If you are short on time check out our abridged 30 minute interview guide here
Investment banking interview questions have long been secrets passed on from junior bankers to their friends, making sure that banking remained an old boy’s circle.
Banking has become more meritocratic and investment banking questions are now much easier to find, although most sites require you to sign up to their newsletter or do some other annoying thing for a subset of the total question base.
Due to questions becoming widely accessible and the process becoming less opaque, the bar for banking interviews has skyrocketed assuming that the interview candidate is not part of a targeted group that banks want to hire. As such, in order to get into a good investment bank, candidates need to have a very strong grasp of corporate finance beyond regurgitating popular interview guides floating along.
From experience, banks have been looking to replace analysts and associates and interviewing 30 candidates at a time curated from a pool of over 1,000 applicants before selecting no one because none of the candidates passed the technical bar (or failed to put a tie on, something stupid).
Technical knowledge is a must, because unlike the marketing that senior bankers like to throw out during student conferences, not everyone in the room is smart enough to do banking and you cannot learn everything on the job – you need to be prepared.
- 1 Behavioural Interview Questions
- 2 Technical Interview Questions
- 2.1 Valuation Questions – General
- 2.2 Valuation Questions – Basic DCF
- 2.3 Valuation Questions – Advanced
- 2.4 Mergers and Acquisitions (M&A)
- 2.5 Accretion/Dilution Questions
- 2.6 Financial Modeling Questions
- 2.7 Corporate Finance Questions
- 2.8 Leveraged Buyout (LBO) Questions
- 2.9 Accounting Questions
- 2.10 Market Questions
- 2.11 Related Reading for Investment Banking Interviews
Behavioural Interview Questions
The behavioral or fit section of the interview is a must have – a candidate does not have to do all that well to pass the behavioral interview, just well enough so that no team member dislikes the candidate and where they can convey they know what they are getting into and that they want to do this.
Contrary to popular belief, not all team members have to actually like the new hire, although it is ideal, they just have to be tolerable – which means that they do not complain, are not socially awkward – bankers like to say “client-ready” (wannabe bankers say “polished”, but do not say this), and have a positive attitude even when the job gets really bad.
A lot of junior bankers quit or are fired well before their 2-year analyst program is up, so bankers are very cautious in looking for the right candidate. If they mess this up, it means they have to run the process over again and do the grunt work themselves, which no one likes. As such, candidates have to communicate that they only want to do banking, they have always wanted to do banking and they have been proactive in learning skills that will make them a successful banker. Candidates will also need to show that they have a vision for where their banking career will take them in a few years.
Why are you interested in finance?
A safe answer could be avid interest in markets, or desire to work with and learn from smart colleagues. Whatever your answer is, an anecdote to justify your reason would be useful. Do not say it is for the money, everyone already knows that and it is very gauche. However, if you are pressed whether or not money is a motivator, you should be honest and say it is definitely a consideration but reiterate what else draws you to banking.
Why should we hire you?
You should have a quick and concise pitch ready for this question. It is important to present your strengths with confidence but not arrogance. Anything that backs your passion in finance should be discussed in your answer (eg. you follow financial news, you have a personal portfolio, you were in an investing club etc.).
Tell us about yourself.
A relatively open ended question, you want to concisely outline your experience and interests, and how they may be relevant to the position you’re applying for. We have provided a template below, personalize it accordingly.
I am a ____ major from ____ about to write level x of my CFA/CPA designation.
- Lateral Hire
- Career Switcher: Finance
- Career Switcher: Other Industry
I currently work at ____ where I worked on
- Transaction A
- Transaction B
Where I assumed standard analyst responsibilities including financial modeling, compiling industry and comparables analysis, and creating marketing materials such as pitch books.
I have always enjoyed event driven transactions similar to investment banking work the most during my job and as such there has been a very natural progression for me to grow into an investment banking role.
Can you multitask?
In my current job I often deal with several different engagements at the same time. I have supplemented this with the CFA program and sports teams outside of work.
What are your weaknesses?
The key is to answer with something that does not inhibit you from doing your job at the role you are interviewing for, and have a brief expository on how you are mitigating/improving on your weakness(es) (Do not say you have poor communication skills or are bad at math for an investment banking analyst interview). Also avoid cliché answers such as I work too hard or I care too much.
Most bankers are cognisant that this is a stupid question and we have heard of people getting away with satirical answers such as “back pain” or “beautiful women” (one acquaintance at a prominent Canadian hedge fund straight up told the interviewer it was a stupid question) but would advise to err on the side of caution.
What are your strengths?
Prepare a few strengths and anecdotes supporting them. You should tailor those strengths to the role that you are applying for (as a rule of thumb, analytical, attention to detail and teamwork are skills that should be conveyed by your anecdotes).
What do you do for fun?
Extracurricular activities is a common way for interviewers to judge fit. If you do not do anything outside of academics, you should find a hobby/sport as soon as possible, team sports are especially valued as they highlight compromise and experience working with people.
Walk me through your resume.
Same as tell me about yourself. Keep it to 1 minute and make it concise. At the end of your resume pitch, tie it back into how there has been a natural progression for you to move into investment banking.
Why did you not get an investment banking position out of school?
You need to prepare a valid reason for not getting a investment banking role straight out of university. Spinning an interesting narrative could give you an advantage over the conventional candidate.
There was a great opportunity to do something in an industry I was interested in. However, I found that I enjoyed _____ the most and as I am interested in (securities/markets/transactions) outside of work and liked the material in the CFA, I would like to participate in the idea generation and structuring of deals itself.
Why did you choose to go to your university?
If you went to one of the target schools, you should be in good shape for this question. Otherwise, you need to justify your choice and persuade the interviewer to hire you instead of someone from Ivey (affordability from tuition and living at home).
Why did you want to work for our firm? Who’s the CEO of JP Morgan? What do you think about his strategy?
You should know some key facts (eg. market cap, CEO, current/recent mergers & acquisitions transactions) about the firm you’re interviewing for.
Major US banks have asked “what do you think about our CEO’s current strategy?”, so be prepared by screening Bloomberg for transactions the bank advised on, reading the bank’s annual report to understand the business and reading the CEO’s letter to shareholders.
If you are interviewing with a big bank, there is absolutely no excuse not to know the CEO as he should be all over the news. Anyone who does not know the financial titans of today (Jamie Dimon, Larry Fink, Lloyd Blankfein) is interviewing for the wrong industry. If you are interviewing for a smaller bank, you still need to know this.
The follow up question is a little trickier as it proves that you know something beyond the rehearsed answer for “why our bank”?
For a recent interview, a candidate was asked, “what M&A deal did we do recently”? The candidate began listing deals he saw on the league tables when he was stopped, “No, what did we buy last month”?
Basically, the bank was expanding into wealth management as wealth offers a higher return on invested capital and is much more stable. The candidate was then asked about what he thought about the strategy. The best answer is “it’s a good strategy”, with supporting statements basically copied verbatim from company press releases.
You’re a commercial banker – why investment banking?
- Transactions/deals – I do have exposure to transactions such as acquisition finance, but I want to be always involved in new deals and support the deal team in making transactions happen in a dynamic environment
- I want to be further upstream in the process in supporting idea generation and the catalyst rather than more after-the-fact work (the financing of the transaction). I want to be the first to know about a deal and push it past the finish line.
- Valuation – I want to see what something is worth and use analytical skills in this regard. I like seeing what drives prices and returns and enjoy critical thinking.
Why a midmarket bank?
I like midmarket because I think it will offer me the best deal flow and exposure. As there is more sell side focus on transactions, I will get to participate in more advisory work independent of ancillary opportunities by other parts of the bank. I think valuation will be more focused on core business and be more academic in nature. I have also met with various members of the team and consider them to be great people and they have told me it is a good culture.
Usually if you are interviewing for a small boutique, they know this is a fluff answer and that you (and they) would rather work in a Big 5, however you still need to be prepared for this question.
Why the energy industry?
Review our energy section to familiarize yourself with the industry. Any industry group you interview with will expect a base level of understanding – for energy and mining, this can get very technical. We have industry primers that can get you up to speed with any major Canadian industry coverage group.
I have always been interested in the energy space because it is a global industry despite being a regional operation. For me to understand what drives profitability of a Canadian energy company, I have to be cognizant of global macroeconomic trends that drive the oil price. Also, the energy industry has a disproportionate share of the Canadian market, with Canada having the third largest energy reserves in the world after Saudi Arabia and Venezuela. As such, I feel the industry offers the most learning and demands strong technical skills as well.
What books have you read?
Variants of this question include a) what finance books have you read? b) what non-finance books have you read? c) what is your favorite book and why?
Have a list of books that are interesting – generally this is a gauge of your intellectual curiosity, so non-fiction on the New York Times bestsellers list is usually a good way to go about this.
If you want to select a finance book, Liar’s Poker and Monkey Business are very cliche and Securities Analysis or the Intelligent Investor are extremely dry and will make you look like a loser.
Peter Lynch’s One Up on Wall Street, Seth Klarman’s Margin of Safety, Joel Greenblatt’s The Little Book that Beats the Market, and David Einhorn’s Fooling Some of the People All of the Time are good picks. As an aside, traders like Reminiscences of a Stock Operator by Edwin Lefevre.
Do not say anything like Harry Potter, Twilight or Clifford the Big Red Dog even if it is an attempt at humour.
Can you walk us through a recent merger you read about?
Keep up to date with the Globe and Mail or Financial Post – if you cannot get a subscription keep your eyes peeled on Bloomberg and set the location to Canada. We have provided a few Weekly M&A Updates on our blog which highlight parts of the deal that bankers care about.
Describing the deal should involve the target, the acquirer, the rationale, the source of funds, the implied purchase multiples and the advisors. Sometimes they will ask about a recent deal their group specifically has worked on, in which case you should familiarize yourself with recent transactions on Bloomberg.
TransCanada purchased Columbia Pipeline in a $10.2 billion deal, creating a major force in distribution of natural gas in the Northeastern USA (servicing the Marcellus). It also adds to TransCanada’s pipelines and storage facilities allowing for end-to-end solutions and expansionary opportunities.
At $25.50 a share, this represented an 11% premium and was funded by $4.2 billion equity issuance and a $2.8 billion assumption of debt.
Why do you want to work 80 hour weeks??
Say that the 80 hours a week is not attractive for anyone, but it is worthwhile because corporate finance is the only type of work that you are interested in. This allows the banker to know you that you know what you are getting into and you do not have a romanticized view of the banking grind.
What does an investment banker do?
Review our investment banking guide.
We are going to see a client for the first time, what are you going to put together for us?
You can compile a public information binder/book (PIB) which includes annual reports, annual information forms, historical financials, management proxy circulars, investor presentations, equity research reports and credit agency reports (Moody’s/S&P). These are generally read internally in the office.
For actually going to the meeting, bankers may want a small book with management profiles, a business overview, recent financials etc. that are built on PowerPoint. This fluff will often be shown to the management as well alongside marketing materials to show that the bankers understand the company (although it is more for bankers to read on the plane to get up to speed quickly).
What goes into a pitch book?
- Deal team slide
- A slide that lists all the bankers that are accessible to the client in each product group. Usually heavily loaded with executives that the client does not actually have access to (the CEO of the bank, the head of Capital Markets) and across product groups (Syndications, DCM, ECM, Corporate Banking).
- Credentials or Tombstones (can also go in back)
- A list of relevant deals that the bank played a lead role in. If the bank is pitching for a merger, they will list recent M&A activity that they were the lead on while if they are doing a debt markets update, they will list recent bond issues where the bank was the lead or co-lead.
- Executive Summary
- This is an overview of what the bank tries to convey throughout the presentation. For an M&A pitch this could discuss where the company is at in terms of the capital expenditure cycle and how they can realize the most value.
- Valuation Summary
- Various valuation methodologies for the company, from various DCFs and LBOs given certain assumptions to comparable companies analysis.
- Recommendation of Strategic Options
Can you walk us through a recent deal we worked on?
Read up on the bank’s recent deals and familiarize yourself with at least one of them.
Scotia advised on Fortis’ purchase of ITC holdings, an American utility. The transaction was US$11 billion, of which consideration was paid via $3.5 billion in cash, $3.4 billion in stock and $4.4 billion in assumption of debt. Fortis raised cash through a $2 billion debt raise and the selling down of 15-20% of ITC to an infrastructure fund.
At a 1.9x rate base, the transaction was pricy vs a standard 1.5-1.6x multiple. It is estimated to be accretive to 2017 earnings given 60% equity thickness for ITC vs 40% for Fortis and a higher ROE allowed in ITC’s jurisdiction.
The merger made sense from a strategy perspective as the footprint in the US compliment’s Fortis’ existing operations and moved Fortis’ profile more towards transmission (higher ROE) from distribution and allowed for dividend growth.
Can you walk through a deal you worked on in your resume?
Basically, closeness to the deal is rare so this part may need to be embellished to show that you understand the M&A rationale for the transaction and what sort of analysis you did. If you did not do any analysis you will have to make something up and possibly build a fake model so you can walk through it and not look like you were faking it.
At Scotia, I worked on a term loan for Goldcorp’s failed hostile takeover of Osisko – the rationale for the deal was an opportunity for Goldcorp to pick up a low-cost premium single mine asset with corporate and regional cost synergies and a lower all-in sustaining cash cost to their portfolio ($759 per oz vs $975 for Goldcorp at the time).
I sat in on calls with the treasurer and CFO and helped perform pro-forma debt capacity analysis to communicate business and financial rationale to the credit team and deal committes resulting in loan approval. Continued support for the client was rewarded by bookrunner economics in subsequent DCM issues.
Do you have a return offer or any offers right now? Why did you not do an investment banking internship last summer?
If you are a summer interviewing for full time, having a return offer is ideal as it means that you have been deemed competent and tolerable (or help meet quotas) for another bank. Not receiving a return offer is usually a red flag and will be seen as a negative, but we have seen many rejected summer interns land jobs at even bigger brand name banks than the one they just left.
If you do not have a return offer, you have to say no and explain why. Non-answers include lack of headcount (unless the firm shut down) or making an excuse/blaming other people is not helpful. It is important to speak to where you may have gone wrong but bring up what you have learned and what skills you have acquired. Not getting a return offer is still better than not having had a summer internship at all.
If you do not have any offers or experience, mention that you have improved for this recruiting cycle with more polish, but you have always been interested in finance and have been keeping proactive with doing finance research projects, writing articles about investing and building models.
Do not lie about your return or other offers. Generally, people at banks talk and if you are found out you will be blacklisted.
Why this city? Why Toronto? Why Calgary?
If you are interviewing for a position in New York or London, you are less likely to get this question. However, if you are from an East Coast school and are interviewing in Toronto, you are not likely to get this question.
If you have excellent grades and are also interviewing in a global city such as NYC/London/Hong Kong, bankers in Toronto are skeptical that you would rather work in Canada so you should mention that you need to take advantage of any opportunity, but would prefer to work in Toronto because of family or long-term goals.
If you do not have excellent grades, this question depends on what school you attend. This is more of a question for out-of-towner to give the interviewer confidence that they will not be overwhelmed with moving to a new city when they have spent their whole life on the West Coast. Being originally from Toronto or having family is helpful. Having done networking trips out of pocket is even more helpful.
For satellite offices such as Calgary, you must convey that you like the regional industry and have been in the city and met people. Often, banks will prefer a less qualified candidate that already lives in the city over a high flyer from somewhere else.
Why [our bank]?
Depending on what type of bank it is, the answer will focus on different aspects.
Bulge Bracket – Global reach, full service product suite, leading platform, transformational deal size
Major Domestic Banks – Higher and consistent deal flow than bulge brackets, domestically dominant, perennial league table leader
Mid-Market/Boutique – More responsibility, flatter structure, better learning – if there is a strong group, talk about interest in the industry
It is also helpful to know about some deals that the bank has worked on lately and be able to speak about them at a high level for strategy.
Preference for group?
If this is during the generalist hiring cycle, M&A and an industry group that is not particularly niche is good to mention. If hiring for a specific industry, such as mining, you have to be prepared with mining specific responses.
Who got you into the process / how did you get into the process?
Even if you found out about investment banking last week, it is not prudent to admit you are that green – after all, how can you be so sure about committing yourself to 100-hour weeks of work you do not understand?
A better approach is to talk about friends in the industry and the abundance of literature you have read on investing, investment banking and corporate finance activity, and the stocks you started to follow.
Tell me about a mistake you made on the job.
It is good to mention a specific example where you did not ask for enough direction or managed time poorly – as a result, you can speak to how you learned from the experience and are better positioned to deal with similar situations going forward.
How do you handle pressure?
If it is related to deadlines, it can be managed through effective scheduling. If it is from stressful situations where answers are needed quickly or you are put on the spot, talk about how you can step back and look at things rationally and come up with a solution. Mention an experience where you were put under pressure in the past and how you pulled through.
Amusingly, investment bankers can be prone to blow-ups from associate to MD.
Tell me a time when you failed.
Cookie cutter question where you have to mention that you did fail somewhere – to say otherwise makes you look unrealistic and arrogant.
