Investment Banking Interview Questions

Why do you want to do investment banking?

In no other field out of college can you get a more meaningful corporate experience, I feel like I would be selling myself short any other way. I'm always looking for a challenge, and by working with the sharpest people in the industry, it will force me t

What do investment bankers do?

Investment bankers help companies raise capital or advise them on a transactions like mergers or acquisitions.

Walk me through your resume.

� Growing up in valley, I never had a set path in mind. I worked in retail and even took some time off from school trying to get signed as a drummer in a rock band, but once college came around, I decided to make my mom happy, I entered UCLA as a pre-med

Say you are supposed to meet your girlfriend for dinner but the MD asks you to stay late. What do you do? Can you give me an example of a similar situation you have faced before?

My job is always my top priority, and I will have to reschedule with my girlfriend. There was a time at Siemer where I took on a larger role than I was used to, and had to reschedule with some of my friends.

Why should we hire you?

If I were in your shoes, I would be looking for a candidate that is hard working, does great work and is someone that you can spend however many hours with every week. I really believe I can bring you a Summer Analyst who will fulfill each of those roles,

Why do you want to work for Citi?

After speaking with Ryan, Sarah and Brent, I was drawn to the leaner deal teams at Citi, and the greater responsibilities it gives you at the analyst level. Something that also stood out to me is how much Citi invests in their analysts. After finding out

Give me an example of a project that you've done that involved heavy analytical thinking.

One of the deals I worked on was the sale of a $23M NFC mobile advertising company. They were looking to sell because of projected mobile advertising spend growing at a CAGR of 58% into 2015. With ad budgets shifting toward mobile, the company thought tha

What is your favorite website?

techcrunch.com

Tell me about a stock you like?

� Textura is a construction software company that allows construction projects to consolidate all of the operations
� Revenue has grown over the 72% over the past period, with construction projects increasing by 32% y-o-y.
� Just acquired LATISTA, a mobil

Give me an example of a time you worked as part of a team.

� A client presentation needed to be produced by the end of the week at Siemer. Worked in a team of five interns, and we each had our own set of skills
o Delegated assignments based on talent and sections
o Compiled and revised together quickly and effici

What is the most striking thing you've read recently in The Wall Street Journal?

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Can you give me an example of an experience of failure?

As a sophomore in high school, I left public school and began an independent study home school program to dedicate all of my time to playing the drums in a rock band I had at the time. We had producers and an EP that we were shopping to record labels, but

Tell me about an accomplishment you are proud of.

Disclaimer first
my father actually passed away while I was pursuing my musical career, and it was a wakeup call for me to essentially find my priorities. It was then that I was able to make it back into my old high school, apply myself and get accepted i

What are the four most commonly used valuation techniques?

1. Discounted cash flow (DCF) analysis
2. Multiples method
3. Market valuation
4. Comparable transactions method

What are the four financial statements?

1. Income Statement
2. Balance Sheet
3. Statement of Cash Flows
4. Statement of Retained Earnings

What are cash flows from operating activities?

Includes the cash effects of transactions involved in calculating net income.

What are cash flows from investing activities?

Cash from non-operating activities or activities outside the normal scope of business. This involves items classified as assets in the Balance Sheet and includes the purchase and sale of equipment and investments.

What are cash flows from financing activities?

Involves items classified as liabilities and equity in the Balance Sheet; it includes the payment of dividends as well as issuing payment of debt or equity.

What is the CAPM equation?

reL =rf +�L (rm -rf)

What is the difference between the Income Statement and the Statement of Cash Flows?

The Income Statement is a record of Revenues and Expenses while the Statement of Cash Flows records the actual cash that has either come into or left the company. The Statement of Cash Flows has the following categories: Operating Cash Flows, Investing Ca

What is the link between the Balance Sheet and the Income Statement?

The main link between the two statements is that profits generated in the Income Statement get added to shareholder's equity on the Balance Sheet as Retained Earnings. Also, debt on the Balance Sheet is used to calculate interest expense in the Income Sta

What is the link between the Balance Sheet and the Statement of Cash Flows?

The Statement of Cash Flows starts with the beginning cash balance, which comes from the Balance Sheet. Also, Cash from Operations is derived using the changes in Balance Sheet accounts (such as Accounts Payable, Accounts Receivable, etc.). The net increa

Whats is EBITDA?

A proxy for cash flow, EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization.

Say you knew a company's net income. How would you figure out its "free cash flow"?

Start with the company's Net Income. Then add back Depreciation and Amortization. Subtract the company's Capital Expenditures (called "CapEx" for short, this is how much money the company invests each year in plant and equipment). The number you get is th

Walk me through the major line items on a Cash Flow statement.

First the Beginning Cash Balance, then Cash from Operations, then Cash from Investing Activities, then Cash from Financing Activities, and finally the Ending Cash Balance.

What happens to each of the three primary financial statements when you change gross margin?

Think about the definitions of the variables that change. For example, gross margin is gross profit/sales, or the extent to which sales of sold inventory exceeds costs. Hence, if gross margin were to decrease, then gross profit decreases relative to sales

What happens to each of the three primary financial statements when you change capital expenditures?

If capital expenditure were to say, decrease, then first, the level of capital expenditures would decrease on the Statement of Cash Flows. This would increase the level of cash on the balance sheet, but decrease the level of property, plant and equipment,

Why might there be multiple valuations for a single company?

There are several different methods by which one can value a company. And even if you use the rigorously academic DCF analysis, the two main methods (the WACC and APV method) make different assumptions about interest tax shields, which can lead to differe

Why are the P/E multiples for a company in London different than that of the same company in the States?

The P/E multiples can be different in the two countries even if all other factors are constant because of the difference in the way earnings are recorded. Overall market valuations in American markets tend to be higher than those in the U.K.

What are the different multiples that can be used to value a company?

The most commonly used multiple is price-to-earnings multiple, or "P/E ratio." Other multiples that are used include revenue, EBITDA, EBIT, and book value. The relevant multiple depends on the industry.
For example, Internet companies are often valued wit

How do you get the discount rate for an all-equity firm?

You use the Capital Asset Pricing Model, or CAPM.

How much would you pay for a company with $50 million in revenue and $5 million in profit?

If this is all the information you are given you can use the comparable transaction or multiples method to value this company (rather than the DCF method). To use the multiples method, you can examine common stock information of comparable companies in th

What is the difference between the APV and WACC?

WACC incorporates the effect of tax shields into the discount rate used to calculate the present value of cash flows.
APV adds the present value of the financing effects (most commonly, the debt tax shield) to the net present value assuming an all-equity

How would you value a company with no revenue?

First you would make reasonable assumptions about the company's projected revenues (and projected cash flows) for future years. Then you would calculate the Net Present Value of these cash flows.

What is Beta?

Beta is the value that represents a stock's volatility with respect to overall market volatility.

How do you unlever a company's Beta?

Unlevering a company's Beta means calculating the Beta under the assumption that it is an all-equity firm.
The formula is as follows:
�L = �u [1+(1-t)(D/E)]

Name three companies that are undervalued and tell me why you think they are undervalued.

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Walk me through the major items of an Income Statement.

Revenues
Expenses
Net Income

Which industries are you interested in? What are the multiples that you use for those industries?

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Is 10 a high P/E ratio?

It Depends.
P/E ratios are relative measurements, and in order to know whether a P/E ratio is high or low, we need to know the general P/E ratios of comparable companies. Generally, higher growth firms will have higher P/E ratios because their earnings wi

Quick Ratio

Cash + AR/ Current Liabilities
Shows the amount of liquid assets (i.e., cash or assets that can be quickly converted to cash) on hand to cover current debts
Good if: Rising

Current Ratio

Current Assets/Current Liabilities
Similar to the Quick Ratio, but broader, since it includes less liquid assets that may be used to cover current debts
Good if: Rising

Cash Ratio (Liquidity Ratio)

Cash/ Current Liabilities
Shows the cash on hand to cover current liabilities
Good if: Rising

Debt to Equity

Debt/Equity
Shows the amount of shareholders' equity available to cover debts
Good if: Falling

Current Liabilities to Inventory

Current Liabilities/Inventory
Shows how much a company can rely on unsold inventory to cover debts
Good if: Falling

Total Liabilities to Net Worth

Total Liabilities/ Net Worth
Similar to the debt to equity ratio, but broader since it includes all the company's liabilities, not just debt
Good if: Rising

Collection Period (Day Sales Outstanding)

Account Receivable/ Sales X 365
Shows the average amount of time it takes a company to collect from customers
Good if: Falling

Inventory Turnover

Sales/Inventory
Shows how quickly a company is selling its inventory
Good if: Rising

Sales to Assets

Sales/Assets
Measures how efficiently a company is using its assets to generate sales
Good if: Rising

Sales to Net Working Capital

Sales/NWC
Shows a company's ability to use short-term assets and liabilities to generate revenue
Good if: Rising

Gross Profit Margin (Return on Sales)

Gross Profit/Sales
A measure of efficiency � shows profits earned per dollar of sales
Good if: Rising

Return on Assets

Net Income/Assets
Shows profits relative to a company's assets
Good if: Rising

Return on Equity (Return on Net Worth)

Net Income/ Net Worth
Shows profits relative to equity
Good if: Rising

If you add a risky stock into a portfolio that is already risky, how is the overall portfolio risk affected?

It depends on the stock's risk relative to that of the portfolio
In modern portfolio theory, if you add a risky stock into a portfolio that is already risky, the resulting portfolio may be more or less risky than before.
A portfolio's overall risk is dete

Put the following portfolios consisting of 2 stocks in order from the least risky to the most risky and explain why:
A. A portfolio of a cable television company stock and an oil company stock
B. A portfolio of an airline company stock and a cruise ship c

Least risky: C. Then A. B is the most risky.

Gotham Energy just released second quarter financial results. Looking at its balance sheet you calculate that it's Current Ratio went from 1.5 to 1.2. Does this make you more or less likely to buy the stock?

Less likely. This means that the company is less able to cover its immediate liabilities with cash on hand and other current assets than it was last quarter.

Xeron Software Corporation's days sales outstanding have gone from 58 days to 42 days. Does this make you more or less likely to issue a Buy rating on the stock?

More likely. When the company's days sales outstanding (DSOs) decreases, it means the company is able to collect money from its customers faster. In other words, Xeron's customers went from taking an average of 58 days to pay their bills to 42 days. All t

What kind of stocks would you issue for a startup?

A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of commo

When should a company buy back stock?

When it believes the stock is undervalued, has extra cash, and believes it can make money by investing in itself. This can happen in a variety of situations. For example, if a company has suffered some decreased earnings because of an inherently cyclical

Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?

The dividend paid on common stock is taxable on two levels in the U.S. First, it is taxed at the firm level, as a dividend comes out from the net income after taxes (i.e., the money has been taxed once already). The shareholders are then taxed for the div

When should a company issue stock rather than debt to fund its operations?

There are several reasons for a company to issue stock rather than debt. If the company believes its stock price is inflated it can raise money (on very good terms) by issuing stock. Second, if the projects for which the money is being raised may not gene

Why would an investor buy preferred stock?

An investor that wants the upside potential of equity but wants to minimize risk would buy preferred stock. The investor would receive steady interest-like payments (dividends) from the preferred stock that are more assured than the dividends from common

Why would a company distribute its earnings through dividends to common stockholders?

Regular dividend payments are signals that a company is healthy and profitable. Also, issuing dividends can attract investors (shareholders). Finally, a company may distribute earnings to shareholders if it lacks profitable investment opportunities.

What stocks do you like?

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Can you tell me about a recent IPO that you have followed?

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What is your investing strategy?

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If you read that a given mutual fund has achieved 50 percent returns last year, would you invest in it?

You should look for more information, as past performance is not necessarily an indicator of future results. How has the overall market done? How did it do in the years before? Why did it give 50 percent returns last year? Can that strategy be expected to

You are on the board of directors of a company and own a significant chunk of the company. The CEO, in his annual presentation, states that the company's stock is doing well, as it has gone up 20 percent in the last 12 months. Is the company's stock in fa

It Depends
First, ask what the Beta of the company is. (Remember, the Beta represents the volatility of the stock with respect to the market.) If the Beta is 1 and the market (i.e. the Dow Jones Industrial Average) has gone up 35 percent, the company actu

Which do you think has higher growth potential, a stock that is currently trading at $2 or a stock that is trading at $60?

It Depends
While at first glance it may appear that the stock with the lower price has more room for growth, price does not tell the entire picture. Suppose the $2 stock has 1 billion shares outstanding. That means it has $2 billion market cap, hardly a s

Where do you think the DJIA will be in three months and six months - and why?

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Why do some stocks rise so much on the first day of trading after their IPO and others don't? How is that money left on the table?

Why this happens is not easy to predict from responses received from investors during roadshows. Moreover, if the stock rises a lot the first day it is good publicity for the firm. But in many ways it is money left on the table because the company could h

What is insider trading and why is it illegal?

Insider trading describes the illegal activity of buying or selling stock based on information that is not public information. The law against insider trading exists to prevent those with privileged information (company execs, I-bankers and lawyers) from

Who is a more senior creditor, a bondholder or stockholder?

The bondholder is always more senior. Stockholders (including those who own preferred stock) must wait until bondholders are paid during a bankruptcy before claiming company assets.

What is the relationship between a bond's price and its yield?

They are inversely related. That is, if a bond's price rises, it's yield falls, and vice versa. Simply put, current yield = interest paid annually / market price * 100%.

How are bonds priced?

Bonds are priced based on the net present value of all future cash flows expected from the bond.

How would you value a perpetual bond that pays you $1,000 a year in coupon?

Divide the coupon by the current interest rate. For example, a corporate bond with an interest rate of 10 percent that pays $1,000 a year in coupons forever would be worth $10,000.

When should a company issue debt instead of issuing equity?

First, a company needs a steady cash flow before it can consider issuing debt (otherwise, it can quickly fall behind interest payments and eventually see its assets seized). Once a company can issue debt, it should almost always prefer issuing debt to iss

What major factors affect the yield on a corporate bond?

1) interest rates on comparable U.S. Treasury bonds, and 2) the company's credit risk. A more elaborate answer would include a discussion of the fact that corporate bond yields trade at a premium, or spread, over the interest rate on comparable U.S. Treas

If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero coupon bond?

The 10-year zero coupon bond. A zero coupon bond is more sensitive to changes in interest rates than an equivalent coupon bond, so its price will increase more if interest rates fall.

Which is riskier: a 30-year coupon bond or a 30-year zero coupon bond?

A 30-year zero coupon bond.
A coupon bond pays interest semi- annually, then pays the principal when the bond matures (after 30 years, in this case). A zero coupon bond pays no interest, but pays one lump sum upon maturity (after 30 years, in this case).

What is The Long Bond trading at?

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If the price of the 10-year Treasury note rises, does the note's yield rise, fall or stay the same?

Since bond yields move in the opposite direction of bond prices, if the price of a 10-year note rises, its yield will fall.

If you believe interest rates will fall, should you buy bonds or sell bonds?

Since bond prices rise when interest rates fall, you should buy bonds.

How many basis points equal .5 percent?

Bond yields are measured in basis points, which are 1/100 of 1 percent. 1 percent = 100 basis points. Therefore, .5 percent = 50 basis points.

Why can inflation hurt creditors?

If you are a creditor lending out money at a fixed rate, inflation cuts into the percentage that you are actually making. If you lend out money at 7 percent a year, and inflation is 5 percent, you are only really clearing 2 percent.

How would the following scenario affect the interest rates: the President is impeached and convicted.

While it can't be said for certain, chances are that these kind of events will lead to fears that the economy will go into recession, so the Fed would want to balance those fears by lowering interest rates to expand the economy.

Where do you think the U.S. economy will go over the next year?

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How would you value a perpetual zero coupon bond?

The value will be zero. A zero coupon doesn't pay any coupons, and if that continues on perpetually, when do you get paid?

Let's say a report released today showed that inflation last month was very low. However, bond prices closed lower. Why might this happen?

Bond prices are based on expectations of future inflation. In this case, you can assume that traders expect future inflation to be higher (regardless of the report on last month's inflation figures) and therefore they bid bond prices down today (A report

If the stock market falls, what would you expect to happen to bond prices, and interest rates?

You would expect that bond prices would increase and interest rates would fall.

If unemployment is low, what happens to inflation, interest rates, and bond prices?

Inflation goes up, interest rates also increase, and bond prices decrease.

What is a bond's "Yield to Maturity"?

A bond's yield to maturity is the yield that would be realized through coupon and principal payments if the bond were to be held to the maturity date. If the yield is greater than the current yield (the coupon/price), it is said to be selling at a discoun

What do you think the Fed will do with interest rates over the next 2 years?

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What is the currency risk for a company like Microsoft?

Its currency risks are created by its sales in foreign countries. For example, if it markets a software program for 100 RMB in China, and the dollar strengthens against the RMB (and the company doesn't change its price), Microsoft will be making less in U

When the currencies in countries like Thailand, Indonesia, and Russia fell drastically in 1998, why were U.S. and European-based investment banks hurt so badly?

I-banks were hurt on trading losses in Asia and Russia. If banks held either currency or bonds in the currencies that dropped, these assets suddenly turned non-performing, in other words, essentially worthless. (In fact, Russia's government defaulted on i

If the U.S. dollar weakens, should interest rates generally rise, fall or stay the same?

Rise.
A weak dollar means that the prices of imported goods will rise when measured in U.S. dollars (i.e., it will take more dollars to buy the same good). Rising prices of imported goods contributes to higher inflation, which raises interest rates.

If U.S. inflation rates fall, what will happen to the relative strength of the dollar?

It will strengthen.

If the interest rate in Brazil increases relative to the interest rate in the U.S., what will happen to the exchange rate between the Brazilian real and the U.S. dollar?

The real will strengthen relative to the dollar.

If inflation rates in the U.S. fall relative to the inflation rate in Russia, what will happen to the exchange rate between the dollar and the rouble?

The dollar will strengthen relative to the rouble.

What is the difference between currency devaluation and currency depreciation?

Devaluation occurs in a fixed-exchange-rate system and is usually fixed as a function of government policy, while depreciation occurs when a country allows its currency to move according to the international currency exchange market.

What is the effect on U.S. multinational companies if the U.S. dollar strengthens?

U.S. multinationals see their earnings decrease when the dollar strengthens. Essentially, sales in foreign currencies don't amount to as many U.S. dollars when the dollar strengthens.

What are some of the main factors that govern foreign exchange rates?

Chiefly: interest rates, inflation, and capital market equilibrium.

If the spot exchange rate of dollars to pounds is $1.60/�1, and the one-year forward rate is $1.50/�1, would we say the dollar is forecast to be strong or weak relative to the pound?

The forward exchange rate indicates the rate at which traders are willing to exchange currencies in the future. In this case, they believe that the dollar will strengthen against the pound in the coming year (that one dollar will be able to buy more pound

When would you write a call option on Disney stock?

When you expect the price of Disney stock to fall (or stay the same). Because a call option on a stock is a bet that the value of the stock will increase, you would be willing to write (sell) a call option on Disney stock to an investor if you believed Di

Explain how a swap works.

A swap is an exchange of future cash flows. The most popular forms include foreign exchange swaps and interest rate swaps. They are used to hedge volatile rates, such as currency exchange rates or interest rates.

Say I hold a put option on Microsoft stock with an exercise price of $60, the expiration date is today, and Microsoft is trading at $50. About how much is my put worth, and why?

Your put is worth about $10, because today, you can sell a share of stock for $60, and buy it for $50. (If the expiration date were in the future, the option would be more valuable, because the stock could conceivably drop more.)

When would a trader seeking profit from a long-term possession of a future be in the long position?

The trader in the long position is committed to buying a commodity on a delivery date. She would hold this position if she believes the commodity price will increase.

All else being equal, which would be less valuable: a December put option on Amazon.com stock or a December put option on Bell Atlantic stock?

The put option on Bell Atlantic should be less valuable. Amazon.com is a more volatile stock, and the more volatile the underlying asset, the more valuable the option.

All else being equal, which would be more valuable: a December call option for eBay or a January call option for eBay?

The January option: The later an option's expiration date, the more valuable the option.

Why do interest rates matter when figuring the price of options?

Because of the ever-important concept of net present value, all else being equal, higher interest rates lower the value of call options.

If the strike price on a put option is below the current price, is the option holder at the money, in the money or out of the money?

Because a put option gives the holder the right to sell a security at a certain price, the fact that the strike (or exercise) price is below the current price would mean that the option holder would lose money.

If the current price of a stock is above the strike price of a call option, is the option holder at the money, in the money, or out of the money?

Because a call option gives the holder the right to buy a security, the holder in this scenario is in the money (making money).

When would you buy a put option on General Mills stock?

Because buying a put option gives you the option to sell the stock at a certain price, you would do this if you expect the price of General Mills stock to fall.

What is the main difference between futures contracts and forward contracts?

The main difference between forward and futures contracts is that futures contracts are traded on exchanges and forwards are traded over-the-counter. Because of this distinction, you can only trade specific futures contracts that are traded on the exchang

Describe a recent M&A transaction that you've read about.

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What were the reasons behind an M&A transaction you've read about? Does that transaction make sense?

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Your client is a privately held human resources software company. You are advising the company in the potential sale of the company. Who would you expect to pay more for the company: Oracle Software (a competitor), or Kohlberg Kravis Roberts (an LBO fund)

Oracle.
A strategic buyer like Oracle would typically pay more than a financial buyer like KKR. Oracle would be able to derive additional benefits and therefore higher cash flows from the purchase than would KKR. For example, Oracle would be able to cut s

Are most mergers stock swaps or cash transactions and why?

In strong markets, most mergers are stock swaps, largely because the stock prices of companies are so high.

What is a dilutive merger?

A merger in which the acquiring company's earnings per share decreases as a result of the merger. Also remember the P/E rule: A dilutive merger happens when a company with a lower P/E ratio acquires a company with a higher P/E ratio.

What is an accretive merger?

The type of merger in which the acquiring company's earnings per share increase. With regard to P/E ratio, this happens when a company with a higher P/E ratio acquires a company with a lower P/E ratio. The acquiring company's earnings per share should ris

Company A is considering acquiring Company B. Company A's P/E ratio is 55 times earnings, whereas Company B's P/E ratio is 30 times earnings. After Company A acquires Company B, will Company A's earnings per share rise, fall, or stay the same?

Company A's earnings per share will rise, because of the following rule: When a higher P/E company buys a lower P/E company, the acquirer's earnings-per-share will rise. The deal is said to be accretive, as opposed to dilutive, to the acquirer's earnings.

Can you name two companies that you think should merge?

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What is a hostile tender offer?

If company A wants to acquire company B, but company B refuses, company A can issue a tender offering. In this offer, company A will take advertisements in major newspapers like The Wall Street Journal to buy stock in company B at a price much above the m

What is a leveraged buyout? How is it different than a merger?

A leveraged buyout occurs when a group, by refinancing a company with debt, is able to increase the valuation of the company. LBOs are typically accomplished by either financial groups such as KKR or company management, whereas M&A deals are led by compan

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?

You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income St

Walk me through how Depreciation going up by $10 would affect the statements.

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6.
Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so ov

If Depreciation is a non-cash expense, why does it affect the cash balance?

Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

Where does Depreciation usually show up on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

What happens when Accrued Compensation goes up by $10?

For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation).
Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax In

What happens when Inventory goes up by $10, assuming you pay for it with cash?

No changes to the Income Statement.
On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations - it goes down by $10, as does the Net Change in Cash at the bottom.
On the Balance Sheet under Assets, Inventory is up

Why is the Income Statement not affected by changes in Inventory?

This is a common interview mistake - incorrectly stating that Working Capital changes show up on the Income Statement.
In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if it's just sitting in a warehou

Let's say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?

At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement (yet).
On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in

Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

After a year has passed, Apple must pay interest expense and must record the depreciation.
Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements.
First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?

No changes to the Income Statement.
Cash Flow Statement - Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10.
On the Balance Sheet, Inventory is up by $10 and Cash is down by

Now let's say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6.
Cash Flow Statement: Net Income at the top is up by $6 and Inventory has

Could you ever end up with negative shareholders' equity? What does it mean?

Yes. It is common to see this in 2 scenarios:
1. Leveraged Buyouts with dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number nega

What is Working Capital? How is it used?

Working Capital = Current Assets - Current Liabilities.
If it's positive, it means a company can pay off its short-term liabilities with its short- term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive)

What does negative Working Capital mean? Is that a bad sign?

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:
1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Reven

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write- down of $100.

First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60.
On the Cash Flow Statement, Net Income is down by $60 but the write-down is a non- cash expense, so we add it back -

Walk me through a $100 "bailout" of a company and how it affects the 3 statements.

First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens:
No changes to the Income Statement. On the Cash Flow Statement, Cash Flow from

Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a company's balance sheet and how it affects the 3 statements.

This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $6

When would a company collect cash from a customer and not record it as revenue?

Three examples come to mind:
1. Web-based subscription software.
2. Cell phone carriers that sell annual contracts.
3. Magazine publishers that sell subscriptions.
Companies that agree to services in the future often collect cash upfront to ensure stable

If cash collected is not recorded as revenue, what happens to it?

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.
Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and the Deferred Revenue balance decreases.

What's the difference between accounts receivable and deferred revenue?

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been.
Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it has already collected in c

How long does it usually take for a company to collect its accounts receivable balance?

Generally the accounts receivable days are in the 30-60 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction- value companies.

What's the difference between cash-based and accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they

Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

In cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - at which point it would show up as both Revenue on the Income Statement and

How do you decide when to capitalize rather than expense a purchase?

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years.

Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?

These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how p

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Several possibilities:
1. The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be cash-flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3.

Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought.
It often happens

Under what circumstances would Goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios:
1. The company gets acquired or bought out and Goodwill changes as a result, since it's an

What's the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

First, note that this question does not apply to you if you're outside the US as IFRS does not permit the use of LIFO. But you may want to read this anyway because it's good to know in case you ever work with US-based companies.
LIFO stands for "Last-In,

How is GAAP accounting different from tax accounting?

1. GAAP is accrual-based but tax is cash-based.
2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).
3. GAAP is more complex and more accurately tracks assets/liabilities whereas ta

What are deferred tax assets/liabilities and how do they arise?

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.
Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven't actually pai

Walk me through how you create a revenue model for a company.

There are 2 ways you could do this: a bottoms-up build and a tops-down build.
1. Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything

Walk me through how you create an expense model for a company.

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward.
Usually you assume that the number of employees

Let's say we're trying to create these models but don't have enough information or the company doesn't tell us enough in its filings - what do we do?

Use estimates. For the revenue if you don't have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years.
For the expenses, if you don't have employee-level information t

Walk me through the major items in Shareholders' Equity.

1. Common Stock - Simply the par value of however much stock the company has issued.
2. Retained Earnings - How much of the company's Net Income it has "saved up" over time.
3. Additional Paid in Capital - This keeps track of how much stock-based compensa

Walk me through what flows into Retained Earnings.

Retained Earnings = Old Retained Earnings Balance + Net Income - Dividends Issued
If you're calculating Retained Earnings for the current year, take last year's Retained Earnings number, add this year's Net Income, and subtract however much the company pa

Walk me through what flows into Additional Paid-In Capital (APIC).

APIC = Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises
Take the balance from last year, add this year's stock-based compensation number, and then add in the value of new stock created by employees exercising options this y

What is the Statement of Shareholders' Equity and why do we use it?

This statement shows everything we went through above - the major items that comprise Shareholders' Equity, and how we arrive at each of them using the numbers elsewhere in the statement.
You don't use it too much, but it can be helpful for analyzing comp

What are examples of non-recurring charges we need to add back to a company's EBIT / EBITDA when looking at its financial statements?

1. Restructuring Charges
2. Goodwill Impairment
3. Asset Write-Downs
4. Bad Debt Expenses
5. Legal Expenses
6. Disaster Expenses
7. Change in Accounting Procedures
Note that to be an "add-back" or "non-recurring" charge for EBITDA / EBIT purposes, it need

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?

Normally you make very simple assumptions and assume these are percentages of revenue, operating expenses, or cost of goods sold.
Examples:
1. Accounts Receivable: % of revenue.
2. Deferred Revenue: % of revenue.
3. Accounts Payable: % of COGS.
4. Accrued

How should you project Depreciation and Capital Expenditures?

The simple way: project each one as a % of revenue or previous PP&E balance.
The more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset's useful life, and then as

How do Net Operating Losses (NOLs) affect a company's 3 statements?

The "quick and dirty" way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same).
The way

What's the difference between capital leases and operating leases?

Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement.
Capital leases are used for longer-term items and give th

Why would the Depreciation & Amortization number on the Income Statement be different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you're undercounting D&A.

Why do we look at both Enterprise Value and Equity Value?

Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees

When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?

Enterprise Value, because that's how much an acquirer really "pays" and includes the often mandatory debt repayment.

What's the formula for Enterprise Value?

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest - Cash
This formula does not tell the whole story and can get more complex - see the Advanced Questions. Most of the time you can get away with stating this formula in an interview, thou

Why do you need to add the Noncontrolling Interest to Enterprise Value?

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance.
So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial p

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each - what is its fully diluted equity value?

Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all "in-the-money" - their exercise price is less than the current share price.
When these options are exercised, t

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its fully diluted equity value?

$1,000. In this case the options' exercise price is above the current share price, so they have no dilutive effect.

Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

The "official" reason:
Cash is subtracted because it's considered a non-operating asset and because Equity Value implicitly accounts for it.
The way I think about it:
In an acquisition, the buyer would "get" the cash of the seller, so it effectively pays

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller's debt, so it is accurate to say that any debt "adds" to the purchase price.
However, the

Could a company have a negative Enterprise Value? What would that mean?

Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with:
1. Companies on the brink of bankruptcy.
2. Financial institutions, such as banks, that have large cash balances - bu

Could a company have a negative Equity Value? What would that mean?

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

Why do we add Preferred Stock to get to Enterprise Value?

Preferred Stock pays out a fixed dividend, and preferred stockholders also have a higher claim to a company's assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

How do you account for convertible bonds in the Enterprise Value formula?

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they're out-of-the-money then you count the face value of the co

A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?

First, note that these convertible bonds are in-the-money because the company's share price is $100, but the conversion price is $50. So we count them as additional shares rather than debt.
Next, we need to divide the value of the convertible bonds - $10

What's the difference between Equity Value and Shareholders' Equity?

Equity Value is the market value and Shareholders' Equity is the book value. Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders' Equity could be any value. For healthy companies, Equi

Are there any problems with the Enterprise Value formula you just gave me?

Yes - it's too simple. There are lots of other things you need to add into the formula with real companies:
1. Net Operating Losses - Should be valued and arguably added in, similar to cash.
2. Long-Term Investments - These should be counted, similar to c

Should you use the book value or market value of each item when calculating Enterprise Value?

Technically, you should use market value for everything. In practice, however, you usually use market value only for the Equity Value portion, because it's almost impossible to establish market values for the rest of the items in the formula - so you just

What percentage dilution in Equity Value is "too high?

There's no strict "rule" here but most bankers would say that anything over 10% is odd. If your basic Equity Value is $100 million and the diluted Equity Value is $115 million, you might want to check your calculations - it's not necessarily wrong, but ov

Rank the 3 valuation methodologies from highest to lowest expected value.

Precedent transactions methodology is likely to give a higher valuation than Comparable Companies methodology. This is because when companies are purchased, the target's shareholders are typically paid a price that is higher than the target's current stoc

When would you not use a DCF in a Valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or biotech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not reinvest debt and working ca

What other Valuation methodologies are there?

1. Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
2. Replacement Value - Valuing a company based on the cost of replacing its

When would you use a Liquidation Valuation?

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company's debts have been paid off. It is often used to advise struggling businesses on whether it's better to sell off assets se

When would you use Sum of the Parts?

This is most often used when a company has completely different, unrelated divisions - a conglomerate like General Electric, for example.
If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division a

When do you use an LBO Analysis as part of your Valuation?

Obviously you use this whenever you're looking at a Leveraged Buyout - but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay.
It is often used to set a "floor" on a possible Valuatio

What are the most common multiples used in Valuation?

The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).

What are some examples of industry-specific multiples?

Technology (Internet): EV / Unique Visitors, EV / Pageviews
Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense)
Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization &

When you're looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?

You use Enterprise Value because those scientists or subscribers are "available" to all the investors (both debt and equity) in a company. The same logic doesn't apply to everything, though - you need to think through the multiple and see which investors

Would an LBO or DCF give a higher valuation?

Technically it could go either way, but in most cases the LBO will give you a lower valuation.
Here's the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you're o

How would you present these Valuation methodologies to a company or its investors?

Usually you use a "football field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.

How would you value an apple tree?

The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree's cash flows (intrinsic valuation).

Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together.
Equity Value / EBITDA, however, is comparing apples to orange

When would a Liquidation Valuation produce the highest value?

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality).
As a result, the company's Comparable Companies and Precedent

Let's go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

You would use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.
You would not use a "far in the future DCF" because you can't reasonably p

What would you use in conjunction with Free Cash Flow multiples - Equity Value or Enterprise Value?

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value.
Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Lev

You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?

It's very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values - so you might use Equity Value / Revenue instead.
You might see Equity Value / Revenue if you've listed a set of financial insti

How do you select Comparable Companies / Precedent Transactions?

The 3 main ways to select companies and transactions:
1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography
For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2

How do you apply the 3 valuation methodologies to actually get a value for the company you're looking at?

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you're valuing.
Example: If the median EBITDA m

What do you actually use a valuation for?

Usually you use it in pitch books and in client presentations when you're providing updates and telling them what they should expect for their own valuation.
It's also used right before a deal closes in a Fairness Opinion, a document a bank creates that

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

This could happen for a number of reasons:
1. The company has just reported earnings well-above expectations and its stock price has risen recently.
2. It has some type of competitive advantage not reflected in its financials, such as a key patent or othe

What are the flaws with public company comparables?

1. No company is 100% comparable to another company.
2. The stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates depending on the market's movements.
3. Share prices for small companies with thinly-traded sto

How do you take into account a company's competitive advantage in a valuation?

