MBAs are a useful people, if for no other reason than the help they can provide to the investment bankers of future. Below are a collection of real questions that were asked of investment banking candidates at the MBA level, along with suggested answers that they later put together. If you find yourself on a 'superday' interview at a big bank, you can bet that you'll be asked at least of few of these questions. Disagree with an answer? Let us know in the comments below.
An LBO is a transaction in which a party purchases a business and brings it private. The transaction is funded using a large portion of debt. Three main characteristics of LBOs – 1) high debt, which is intended to be paid down, 2) incentives, managers are given greater stake in business, 3) private ownership, many LBOs go public again once debt has been paid down.
1) Whether they will generate enough cash flows to cover interest obligations. How many multiples in excess of current interest payments is their operations generating in cash flow?
2) What is their current capital structure and can they bring on more debt and leverage the company further without being too levered versus industry and peers so that their credit rating and stock price isn’t negatively impacted.
3) What is the current equity value? If the stock price is appropriately valued or has a potentially high value, then equity might be better.
The FED can adjust the Federal Funds Rate which is the interbank overnight rate at which the FED lends money. The lower the Federal Funds Rate, the lower real interest rates. The FED can also adjust the money supply through the purchase or sale of government bonds, whereby affecting inflationary expectations which will adjust nominal interest rates.
Interest coverage rate is operating income divided by interest expense (EBIT/interest). This basically measures how much leadway a company has between its earnings and interest payments (a hurdle they must keep jumping to avoid default).
In event of bankruptcy, the senior debt would have to be paid before the junior. However, when using the interest coverage ratio to analyze a company’s ability to keep up with their debt payments, I would look at the EBIT divided by ALL forms of debt as a failure to make payments for any form of debt results in default.
The Net Income on the bottom line of the income statement gets added into the retained earnings on the balance sheet. The net income from the income statement is also the starting line of the statement of cash flows.
There are five common valuation methodologies.
In addition, valuation can be framed through:
Valuation for a private company is the same as the valuation of a public company with some complications, particularly as it relates to DCF (discounted cash flow). Because a private company has no publicly traded equity, a beta cannot be directly computed.
To find the cost of equity (KE)
1. Estimate the total value of the private company based on comparables (use average EV/EBITDA)
2. Deduct the value of the debt to get estimated “market” value of equityor internal use only
3. Get the average levered beta from the comparables and unlever it
4. Re-lever the beta for the private company based on the target D/E (debt-to-equity) ratio
5. Calculate Ke based on CAPM (capital asset pricing model)
To find the cost of debt (Kd)
1. Some privately held companies have publicly traded debt – so look up trading yields to estimate Kd
2. Alternatively, estimate what the credit rating of the company would be based on comparables (look at credit statistics)
3. For estimated credit ratings, use current market yields for similarly rated companies to determine Kd
Then calculate WACC as normal and DCF as normal
First, you must define what you think is significant excess cash. For companies that are in cyclical industries, paying out large amounts of cash might leave the company unprepared for a subsequent market downturn. Once you have established that your client does indeed have excess cash on the books, there are a few tried and tested uses for excess cash.
They have different betas. The beta of a stock measures that stock’s sensitivity to movements in the overall stock market. More volatile stocks have a beta higher than one; less volatile stocks have a beta less than one.
The point of this question is to get you to say whether the acquisition is accretive or dilutive. Generally, companies do not want dilutive acquisitions since they destroy shareholder value. The combined company’s ratio will have a higher P/E than the acquirer originally did (but lower than the seller, obviously). However, since more shares will have to be issued by the lower P/E company (than would have been needed if the acquirer had a higher P/E ratio), the combined company will have a lower EPS (dilutive acquisition). Typically, the company with the higher growth rate and growth potential commands a higher P/E . The opposite is true for companies with lower P/E ratios. If you throw in debt/cash, fewer shares will be needed for the acquisition, thus the transaction will be less dilutive, and potentially accretive.
If a company changes its method of inventory valuation from LIFO (last in, first out) to FIFO (first in, first out) in an inflationary environment, it means that the cost of goods sold (COGS) will fall, since goods purchased earlier are being charged to COGS and ending balance of inventory will rise since recently purchased goods will now be reflected in ending inventory. This means that income will rise in the I/S, and value of assets will increase in the B/S.
Simple answer – it depends. Depends on discount rate in DCF model, depends on the comparable companies used, depends on whether the market is hot/cold and the companies are overvalued/undervalued for no good reason. Generally, however, transaction comps would give the highest valuation, since a transaction value would include a premium for shareholders over the actual value. The second highest valuation would probably be the DCF, since there are a lot more assumptions that are involved (growth rate, discount rate, terminal value, tax rates, etc), but it can also be the most accurate depending on how good the assumptions are.
No right answer – can go with whichever one you like. Each has its advantages: income statement – shows the profitability of a company, trends in sales/expenses, margins, etc; balance sheet is a great way to see what items make up the company’s assets and who the company needs to pay back for those assets. Personally, I would go with the cash flow statement. At the end of the day, cash is king. A company that has positive income but very little cash is in deep trouble. Cash flows are used for DCF models, not net income. The cash flow statement allows observing important performance metrics from both income statements and balance sheets such as net income, depreciation, sources and uses of funds, changes in assets and liabilities.
1) Changing accounting practices under GAAP (e.g. switching between S‐L Depreciation and Double Declining Balance; changing between LIFO and FIFO; etc…).
2) “Big bath” (taking negative hits in an already bad year and basically just writing the year off) or “Cookie Jar Accounting” (reducing top‐line revenues in good years and keeping them on reserve for bad years).
It is difficult to define the characteristics of a typical LBO candidate, but the following things are very important:
Beta tells you how much the price of a given security moves relative to movements in the overall market.
A Beta of 1 means that if the market moves, the stock moves in unison with the market.
A Beta < 1 means that if the market moves a certain amount, the stock will move less than that amount
A Beta >1 means that if the market moves a certain amount, the stock will move more than that amount.
Common ratios used to compare equity performance:
Common ratios used to compare enterprise performance:
A creditor’s measure of an individual’s or company’s ability to meet debt obligations. Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:
Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively.
There are three major ways to valuation: