Investment Banking Practice Questions

QUESTION: "Explain the big idea behind a DCF analysis and how it is used to value a company."

ANSWER: A DCF is an expansion of this formula: Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate The problem is that that formula assumes the company's Discount Rate and Cash Flow Growth Rate never change - but in real life, they keep changing until the company reaches maturity. So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: One where those assumptions change (the explicit forecast period) and one where they stay the same (the Terminal Period). You then project the company's cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s). Then, you compare this sum - the company's Implied Value - to the company's Current Value or "Asking Price" to see if it's valued appropriately.

QUESTION: "What might cause a company's Present Value (PV) to increase or decrease?"

ANSWER: A company's PV might increase if its expected future cash flows increase, its expected future cash flows start to grow at a faster rate, or the Discount Rate decreases (e.g., because the expected returns of similar companies decrease). The PV might decrease if the opposite happens.

QUESTION: "Which of the main 3 valuation methodologies will produce the highest valuations?"

ANSWER: Any methodology could produce the highest valuations depending on the industry, period, and assumptions. But you can say that Precedent Transactions often produce higher values than the Public Comps because of the control premium - the extra amount that acquirers must pay to acquire sellers. It's tough to say how a DCF stacks up because it's far more dependent on the assumptions and far-in-the-future projections. So: "A DCF tends to produce the most variable output since it's so dependent on the assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium."

QUESTION: "A company goes from 20% Debt / Total Capital to 30% Debt / Total Capital. How do its Cost of Equity, Cost of Debt, and WACC change? Assume it only has Debt and Equity."

ANSWER: As a company uses more Debt, the Cost of Debt and Cost of Equity always increase because more Debt increases the risk of bankruptcy, which affects all investors. As the company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts to increase at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt. In this case, we can't tell how WACC will change because we don't know where we are on this "curve" - but we guess that WACC will likely decrease because 30% Debt / Total Capital is still in a fairly low/normal range for most industries.

QUESTION: "What are the Combined Equity Value and Enterprise Value in this same deal? Assume that Equity Value = Enterprise Value for both the Buyer and Seller."

ANSWER: Combined Equity Value = Buyer's Equity Value + Value of Stock Issued in the Deal = $250 + $150 = $400. Combined Enterprise Value = Buyer's Enterprise Value + Purchase Enterprise Value of Seller = $250 + $150 = $400.

QUESTION: "A company generates $200 of cash flow today, and its cash flow is expected to grow at 4% per year for the long term. You could earn 10% per year by investing in other, similar companies. How much would you pay for this company?"

ANSWER: Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate. So, this one becomes: $200 / (10% - 4%) = $3,333.

QUESTION: "What do Equity Value and Enterprise Value mean, intuitively?"

ANSWER: Equity Value is the value of ALL the company's Assets, but only to EQUITY INVESTORS (common shareholders). Enterprise Value is the value of only the company's core-business Assets, but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

QUESTION: "Walk me through a leveraged buyout model."

ANSWER: In a leveraged buyout, a PE firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells it. The math works because leverage amplifies returns the PE firm earns a higher return if the deal goes well because it uses less of its own money upfront (and it earns an even lower return if the deal goes poorly!). In Step 1, you make assumptions for the Purchase Price, Debt and Equity, Interest Rate on Debt, and Revenue Growth and Margins. In Step 2, you create a Sources & Uses schedule to calculate the Investor Equity paid by the PE firm. In Step 3, you adjust the Balance Sheet for the effects of the deal, such as the new Debt, Equity, and Goodwill. In Step 4, you project the company's statements, or at least its cash flow, and determine how much Debt it repays each year. Finally, in Step 5, you make assumptions about the exit, usually using an EBITDA multiple, and calculate the IRR and cash-on-cash multiple.

QUESTION: "A company runs into financial distress and needs cash immediately. It sells a factory that's listed at $100 on its Balance Sheet for $80. What happens on the 3 statements, assuming a 40% tax rate?"

ANSWER: Income Statement: Record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate. Cash Flow Statement: Net Income is down by $12, but you add back the $20 Loss since it's non-cash. You also show the full proceeds, $80, in Cash Flow from Investing, so cash at the bottom is up by $88. Balance Sheet: Cash is up by $88, but PP&E is down by $100, so the Assets side is down by $12. The L&E side is also down by $12 because Retained Earnings fell by $12 due to the Net Income decrease, so both sides balance.

QUESTION: "You buy a $100 EBITDA business for a 10x multiple, and you believe that you can sell it again in 5 years for 10x EBITDA. You use 5x Debt / EBITDA to fund the deal, and the company repays 50% of that Debt over 5 years, generating no extra Cash. How much EBITDA growth do you need to realize a 20% IRR?"

ANSWER: Initial Investor Equity = $100 * 10 * 50% = $500. 20% IRR Over 5 Years = ~2.5x multiple (2x = ~15% and 3x = ~25%). Required Exit Equity Proceeds = $500 * 2.5 = $1,250. Remaining Debt = $250, so Exit Enterprise Value = $1,500. Required EBITDA = $150, since $1,500 / 10 = $150. So, EBITDA must grow by 50%.

QUESTION: "A PE firm acquires a $100 million EBITDA company for a 10x multiple using 60% Debt. The company's EBITDA grows to $150 million by Year 5, but the exit multiple drops to 9x. The company repays $250 million of Debt and generates no extra Cash. What's the IRR?"

ANSWER: Initial Investor Equity = $100 million * 10 * 40% = $400 million. Exit Enterprise Value = $150 million * 9 = $1,350 million. Debt Remaining Upon Exit = $600 million - $250 million = $350 million. Exit Equity Proceeds = $1,350 million - $350 million = $1 billion. This represents a 2.5x multiple over 5 years, and you should know that a 2x multiple over 5 years is a ~15% IRR, while a 3x multiple is a ~25% IRR, so this IRR is approximately 20%.

QUESTION: "A company issues $200 million in new shares, and then it uses $100 million from the proceeds to issue Dividends to shareholders. How do Equity value and Enterprise Value change in each step?"

ANSWER: Initially, Equity Value increases by $200 million because Total Assets increases by $200 million and the change is attributable to common shareholders. Enterprise Value stays the same because Cash is a non-core-business Asset you can also say that the increases in Cash and Equity Value offset each other in the Enterprise Value formula. In the next step, Equity Value decreases by $100 million because Cash, and therefore Total Assets, falls by $100 million and this change is attributable to common shareholders. Enterprise Value stays the same because Cash is a non-core-business Asset, or because the reduced Cash and reduced Equity Value offset each other.

QUESTION: "A company buys a factory using $100 of debt. A year passes, and the company pays 10% interest on the debt as it depreciates $10 of the factory. It repays $20 of the loan as well. Walk me through the statements from beginning to end, and assume a 40% tax rate."

ANSWER: Initially, nothing changes on the IS. The $100 factory purchase shows up as CapEx on the CFS, and the $100 debt issuance shows up on the CFS as well, offsetting it, so Cash does not change at the bottom. On the Balance Sheet, PP&E is up by $100, and Debt is up by $100, so both sides balance. Then in the first year, you record $10 of interest and $10 of depreciation on the IS, reducing Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate. On the CFS, Net Income is down by $12, but you add back the $10 of depreciation since it is non-cash, and the $20 loan repayment is a cash outflow, so Cash is down by $22. On the BS, Cash is down by $22, and PP&E is down by $10, so the Assets side is down by $32. On the L&E side, Debt is down by $20 and Retained Earnings is down by $12, so the L&E side is down by $32 and both sides balance.

QUESTION: "How much would you pay for a company that generates $100 of cash flow every single year into eternity?"

ANSWER: It depends on your Discount Rate, or "targeted yield." If your Discount Rate is 10%, meaning you could earn 10% per year in companies with similar risk/potential return profiles, you would pay $100 / 10% = $1,000. But if your Discount Rate is 20%, you would pay $100 / 20% = $500.

QUESTION: "What does it mean if a company's Free Cash Flow is growing, but its Change in Working Capital is increasingly negative each year?"

ANSWER: It means that the company's Net Income or non-cash charges are growing by more than its Change in WC is declining, or that its CapEx is becoming less negative (i.e., shrinking) by more than the Change in WC is declining. If a company's Net Income is growing for legitimate reasons, this is a positive sign. But if higher non-cash charges or artificially low CapEx are boosting FCF, both of those are negative.

QUESTION: "What's an ideal LBO candidate?"

ANSWER: Price is the most important factor because almost any deal could work at the right price (i.e., one that's low enough) - but if the price is too high, the chances of failure increase substantially. Beyond that, stable and predictable cash flows are important, there shouldn't be a huge need for ongoing CapEx or other big investments, and there should be a realistic path to exit, with returns driven by EBITDA growth and Debt paydown instead of multiple expansion.

QUESTION: "Walk me through a merger model."

ANSWER: Start by projecting the financial statements of the Buyer and Seller. Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition and its effects. Then, you combine the Balance Sheets of the Buyer and Seller, reflecting the Cash, Debt, and Stock used, new Goodwill created, and any write-ups. You then combine the Income Statements, reflecting the Foregone Interest on Cash, Interest on Debt, and synergies. If Debt or Cash changes over time, the Interest figures should also change. The Combined Net Income equals the Combined Pre-Tax Income times (1 - Buyer's Tax Rate), and you divide that by (Buyer's Existing Share Count + New Shares Issued in the Deal) to get the Combined EPS. You calculate the accretion/dilution by dividing the Combined EPS by the Buyer's standalone EPS and subtracting 1.

QUESTION: "What does the Change in Working Capital mean, intuitively?"

ANSWER: The Change in Working Capital tells you if the company needs to spend in advance of its growth, or if it generates more money as a result of its growth. For example, the Change in Working Capital is usually negative for retailers because they must spend money on Inventory before being able to sell their products. But the Change in Working Capital is often positive for subscription-based companies that collect cash in advance because Deferred Revenue increases when they do that. The Change in Working Capital increases or decreases Free Cash Flow, which, in turn, directly affects the company's valuation.

QUESTION: "What does the internal rate of return (IRR) mean?"

ANSWER: The IRR is the Discount Rate at which the Net Present Value of an investment, i.e., Present Value of Cash Flows - Upfront Price, equals 0. You can also think of it as the "effective compounded interest rate on an investment" - so, if you invest $1,000 today, end up with $2,000 in 5 years, and contribute and earn nothing in between, the IRR is the interest rate you'd have to earn on that $1,000, compounded each year, to reach $2,000 in 5 years.

QUESTION: "Let's say it is a 100% Stock deal. The Buyer has 10 shares at a share price of $25.00, and its Net Income is $10. It acquires the Seller for a Purchase Equity Value of $150. The Seller has a Net Income of $10 as well. Assume the same tax rates for both companies. How accretive is this deal?"

ANSWER: The buyer's EPS is $10 / 10 = $1.00. It must issue $150 / $25.00 = 6 additional shares to do the deal, so the Combined Share Count is 10 + 6 = 16. Since both companies have the same tax rate and since no Cash or Debt is used, Combined Net Income = $10 + $10 = $20, and Combined EPS = $20 / 16 = $1.25, so the deal is 25% accretive.

QUESTION: "Without doing any math, what ranges would you expect for the Combined EV / EBITDA and P / E multiples, and why?"

ANSWER: They should be somewhere in between the Buyer's multiples and the Seller's purchase multiples. It's almost never a simple average because of the relative sizes of the Buyer and Seller - and for P / E multiples, the purchase method also plays a role.

QUESTION: "How do the 3 financial statements link together? Assume the Indirect Method for the Cash Flow Statement."

ANSWER: To link the statements, make Net Income at the bottom of the Income Statement the top line of the Cash Flow Statement. Then, adjust this Net Income number for any non-cash items such as Depreciation & Amortization. Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or decrease the company's cash flow depending on how they've changed. That gets you to Cash Flow from Operations. Next, reflect investing and financing activities, which may increase or decrease cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom. Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net Income to Retained Earnings within Equity on the Balance Sheet. Then, link each non-cash adjustment to the appropriate Asset or Liability SUBTRACT links on the Assets side and ADD links on the L&E side. Link each CFI and CFF item to the matching item on the Balance Sheet, using the same rule as above. Check that Assets equals Liabilities + Equity at the end if this is not true, you did something wrong and need to re-check your work.