1. Look at the 75th percentile or higher for the multiples rather than the Medians.
2. Add in a premium to some of the multiples.
3. Use more aggressive projections for the company.
In practice you rarely do all of the above - these are just possibilities

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

There's no "rule" that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you're valuing is distressed, is not performing well, or is at a competitive disadvantage, you might u

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies - can you think of a situation where this is not the case?

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuation

What are some flaws with precedent transactions?

1. Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market sentiment all have huge effects.
2. Data on precedent transactions is generally more difficult to find than it is for public company comparables,

Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?

Possible reasons:
1. One process was more competitive and had a lot more companies bidding on the target.
2. One company had recent bad news or a depressed stock price so it was acquired at a discount.
3. They were in industries with different median mult

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?"
He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their oper

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's profitability. What's the difference between them, and when do you use each one?

P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical.
EV / EBIT in

If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amoun

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower as a

How do you value a private company?

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:
1. You might apply a 10-15% (or more) discount to the public company comparable multiples because the pri

Let's say we're valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?

There's no discount because with precedent transactions, you're acquiring the entire company - and once it's acquired, the shares immediately become illiquid.
But shares - the ability to buy individual "pieces" of a company rather than the whole thing - c

Can you use private companies as part of your valuation?

Only in the context of precedent transactions - it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or B

How do you value banks and financial institutions differently from other companies?

For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:
1. You screen based on assets or deposits in addition to the normal criteria.
2. You look at metrics like ROE (Re

Walk me through an IPO valuation for a company that's about to go public.

1. Unlike normal valuations, in an IPO valuation we only care about public
company comparables.
2. After picking the public company comparables we decide on the most relevant multiple to use and then estimate our company's Enterprise Value based on that.

I'm looking at financial data for a public company comparable, and it's April (Q2) right now. Walk me through how you would "calendarize" this company's financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.

The "formula" to calendarize financial statements is as follows:
TTM = Most Recent Fiscal Year + New Partial Period - Old Partial Period
So in the example above, we would take the company's Q1 numbers, add the most recent fiscal year's numbers, and then s

Walk me through an M&A premiums analysis.

The purpose of this analysis is to look at similar transactions and see the premiums that buyers have paid to sellers' share prices when acquiring them. For example, if a company is trading at $10.00/share and the buyer acquires it for $15.00/share, that'

Walk me through a future share price analysis.

The purpose of this analysis is to project what a company's share price might be 1 or 2 years from now and then discount it back to its present value.
1. Get the median historical (usually TTM) P / E of your public company comparables.
2. Apply this P / E

Both M&A premiums analysis and precedent transactions involve looking at previous M&A transactions. What's the difference in how we select them?

1. All the sellers in the M&A premiums analysis must be public.
2. Usually we use a broader set of transactions for M&A premiums - we might use fewer than 10 precedent transactions but we might have dozens of M&A premiums. The industry and financial scree

Walk me through a Sum-of-the-Parts analysis.

In a Sum-of-the-Parts analysis, you value each division of a company using separate comparables and transactions, get to separate multiples, and then add up each division's value to get the total for the company. Example:
We have a manufacturing division

How do you value Net Operating Losses and take them into account in a valuation?

You value NOLs based on how much they'll save the company in taxes in future years, and then take the present value of the sum of tax savings in future years.
Two ways to assess the tax savings in future years:
1. Assume that a company can use its NOLs to

I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?

This varies by bank and group, but two common methods:
1. You pick the report with the most detailed information.
2. You pick the report with numbers in the middle of the range.
Note that you do not pick reports based on which bank they're coming from. So

I have a set of precedent transactions but I'm missing information like EBITDA for a lot of the companies - how can I find it if it's not available via public sources?

1. Search online and see if you can find press releases or articles in the financial press with these numbers.
2. Failing that, look in equity research for the buyer around the time of the transaction and see if any of the analysts estimate the seller's n

How far back and forward do we usually go for public company comparable and precedent transaction multiples?

Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years. You're more likely to look backward more than 1 year and go forward more than 2 years for public company comparables; for precedent t

I have one company with a 40% EBITDA margin trading at 8x EBITDA, and another company with a 10% EBITDA margin trading at 16x EBITDA. What's the problem with comparing these two valuations directly?

There's no "rule" that says this is wrong or not allowed, but it can be misleading to compare companies with dramatically different margins. Due to basic arithmetic, the 40% margin company will usually have a lower multiple - whether or not its actual val

Walk me through how we might value an oil & gas company and how it's different from a "standard" company.

Public comps and precedent transactions are similar, but:
1. You might screen based on metrics like Proved Reserves or Daily Production.
2. You would look at the above metrics as well as R/P (Proved Reserves / Last Year's Production), EBITDAX, and other i

Walk me through how we would value a REIT (Real Estate Investment Trust) and how it differs from a "normal" company.

Similar to energy, real estate is asset-intensive and a company's value depends on how much cash flow specific properties generate.
1. You look at Price / FFO per Share (Funds From Operations) and Price / AFFO per Share (Adjusted Funds From Operations), w

Walk me through a DCF.

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.
First, you project out a company's financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free C

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.
Note: This gets you to Unlever

What's an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Take Cash Flow From Operations and subtract CapEx and mandatory debt repayments - that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Why do you use 5 or 10 years for DCF projections?

That's usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

What do you usually use for the discount rate?

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you've set up the DCF.

How do you calculate WACC?

The formula is: Cost of Equity
(% Equity) + Cost of Debt
(% Debt)
(1 - Tax Rate) + Cost of Preferred
(% Preferred).
In all cases, the percentages refer to how much of the company's capital structure is taken up by each component.
For Cost of Equity, you c

How do you get to Beta in the Cost of Equity calculation?

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company's capital structure. Then you use this Levered Beta in the Cost of Equity calculation.
For your

Why do you have to un-lever and re-lever Beta?

When you look up the Betas on Bloomberg (or from whatever source you're using) they will be levered to reflect the debt already assumed by each company.
But each company's capital structure is different and we want to look at how "risky" a company is rega

Would you expect a manufacturing company or a technology company to have a higher Beta?

A technology company, because technology is viewed as a "riskier" industry than manufacturing.

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

You would use the Cost of Equity rather than WACC since we're not concerned with Debt or Preferred Stock in this case - we're calculating Equity Value, not Enterprise Value.

How do you calculate the Terminal Value?

You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.
The formula for Terminal Value using Go

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's much easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate, by contrast, is always

What's an appropriate growth rate to use when calculating the Terminal Value?

Normally you use the country's long-term GDP growth rate, the rate of inflation, or something similarly conservative.
For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing a

How do you select the appropriate exit multiple when calculating Terminal Value?

Normally you look at the Comparable Companies and pick the median of the set, or something close to it.
As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than p

Which method of calculating Terminal Value will give you a higher valuation?

It's hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth ra

What's the flaw with basing terminal multiples on what public company comparables are trading at?

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you're looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes ove

How do you know if your DCF is too dependent on future assumptions?

The "standard" answer: if significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.
In reality, almost all DCFs are "too dependent on future assumptions" - it's a

Should Cost of Equity be higher for a $5 billion or $500 million market cap company?

It should be higher for the $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be "more risky"). Using a Size Premium in your calculation would also ensure th

What about WACC - will it be higher for a $5 billion or $500 million company?

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates and such, then WACC should be higher for the $500

What's the relationship between debt and Cost of Equity?

More debt means that the company is more risky, so the company's Levered Beta will be higher - all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company - but what about dividends? Shouldn't we factor dividend yield into the formula?

Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include dividends.

How can we calculate Cost of Equity WITHOUT using CAPM?

There is an alternate formula:
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
This is less common than the "standard" formula but sometimes you use it for companies where dividends are more important or when you lack prope

Two companies are exactly the same, but one has debt and one does not - which one will have the higher WACC?

The one without debt will generally have a higher WACC because debt is "less expensive" than equity. Why?
1. Interest on debt is tax-deductible (hence the (1 - Tax Rate) multiplication in the WACC formula).
2. Debt is senior to equity in a company's capit

Which has a greater impact on a company's DCF valuation - a 10% change in revenue or a 1% change in the discount rate?

It Depends
Most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn't affect only the current year's revenue, but also the revenue/EBITDA far into the future and even the terminal value.

What about a 1% change in revenue vs. a 1% change in the discount rate?

In this case the discount rate is likely to have a bigger impact on the valuation, though the correct answer should start with, "It could go either way, but most of the time...

How do you calculate WACC for a private company?

This is problematic because private companies don't have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

What should you do if you don't believe management's projections for a DCF model?

You can take a few different approaches:
1. You can create your own projections.
2. You can modify management's projections downward to make them more conservative.
3. You can show a sensitivity table based on different growth rates and margins and show t

Why would you not use a DCF for a bank or other financial institution?

Banks use debt differently than other companies and do not re-invest it in the business - they use it to create their "products" - loans - instead. Also, interest is a critical part of banks' business models and changes in working capital can be much larg

What types of sensitivity analyses would we look at in a DCF?

Example sensitivities:
1. Revenue Growth vs. Terminal Multiple
2. EBITDA Margin vs. Terminal Multiple
3. Terminal Multiple vs. Discount Rate
4. Long-Term Growth Rate vs. Discount Rate
And any combination of these (except Terminal Multiple vs. Long-Term Gr

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Trick question. You don't account for this at all in an Unlevered DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement - but we only take into account EBIT * (1 - Tax Rate), and then a few items from Cash

Explain why we would use the mid-year convention in a DCF.

You use it to represent the fact that a company's cash flow does not come 100% at the end of each year - instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year,

What discount period numbers would I use for the mid-year convention if I have a stub period?

The rule is that you divide the stub discount period by 2, and then you simply subtract 0.5 from the "normal" discount periods for the future years.

How does the terminal value calculation change when we use the mid-year convention?

When you're discounting the terminal value back to the present value, you use different numbers for the discount period depending on whether you're using the Multiples Method or Gordon Growth Method:
1. Multiples Method: You add 0.5 to the final year disc

If I'm working with a public company in a DCF, how do I calculate its per-share value?

Once you get to Enterprise Value, ADD cash and then subtract debt, preferred stock, and noncontrolling interest (and any other debt-like items) to get to Equity Value.
Then, you need to use a circular calculation that takes into account the basic shares o

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

The mechanics are the same as a DCF, but we use dividends rather than free cash flows:
1. Project out the company's earnings, down to earnings per share (EPS).
2. Assume a dividend payout ratio - what percentage of the EPS actually gets paid out to shareh

When you're calculating WACC, let's say that the company has convertible debt. Do you count this as debt when calculating Levered Beta for the company?

Trick question. If the convertible debt is in-the-money then you do not count it as debt but instead assume that it contributes to dilution, so the company's Equity Value is higher. If it's out-of-the-money then you count it as debt and use the interest r

We're creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing) in Year 4. Currently the present value of its Enterprise Value according to the DCF is $200. How would we change the DCF to account for the

In this scenario, you would add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow.
The actual math h

Walk me through a basic merger model.

A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer's EPS increases or decreases.
Step 1 is making assumptions about the acquisition - the price and wh

What's the difference between a merger and an acquisition?

There's always a buyer and a seller in any M&A deal - the difference between "merger" and "acquisition" is more semantic than anything. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

Why would a company want to acquire another company?

Several possible reasons:
1. The buyer wants to gain market share by buying a competitor.
2. The buyer needs to grow more quickly and sees an acquisition as a way to do that.
3. The buyer believes the seller is undervalued.
4. The buyer wants to acquire t

Why would an acquisition be dilutive?

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer's foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares.
Acquisition effects - s

A company with a higher P/E acquires one with a lower P/E - is this accretive or dilutive?

Trick question. You can't tell unless you also know that it's an all-stock deal. If it's an all-cash or all-debt deal, the P/E multiples of the buyer and seller don't matter because no stock is being issued.
Sure, generally getting more earnings for less

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.
On an intuitive level if you're paying more for earnings than what the market values your own earnings at, you ca

What are the complete effects of an acquisition?

1. Foregone Interest on Cash - The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition.
2. Additional Interest on Debt - The buyer pays additional Interest Expense if it uses debt.
3. Additional Shares Outstanding -

If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?

It might be saving its cash for something else or it might be concerned about running low if business takes a turn for the worst; its stock may also be trading at an all-time high and it might be eager to use that instead (in finance terms this would be

Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?

Because the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effective valuation for the target company.

Why do Goodwill & Other Intangibles get created in an acquisition?

These represent the value over the "fair market value" of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price.
More specifically, Goodwill and Other Intangibles represent t

What is the difference between Goodwill and Other Intangible Assets?

Goodwill typically stays the same over many years and is not amortized. It changes only if there's goodwill impairment (or another acquisition).
Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitt

Is there anything else "intangible" besides Goodwill & Other Intangibles that could also impact the combined company?

Yes. You could also have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off.
The first refers to any Research & Development projects that were purchased in the acquisition but which have not been completed yet. The logic is that unfinis

What are synergies, and can you provide a few examples?

Basically, the buyer gets more value than out of an acquisition than what the financials would predict.
There are 2 types: revenue synergies and cost (or expense) synergies.
1. Revenue Synergies: The combined company can cross-sell products to new custome

How are synergies used in merger models?

Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue - this additional Revenue then flows through the rest of the combined Income Statement.
Cost Synergies: Normally you r

Are revenue or cost synergies more important?

No one in M&A takes revenue synergies seriously because they're so hard to predict. Cost synergies are taken a bit more seriously because it's more straightforward to see how buildings and locations might be consolidated and how many redundant employees m

All else being equal, which method would a company prefer to use when acquiring another company - cash, stock, or debt?

Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company. Why?
1. Cash is "cheaper" than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than t

How much debt could a company issue in a merger or acquisition?

Generally you would look at Comparable Companies/ Precedent Transactions to determine this. You would use the combined company's LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of whatever companies you're looking at, and apply t

How do you determine the Purchase Price for the target company in an acquisition?

You use the same Valuation methodologies we already discussed. If the seller is a public company, you would pay more attention to the premium paid over the current share price to make sure it's "sufficient" (generally in the 15-30% range) to win sharehold

Let's say a company overpays for another company - what typically happens afterwards and can you give any recent examples?

There would be an incredibly high amount of Goodwill & Other Intangibles created if the price is far above the fair market value of the company. Depending on how the acquisition goes, there might be a large goodwill impairment charge later on if the compa

A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it's only worth $50 million. What happens?

The buyer's share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would not necessarily be cut in half.
Depending on how the deal was structured, the seller would effectively only be receivin

Why do most mergers and acquisitions fail?

Like so many things, M&A is "easier said than done." In practice it's very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division.
Many deals are also done for the w

What role does a merger model play in deal negotiations?

The model is used as a sanity check and is used to test various assumptions. A company would never decide to do a deal based on the output of a model.
It might say, "Ok, the model tells us this deal could work and be moderately accretive - it's worth expl

What types of sensitivities would you look at in a merger model? What variables would you look at?

The most common variables to look at are Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies. Sometimes you also look at different operating sensitivities, like Revenue Growth or EBITDA Margin, but it's more common to build these i

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

In purchase accounting the seller's shareholders' equity number is wiped out and the premium paid over that value is recorded as Goodwill on the combined balance sheet post-acquisition. In pooling accounting, you simply combine the 2 shareholders' equity

Walk me through a concrete example of how to calculate revenue synergies.

Let's say that Microsoft is going to acquire Yahoo. Yahoo makes money from search advertising online, and they make a certain amount of revenue per search (RPS). Let's say this RPS is $0.10 right now. If Microsoft acquired it, we might assume that they c

Walk me through an example of how to calculate expense synergies.

Let's say that Microsoft still wants to acquire Yahoo!. Microsoft has 5,000 SG&A-related employees, whereas Yahoo has around 1,000. Microsoft calculates that post-transaction, it will only need about 200 of Yahoo's SG&A employees, and its existing employ

How do you take into account NOLs in an M&A deal?

You apply Section 382 to determine how much of the seller's NOLs are usable each year.
Allowable NOLs = Equity Purchase Price * Highest of Past 3 Months' Adjusted Long Term Rates
So if our equity purchase price were $1 billion and the highest adjusted lon

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

These get created when you write up assets - both tangible and intangible - and when you write down assets in a transaction. An asset write-up creates a deferred tax liability, and an asset write-down creates a deferred tax asset.
You write down and write

How do DTLs and DTAs affect the Balance Sheet Adjustment in an M&A deal?

You take them into account with everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma balance sheet. The formulas are as follows:
Deferred Tax Asset = Asset Write-Down * Tax Rate
Deferred Tax Liability = A

Could you get DTLs or DTAs in an asset purchase?

No, because in an asset purchase the book basis of assets always matches the tax basis. They get created in a stock purchase because the book values of assets are written up or written down, but the tax values are not.

How do you account for DTLs in forward projections in a merger model?

You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pre-tax Income on its books, and then you determine what it actually pays in cash taxes based on its NOLs and newly created amortization and depreciation ex

Explain the complete formula for how to calculate Goodwill in an M&A deal.