A good answer shows something not going as planned (not entirely your fault either), how you looked to solve it and what you learned. A good way to finish is how you were faced with a similar situation later and succeeded.
For a previous group project, team members were assigned different roles and we failed to deliver a complete product because one of the team members did not finish their part.
I learned that we succeed as a team and fail as a team – it is important to learn how to manage higher as well as lower. There were many things that we could have done differently, such as setting checkpoints for completion and offering to help out where a teammate is unable to perform.
I have applied the lessons from this experience where we ended up with an excellent finished product despite initial obstacles.
How do you handle multiple tasks and deadlines?
Speak to good time management and setting checkpoints and milestones. Mention that you are comfortable prioritizing hard deadlines over soft deadlines and can communicate up the food chain in managing expectations should deadlines be unrealistic or if something else has come up. Use/make up an example in the past where you did these things – whether a school project or in another office job.
Tell me about an ethical dilemma you’ve faced.
Mention a time when someone has offered an easy out from fudging numbers, taking a shortcut or otherwise being dishonest and how you were not willing to compromise your integrity but at the same time how you provided a workable solution.
If you are asked whether you would do something unethical if a direct superior asked you to, you should say no – mention that long term, banks do business based on reputation and putting that in jeopardy over a small figure makes no sense. Remember the Goldman mantra of being “long term greedy”.
Tell me about a time you handled conflict in a team.
Many ways to tackle this question – but the point is that there is rarely work without some sort of conflict or disagreement and a middle ground has to be negotiated. Answers such as “someone I worked on a group project with refused to do any work so I did all of it” are not the right way to approach the question.
A better one is that two people wanted to do things differently so there was a compromise to include elements from both streams of thought. After talking it through and weighing pros and cons of each, the team agreed on a preliminary plan supported by a data driven approach.
Can you let me know a time when you demonstrated qualities in entrepreneurship?
This is actually a total BS question because investment bankers do not want you to be entrepreneurial or think outside the box ever when it comes to putting together a pitch book. There is a tried and tested method and what constitutes innovation such as being the first bank to offer a particular type of hybrid bond or merger strategy before every other peer in the industry group tries to emulate it – this is neat but no peasant analyst will ever have the opportunity to tell an MD about this idea.
However, it makes sense to have a good story in terms of where you spotted an arb and exploited it (or more politely, you saw a problem in society and you looked for a solution).
Tell me about a time you said no to a superior / boss.
Managing up is very important in the job as you need to communicate your capabilities and bandwidth so things can be done effectively and no one is left empty handed when deadlines near.
Senior staff, especially those who joined as post-MBA associates often have no idea how long a particular task takes, whether or not it can be done or whether or not something makes sense. Sometimes you have to say:
- No, I cannot build the model in 2 days, I will need 4 and it is because this schedule and this schedule will require x and y and will take this long.
- No, this analysis is not possible as we would need specialized software – what I can do this _____
- No, that data would not support our analysis because of ____, but this works.
From these examples, the interviewer can tell that you were diplomatic in your approach and offered a working solution.
Tell me about a difficult time with a teammate, client, or boss.
Everyone butts heads with someone and you do not have to be friends with everyone you work with. Mention that you compromised on certain tasks and that there was professional respect, you were stern with pushing back for unreasonable tasks but offered solutions that helped get to the end goal (something to the client). You do not take this stuff personally and let it get to you, so when there is no easy compromise, you put your head down and grind.
What did you do this summer? (for summer interns recruiting for full time)
Speak about your experience at a high level and try to mention as many transferable tasks as possible, such as making PIBs, creating marketing materials such as pitch books and writing call memos and summaries. If you were given the opportunity to use Excel in light modeling activity, you should highlight a flagship product – it does not matter if it was investment banking.
For instance, if you were in securitizations, you could mention how you put together a debt waterfall for the various payment tranches.
We like to get our junior staff in front of clients early. If you are with a client and I’m not in the room, what sort of small talk are you going to make?
Ask how he is doing and how his weekend was – listen to what the client wants to talk about.
Technical Interview Questions
For a technical interview, the interviewer is looking for someone who understands the theory behind the answer. This is not to say that you can definitely get past the interview process with a Canadian bank without a strong grasp of underlying concepts, but in a proper process, you will be weeded out if there is an obvious knowledge gap.
Valuation Questions – General
What are some common ways to value a company?
- Discounted cash flow
- The future free cash flows of the firm are discounted by a risk-adjusted rate to calculate the intrinsic value of the firm (for an expanded example click on the link above for our blog post)
- Comparable companies’ analysis
- “Comps” show a selected (the selection process is in itself an art) group of companies that are similar to the company being valued via valuation multiples that are industry and geography specific
- It is important to understand whether multiples are valued on a pre or post leverage basis (Enterprise Value versus Equity Value) – as such, Sales and EBITDA should be to EV and Earnings should be to Price
- Each industry will have unique valuation multiples and metrics in addition to the standard EV/EBITDA and Price/Earnings – for example, exploration and production companies look at EV/DACF
- Precedent transactions analysis
- “Precedents” show previous examples where comparable companies were actually transacted on (they were purchased) – this implies a premium to market price in most cases (or a discount if the company was actually distressed and it was not reflected in the market value – a recent example being Crescent Point purchasing Legacy Oil and Gas)
- Some interview guides say that if a company offers to sell itself, there may be a valuation discount as well – this is rarely the case in reality as every company which puts out a press release saying that it is looking at “strategic options” (corporate-speak for selling itself) usually gets a bump-up as it goes through the sell-side process
What are the pros and cons of those valuation methods – and which one should you use?
For DCF, the most obvious pro is that is a representation of intrinsic value. There is a sound methodology in calculating what the company is worth. Problems with the DCF are that it is not market based (it does not matter if an internal model shows $10 a share and it is trading at $20 because you will have to pay more than $20 to buy) and it is extremely dependent on the assumptions behind the DCF – DCFs are forward looking, and no one can predict the future.
Comparables are the best representation of market value, but the market can be wrong (in the long run). Additionally, it may be difficult to come up with a good set of comps – and there are many factors that can explain differences in comps (growth, market position). For a large conglomerate such as Sony, a certain division may compare against video games (Electronic Arts, Activision Blizzard) and another division may have a different peer group, making it hard to value on this basis.
Precedents convey the history of what buyers had to pay on top but do not tell a full story. For instance, the buyer may have paid more because of perceived synergies or less because the target was in distress. Also, precedent transactions can be too dated – market conditions may have changed. Similar to comps, precedents also may not have good companies that are similar to the target.
It is hard to say which method is the most useful – comps and precedents obviously serve different purposes and an individual investor would not use precedents unless they were a special situations investor looking to bet on a merger. Alternatively, an acquirer would have to consider a takeover premium as a realistic measure of what they would actually pay.
Generally, analysts will use a multiple that is supported by a DCF (if the DCF is way off for implied comp multiples, the DCF is probably way off or vice versa).
Why would a precedent transactions analysis produce a 20x P/E median but comparable companies analysis produce only 15x P/E?
There are many possible reasons, but the most logical one in this case is that the precedents are deals that have happened, usually entailing a control premium paid to take over the company justified by synergies or foolish management.
Can you use Market Cap/EBITDA as a valuation multiple?
No – this is not an apples-to-apples comparison. Market cap represents the cash flows to equity while EBITDA is a pre-leverage metric (before capital structure).
Theoretically, sales are to the whole firm, so EV to Sales is academically correct while Price to Sales is not.
Where we see this ignored is with tech companies, who often are valued on Price/Sales. However, the amount of debt in their capital structure is non-existent or negligible, so this is OK.
Which of the primary valuation methods is likely to produce the highest value?
This is a little tricky. Since the DCF is a measurement of intrinsic value while comparables and precedent transactions are market based, it could be the DCF.
The DCF’s value is based on the assumptions that underpin the DCF – aggressive assumptions can yield the highest value, but maybe not.
As for comparables and precedents, generally precedents will yield a higher value because most transactions involve a control premium. After all, shareholders are reluctant to part with their shares unless they get a hefty amount on top – otherwise why not just hold them on the open market?
Comparables could theoretically be lower than precedents but there would be the rare case where there are no recent transactions while a lot of consolidation happened while trading multiples were a lot lower.
Any other valuation methods?
Sum-of-the-Parts (SOTP) and Net Asset Value (NAV) – This valuation methodology values the different segments of a company separately – for instance TELUS has wireless, wireline, real estate and healthcare divisions which will be valued on different multiples before being summed. From there the SOTP asset value less debt plus cash and other adjustments will yield the equity value
Liquidation Value – Assuming all of the assets are liquidated this calculates the return to equityholders after all stakeholders that rank above in the capital structure (debt, preferred shares) are paid out. This is a good floor value for distressed companies.
