Earlier this month, we posted a cheat sheet of actual interview questions asked of Ivy League MBA students by U.S. investment banks. We had more than we knew what to do with. Below are the remaining, along with suggested answers compiled by the students themselves.
Why might two companies have a different cost of equity?
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.
In an all-stock transaction, a company with a lower P/E is buying a company with a higher P/E. What is the effect of this transaction? What happens if you use debt/cash to make part of the above transaction? Why?
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 to FIFO in an inflationary environment, what is the impact on the three financial statements?
If a company changes its method of inventory valuation from LIFO to FIFO in an inflationary environment, it means that 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.
Of the three main valuation methods (DCF, Public comparables and transaction comparables), rank them in terms of which gives you the highest price. Which one typically yields the highest valuation?
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.
If you had to pick one statement to look at (balance sheet, cash flow, income statement), which one would it be and way?
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.
Name two common ways companies can manage their earnings?
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).
How do you value a company?
There are five common valuation methodologies.
In addition, valuation can be framed through:
What type of a company would be a good candidate for an LBO?
It is difficult to define the characteristics of a typical LBO candidate, but the following things are very important: