in reserves reduces the money availability for lending and decrease in reserves increase the money availability for lending.

Open Market Operations: Government always borrow money from banks and other financial institutions through issue of bonds. These bonds are tradable in the open market. When central bank wants to reduce the excess liquidity, they sell bonds in the market offering a higher rate of interests thus reducing the availability of money to lend. When they want to increase the liquidity, they offer to buy the bonds from the market. This is termed as open market operations.