Leveraged Buy-Out – Solving for an IRR gives an indication of what a private equity firm would be willing to pay and is a good floor for undervalued, financially healthy companies with good cash flow.
How would you value Lululemon?
Same as the valuation methods above – if looking to impress, there could be a discussion on specific retail metrics such as same store sales or sales per square foot.
Lululemon is a fairly standard revenue and cost of goods sold company, so the three main valuation methods could be used as well as an LBO (what a financial buyer is willing to pay) to see what a floor valuation is.
When would you use sum of the parts?
Conglomerate structure where segments of the company should have cash flows discounted at relevant cost of capital. Existence of non-core business streams or assets that should be segregated.
Can you name a good historical example of when sum-of-the-parts would be worthwhile?
Retail companies spinning off real estate assets as REITs to unlock value (worth more outside the firm as REITs trade at higher multiples). You should be prepared to discuss conglomerate discounts, as 1) companies may be more optimally run as a pure play and 2) arguably a simpler to understand company trades at a higher multiple (transparency is key, and companies will often see share price boosts from good disclosure and other potential investor-friendly actions).
When would you use liquidation value?
Usually when you see a company in distress, to see what you could get from stripping the assets. Also useful if you are looking at a company which has had a very beaten down stock and are looking to perform deep value analysis
When would you use a revenue multiple instead of an earnings multiple?
When the company has negative earnings, PE is no longer a reasonable method to value a company. Also, revenue multiples such as EBITDA and EBIT are independent of the company’s capital structure, so they could offer more insight on the operations of the company relative to its peer group.
How would you value a company with no revenue?
Companies with no revenue is common for stocks listed on TSX Venture (especially junior mining companies). You can project their future cash flows based on their reserves and resources, and discount it back at a rate appropriate for a company with no revenue (a much higher discount rate than a producing asset).
Pre-revenue tech stocks may be valued on their user base (EV – although it is unlikely there is any debt in the capital structure if there is no revenue, so effectively equity value – to DAU/MAU daily average users/monthly average users, or pageviews).
Pharmaceuticals may be in stages of drug testing and assumptions can be made should the trials be successful. If that is the case, these cash flows must be probability weighted (with a higher risk discount).
How would you value a company with a negative net income?
You would start by deriving the free cash flow from the net income, it may still be positive despite the net income being negative. If the FCF is negative, and future FCF is expected to be negative it can be valued via multiples.
What is the equity value of a distressed company in bankruptcy?
Equity value is most likely zero for a company in bankruptcy.
Why should you use the market value of debt to calculate EV for distressed companies?
If you use the face value of debt and the equity value of the company you may not have an accurate look at how the market is valuing the company. For example, if bonds are trading at 60 cents on the dollar, the market is predicting that there may not be full recovery on the bonds. Now if the bonds are trading below par and shareholders are only paid after bondholders are paid in full, why is there a market cap for the company (equity value)? The answer is that it is option value.
If two comparable companies have similar revenue, why would one trade at a higher EV multiple?
Better growth prospects, lower corporate tax rate, cheaper financing options and higher quality management could all be reasons why one company is priced higher than the other.
Can the growth rate exceed the discount rate (g > r)?
Not in the long run as this will give you a negative perpetuity value – if growth is higher than the discount, the discount is inappropriate as people will come and bid up the stock.
Accounts receivable increases – does this affect valuation?
Yes – AR rising means a positive change in NWC, which reduces free cash flow thus reducing the valuation of the firm. These working capital changes are difficult to forecast and the question is meant to test knowledge of finance identities rather than spark a real discussion.
Why would EV/EBITDA be higher for one company than another if the EBITDA is the same and they are in the same industry?
Could be a number of factors including growth, better margins or non-normal items that have not been adjusted.
What justifies a higher valuation multiple?
- Higher growth prospects
- Higher EBITDA or net income margin
- Lower capital needs in near term (execution risk)
- More stable business model
- Optimal capital structure (versus firms in financial distress)
- Near-term commercial operation of project that will increase future EBITDA
Company A has higher EBITDA than company B, but lower cash flow. What are some reasons?
Can you explain mid-year convention and how it affects valuation?
The idea is that you get cash flows throughout the year instead of a simple accounting dream in a lump sum at the end of the year so the discount should acknowledge the timing of cash flows using the mid-point as a proxy. So instead of having discount factors of t = 1, 2, 3, 4… you use .5, 1.5, 2.5… and that will result in a higher valuation
What is capital structure like for a company with no revenue?
Likely little to no debt although could have security against land or intangibles, but these will tend to be overcollateralized for lender comfort.
What happens to EV if we add $100 million in debt?
Debt + 100, EV + 100
Cash + 100, EV – 100
Be prepared to discuss MM I & II with tax or at least explain why the tax shield makes sense from a corporate finance perspective.
This depends on where you are from a weighted-average cost of capital perspective – if the cost of debt is below the current WACC this applies.
If a company is mature what is wrong with using Price/Sales?
Price is post-leverage (equity is stripped out from EV) and sales are pre-leverage
Why is debt cheaper than equity?
Debt is cheaper than equity because it ranks ahead of equity in the capital structure. This means that the risk of holding debt is less than the risk of holding equity, so the return on equity must be higher than the return on debt for people to hold equity.
Additionally, interest payments on debt are tax-deductible in most jurisdictions, which makes the effective cost of debt lower.
From an M&A accretion/dilution analysis perspective, if the inverse of the price/earnings ratio is below the after-tax cost of debt, theoretically equity is cheaper – however this signals to the market that the stock may be overvalued unless there are substantial synergies.
What should trade a higher multiple, Pepsi or Coke?
Coke – higher brand value and best in class. Same as Starbucks trading above other coffee shops.
How do you get to your price target?
At the end of all reputable equity research reports, the equity research analyst will disclose their valuation methodology.
The price target will depend on valuation convention for the industry that the company is part of – but usually this will be Price/Earnings or EV/EBITDA. Equity research analysts will use multiples (P/E or EV/EBITDA) because they are market based, but usually will have a DCF as a secondary opinion from an intrinsic standpoint. Some analysts will switch it up and use a DCF as the primary methodology, but end up with implied P/E or EV/EBITDA multiples to back it up (as such, price targets usually line up with other analysts – assumptions are also based on company guidance).
The price target is usually a target to be reached within 12-18 months, so it is not really what the price should be today. The multiples are based on next twelve months (NTM) earnings or EBITDA, so they may not actually tell much of a story today. Tricky, tricky.
Valuation Questions – Basic DCF
Walk me through a DCF
1) Project free cash flows for a forecast period until the business reaches a steady state; 2) Determine terminal value for steady state cash flows in perpetuity; 3) Discount all free cash flows by a risk-adjusted discount rate to get the present value.
How would the DCF change for a mining company?
Mining companies (and other resource companies) have finite lives defined by the projected lives of their mines. Therefore, you would not project a terminal value using steady state cash flows. See our Metals and Mining Primer for more details.
For the terminal value, what methods can you use?
- Gordon Growth Method or a perpetuity with growth assuming the company is a going concern forever or Cash flow of the final year multiplied by the growth rate divided by the discount rate minus the growth rate
- An exit multiple for EV/EBITDA
How would an increase in interest affect your DCF?
Your cost of debt rises by the incremental interest multiplied by one less the corporate tax rate.
As such, your WACC/discount rate will increase, lowering the present value of the firm. The cash flows themselves do not change as they are looked at from an unlevered basis.
How do you get to free cash flow?
It is good to ask whether the interviewer is asking for levered or unlevered FCF. They will usually say UFCF, where they may or may not tell you to begin at a certain point (which can be from EBITDA, EBIT, Net Income or Operating Cash Flow). It is important to understand all of the identities and practice going to UFCF from all starting points and being able to explain from an academic perspective.
Unlevered Free Cash Flow (UFCF)
Net income + Interest (1-corporate tax rate or Tc) + non-cash charges (depreciation, etc.) – capital expenditures – changes in net working capital
EBIT*(1-tc) + depreciation – capital expenditures – changes in net working capital
EBITDA*(1-tc) + depreciation (tc) – capex – changes in net working capital
Levered Free Cash Flow (LFCF)
UFCF + debt issuance – debt repayments
Operating cash flow – Capex
In this equation, net working capital changes are reflected in OCF (usually recorded after funds from operations on the cash-flow statement)
The addition of debt issuance and reduction of repayments is because you are looking for cash flows available to equityholders only. This will naturally lead to a question such as…
Would you prefer to use UFCF or LFCF?
The standard approach is to use unlevered free cash flow because it allows for a capital structure independent look at a company. Afterwards, someone analyzing the company can layer on financing assumptions as they see fit. If capital structure changes, LFCF would have to be re-evaluated.
