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).
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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.
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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.
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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?
What is the difference between cash-based accounting and accrual accounting?
What is Weighted Average Cost of Capital / WACC and how do you calculate it?
What is the difference between Goodwill and Other Intangible Assets?
What is Acquisition Premium?
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.