Graduate Finance Association

Investment Banking Technical Interview Guide

FOR NYU STERN INTERNAL DISTRIBUTION ONLY

September 2010
Contents
Disclaimer...................................................................................................................................................... 3
1. Top 10 Questions .................................................................................................................................. 4
2. Basic Investment Banking ..................................................................................................................... 5
3. Valuation ............................................................................................................................................... 8
4. M&A and IPOs ..................................................................................................................................... 14
5. Accounting .......................................................................................................................................... 18
6. Macro, Markets and Other Random Questions.................................................................................. 32

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Disclaimer
This guide is intended to provide a sampling of investment banking interview questions and is by NO
means an all-inclusive preparatory guide. The latest version of this guide is itself a work in-progress and
will be updated continually by Stern’s Graduate Finance Association. We encourage you to use this
guide as a starting point in your preparation; however, we also encourage you to use all of the other
well-known guides, many of which are provided for free by OCD, throughout the recruiting process.

As the process itself is extremely competitive, the extent to which you’ve prepared relative to your
colleagues is your competitive advantage. While we highly encourage you to prepare with your
classmates, we also strongly suggest that you DO NOT DISTRIBUTE this guide to colleagues at other
schools. Sharing this guide with non-Stern candidates will only serve to better prepare those candidates
and will reduce the extent to which you can differentiate yourself.

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1. Top 10 Questions
The questions that follow are those that you will most likely encounter through the interview process. It
is critical that you know the answers to these questions. The answer to many of these questions can be
found herein.

1. Walk me through your résumé.

2. Why do you want to do investment banking?
3. We have hundreds of applicants for this position—why should we choose you (in a few words)?
4. What happened to the capital markets over the past few years? Why did it happen?
5. What are the major valuation methodologies and what are the pros / cons of each?
6. Which valuation methodology is most likely to produce the highest / lowest valuation? When? Why?
7. Walk me through a DCF / comparable companies / precedent transactions analysis.
8. If I were a CEO looking to sell my company, what would you ask / tell me?
9. What is beta? Describe it to me in simplistic terms.
10. How do you estimate the cost of debt / equity? Why is debt cheaper than equity?

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2. Basic Investment Banking
What is in a pitch book?
• A pitch book address the needs of the client and possible solutions to those needs and includes
the following general format:
o Bank “credentials” (similar deals they’ve done to “prove” their expertise)
o Summary of a company’s options (“strategic alternatives” in banker-speak)
o Valuation and appropriate financial models (for example, if you’re pitching for an IPO
you might show where the IPO proceeds would go)
o Potential acquisition targets (buy-side M&A deal) or potential buyers (sell-side M&A
deal). This is not applicable for equity/debt deals
o Summary and key recommendations

Why would a company decide to split its stock?

• Reduce trading price of its stock
• Enhance liquidity

What is the treasury stock method and how is it calculated?

It is a method of accounting for options in order to determine a company’s fully diluted share count. It
assumes that all in-the-money (ITM) options are exercised and that the proceeds received by the
Company are used to repurchase stock.

To calculate the fully diluted share count:

• Note the current undiluted share count and in-the-money options and warrants by looking at
the company’s latest 10K, 10Q or other SEC filing
• Find the average exercise price of each tranche of options
• Calculate the number of ITM options by comparing each tranche’s exercise price and the current
price of the stock
• Determine the proceeds to the company of the exercised options by multiplying the option
exercise price by the exercisable ITM options
• Determine the shares repurchased by dividing the option proceeds by the current share price
• Determine the net new shares by subtracting the exercisable ITM option count by the shares
repurchased
To illustrate, HoldCo, a manufacturing company has 100 million common shares outstanding at $20
stock price and three tranches of options: Tranche A has 40,000 options with a WAEP of $22; Tranche B
has 20,000 options with a WAEP of $18; Tranche C has 20,000 options with a WAEP of $16.
Common shares: 100,000,000
+ In-the-money options: 40,000 (20,000 Tranche B + 20,000 Tranche C)
Proceeds from options: $680,000 (20,000 x $18 + 20,000 x $16)
– Shares repurchased: 34,000 ($680,000 / $20)

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= Fully diluted shares: 100,006,000
Market capitalization: $20 x 100,006,000 = $2,000,012,000

What do the betas look like for companies in the following industries?
Industry Median Beta
Newspaper 1.94
Entertainment 1.81
Cable 1.69
Semiconductor 1.56
Financial services 1.39
Reinsurance 1.07
Oil 0.89
Tobacco 0.78
Thrift 0.73

Can a stock have a negative beta?

• Yes, it is possible but rare
• Other examples include: put options; short funds

As a lender, walk me through some of your considerations as you analyze a borrower's financial
statements?
As a lender, you care most about the borrower’s future cash flows, i.e., their ability to cover the interest
expense on the loan
Useful information includes:
• Expected future cash flows
o Working capital requirements
o D&A
o Industry risks
• Quick and current ratio
• Coverage ratios

Tell me 5 questions you would ask the CEO of a cable company to perform an analysis of the firm.
In general, we want to analyze the growth, profitability, and risks of the company. As such, we’d ask
about:
• Revenue growth
• Net margins
• Capital expenditures
• Risks
• Rivals

Describe a typical company’s capital structure in order of seniority.

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 • Short-term bank borrowings
• Commercial paper
• Senior secured debt
• Senior debentures
• Subordinated debentures
• Preferred stock
• Common equity

What are the ways in which companies can raise capital?

The following diagram illustrates the various ways in which a company can raise capital:

Follow-on
offering
Public equity
Equity IPO
Private equity

Preferred
stock
Hybrid

Choices in Convertibles
raising capital
Public issue

Private
Debt
placement

Syndicated
Asset Sale
bank loans

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3. Valuation
General

What are the 3 major valuation methodologies?

• Public comparables analysis
o Business factors to consider
 Product
 Geography
 Customers
o Financial factors to consider
 Quality
 Risk
 Growth
• Acquisition comparables
o Similar company
o Similar time frame
o Similar point in business cycle
• Discounted Cash Flow
o Determine projection period
 Must cover business cycle
 Must cover company’s growth period and until the point it reaches steady-state
 5-10 years on average
o Project unlevered free cash flows
 Cash flows that are unaffected by capital structure (interest expense)
 Capital structure is factored into WACC
o Determine terminal value
 Remaining value of firm after projection period
 Exit multiple (EV/EBITDA)
 Perpetuity growth (PV=CFn(1+g)/WACC-g

What are some other valuation methodologies?

• LBO analysis: modeling the company’s financial performance under an initially highly leveraged
capital structure
• Breakup analysis: based on valuation of individual segments using comps, precedents, LBO, and
DCF
• Merger consequence: also called an affordability analysis
• Trading range

Take me through a comparable company analysis.

• Identify peer companies with similar:

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 o Industry
o Business mix
o Geographic location
o Operations
o Size
o Financial parameters (leverage, growth, margins, dividend yield)
• Use mean and median multiple values for each relevant metric (exclude outliers from mean to
avoid skewing data)

How would you value the following types of companies?

• Bank
o Relative analysis using Price / Book as a relative measurement because most assets and
liabilities of banks are constantly valued at market values
• Manufacturing company
o Relative analysis using EBITDA multiples
• Internet company
o Relative analysis using one of the following:
 P/E
 EV/EBITDA
 EV/Sales

How would you value a company that is considering going public?

• You could compare the private company to publicly traded companies (public comps) using a set
of valuation multiples that are appropriate for the industry
• Use a relevant multiple to a similar company in terms of size, geography, margins, growth, risk,
etc.

What is free cash flow to the firm (“FCFF”) and how do we calculate it?
FCFF is the cash made available to stakeholders in the company and is derived as:

• FCFF from EBITDA:

o FCFF = (EBITDA – D&A)*(1-t) + D&A – CAPEX – Increase in WC
• FCFF from EBIT:
o FCFF = EBIT*(1-t) + D&A – CAPEX – Increase in WC
• FCFF from Net Income:
o FCFF = Net income + interest expense*(1-t) + D&A – CAPEX – Increase in WC

What is free cash flow to equity (“FCFE”)?

• FCFE is a measure of how much cash can be paid to the equity shareholders of the company
after all expenses, reinvestment and debt repayment
• FCFE = Net income + D&A – CAPEX – Increase in WC

What are the key issues you need to evaluate when analyzing cash flow?

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 • What cash flows are generated by operations? Do they exclude “one time” events?
• Will firm meet its short term commitments and does it have a sufficient safe margin?
• What are the working capital expectations?
• How are asset replacement and expansion financed?

When would you use EBITDA for valuation? What are the pitfalls of relying primarily on EBITDA?
• EBITDA is used in comparable company and precedent transaction valuations methodologies
• EBITDA should be used only for relatively stable and profitable companies/industries
• EBITDA excludes capital expenditures, working capital needs, dividends and principal
repayments on debt, which can lead to distortions across industries
• However, EBITDA is easily manipulated

Walk me through what happens to your DCF if payables increase.

• FCFF increases since relatively less cash is being paid to suppliers; therefore, your DCF valuation
also increases

Why does a company issue debt over the equity?

For a stable company:
• Issuing debt is cheaper than equity because debt does not require as high of a return as equity
• Debt has a tax shield, i.e., interest on debt is tax-deductible
• Issuing equity has a dilutive effect on earnings
• Dividends are taxed whereas as interest expense is tax-deductible

What are the main differences between WACC and APV methods?
• WACC takes the target debt to equity ratio (levered) to calculate the discount rate; however, a
target debt to equity ratio is not reached until a few years in the future
• The APV method assumes an all-equity capital structure and uses an unlevered beta; it then
adds back the PV of tax benefits
• Two methods may make slightly different assumptions about the value of interest rate shields,
resulting different values

How do you calculate LTM (last twelve months) or TTM (trailing twelve months)?
• Report from most recent 12 month period + figures for periods since last annual report –
corresponding figures for the previous year

Cost of Capital

In a regular market, which is more expensive debt or equity? Explain your thought process.
Equity is more expensive for the following reasons:
• Equity holders are last in-line to claim a company’s assets
• Dividends are not guaranteed unlike coupon-bearing bonds
• No tax shield like debt

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For these reasons, equity investors require a higher return on their investment

How do you estimate the cost of debt? Cost of equity?

The cost of debt can be estimated using:

• The yield on a recent issuance of similar risk

• The weighted yield on a company’s publicly traded bonds
The cost of equity can be estimated using CAPM

Tell me the formula to unlever and relever beta. Why do we unlever / relever beta?
Unlever to factor out capital structure of each comparable firm and find median unlevered beta.
Relever for the target firms’ specific capital structure.

What would you expect the WACC to be for a small-midsized manufacturing firm?
The idea here is to walk through how you could calculate WACC and what the assumptions are:
• Cost of equity will be high since the stock likely has a higher beta
• Weight of equity will probably be low since it’s a manufacturing firm
• Cost of debt will be in line with comparable companies
• Weight of debt will likely be high

How would you describe cost of capital to a non-finance person?

It is the minimum return which debt and equity holders require

Define beta for a non-finance person.

Beta reflects risk. It is basically the extent to which an asset’s price moves lock-step with the general
market

What is a terminal value?

• Terminal value = represents the remaining value in a firm after the projection period
• There are two methods to determine the terminal value:
o Exit multiple method
 Used when company is expected to be sold at end of projection period
 Use an enterprise value such as EV/EBITDA and multiply against the final
projection year’s FCF
o Perpetuity growth method
 Used when the company is expected to continue into foreseeable future
 Using the perpetuity growth formula to project the value of future FCF

What is the optimal capital structure of a company?

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Theoretically, the optimal capital structure of any company is the structure that minimizes its cost of
capital; however, and in practice, most CEOs aim to minimize their company’s interest payments and/or
covenant restrictions, regardless of optimal capital structure
The diagram below illustrates how a company’s optimal capital structure maximizes its firm value:

What are the major assumptions of the CAPM model?

• All investors:
o Aim to maximize economic utility
o Are rational and risk-averse
o Are price takers, i.e., they cannot influence prices
o Can lend and borrow unlimited under the risk free rate of interest
o Trade without transaction or taxation costs
• Markets are perfectly competitive
• All information is public, i.e., there is no private information
• There are no arbitrage opportunities.
• Returns are distributed normally.
• No inflation and no change in the level of interest rate exist.

Random

If you value a company at $100mm, what’s the most you should pay for this company?
• $100mm
• If you pay more than $100mm you are effectively investing in a negative NPV project

How would you go about valuing the hot dog cart outside of school?
Discounted cash flow analysis (assuming there are no public comps)
• Project cash flows using bottom up approach
o Revenues

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  How much is hot dog sold for
 How many hot dogs are sold each day
o Costs
 How much does hot dog cost
 How much does rent cost
o Sales = ($/dog * number of dogs per day) * 350 days
o COGS = (cost/dog * number of dogs per day) * 350 days + yearly rent
o EBITDA = Sales – COGS; assume no D&A
o EBIT = EBITDA
o FCFF = EBIT*(1-t) + D&A – CAPEX – Increase in WC

What is the value of $1 today that you will get 10 years later?
Depends on interest rate (or in this case the inflation rate, which could be taken from CPI). Let’s assume
3%:
$1
𝑃𝑃𝑃𝑃 =
1.0310

How could a company have a negative Enterprise Value?

Since Enterprise Value = Total debt – (cash and cash equivalents) + Equity value; a company that has
more cash on hand than total market cap could have a negative Enterprise Value
This is likely to be found in special financial corporations, technology firms, healthcare; examples include:

• Sycamore Networks (TEV = -56.9; Cap = 587); Technology

• Myriad Pharma (TEV = -32.6; Cap = 126.4); Pharma
• Fidelity Magellan Fund (TEV = -702.5; Cap = 27.8); Financials

Why are financial institutions valued on price-to-book ratios? What are the pros/cons of using price-
to-book ratios?
Financial institutions, as well as asset-heavy companies, use price/book ratios for valuation purposes as
opposed to return related ratios that are often distorted by depreciation. For Bank Holding Companies,
operating and financing activities are intertwined, and financing activities are essential for value creation.
Thus, a valuation approach that focuses on operating activities would omit a major part of value
creation for banks. Further, BHCs are required by regulators to maintain minimum equity capital at
levels proportional to their assets. This makes book equity a relatively useful measure of the scale of
bank operations

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4. M&A and IPOs
Why would two companies merge? What major factors drive M&A?
• For financial sponsors
o Company is a deal; able to take it private; fix operations; and re-IPO it
• For strategic buyers
o Synergies (cost and revenue)
o Enter new geography
o Acquire new customer base
o Defend from competition

What are the key considerations to take into account when considering an M&A deal?
• Strategic considerations
o Synergies
o Enter new market
o Regulatory and political issues
o Etc.
• Financial considerations
o Will the deal increase shareholder value (NPV > 0)
o Ability to finance acquisition
o Impact on margins
o Cost of capital concerns

Walk me through the process of a typical sell-side M&A deal.

• A typical sell-side M&A deal with many potential buyers would look like this:
o Meet with company, create initial marketing materials like the Executive Summary and
Offering Memorandum (OM), and decide on potential buyers
o Send out Executive Summary to potential buyers to gauge interest
o Send NDAs (Non-Disclosure Agreements) to interested buyers along with more detailed
information like the Offering Memorandum, and respond to any follow-up due diligence
requests from the buyers
o Set a “bid deadline” and solicit written Indications of Interest (IOIs) from buyers
o Select which buyers advance to the next round
o Continue responding to information requests and setting up due diligence meetings
between the company and potential buyers
o Set another bid deadline and pick the “winner”
o Negotiate terms of the Purchase Agreement with the winner and announce the deal

What are some common anti-takeover tactics?

• Poison pill: increase the likelihood of negative results over positive ones for a party that
attempts any kind of takeover

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 • Greenmail: the practice of purchasing enough shares in a firm to threaten a takeover and
thereby forcing the target firm to buy those shares back at a premium in order to suspend the
takeover

Company A trades at a P/E of 20. Company B trades at a P/E of 10. Both are considering acquiring
Company C, which trades at a P/E of 15. For which of the two acquiring companies would the deal be
dilutive. For which would it be accretive? Explain why for each.
• THE RULE OF THUMB IS ONLY VALID FOR ALL-STOCK TRANSACTIONS
• For company A the transaction will be accretive to company A’s EPS
o Accretive since A > C
• For company B the transaction will be dilutive to company B’s EPS
o Dilutive since B < C
• This is because the acquirer has to pay more for each dollar of earnings than the market values
its own earnings; hence, the acquirer will have to issue proportionally more shares in the
transaction

What is the difference between a primary and secondary equity offering?

• Primary = IPO
• Secondary (follow-on equity offering) = is an issuance of stock subsequent to the company's
initial public offering

Why would a company IPO?

• Monetize the owners’ investment
• Obtain a “currency” for future deals
• Advertise that the firm has “arrived”

Which is more important, an IPO or an M&A transaction?

Generally, an IPO is more important for both client and banker because it is an advertisement that the
firm has “arrived” and is thus a “branding opportunity”. There is also the personal gratification for the
CEO and the rest of the senior management team. For the banker, it brings in the highest fees right now,
and establishes a banking/client relationship.

How would you value an IPO?

You would generally use a comparable companies analysis.

What is an IPO discount?

• The discount (said to be around 10%) given to an IPO offer price in order to give the IPO room
for upside

What is a “green shoe”?

• Gives the underwriters the option to purchase as much as 15% more shares than originally
agreed to during a 30-day period after the offering

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 • Note that the green shoe does NOT provide a windfall for the IB, since the additional shares also
must be sold at the offering price
• The green shoe can increase the IPO proceeds by up to 15%

How are IPO fees usually divided?

• The management fee (20%)
• The underwriting fee (20%)
• The selling concession (60%)
• As a practical matter, the lead gets the lion’s share, no matter what you call it

Why is one bank chosen over others in a “beauty contest”?

• The bank’s track record with IPOs
• If the bank is willing to put up capital to trade the shares of the firm
• The bank’s “distribution capabilities” i.e., its relationship with institutional investors

What is the role of ECM in the IPO process?

• Equity capital markets:
o They communicate with bankers and keep them aware of investor attitudes, market
movements, etc.
o They create the “pitch” to win an underwriting mandate
o They market the IPO through the roadshow
o They negotiate the formation of the syndicate

What type of information is contained in an S-1 document?

SEC document required for an IPO, includes:
• Risk factors
• Use of proceeds
• Dividend policy
• Capitalization
• Legal
• Financial statements

Describe the IPO process.

• Beauty Contest
o 7% Fee, bank may undercut
o I-banks trying to convince client that they can raise a specific amount of money
o Client chooses bank(s) (Book runner, ECM keep track of shares allocated) to lead, then
lead bank chooses syndicates (help sell offer)
• Due diligence/Valuation
o Management
o Financials
o Market

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• SEC Filing (S-1)
o Prospectus
o Announcement of intent to IPO
o Work with lawyers and syndicates
• Roadshow
o Sell securities to institutional investors
o Research goes on separate road show to institutional investors
o Offering date

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5. Accounting
General

If you could pick two financial statements, which would you pick and why?
There is no single correct answer; however, you should choose either the Balance Sheet or Income
Statement since you can build the Cash Flow Statement from those statements

What is EBITDA?
• EBITDA = Earnings Before Interest Taxes Depreciation & Amortization
• EBITDA is an Enterprise Value, not an Equity Value, since this represents earnings available to all
shareholders
• By excluding interest and taxes (effects of capital structure) as well as depreciation and
amortization (non-cash expenses), EBITDA gives a sense of a company’s ability to turn profits
• EBITDA is a proxy for cash flow, but not a great proxy because it doesn’t take into account
working capital changes

What is EBIT?
• EBIT = Earnings Before Interest Taxes
• EBIT is an approximate measure of operating income and a common measure of operating
comparability
• EBIT is an Enterprise Value, not an Equity Value, since this represents earnings available to all
shareholders

Which of the three financial statements is the most important and why?
There is no single correct answer to this question; however, each statement has the following pros/cons:
• Income Statement
o Pros
 Shows revenues and expenses as they are earned/incurred
 Shows interest expense (not found on other statements); interest paid found on
direct cash flow represents coupon payments but not expense (expense comes
from discount rate)
 Shows taxes (not found on other statements)
 EBITDA/EBIT are commonly used as inputs into operating ratios
o Cons
 Snapshot in time
 Does not show how cash enters/leaves the firm
• Cash Flow Statement
o Pros
 Shows how cash enters/leaves the firm, i.e., shows when cash is received and
expenses are paid

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  Cannot easily be manipulated by “earnings management”
 Shows dividends paid
o Cons
 Snapshot in time
 Does not show revenues and expenses as they are earned/incurred
• Balance Sheet
o Pros
 Reflects a company’s assets, liabilities, and shareholder’s equity over the life of
the firm, i.e., is not a snapshot in time
 Shows a business’s economic resources that creditors and shareholders can
claim
o Cons
 Does not show a firm’s operating results during a time period

Walk me through each of the three major financial statements and explain how they relate to one
another.
Describe the three statements and their major line items:

Income Statement Cash Flow Statement Balance Sheet

Revenues Operating Cash Flow Assets
(COGS) Net income Current assets
= Gross profit (Change in receivables) Long-term assets
(SG&A, Other) (Change in inventory) Liabilities
= EBITDA (Change in prepayments) Current liabilities
(Depreciation & Amortization) Change in payables Long-term liabilities
= EBIT (Gain) loss on sale of PPE Long-Term Debt
(Interest Expense) Stock-based compensation Capital Leases
+ Interest Income Minority interest in earnings Minority Interest
= EBT Other operating activities Pension & Other Post-Retire.
(Restructuring Charges) = OCF Benefits
(Impairment of Goodwill) Investing Cash Flow Def. Tax Liability, Non-Curr.
(Legal Settlements) (CAPEX) Equity
(Other Unusual Items) Proceeds from Sale of PPE Common Stock
= EBT including unusual items Cash acquisitions Additional Paid In Capital
(Taxes) Divestitures Retained Earnings
= Net income Sale (purchase) of intangible asset Treasury Stock
(Preferred dividends) Investments in marketable securities Comprehensive Inc. and Other
= Net income to common = ICF
Financing Cash Flow
Proceeds from Loans
Proceeds from debt
(Repayments) of principal
(Dividends)
Capital (Distributions)
= FCF
Net Cash Flow
= OCF + ICF + FCF

The statements are linked in numerous ways; however, the following is a short list:

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 • Net Income from the Income Statement = Net Income on the Operating Cash Flow Statement
• Net Income from the Income Statement minus dividends paid = Change in Retained Earnings on
the Balance Sheet
• Net Cash Flow from the Cash Flow Statements = Change in Cash on the Balance Sheet
• Depreciation expense from Income Statement shows up on Operating Cash Flow and reduces
PPE on Balance Sheet

What is the difference between a Balance Sheet, Income Statement, and statement of cash flows?
There are many differences; however, the following differences should be highlighted:

• Balance Sheet
o The Balance Sheet reflects a company’s assets, liabilities, and shareholder’s equity over
the life of the firm as opposed to operating performance over one period
• Income Statement
o The Income Statement presents earnings activities between two points in time
o The Income Statement summarizes two parts of business earnings -revenues and
expenses and tells us the economic results of the firm's activities during a period of time
o The Income Statement is based on accrual accounting
• Cash Flow Statement
o The Cash Flow Statement reflects the cash that enters/exits the firm and is based on
cash accounting

What is the impact of X on the three financial statements?

This is one of the most popular questions as it requires the interviewee to both understand accounting
and logically walk through a solution. While questions about depreciation and its impact on the financial
statements is most typical, you should be prepared to walk through any of the following scenarios:

• Depreciation of an asset
• Sale of PP&E
• Issuing debt
• Issuing equity
• Paying dividends
The best approach is to start with the Income Statement, recognizing that taxes will not be paid on
interest and depreciation (or anything else above the “line”). Using Net Income as a starting point, walk
through the Cash Flow Statements. Lastly, using Net Cash Flow, walk through the Balance Sheet

What is the impact of a $10 pre-tax depreciation expense (assume a tax-rate of 40%)?
• Changes to the Income Statement
o EBITDA = $110
o EBIT = $100
o Net Income = $100*(1-0.40) = 60
• Changes to the Cash Flow Statements

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 o Operating Cash Flow
 Net Income = $60
 Depreciation = $10; therefore Operating Cash Flow = 70
o Net Cash Flow = $70

What is the impact on the three statements of paying a dividend (assume $10)?
• Changes to the Income Statement
o No changes
• Changes to the Cash Flow Statement
o Financing Cash Flow
 Dividends = (10); therefore Financing Cash Flow = (10)
o Net Cash Flow = (10)
• Changes to the Balance Sheet
o Cash = (10)
o Retained Earnings = (10)

What is the impact of a backdated option on the three financial statements?

In general:

• The total grant date intrinsic value of all in-the-money options is apportioned to and recorded as
compensation expense in the periods in which employees vest in the options
• Like cash compensation, option-related compensation expense reduces net income and
retained earnings in each such period; however, unlike cash compensation, option-related
compensation increases paid-in-capital
• Recording option-related compensation in this manner results in lower retained earnings and
more permanent capital

What is the impact on the three statements of an asset write-down?

In general:

• This period
o The current Income Statement will include an impairment loss in income before taxes;
therefore, net income in that period will be lower
o On the Balance Sheet, assets will be reduced by the impairment as will shareholder’s
equity
o Debt-to-equity will be lower
o Debt-to-assets will be higher
o NO effect on cash flow
o Asset turnover will be higher
• Future periods
o Future net income will be higher since there will be a smaller depreciation expense
o Current and future fixed-asset turnover will increase
o ROA and ROE will be higher

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What is the impact on the three financial statements of capital leases?
• Income Statement
o Capital lease is depreciated so depreciation expense shows up
o Interest expense also shows up
o These expenses are higher in the early years but the lifetime charge is identical between
capital and operating leases
• Cash Flow Statement
o Interest paid will show up in the direct operating cash flow
o Repayments of principal will show up under financing cash flow
• Balance Sheet
o Capital leases shows up as an asset and liability
o The PV of lease payments is recognized as a liability
Debt/Equity ratio rises, so the company prefers operating leases since they keep debt off the Balance
Sheet

What happens to each of the three primary financial statements when you change a) gross margin b)
capital expenditure c) any other change?
• Gross margin decreases
o Gross margin = gross profit/sales
o Income Statement
 Gross profit would decrease; Taxes would decrease; Net income would decrease
o Cash Flow Statement
 Net income would decrease; Net cash flow would decrease
o Balance Sheet
 Cash would decrease; Shareholder’s equity would decrease
• CAPEX decreases
o Income Statement
 Depreciation expense would be lower in subsequent years; operating income
would be greater; taxes would be higher; net income would be higher
o Cash Flow Statement
 CAPEX and investing cash flow would be lower; Net cash flow would increase
o Balance Sheet
 Cash would increase but Net PPE would be lower so assets would stay the same

What is an operating lease and how is it treated? How is a capital lease different from an operating
lease?
• Operating lease
o In an operating lease, the lessor (or owner) transfers only the right to use the property
to the lessee
o At the end of the lease period, the lessee returns the property to the lessor

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 o Since the lessee does not assume the risk of ownership, the lease expense is treated as
an operating expense in the Income Statement and the lease does not affect the
Balance Sheet
o The lease does not show up as part of the capital of the firm
• Capital lease
o Lessee economically owns the property
o Lessee records the leased asset in the Balance Sheet (i.e. capitalizes the asset) and
reflects the corresponding lease obligation
o The firm gets to claim depreciation each year on the asset and also deducts the interest
expense component of the lease payment each year
o The present value of the lease expenses is treated as debt, and interest is imputed on
this amount and shown as part of the Income Statement
o In general, capital leases recognize expenses sooner than equivalent operating leases
o The present value of capital lease payments is computed using the cost of debt at the
time of the capital lease commitment, and is not adjusted as market rates change

What would happen to the three statements if a company would suddenly start to capitalize its R&D
(assume that before it was treating R&D as a period cost)?
• Income Statement
o R&D asset would incur a depreciation expense (and initially would be lower than the full
R&D expense)
o In general, the expense would be spread out over several periods thereby decreasing
the per period expense and increases per period net income
• Cash Flow Statement
o Deprecation would be added back to net income
o Cash flow would decrease as a result of increased taxes

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 • Balance Sheet
o R&D would be treated as an asset and added to the Balance Sheet as such

The Cash Flow Statement contains information from the other financial statements. Provide some
examples.
• Net income from the Income Statement is shown as the top-line in the operating cash flow
section
• Dividends from statement of retained earnings is shown as cash flow from financing activities
• Change in receivables, inventory, prepayments, payables, etc. are shown as adjustments in the
operating cash flow section

Why might a bond’s cash payment and interest expense be different during a given period?
In general:

• A bond's cash payment is its coupon rate times its face value
• A bond’s interest expense is its market yield times the value of the Balance Sheet debt liability
• The cash payment and interest expense will only be identical if the bond is issued at par because
the yield and coupon rates are identical
• If the bond is issued at a premium or discount, the rates will be different as will the face value
and liability

If a company has Days Sales Outstanding of 50 and Days Payable of 25, what would you say to its
management?
• Days Sales Outstanding =365/Receivables turnover, Receivables turnover = 365/50 = 7.3
• Days Payables =365/payables turnover, Payable turnover = 365/25 = 14.6
• The company pays much quicker to its suppliers than receives payment from its customers,
which means less cash available for its operation during the operational cycle

To calculate Operating Cash Flow do you add or subtract an increase in receivables? Why?
• Subtract an increase in receivables from the net income figure to account for sales that have
occurred, but for which you have not yet received cash payment

Are assets acquired via capital leases listed under PP&E?

• No, when an asset is acquired under capital lease the company does not actually pay the full
price in cash, it only signs a contract to make payments
• Capital leases are listed under significant non-cash events

How do you compute asset turnover? What does it tell you? How can you improve a company’s asset
turnover?
• Asset turnover = Sales / Assets
• Measures a firm’s efficiency at using its assets in generating sales; may also indicate pricing
strategy; companies with low profit margins tend to have high asset turnover, while those with
high profit margins tend to have lower asset turnover

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 • A company can improve asset turnover by reducing current or fixed assets

When does leverage help a company?

• When the marginal return on a borrowed dollar is greater than the marginal cost per borrowed
dollar
• The company can magnify excess returns through leverage

When does leverage hurt a company?

• When the company earns less per marginal dollar than the interest expense per marginal dollar
• Losses may be magnified by leverage

What is the tangible net worth of a company?

• A measure of the value of hard assets, which excludes the value of intangibles such as goodwill,
copyrights, etc.
• Tangible net worth = Total Assets – Total Liabilities – Intangible Assets

Why do banks focus on the tangible net worth?

• Tangible net worth represents the liquidation value of the company
• Also, intangible assets are considered poor collateral

What is operating margin? What are the major drivers of operating margin?
• Operating margin = Operating Income or EBIT/Revenue
• The major drivers of operating margin are COGS, SG&A and D&A

What is the difference between depreciation and amortization?

• Depreciation is for tangible assets. Amortization is for intangible assets.

What is meant by “earnings management”?

Also known as “creative accounting” and refers to a strategy used by a management company to
manipulate earnings to match a pre-determined target. This practice is carried out for the purpose of
income smoothing
The most common methods involve:

• Deliberately NOT recognizing top-line revenues in good years to spread out gains over bad years
• Adjusting depreciation schedules
• Buying back shares to increase EPS

Other methods involve:

• Taking on large, one-time charges

• Capitalizing expenses previously expensed
• Increasing the extent of capitalization

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 • Slowing down amortization of previously capitalized expenses and reducing the provisions for
bad debts

What is minority interest?

• A significant but non-controlling ownership of less than 50% of a company's voting shares by
either an investor or another company
• A subsidiary is a company controlled by another company through ownership of at least a
majority of the voting stock; since subsidiaries are controlled by their parent companies,
accounting rules allow for them to be carried on the parent company's Balance Sheet
• A non-current liability that can be found on a parent company's Balance Sheet that represents
the proportion of its subsidiaries owned by minority shareholders
• Beginning in 2008 and 2009, the FASB is requiring companies to classify minority interest under
Shareholder Equity and not Liabilities

What could a company do with excess cash on the Balance Sheet?

There are two basic things a company should do with excess cash:

• Invest in positive NPV projects

• Pay a dividend to shareholders
• Buyback stock
• Adjust capital structure by paying down debt

If I am looking at a company in industry X and we want to determine how much leverage the company
can withstand and continue to pay the shareholders the same dividend, how would you determine
the maximum amount of leverage for this corporation?
• The company should be able to lever such that its free cash flow to equity is greater than the
dividend payment (since interest expense is already built into FCFE); FCFE > dividend payment
• FCFE = net income + D&A + interest expense*(1-t) – CAPEX – increase in WC
• FCFE = net income + D&A + (debt*rate)*(1-t) – CAPEX – increase in WC

If revenues increase by 10% and expenses remain the same, will net income increase by more than
10%, less than 10%, or by 10% exactly?
Net income increase more than 10% because of the tax shield

Which method gives higher net margin, FIFO or LIFO?

It depends on the price of inventory
• FIFO will give higher net margins if the cost of inputs is increasing
• LIFO will give higher net margins if the cost of inputs is decreasing

What is the lever for improving ROE?

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Leverage improves ROE only If ROA > cost of debt

What are the differences between fixed assets and intangible assets?
• Fixed assets
o A long-term tangible piece of property that a firm owns and uses in the production of its
income and is not expected to be consumed or converted into cash any sooner than at
least one year's time
o Buildings, real estate, equipment, etc.
o Show up on Balance Sheet as PPE
o The value of the asset is generally well-known
• Intangible assets
o Brand name, trademarks, patents, goodwill, etc.
o Show up on Balance Sheet as goodwill
o The value of the asset is generally unknown or not calculated

What is goodwill? How is it calculated? How does it affect net income?

Goodwill represents the difference between the price paid in an acquisition and the book value (re-
appraised to their estimated fair value) of the target. It’s basically the amount that acquirer “overpays”
for the target

Goodwill is represented on the Balance Sheet as an asset. Companies must perform an annual test of
their goodwill. If the test reveals that the acquisition's value has decreased, then the company must
impair, or write-down, the value of the goodwill. This will create an expense, which is often buried in a
one-time restructuring cost, and an equivalent decrease in the goodwill account

Goodwill affects net income through one-time restructuring costs due to goodwill impairment

What is GAAP?
Generally Accepted Accounting Principles (GAAP) is the Americanized term used to refer to the standard
framework of guidelines for financial accounting used in any given jurisdiction which are generally
known as Accounting Standards.

GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing
transactions, and in the preparation of financial statements

If a firm switches from LIFO to FIFO what are the effects on the three financial statements?
The effects of inventory costing on financial statements depend on whether costs are increasing or
decreasing:

• If costs are increasing, LIFO to FIFO will:

o Increase COGS

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 o Decrease net income
o Reduce inventory
o Increase cash flow
• If costs are decreasing, LIFO to FIFO will:
o Decrease COGS
o Increase net income
o Reduce inventory
o Increase cash flow

What are deferred taxes? How do they arise?

Deferred taxes represent future tax liabilities or assets, resulting from differences between GAAP values
and tax values:

• Temporary differences between book (accounting) value of assets and liabilities and their tax
values
• Timing differences between the recognition of gains and losses in financial statements and their
recognition in a tax computation

Timing differences include, for example:

• Depreciation
o GAAP allows for different depreciation methods, e.g., straight-line, accelerating, etc.,
whereas the tax code restricts it to accelerated depreciation
o GAAP allows for residual value; tax code does not allow residual value

Deferred tax liabilities arise/increase when a timing difference leads to:

• Taxable income < pretax income

Deferred tax assets arise/increase when a timing difference leads to:

• Taxable income > pretax income

What is working capital? How would you calculate it?

Working capital is defined as the capital necessary for the company to keep operating

Working capital = (current assets – cash) – (current liabilities – short term debt)

Important things to note:

• When working capital requirements go up, there is a negative cash flow (you need to provide
funds)
• When working capital requirements go down there is a positive cash flow (funds freed up)

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Using the indirect method, what are the four major adjustments you make to Net Income to arrive at
Operating Cash Flow?
The following adjustments should be made to Operating Cash Flow since they are non-cash events:

• Add back depreciation

• Subtract increase in receivables
• Subtract increase in inventory
• Add increase in payables

What's the difference of the Balance Sheet between a bank and a manufacturing company?
• Bank
o Loans and investments as assets
o Low cash because the bank will most likely put the cash to work earning interest; called
“earning assets”
 Money market investments
 Investment securities
 Portfolio loans
o Deposits and borrowings as liabilities; called “interest bearing liabilities”
 Deposits
 Short-term borrowings
 Long-term debt
o No inventory, accounts receivable, or accounts payable
• Manufacturing company
o Large amount of PPE
o Lots of cash
o Lots of inventory
o Large accounts payable
o Possibly large accounts receivable

EV/EBITDA and Equity Value/Net Income; what is the difference? What does one signify over the
other?
EV/EBITDA:

• EV/EBITDA is a valuation multiple

• Typically, this ratio is applied when valuing cash-based businesses
• This valuation multiple is capital structure neutral and can be used for direct cross-companies
comparison

Equity Value / Net Income:

• Equity Value / Net Income is valuation multiple that relates the value available to equity
investors to earnings available to equity investors

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Say you are looking at two ratios: PE ratio and Equity Value / EBITDA. Talk to me about what happens
to these ratios when a) revenues increase, b) taxes increase, and c) depreciation increases.
• Revenue Increase
o Increases net income, reduces PE
o Increases EBITDA, reduces ratio
• Taxes Increase
o Reduces net income, increases PE
o No change in EBITDA, no change in ratio
• Depreciation Increase
o Reduces net income, increases PE
o No change in EBITDA, no change in ratio

Ratios
Balance Sheet

• Current assets = cash + cash equivalents + inventory + receivables + prepayments

• Current liabilities = short term debt + payables + deferred revenues + other short term liabilities
• Working capital = current assets – current liabilities
• Operating current assets = current assets – cash and cash equivalents
• Operating current liabilities = current liabilities – short-term debt
• Operating working capital = operating current assets – operating current liabilities
• Invested capital = net debt + equity
• Net operating assets = operating working capital + long-term assets – long-term liabilities
• NOPAT (net operating profit after tax) = operating income * (1-tax rate)
• Debt = short-term + long-term debt
• Net debt = total debt – cash and short term equivalents of cash
• Shareholders' equity = assets - liabilities

Value Drivers

• Benefit of leverage = invested capital / equity

• Invested capital turnover = sales / invested capital
• Operating margin = operating income (EBIT) / sales
• Dividend payout ratio = dividends / net income
• Earnings growth = changes in net income / net income

Analysis of Margins

• Sales growth = change in sales / sales

• Gross profit = sales - cogs
• Gross margin = gross profit / sales
• EBITDA interest coverage = EBITDA / interest expense

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 • EBIT interest coverage = EBIT / interest expense
• Pre-tax margin = EBT / sales
• Effective tax rate = 1 – (net income / EBT) = tax expense / EBT
• Net margin = net income / sales

Analysis of Volume

• Days of receivables = days sales outstanding = receivables / sales per day

• Receivables turnover = sales / receivables
• Days of inventory = inventory / cogs per day
• Inventory turnover = cogs / inventory
• Days of prepaid insurance = prepaid insurance / insurance expense per day
• Days of deferred revenues = deferred revenue / sales per day
• Days of accounts payable = accounts payable / cogs per day
• Days of salary payable = salary payable / salary expense per day
• Cash-to-cash cycle = days of receivables + days of inventories – days of payables

Analysis of Leverage

• Pre-tax ROIC = operating income / invested capital

• After-tax ROIC = NOPAT / invested capital
• After-tax roe = net income / equity
• Net benefit of leverage = after-tax roe / after-tax ROIC
• Pre-tax spread % = pre-tax ROIC – interest rate
• Pre-tax spread in dollars = pre-tax spread as percentage * net debt
• After-tax spread in dollars = pre-tax spread in dollars * (1-tax rate)
• Spread as % of equity = after-tax spread / equity

Credit Risk Analysis

• Quick ratio = liquid assets / current liabilities

• Current ratio = current assets / current liabilities
• EBITDA interest coverage = EBITDA / interest expense
• EBIT interest coverage = EBIT / interest expense
• Net debt / EBITDA ratio = net debt / EBITDA
• Net debt / EBIT ratio = net debt / EBIT
• Net debt / equity ratio = net debt / equity

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6. Macro, Markets and Other Random Questions
What happened in the markets in the past three months?
Read the latest Economist, Wall Street Journal and/or Financial Times to get a sense of what’s going on
in the economy

What would you tell the President to do?

Again, think of something and provide support for your argument

Talk about the market or an industry you follow outside of school projects.
While I’m interested in many industries, I follow technology the most. The trends I see in the technology
sector over the next year include:
• More technology companies entering the mobile phone market
• More pressure from Apple on Microsoft on the OS space
• Web-based software
• Web-enabled devices, i.e., televisions, tablets, smartphones

What impact would the weakening of the US dollar have on the stock market?
• Make cash-based goods cheaper
• For outside investors this should make cash-based assets more attractive
• A weak dollar usually means weak spending
• Domestic investors are unlikely to invest in dollar assets and will look to emerging markets for
returns

Which is worse for the economy: Inflation or Deflation?

• Deflation because it is hard to get out of
• A dollar today is worth more than a dollar tomorrow
• In a deflationary economy nobody wants to buy or invest.

Talk to me about a company you admire.

Again, think of something and provide support for your argument

If you had an option to purchase an asset that was going to be worth either -$0 or $100 with equal
probability (ignoring time to maturity, and with a 0% interest rate), how much would you pay for that
asset?
Expected return = 0.50(0) + 0.50(100) = $50

We have $20mm to invest. We never want to work again. How would you advise us?
You need the following information to answer this question:

• When do you want to retire (number of years before retirement)?

• How long do you plan on living (number of years during retirement)?

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 • How much money do you plan on using each year during retirement (money spent each year)?
The basic answer is that you should invest in a fixed income investment vehicle that will pay regular
dividends that are sufficient to cover your spending needs.

Let’s assume that you could invest in a relatively safe investment vehicle that could return at least 5%
per year. This investment strategy would yield $1mm per year while maintaining one’s principal
(although inflation may be an issue).
I have $90MM in cash to invest. How much can I spend without dipping into my principal?

• Let s = spending availability in dollars

• Let r = interest rate on investment vehicle; 5% for this example
• Therefore, you can spend per year such that: s<$90mm*0.05 then s<$4.5mm
• If you spend all of your dividends your real return will be negative because of inflation

Suppose you are putting together a portfolio for a client who has $90mm. You can ask me any
questions you want about this person to get a better sense of what might suit them. Then put
together the allocation for me.
Ask the following questions:

• When will you need the money?

• Do you require regular payments/dividends? If so, how much per payment?
• How risk averse are you?
Put together an appropriate portfolio such that:

• The portfolio includes the market portfolio (from the CML)

• The portfolio includes a bond or other safe investment vehicle
• The portfolio includes a coupon-paying instrument

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