Discounting UFCF will yield enterprise value. Discounting LFCF will yield equity value.
When would you choose to not use unlevered free cash flow?
Banks, insurers and other financial institutions where debt is not necessarily seen in a traditional capital structure context. Much debt is sourced in order to fund loans and there is duration matching, so interest can be seen as a cost of goods sold. Some candidates will say financial institutions, which is not precise enough as asset managers (Blackrock, CI Financial) follow business models more in line with other corporates.
What is the appropriate discount rate to use for discounting your cash flows?
Weighted average cost of capital for unlevered free cash flows and required return on equity (kE or rE) for a levered firm.
How do you get to the weighted average cost of capital?
Cost of debt*percentage of debt in the capital structure*(1-tax rate) + cost of equity*percentage of equity in capital structure + cost of preferred equity*percentage of preferred equity in the capital structure
What is the debt tax shield?
Conceptually, interest expense is tax deductible (they come above tax expense on the income statement), and a part of the interest expense works to offset the tax expense (specifically, by 1-tax rate).
How do you get to the required return on equity?
According to the capital asset pricing model (CAPM):
Return on a risk free asset + equity beta*(expected return of market – return on risk free asset)
What is the CAPM?
A model that describes the relationship between market or systematic risk and the expected return for a security (which in this case is the equity of the company). Accordingly, the greater the relative risk, the greater the return must be to compensate holding the risky asset. This does not explain idiosyncratic or unsystematic risk (factors that only affect that company), which for the purposes of discussion can be diversified away by holding different assets.
What is beta?
Measure of systematic risk of the security (or a portfolio of securities) in relation to the market.
Beta is calculated through regressing changes in a security’s returns vs changes in the market. Given that this is a historical figure and does not necessarily reflect the future, there are limitations to beta.
You should not use beta when the underlying regression analysis does not have strong explanatory power (low r-squared).
What do you think would be a high beta stock? What do you think would be a low beta stock?
A high growth stock that would appreciate more in a booming economy and suffer more in a contracting one would have higher beta. Usually, people will say technology for high beta and a defensive sector such as utilities for a low beta. This depends on a case by case basis, of course, as there are many steady state technology companies which generate very stable cash flows without major growth catalysts.
Rank the beta of Fortis, a $20 bill and Blackberry.
A $20 bill does not move with the market – it’s always $20. The beta is 0. Fortis is a regulated utility with stable cash flows (and a defensive stock), so beta is lower but should still move with the market. Blackberry is a risky stock so the beta should be the highest.
What is the beta for a technology company?
It depends. Facebook might have a high beta as it has zoomed up along with the market, and should market confidence fade it may drop precipitously as well. However, companies such as Microsoft have become big cash cows and have utility like cash flows.
How do you get to the appropriate beta for a private company?
Find beta for comparable company and de-lever the equity beta to get the asset beta. After, lever the beta to the capital structure of the company being analyzed.
Because you cannot solve for a beta as there is no share price history, you will estimate a beta using a peer set of comparable companies.
So you must take the equity betas of the comparables and delever them to get to an asset beta, thereby stripping out the effects of capital structure. Then you can average the asset betas of the peer set to get your unlevered beta for the private company you are looking at.
Afterwards, you must relever the beta to the capital structure of the firm you are looking at.
Asset beta = Equity Beta x 1/ [1+(debt/equity)*(1-Tc)]
How do you get to an appropriate terminal multiple for a DCF?
You could look at peer comparables to see if that is an appropriate trading range, adjusted for whether the company has better growth prospects or not.
You could use the perpetuity/Gordon Growth method and solve for/back out a terminal growth rate. If the terminal growth rate is 2 or 3%, you could think that the terminal multipe makes sense. If you are at 5-6% you are probably off by a little.
What is an appropriate time period for your beta?
You can use different time periods and different intervals to calculate your beta. The most common are 2 years and 5 years (the most standard answer) and weekly and monthly. However, if you look at beta over 2 years, you will want weekly data as 24 months is not a big enough sample size.
However, there are times when the swings in the stock are not necessarily explained by swings in the market – if you have a low R-squared, the beta may be meaningless in predictive power (you could argue that beta as a predictive measure is flawed in itself). Sometimes the theoretical beta is actually high while the R-squared is low. An astute analyst may use multiple regression to strip out the noise or other major influences to see how the stock would move with the market in a normalized environment.
A major Chinese technology company trades in the US as a sponsored American Depository Receipt (ADR). Is the S&P the appropriate benchmark for it?
Probably not – although you would imagine it would trade in line with tech stocks broadly if there is sufficient momentum in the market and global equities do tend to move together, there is much more explanatory power in the appropriate Chinese index.
How would your DCF change with a small cap company?
According to Duff and Phelps, which is a guidebook that most bankers use to grab the latest equity risk premium (the one in the cost of equity formula), companies should have a size premium assigned to them which is inversely correlated with the size of the company. So very small companies will have the standard rE formula plus a size premium in the discount rate. All things equal, the discount rate is higher, which means the DCF is lower.
Should you regress Google’s beta against the NASDAQ?
This is a tricky question to see if the interviewee truly understands CAPM. The answer is no, because beta represents the torque relative to the market portfolio, of which the NASDAQ only makes up a part of while heavily concentrated in technology and healthcare.
What is the appropriate rate of debt to use?
More of a theoretical question – could be the blended rate of debt that the company currently pays or the theoretical rate of debt it would pay under new issuance (which in turn depends on other factors such as tenor). We would go with the blended rate of debt.
If you were a financial buyer which multiple would you use?
Exit multiple as you are looking for your selling price and using that to calculate your IRR
If you were a strategic buyer, which multiple would you use?
Perpetuity with growth because you are looking at the intrinsic value of the company as it will be part of your firm going forward
Who would pay more, all things equal – a financial buyer or a strategic buyer?
Strategic because you will have synergies so it is worth more to you.
To be clear, a financial buyer is usually a private equity firm whereas a strategic buyer is a company that is in the same value chain as the target company whether vertically upstream (a supplier to the company), vertically downstream (a customer of the company) or horizontally (a competitor of the company). There are integration synergies for all three.
Give me the formula for Enterprise Value
EV = Debt + Equity – Cash
Give me more!
EV = Debt + Preferred Shares + Equity – Cash – Investments + Pension + Minority Interest – Associates + Asset Retirement Obligations + Capitalized Operating Leases
How do you get to your equity value?
You multiply fully diluted shares outstanding by the share price to get the market capitalization (current market value of equity not book equity).
How do you get to fully diluted shares outstanding?
You can use the treasury method – take basic shares outstanding (found on the first/cover page of the latest 10Q or 10K – do not mix this up with average shares outstanding for EPS calculations) and adjust for the effects of dilutive securities (in-the-money options from equity compensation, in-the-money convertible bonds) while ignoring anti-dilutive securities that would not be exercised.
For options, assume all in-the-money options are exercised, so you add that many shares to the share count. However, you will use the cash proceeds from the options (the strike prices multiplied by the new shares issued) and assume that those are immediately used to purchase back shares at the same price.
So in all dilutive effects (for options) can be described in these identities
# of New Shares = ITM Options – (ITM Options x Average Strike = Cash Proceeds)/Share Price
= ITM Options (1 – Average Strike/Share Price)
How do you get to your debt value?
You sum up the market value of the debt and any accrued interest. If the company is not distressed, usually the book value of debt is sufficient.
Valuation Questions – Advanced
What projection life would you use for a pharmaceutical?
You would use the life of patents until expiry, as this monopolistic period will have more predictable cash flows before it becomes a generic drug. (for very popular OTC like Tylenol, there is a brand name that has value, but for a random new oncology development less likely)
What terminal value would you use for a pharmaceutical?
Perpetuity based on splitting the market with other generics or a standard multiple.
Mergers and Acquisitions (M&A)
What is easier, revenue synergies or cost synergies?
Cost synergies – revenue synergies are notoriously unreliable and require execution and assumptions to turn out whereas cost synergies can be as simple as firing someone
What would you rather have, revenue synergies or cost synergies given the same amount?
Cost synergies as revenue synergies come with associated costs whereas cost synergies flow right into operating profit.
What happens to financial statements post-merger? Walk me through the pro-forma.
Add revenue for combined revenue, add pre-tax income for combined pre-tax income pre-adjustment, subtract transaction fees (legal, advisory, accounting, etc.), adjust for asset write-ups and write-downs and corresponding amortization, apply buyer’s tax rate
A merger is dilutive, do you always say no as a shareholder?
No, you need to evaluate future growth expectations and future year accretion instead of just year one results as synergies may take time.
A company trading at 20x PE purchases a company trading at 10x PE – what is the breakeven if it is 100% debt financed?
After-tax cost of debt equals the earnings yield on the target co. – 1/10 = 10% so kD x (1 – tax) = 10%
When would you prefer to use equity in a merger?
You think that your equity is overvalued and lower than your incremental cost of debt. You cannot raise further debt. You think that the target’s growth potential offers a much greater return than the return on equity you are offering.
How would you calculate “break-even synergies” in an M&A deal and what does the number mean?
The quantum of synergies required to make accretion/dilution zero.
What is the purpose of Purchase Price Allocation (PPA) in an M&A deal? Can you explain how it works?
Purchase Price Allocation makes the pro-forma/combined Balance Sheet balance. Items get remarked/adjusted up or down based on the fair value (e.g. Property, Plant & Equipment via an asset write-up), while the seller’s Shareholders’ Equity is wiped out. Excess purchase price over written-up net identifiable assets is recorded as goodwill.
Would a seller prefer a Stock Purchase or an Asset Purchase? What about the buyer?
Seller Perspective in M&A
Prefers a Stock Purchase to avoid double taxation and to dispose of all of its Liabilities – for example, if they sell only the asset, they may be responsible for legal or regulatory accounts and contingencies as the historical operator
Buyer Perspective in M&A
Prefers an Asset Purchase so they can be specific about what they acquire and for the tax benefit from being able to deduct depreciation on the Asset Write-Up above net identifiable assets
You are running a sell side process for a company that has been narrowed down to only two financial buyers (Private Equity) – one firm bids materially higher than the other, what could be the justification?
They are paying for an upside case for operations or the macroeconomy
There are synergies with other portfolio companies
They are able to secure more or cheaper debt from their secured financing package that would improve IRRs
They have a lower hurdle IRR
They do not pay taxes (pensions)
A lot of junior bankers have spoken to not needing to know accretion dilution beyond the first cookie cutter question. That is an unnecessary gamble, as there are many bankers who use accretion dilution questions as a screen in the first round and sometimes even in informational coffees. It is a great screen, because 4/5 candidates do not understand it theoretically (including many junior bankers at Canadian banks, if they are in coverage and not M&A) which identifies who is intellectually curious.
For a more thorough explanation of accretion/dilution and additional questions please read the following links:
Accretion/Dilution Part I: EPS, Earnings Yield & All-Stock Transactions
Accretion/Dilution Part II: Math and Breakeven Premiums
Accretion/Dilution Part III: Using Debt for Acquisitions
Accretion/Dilution Part IV: Synergies & Sources of Funds
Cash or Stock Consideration for M&A
Walk me through accretion/dilution analysis
If earnings per share goes up, it is accretive post any corporate finance activity – so after a recap or a merger, look at new net income and divide by pro-forma shares
If company A has 10x P/E and acquires company B with 5x P/E, is the transaction accretive or dilutive?
It depends on whether the funding source is stock, debt or cash. If the transaction is funded entirely by stock, it is accretive to earnings.
Is purchasing a company with debt always accretive?
No, if the after-tax cost of debt exceeds the earnings yield (inverse of price earnings), it will not be accretive. Think about the earnings yield of the target as the return on investment you are getting back. So if the return is less than your funding cost, this will be dilutive to earnings.
If company A trades at 8x price earnings and purchases company B with 10x price earnings with 30% debt and 20% cash, is the transaction accretive or dilutive?
The interviewee needs to ask what is the after-tax cost of debt and the after-tax return on cash (you get interest on cash you hold, so you are looking at the foregone interest income). Assuming kD after tax of 5% and kC after tax of 2%… 0.5*.125 + 0.3*0.05 + 0.2*0.02 = .06125 + .015 + .004 = .07665. This is your cost of funding and your return on investment gained is 10%, so the transaction is accretive.
If a company trades at 10x and purchases a company at 5x, how large of a premium could it pay before the transaction is at its breakeven?
Assuming all stock the answer is a 100% premium.
If you look at it from a simple perspective of 10/1 is the breakeven P/E, you multiply the purchase price by 1 x to get from 5x to 10x. If earnings are the same, doubling the price makes it 10x.
So does this mean this rule makes a transaction that is accretive make sense all the time?
No, there needs to be synergies that compensate for the costs of the merger. Sometimes, there is a good reason why a company is trading at a lower multiple, and you may be saddled with an additional conglomerate discount (if the reason behind the multiple discrepancy was a difference in sector).
A company is trading at 20x PE and undergoes a leveraged recapitalization with debt with a 5% coupon. Is the transaction accretive or dilutive?
Ask about the tax, but unless tax is zero the transaction is accretive as the after-tax cost of debt is lower than the earnings yield purchased.
How do I account for the dilutive effect of stock options in getting to share equivalents?
You look at all of the in-the-money stock options the company has issued (current share price is above the exercise price) and multiply that by the current share price. That is the amount of stock the company will issue in terms of value. Multiply the strike price by the number of ITM stock options. This will determine the amount paid to the company in exchange for shares. We assume the company uses all these cash proceeds to repurchase shares, so you divide the proceeds by the current share price. There is your adjustment.
Financial Modeling Questions
Walk me through how to model a pension
Modeling a pension involves modeling changes to the Pension Benefit Obligation (PBO) and Plan Assets (PA).
Certain assumptions must be set, the most important ones being the discount rate (which feeds into pension interest and actuarial gains and losses for the PBO) and the expected return on plan assets (EROA). As predicting actual returns is impossible, for modeling purposes the actual return is set to equal the expected return.
Net Pension Expense = Service Cost + Interest Cost + Prior Service Cost – Expected Return on Plan Assets +/- Actuarial Gain/Loss
Service Cost – Present value of retirement benefits accrued for plan participants who work over the year. This considers a host of demographic factors, mortality assumptions and can be extremely detailed. If it is detailed enough, it may look like an actuary’s model instead. Bankers will use last year’s service cost on a go-forward basis unless there is a material change. Adjustments for prior service costs may also be considered.
Interest Cost – The accretion for rolling forward one year on the pension benefit obligation payouts. This will be determined by the interest rate.
Expected Return on Plan Assets – The EROA rate multiplied by beginning of year plan assets.
Actuarial Gain/Loss – Changes to the pension benefit obligation due to changes in the discount rate. A fall in the discount rate will result in an increase to PBO and vice versa.
Pension expense flows through the income statement and will be taxed.
Changes in Pension Benefit Obligation
Ending PBO = Beginning PBO + Service + Interest + Employee Contributions +/- Actuarial Loss/Gain – Benefits Paid
Changes in Plan Assets
Ending PA = Beginning PA + Actual Return + Contributions + Employee Contributions – Benefits Paid
The difference between plan assets and PBO is the funded status. A change in funded status will give rise to changes in deferred tax assets or deferred tax liabilities. Unfunded pensions give rise to a deferred tax asset.
When does the interest function become circular?
If the interest calculation is the average of the beginning and ending debt that it must be paid on (as interest is paid throughout the year as opposed to a lump sum in the end), the function will become circular as debt/cash determines interest which determines net income which determines cash flow which determines debt/cash.
A good fix is to install a circuit breaker.
Corporate Finance Questions
What are some reasons why a company may be highly leveraged?
Aggressive spending (organic and inorganic) that has not seen higher concomitant cash flows so far
Stable cash flows that can support leverage
Shareholder friendly corporate actions such as using debt for share buybacks and dividend hikes
How does higher leverage affect WACC and valuation?
According to corporate finance theory (Mogliandi Miller et al)， more debt in the capital structure lowers the WACC until an inflection point where the costs of financial distress drive up the cost of debt and the cost of equity. So, until the optimal capital structure, higher leverage means a lower WACC (and therefore a higher valuation as the future cash flows are discounted at the lowest possible cost of capital).
A company generates material excess cash flow or free cash flow. What should the CFO do?
So assuming there is no upcoming capex plan (hence the excess cash flow), corporate finance options include instigating a dividend or bumping up the dividend, repurchasing shares and repaying debt.
Now this is an advanced question beyond the knowledge of an aspiring university student investment banker – in fact, MDs are paid millions of dollars to answer this question for clients.
However, an interviewing candidate should know to compare dividends and share repurchases – dividends attract a larger investor base (income investors) but are “sticky” while share repurchases are more pragmatic. Dividend payout must be sustainable while share repurchases are a one-time item.
Looking at share repurchases versus debt repayment is more theoretical. You have to compare the cost of debt (after-tax) versus the implied cost of equity. So on paper, if the cost of debt is high (high coupon, high yield company), there becomes more of an argument to pay down debt versus buying back shares. Likewise, if the P/E of the company is extremely high, equity is expensive to repurchase and buying back debt could be more accretive to earnings.
However, earnings accretion and intrinsic value are separate concepts. If the management team feels that shares are trading below intrinsic value they should look to repurchase shares.
In a very advanced corporate finance conversation, a candidate could discuss that the true cost of buying back debt is not the coupon because the debt is not necessarily bank debt. If high yield bonds are callable, there is a premium that needs to be paid on the principal. If bonds are not callable, a punitive make whole may make debt repayment prohibitively expensive – liability management options such as open market repurchases and tender offers for debt may have to be considered. What tranche of debt to consider is also a service that investment bankers offer – so which series of bonds should we retire – the 2021’s, the 2023’s the 2024’s.
How do you choose what valuation metrics to use for a company?
In theory, you need to select multiples that are appropriate for the industry or subsector. So for financial institutions such as banks or insurers, EBITDA multiples do not make sense. For early stage tech companies, cash flow may not make sense and revenue multiples should be looked at instead. The multiples chosen should be in line with other wall street brokers unless there is a good reason for doing so or the purpose of the analysis is different (liquidation and restructuring).
What is a greenshoe or overallotment?
The greenshoe or overallotment is the option afforded to underwriters of an equity offering (the investment bank) to sell more than the number of shares initially set aside for the issue.
Usually, the overallotment can be up to 15% of the original issue size. This usually happens when demand for the company’s equity is robust (institutional or retail demand covers the issue size by a large multiple) and the investment banks are confident a good price per share can be obtained.
The overallotment is not only for IPOs, but can be for secondary issues as well.
Leveraged Buyout (LBO) Questions
What is IRR?
IRR or the internal rate of return is the discount rate for a series of cash flows that makes NPV equal 0.
What are some plugs in an LBO model?
- Goodwill – based on purchase price
- Equity – based on purchase price
- Debt repayments – based on cash flow, may be optional or not depending on cash sweep provisions – if certain debt does not need to be paid down immediately dividends may boost IRR
What drives IRR in an LBO?
Entry multiple, exit multiple, interest, loan to value, EBITDA expectations.
What is IRR from a WACC perspective?
The return on equity.
Do you discount cash flows in an LBO?
No, rather you are implicitly solving for the return on equity via the IRR. The cash flows will be used for debt service (interest and upcoming principal payments).
What is a good LBO candidate?
High and stable free cash flow, lots of free cash and low leverage.
What are some forms of debt used in an LBO?
- Term Loan A
- Term Loan B
- Senior Notes
- Junior or Subordinated Notes
- Preferred Shares (depending how debt-like it is)
What is circular in an LBO model?
Interest expense – You will use the average of the beginning of the period and end of the period for debt, however the interest affects net income which affects cash flow which affects revolver draws and repayments which affect interest.
What are some differences between bank debt and high yield bonds?
- Maintenance vs incurrence covenants
- Amortizing payments vs bullet payments
- Floating rates swapped to fixed vs fixed coupon
- Interest presumably higher for high yield given differences in levels of security (of course all of these are just typical and can vary greatly)
You buy a company for $1 billion using 15% equity and sell it for $1 billion 5 years later with 30% equity ownership. What is your IRR?
This is a tricky question – basically the equity value has doubled so you can use the rule of 72 quickly to figure out the approximate return per annum. 72/5 = ~14.4%
We are advising a sponsor on this deal, do we suggest it as is?
No, PE hurdles are closer to 25 – 30%.
What is an acceptable IRR?
For traditional private equity firms, the lowest they are willing to go is usually 20%-25%. For different mandates, such as infrastructure funds, IRR may be 15% or lower even depending on how low their cost of funds is and how accessible financing can be – usually requires very stable cash flow.
Likewise, for institutional real estate, IRR on an unlevered basis can be sub-10%. IRR thresholds are a function of risk and reward just like anything else in finance – the riskier the investment, the higher the IRR must be.
In an LBO, a private equity firm has a 30/70 financing split for debt/equity. The IRR is 17%. What happens to returns if a bank offers more aggressive terms and allows 60/40 debt/equity?
In most cases, debt is far cheaper than equity both because it is more “safe” and senior in the capital structure (risk and reward) and the cost of debt or interest is tax deductible. So returns on the asset being the same will juice the return on equity, all things equal. Accordingly the IRR should go up.
Now there will eventually be a point where debt is too high (not realistic in an LBO scenario) where the cost of debt becomes very high too.
What is the Multiple on Invested Capital (MoIC)?
MoIC is how many times the initial investment is paid back over the investment period. For instance, if a financial sponsor invests $150 million and exits at $450 million, the MoIC is 3x. This figure is meaningful but does not give a full picture of acceptable return until a time period/holding period is taken into account.
When would you conduct an ability to pay analysis?
From a sell side perspective – an investment bank looking to help sell a company or a company looking to put itself up for sale – you conduct the ability to pay analysis to figure out what is the maximum a company could pay when factoring in their required rate of returns. Your objective is to get the highest price possible.
From a buy side process perspective – an investment bank looking to help a potential buyer – you are looking at what your maximum price can be given your assumptions for the company, and you may also solve to see what other potential bidders may be willing to pay by backing out their expected required return. Then you can bid to just outprice them as long as it falls into your acceptable range of prices.
Walk me through an ability to pay analysis.
An ability to pay analysis is conducted to find out what is the maximum amount a potential bidder could pay.
This is a reversal of the standard LBO focus – plugging in an equity value to find the IRR. The ability to pay starts with the required IRR (possibly a few different IRRs – for instance 20%, 25% and 30%) and solving for the equity value. When this is a public company, this translates to how much per share – which implies the premium to current market price.
First, an analyst will take the IRR and the holding period/time horizon from purchase to exit/when the financial sponsor sells the firm.
Take the required IRR and compound it by the number of years, which is usually 5. So this would be (1 + IRR)^5.
Assuming a normal IRR, this could be (1+0.25)^5 = 3.05x. This implies a multiple on invested capital (MoIC) of 3.05x.
Now, the value of the company at the exit period must be projected. If year 5 EBITDA is expected to be $100 million and the exit multiple is expected to be 8x, this implies an enterprise value of $800 million. Subtracting the net debt at the time of exit from the enterprise value will yield the equity value. Let’s assume that the debt at the time of exit is $300 million – this means that the equity value will be $500 million.
This means the invested equity must be no more than $300 million/3.05x – the required MoIC – or $95 million. The ability to pay analysis will assume that the potential buyer will be able to attain a financing package from banks and the public markets via banks – something that is constrained by leverage, coverage and capitalization metrics/covenants at the time. So, for instance, banks may not allow a debt number that exceeds 5x EBITDA for certain industries.
Assuming that a buyer could secure $300 million in debt financing for their bid, this means that that the total purchase price can be no more than $395 million (the transaction value). For a public company, this figure can be used to solve for the implied price per share and a premium per share to what it is currently trading at.
What has a higher IRR all things equal, letting an LBO go on or using a dividend recap?
A dividend recap will lower the IRR for your model because you have to pay make-whole premiums or premiums for tendering old debt as well as fees to investment banks to issue new debt.
Why would a PE firm look at a dividend recap when the IRR is lower?
Lock in your original capital – a trade off between certainty of recovery of capital and a better return.
Standard accounting questions such as how does depreciation flow through the three statements are extremely common. You will be expected to know them cold. We like to ask broadly on topics that really test if a candidate has a good grasp of accounting.
Walk me through an income statement
Revenue – COGS = Gross Profit
Gross Profit – Other Expenses (SG&A etc.) = EBITDA
EBITDA – Depreciation and Amortization = EBIT
EBIT – Interest Expense = EBT
EBT – Tax Expense = Net Income
Walk me through a cash flow statement
Operating Cash Flow + Investing Cash Flow + Financing Cash Flow = Net Change in Cash
How do the three statements link together?
Income statement ends with net income. Net income is the first line of the cash flow statement and ends with ending cash. Ending cash is the cash balance on the statement of financial position
If you could only look at one statement which one would you look at?
Cash flow statement as you can see net income – as well as the actual cash entering the company (and accordingly its ability to satisfy its liabilities) and quality of cash flow (is it from recurring operations or one time sales or working capital releases? Is it from further leverage?). You can construct the cash flow statement using the income statement and balance sheet, however
When would you classify a lease as a capital lease?
The answer is if it satisfies any of the following four conditions.
a) Ownership is transferred at the end of the lease term
b) Option to purchase the asset at a “bargain price” at the end of the term (below fair market value)
c) Term of lease is 75% or greater of useful life
d) PV of lease payments is greater than 90% of asset fair market value
How are operating and capital leases accounted for in the financial statements?
The present value of capital lease payments will show up on the balance sheet. Capital lease obligations are recorded as debt. Operating leases are expensed in the income statement. Usually the company will break out operating lease obligations in the notes to the financial statements under a section that has some variant of: contingencies, commitments, obligations.
Why should we adjust for operating leases to find the appropriate capitalization of a company?
Operating leases have debt-like characteristics that should be recognized on the balance sheet. We acknowledge the parallels are less clear when the leases can be easily canceled or restructured.
How does EV/EBITDA change whether you use an operating lease or a finance/capital lease?
The answer is that it is inconclusive. Capitalizing leases will increase EV as it is a debt-like entity on the balance sheet. However, EBITDA is higher than under an operating lease because there is incremental depreciation from the capital lease and you no longer subtract operating lease expense from EBITDA. It is important to normalize so that companies are comparable regardless of how they choose to structure leases.
How should we normalize operating leases?
Theoretically, take the present value of operating lease commitments. In practice, you will slap on an industry relevant multiple (usually 7x for valuation and 8x for credit, despite lower multiples ascribed by the credit agencies). Rent or operating lease can also be broken into lease interest and lease depreciation. The lease interest will be determined by multiplying the capitalized lease obligation by an appropriate interest rate (usually the blended cost of debt the company currently pays) and the depreciation expense will be the residual
Where are areas where debt or debt-like items may be understated?
It is possible that in defined benefit pension plans, the projected benefit obligations (PBO) are understated due to an inappropriate discount rate
Inventory goes up by $30 and Accounts Payable fall by $50, what happens to cash?
Cash falls by $80
How does share based compensation (SBC) affect financials?
- Income Statement – SBC + SBC*tax
- Cash Flow – lower net income + SBC (assuming physical settlement instead of cash)
- Balance Sheet – Cash goes up Shareholders Equity goes up (assuming physical settlement) from the SBC less the decrease in net income
A company has positive EBITDA but files for bankruptcy – what happened?
Could be interest on debt was too high, debt maturity was too large and could not fundraise and did not have liquidity to pay it off, capex needs were too high, taxes owed came due, a legal obligation arose that was too large, etc.
However, as this is a cash flow positive company, it is likely that after the equityholders get zero and the assets are stripped, they can be sold off elsewhere.
Can you have negative net income but positive operating cash flow?
Yes – non-cash charges such as depreciation and impairment do not affect your cash balance. Working capital releases can also boost OCF.
You buy equipment with a useful life of 5 years for $100 with straight line depreciation. After year one you sell it for $150, walk me through the three statements.
First, ask what the tax rate is. Let’s say it’s 40%.
depreciation – 20 so EBT is -20. You have tax savings of $8 (20 x .4). Your net income falls by $12
Cash flow statement
net income is lower by $12, however depreciation is a non-cash charge so you add back $20. OCF is +8 (the amount you saved on taxes).
Cash flow from investing is lower by $100, because you bought the equipment. Assuming it was cash financed, cash flow from financing does not change. Cash is down $92.
For the balance sheet, cash is down $92, equipment is up $80 (+$100 from the purchase less $20 from the depreciation) and retained earnings is down $12 (net income fell). As it follows, Assets are down $12 and Equity is down $12 – we have balance.
Beginning of Year 2
You sell an asset for $150 when the amortized book value is $80, so you realize a gain on sale of $70. This gain is taxed (assume corporate tax instead of some random capital gains tax) so you have $42 in net income.
Net income is up by $42, but you subtract the gain on sale of $70 as this gain is an accounting number only.
CFO falls by $28 (the amount you paid on tax).
With the sale for $150, your Cash flow from Investing goes up by $150.
Overall, your cash rises by $122.
Cash rises by $122 and equipment falls by $80. Your retained earnings goes up by your net income of $42. Assets + 42 SE + 42.
What would you rather have – a 10% bump to revenue or a 2% expansion of operating margin?
The answer is that it depends on what operating margin was to begin with because your end goal is net income. If you had $100 in revenue and operating margin was 20%, a 10% increase in revenue will translate to $2 in incremental operating margin – as would a 2% expansion in operating margin.
What happens to net income in an inflationary LIFO environment?
COGS are going up so net income is going down.
When does minority interest arise?
A subsidiary a firm controls is partially owned by non-controlling shareholders
How do you treat minority interest in the EV calculation?
You add it to EV, just like debt.
How do you treat investments in associates in the EV calculation?
You subtract it from EV, similar to cash or investments, as theoretically if you purchased the firm you could use that to sell for proceeds.
How do you consolidate investments in associates?
You consolidate them using the equity method – add the equity value of the associate multiplied by the percentage of ownership
What is PIK interest?
Payment-in-kind – as in your interest is paid in the form of more debt.
What is EBITDA?
Earnings before interest, tax, depreciation and amortization
If capex spend is $10 million per year forever, what is depreciation in year 100?
What are 3 significant things that happened in the markets this past week?
Bankers are looking for someone intellectually curious who will be engaged with the drivers behind the work. For Canada, the Globe and Mail is the newspaper of record and has the most relevant business section for Canadian corporate finance activity.
The National Post is also OK, so those should be the two websites you frequent on a regular basis. On a global level, the FT is the runaway best publication, followed by the WSJ and DealBook from the Times. Knowing commodity prices and where the TSX is at is very important when interviewing for a Canadian bank.
Bonus points for M&A deals by the bank that you are interviewing for, although you must be prepared to speak about it if they press.
Why did the tech bubble burst?
Generally, bubbles occur when investor confidence pushes the price of the securities significantly above its fundamental value. The tech bubble is no different. The term “Irrational Exuberance” was coined by Fed Chairman Alan Greenspan to describe this phenomena. The sentiment behind this bubble was that the growth of companies with any online presence or loose relation would be astronomical, but a realisation that normal valuation principles still applied and that many of these companies had no feasible timeline to profit (or even revenue) resulted in markets receding. Literature suggests that a Barron’s article sparked the reversal.
If you had $1 million what would you invest in?
There is no single correct answer to this question. You may want to start with communicating your risk tolerances based on your financial position and your expected outlay. Then based on the current market conditions (stock market, bond market, commodities market), allocate assets based on how far they deviate away from their fundamental levels.
The main thing that the interviewer is looking for is the quality of your thought process and your ability to articulate your ideas.
What if you had to invest that in a single company?
Start the answer the same way you would with the previous question, and transition into a stock pitch. You may need to prepare multiple stock pitches beforehand, see our section on it for more details.
If the interest rate in the U.S. increases, how would this affect the exchange rate?
The US dollar would strengthen relative to the Canadian dollar, holding all other things constant. Investors will pour into a higher yielding asset assuming no significant delta in risk or expected devaluation. Empirical evidence suggests that the economy is relatively hotter as well if the central bank is raising rates. Recent Federal Reserve and Bank of Canada actions have supported this.
You may segue into a discussion on purchasing power parity and expectations where you expect the Canadian dollar to appreciate instead, but do not do that.
Should a company issue debt or equity under current market conditions?
The decision is largely influenced by the cost of capital, which is partially determined by stock market conditions and interest rates (remember interest expense is tax deductible). Generally, the company will choose the cheaper financing option (however, there are other factors at play, eg. pecking order theory).
Where do you think the Canadian economy is going next year?
Understanding the current trends in commodity prices (especially oil), unemployment, the stock market, and government policies (fiscal, monetary, foreign etc.) is crucial when answering this question. There is no single correct answer, but speaking articulately on all the relevant points is expected.
What is the current state of interest rates?
You need to know what the interest rates are in Canada and the US, and the consensus on where they’re moving towards. You also need to know who the governor of the Bank of Canada is (Stephen Poloz), and who the Chair of the Federal Reserve is (Janet Yellen) – and probably who the governor of the Bank of England is (Mark Carney).
What are the objectives of the Federal Reserve?
The main objectives of the Federal Reserve are identified to be “maximum employment, stable prices, and moderate long-term interest rates”. The Fed uses various instruments of monetary policy in order to fulfill their dual mandate.
What is the difference between currency depreciation and devaluation?
Depreciation occurs in a flexible exchange rate system, where the value of the domestic currency decreases relative to foreign currency. Devaluation occurs in a fixed exchange rate system.
What are the different levels of debt?
Debtor in possession lenders – unique financing method for a company in bankruptcy usually has seniority over all other types of debt
Secured creditors – those with revolvers and bank debt
Unsecured creditors – high yield bonds
Mezzanine – convertibles bond, convertible preferred, preferred, PIK
What is quantitative easing?
Quantitative easing is a monetary policy instrument used by the Fed to depress interest rates. It is achieved through the purchase of securities from the market, and flooding financial institutions with money to give them more incentive to increase lending.