Oasis Technical Questions
What factors affect foreign exchange rates?
Differences in interest rates, differences in inflation, budget deficits, public debt, trade policies, and capital market equilibrium.
What is "face value"?
Face value, or par value, of a bond is the amount the bond issuer must pay back at the time of maturity. Bonds are usually issued with a $1,000 face value.
How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?
A $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT(1-T) by 10(1-T). Assuming a 40% tax rate, it drops EBIT(1-T) by $6, but you must add back the $10 depreciation in the calculation of Free Cash Flows. Therefore your FCF increases by $4 and your valuation will increase by the present value of that $4, the equation for PV is below: PV of the $4 increase in year 4 = $4/(1+WACC)^4
What is a Eurodollar bond?
A Eurodollar bond is a bond issued by a foreign company, but issued in U.S. Dollars rather than their home currency. Note that a Eurodollar bond does not have to be issued by a company actually in Europe, it can be a bond issued by any foreign company.
When should a company buy back stock?
A company may buy back its own stock for a number of reasons. If it believes the stock is undervalued, when it has extra cash, if it believes it can make money by investing in itself, or if it wants to increase its stock price by increasing its EPS due to a reduction in shares outstanding or send a positive signal to the market.
Who is a more senior creditor, a bondholder or stockholder?
A bondholder is always a more senior creditor than a stockholder. In the event of bankruptcy/liquidation, the bondholder will be paid first. Additionally, interest payments are paid to bondholders before equity holders receive any profits in the form of dividends.
What is a Callable Bond?
A callable bond allows the issuer of the bond to redeem the bond prior to its maturity date, therefore ending their coupon payments. However, a premium is usually paid by the issuer to redeem the bond early.
What is a collateralized debt obligation (CDO)?
A collateralized debt obligation is a type of security that pools together a number of interest paying assets, and pays "coupon payments" based on those assets' future cash flows. A CDO is the broad asset class in which a number of interest paying assets are packaged together (securitized) and sold in the form of bonds. An investor pays the market value for the CDO and then has the rights to the interest payments in the form of coupon payments over time.
When should a company issue debt instead of issuing equity?
A company will normally prefer to issue debt since it is cheaper than issuing equity. In addition, interest payments are tax deductible and therefore provide interest tax shields. However, a company needs to have a steady cash flow in order to be able to pay the coupon payments every year, whereas that is not necessary when issuing equity. It may also try to raise debt if it feels its stock is particularly undervalued and would not raise the capital needed from an equity offering.
Describe a company's typical capital structure.
A company's capital structure is made up of debt and equity, but there may be multiple levels of each. Debt can be broken down into senior, mezzanine, and subordinated, with senior being paid off first in the event of a bankruptcy, then mezzanine, then subordinated. Since senior is paid off first, it will have a lower interest rate. Debt may consist of bank loans (which are normally most senior in the capital structure) and/or bonds which can be issued to the general public. Equity can also be broken down into preferred stock and common stock. Preferred stock is like a combination of debt and equity in that it has the opportunity for some appreciation in value, but more importantly pays out a consistent dividend that is not tied to the market price of the stock. Common stock is the final piece of the capital structure, and is the stock that is traded on the exchanges if the company is public. In the event of bankruptcy, the common stockholders will have the last right to assets in the event of liquidation, and therefore are bearing the highest level of risk. Due to this they will demand the highest return on their investment. Those shareholders are the owners of the company and have the rights to the firm's profits, which may be paid out in the form of dividends or reinvested back into the business.
What is the difference between the income statement and the statement of cash flows?
A company's sales and expenses are recorded on their income statement. The statement of cash flows records what cash is actually being used and where it is being spent by the company during that time period. Some additional items included on the cash flow statement could be issuance.
What is a convertible bond?
A convertible bond can be "converted" into equity over the course of the life of the bond. Therefore, a bondholder can decide that equity in the company is worth more to them than the bond, and the company can essentially buy back their debt by issuing new equity.
What is a credit default swap?
A credit default swap is essentially insurance on a company's debt and is a way to insure that an investor will not be hurt in the event of a default. It can be used for hedging (as an insurance policy against the bond defaulting) or speculating (purchase the swap with the thought that the bond will become distressed, and more investors will desire the insurance, raising the value of the swap which can be sold).
What is a mortgage backed security?
A mortgage backed security is a security that pays its holder a periodic payment based on the cash flows from the underlying mortgages that fund the security. They will pay a periodic payment that are very similar to a coupon payment from bonds. These cash flows come from a package of mortgages that have been bought up by a bank. The MBS market essentially allowed the investment community to lend money to homeowners, with banks acting as the middlemen. An investor pays to purchase an MBS, and is paid back over time with the mortgage payments from the homeowners. Many MBS were rated AAA because they were considered highly diversified, but the financial crisis proved against this when the housing market collapsed.
What is a perpetual bond?
A perpetual bond is a bond that simply pays a coupon payment indefinitely (or the company goes into default) and doesn't ever pay back a principle amount.
What is a Put Bond?
A put bond is essentially the opposite of a callable bond. A put bond gives the owner of the bond the right to force the issuer to buy back the security from them (usually at face value) prior to the maturity date.
What is the difference between a "strong" and "weak" currency?
A strong currency is one whose value is rising relative to other currencies. A weak currency is one whose value is falling relative to other currencies.
Which is riskier, a 30 year coupon bond or a 30 year zero coupon bond?
A zero coupon bond will yield $0 until its date of maturity, while a coupon bond will pay out some cash every year. This makes the coupon bond less risky since even if the company defaults on its debt prior to its maturity date, you will have received some payments with the coupon bond.