QUESTION: "Explain what WACC means intuitively and how you might calculate each component of it."

ANSWER: WACC is the expected annualized return over the long term if you invest proportionately in all parts of the company's capital structure - Debt, Equity, Preferred Stock, and anything else it has. To a company, WACC represents the cost of funding its operations by using all its sources of capital and keeping its capital structure percentages the same over time. The formula is simple: WACC = Cost of Equity * % Equity + Cost of Debt * (1 - Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock You usually estimate the Cost of Equity with Risk-Free Rate + Equity Risk Premium * Levered Beta. The Cost of Debt and Cost of Preferred can be based on the Yield to Maturity (YTM) of the current issuances, the median rates or YTMs on the issuances of peer companies, or you can take the Risk-Free Rate and add a default spread based on the company's credit rating after it issues more Debt or Preferred.

QUESTION: "What are the advantages and disadvantages of EV / EBITDA vs. EV / EBIT vs. P / E as valuation multiples?"

ANSWER: With EV / EBITDA vs. EV / EBIT, EV / EBITDA is better in cases when you want to completely exclude the company's CapEx, Depreciation, and capital structure. EV / EBIT is better when you want to exclude capital structure but partially factor in CapEx and Depreciation. It is common in industries where those items are key value drivers for companies (e.g., manufacturing). The P / E multiple is not terribly useful in most cases because it's affected by different tax rates, capital structures, non-core-business activities, and more - so, you often use it in the interest of "completeness" or because you want a multiple that reflects a company's true bottom line. Also, it's important in industries such as commercial banking and insurance where you do need to factor in the interest income and expense.

QUESTION: "How do you calculate and sanity check Terminal Value in a DCF?"

ANSWER: You apply a Terminal Multiple, such as an EV / EBITDA figure based on the comparable companies, to EBITDA in the final year of the forecast period, or you pick a Terminal FCF Growth Rate and use a variation of the "Company Value" formula: Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate) To check yourself, back into the Terminal FCF Growth Rate implied by the first method and the Terminal Multiple implied by the second method. If you get, say, a 10% Implied Terminal FCF Growth Rate for a company in a developed country, you're way off and need to pick a lower multiple that results in a growth rate below the long-term GDP growth rate.

QUESTION: "A company with a P / E multiple of 25x acquires another company for a purchase P / E multiple of 15x. Will the deal be accretive or dilutive?"

ANSWER: You can't tell unless it's a 100% Stock deal. If it is, it will be accretive because the Cost of Acquisition is 1 / 25, or 4%, and the Seller's Yield is 1 / 15, or 6.7%. Since the Seller's Yield is higher, it will be accretive.

QUESTION: "How might you select a set of comparable public companies for use in a valuation?"

ANSWER: You screen based on geography, industry, and size. For example, your screen might be "U.S.-based steel manufacturing companies with over $500 million in revenue" or "European legacy airlines with over €1 billion in EBITDA."

QUESTION: "Walk me through an Unlevered DCF."

ANSWER: You start by projecting the company's Unlevered Free Cash Flows over the next 5-10 years by making assumptions for revenue growth, margins, Working Capital, and CapEx. Unlevered FCF excludes all financing and non-core-business activities and equals EBIT * (1 - Tax Rate) + D&A +/- Change in Working Capital - CapEx. Then, you discount the UFCFs to Present Value using the Weighted Average Cost of Capital and sum up everything. Next, you estimate the company's Terminal Value using the Multiples Method or the Gordon Growth Method it represents the company's value after those first 5-10 years into perpetuity. You then discount the Terminal Value to Present Value using WACC and add it to the sum of the company's discounted UFCFs. Finally, you compare this Implied Enterprise Value to the company's Current Enterprise Value you'll often calculate the company's Implied Share Price so you can compare that to the Current Share Price as well.