Goodwill = Equity Purchase Price - Seller Book Value + Seller's Existing Goodwill - Asset Write-Ups - Seller's Existing Deferred Tax Liability + Write-Down of Seller's Existing Deferred Tax Asset + Newly Created Deferred Tax Liability
A couple notes here:

Explain why we would write down the seller's existing Deferred Tax Asset in an M&A deal.

You write it down to reflect the fact that Deferred Tax Assets include NOLs, and that you might use these NOLs post-transaction to offset the combined entity's taxable income.
In an asset or 338(h)(10) purchase you assume that the entire NOL balance goes

What's a Section 338(h)(10) election and why might a company want to use it in an M&A deal?

A Section 338(h)(10) election blends the benefits of a stock purchase and an asset purchase:
1. Legally it is a stock purchase, but accounting-wise it's treated like an asset purchase.
2. The seller is still subject to double-taxation - on its assets that

What is an exchange ratio and when would companies use it in an M&A deal?

An exchange ratio is an alternate way of structuring a 100% stock M&A deal, or any M&A deal with a portion of stock involved.
Let's say you were going to buy a company for $100 million in an all-stock deal. Normally you would determine how much stock to i

Walk me through the most important terms of a Purchase Agreement in an M&A deal.

1. Purchase Price: Stated as a per-share amount for public companies.
2. Form of Consideration: Cash, Stock, Debt...
3. Transaction Structure: Stock, Asset, or 338(h)(10)
4. Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
5. Employee Rete

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

An Earnout is a form of "deferred payment" in an M&A deal - it's most common with private companies and start-ups, and is highly unusual with public sellers.
It is usually contingent on financial performance or other goals - for example, the buyer might s

How would an accretion / dilution model be different for a private seller?

The mechanics are the same, but the transaction structure is more likely to be an asset purchase or 338(h)(10) election; private sellers also don't have Earnings Per Share so you would only project down to Net Income on the seller's Income Statement.
Note

How would I calculate "break-even synergies" in an M&A deal and what does the number mean?

To do this, you would set the EPS accretion / dilution to $0.00 and then back-solve in Excel to get the required synergies to make the deal neutral to EPS.
It's important because you want an idea of whether or not a deal "works" mathematically, and a high

Normally in an accretion / dilution model you care most about combining both companies' Income Statements. But let's say I want to combine all 3 financial statements - how would I do this?

You combine the Income Statements like you normally would (see the previous question on this), and then you do the following:
1. Combine the buyer's and seller's balance sheets (except for the seller's Shareholders' Equity number).
2. Make the necessary P

How do you handle options, convertible debt, and other dilutive securities in a merger model?

The exact treatment depends on the terms of the Purchase Agreement - the buyer might assume them or it might allow the seller to "cash them out" assuming that the per-share purchase price is above the exercise prices of these dilutive securities.
If you a

What are the main 3 transaction structures you could use to acquire another company?

Stock Purchase, Asset Purchase, and 338(h)(10) Election.
The basic differences:
Stock Purchase:
1. Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
2. The seller is taxed at the capital gains tax rate.
3. The buye

Would a seller prefer a stock purchase or an asset purchase? What about the buyer?

A seller almost always prefers a stock purchase to avoid double taxation and to get rid of all its liabilities. The buyer almost always prefers an asset deal so it can be more careful about what it acquires and to get the tax benefit from being able to de

Explain what a contribution analysis is and why we might look at it in a merger model.

A contribution analysis compares how much revenue, EBITDA, Pre-Tax Income, cash, and possibly other items the buyer and seller are "contributing" to estimate what the ownership of the combined company should be.
For example, let's say that the buyer is se

How do you account for transaction costs, financing fees, and miscellaneous expenses in a merger model?

In the "old days" you used to capitalize these expenses and then amortize them; with new accounting rules introduced at the end of 2008, you're supposed to expense transaction and miscellaneous fees upfront, but capitalize the financing fees and amortize

Walk me through a basic LBO model.

In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume something about the company's operations, such as Revenue Growth or Margins, depending on how much

Why would you use leverage when buying a company?

To increase your returns.
Remember, any debt you use in an LBO is not "your money" - so if you're paying $5 billion for a company, it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of y

What variables impact an LBO model the most?

Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margins.

How do you pick purchase multiples and exit multiples in an LBO model?

The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity tables.
Sometimes you set p

Why are Goodwill & Other Intangibles created in an LBO?

Remember, these both represent the premium paid to the "fair market value" of the company. In an LBO, they act as a "plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.

We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that's the case, why would a PE firm want to use debt in an LBO?

1. The PE firm does not intend to hold the company for the long-term - it usually sells it after a few years, so it is less concerned with the "expense" of cash vs. debt and more concerned about using leverage to boost its returns by reducing the amount o

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

Yes, there are shortcuts and you don't necessarily need to project all 3 statements.
For example, you do not need to create a full Balance Sheet - bankers sometimes skip this if they are in a rush. You do need some form of Income Statement, something to t

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

Let's say we're analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?

This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions.
To figure out the numbers, you would look at "debt comps" showing the types, tranches, and terms of debt that similarly sized

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

This is a simplification, but broadly speaking there are 2 "types" of debt: "bank debt" and "high-yield debt." There are many differences, but here are a few of the most important ones:
1. High-yield debt tends to have higher interest rates than bank debt

Why might you use bank debt rather than high-yield debt in an LBO?

If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt; they might also use bank debt if they are planning on major expansion or Capital Expenditures and don't want to be restrict

Why would a PE firm prefer high-yield debt instead?

If the PE firm intends to refinance the company at some point or they don't believe their returns are too sensitive to interest payments, they might use high-yield debt. They might also use the high-yield option if they don't have plans for major expansio

Why would a private equity firm buy a company in a "risky" industry, such as technology?

Although technology is more "risky" than other markets, remember that there are mature, cash flow-stable companies in almost every industry. There are some PE firms that specialize in very specific goals, such as:
1. Industry consolidation - buying compet

How could a private equity firm boost its return in an LBO?

1. Lower the Purchase Price in the model.
2. Raise the Exit Multiple / Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company's growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees,

What is meant by the "tax shield" in an LBO?

This means that the interest a firm pays on debt is tax-deductible - so they save money on taxes and therefore increase their cash flow as a result of having debt from the LBO.
Note, however, that their cash flow is still lower than it would be without th

What is a dividend recapitalization ("dividend recap")?

The company takes on new debt solely to pay a special dividend out to the PE firm that bought it.

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

Primarily to boost returns. Remember, all else being equal, more leverage means a higher return to the firm.
With a dividend recap, the PE firm is "recovering" some of its equity investment in the company - and as we saw earlier, the lower the equity inve

How would a dividend recap impact the 3 financial statements in an LBO?

No changes to the Income Statement. On the Balance Sheet, Debt would go up and Shareholders' Equity would go down and they would cancel each other out so that everything remained in balance.
On the Cash Flow Statement, there would be no changes to Cash Fl

Tell me about all the different kinds of debt you could use in an LBO and the differences between everything.

...

How would an asset write-up or write-down affect an LBO model? / Walk me through how you adjust the Balance Sheet in an LBO model.

All of this is very similar to what you would see in a merger model - you calculate Goodwill, Other Intangibles, and the rest of the write-ups in the same way, and then the Balance Sheet adjustments (e.g. subtracting cash, adding in capitalized financing

Normally we care about the IRR for the equity investors in an LBO - the PE firm that buys the company - but how do we calculate the IRR for the debt investors?

For the debt investors, you need to calculate the interest and principal payments they receive from the company each year.
Then you simply use the IRR function in Excel and start with the negative amount of the original debt for "Year 0," assume that the

Why might a private equity firm allot some of a company's new equity in an LBO to a management option pool, and how would this affect the model?

This is done for the same reason you have an Earnout in an M&A deal: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment.
The difference is that there's no technical limit on how much management m

Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?

Unlike "normal" debt, a PIK loan does not require the borrower to make cash interest payments - instead, the interest just accrues to the loan principal, which keeps going up over time. A PIK "toggle" allows the company to choose whether to pay the intere

What are some examples of incurrence covenants? Maintenance covenants?

Incurrence Covenants:
1. Company cannot take on more than $2 billion of total debt.
2. Proceeds from any asset sales must be earmarked to repay debt.
3. Company cannot make acquisitions of over $200 million in size.
4. Company cannot spend more than $100

Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use Section 338(h)(10) election?

In most cases, no - because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC sh

Walk me through how you calculate optional repayments on debt in an LBO model.

First, note that you only look at optional repayments for Revolvers and Term Loans - high-yield debt doesn't have a prepayment option, so effectively it's always $0.
First, you check how much cash flow you have available based on your Beginning Cash Balan

Explain how a Revolver is used in an LBO model.

You use a Revolver when the cash required for your Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment - Cash Flow Available to Repay Debt).
The Revol

How would you adjust the Income Statement in an LBO model?

1. Cost Savings - Often you assume the PE firm cuts costs by laying off employees, which could affect COGS, Operating Expenses, or both.
2. New Depreciation Expense - This comes from any PP&E write-ups in the transaction.
3. New Amortization Expense - Thi

In an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell us about the company we're modeling?

Yes, and it happens more commonly than you'd think. Remember, high-yield debt investors often get interest rates of 10-15% or more - which effectively guarantees an IRR in that range for them.
So no matter what happens to the company or the market, that d

Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes.
Sometimes in LBO models, increasing the

A car drives 60 miles at an average speed of 30 miles per hour. How fast should the driver drive to travel the same 60 miles in the same time period, but at an average of 60 miles per hour?

This is not possible. To travel 60 miles at an average speed of 30 miles per hour, 2 hours are required; to travel at an average of 60 miles per hour in those same 2 hours, you'd need to go 120 miles rather than 60 miles.
The most common mistake is to res

What is the angle formed by the hands of the clock when it is 1:45?

142.5 degrees. If we just think of the clock hour hand at 1 and the minute hand at the 45 position (near 9 o'clock), that is 120 degrees since they are 4 "numbers" apart, and each number on the clock represents 30 degrees (360/12).
However, recall that th

You have stacks of quarters, dimes, nickels and pennies (these represent $0.25, $0.10, $0.05 and $0.01, respectively, in the US monetary system for anyone international). There are an unlimited number of coins in each stack.
You can take coins from a stac

$1.19. There are a few ways to think about this, but the easiest is to start with the largest coin - quarters - first and then work your way down.
4 quarters equals $1.00, so we clearly can't do that - but 3 quarters are ok because that's only $0.75.
Next

You have a hose along with a 3 liter bucket and a 5 liter bucket. How do you get exactly 4 liters of water?

First, fill the 3 liter bucket and pour it into the 5 liter one. Then, re-fill the 3 liter bucket and pour it into the 5 liter bucket until it's full - that leaves 1 liter in the 3 liter bucket and 5 in the 5 liter bucket.
Then, pour out the 5 liter bucke

Two companies are exactly the same, but one has debt and one does not-which one will have the higher WACC?

The one without debt will have a higher WACC up to a certain point, because debt is "less expensive" than equity. Why?

Which is less expensive capital, debt or equity?

Debt is less expensive (aka cost of debt is lower than the cost of equity). Why?

What is the difference between enterprise value and equity value?

Enterprise Value: represents the value of the operations of a company attributable to all providers of capital. Also helpful to think of Enterprise value as the takeover value. The main use for enterprise value is to create valuation ratios/metrics (e.g.

A company makes $100 debt purchase of equipment on Dec. 31. How does this impact the three financial statements this year and next year?

IS: No depreciation and no interest expense.
CFS: No change to net income = no change to cash flow from operations. $100 increase in capex = $100 use of cash in cash flow from investing activities. Increase in cash flow from financing section = increase o

A company has had a positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

1. Excessive capital expenditures (cash-flow neg)
2. Unaffordable high interest expense
3. Credit crunch for loan maturity.
4. Significant one-time charges (from litigation, etc.) that are high enough to bankrupt the company.

When using the CAPM for purposes of calculating WACC, why do you have to unlever and then relever Beta?

When using the CAPM for purposes of calculating WACC, why do you have to unlever and then relever Beta?We typically get the appropriate Beta from our comparable companies; however, before using an "industry" beta, we must first unlever the Beta of each of

What is minority interest and why do we add it in the enterprise value formula?

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance.
So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial p

What is the difference between basic shares and fully diluted shares?

Basic shares: the number of common shares that are outstanding today.
Fully diluted shares: basic shares + potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt.

How do we use the Treasury Stock Method to calculate diluted shares?

1. Tally the company's issued stock options and weighted average exercise prices (from the company's 10K)
If using for precedent transactions or M&A analysis, we will use all of the options outstanding.
If our calculation is for a minority interest based

How do you calculate fully diluted shares?

Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt or convertible preferred stock.
To calculate the dilutive effect of options, you use the Treasury Stock Method

What drivers to the LBO model will increase the return for the private equity firm?

1. Reduce purchase price.
2. Increase the amount of leverage.
3. Increase selling price, i.e. increase selling multiple.
4. Increase the company's growth rate in order to raise operating income/cash flow/EBITDA in projections.
5. Decrease the company's co

What are some characteristics of a company that is a good LBO candidate?

1. Steady cash flows
2. Limited business risk
3. Limited need for ongoing investment
4. Strong working capital
5. Strong management
6. Opportunity for cost reductions
7. High asset base (to use as debt collateral)

Walk me through an accretion/dilution analysis.

Purpose is to project the impact of an acquisition to the acquiror's EPS and compare how the new EPS ("proforma EPS") compares to what the company's EPS would have been without the transaction.
1. Project the combined company's net income ("proforma net i

What facts can lead to the dilution of EPS in an acquisition?

1. Target has negative net income.
2. Target's Price/Earnings ratio is greater than the acquirer's.
3. Transaction creates a significant amount of intangible assets that must be amortized going forward.
4. Increased interest expense due to new debt used t

If a company with a low P/E acquires a company with a high P/E in an all stock deal, will the deal likely be accretive or dilutive?

The deal will be dilutive to the acquirer's EPS because the acquirer has to pay more for each dollar of earnings than the market values its own earnings; therefore, the acquirer will have to issue proportionally more shares in the transaction.
Proforma ea

What is goodwill and how is it calculated?

Goodwill is an intangible asset and reflects the value of a company that is not attributed to its other assets and liabilities.
Goodwill =Equity purchase price paid for company - Target's book value (i.e. excess purchase price). This can remain on a compa

What are the three main valuation methodologies?

1. Comparable company analysis.
2. Precedent transaction analysis.
3. Discount cash flow analysis.

How do you select Comparable Companies/ Precedent Transactions?

The 3 main ways to select companies and transactions:
1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography
For precedent transactions, you often limit the set based on date and only look at transactions within the past 1-2

What are some common valuation metrics?

Most common is:
Enterprise Value (EV)/EBITDA
EV/Sales
EV/EBIT
Price to Earnings (P/E)
Price to Book Value (P/BV)

The EV/EBIT, EV/EBITDA, and P/E multiples all measure a company's profitability. What's the difference between them, and when do you use each one?

P/E depends on the company's capital structure. You use P/E for banks, financial institutions, and other companies where interest payments/expenses are critical.
EV/EBIT and EV/EBITDA are capital structure neutral. Use EV/EBIT in industries where D&A is l

Why can't you use EV/Earnings or Price/EBITDA as valuation metrics?

EV = value of the operations of the company attributable to all providers of capital (it incorporates all of both debt and equity and is not dependent on the choice of capital structure). If we use EV in the numerator, we must use an operating or capital

How would you judge a company's creditworthiness?

Risk
1. Cash flows
2. Assets (ability to get money back)
3. Type of Investment (new business, extension of business)
4. Type of loan (what is it for)

How long of a period do you do a DCF for?

As long as it takes for it to start generating a steady cash flow for you to predict

Issue $100M in debt, what happens to the 3 statements at year end considering 10% interest?

IS: interest expense -10
Net Income -6
CF:
CFO -6
CFF +100
Overall cash: +94
BS:
Cash +94 = Liabilities +100 + Equity -6

Calculate EV: $15/share, 60M shares outstanding, $20M debt, $10M cash, $5M minority interest

($15*60,000,000) + 20,000,000 + 5,000,000 - 10,000,000 = 95M EV

If you have an investment that pays $100 per year going to infinity (perpetuity), then next year on top of the $100 you get another $100 going to infinity, and the year after that you get another one, etc. 10% hurdle rate, how much is this worth to you?

Perpetuity of a perpetuity: $100/.10 = $1000. $1000/.1 = $10,000

Two companies are exactly identical, same revenue, same EBITDA, same management, why might they be trading at different multiples?

The companies can be levered differently -- interest expense can reduce net income and therefore equity value will be lower due to a decreased stock price at that point. A company could also expense CapEx rather than

If you issue a bond at $100M, and it is now trading publicly at $0.50, how do you update the financials?

You don't change anything because of historical value and GAAP

If you buy back a bond that is trading lower than when you originally issued it, how does that flow through the statements?

You would decrease your liabilities and decrease cash, but since you are buying them back at a lower price, you will have a gain which flows into your retained earnings (increasing shareholder's equity)

When do we decide when a company has relatively stable cash flows? What two things in particular do we look at?

Look at capital expenditures and depreciation and see when these values level out to determine stability

Why do tech companies have large cash balances?

Tech companies have large cash balances in order to reinvest into the business should innovation be necessary