Can you tell me about a recent IPO you have followed? (Opinion)
Again, this is a question that you need to do some research for around the time of your interview. You can find an IPO which is written about in the WSJ. Another option is to go to dealbook.blogs.nytimes.com and click on the IPO/Offerings tab to see what recent IPOs have occurred. Know the company that went public, a little information about the company, what the offer price was, which banks completed the IPO, etc.
What is an Initial Public Offering (IPO)?
An IPO occurs the first time a company sells shares of stock to the public market. Most times the company will either go public to raise capital in order to grow the business, or to allow the original owners and investors to cash out some of their investment.
What is an LBO valuation?
An LBO (leveraged buyout) is when a firm (usually a private equity firm) uses a higher than normal amount of debt (known as leverage) to finance the purchase of a company. The PE investors will purchase the company with a percentage (anywhere from 10% to 40%) of its own equity capital, and the remainder will be financed with debt either through bank loans, bonds, or a combination of the two. The PE firm then uses the cash flows from the acquired company to pay off the debt over time. Many time the PE Firm uses the assets of the company being acquired as collateral for the loan. When the PE firm is ready to sell the company, ideally the debt has been partially or fully paid off and they can collect most of the profits from the sale as the majority equity owners of the company. Since a smaller equity check was needed up front due to the higher level of debt used to purchase the company, this can result in higher returns to the original investors than if they had paid for the company with entirely their own equity (i.e. without any debt).
What is the difference between an investment grade bond and a "junk bond?"
An investment grade bond is a bond issued by a company that has a relatively low risk of bankruptcy and therefore has a low interest payment. These are usually low-risk, fundamentally sound companies which produce steady, reliable cash flows significantly greater than their interest requirements. A "junk bond" is one issued by a company that has a high risk of bankruptcy but is paying high interest payments. These companies usually are characterized as having less consistent cash flows, or they may be in relatively more volatile industries,
What kind of investment would have a negative beta?
An investment with a negative beta is one which moves opposite the stock market as a whole. In other words, if the stock market moves up, the value of the negative beta investment would drop. Gold is a type of investment that would have a negative beta. When the stock market goes up, the price of gold typically drops as people flee the "safe haven" of gold. The opposite happens when the market goes down, implying a negative correlation.
When should an investor buy preferred stock?
An investor should buy preferred stock if they want the upside of potential of equity, but wants to limit risk and provide themselves with the stability of current income in the form of a dividend. The investor would receive steady interest-like payments (dividends) that are more secure than the dividends from common stock. Preferred Stock owners also get a superior right to the company's assets should the company go bankrupt (although less rights than debtholders). Warren Buffet made a large investment in Goldman Sachs in the form of preferred stock in 2010.
How would the following scenario affect the interest rates: the president is impeached and convicted?
Any negative news about the country as a whole may lead fears that the economy will decline, so the Fed would most likely lower interest rates to stimulate economic expansion.
How can a company raise its stock price?
Any type of positive news about the company could potentially raise the stock price. If the company repurchases stock, it lowers the shares outstanding, raises the EPS (earnings per share) which will raise the stock price. A repurchase is also seen as a positive signal in the market. A company could also announce a change to its organizational structure like cost-cuts or consolidations or they could announce an accretive merger or acquisition that will increase their earnings per share. Any of these occurrences would most likely raise the company's stock price.
What is the formula for the balance sheet?
Assets = Liabilities + Shareholder's Equity
What is the formula for the statement of cash flows?
Beginning Cash + Cash Flows from Operations + Cash Flows from Investing + Cash Flows from Financing = Ending Cash
What is Beta?
Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a beta of 1, while investments that are more volatile than the market have a beta greater than 1 and those that are less volatile have a beta of less than 1. The higher the beta, the higher the risk, and the higher the reward. A beta of 1.2 means that an investment will theoretically be 20% more volatile than the market. If the market goes up 10%, that investment should go up 12%.
What are bond ratings?
Bond ratings are a grade given to a bond based on its risk of defaulting. These ratings are issued by independent firms and are updated over the life of the bond. They range from AAA which are highly rated "investment grade" bonds with a low default risk, to C, which means the bond is "non-investment grade" or "junk" or even D which means the bond is actually in default and not making any payments.
How/why do you lever/unlever Beta?
By unlevering the beta, you are removing the financial effects from leverage (debt in the capital structure). This unlevered beta shows you how much risk a firm's equity has compared to the market. Comparing unlevered betas allows an investor to see how much risk they will be taking by investing in a company's equity (i.e. buying stock in the public market). When you have a Company A that doesn't have a beta, you can find comparable Company B, take their levered beta, unlever it, and then relever it using the Company A's capital structure to come up with their beta. The unlevered beta is the beta of a company without any debt. Unlevering a beta removes the financial effects from leverage. This number provides a measure of how much systematic risk a firm's equity has when compared to the market.
What are the components of each of the items on the statement of cash flows?
Cash flow from operations is the cash generated from the normal operations of a company. The cash flow from investing is the change in cash due to activities outside the normal scope of the business, such as the purchase or sale of property, plant, and equipment, or any other investments. Cash flow from financing involves the increase or decrease in cash due to the issuance or repurchase/repayment of equity and debt. Cash flow from financing also includes the issuance of dividends.
What is the difference between currency devaluation and currency depreciation?
Currency devaluation occurs in a fixed-exchange rate system like China, when the government changes the exchange rate of its currency. Currency depreciation occurs when a country allows its currency to move according with the currency exchange market, and the country's currency loses value.
What is correlation?
Correlation is the way that two investments move in relation to one another. If two investments have a strong positive correlation, they will have a correlation near 1 and when it goes up, the other will go up. When you have two with a strong negative correlation, they will have a correlation near -1 and when one investment moves up in value, the other should move down. A correlation of 0 means that there is no correlation and that investments move independently.
What are some ways to determine if a company poses a credit risk?
Determining the credit risk of a company takes an incredible amount of work and research. However, some quick things to look at would be their credit ratings from Moody's or Standard and Poor's, their current ratio (current assets/current liabilities), their quick ratio ((current assets-inventories)/(current liabilities)), their debt to equity ratio (total debt/EBITDA), and their interest coverage ratio (EBITDA/Interest Expense). Compare these ratios to other similar companies in their industry. You can also look at a company's cash flows and how steady/consistent they are. A company with predictable cash flows poses far less default risk.
What is diversification?
Diversification is the process of creating a portfolio of different types of investments. It means investing in stocks, bonds, alternative investments etc. It also means investing across different industries. If an investor is properly diversified, they can essentially eliminate all unsystematic risk from their portfolio, meaning that they can limit the risk associated with one individual stock and their portfolio will only be affected by factors affecting the entire market. Balancing between junk bonds/tech stocks and government bonds/AAA corp bonds demonstrates diversification.
What is duration?
Duration is a measure of the sensitive of the price of a bond to a change in interest rates. Duration is expressed as a number of years. When interest rates rise, bond prices fall, and falling interest rates means rising bond prices. Formally, it is the "weighted average maturity of cash flows." in simple terms, it is the price sensitivity to changes in interest rates. If your cash flows occur faster or sooner your duration is lower and vice versa. In other words, a 4 year bond with semi-annual coupons will have a lower duration that a 10-year zero-coupon bond. The larger the duration number, the greater the impact of interest-rate fluctuations. on bond prices.
What is EBITDA?
EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization and is an indicator of a company's financial performance. It is a good way of comparing the performance of different companies because it removes the effects of financing and accounting decisions like interest and depreciation. It is also considered a rough estimate of free cash flows.
Why might there be multiple valuations of a single company?
Each method of valuation will each give a different value of a given company. The reason for these differences is due to different assumptions, different multiples, or different comparable companies and/or transactions. Generally, the precedent transaction methodology and discounted cash flow methodology will give a higher valuation than the comparable companies analysis or market valuation. This is because a prior transaction will include a "control premium" over the company's market value to entice shareholders to sell, and will account for the "synergies" that may occur when the two companies become one. The DCF will also normally produce a higher valuation than the comparable companies due to the fact that when an analyst makes their projections and assumptions for a company's future cash flows, they are usually somewhat optimistic.
If the enterprise value is 150, and the equity value is 100, what is the total debt?
Enterprise value = Equity Value + Net Debt + Preferred Stock + Minority Interest - Cash = 50
What is enterprise value?
Enterprise value is the value of a firm as a whole, to both debt and equity holders. In order to calculate the value, you take the market value of equity (AKA the company's market cap), add the debt, add the value of outstanding preferred stock, add the value of any minority interests the company owns and then subtract the cash the company currently holds.
How do you calculate free cash flow?
Free cash flow is EBIT (earnings before interest and taxes) times 1 minus the tax rate plus depreciation and amortization minus capital expenditures minus the change in net working capital.
What are positive movements for the GDP, unemployment, inflation, interest rate, new home sales, and existing home sales?
GDP would increase; unemployment would decrease; inflation would decrease; interest rates would decrease; new home sales would increase; existing home sales would increase.
What is goodwill and how does it affect net income?
Goodwill is an intangible asset found on a company's balance sheet. Goodwill may include things like intellectual property rights, a brand name, etc. Usually goodwill is acquired when purchasing a firm, in that the acquirer pays a higher amount for the firm than the book value of its assets. If an event occurs that diminishes the value of these intangible assets, the assets must be "written down" in a process much like depreciation. Goodwill is then subtracted as a non-cash expense and therefore reduces net income.
From the three main financial statements, if you had to choose two, which would you choose and why?
If I had to choose two financial statements, I would choose the balance sheet and the income statement. As long as I had the balance sheet from the beginning and the end of the period, as well as the end of period income statement, I would be able to general a cash flow statement.
How would you calculate the discount rate for an all equity firm?
If a firm is all equity, then you would use CAPM to calculate the cost of equity, and that would be the discount rate.
If you believe interest rates will fall, should you buy bonds or sell bonds?
If interest rates fall, bond prices will rise, so you should buy bonds.
What will happen to the price of a bond if the Fed raises interest rates?
If interest rates rise, newly issued bonds offer higher yields to keep pace. Therefore, existing bonds with lower coupon payments are less attractive, and the price must fall to raise the yield to match the new bonds.
If inflation rates in The United States fall relative to Great Britain, what happens to the exchange rate?
If the United States' inflation rate is expected to fall relative to Great Britain, relatively more pounds will be in circulation and dollars will be worth more pounds. This means that each dollar is worth more pounds than before.
What would cause the price of a Treasury note to rise?
If the stock market is extremely volatile, and investors are fearful of losing money, they will desire risk free securities, which are government bonds. The increase in demand for these securities will drive the price up, and therefore the yield will fall.
How would you calculate an equity beta?
In order to calculate an equity beta you must perform a regression of the return of the stock versus the return of the market as a whole (the S&P 500). The slope of the regression line is the beta.
How would you value a company with no revenue?
In order to value a company with no revenue, such as a start up, you must project the company's cash flows for future years and then construct a discounted cash flow model of those cash flows using an appropriate discount rate. Alternatively, you could use other operating metrics to value the company as well. If you took a start-up website with 50,000 subscribers, but no revenue, you could look at a similar website's value per subscriber and apply that multiple to the website you are valuing.
Why can inflation hurt creditors?
Inflation can definitely hurt creditors. Creditors assign their interest rates base don the risk of default as well as the expected inflation rate. If a creditor lends at 7% and inflation is expected at 2% they are expecting to make 5%. But if inflation actually increases to 4%, the are only making 3%.
How does a stock market drop affect inflation, interest rates, and bond prices?
Inflation decreases, interest rates decrease, and bond prices increase.
How do healthy company earnings reports affect inflation, interest rates, and bond prices?
Inflation increases, interest rates increase, and bond prices decrease.
How does a low unemployment figure affect inflation, interest rates, and bond prices?
Inflation increases, interest rates increase, and bond prices decrease.
How does a weaker dollar against the yen affect inflation, interest rates, and bond prices?
Inflation increases, interest rates increase, and bond prices decrease.
What is insider trading and why is it illegal?
Insider trading is the action of buying or selling stock in a company based on information that is not publicly available. For example, if a CEO of a pharmaceutical company knows that a drug is going to be pulled from the shelves by the FDA, he cannot sell his stock until that information has been released to the public.
If you add a risky stock to a portfolio, what happens to the overall risk of your portfolio?
It depends on the correlation of the new investment in the portfolio. It oculd potentially lower the overall risk of the portfolio.
A stock is trading at $5 and a stock is trading at $50, which has greater growth potential?
It depends. the stock with the higher growth potential is most likely the stock with the lower market cap, so if the $5 stock has 1 billion share outstanding and the $50 stock has 10,000 shares outstanding, the $50 stock would actually most likely have higher growth potential.
How would a $10 increase in depreciation expense affect the three financial statements?
Let's start with the income statement. The $10 increase in depreciation will be an expense, and will therefore lower your operating profit by $10 and you will pay less taxes. Your taxes will decrease by the added depreciation times the tax rate ($10xT) and therefore your net income will decrease by ($10x(1-T)). Assuming a 40% tax rate, the drop in net income will be $6. This will flow to the statement of cash flows where the cash from operations where net income will be reduced by $6. However, since the depreciation is a non-cash expense, the result is you increase cash from operations by $10 as you add back depreciation. This results in an increase of $4 for the ending cash. Cash then flows onto the balance sheet, where cash increases by $4, PP&E decreases by $10, and retained earnings decreases by $6, causing everything to balance.
What is liquidity?
Liquidity is how easily an asset can be bought and sold by an investor. Some examples of liquid assets include money market accounts, large-cap stocks, etc. Some non-liquid assets include many micro-cap stocks, or in the example of a large corporation, a large specialized factory or production plant in which could take years to convert into cash. A more liquid investment is relatively safer, all else equal, since the investor can sell it at any time.
Why do some stock prices rise so much on the first day of trading after their IPO and others don't? How is that "money left on the table"?
Money left on the table means the company could have completed the offering at a higher price, and that difference in valuation goes to the initial investors in the stock, rather than the company raising the money. This means the company could have sold the same stock in its IPO at a higher price than it actually offered it at. This happened a lot more during the .com boom. Company's stock would skyrocket on the first day of trading due to the huge hype over the stock.
If the U.S. dollar weakens, should interest rates generally rise, fall, or stay the same?
Most times, when the U.S. dollar weakens, the price of imported goods will rise, which means higher inflation, which in turn will put pressure on The Fed to increase interest rates.
What effect on earnings of U.S. multinational companies will a strengthening of the U.S. dollar have?
Negative
What is net working capital?
Net working capital is equal to current assets minus current liabilities. It is a measure of whether a company is able to pay off its short term liabilities with its short-term assets. A positive number means they can cover their short term liabilities with their short term assets. If the number is negative, the company may run into trouble paying off their creditors which could result in bankruptcy if their cash reserves are low enough.
Which of the valuation methodologies will result in the highest valuation?
Of the four main valuation techniques, the highest calculation will normally come from the precedent transactions technique because a company will pay a premium for the projected synergies coming from the merger. A DCF will normally give you the next highest valuation simply because those building the DCF tend to be somewhat optimistic in the assumptions and projections going into their model. Market comps and market value will normally give the lowest valuation.
What is operating leverage?
Operating leverage is the percentage of costs that are fixed versus variable. A company whose costs are mostly fixed has a high level of operating leverage. If a company has a high amount of operating leverage, it means that if they have an increase in their revenues, much of that increase will fall straight to the bottom line in the form of profit, because the incremental cost of producing another unit is so low. For example, a swim club is a business which operates with a high amount of operating leverage. Once the club is built and opened the costs are relatively fixed. If the club goes from 500 members to 510 members, they most likely would not have to spend any additional money for those 10 new members. They can have the same amount of staff, same size pool, same locker rooms, etc. Nearly 100% of the membership fees collected from the 10 new members will turn into profit. Operating leverage is the relationship between a company's fixed and variable costs. A company whose costs are mostly fixed has a high level of operating leverage.
What effect on earnings of U.S. multinational companies will a weakening of the U.S. dollar have?
Positive
What happens to free cash flow if net working capital increase?
Since you subtract the change in net working capital in the calculation of free cash flow, if net working capital increases, your free cash flow will decrease. Intuitively, you can think of working capital as the net dollars tied up to run the business. As more cash is tied up (either in account receivable, inventory, etc.), there will be less free cash flow generated.
What is the formula for the income statement?
Revenues - COGS - Expenses = Net Income
What does it mean to short a stock?
Short selling a stock is essentially the opposite of going long in a stock. When an investor buys a stock, they believe they will be able to sell the stock for a higher price in the future. When short-selling, the investor sells a stock that they do not actually own, under the belief that they will be able to purchase it for a lower price in the future.
If the spot exchange rate of dollars to pounds is 1.6 U.S. dollars to 1 pound, and the one-year forward rate is 1.5 U.S. dollars to 1 pound, would we say the dollar is forecast to be strong or weak relative to the pound?
Since 1 pound costs more dollars now than it will in the future, the dollar is expected to strengthen in the next year.
How would you value a zero-coupon perpetual bond?
Since a zero coupon bond doesn't have any interest payments, and a perpetual bond has no par value, the value of the bond is zero since it will pay out nothing.
How many basis points equal 0.5 percent?
Since one basis point is equal to one-hundredth of a percent, one-half of a percent is equal to fifty basis points.
If you believe interest rates will fall, and are looking to make money due to the capital appreciation on bonds, should you buy them or short sell them?
Since price moves inversely to interest rates, if you believe interest rates will fall, bond prices will rise. Therefore, you would want to buy bonds.
If you bought a Stock X a year ago for $10, sold it today for $15, and received a $5 dividend over the year, what would your overall return be?
Since the return on a stock is the sales price plus dividends minute the purchase price, all divided by the purchase price, for stock X it would be: ROS=(($15+$5-$10)/$10)*100=100%
How much would you pay for a company with $50 million in revenue and $5 million in profit?
Since you have no information about historical or projected performance, as well as no details about the firm's capital structure, it would be impossible to do a DCF analysis. Assuming you known the firm's industry, and can identify a group of comparable companies, your best bet would be to do a multiples analysis using the ratios from those comparable companies that are most relevant to the given industry.
What does spreading comps mean?
Spreading comps is the process of calculating relevant multiples from a number of different comparable companies and summarizing them for easy analysis/comparison. Many times, an analyst can simply pull the relevant multiples from a resource. Sometimes, however, the analyst will research the company's data and financial information in their 10-K/10-Q to make sure they have adjusted for non-recurring charges or irregular accounting across an industry which can skew multiples across comparable companies.
What is the difference between technical analysis and fundamental analysis?
Technical analysis is the process of picking stocks based on historical trends and stock movements mainly based on charts. Fundamental analysis is examining a company's fundamentals, financial statements, industry, etc and picking stocks that are undervalued.
What effect on the dollar will a rise in U.S. interest rates have?
Strengthening
What is the Capital Assets Pricing Model?
The Capital Assets Pricing Model is used to calculate the required return on equity (ROE) or the cost of equity. The return on equity is equal to the risk free rate (which is usually the yield on a 10-year U.S. government bond) plus the company's beta (which is a measure of how volatile the stock is in relation to the stock market) times the market risk premium. Re=Rf+B(Rm-Rf). If the expected return does not make the risk worth it, the investment should not be made.
What steps can the Fed take to influence the economy?
The Fed can influence the economy through open market operations, interest rate manipulation, and manipulating the reserve requirements. Open market operations are the Fed buying and selling securities (government bonds) to change the money supply. Buying government securities increases the money supply and stimulates expansion, selling securities shrinks the money supply and slows the economy. The discount rate is the interest rate that the Fed charges banks on short-term loans. The federal funds rate is the rate banks charge each other on short-term loans. When the Fed lowers these rates, it signals an expansionary monetary policy. The reserve requirement is the amount of cash a bank must keep on hand to cover its deposits (money not loaned out). When this requirement is lowered, more cash is loaned out and is pumped into the economy, and is therefore expansionary policy.
What is the comparable companies or multiples analysis technique?
The basic premise of the comparables approach is that an company value should bear some resemblance to other companies in a similar class. The most common comparable approach looks at market comparables for a firm and its peers. Common market multiples include the following: (EV/EBITDA), enterprise value to sales (EV/S), enterprise multiple, price to earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF). To get a better indication of how a firm compares to rivals, analysts can also look at how its margin levels compare. For instance, an activist investor could make the argument that a company with averages below peers is ripe for a turnaround and subsequent increase in value should improvements occur. Most often an analyst will take the average multiple from comparable companies (based on size, industry, etc) and use that multiple with the operating metric of the company he or she is valuing.
How do you determine which of the valuation methodologies to use?
The best way to determine the value of a company is to use a combination of all the methodologies and zero in on an appropriate valuation. If you have a precedent transaction you feel is extremely accurate, you may give that more weight. If you are extremely confident in your DCF you may give that more weight. Valuing a company is as much an art as it is a science.
What is the coupon payment?
The coupon payment is the amount that a company will pay a bondholder normally on an annual or semi-annual basis. It is the coupon rate times the face value of the bond. For example, the coupon payment on an annual 10% bond with a $1,000 face value is $100.
What is the default premium?
The default premium is the difference between the yield on a corporate bond and the yield on a government bond with the same time to maturity to compensate the investor for the default risk of the corporate, compared with the "risk-free" comparable government security.
What is the default risk?
The default risk is the risk of a given company not being able to make its interest payments or pay back the principle amount of their debt. The higher a company's default risk, the higher the interest rate a lender will require them to pay.
How do you determine the discount rate on a bond?
The discount rate is determined by the company's default risk. Some of the factors that influence the discount rate include a company's credit rating, the volatility of their cash flows, the interest rate on comparable U.S. Bonds, and the amount of current debt outstanding.
Why would a company distribute its earnings through dividends to common stock holders?
The distribution of a dividend signals to the public that a company is healthy and profitable and it can also attract more investors, potentially driving up the company's stock price.
What are some ways the market exchange rate between two country's currencies is determined?
The exchange rate between two countries' currencies is determined by a few factors. One is the interest rates in the two countries. If the interest rate in the home country increases relative to the foreign country, the demand for the home country's currency tends to increase because investors can get higher rates of return. The increased demand strengthens the home currency. Also impacting the exchange rate is the expected inflation rates in the two countries. If one country is expected to experience relatively high inflation, in the long rung the inflating currency will because less valuable, all else equal.
What is the order of creditor preference in the event of a company's bankruptcy?
The first creditors to get paid in the event of liquidation would be the senior debt holders. These are usually banks, or senior bondholders. Usually they have some of the firm's assets as collateral. Then comes those holding subordinated debt, followed by preferred stockholders. Common stockholders have the absolute last rights to any assets in the event of liquidation or bankruptcy.
Walk me through the major line items of an income statement.
The first line of the income statement would be revenues or sales. From that you subtract cost of goods sold which leaves you with your gross margin. Then you subtract your operating expenses, leaving you with operating income. From operating income, you subtract any other expenses, and your income taxes, which leaves you with your net income.
What is the forward exchange rate?
The forward exchange rate is the price that a foreign currency will cost at some time in the future. A company can enter into a forward contract on exchange rates to help hedge against exchange rate fluctuations in the future.
What does the government do when there is a fear of hyperinflation?
The government can do a number of things to slow the economy and defuse hyperinflation. They can use taxation and government spending to regulate the level of economic activity. Increasing taxes and decreasing government spending slows down growth in the economy and fights inflation. Additionally, raising key interest rates will slow the economy, reduce the supply, and slow inflation.
Why is a firm's credit rating important?
The lower a firm's credit rating, the higher its risk of bankruptcy and therefore the higher the cost of borrowing capital.
What is the difference between a corporate bond and a consumer loan?
The main difference between a corporate bond and a consumer loan is the market that it is traded on. A bond issuance is usually for a larger amount of capital, is sold in the public market, and can be traded. A loan is issued by a bank and is not traded on a public market.
What is the market risk premium?
The market risk premium is the required return that investors require for investing in stocks over investing in "risk-free" securities. It is calculated as the average return on the market minus the risk free rate (current yield on a 10-year treasury)
What is the market valuation technique?
The market value of equity is only used for publicly traded companies and is calculated by multiplying the number of shares outstanding by the current stock price. This is also known as the market cap, and is the equity value of the firm (EV).
If the price of the 10-year Treasury note rises, what happens to the note's yield?
The price and yield are inversely related, so when the price goes up, the yield goes down.
If the price of a bond goes up, what happens to the yield?
The price and yield of a bond move inversely to one another. Therefore, when the price of a bond goes up, the yield goes down.
How do you price a bond?
The price of a bond is the net present value of all future cash flows (coupon payments and par value) expected from the bond using the current interest rate.
If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero-coupon bond?
The price of a zero-coupon bond is more sensitive to fluctuations in interest rates and the price moves in the opposite direction of interest rates. So, when interest rates fall, the price of the zero-coupon bond will rise more than the price of the coupon bond. therefore, if you believe interest rates will fall, you should purchase the zero-coupon bond.
What is a primary market and what is a secondary market?
The primary market is the market that a firm sells a new stock or bond issuance to the first time it comes to market. With an IPO or bond issuance, the majority of these buyers are institutional investors who purchase large amounts of the security. The secondary market is the market that the security will trade on after its initial public offering. Examples of these secondary markets are the New York Stock Exchange and Nasdaq.
If you have two companies that are exactly the same in terms of revenue, growth, risk, etc. but one is private and one is public, which company's shares would be higher priced?
The public company will likely be priced higher for a few reasons. The main reason is the liquidity premium an investor would be willing to pay for the ability to quickly and easily trade their stock on the public exchanges. A second reason would be a sort of "transparency premium" an investor would pay since the public company is required to file their financial documents publicly.
What is the spot exchange rate?
The spot exchange rate is the rate of a foreign-exchange contract for immediate delivery. Spot rates are the price that a buyer will pay for a foreign currency.
Why do you project out free cash flows for the DCF model?
The reason you project free cash flow for the DCF is because free cash flow is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company.
Where do you find the risk free rate?
The risk free rate is usually the current yield on the 10-year government treasury bond, which can be found on the front page of The Wall Street Journal. This is considered "risk-free" because the U.S. government is considered a risk-free borrower meaning the government should never default on its debt.
If a company's stock has gone up 20% in the last 12 months, is the company' stock in fact doing well?
This depends on a number of different factors including the beta of the company and the performance of the market. If the stock's beta is 1 (meaning it should be as volatile as the market and therefore produce market returns) and the market was up 30% over the past 12 months, then the stock is doing relatively poorly.
What are the three components of the statement of cash flows?
The three components of the statement of cash flows are cash from operations, cash from investing, and cash from financing.
What are the three main financial statements?
The three main financial statements are the income statement, the balance sheet, and the statement of cash flows.
What is WACC and how do you calculate it?
The weighted average cost of capital is the average rate of return that a company expects to compensate all of its different investors. WACC is the percentage of equity in the capital structure times the cost of equity (which is calculated using the capital assets pricing model) plus the percentage of debt in the capital structure times one minus the corporate tax rate times the cost of debt (which is the current yield on their outstanding debt) plus the percentage of preferred stock in their capital structure times the cost of preferred stock (if there is any preferred stock outstanding
What is the yield to maturity on a bond?
The yield to maturity on a bond is the rate of return on a bond if it is held through its maturity date based on its current price, coupon payments, face value, and maturity date. The YTM is the rate of return on a bond if it is purchased today for its current price and held through its maturity date and is paid off in full at maturity. If the coupon yield of a bond (coupon/face) is lower than it current yield (coupon/price) it is selling at a discount. If the coupon yield of a bond (coupon/face) is higher than its current yield (coupon/price) it is selling at a premium.
How do you calculate a firm's terminal value?
There are two ways to calculate terminal value. The first method is the terminal multiple method. To use this method, you choose an operation metric (most common is EBITDA) and apply a comparable company's multiple to that number from the final year of projections. The second method is the perpetuity growth method. To use this method you choose a modest growth rate, usually a bit higher than the inflation rate or GDP growth rate, in order to assume that the company can grow at this rate infinitely. We then multiple the FCF from the final year by 1 plus the growth rate, and divide that number by the discount rate (WACC) minus the assumed growth rate.
Why do you subtract cash from the enterprise value?
There are a few reasons for subtracting cash from the enterprise value. First off, cash is already counted for within the market value of equity. You also subtract cash because you can either use that cash to pay off some of the debt, or pay yourself a dividend, effectively reducing the purchase price of the company.
When should a company issue equity rather than debt to fund its operations?
There are a number of reasons a company may issue stock rather than debt to fund its operations. First, if it believes its stock price is inflated, it can issue stock and raise a relatively significant amount of capital for the ownership sold. If the projects for which the money is being raised may not generate predictable cash flows in the immediate future, the company may have a difficult time paying the consistent coupon payments required by the issuance of debt. The company could also choose to issue stock is they want to adjust the debt/equity ratio of their capital structure. They could do this by using the money raised through the issuance of equity to pay off debt.
What are some ways you can value a company?
There are a number of ways to value a company. The most simple would be the market valuation, which is just the equity value of the company based on the public markets - this is simply the market capitalization of the company plus the net debt on its books to get to total enterprise value. You can also use comparable company analysis, precedent transactions analysis, discounted cash flows analysis, as well as a leverage buyout valuation.
What is the link between the balance sheet and the income statement?
There are many links between the balance sheet and the income statement. The major link is that any net income from the income statement, after the payment of any dividends, is added to retained earnings. In addition, debt on the balance sheet is used to calculate the interest expense on the income statement, and property plant and equipment will be used to calculate any depreciation expense.
How are the three main financial statement connected?
There are many links between the three financial statements. Starting with the income statement, the last line item is net income. Net income is added to the cash flows from operations on the cash flows statement. Beginning cash balance on the statement of cash flows is the cash on the balance sheet from the prior period. After making adjustments to net income for non-cash items, the cash flow from operations, investing, and financing, the ending cash balance becomes the cash on the current period's balance sheet under assets. Net income (minus any dividends paid) flows from the income statement onto the retained earning column of the shareholder's equity on the balance sheet. Also, interest expense on the income statement is calculated from the long-term debt on the balance sheet. Depreciation on both the income statement and cash flow statement is calculated based on the property, plant, and equipment from the balance sheet.
Company XYZ released increased quarterly earnings yesterday, but their stock price still dropped. Why did this happen?
There are two main reasons that this could occur. First, the entire market could have been down in the day (or the industry to which XYZ belongs), which had more of an impact than the company's positive earnings. More likely, however, is that even though they released increased earnings, the figures were not as high as the Wall Street analyst estimates therefore creating disappointment in the company's performance.
Is 15 a high P/E (price to earnings) ratio?
This depends on the industry of the company you are looking at. P/E can be thought of as how many dollars an investor is willing to pay for one dollar of earnings. A P/E ratio of 15 in an industry like basic materials may be considered a bit high, but if this company is a high-growth tech company, 15 may be considered rather low. A high P/E ratio represents a high anticipated growth in earnings. (Goldman 6.8x, Ford 6.8x, AT&T 11.4x, Exxon Mobil 13.4x, Apple 19.6x, Caterpillar 28.4x)
What is the current yield on the 10-year treasure note?
This information can be found in the WSJ.
Where do you think the stock market will be in 3/6/12 months? (Opinion)
This is another question that you can use to show your interest in the markets. there is no right or wrong answer since everyone has different opinions on where the market is going. You need to have an opinion and a well thought out reasoning for that opinion. If you think the market is going to drop in the next three months, hit a bottom and then begin to bounce back, have a reason as to why you think it is going to drop, why is it going to bottom out, and why it will begin to rise. It is important that you display logical reasoning than whether or not your prediction turns out to be true. Do some research prior to your interview and see what writers for major newspapers are saying and predicting. Also remember to stick to your reasoning. if you have come up with solid reasoning behind your response, be confident in your answer and try and explain your rationale. If your logic makes sense, do not change you opinion just to agree with your interviewer.
what do you think is going on with XYZ company/industry? (Opinion)
This is another question to gauge your general interest in the financial markets. You cannot prepare for this question in any other way than to keep up with reading the WSJ. Chances are they would ask you about a company or industry that has been in the news recently, or something that you have shown interest in on your resume, rather than a completely arbitrary company or industry.
Name three stocks/companies that you think are undervalued. (Opinion)
This question is unique to you and is particularly common in Sales and trading interviews. Do some research and find a few stocks you believe are good buys at their current market price. You must have a good reason behind each of your picks. The best way to find these stocks are to use equity research reports if you have access to them. Many schools will have access to them through their library website. If not, you can use sites like Jim Cramer's TheStreet.com, or Motleyfool.com to look at articles and their stock picks and reasons behind them. Generally speaking we have found you are better off picking a less known company so your interviewer has less of an ability to cross-examine you on your reasoning. If they know the stock well, they will be able to really test you and push you on specifics about the stock. You could go through the process of valuing the stocks yourself using any of the valuation techniques if you are feeling ambitious. Variations of this question include "Pitch me a stock" or "What stocks would you short right now?"
Let's say a report released today showed that inflation last month was very low. However, bond prices closed lower. Why might this happen?
This would occur because bond prices are based on expectations of future inflation. Bond traders may expect future inflation to be higher, and therefore the demand for bonds today will be lower, increasing the yields to match the increased inflation expectations.
Walk me through a discounted cash flow model.
To begin we would project the free cash flows of the company for about 5 years. Free cash flow is EBIT time 1 minus the tax rate, plus depreciation and amortization, minus capital expenditures, minus the change in net working capital. Then you must predict the free cash flows beyond 5 years which is done either using a terminal value multiple or using the perpetuity method. To calculate the perpetuity you establish a terminal growth rate which is usually around the rate of inflation or GDP growth. Then multiply the year 5 cash flow by 1 plus the growth rate and divide it by your discount rate minus the growth rate. Now, in order to do this you must have established a discount rate. For a discounted cash flow you use WACC, which is the weighted average cost of capital, as your discount rate. You discount all of your cash flows back to year zero using that rate. The sum of the present values of all those cash flows is the estimated present value of the firm.
What is valuation?
Valuation is the procedure of calculating the worth of an asset, security, company, etc. This is one of the primary tasks that investment bankers do for their clients. Value their company, or value the company they are thinking about purchasing or divesting.
What is the difference between AVP and WACC?
WACC incorporates effect of interest tax shields into the discount rate. It is typically calculated from actual data from balance sheets and used for a company with consistent capital structure over the period of the valuation. APV adds present value of financing effects to NPV assuming all-equity value. APV is useful where costs of financing are complex and if capital structure is changing. It is also useful for leveraged buyouts.
What effect on the dollar will a rise in U.S. inflation rates have?
Weakening
How would you value a perpetual bond that pays a $1,000 coupon per year?
Well, a perpetual bond is one that pays a coupon payment every period for eternity, with no repayment of principal (par value). If it is a perpetual bond, then the value of the bond will be the coupon payment divided by the current interest rate.
What is the link between the balance sheet and the statement of cash flows?
Well, the beginning cash on the statement of cash flows comes from the previous period's balance sheet. The cash from operations is impacted by the change in net working capital which is current assets minus current liabilities. Depreciation comes from property, plant, and equipment, which effects cash from operations. Any changes in property, plant, and equipment due to the purchase or sale of that equipment will affect cash from investing. Finally, ending cash balance from the cash flow statement is the cash balance on the new balance sheet.
If the stock market falls, what would you expect to happen to bond prices and yields?
When the stock market falls, investors flee to safer securities, like bonds, which cause the demand for those securities to rise and therefore the price. Since prices and yields move inversely, if bond prices rise, yields will fall. The government may lower interest rates in an attempt to stimulate the economy.
What would a company do with excess cash on its balance sheet?
While at first it may seem that having a lot of cash on hand would be a good thing, especially in a recession, there is an opportunity cost to holding cash on the balance sheet. A company should have enough cash to protect itself from bankruptcy in a downturn, but above that level the cash should be used in one way or another. The main ways a company could use its cash would be to either reinvest into the firm (whether it be equipment, employees, marketing, etc) or the company could pay out the excess earnings/cash in the form of a dividend to its equity holders. A growing company will tend to reinvest rather than paying a dividend. Other ways the cash could be spent would include paying off debt, repurchasing equity, or buying out a competitor/supplier/distributor.
What is the precedent transactions technique?
With this valuation technique an analyst would need to research historical transactions that are similar to the transaction in question. This would include looking at the size of the companies involved, their industry, the economic situation at the time of the transaction, etc. Once an analyst has found transactions that are comparable, they look at how those companies were valued. What were the EV/EBITDA and EV/Sales multiples paid? They would calculate a valuation multiple based on the sale prices in those transactions, and apply the multiple to the appropriate metric of the company being valued. Most of the time this valuation technique will result in the highest valuation due to the inclusion of the "control premium" a company is willing to pay for the assumed "synergies" they hope will occur after the purchase.
What is the difference between yield to maturity and yield to worst?
Yield to maturity assumes the debt holder will maintain their investment through its maturity date, collecting all interest payments and is repaid in full at the time of maturity. Yield to worst is the lowest potential yield an investor can earn on their debt investment without the issuer defaulting. This means that if a bond is callable, or has other provisions, an investor could earn less than the yield to maturity if the company exercises a prepayment option to get out of the bond early.
If you read that a given mutual fund has achieved 50% returns last year, would you invest in it?
You should do more research because past performance is not an indicator of future results. A mutual fund full of Mortgaged Back Securities could have been up 50% a few years ago and then been down 90% last year due to the market for MBSs collapsing. To make an investment decision, you need to research more in depth into the fund's holdings, management, fee structure, etc.
How does a low consumer confidence level affect inflation, interest rates, and bond prices?
inflation decreases, interest rates decrease, and bond prices increase.
Why could two bonds with the same maturity, same coupon, from the same issuer, be trading at different prices?
there are a few reasons why they could be trading at different prices. A bond that is putable or convertible demands a premium, and a callable bond will trade at a discount.
What did the S&P 500/DJIA/NASDAQ close at yesterday?
yesterday the XXXX closed at XXX, up/down from the open. I also noticed that it was up XXX on the day before I came into my interviews due to _______________. This is a question used to gauge your general interest in the financial markets. You probably will not be expected to know the number to the penny, but knowing the levels of the three major exchanges/indices, as well as if they were up or down and why will show your interviewer that you keep track of what is going on in the world of finance.