10X EBITDA is proud to present the Core Technicals Guide (February 2023 Edition). You can use this guide to prepare for investment banking, private equity, hedge funds, and other finance-heavy roles.
Candidates often ask us for investment banking interview questions and answers, private equity interview questions and answers, and so forth. We heard you, so here’s a complete list of the “core technicals” questions and answers.
What is “Core Technicals” Exactly?
In finance, people often say “investment banking technical questions” or “hedge fund technical questions” or “private equity technical questions”. The usage of these terms imply that each of these fields have its own set of unique and specific technical questions. That’s partially true, but it’s also somewhat incomplete.
While each of these fields have its own set of specific questions, there’s also a common set of core technical knowledge that’s applicable to investment banking, private equity, hedge funds, and other finance-heavy roles.
For example, regardless of which one of these roles you interview for, you need to know financial statements. It’s not like Income Statement or Balance Sheet is different for investment banking than it is for private equity. It’s not like there’s one batch of accounting principles for hedge funds and another for investment banking. Same idea applies to valuation. It’s not like time value of money is different in credit investing versus investment banking. Regardless of which one of these roles you interview for, you need to know how to value companies.
Investment banking, private equity, hedge funds, equity research, and other fields all ask questions on this common set of core technical knowledge. Hence, we coined the term “Core Technicals” to encapsulate this set of common questions. Core Technicals includes Accounting, Enterprise Value / Equity Value, Valuation Methodologies (i.e. DCF, Multiples, LBO), and M&A. You need to understand each of these topics regardless of which field you interview for.
Core Technicals + Buyside Add-On
Core Technicals serve as the foundational technical knowledge you need to know regardless of which field you interview for. But remember we said in the beginning that each field have its own set of specific technical questions? There are in fact PE-specific and HF-specific questions. These buyside-specific technical questions layer on top of the Core Technicals. This guide covers all of the Core Technicals. For private equity and hedge fund technicals, we have the Buyside Technicals Add-On Guide. It’s called an “add-on” because it covers investing-specific questions that build on top of the Core Technicals. Please note, however, unlike this guide, the Buyside Technicals Add-On Guide only includes questions but does not include answers.
So, how you should think about technicals is that you need to know Core Technicals for all finance fields. In addition, you need to know field-specific technicals for whatever role you’re interviewing for. Here’s an illustration of how things work.
How to Learn Technicals
So how do you go about preparing for technical interviews? Think back to any classes you took and exceled (i.e. math, chemistry, history, SAT, etc). How did you prepare for the exams? It probably involved 3 steps.
First, you learn the concepts, whether that’s by reading textbooks or attending lectures. It’s the same idea with technical interview questions. You start by learning the finance concepts. We recommend clients to use the Online Finance Course. It’s taught by a Goldman Sachs TMT investment banker.
Second, you review practice questions and solve problem sets. The Online Finance Course has financial modeling exercises and practice quizzes. This Core Technicals Guide provides an extensive list of frequently asked technical questions and answers.
Third, you should do practice exams. What’s the equivalent of practice exams for technical interview questions? Mock interviews. You can do them with your friends or with us if you want to practice with professionals.
And that’s it. Follow these 3 steps and you can crush finance interview technical questions.
Now, without further ado, let’s jump into the Core Technicals.
I. Accounting (Financial Statements)
General Understanding
1. What are the three financial statements?
“The three financial statements are the Income Statement, Cash Flow Statement and Balance Sheet. The Income Statement tells us the company’s profitability. The Cash Flow Statement tells us how much cash is coming in and going out of the company. And the Balance Sheet tells us what it owns and what it owes.”
Online Finance Course References:
Course 4, Lesson 1 (Introduction to Financial Statements)
–
2. Can you walk me through the three financial statements?
“On the Income Statement, we start with Revenue. From here, we subtract Cost of Goods Sold to get Gross Profit. Then we subtract SG&A, R&D and other operating expenses to get Operating Income. Then we subtract Interest and Taxes to get Net Income.
Net Income flows to the top of the Cash Flow Statement. The Cash Flow Statement has three main sections: Cash Flow from Operations, Cash Flow from Investing, and Cash Flow from Financing. The sum of these three types of cash flows gives us the Net Change in Cash.
Net Change in Cash then flows to the top of the Balance Sheet. The Balance Sheet also has three sections: Assets, Liabilities and Equity. Assets must equal Liabilities plus Equity.”
Online Finance Course References:
Course 4, Lesson 1 (Introduction to Financial Statements)
Course 12, Lesson 2 (How 3 Statements are Linked)
–
3. If you can only pick one financial statement to analyze the financial attractiveness of a company and the statement would only display the numbers for a single year, which one would you pick and why?
“I would pick the Cash Flow Statement because a company’s valuation is based on how much cash flow it can generate.”
–
4. If you can only pick one financial statement to analyze the financial attractiveness of a company and the statement would display the numbers for two years, which one would you pick and why?
“I would still pick the Cash Flow Statement.”
Some people say that they would pick the Balance Sheet because by comparing how the numbers changed between two years, they can back out the Income Statement / Cash Flow Statement. That’s wrong.
You might be able to back out some line items, such as Changes in Working Capital. However, you won’t be able to deduce most of the line items, such as Revenue, EBIT, Net Income, EPS, Cash Flow from Operations and CapEx.
–
5. If you can pick two financial statements among the three, which two would you pick and why?
“I would pick the Cash Flow Statement and the Balance Sheet. The former tells me how much cash flow the company can generate, which allows me to value the company. The latter tells me how much debt and cash it has, which allows me to bridge from Enterprise Value to Equity Value.”
Some people say that they would pick the Income Statement and the Balance Sheet because they can back solve for the Cash Flow Statement. While this works in theory for companies with very simple financials organized in the most convenient fashion, it doesn’t work in practice because most large companies have complicated financials.
–
6. What is the difference between calendar year and fiscal year?
“Calendar Year is the 12-months period from January 1st to December 31st.
Fiscal Year is the 12-months period that a company uses to report financials. The 12-month period may begin on any date, doesn’t have to be January 1st. Most companies’ Fiscal Year is the same as Calendar Year. Other companies have their Fiscal Year begin on a date other than January 1st and end on a date other than December 31st. For example, Apple’s 2023 Fiscal Year is from September 25th 2022 to September 24th 2023.”
–
7. What is seasonality?
“Seasonality is when a company’s financials are meaningfully different in certain period within a year relative to other periods. For example, a lot of companies experience greater sales during November and December than they do in other months because of Black Friday, Christmas and New Year sales.”
Likewise, swimming pool companies generate more revenue in the summer when the weather’s the hottest. School suppliers experience greater sales in August and September when students return to school. That’s all because of seasonality.
–
8. Can you explain to me the difference between GAAP and Non-GAAP?
“GAAP stands for Generally Accepted Accounting Principles. When we describe a metric or a set of financial statements as “GAAP”, we mean the numbers are based on the accounting standards set by the Financial Accounting Standards Board (FASB). The standards are rules specifying exactly when and how companies should record each financial metric.
By contrast, non-GAAP describes metrics that are not prepared in accordance to FASB’s standards. That’s often because the FASB don’t have rules covering these metrics. For example, Adjusted EPS is a non-GAAP metric.”
Online Finance Course References:
Course 6, Lesson 2 (GAAP vs. Non-GAAP)
–
9. Can you provide some examples of GAAP and Non-GAAP metrics that analysts care about?
“Some GAAP metrics that analysts care about are Revenue, Operating Income, Net Income, and EPS.
Some non-GAAP metrics that analysts care about are EBITDA, Adjusted EBITDA, and Unlevered Free Cash Flow.”
Online Finance Course References:
Course 6, Lesson 6-7 (EBITDA and Adjusted EBITDA)
–
10. What is the difference between cash-based accounting and accrual-based accounting?
“Cash-based accounting records revenue and expenses based on when cash is received and paid. Accrual-based accounting records revenue and expenses based on revenue is accrued and expenses are incurred, regardless of whether cash is received or paid.”
–
11. What’s the difference between expensing an item versus capitalizing an item?
“Expensing an item means recording a spending as an expense on the Income Statement. By contrast, capitalizing an item means recording a spending as an asset or a liability on the Balance Sheet.”
–
12. How do companies determine whether to expense an item versus to capitalize an item?
“In general, companies should capitalize expenditures that provide benefits beyond the reporting period and expense ones for which the benefits were consumed during the reporting period.”
–
13. What is the Conservatism Principle in accounting?
“The Conservatism Principle in accounting directs the accountant to choose the option that will result in lower profit and/or net asset in situations where there is more than one acceptable option to record a financial number.”
–
14. What is the Matching Principle in accounting?
“The Matching Principle requires firms to recognize expenses that coincide with Revenue in the same period they recognize Revenue.”
For example, say the company spent $10 in June to produce a chair. It sells the chair in October for $13 and records Revenue. The $10 is attributable to the chair. Under the Matching Principle, the company must recognize the $10 cost in October when it recognizes Revenue.
–
15. What is the Accrual Principle in accounting?
“The Accrual Principle requires firms to record transactions in the time period they occur, regardless of when cash flows for the transaction are received or paid.”
Income Statement
16. How is the Income Statement organized? / What are the major line items on the Income Statement?
“The Income Statement starts with Revenue. From here, we subtract Cost of Goods Sold to get Gross Profit. From here, we subtract SG&A, R&D and other operating expenses to calculate Operating Income. Then we subtract Interest Expense and Taxes to get Net Income. At the bottom, the Income Statement will show the Weighted Average Shares Outstanding and the corresponding Earnings per Share.”
–
17. In a 10-K, how many years does the Income Statement typically show?
“The 10-K Income Statement usually shows 3 years.”
–
18. What does “Top-Line” and “Bottom-Line” mean on the Income Statement?
“Top-Line means Revenue or Sales while Bottom-Line means Net Income.”
–
19. Can you explain to me how Revenue is recognized on the Income Statement?
“Under US GAAP (and IFRS for jurisdictions outside the US), companies recognize Revenue on an accrual basis. This means that companies record Revenue when they deliver the product or service and collection of payment is reasonably certain.”
Online Finance Course References:
Course 4, Lesson 3 (Revenue Recognition)
–
20. What is EBITDA and why do we use it?
“EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It measures the business profitability. We use EBITDA because it removes discretionary accounting and financing decisions that often vary based on management choices. This allows analysts to compare companies’ profitability on a standardized basis.
Also, EBITDA is a proxy for cash flow.”
Online Finance Course References:
Course 6, Lesson 6 (EBITDA)
–
21. What are some flaws of using EBITDA?
“One criticism is that we add back non-cash items but we don’t subtract cash items. For example, we add back D&A because it’s a non-cash expense and makes EBITDA a closer proxy to cash flow. However, we don’t subtract out CapEx, even though it’s a cash item that replenishes the business from the D&A.”
–
22. Walk me through at least three different ways to calculate EBITDA.
“1st way: EBIT + Depreciation + Amortization
2nd way: Net Income + Taxes + Net Interest Expense + Depreciation + Amortization
3rd way: Revenue x EBITDA Margin %”
–
23. What are some common adjustments we make to EBITDA to calculate Adjusted EBITDA?
“Some common adjustments are Restructuring Charges, Asset Impairment, Gains & Losses, and Stock-Based Compensation.”
Online Finance Course References:
Course 6, Lesson 7 (Adjusted EBITDA)
–
24. Why doesn’t EBITDA appear on companies’ Income Statements?
“Income Statement is GAAP while EBITDA is a non-GAAP metric. Companies don’t include non-GAAP items on GAAP documents.”
Online Finance Course References:
Course 6, Lesson 6 (EBITDA)
–
25. Since D&A is an expense, how come some companies don’t show it on the Income Statement?
“That’s because some companies embed D&A into other cost buckets, such as COGS, SG&A, and R&D. Though they don’t show D&A in its own line on the Income Statement, they’re still including it in the numbers. It’s just not as obvious because companies often embed D&A in the other cost buckets.”
–
26. What do people mean when they say Depreciation is a non-cash expense?
“They mean that this is not an expense companies pay with cash. For example, if a company incurs $100 Depreciation, it doesn’t have to send the $100 to anyone. Since there’s no cash payments involved, it’s a non-cash expense.”
Online Finance Course References:
Course 5, Lesson 14 (Depreciation & Amortization)
–
27. If D&A is a non-cash expense, does it affect Net Income? Why and why not?
“Yes, it still affects Net Income. Net Income does not measure cash flow. It measures profitability. While D&A is non-cash, it does measures asset erosion, which impacts profitability.”
Online Finance Course References:
Course 5, Lesson 14 (Depreciation & Amortization)
–
28. What is the difference between straight-line depreciation and accelerated depreciation? Which one do companies prefer?
“Straight-line depreciation spreads the depreciation expense over an asset’s lifespan evenly throughout the years.
Accelerated depreciation records disproportionally high depreciation expense in the early years and disproportionally low depreciation expense in the final years of an asset’s lifespan. This is based on the idea that an asset may be most useful in the first few years.”
–
29. When you bridge from EBIT to EBITDA, where should you obtain the D&A amount?
“You should obtain the D&A amount from the Cash Flow Statement, under Cash Flow from Operations.”
It is incorrect to say you should obtain the D&A amount from the Income Statement. The Income Statement D&A value might be correct for some companies but it’s wrong for many others.
–
30. What are some examples of “extraordinary items”?
“Extraordinary items are impacts to the company’s financials that are extraordinary in nature. This means they are not part of the regular course of business and unlikely to occur again. Some examples of ‘extraordinary items’ are litigation expenses, natural disaster expenses, and restructuring charges.”
Online Finance Course References:
Course 5, Lesson 6 (Non-Recurring Items)
–
31. What are the different line items that you may need to add or subtract from Operating Income to calculate Pre-Tax Income?
“From Operating Income, we add Interest Income, add Other Incomes, subtract Interest Expense, and subtract Other Expenses.”
What goes into “Other Income” and “Other Expenses” vary by company. The two are different from “Other Operating Income” and “Other Operating Expenses”.
–
32. What is Inventory Impairment / Goodwill Impairment / Asset Impairment? What causes this to happen?
“These are write-downs to the value of the company’s assets on the Balance Sheet. Essentially, companies recorded these assets on the Balance Sheet at certain values. But something happened and company realized these assets are worth less than what they recorded on the Balance Sheet. Thus, they record an “impairment” expense on the Income Statement to reflect a loss.”
Online Finance Course References:
Course 5, Lesson 17 (Impairment)
–
33. What is the difference between Interest Expense and Interest Income?
“Interest Expense is the interest that the company has to pay to other parties. This usually shows up because the company borrowed debt.
Interest Income is the interest that other parties have to pay to the company. For example, if the company has cash deposits at banks, the banks will pay interest on these deposits.”
Online Finance Course References:
Course 5, Lesson 20 (Interest Expense)
–
34. Can you explain to me the concept of the tax shield?
“Because expenses are tax-deductible, an incremental dollar of expense reduces after-tax profit by less than a dollar.”
–
35. What is the current corporate income tax rate in the United States?
“Federal corporate income tax is ~21%. State & local corporate income taxes vary. All in, that’s probably around ~25%.“
–
36. Where do you find the Effective Tax Rate a company is paying in the annual report?
“We can find the Effective Tax Rate on the Income Statement by dividing Income Taxes by Pre-Tax Income.”
Online Finance Course References:
Course 5, Lesson 21 (Income Taxes)
Course 5, Lesson 28 (Effective Tax Rate)
–
37. What are some differences between financial accounting and tax accounting?
“Financial accounting records revenue and expenses on an accrual basis. Tax accounting gives taxpayers the option to choose accrual vs. cash basis.
“Financial accounting often use straight-line depreciation whereas tax accounting often use accelerated depreciation.
Financial accounting calculates an ‘Income Tax Expense’, which the company may or may not pay in cash during the period. Tax accounting calculates the actual cash tax payment the company has to make.”
–
38. What is the difference between the Income Statement and the Cash Flow Statement?
“The Income Statement tracks profitability while the Cash Flow Statement tracks cash movements. The Cash Flow Statement bridges Net Income, which is the punchline number from Income Statement, to actual cash flow.”
Cash Flow Statement
39. How is the Cash Flow Statement organized? / What are the major line items on the Cash Flow Statement?
“The Cash Flow Statement is organized into three sections: Cash Flow from Operations, Cash Flow from Investing and Cash Flow from Financing. At the bottom, it sums up these sections to calculate the Net Change in Cash and the resulting Cash & Cash Equivalents balance.
The major line items on the Cash Flow Statement are Net Income, D&A, Stock-Based Compensation, Changes in Working Capital, Capital Expenditures, Dividend Payments, and Share Repurchases.”
Online Finance Course References:
Course 7, Lesson 2 (Cash Flow Statement)
–
40. In a 10-K, how many years does the Cash Flow Statement typically show?
“The 10-K Cash Flow Statement usually shows 3 years.”
–
41. How do you project D&A?
“Usually, we simply project D&A as a percentage of Revenue. In some instances, we may build a granular D&A schedule based on PP&E and Intangible Assets.”
Online Finance Course References:
Course 5, Lesson 31 (Forecasting Costs)
–
42. In Year 1, a company has Operating Current Assets of $100 million and Operating Current Liabilities of $80 million. In Year 2, the company has Operating Current Assets of $130 million and Operating Current Liabilities of $70 million. What is the impact of Change in Working Capital on cash flow?
“Change in Working Capital decreases cash flow by $40.”
Here’s the math.
Year 1 Net Working Capital (NWC) = $100 – $80 = $20.
Year 2 Net Working Capital = $130 – $70 = $60.
Change in Working Capital = Year 1 NWC – Year 2 NWC = $20 – $60 = $(40).
Online Finance Course References:
Course 1, Lessons 2-6 (Changes in Working Capital)
–
43. Walk me from Net Income to Cash Flow from Operations.
“Starting with Net Income, we add D&A, Stock-Based Compensation and adjust for Changes in Working Capital.”
Online Finance Course References:
Course 7, Lessons 3 (Cash Flow from Operations)
–
44. Is Cash Flow from Operations levered or unlevered?
“It’s levered because Cash Flow from Operations is based on Net Income. Net Income is based on Interest Expense and Interest Expense is based on the company’s Debt Outstanding.”
Online Finance Course References:
Course 7, Lessons 3 (Cash Flow from Operations)
–
45. Two companies have the exact same EBITDA but one company has higher Cash Flow from Operations than the other company. How can this happen?
“This could happen due to lower Interest Expense, lower tax rates, higher D&A, and more efficient working capital.”
–
46. Tell me at least 5 different line items under Cash Flow from Investing.
“Capital Expenditures. Proceeds from Sale of PP&E. Business Acquisitions. Purchases of Marketable Securities. Sale of Marketable Securities.”
Online Finance Course References:
Course 7, Lessons 4 (Cash Flow from Investing)
–
47. How does Cash Flow Statement usually label CapEx?
“Purchases of Property, Plant and Equipment.”
Online Finance Course References:
Course 7, Lessons 9 (CapEx)
–
48. What is the difference between Growth CapEx and Maintenance CapEx?
“Growth CapEx is capital expenditures company spends to grow the business. Its purpose is to enable the business to earn more money than what it earns now.
Maintenance CapEx is capital expenditures company spends to maintain the business. Its purpose is to allow the company to keep earning what it earns now.”
Online Finance Course References:
Course 7, Lessons 9-10 (CapEx)
–
49. How do you project CapEx?
“It depends. For some companies, we can just project CapEx as a percentage of Revenue. For others, we may project Maintenance CapEx as a percentage of Revenue and Growth CapEx based on the actual projects. Management will usually need to provide estimate on the Growth CapEx needs of projects.”
Online Finance Course References:
Course 7, Lessons 9-10 (CapEx)
–
50. What is the difference between cash flow and free cash flow?
“Cash flow is kind of a catch-all term. It may or may not be ‘free cash flow’. By contrast, free cash flow is the generation of cash that the company is ‘free’ to send back to investors.”
Online Finance Course References:
Course 7, Lessons 18 (Free Cash Flow)
–
51. What is Unlevered Free Cash Flow (UFCF) and how do you calculate it?
“Unlevered Free Cash Flow (UFCF) is the free cash flow before taking into consideration the impact of debt. It’s entitled to both debt and equity holders.
To calculate UFCF, we can start with EBITDA. Less D&A to get EBIT and then tax-effect it to get NOPAT. Then we add back D&A, adjust for Changes in Working Capital and subtract CapEx.”
Unlevered Free Cash Flow = ((EBITDA – D&A) * (1 – Tax Rate)) + D&A +/- Changes in Working Capital – CapEx
Online Finance Course References:
Course 7, Lessons 24 (Unlevered Free Cash Flow)
–
52. If I were to only give you the Cash Flow Statement, are you able to calculate the Unlevered Free Cash Flow?
“In most cases, no I can’t. I don’t know what the Interest Expense and Interest Income is from the Cash Flow Statement. So, I can’t back it out to calculate Unlevered Free Cash Flow. I might be able to get close to it, but not precisely.”
–
53. If EBIT goes up by $10, how does this affect UFCF?
“Assuming a tax rate of 20%, UFCF increases by $8.”
Can you guess where the other $2 went? They went to taxes.
UFCF = ((EBITDA – D&A) * (1 – Tax Rate)) + D&A +/- Changes in Working Capital – CapEx
–
54. If D&A increases by $20 million, how does that affect UFCF?
“Assuming a tax rate of 20%, UFCF increases by $4.”
D&A increases by $20, which means EBIT decreases by $20. Assuming a 20% tax rate, Income Taxes decreases by $4. Since the business is paying $4 less in taxes, UFCF naturally increases by $4.
See if you can figure out what happens here if the tax rate is 25%. Answer is listed below in the footnote [1].
–
55. What is Levered Free Cash Flow (LFCF) and how do you calculate it?
“Starting from Net Income: Net Income + D&A +/- Changes in Working Capital – CapEx.”
“Starting from EBITDA: EBITDA – D&A – Net Interest Expense – Taxes + D&A +/- Changes in Working Capital – CapEx.”
Online Finance Course References:
Course 7, Lessons 20 (Levered Free Cash Flow)
–
56. If I were to only give you the Cash Flow Statement, are you able to calculate the Levered Free Cash Flow?
“Yes, you can. You can subtract CapEx from Cash Flow from Operations.”
Online Finance Course References:
Course 7, Lessons 20 (Levered Free Cash Flow)
–
57. How do you calculate Net Change in Cash?
“Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing.”
Online Finance Course References:
Course 7, Lessons 17 (Net Change in Cash)
–
58. What is the difference between Net Change in Cash and LFCF?
“The main difference between the two is that Net Change in Cash includes Cash Flow from Financing while LFCF excludes Cash Flow from Financing.
In addition, Net Change in Cash also includes certain investing line items, such as Purchases of Marketable Securities. By contrast, LFCF excludes these items.”
Online Finance Course References:
Course 7, Lessons 17-20 (Net Change in Cash; Levered Free Cash Flow)
Balance Sheet
59. How is the Balance Sheet organized? What are the major line items on the Balance Sheet?
“The Balance Sheet has three main sections: Assets, Liabilities, and Equity. Total Assets must equal Total Liabilities plus Total Equity.
Assets: Cash & Cash Equivalents, Accounts Receivables, Inventory, and PP&E.
Liabilities: Short-Term Debt, Accounts Payables, Deferred Revenue, Long-Term Debt.
Equity: Common Stock, Retained Earnings.”
Online Finance Course References:
Course 10, Lessons 1-2 (Balance Sheet)
–
60. In a 10-K, how many years does the Balance Sheet typically show?
“The 10-K Balance Sheet usually shows 2 years.”
–
61. Why must Assets equal Liabilities plus Equity?
“However much assets a company has left after paying off its liabilities all belong to the equity holders. Therefore, Liabilities plus Equity must equal Assets.”
Online Finance Course References:
Course 10, Lesson 4 (Accounting Equation)
–
62. Explain to me the difference between Accounts Receivables and Deferred Revenue.
“Accounts Receivables is the portion of Revenue for which the company has not yet received cash payments.”
Deferred Revenue is the value of cash payments that the company received, but not yet recorded as Revenue.”
Online Finance Course References:
Course 4, Lessons 4-5 (Accounts Receivable and Deferred Revenue)
Course 10, Lesson 7 (Accounts Receivable)
Course 10, Lesson 15 (Deferred Revenue)
–
63. For businesses that have Accounts Receivables, how long does it take for businesses to collect payment?
“Usually 30-90 days.”
–
64. For businesses that have Deferred Revenue, how far in advance do businesses collect the cash?
“Usually 30-365 days.”
See if you can figure out why 30 to 365 days. Answer is listed below in footnote [2].
–
65. What are some examples of Working Capital?
“Assets: Accounts Receivables. Inventory. Prepaid Expenses.
Liabilities: Accounts Payables. Deferred Revenue. Accrued Compensation.”
Online Finance Course References:
Course 11, Lessons 1-2 (Working Capital)
–
66. What does a positive or negative Working Capital mean?
“Working Capital equals Operating Current Assets minus Operating Current Liabilities. A positive working capital means there’s a cash surplus from the company’s working capital needs while a negative working capital means there’s a cash shortage.”
You can think of Operating Current Assets as things that will convert into cash within the next 12 months. Likewise, you can think of Operating Current Liabilities as things cash need to pay for within the next 12 months. Therefore, the difference between the two is a cash surplus versus a cash shortage. A positive working capital is a cash surplus that add to cash balance. Meanwhile, a negative working capital is a cash shortage that the company needs to use its bank savings to fill.”
–
67. Is it bad for a company to have negative Working Capital?
“It depends. For most businesses, negative working capital doesn’t matter at all. They can just use the cash in their bank account to pay for the shortage. And if they don’t have enough cash in their bank account, they can just borrow debt.
Where negative working capital becomes a killer is if the businesses don’t have enough cash and can’t borrow debt. Then they can’t pay what they owe to employees, suppliers, customers and could potentially go bankrupt.”
–
68. How do you evaluate a company’s working capital efficiency?
“We can calculate various working capital ratios such as Accounts Receivables Collectable Days, Inventory Turnover, and Deferred Revenue Days.”
Online Finance Course References:
Course 11, Lesson 7 (Working Capital Ratios)
–
69. How are Operating Current Assets and Operating Current Liabilities different from Current Assets and Current Liabilities?
“Operating Current Assets is Current Assets less Cash and Marketable Securities.”
“Operating Current Liabilities is Current Liabilities less Short-Term Debt.”
Online Finance Course References:
Course 11, Lessons 1-2 (Working Capital)
–
70. What are the different inventory accounting methods to record Cost of Goods Sold?
“There are two main methods: LIFO and FIFO.
LIFO stands for Last In, First Out. Under the LIFO method, when a company sells a product, it records the value of the newest inventory additions as that product’s COGS.
FIFO stands for Fist In, First Out. Under the FIFO method, when a company sells a product, it records the value of the oldest inventory additions as that product’s COGS.”
The need for LIFO and FIFO arises due to the fact that inventory is usually fungible. For example, let’s say Tesla bought a bunch of aluminum every month from January to December. It’s not like aluminum from one month is different from aluminum in another month. They’re all the same: aluminum. While the aluminum itself is identical, the price of aluminum may vary from January to December. If you’re Tesla and you sell a car, how do you decide whether the aluminum that went into a specific car was the aluminum from January, February, March, and so forth? And even if you can tell the aluminum apart, how do you decide which to use as COGS for each car that you sell?
To standardize how companies record COGS, the US GAAP offers companies two options: LIFO and FIFO. Countries outside the US use IFRS and IFRS only allows FIFO.
See next question for mathematical example.
–
71. In an increasing cost environment, would a company want to use LIFO or FIFO to maximize the profits it can report?
“In an increasing cost environment, FIFO would maximize a company’s profits.”
Let’s take a look at an example. Let’s say Tesla begins the year without any aluminum. In January, it buys 100 boxes of aluminum at $1 each (total = $1 x 100 = $100). In February, it buys 100 boxes of aluminum at $2 each (total = $200). And in March, it buys 100 boxes of aluminum at $3 each (total = $300). Because cost is increasingly higher, we call this an increasing cost environment. During this period, it sold cars that used 200 boxes of aluminum.
Under the LIFO method, the cost of aluminum that went into the cars would be the $300 from March and the $200 from February, totaling $500 in COGS.
Under the FIFO method, the cost of aluminum that went into the cars would be the $100 from January and the $200 from February, totaling $300 in COGS.
Tesla’s Revenue is the same. It doesn’t change based on LIFO vs. FIFO. But COGS is $500 under LIFO and $300 under FIFO. Therefore, in an increasing cost environment, FIFO produces lower COGS. Given the same Revenue, FIFO would enable the company to report higher profit.
–
72. In a decreasing cost environment, would a company want to use LIFO or FIFO to maximize the profits it can report?
“In a decreasing cost environment, LIFO would maximize a company’s profits.”
Let’s take a look at an example. Let’s say Apple begins the year without any copper. In Q1, it buys 100 boxes of copper for $8 each (total = $8 x 100 = $800). In Q2, it buys 100 boxes of copper for $7 each (total = $700). In Q3, it buys 100 boxes of copper for $6 each (total = $600). In Q4, it buys 100 boxes of copper for $5 each (total = $500). Because cost is progressively lower, we call this a decreasing cost environment. During this period, Apple sold iPhones that used 200 boxes of copper.
Under the LIFO method, the cost of copper that went into the iPhones would be the $500 from Q4 and the $600 from Q3, totaling $1,100.
Under the FIFO method, the cost of copper that went into the iPhones would be the $800 from Q1 and the $700 from Q2, totaling $1,500.
Apple’s Revenue is the same. It doesn’t change based on LIFO vs. FIFO. But COGS is $1,100 under LIFO and $1,500 under FIFO. Therefore, in a decreasing cost environment, LIFO produces lower COGS. Given the same Revenue, LIFO would enable the company to report higher profit.
–
73. Between LIFO and FIFO, which one gives you a better estimate of the value of a period’s ending inventory?
“FIFO gives you a better estimate of the value of a period’s ending inventory.”
Here’s the explanation. The more recent the inventory, the more reflective of what it’s worth at the end of the period. By using FIFO, the oldest inventory is taken out and goes into COGS. This means more of the remaining inventory are recent inventory additions.
–
74. Over how many years is land depreciated?
“None. Land cannot be depreciated.”
–
75. What is the difference between Intangible Assets and Goodwill?
“Both Intangible Assets and Goodwill are ‘intangible’ assets. The difference is that the former is identifiable whereas the latter is unidentifiable.”
Online Finance Course References:
Course 10, Lessons 11-12 (Intangible Assets; Goodwill)
–
76. Why do some companies have Goodwill while others don’t?
“Goodwill is created when companies acquire other companies. Those that don’t make acquisitions won’t have Goodwill.”
–
77. Can Goodwill be amortized? If so, over how many years?
“As of 2023, public companies can’t amortize Goodwill while private companies can elect to amortize Goodwill, usually over 10 years.”
The FASB flips back and forth on the issue of whether to amortize Goodwill. There’s endless debate on this issue in the accounting world. Whether companies can amortize Goodwill is ultimately up to the humans in charge of FASB. Therefore, when they say companies may amortize Goodwill, then Goodwill is amortizable. When they say companies may not amortize Goodwill, then Goodwill is not amortizable.
–
78. How can a company increase its Goodwill?
“A company can increase its Goodwill by making more acquisitions.”
79. What are the different types of liabilities on the Balance Sheet?
“There are Current vs. Non-Current Liabilities and Operating vs. Financial Liabilities.”
Online Finance Course References:
Course 10, Lessons 13 & 21 (Types of Liabilities)
–
80. What’s the difference between Short-Term Debt and Long-Term Debt?
“Short-Term Debt is debt that a company has to repay within 1 year.
Long-Term Debt is debt that a company has to eventually repay but not within 1 year.”
–
81. What is Non-Controlling Interest and why do some companies have it?
“Non-Controlling Interest (NCI) is the value of equity that the company does not own in a subsidiary it controls. Say the company controls a subsidiary but only owns 70% of it. Then the value of the 30% ownership is NCI.”
Online Finance Course References:
Course 10, Lesson 28 (Non-Controlling Interest)
–
82. Is Non-Controlling Interest and Minority Interest the same?
“No, they are not.
Non-Controlling Interest (NCI) is the value of equity that the company does not own in a subsidiary it controls. The test for this is whether the company controls the subsidiary.
Minority Interest is the value of equity that the company does not own in a subsidiary it majority-owns. The test for this is whether the company owns more than 50% of the subsidiary.”
–
83. What are the common lines under Shareholder’s Equity?
“The most common lines are: Common Stock, Additional Paid-In Capital, Retained Earnings, Treasury Stock, Non-Controlling Interest.”
Online Finance Course References:
Course 10, Lessons 22-29 (Shareholder’s Equity)
–
84. How do you calculate Retained Earnings?
“Current Period’s Retained Earnings = Previous Retained Earnings + Net Income – Dividends.”
Online Finance Course References:
Course 10, Lessons 26 (Retained Earnings)
–
85. Can Shareholder’s Equity be negative? If so, how?
“Yes, Shareholder’s Equity can be negative. There could be many different reasons, but the most common reason is that companies that lose a lot of money will have negative Net Income, which causes Retained Earnings to go negative, which in turn causes Shareholder’s Equity to become negative.”
–
86. Which number is usually larger: Shareholder’s Equity or Equity Value?
“A company’s Equity Value is usually far larger than its Shareholder’s Equity. The former is based on how much cash flow the company can earn in the future. The latter is based on how much money shareholders invested into the company and the profits retained to date. Successful companies make more money than what investors put into the company and the profits they earned in the past. Naturally, Equity Value tend to be larger than Shareholder’s Equity.”
–
87. Which of the following is carried on the book closest to fair market value: Current Assets, Long-Term Assets, Shareholder’s Equity?
“Current Assets is carried on the book closest to fair market value.”
We established in the previous question that the Equity Value (fair market value) is far greater than the Shareholder’s Equity. Long-Term Assets, by definition, are assets that last longer than one year. The most important Long-Term Assets are PP&E and Intangible Assets. In fact, some of these assets can last for decades. If these assets were recorded at cost 10 years ago, how close are they to today’s fair market value? By contrast, the main items under Current Assets are Cash & Cash Equivalents, Marketable Securities, Accounts Receivable and Inventory. These are either exactly at fair market value or very close to it.
Impact to Three Statements
88. Walk me through how the three financial statements are linked together.
“Net Income on the Income Statement flows to the top of the Cash Flow Statement and into Retained Earnings on the Balance Sheet.
Changes in Working Capital on the Cash Flow Statement alters the working capital values on the Balance Sheet.
D&A from the Income Statement, coupled with CapEx on the Cash Flow Statement, flows into PP&E and Intangible Assets on the Balance Sheet.”
There are many more links, but these are some most common ones.
Online Finance Course References:
Course 12, Lesson 2 (How the 3 Financial Statements are Linked)
–
89. Can you walk me through how $10 increase in Depreciation will affect the 3 financial statements?
“On the Income Statement, Depreciation expense goes up by $10 so Pre-Tax Income goes down by $10. Assuming a 20% Tax Rate, Net Income goes down by $8.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes down by $8. But we need to add back the $10 of additional Depreciation because it’s a non-cash expense. So, Cash Flow from Operations increases by $2. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes up by $2.
On the Balance Sheet, on the Assets side, Cash goes up by $2. PP&E goes down by $10 because of the extra Depreciation. So Total Assets decreases by $8. On the Liabilities and Equity side, Retained Earnings went down by $8 because of Net Income. And the Balance Sheet balances.”
–
90. Can you walk me through how $10 decrease in Amortization will affect the 3 financial statements?
“On the Income Statement, Amortization expense goes down by $10 so Pre-Tax Income goes up by $10. Assuming a 20% Tax Rate, Net Income goes up by $8.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes up by $8. But we need to subtract out the $10 of lower Amortization because it’s non-cash. So, Cash Flow from Operations decreases by $2. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes down by $2.
On the Balance Sheet, on the Assets side, Cash goes down by $2. Intangible Assets goes up by $10 because there’s less Amortization. So Total Assets increases by $8. On the Liabilities and Equity side, Retained Earnings went up by $8 because of Net Income. And the Balance Sheet balances.”
–
91. A company purchased a chair for its office needs for $100. Walk me through the impact to the three financial statements.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations. Under Cash Flow from Investing, CapEx decreases cash flow by $100. No changes to Cash Flow from Financing. So, the Net Change in Cash goes down by $100.
On the Balance Sheet, on the Assets side, Cash goes down by $100 but PP&E goes up by $100. So Total Assets remain unchanged. Nothing changes on the Liabilities and Equity side. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 10 (Building a Warehouse)
–
92. Continuing from the previous question, the company just found out the chair is an antique worth $1,000,000. Walk me through the impact to the three financial statements.
“No changes to the Income Statement, Cash Flow Statement and the Balance Sheet.“
PP&E is recorded on the Balance Sheet at cost. Companies don’t get to increase the value of PP&E just because they think it’s worth a higher price.
93. Let’s say you purchase an annual membership on Adobe for $100 on January 1st. Walk me through the changes to Adobe’s three financial statements on January 1st.
“No changes to the Income Statement.
On the Cash Flow Statement, Changes to Deferred Revenue increases cash flow by $100. No changes to Cash Flow from Investing and Cash Flow from Financing. Therefore, Net Change in Cash goes up by $100.
On the Balance Sheet, on the Assets side, Cash goes up by $100. On the Liabilities and Equity side, Deferred Revenue goes up by $100. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 7 (Selling Memberships)
–
94. Now let’s say 3 months passes. Walk me through the changes to Adobe’s three financial statements on March 31st. Assume Adobe didn’t incur any cost associated providing the service during the 3 months.
“On the Income Statement, Revenue increases by $25. Since there’s no cost, Pre-Tax Income increases by $25. Assuming a 20% tax rate, Net Income goes up by $20.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes up by $20. However, Changes in Deferred Revenue decreases cash flow by $25. Therefore, Cash Flow from Operations goes down by $5. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes down by $5.
On the Balance Sheet, on the Assets side, Cash goes down by $5. On the Liabilities and Equity side, Deferred Revenue goes down by $25 while Retained Earnings goes up by $20, and so Total Liabilities and Equity goes down by $5. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 7 (Selling Memberships)
–
95. On January 1st, Under Armour ordered $100 of raw materials from its suppliers and paid with cash on hand. It hasn’t sold any merchandises made from the $100 of raw materials yet. Walk me through the changes to Under Armour’s three financial statements.
“No changes to the Income Statement.
On the Cash Flow Statement, Changes in Inventory decreases cash flow by $100 and so Cash Flow from Operations decreases by $100. No Changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes down by $100.
On the Balance Sheet, on the Assets side, Cash goes down by $100 but Inventory goes up by $100. No changes to Liabilities and Equity. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 5 (Purchasing Supplies)
–
96. By June 30th, Under Armour had turned the raw materials it purchased from suppliers into sneakers that it sold for $300. Walk me through the changes to Under Armour’s three financial statements.
“On the Income Statement, Revenue goes up by $300 and Cost of Goods Sold goes up by $100, so Gross Profit goes up by $200. No other changes so Pre-Tax Income goes up by $200. Assuming a 20% tax rate, Net Income goes up by $160.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes up by $160. Changes in Inventory increases cash flow by $100. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Case goes up by $260.
On the Balance Sheet, on the Assets side, Cash goes up by $260 but Inventory goes down by $100, so Total Assets goes up by $160. On the Liabilities and Equity side, Retained Earnings goes up by $160 because of Net Income. And the Balance Sheet balances.”
–
97. On January 1st, WeWork decided to give an extra $100 worth of stock-based compensation to its CEO. Walk me through the changes to WeWork’s three financial statements.
“On the Income Statement, SG&A expense goes up by $100 because CEO compensation is a component of SG&A. Pre-Tax Income goes down by $100. Assuming a 20% tax rate, Net Income goes down by $80.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes down by $80. However, Stock-Based Compensation is a non-cash expense, so we need to add back the $100. Therefore, Cash Flow from Operations increases by $20. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes up by $20.
On the Balance Sheet, on the Assets side, Cash goes up by $20. On the Liabilities and Equity side, Common Stock and Additional Paid-In Capital goes up by $100. However, Retained Earnings goes down by $80. Therefore, Total Liabilities and Equity goes up by $20. And the Balance Sheet balances.”
–
98. On January 1st, Nike ordered $100 of raw materials from its suppliers on credit (didn’t pay yet). It hasn’t sold any merchandises made from the raw materials yet. Walk me through the changes to Nike’s three financial statements.
“No changes to the Income Statement.
On the Cash Flow Statement, Changes in Inventory decreases cash flow by $100 while Changes in Accounts Payable increases cash flow by $100. No changes to Cash Flow from Investing and Cash Flow from Financing. Overall, cash didn’t change.
On the Balance Sheet, on the Assets side, Inventory goes up by $100. On the Liabilities and Equity side, Accounts Payable goes up by $100. And the Balance Sheet balances.”
–
99. On March 31st, Nike made cash payment of $100 to its suppliers for the inventory it ordered on January 1st. It hasn’t sold any merchandises made from the raw materials yet. Walk me through the changes to Nike’s three financial statements.
“No changes to the Income Statement.
On the Cash Flow statement, Changes in Accounts Payable decreases cash flow by $100. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes down by $100.
On the Balance Sheet, on the Assets side, Cash goes down by $100. On the Liabilities and Equity side, Accounts Payable goes down by $100. And the Balance Sheet balances.”
–
100. A recent California wildfire has destroyed $100 worth of a liquor company’s wine inventory. Walk me through the changes to the company’s three financial statements.
“On the Income Statement, the company records a $100 Asset Impairment charge and Pre-Tax Income goes down by $100. Assuming a 20% tax rate, Net Income goes down by $80.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes down by $80. However, we need to add back the $100 of Asset Impairment charge because it’s a non-cash item. Therefore, Cash Flow from Operations increases by $20. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes up by $20.
On the Balance Sheet, on the Assets side, Cash goes up by $20. Inventory goes down by $100. Total Assets goes down by $80. On the Liabilities and Equity side, Retained Earnings goes down by $80. And the Balance Sheet balances.”
–
101. A company borrows $100 million of debt. Walk me through the impact to the three financial statements immediately after the transaction.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Proceeds from Debt Borrowing increases cash flow by $100 million. Net Change in Cash goes up by $100 million.
On the Balance Sheet, on the Assets side, Cash goes up by $100 million. On the Liabilities and Equity side, Debt goes up by $100 million. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 12 (Borrowing Debt)
–
102. A startup just raised $100 million from venture capital firms. Walk me through the impact to the three financial statements immediately after the transaction.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Proceeds from Stock Issuance increases cash flow by $100 million. Net Change in Cash goes up by $100 million.
On the Balance Sheet, on the Assets side, Cash goes up by $100 million. On the Liabilities and Equity side, Shareholder’s Equity goes up by $100 million. And the Balance Sheet balances.”
–
103. A company borrowed $120 million of debt and used the proceeds to pay for $100 million in dividends. The rest of the cash it kept in the bank. Walk me through the impact to the three financial statements.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Proceeds from Debt Borrowing increases cash flow by $120 million while Dividend Payments decreases cash flow by $100 million. Overall, Net Change in Cash goes up by $20 million.
On the Balance Sheet, on the Assets side, Cash goes up by $20 million. On the Liabilities and Equity side, Debt goes up by $120 million while Retained Earnings goes down by $100 million. Therefore, Total Liabilities and Equity goes up by $20 million. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 12 (Borrowing Debt)
Course 12, Lesson 16 (Paying Dividends)
–
104. A company spent $50 million on share repurchase and $100 million in dividends. Walk me through the impact to the three financial statements immediately after the transaction.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Share Repurchases decreases cash flow by $50 million while Dividend Payments decrease cash flow by $100 million. Overall, Net Change in Cash goes down by $150 million.
On the Balance Sheet, on the Assets side, Cash goes down by $150 million. On the Liabilities and Equity side, Treasury Stock goes down $50 million while Retained Earnings goes down $100 million. Therefore, Total Liabilities and Equity goes down by $150 million. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 15 (Repurchasing Shares)
Course 12, Lesson 16 (Paying Dividends)
–
105. Let’s say Royal Caribbean purchased a ship for $10 million. The ship is expected to last 10 years and the company will be able to recoup $1 million after scrapping it. What’re the Depreciation, CapEx, and PP&E numbers the Royal Caribbean company will record on the financial statements for the ship?
“Depreciation = $900K; CapEx = $10 million; PP&E = $10 million”
Online Finance Course References:
Course 5, Lesson 14 (Depreciation & Amortization)
–
106. Continuing with the previous question. Suppose the company sells the same ship for $5 million after 5 years. Walk me through the impact to the three financials statements.
“On the Income Statement, the company records a Loss on Sale of Asset of $500,000. Pre-Tax Income goes down by $500,000. Assuming a 20% tax rate, Net Income goes down by $400,000.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes down by $400,000. Then, we add back the $500,000 Loss on Sale of Asset because it’s a non-cash expense. Overall, Cash Flow from Operations increases by $100,000. Under Cash Flow from Investing, Proceeds from Sale of Asset goes up by $5 million. No changes to Cash Flow from Financing. Net Change in Cash goes up by $5.1 million.
On the Balance Sheet, on the Assets side, Cash goes up by $5.1 million. PP&E goes down by $5.5 million. Total Assets goes down by $400,000. On the Liabilities and Equity side, Retained Earnings goes down by $400,000. And the Balance Sheet balances.”
Online Finance Course References:
Course 12, Lesson 11 (Selling a Warehouse)
–
107. A company purchases a computer on January 1st for $1,000 expecting a 10-year useful life with no residual value. On December 31st of the first year, the computer breaks down and is not fixable. Walk me through the impact to the three financial statements.
“On the Income Statement, Depreciation expense goes up by $100. In addition, the company records an Asset Impairment expense of $900. Therefore, Pre-Tax Income goes down by $1,000. Assuming a 20% tax rate, Net Income goes down by $800.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income goes down by $800. However, we need to add back $100 of Depreciation and $900 of Asset Impairment because they are non-cash expenses. Therefore, Cash Flow from Operations goes up by $200. No Changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash goes up by $200.
On the Balance Sheet, on the Assets side, Cash goes up by $200. PP&E goes down by $1,000. Total Assets goes down by $800. On the Liabilities and Equity side, Retained Earnings goes down by $800. And the Balance Sheet balances.”
–
108. A company’s stock price increases by 20%. Walk me through the impact to the three financial statements.
“No immediate changes to the three financial statements.”
–
109. During the COVID-19 outbreak, the US government bailed out many businesses. How does a government bailout flow through the three financial statements?
The concept of a “bailout” is that the government gives money to businesses in exchange for something. You should clarify with the interviewer the terms of the bailout. Is the government bailing out the businesses in the form of an equity investment, a loan or conditional grants? Assuming it’s a loan, here’s what you can say.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Proceeds from Debt Borrowing increases cash flow.
On the Balance Sheet, cash increases on the Assets side and Debt increases on the Liabilities and Equity side.”
II. Enterprise Value & Equity Value
General Understanding
110. Explain to me the concept of Enterprise Value and who this value belongs to.
“Enterprise Value is the value of the core business operations. This value belongs to all investors in the company, both debt and equity.”
Online Finance Course References:
Course 3, Lessons 2-3 (Valuation; Enterprise Value vs. Equity Value)
Course 3, Lesson 12 (Enterprise Value)
–
111. Explain to me the concept of Equity Value and who this value belongs to.
“Equity Value is the value of the company leftover to equity investors after repaying debt. This value belongs only to the equity investors.”
Note that Equity Value = Market Capitalization (for public companies).
Online Finance Course References:
Course 3, Lessons 2-3 (Valuation; Enterprise Value vs. Equity Value)
Course 3, Lesson 5 (Market Capitalization)
–
112. Why do we need to know the Enterprise Value and Equity Value of a company? Why are they important?
“We need to know the Enterprise Value and Equity Value because they measure what a company is worth. Financial analysts need to know how much a company is worth to decide whether to invest.”
Online Finance Course References:
Course 3, Lessons 2-3 (Valuation; Enterprise Value vs. Equity Value)
–
113. How do you calculate Enterprise Value?
“Enterprise Value = Equity Value + Debt – Cash.”
Online Finance Course References:
Course 3, Lessons 2-3 (Valuation; Enterprise Value vs. Equity Value)
Course 3, Lesson 12 (Enterprise Value)
–
114. Do you calculate Enterprise Value using market value or book value of the different items in the formula you just laid out?
“Usually, you use the market value for equity and the book value of debt and cash.”
Online Finance Course References:
Course 3, Lessons 2-3 (Valuation; Enterprise Value vs. Equity Value)
Course 3, Lesson 12 (Enterprise Value)
Course 3, Lesson 13 (Debt)
Course 3, Lesson 14 (Cash & Cash Equivalents)
–
115. Where do you get the cash and debt numbers from?
“You get the cash and debt numbers from the company’s Balance Sheet.”
Online Finance Course References:
Course 3, Lesson 13 (Debt)
Course 3, Lesson 14 (Cash & Cash Equivalents)
–
116. How do you calculate Equity Value?
“Method 1: Equity Value = Enterprise Value + Cash – Debt
Method 2: Stock Price x Shares Outstanding”
Online Finance Course References:
Course 3, Lessons 2-3 (Valuation; Enterprise Value vs. Equity Value)
Course 3, Lesson 5 (Market Capitalization)
–
117. Walk me from Stock Price to Enterprise Value.
“Starting with the Stock Price, we multiply Shares Outstanding to get Equity Value (also known as Market Capitalization). Then we add Debt and subtract Cash to calculate Enterprise Value.”
Online Finance Course References:
Course 3, Lessons 2-4 (Enterprise Value / Equity Value)
–
118. Are there other items that can go into the Equity Value/Enterprise Value formula? / Is there a more wholesome Enterprise Value formula?
“Yes, some other items that can go into Equity Value/Enterprise Value formula are Marketable Securities, NPV of Tax Shield, Equity Investments, Unfunded Pension, Preferred Stock, and Non-Controlling Interest.”
In general, we only need to add Debt and subtract Cash from Equity Value. Therefore, you can just say that formula by default in interviews. However, that’s a simplified formula and some companies have a lot more complexities. For these companies, the formula might need to take into account a whole bunch of other items. Here’s how you can treat these items.
- Marketable Securities: Companies can easily liquidate them into cash. You should treat this like you would Cash.
- NPV of Tax Shield: This is the value of potential tax savings, which would save the company cash. You should treat this like you would Cash.
- Equity Investments: This is the value of investment in other companies. You should treat this like you would Cash.
- Preferred Stock: For public companies, Preferred Stock is basically a debt tranche with a fixed dividend payment. You should treat this like you would Debt.
- Unfunded Pension: This is a company-sponsored retirement plan that has more liabilities than assets. You should treat this like you would Debt.
- Non-Controlling Interest: This is a portion of the value in the consolidated company that belong to other equity investors. You should treat this like you would Debt.
With that, a more extended Enterprise Value / Equity Value formula becomes as follows.
Enterprise Value = Equity Value + Debt + Preferred Stock + Unfunded Pension + Non-Controlling Interest – Cash – Marketable Securities – NPV of Tax Shield – Equity Investments.
–
119. What is Fully-Diluted Shares Outstanding (FDSO)?
“Fully-Diluted Shares Outstanding is the number of shares a company has after dilution.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
120. What’s the difference between Basic Shares Outstanding and Fully-Diluted Shares Outstanding?
“Basic Shares Outstanding is the number of shares a company has before dilution. It’s the company’s share count right now.
Fully-Diluted Shares Outstanding is the number of shares a company after dilution. It’s what the company’s share count will be after dilution occurs.
Fully-Diluted Shares Outstanding = Basic Shares Outstanding + Dilution.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
121. Should we calculate Equity Value using Basic Shares Outstanding or Fully-Diluted Shares Outstanding?
“We should calculate Equity Value using Fully-Diluted Shares Outstanding.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
122. What are some dilutive securities you need to take into account when calculating FDSO?
“The common dilutive securities are Stock Options, Restricted Stock Units, and Performance Stock Units. Some companies may also have Convertible Debt that entitles the holders to convert from debt into shares. That would naturally increase the number of shares outstanding.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
123. What is the Treasury Stock Method?
“Treasury Stock Method (TSM) is a method we use to calculate dilution from stock options.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
124. Where do you find the information on the dilutive securities you need to calculate FDSO?
“You can find this information in the 10-K and the 10-Q. Most public companies disclose details of their dilutive securities in these filings.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
125. A company has 1,000 shares outstanding trading at $10 per share. It has 100 Restricted Stock Units with a Weighted Average Fair Value per Share of $75 per RSU. It has $3,000 in Cash and $5,000 in Debt. What is the Fully-Diluted Shares Outstanding? What is the Equity Value? What is the Enterprise Value?
“FDSO = 1,100; Equity Value = $11,000; Enterprise Value = $13,000.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
126. A company has 1,000 shares outstanding trading at $20 per share. It has 100 Performance Stock Units with a Weighted Average Fair Value per Share of $55 per PSU. It has no cash or debt. What is the Fully-Diluted Shares Outstanding? What is the Equity Value? What is the Enterprise Value?
“FDSO = 1,100; Equity Value = $22,000; Enterprise Value = $22,000.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
127. A company has 1,000 shares outstanding trading at $80 per share. It has 200 Stock Options Outstanding with an exercise price of $50. It has no cash and $7,000 in debt. What is the Fully-Diluted Shares Outstanding? What is the Equity Value? What is the Enterprise Value?
“FDSO = 1,075; Equity Value = $86,000; Enterprise Value = $93,000.”
Online Finance Course References:
Course 3, Lessons 6-11 (Shares Outstanding; Dilutive Securities)
–
128. How are Preferred Stocks treated in the Equity Value / Enterprise Value calculations?
“Preferred Stocks are treated like Debt in the Equity Value / Enterprise Value calculations. Enterprise Value = Equity Value + Debt + Preferred Stock – Cash.”
–
129. Do we use the Non-Controlling Interest on a book value basis or a market value basis?
“Usually, we use Non-Controlling Interest on a book value basis. That’s because the value of the subsidiary the parent company owns usually isn’t publicly observable in the market. However, there are some instances where the subsidiary is a publicly-traded company and its value is observable. In these situations, we should use the Non-Controlling Interest on a market value basis.”
–
130. Can Enterprise Value be negative?
“Yes, Enterprise Value can be negative.”
Online Finance Course References:
Course 3, Lesson 18 (Can EV be Negative?)
–
131. Can Equity Value be negative?
“For publicly-traded companies, Equity Value cannot be negative. Equity Value equals Stock Price times Shares Outstanding. Stock Price can’t be negative and Shares Outstanding can’t be negative. Since neither can be negative, Equity Value can’t be negative.”
In reality, things are a bit more complicated. See Online Finance Course lesson below for further information. For purpose of the interview, the above answer is good enough.
Online Finance Course References:
Course 3, Lesson 18 (Can EV be Negative?)
132. Can Shareholder’s Equity (on the Balance Sheet) ever be greater than Equity Value?
“Yes, Shareholder’s Equity can be greater than Equity Value. In such a case, you’ll see companies have Price / Book less than 1.0x. This is known as ‘trading below book value’. There are many businesses that trade below their book value in the stock market.”
–
133. Would you ever pair Enterprise Value with EBITDA?
“Yes. In fact, you always pair Enterprise Value with EBITDA.”
–
134. Would you ever calculate a multiple using Enterprise Value and Net Income?
“No, you should not pair Enterprise Value with Net Income because that would be comparing apples to oranges. Enterprise Value represents value to both debt and equity holders. On the other hand, Net Income represents profit that the company earned solely for equity holders. The two metrics are not on the same basis. Therefore, you should not pair Enterprise Value with Net Income.”
–
135. You and a friend founded a startup and have equal ownership. The company does really well and goes public via an IPO selling 30% of the equity. What is your ownership after the IPO?
“My ownership is 35% after the IPO.”
Impact to Enterprise Value & Equity Value
136. A company uses $100 of cash to pay dividends. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value is unchanged. Equity Value decreases by $100.”
Online Finance Course References:
Course 3, Lesson 17 (Impact to Enterprise Value and Equity Value)
–
137. A company uses $100 of cash to repurchase shares. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value is unchanged. Equity Value decreases by $100.”
Online Finance Course References:
Course 3, Lesson 17 (Impact to Enterprise Value and Equity Value)
–
138. A company uses $100 of cash to buy US Treasuries. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value is unchanged. Equity Value is unchanged.”
Online Finance Course References:
Course 3, Lesson 17 (Impact to Enterprise Value and Equity Value)
–
139. A company divests $100 of US Treasuries for cash. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value is unchanged. Equity Value is unchanged.”
Online Finance Course References:
Course 3, Lesson 17 (Impact to Enterprise Value and Equity Value)
–
140. A company uses $100 of cash to buy another company on a cash-free, debt-free basis. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value increases by $100. Equity Value is unchanged.”
–
141. A company discovers $100 of hidden cash. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value is unchanged. Equity Value increases by $100.”
–
142. A startup raises $100 from venture capital firms. Walk me through the impact to Enterprise Value and Equity Value.
“Enterprise Value is unchanged. Equity Value increases by $100.”
–
143. A company has $20 million of cash, 1 million of shares. The company doesn’t have anything else. In a perfectly efficient market, what is the company’s stock price?
“In a perfectly efficient market, the company’s stock price is $20 per share.”
–
144. Continuing with the previous question, suppose the same company finds an extra $20 million of cash on the street. What happens to its stock price?
“Its stock price will become $40.”
–
145. Continuing with the previous question, suppose the company uses $30 million of its cash to repurchase shares at $50 per share. What would be the stock price after the share repurchase?
“The stock price after the share repurchase is $25.”
Prior to the share repurchase, the company had $40 million of cash and 10 million shares outstanding. There’s nothing else in the company so the stock price is $40 per share. Then the company spent $30 million to repurchase shares at $50 per share. Based on these numbers, the company can repurchase 600,000 shares. Therefore, the company has $10 million of cash and 400,000 shares left after the repurchase. Dividing the $10 million of cash by 400,000 shares equals $25 per share.
146. Continuing with the previous question. Was the share repurchase value accretive?
“No, the share repurchase was value destructive. Management repurchased the shares at a price above intrinsic value.”
–
147. Suppose a company’s stock price is really depressed. What are some things the company can do within a few days to boost the stock price?
“There are a few options.
First, company management and board can buy the company’s shares on the stock market. That executives are willing to use their own money to buy shares sends a very powerful signal to the market. It signals that the executives believe their company is undervalued. Investors will likely follow and stock price will increase.
Second, the company can release positive news if it has any. Positive news will increase the stock price.
Third, the company can repurchase shares on the stock market. Share repurchase can drive up the stock price.”
Valuation Methodologies
148. What are the different valuation methodologies to value a company?
“The most common valuation methodologies are Public Comparables (‘Public Comps’), Precedent Transactions (‘Precedents’), Discounted Cash Flow (‘DCF’), and Leveraged Buyout (‘LBO’).”
There are other ways to value a company as well. These are just the most common ones.
–
149. Which methodology will give you the highest valuation?
“There isn’t one methodology that will always give us the highest valuation. If we use very optimistic projections, the DCF can give us the highest valuation. If we’re in an extremely optimistic and overvalued stock market environment (i.e. 2021), public comps might give the highest valuation. And if we choose precedent deals with very high prices, Precedent Transactions might give us the highest valuation. Therefore, there’s no one single method that will always give us the highest valuation.”
Some people say that Precedent Transactions gives the highest valuation because it includes a control premium. That may sound good in theory. In practice, however, this is simply not the case. Analysts would frequently come across situations where Public Comps or DCF give higher valuations. There are just too many variables, such as the market conditions, the selection of comps, etc.
–
150. Which methodology will give you the lowest valuation?
“The LBO model will usually give the lowest valuation. We usually use LBO model to establish a ‘floor valuation’.”
–
151. Is dividend yield a good way to value a company?
“No, dividend yield is not a good way to value a company. Just because one company has a certain dividend yield does not indicate in any way that another company should trade at a valuation that results in the same dividend yield.”
–
152. What is a football field in the context of valuation?
“A football field is a chart that shows the valuation ranges from the different methodologies side-by-side.”
It looks like this.
–
153. How would you value an apple tree?
“There are a few ways I can value the apple tree.
One way is to value it by looking at what other apple trees are worth. I can look at how much other apple trees were sold for. Each tree would have different numbers of apples. Therefore, I would look at Purchase Price per Apple. Applying this number to the number of apples on our tree, I can determine the value of the apple tree.
Alternatively, I can value it based on how much cash flow the apple tree can generate. I would begin by determining how many apples the tree has. Then, I would find out the market price for an apple. Multiplying these two numbers together gives me the Revenue from selling the apples from the apple tree. From here, I would subtract the cost to harvest the apples, transport the apples to the market. I would also subtract any expenditures I have to make to maintain the tree. That would give me the tree’s Unlevered Free Cash Flow. I can project out this Unlevered Free Cash Flow and discount it back to the present. That will give me the intrinsic value of the apple tree.”
III. Valuation Multiples
General Understanding
154. What are the common multiples you would use in valuation?
“The most common multiples are EV/Revenue, EV/EBIT, EV/EBITDA, and P/E.”
“EV” in this guide is always short for Enterprise Value. It does not mean Equity Value. In fact, it is industry convention for “EV” to mean Enterprise Value, even though Equity Value has the exact same initials.
Online Finance Course References:
Course 13, Lesson 2 (Common Valuation Multiples)
–
155. What are some [technology] industry-specific multiples?
“Some technology -specific multiples are EV/DAU, EV/Website Traffic, EV/GMV, and EV/Subscribers.”
DAU stands for Daily Active Users. GMV stands for Gross Merchandise Value.
If you’re interviewing for a specific industry group, replace [technology] with the name of industry you’re interviewing for.
–
156. When you use an industry-specific KPI, such as Number of Stores or Monthly Active Users (MAU), as the denominator, should you use Enterprise Value or Equity Value as the numerator?
“We should use Enterprise Value because business KPIs relate to the business operations. Enterprise Value captures the value of the business operations.”
Another way you can look at this is that these KPIs help the business generate Revenue, which is entitled by both debt and equity investors.
–
157. What’s the difference between forward multiples and trailing multiples?
“Forward multiples are valuation multiples based on the company’s future performance. By contrast, trailing multiples are valuation multiples based on company’s past performance.”
Online Finance Course References:
Course 13, Lesson 6 (Forward Multiples)
Course 13, Lesson 7 (Trailing Multiples)
–
158. For a company with growing sales, which would be larger: forward or trailing EV / Revenue?
“For a growing company with growing sales, trailing EV/Revenue would be larger.”
Online Finance Course References:
Course 13, Lesson 6 (Forward Multiples)
Course 13, Lesson 7 (Trailing Multiples)
–
159. If Revenue grows by 10% and Enterprise Value stays the same, how would EV/Revenue change?
“It would decline by 9%.”
You can test this with sample numbers.
–
160. How do you calculate how the “street” is valuing a company on a multiple basis?
“I would divide the company’s current valuation by the median of equity research analysts’ estimates. The median of equity research analysts’ estimates is known as the ‘consensus’. By dividing the company’s current valuation by the consensus, I can figure out how the street is valuing the company.”
Online Finance Course References:
Course 3, Lesson 21 (Consensus)
–
161. Are forward consensus multiples based on adjusted or unadjusted earnings (i.e. EBITDA vs. Adjusted EBITDA)?
“Forward consensus multiples are usually based on adjusted earnings. That’s because equity research analysts usually project EBITDA and EPS on an adjusted basis, normalized for extraordinary items.”
–
162. In what circumstances would you use EV/Revenue over EV/EBITDA?
“First, I would use EV/Revenue if the company has negative EBITDA. This is also the case if the EBITDA is so small that it results in an unmeaningfully high EV/EBITDA (i.e. 2,000x). Second, I would use EV/Revenue if the stock price is more reactive to this company’s revenue growth than profitability.”
Online Finance Course References:
Course 3, Lesson 20 (Non-Meaningful Multiples)
–
163. In what circumstances would you use EV/EBITDA over P/E?
“First, I would use EV/EBITDA instead of P/E if the company has negative Net Income or EPS. Second, I would use EV/EBITDA if the companies have very different capital structures. I would also use EV/EBITDA in M&A situations because the deal will likely alter the capital structure.”
–
164. In what circumstances would you use P/E over EV/EBITDA?
“I would use P/E over EV/EBITDA if the company is very capital intensive. This way we can take D&A into account. Another situation I would use P/E is if peers have wildly different EV/EBITDA but very similar P/E.”
The preceding questions asked how you would decide which multiple to use. These questions imply that bankers are very scientific and thoughtful in the choice of valuation multiples. In practice, investment bankers give little thoughts to this. They’ll show as many multiples as they can: EV/Revenue, EV/EBITDA, P/E multiple. You can see this in our Investment Banking Presentations. However, you can’t say that in an interview.
–
165. Let’s say we’re looking at a typical profitable company. Rank the following multiples from highest to lowest: EV/EBITDA, EV/Revenue, P/E, EV/EBIT.
“P/E, EV/EBIT, EV/EBITDA, EV/Revenue.”
Revenue is larger than EBITDA. Therefore, given the same Enterprise Value, EV/EBITDA must be numerically higher than EV/Revenue. And EBITDA is larger than EBIT. Given the same Enterprise Value, EV/EBIT must be greater than EV/EBITDA. P/E has a different numerator. However, P/E is generally higher than EV/EBIT and EV/EBITDA. Therefore, the ranking of the multiples from highest to lowest is P/E, EV/EBIT, EV/EBITDA, EV/Revenue.
–
166. Can EV/EBITDA be lower than EV/EBIT? Why or why not?
“Yes, EV/EBITDA can be lower than EV/EBIT. In fact, EV/EBITDA is always lower than EV/EBIT.”
EBITDA = EBIT + D&A. Therefore, EBITDA is greater than EBIT. Consequently, given the same Enterprise Value, EV/EBITDA must be lower than EV/EBIT.
–
167. Would you use Enterprise Value or Equity Value for free cash flow multiples?
“I would use Enterprise Value for Unlevered Free Cash Flow multiples. I would use Equity Value for Levered Free Cash Flow multiples.”
This is a trick question. The truth is, you can use both values for free cash flow multiples. You just need to pair them with the appropriate free cash flow metric (UFCF vs. LFCF). The important thing the interviewer is looking for is that you pair metrics on an apples-to-apples basis.
Just like how you should know “EBITDA multiple” is EV/EBITDA, you should know “UFCF multiple” is EV/UFCF. You would never pair Equity Value with UFCF because you’d be pairing apples with oranges.
Online Finance Course References:
Course 13, Lesson 5 (Consistency)
–
168. Why do you think EV/EBITDA is more commonly used relative to EV/EBIT or EV/Sales?
“I think both EV/EBITDA and EV/EBIT are better than EV/Sales because they measure company’s value relative to profits. Two companies could have the same Revenue but wildly different profits. Between EV/EBITDA and EV/EBIT, EBITDA is a closer proxy for cash flow because it adds back non-cash items. Ultimately, the value of a business is driven by its ability to generate cash flow. That’s why I think EV/EBITDA is more commonly used.”
This is what you can say in finance interviews but you shouldn’t believe in it. It’s not the real reason why people use EV/EBITDA on Wall Street. The real answer is something that doesn’t sound as pretty and scientific as this interview answer. Therefore, for the purpose of the interview, you can just go with the above.
–
169. Should you use these multiples on a forward or on a trailing basis?
“It depends on what we’re using the multiples for. In valuation, we should use forward multiples. This way, we can take growth into account. In debt financing, we should use trailing multiples. That’s because lenders care more about companies’ trailing earnings.”
–
170. For forward multiples, how far forward do we go? And for trailing multiples, how far back do we go?
“For forward multiples, we usually look twelve months ahead, also known as NTM (Next Twelve Months). For trailing multiples, we look twelve months behind, also known as LTM (Last Twelve Months).”
Online Finance Course References:
Course 13, Lessons 8-9 (Years Forward)
–
171. Let’s say we’re looking at a startup company that doesn’t have any sales. Therefore, it also has negative EBITDA and negative Net Income. What multiples would you use to value the company?
“I would try to value the company in three ways. First, I would see if the company would generate sales next year or the year after. A business might not have sales right now, but it will presumably eventually generate sales. I can apply a forward multiple to these future earnings. Second, I would value it on a cost basis. The idea is to estimate its worth based on how much it costs to build this business. Third, I would value it using KPI metrics that eventually lead to sales. For example, if it’s a website, I can value it using EV / Website Traffic. If it’s an email newsletter, I can try to use EV/Email Recipients. These are some ways I would value a startup.”
Online Finance Course References:
Course 13, Lesson 4 (When to Use Certain Multiples)
–
172. There are some stock platforms that show metrics such as Equity Value/Revenue. Is this a meaningful number? Why or why not?
“No, it’s not a meaningful number because it’s pairing value entitled solely by equity holders with an income metric entitled by both debt and equity holders.”
Remember, you should always pair the numerator and denominator on an apples-to-apples and oranges-to-oranges basis.
Online Finance Course References:
Course 13, Lesson 5 (Consistency)
–
173. A company is trading at EV/Revenue of 4x and an EV/EBITDA of 20x. What is the company’s EBITDA margin?
“The EBITDA Margin is 20%.”
It’s just the 4x divided by 20x, which yields 20%. Here’s something interesting. The larger the difference between EV/Revenue and EV/EBITDA, the less profitable the business and the lower the EBITDA margin. The smaller the difference between EV/Revenue and EV/EBITDA, the more profitable the business and the higher the EBITDA margin.
–
174. Is 70x 1-year forward EV/EBITDA undervalued or overvalued?
“It depends. 70x 1-year forward EV/EBITDA might be undervalued for a high growth startup business with a world-changing product. On the other hand, 70x might be overvalued for a hotdog restaurant chain losing significant market share. We need to know what type of business it is and how peers are valued.”
Impact to Multiples
175. A company decides to borrow debt. How will this affect its EV/EBITDA multiple?
“The impact is indeterminate. On the one hand, increasing debt could optimize the cost of capital and lead to a higher Enterprise Value. On the other hand, borrowing debt adds restrictive covenants, which could limit the business’s pursuit of growth. It also depends on what the company will use the debt for. I think if management uses debt in value-creative ways, the stock market will react very positively. This can increase the EV/EBITDA multiple. By contrast, if management uses debt is value-destructive ways, the stock price will go down. This will decrease the EV/EBITDA multiple. And so it really depends.”;
–
176. A company decides to borrow debt. How will this affect its P/E multiple?
“The impact is indeterminate. There are factors pulling P/E multiple up and factors pulling P/E multiple down.”
Please see our article on this topic here for a detailed write-up.
–
177. Company A and Company B are in the exact same industry and exact same country. They sell the same products and have the same Revenue and EBITDA. And yet, Company A is trading at 15x EV/EBITDA while Company B is trading at 10X EV/EBITDA. What can cause this to happen?
“While Company A and B have the same Revenue and EBITDA, they might have different growth prospects going forwards. They might also have different capital structure.”
Online Finance Course References:
Course 13, Lessons 14-19 (Drivers of Valuation Multiples)
–
178. Company C is an EXACT duplicate of Company D. Everything about these two companies are exactly the same. Company C was acquired for 11X EV/EBITDA while Company D was acquired for 12x EV/EBITDA. What can cause this to happen?
“There are many reasons that cause this. First, Company C and Company D might be acquired at different times under different stock market conditions. Second, the acquirer for Company D might be larger and more deep-pocketed than Company C. Third, the CEO of Company D might be a better negotiator than the CEO of Company C. Fourth, it could be due to natural market inefficiency. Two buyers valuing the exact same business could naturally arrive at different valuations.”
Online Finance Course References:
Course 13, Lessons 14-19 (Drivers of Valuation Multiples)
–
179. Company Z and Company E are direct competitors in the same industry. Company Z is bigger and is growing faster than Company E. Company Z is trading at 3x EV/Revenue while Company E is trading at 5x EV/Revenue. What can cause this to happen?
“While Company Z is bigger and growing faster, Company E is trading at a higher EV/Revenue multiple. This can happen if Company E is more profitable than Company Z. This can also happen if Company Z grows Revenue through one-time sales while Company E grows Revenue through recurring sales. If Company E is larger than Company Z, it could also trade at a higher multiple just because of size advantage.”
Online Finance Course References:
Course 13, Lessons 14-19 (Drivers of Valuation Multiples)
–
180. Company F and Company G sells the exact same products, but operate in two different countries. Company F trades at a much higher multiple than Company G. Why does the location of country affect valuation multiples?
“Different countries have different geopolitical and macroeconomic profiles. This means different countries have different levels of risks. A country facing ongoing civil wars or disputes with neighbors is riskier than a peaceful country with stable government. So that’s one reason why country location affects valuation multiples. Another reason could be due to tax rates. One country might have much higher tax rates than the other.”
Online Finance Course References:
Course 13, Lessons 14-19 (Drivers of Valuation Multiples)
–
181. Company H is a supermarket chain. Company H recently discovered and took possession of an authentic Leonard DaVinci painting inside the supermarket. How does this affect Company H’s EV/EBITDA multiple? How does this affect Company H’s P/E multiple?
“EV/EBITDA is unchanged. P/E multiple should increase.”
–
182. Company I is an operator of diamond mines. It recently announced that it discovered a new large trove of diamonds in one of its mines. How does this affect Company I’s EV/EBITDA multiple? How does this affect Company I’s P/E multiple?
“Both EV/EBITDA and P/E multiple should increase”.
–
183. Company J and Company K are in the exact same business and are direct competitors to one another. Company J has a 30% EBITDA margin while Company K has a 40% EBITDA margin. Which one would you be willing to pay a higher multiple for?
An interviewer at Warburg Pincus Private Equity asked this question to one of our clients.
The obvious answer here might be that you’d pay a higher multiple for Company K because it has higher margin. That’s technically correct and some interviewers will accept this answer.
Other interviewers, such as the one at Warburg, wants a more wholesome answer. At issue here is that the two companies could have different EBITDA margins for good reasons. The 30% EBITDA margin might have less profits because it’s investing more into future growth, such as R&D. Therefore, we recommend you to ask for more information about the two businesses before giving your answer.
–
184. Company L is in a country with high interest rate and Company M is in a country with low interest rate. All else equal, which company has a lower P/E?
“All else equal, Company L will have a lower P/E.”
The higher the interest rate, the lower stocks’ valuation multiples. The lower the interest rate, the higher stocks’ valuation multiples.
–
185. The Federal Reserve just announced that they will increase the interest rate. How does this affect companies’ EV/EBITDA multiples? How does this affect companies’ P/E multiples?
“If the Federal Reserve increases the interest rate, this will compress both EV/EBITDA and P/E multiples.”
Remember this concept. Increasing interest rate decreases valuation multiples. Decreasing interest rate increases valuation multiples.
–
186. What do you think [airline] stocks are trading at right now on a 1-year forward EV / EBITDA basis?
Valuation multiples change every day so we won’t write an answer for this. This question is more relevant for candidates interviewing for post-IBD buyside roles than for IBD SA and FT candidates. Swap out [airline] for whatever sectors that might be more relevant.
Public Comps and Precedent Transactions
187. What is Public Comparables analysis?
“Public Comparables analysis is a valuation methodology. It estimates what a company is worth based on how similar companies are trading in the stock market.”
Trading Comps = Public Comps = Company Comps.
–
188. What is Precedent Transactions analysis?
“Precedent Transactions analysis is a valuation methodology. It estimates what a company is worth based on what acquirers paid in similar M&A transactions.”
Precedent Transactions = Precedent Comps.
–
189. Information for Trading Comps is easily observable in the stock market. Where do you find the information for Precedent Transactions?
“Investment bankers have proprietary database with extensive precedent transactions. Therefore, one place we can find precedent transactions is by contacting the M&A bankers. We can also find precedent transactions from commercial databases, such as Mergermarket.”
–
190. How should you select the companies to include in your Public Comps and Precedent Transactions?
“We should select comparable companies that are similar to the one we’re trying to value. First, I would narrow the universe of comparable companies down to ones in the same line of business. Then, I would choose those that operate in the same country and are similar in size.”
In general, you select peers based on comparability of business, geography and size. You can measure size by Market Cap or by Revenue.
–
191. Between Public Comps and Precedent Transactions, which methodology would usually give you a higher valuation and why?
“It depends. Either methodology can give you the higher valuation depending on the selection of comps and the time period.”
Some people say that Precedent Transactions would usually give you a higher valuation because it includes control premium. While Precedent Transactions theoretically includes a control premium, this premium is usually 20-30%. Stocks can easily surpass this in a bull market. Furthermore, there’s always a time lag. Public Comps measure how the market is valuing stocks right now. By contrast, Precedent Transactions are past M&A transactions. The stock market’s valuation can change significantly during that time lag. In fact, in many investment banking pitch decks, you can see that Public Comps yield a higher valuation than Precedent Transactions.
–
192. What are some advantages and disadvantages of Public Comps and Precedent Transactions?
“An advantage of these two analyses is that we can see how our company compares against peers. It’s also very flexible, so bankers can alter peer sets to arrive at the valuation that best serve them. This flexibility can also be a disadvantage. Stock market is volatile so the multiples will fluctuate. Another big disadvantage is that the two methodologies promote group-think. They value our company based on how investors value similar peers. As a result, if investors undervalue peers, they’ll also undervalue our company.”
–
193. Can you use Trading Comps and Precedent Transactions to value a public company? What about a private company?
“Yes, we can use Public Comps and Precedent Transactions to value both public companies and private companies.”
–
194. Which valuation methodology do you think is the most important in an IPO?
“Public Comps is the most important valuation methodology in an IPO.”
The company going public is not being acquired. Therefore, you wouldn’t use Precedent Transactions or LBO analysis. IPO doesn’t involve very heavy financial modeling. Bankers usually just rely on Public Comps to set the valuation.
–
195. Let’s say you’re an investment banking summer analyst working on a deal. How would you visually present these valuation multiples to the client?
“There are four ways I can present these valuation multiples to the client. First, I can show Public Comparables and Precedent Transactions in a table. Second, I can show these multiples in a bar chart. Third, I can show Public Comparables as a line chart, showing how the multiples evolve over time. And lastly, I can show the results from the two analyses in a football field chart.”
IV. Discounted Cash Flow (DCF)
General Understanding
196. Can you walk me through a DCF model?
“Our first step in the DCF is to determine the discount rate, which is usually WACC. We weigh the After-Tax Cost of Debt and Cost of Equity by their respective percentage of capital structure.
Second, we project out Unlevered Free Cash Flow for a period of time, usually 5 to 7 years. To calculate Unlevered Free Cash Flow, we start by tax-effecting EBIT to arrive at NOPAT. Then we add back D&A, adjust for Changes in Working Capital and subtract CapEx.
Next, we need to calculate the company’s terminal value beyond our projected period. We can use either the Perpetuity Growth Method or the Terminal Multiple Method.
Lastly, we can discount these future Unlevered Free Cash Flow and Terminal Value back to the present using WACC. This will tell us the company’s intrinsic Enterprise Value.”
Online Finance Course References:
Course 8, Lesson 3 (Discounted Cash Flow)
–
197. Do you usually build DCF models on an unlevered or a levered basis?
“We usually build DCF models on an unlevered basis, using WACC and Unlevered Free Cash Flow.”
–
198. How would your DCF model change if you were to switch from an unlevered basis to a levered basis?
“First, instead of calculating WACC as our discount rate, we should only use Cost of Equity. Second, instead of calculating Unlevered Free Cash Flow, we should calculate Levered Free Cash Flow. And third, instead of arriving at intrinsic Enterprise Value, we’ll arrive at intrinsic Equity Value.”
–
199. Does it make sense to do a DCF on a mature company?
“Yes, it makes sense to do a DCF on a mature company because it reached steady state. Its cash flows are stable and predictable.”
–
200. How about a startup?
“Startups are fast-growing and fast-changing. A startup can look vastly different in 5 years, which makes it very difficult to forecast the financials. Therefore, it does not make sense to do a DCF on a startup.”
–
201. What are some flaws of the DCF analysis?
“There are several flaws of the DCF analysis. First, it’s entirely dependent on assumption inputs. These inputs, such as growth, margins, and CapEx, are very subjective. As a result, different analysts will almost certainly arrive at different valuations from the DCF.
Second, the DCF discount rate changes over time. The “intrinsic value” could be very different depending on the day or month you conduct the analysis. For example, US Treasury Yield changes daily. Equity Risk Premium, Beta and Cost of Debt also change over time. Different discount rates would yield different present values of future cash flow.”
–
202. What are some situations in which you would not use a DCF analysis?
“We shouldn’t use DCF if the company is fast changing and difficult to forecast. We shouldn’t use DCF if we’re selling the company from one private equity firm to another. In that scenario, an LBO model would be better. And we shouldn’t use DCF for certain types of businesses, such as banks.”
–
203. What would you sensitize in a DCF analysis?
“I would sensitize WACC and Terminal Value drivers, such as Perpetuity Growth Rate and Terminal Multiple. I would also sensitize operating metrics, such as Revenue Growth and EBITDA Margin.”
–
204. Walk me through the circular reference in a DCF analysis.
“The circular reference in the DCF is embedded in the end where we calculate intrinsic value. The Intrinsic Value per Share is dependent on the Fully-Diluted Shares Outstanding. To calculate Fully-Diluted Shares Outstanding, we have to calculate dilution from options. However, dilution from options is dependent on Intrinsic Value per Share. This creates a circular logic in the DCF.”
Online Finance Course References:
Course 8, Lesson 25 (DCF Circular Reference)
–
205. Walk me through all the different places where taxes affect the DCF analysis.
“Taxes affect the DCF analysis in two areas. First, it affects the Cost of Debt. There’s a tax shield on debt, so we use the After-Tax Cost of Debt to calculate WACC. Second, it affects Unlevered Free Cash Flow. We need to tax-effect EBIT. Therefore, changes in taxes affect NOPAT and Unlevered Free Cash Flow.“
Cash Flow Projections
206. How many years do you usually project financials in a DCF model?
“We usually project financials for a period of 5 to 7 years.”
–
207. Why that many years?
“Technically, there’s no restriction on the number of years we forecast. However, we want to forecast the cash flow until the company reaches a steady state. 5-7 years is enough time period for many companies to reach steady state.”
This is the “reason” that sounds good and grounded in academic finance. The true reason is two-folds. First, investment bankers use management forecasts or equity research reports for their forecasts. Their models are usually 5-7 years. Second, less than 5 is too short to be meaningful and more than 7 is too uncertain to forecast.
–
208. How does $10 increase in Revenue affect UFCF?
“Assuming a 20% tax rate, $10 increase in Revenue increases UFCF by $8.”
–
209. Explain to me the difference between Mid-Year Convention and End-of-Year Convention.
“Mid-Year Convention assumes that the company receives the cash flow evenly throughout the year. End-of-Year Convention assumes that the company receives the cash flow at the end of the year.”
Online Finance Course References:
Course 8, Lessons 16-17 (Discount Period)
–
210. Should we use Mid-Year Convention or End-of-Year Convention in a DCF?
“For the projected Unlevered Free Cash Flow, we should discount using Mid-Year Convention.
For the Terminal Value, it depends. If we use the Perpetuity Growth Method, we should discount using the Mid-Year Convention. However, if we use the Terminal Multiple Method, then we should discount using the End-of-Year Convention.”
Online Finance Course References:
Course 8, Lessons 16-17 (Discount Period)
Course 8, Lessons 23-24 (Present Value of Terminal Value)
–
211. Let’s say we’re building the DCF model to value a company as of March 31, 2022. Year 1 ends on December 31, 2022 and Year 2 ends on December 31, 2023. Using the Mid-Year Convention, what is the discount period for Year 1 & Year 2?
“The discount period for Year 1 is 0.375. The discount period for Year 2 is 1.25.”
Online Finance Course References:
Course 8, Lessons 16-18 (Discount Period)
Terminal Value
212. Explain to me the concept of Terminal Value.
“Terminal Value is the value of the business at the end of our UFCF forecast period.”
For example, if you forecast 5 years of UFCF, the Terminal Value is what the business is worth on the last day of Year 5.
Online Finance Course References:
Course 8, Lesson 20 (Terminal Value)
–
213. Walk me through the different ways you can calculate Terminal Value.
“We can calculate Terminal Value in two ways. First, we can calculate Terminal Value using the Perpetuity Growth Method. This method assumes that the company keeps operating and generates cash flow forever into the future. Second, we can calculate Terminal Value using the Terminal Multiple Method. This method assumes we sell the company to an acquirer at the end of our forecast period.”
Online Finance Course References:
Course 8, Lesson 21 (Perpetuity Growth Method)
Course 8, Lesson 22 (Terminal Multiple Method)
–
214. What’s the formula for the Perpetuity Growth Method?
“First, we multiply the final year’s Unlevered Free Cash Flow by the Perpetuity Growth Rate. Then we divide that by the difference between WACC and Perpetuity Growth Rate.”
Terminal Value = (Final Year UFCF x (1 + PGR)) / (WACC – PGR)
PGR = Perpetuity Growth Rate
Online Finance Course References:
Course 8, Lesson 21 (Perpetuity Growth Method)
–
215. What’s the formula for the Terminal Multiple Method?
“We take the final year’s forecasted EBITDA and multiply it by what we think it’ll be worth on an LTM EV/EBITDA basis.”
Terminal Value = Final Year EBITDA x LTM EV/EBITDA Multiple
Online Finance Course References:
Course 8, Lesson 22 (Terminal Multiple Method)
–
216. Why do you use LTM in this case instead of a forward multiple?
“We use LTM multiple here because we’re applying a multiple against our final year’s forecasted EBITDA. We don’t have the EBITDA beyond our final year. Therefore, mechanically we have to use LTM EBITDA.”
Online Finance Course References:
Course 8, Lesson 22 (Terminal Multiple Method)
–
217. Between Terminal Multiple Method and Perpetuity Growth Method, which one do you think is more commonly used?
“Perpetuity Growth Method is more commonly used in DCF than Terminal Multiple Method. That’s because the Terminal Multiple Method is very similar to Public Comps and Precedent Transactions. It determines the value by applying a multiple to the operating metric.”
If you do a DCF, chances are you’re doing it in addition to Public Comps and Precedent Transactions. With the Terminal Multiple Method, you’re doing the same thing for DCF as you did for the other two methods. You’re multiplying EBITDA by a multiple. There’s less of a point. By contrast, Perpetuity Growth method doesn’t use multiples. Instead, it assesses what a company is worth based on how much cash flow it can generate over its lifetime. So, it kind of offers a different perspective on valuation.
–
218. Can you think of a situation where you would use Terminal Multiples Method over Perpetuity Growth Method to calculate Terminal Value?
“We would use Terminal Multiple Method over Perpetuity Growth Method for high growth businesses. For high growth businesses, we run into a dilemma for Perpetuity Growth Rate. On the one hand, Perpetuity Growth Rate can’t be higher than WACC. Otherwise, the Perpetuity Growth Method formula won’t work. On the other hand, a Perpetuity Growth Rate lower than WACC may yield an unjustifiably low valuation. Because of this dilemma, we should use Terminal Multiple Method for high growth businesses.”
–
219. What is a good growth rate to use for the Perpetuity Growth Method?
“We usually assume a growth rate lower than the GDP growth rate, maybe 2-4%.”
With the Perpetuity Growth Rate, you’re assuming that the business grows its cash flow at this rate forever into the future. If the Perpetuity Growth Rate is higher than the GDP growth rate, what you’re implicitly saying is that the company will eventually grow to become larger than the size of the entire economy.
–
220. Which Terminal Value method will give you a higher valuation?
“Either method can give you a higher valuation depending the assumption you use. There’s no one method that consistently yield a higher valuation.”
If a method does consistently yield a higher valuation, the analyst is probably consistently generous with that method’s assumptions.
–
221. Walk me through how you would discount the Terminal Value.
“If the Terminal Value is calculated using the Perpetuity Growth Method, I would discount it using the Mid-Year Convention. I would divide the Terminal Value by one plus the discount rate raised to the power of the discount period under the Mid-Year Convention.
However, if the Terminal Value is calculated using the Terminal Multiple Method, I would discount it using the End-of-Year Convention. I would discount the Terminal Value by one plus the discount rate raised to the power of the discount period under the End-of-Year Convention.”
Online Finance Course References:
Course 8, Lesson 23-24 (Present Value of Terminal Value)
–
222. Is there a point where DCF valuation is too reliant on Terminal Value? What do you do?
“No. We should look at the assumptions that go into the DCF valuation on an objective basis. If the assumptions are valid and the DCF indicates that the bulk of the value is coming from Terminal Value, that’s just the result of an objective analysis. We shouldn’t alter an otherwise objective analysis to satisfy a preconceived notion that Terminal Value should or shouldn’t make up more than a certain percentage of the value.”
Some people say that if Terminal Value makes up >80% of the intrinsic value, then it’s too reliant. In that case, they say you should adjust your assumptions. To us, that makes no sense. There’s no finance law that says Terminal Value must be less than 80% of the intrinsic value.
–
223. What adjustments, if any, should we make to the final year’s UFCF in a DCF before using it for the Perpetuity Growth Method?
“One common adjustment is to adjust D&A and CapEx so that CapEx is slightly higher than D&A. This way, we’re feeding into our perpetuity model a business that always spends a bit more than what it’s depreciating. Another common adjustment is to normalize tax rates. Sometimes companies have abnormal tax rates in the forecast period.”
The purpose of adjustments to the final year is to reflect how the business will grow into perpetuity might be different from what the business looks like at the end of the final year.
Discount Rate
224. Please provide at least three examples of discount rates.
“Three examples of discount rates are WACC, Cost of Equity and Cost of Debt.”
Online Finance Course References:
Course 8, Lesson 4 (Discount Rate)
Course 8, Lesson 5 (WACC)
Course 8, Lesson 6 (Cost of Debt)
Course 8, Lesson 11 (Cost of Equity)
–
225. What do we usually use as the discount rate in a DCF?
“We usually use WACC (Weighted Average Cost of Capital) as the discount rate.”
Online Finance Course References:
Course 8, Lesson 4 (Discount Rate)
Course 8, Lesson 5 (WACC)
–
226. What does the discount rate represent conceptually?
“Conceptually, the discount rate measures risk. The greater the risk, the higher the discount rate. The less the risk, the lower the discount rate.”
Online Finance Course References:
Course 8, Lesson 4 (Discount Rate)
–
227. How do you calculate Weighted Average Cost of Capital (WACC)?
“First, we take the Cost of Equity and multiply it by the percentage of equity in the capital structure. Then we take the After-Tax Cost of Debt and multiply it by the percentage of debt in the capital structure. We add the two up and that gives us WACC.”
WACC = (Cost of Equity x % of Equity) + ((Cost of Debt x (1 – Tax Rate)) x % of Debt)
% Equity = Equity Value / (Equity Value + Debt Outstanding)
% Debt = Debt Outstanding / (Equity Value + Debt Outstanding)
Online Finance Course References:
Course 8, Lesson 5 (WACC)
Course 8, Lesson 13 (Calculating WACC)
–
228. How do you calculate Cost of Equity (CoE)?
“Using the Capital Asset Pricing Model, Cost of Equity equals Risk Free Rate plus the product of Beta and Equity Risk Premium.”
CAPM = Risk Free Rate + (Beta x Equity Risk Premium)
Online Finance Course References:
Course 8, Lesson 11 (Cost of Equity)
–
229. How do you calculate Cost of Debt (CoD)?
“This is usually a number we need to get from the Debt Capital Markets team. It’s technically the yield on incremental long-term debt that the company issues. If that’s not available, we can use the yield on its existing debt. If that’s also not available, we can use the current interest rate on debt.”
Online Finance Course References:
Course 8, Lesson 6 (Cost of Debt)
–
230. Can you calculate WACC, CoE and CoD for private companies? Or are these for public companies only?
“Yes, you can calculate WACC, CoE and CoD for private companies.”
–
231. Please order WACC, CoE and CoD from smallest to largest.
“The order from smallest to largest is: CoD, WACC, CoE”
–
232. Between a small company and a big company, which company would you expect to have a higher WACC?
“All else equal, I would expect a small company to have higher WACC. WACC measures risk and a small company is riskier than a big company.”
–
233. Between a tech startup and a utility provider, which company would you expect to have a higher Cost of Equity?
“I would expect the tech startup to have higher Cost of Equity. A tech startup is generally riskier with more uncertainties than a utility provider. Therefore, it should have a higher Cost of Equity.”
–
234. Between a company with no debt and a company with lots of debt, which company would you expect to have a higher Cost of Debt?
“I would expect the company with lots of debt to have a higher Cost of Debt. That’s because the greater the amount of debt, the greater the risk of bankruptcy.”
–
235. The US Federal Reserve just announced an increase in interest rate. How will this affect the company’s Cost of Debt?
“The company’s Cost of Debt will likely increase as well.”
–
236. A company decided to borrow more debt. How will this affect the company’s Cost of Equity?
“Higher debt can increase Beta, which can increase the company’s Cost of Equity.”
–
237. Can Cost of Debt be higher than Cost of Equity?
“In theory, no. Cost of Debt cannot be higher than Cost of Equity. Equity is lower than Debt in the capital structure. Therefore, Equity is always riskier than Debt so it should always have a higher discount rate.
In practice, anything’s possible. A company can negotiate a private loan with 35% Cost of Debt while Cost of Equity may be only 10-12%.”
–
238. What is the Risk-Free Rate (RFR) based on and how much is it right now?
“The Risk-Free Rate is based on the 30-Year US Treasury Yield. As of January 2023, it’s 3.6%.”
This number changes every day.
Online Finance Course References:
Course 8, Lesson 8 (Risk-Free Rate)
–
239. Which country do you think has a higher RFR: a country with unstable government vs. a country with stable government?
“A country with unstable government will have higher Risk-Free Rate because it has higher geopolitical risk.”
–
240. How is Beta calculated?
“A security’s Beta is the correlation of the security’s price movements to that of the broader stock market.”
Online Finance Course References:
Course 8, Lesson 10 (Beta)
–
241. What is the stock market’s Beta?
“The stock market has a Beta of 1.”
Online Finance Course References:
Course 8, Lesson 10 (Beta)
–
242. What does a Beta of 0 mean?
“A Beta of 0 means the security’s price movements have no correlation with the movements of the broader stock market.”
Online Finance Course References:
Course 8, Lesson 10 (Beta)
–
243. What does a Beta of 1.2 mean?
“A Beta of 1.2 means the security’s prices are more volatile than that of the broader stock market. If the stock market goes up by 10%, the security’s prices may go up by 12%.”
Online Finance Course References:
Course 8, Lesson 10 (Beta)
–
244. Why do you un-lever and re-lever Beta?
That’s how interviewers phrase this question and it’s somewhat misleading. The “un-lever” exercise applies to a comp set while the “re-lever” exercise applies to the target company. In other words, these are two separate exercises on two separate objects.
Here’s what you can say.
“We un-lever the Beta of the target company’s comp set to quantify the business risk of operating in this industry. But business risk isn’t the only type of risk. There’s also financial risk that debt poses. Our target company may have a different level of debt relative to the comp set. Therefore, we need to re-lever the Beta to our target company’s capital structure. This adds our target company’s specific financial risk to the industry business risk.”
This is a stale practice that is no longer a widely used. Leading investment banks now subscribe to data sources that provide un-levered and re-levered Beta. As an IBD analyst, the data you obtain is already “clean” and ready to use. However, banks that haven’t upgraded data sources might still be relying on analysts to manually un-lever and re-lever Beta.
For the purpose of the interview, we still recommend knowing the formula just in case.
–
245. Walk me through how you would un-lever and re-lever Beta?
“We start by un-levering the Beta for each company in our comp set. We divide each company’s Levered Beta by one plus its tax-effected debt-to-equity ratio.
Then we take the median (usually, not always) of the comp set’s Unlevered Beta and re-lever it. We can re-lever it by multiplying the Unlevered Beta by one plus the target company’s tax-effected debt-to-equity ratio.”
Un-Levered Beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt Outstanding / Equity Value)))
Levered Beta = Un-Levered Beta x (1 + ((1 – Tax Rate) x (Debt Outstanding / Equity Value)))
–
246. Let’s say you roll two dice. One lands on a 6 while the other lands on a 4. What is the Beta?
“Beta is zero.”
–
247. Would you expect the stock of a telecom company or that of a luxury goods company to have a higher Beta?
“I would expect the stock of the luxury goods company to have a higher Beta. The stock of the telecom company will likely have a lower Beta.”
–
248. Would expect a casino’s stock or a $20 bill to have a higher Beta?
“I would expect a casino’s stock to have a higher Beta.”
–
249. What does negative Beta mean?
“Negative Beta means the security’s prices move in the opposite direction relative to that of the stock market. So, if the stock market goes up, that security’s prices will likely go down.”
–
250. Can you have negative Beta? Please provide some examples of securities with negative Beta.
“Yes, there are securities with negative Beta. Inverse stock market ETFs will have negative Beta.”
An inverse stock market ETF is an ETF whose prices move in the opposite direction relative to that of the stock market. When the stock market goes up, the ETF prices go down. When the stock market goes down, the ETF prices go up. Naturally, it’ll have negative Beta.
Some people say gold has negative Beta because it’s a haven for safety. The logic is that when the stock market runs into trouble, investors flee to gold. Consequently, gold price increases while stock market falls. However, we looked up gold’s 5-year Beta and it’s positive as of January 2023.
Intrinsic Value
251. OK, so now you’ve projected out the companies’ future free cash flow and calculated its Terminal Value. Tell me how you’d use these numbers to calculate the Intrinsic Enterprise Value.
“I would discount these projected future Unlevered Free Cash Flow and Terminal Value back to the present. The sum of these present values equals the Intrinsic Enterprise Value.”
Online Finance Course References:
Course 8, Lesson 26 (Calculating Intrinsic Value)
–
252. How does changes in the capital structure affect Enterprise Value?
“Changes in the capital structure affects the % of debt and equity, which affects WACC. A higher WACC will lead to a lower Enterprise Value. A lower WACC will result in a higher Enterprise Value.”
Online Finance Course References:
Course 8, Lessons 1-26 (DCF)
–
253. To maximize Enterprise Value, would you prefer a 1% decrease in WACC or 1% increase in UFCF?
“I would prefer the 1% decrease in WACC. Usually, a change in WACC is more powerful than an equal magnitude change in UFCF.”
–
254. Let’s say we shift the discount rate in our DCF analysis from End-of-Year Convention to Mid-Year Convention. How would this impact the Intrinsic Value per Share?
“It will increase our Intrinsic Value per Share because the discount period is lower, so each future dollar is discounted less.”
–
255. I’m going to give you two options. Option 1: I give you $1 at the end of every day guaranteed for life. Option 2: I give you a lump-sum payment of $1,000 today. Which one would you choose and why?
“Assuming Option 1 is truly guaranteed without any risks, I’ll take Option 1. I know the Risk-Free Rate is around 3.6% (as of January 2023). There’s 365 days which means I’ll earn $365 every year. Using this discount rate, the present value of just the next 3 years from Option 1 alone is more than $1,000. I’m only [19] years old, so the value of Option 1 is far greater than that of Option 2.”
–
256. In our DCF, we projected $100 of Accounts Receivables balance every year for 5-years. Then management tells us that Accounts Receivable balance will drop to $60 in Year 3 and then come back up to $100 in Year 4. In other words, Accounts Receivable balance will be $100 in Years 1, 2, 4, 5 and $60 in Year 3. Will this change from management increase or decrease the Intrinsic Enterprise Value in the DCF?
“It increases the Intrinsic Enterprise Value. In Year 3, Changes in Working Capital will increase cash flow by $40. In Year 4, Changes in Working Capital will decrease cash flow by $40. However, due to discounting, the increase in Year 3 is worth more than the decrease in Year 4. Therefore, it will increase the Intrinsic Enterprise Value.”
V. Leveraged Buyout (LBO)
General Understanding
257. Can you walk me through an LBO model?
“The first step in an LBO model is to calculate the purchase price. We multiply the target company’s EBITDA by an EV/EBITDA multiple.
Second, we need to build our Sources & Uses. We want to know where our capital is coming from and where it’s going.
Third, we project out the company’s Levered Free Cash Flow, usually for a period of 5-7 years. We feed the Levered Free Cash Flow into the Debt Schedule to repay outstanding debt.
Lastly, we can assume an exit and calculate our investment returns. We usually assume an exit EV/EBITDA multiple and calculate IRR and MOIC.”
Online Finance Course References:
Course 16, Lesson 1 (LBO)
Course 16, Lesson 5 (How LBO Works)
–
258. What is the difference between a “standard” LBO model and a “full-blown” LBO model?
“A standard LBO model includes a full Income Statement but only select necessary lines Cash Flow Statement and Balance Sheet. A full-blown LBO model includes a full Income Statement, a full Cash Flow Statement and a full Balance Sheet.”
–
259. How many years do private equity firms typically hold their portfolio companies?
“Usually 5-7 years because private equity funds are required to return capital to their investors.”
–
260. Is LBO analysis a valuation methodology? If so, explain to me how can it act as a valuation methodology.
“Yes, LBO analysis is a valuation methodology. It determines the maximum price that private equity firms can afford to pay to achieve 20-25% IRR. That maximum price prospective buyers are willing to pay is a form of valuation.”
–
261. What makes a great LBO candidate?
“A great LBO candidate is a business that has a clear path to exit, stable cash flow, non-capital intensive, room for operational improvements, and ideally one that we can purchase at a bargain valuation.”
–
262. Walk me through the circular reference in an LBO model.
“The circular reference in an LBO model is between the Income Statement and the Debt Schedule. The company’s Net Income is dependent on Net Interest Expense. Net Interest Expense is dependent on the amount of Debt Outstanding, which is influenced by debt repayment. Debt repayment is driven by Levered Free Cash Flow, which is in turn driven by Net Income. And so this creates a circular logic.”
Online Finance Course References:
Course 16, Lesson 24 (LBO Circularity)
–
263. What are the exit strategies in an LBO?
“The three exit strategies in an LBO are sale, IPO, and dividend recap. In a sale, the private equity firm sells the entire company to another buyer. In an IPO, the private equity firm takes the company public, but it will still hold a significant ownership. After the IPO, the private equity firm will gradually sell down its stake. In a Dividend Recap, the company borrows debt to pay the PE firm dividends.”
–
264. What is a dividend recap and why do private equity firms do it?
“A dividend recap is an exit strategy where the portfolio company takes on debt to pay its PE owner dividends. PE firms do it as a way to extract value from their investment.”
–
265. Why do strategics typically pay more than private equity firms?
“A big reason why strategics pay more than private equity firms is because of synergies. Synergies is a major reason why strategics pursue M&A in the first place. They can increase revenue and decrease cost. Private equity firms don’t benefit from synergies. And so strategics can afford to pay a bit more.”
–
266. If a company has seasonal working capital, how would this affect the LBO?
“With seasonal working capital, PE firms have to pay attention to the liquidity. Otherwise, portfolio companies risk running into periods when they run out of cash. To mitigate this risk, PE firms can keep some extra cash in the companies’ bank accounts. They can also include a Revolver in the debt package.”
–
267. What are the different ways we can receive proceeds back from the LBO?
“We can receive proceeds either by selling a piece of the company or by paying ourselves a dividend.”
Purchase Price
268. How do you calculate the entry purchase price of an LBO for a public company?
“For a public company, we usually calculate the entry purchase price based on a premium to the current stock price. We multiply the current stock price by a premium to arrive at an offer price. We then multiply the offer price by the Fully-Diluted Shares Outstanding to calculate Equity Value and bridge to Enterprise Value.”
Online Finance Course References:
Course 16, Lesson 6 (Modeling Entry)
–
269. How do you calculate the entry purchase price of an LBO for a private company?
“For a private company, we usually calculate the entry purchase price by multiplying EBITDA by a multiple.”
Debt Financing
270. Why do private equity firms use leverage?
“Private equity firms use leverage because it increases their spending power and because it increases their investment returns.”
Online Finance Course References:
Course 16, Lesson 2-3 (Why PE Firms Use Leverage)
–
271. How do you determine how much debt you can borrow in an LBO?
“PE firms determine how much debt they can borrow based on the company’s ability to repay. They usually look at it through gross leverage and net leverage multiples.”
In practice, PE firms want to borrow as much debt as banks will allow them. Banks won’t lend beyond their safe limit because otherwise they risk default. So, the bottleneck is usually the lenders not willing to lend, as opposed to borrower not willing to borrow.
–
272. What is a common split between Term Loan and Bond in an LBO?
“The common debt structure in an LBO is 4x Term Loan and 2x Bond.”
Note: The 4x and 2x is off of EBITDA.
–
273. Why can’t PE firms raise all the debt with Term Loan instead of the Bond?
“Term Loan comes with more attractive terms than Bond. For example, it has lower interest rate. As debt increases, creditors’ risk increases. Term Loan creditors are only willing to lend a certain limit under these terms. However, this amount of debt is usually not enough for the private equity firms. So, PE firms want to borrow more debt than what the Term Loan creditors are willing to commit. Therefore, they have to raise the rest through Bond and offer more attractive terms, such as a higher interest rate.”
–
274. Why don’t PE firms raise all the debt using Bond?
“Because Bond is more expensive than Term Loan. It usually has higher interest rate and doesn’t allow borrowers to repay the debt in advance. Therefore, PE firms want to exhaust as much Term Loan as they can get for their companies. The rest they’ll raise through Bond.”
–
275. Why can’t private equity firms finance the acquisition of a company using 100% debt?
“Because in that case, private equity firms will basically get the ownership in the company for free. Lenders are not willing to participate in deals where they bear all the risk while private equity firms get reward for free, without any risk.”
–
276. Can the use of leverage decrease returns in an LBO?
“Certainly. If the company can’t repay the debt, it’ll go bankrupt. That will wipe out the private equity firms’ investment. Even if it doesn’t go bankrupt, having too much debt limits the company’s operating flexibility. It may not be able to pursue certain growth strategies because it needs to conserve cash to repay debt.”
–
277. What is the difference between debt refinancing and debt rollover in an LBO?
“Debt refinancing is where the borrowers borrow debt and uses proceeds from the new debt to pay off existing debt. Debt rollover is where the existing debt stays with the company while the ownership changes. The debt simply rolls over from the company controlled by one owner to one controlled by another owner.”
–
278. Your private equity firm just LBO’d a company. How do you track its credit health over your holding period?
“The easiest way is through credit metrics, such as leverage multiples and coverage multiples. Healthy companies will have declining leverage multiples and increasing coverage multiples over our holding period.
Additionally, we can also track the rating agencies’ ratings and pay attention to potential upgrades or downgrades. These ratings indicate the credit health of the company.”
Financial Projections
279. In an LBO, do you care more about Levered Free Cash Flow or Unlevered Free Cash Flow?
“In an LBO, we care more about Levered Free Cash Flow because the cash flow after interest expense is what we can use to repay debt.”
This is counter-intuitive for a lot of candidates. Many candidates think UFCF is more important because you can determine the value for both debt and equity holders. In reality, we care more about LFCF because the cash flow after interest expense is what’s available for debt repayment.
Online Finance Course References:
Course 16, Lesson 11 (Modeling LFCF)
–
280. What are some adjustments to the standalone financial projections we have to make in an LBO model?
“Some adjustments we would make to the standalone financial projections include the financial impact of potential operational improvements post-LBO (such as cost reductions), elimination of public company costs (if any), Amortization of Financing Fees, and adjusting the Balance Sheet for the new capital structure.”
Online Finance Course References:
Course 16, Lesson 8 (Amortization of Financing Fees)
–
281. What is meant by opening and closing Balance Sheet in an LBO?
“The opening Balance Sheet means the target company’s Balance Sheet immediately prior to the LBO. The closing Balance Sheet means the target company’s Balance Sheet immediately after the LBO. The difference arises because LBO alters the cash, debt and equity components of the capital structure.”
–
282. Walk me through the debit and credit adjustments on the closing Balance Sheet.
“On the Assets side, we credit Cash & Cash Equivalents for any cash usage in the transaction. We debit Goodwill according to the purchase price allocation.
On the Liabilities and Equity side, we debit Debt for any repayments through the transaction. Then we credit the new Debt tranches that the company is borrowing. We also debit existing Shareholder’s Equity and credit the new equity investment.”
–
283. What are the different ways a company can spend its available cash?
“A company can generally spend its cash on six things.
Operating Expenses: things like SG&A and R&D expenses that it incurs to run the business.
Capital Expenditures: buying assets, such as properties, plants and equipment.
Financial Investments: investing some cash into stocks and bonds.
M&A: acquiring other businesses.
Debt Repayment: de-leveraging the company.
Capital Return: returning capital to shareholders through dividends and share repurchases.”
Returns Analysis
284. What are the different metrics private equity firms use to evaluate returns in an LBO?
“The two main metrics that private equity firms use to evaluate returns in an LBO are IRR and MOIC (Multiple on Invested Capital).”
Online Finance Course References:
Course 9, Lesson 3 (IRR)
Course 9, Lesson 5 (MOIC)
Course 16, Lesson 27 (Modeling LBO Returns)
–
285. How do you calculate IRR in an LBO?
“We can use the XIRR function in Excel.
Alternatively, we can just divide the entry equity by the exit equity, raise it to the power of one divided by years of investment, and then minus one.”
Online Finance Course References:
Course 16, Lesson 27 (Modeling LBO Returns)
–
286. What are the main drivers of returns in an LBO?
“The main drivers of LBO returns are revenue growth, cost reduction, tax savings, leverage, free cash flow and multiple expansion.”
Online Finance Course References:
Course 16, Lesson 29 (Drivers of LBO Returns)
–
287. What are some operational improvements PE firms can do to increase LBO returns?
“This really depends on whether the business was well-managed prior to the LBO. For mismanaged businesses, the PE firm can make a lot of operational improvements. First of all, as the new owner, it can replace the management team. Second, it can review products and services. Oftentimes, the PE firm will raise prices. Third, it will try to reduce cost by cutting excess headcount.”
–
288. How many years does it take to double our investment at 12% IRR?
“At 12% IRR, it takes ~6 years to double our investment.”
–
289. How many years does it take to triple our investment at 5% IRR?
“At 5% IRR, it takes ~23 years to triple our investment.”
–
290. If we triple our money in five years, what is the approximate IRR?
“If we triple our money in five years, the IRR is ~25%.”
–
291. If we double our money in five years, what is the approximate IRR?
“If we double our money in five years, the IRR is ~15%.”
–
292. Would you rather have $100 today or $200 four years from now?
“I would rather have $200 four years from now. That’s 18% IRR, which is a return far greater than what I can get investing $100 in the stock market.”
–
293. If you put $100 in the bank and get $3 back every year for the next 29 years and then at the end of the 30th year, you receive $103. What is your IRR?
“The IRR is 3%.”
–
294. Assume there’s no multiple expansion and no EBITDA growth over your holding period. How can you still generate positive return in an LBO?
“You can still earn a return from the LFCF that the company generates. Even though there’s no multiple expansion and no EBITDA growth, you can still use the LFCF to pay down debt. This will increase equity value.”
–
295. If the Cost of Debt is 8%, what is the minimum return required to not lose money from using debt in an LBO?
“Assuming a 20% tax rate, the company must generate at least 6.4% return.”
The 20% shield on 8% Cost of Debt equals 6.4% After-Tax Cost of Debt. So if a company generates at least a 6.4% return, that’s sufficient to repay creditors.
–
296. Assuming a 5-year investment horizon, what IRRs correspond to 2.0x, 2.5x, and 3.0x MOIC?
“15% IRR for 2.0x. 20% IRR for 2.5x. 25% IRR for 3.0x.”
Impact to Three Financial Statements
297. A PE firm decides to do a raise $100mm of debt for a dividend recap on its portfolio company. Walk me through the impact to the three financial statements.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Proceeds from Debt Issuance increases cash flow by $100mm while Dividend Payments reduces it by $100mm. Therefore, Net Change in Cash is flat.
On the Balance Sheet, there’s no changes to the Assets side. On the Liabilities and Equity side, Debt increases by $100mm while Retained Earnings decreases by $100mm. And the Balance Sheet balances.”
–
298. A PE firm decides to raise $100mm of mezzanine at 10% PIK interest rate. Walk me through the impact to the three financial statements.
“On the Income Statement, Interest Expense increases by $10mm and so Pre-Tax Income decreases by $10mm. Assuming a 20% tax rate, Net Income decreases by $8mm.
On the Cash Flow Statement, under Cash Flow from Operations, Net Income decreases by $8mm. However, we need to add back the $10mm of Interest Expense because it’s PIK (non-cash). Therefore, Cash Flow from Operations increases by $2mm. No changes to Cash Flow from Investing and Cash Flow from Financing. Net Change in Cash increases by $2mm.
On the Balance Sheet, on the Assets side, Cash goes up by $2mm. On the Liabilities and Equity side, Debt goes up by $10mm while Retained Earnings goes down by $8mm. Total Liabilities and Equity goes up by $2mm. And the Balance Sheet balances.”
VI. Mergers & Acquisitions (M&A)
General Understanding
299. Can you walk me through an M&A (Accretion / Dilution) model?
“The first step in an M&A model is to build the purchase price. We want to know what the acquirer is paying for the target.
The second step is to build the Sources & Uses. We need to know how the acquirer will finance the acquisition and where the money is going.
The third step is to build the standalone Income Statements for both the acquirer and the target.
Our next step is to combine the two companies’ standalone Income Statements. We add the acquirer’s Revenue and the target’s Revenue to get the combined Revenue. We add the acquirer’s COGS and the target’s COGS to get the combined COGS. And so forth.
Once that’s done, we need to adjust this combined Income Statement for the impact of the M&A transaction. These adjustments include Synergies, Amortization of Financing Fees, Incremental D&A, Foregone Interest Income, Incremental Interest Expense, and any Stock Issuances.
Lastly, we can compare the acquirer’s standalone EPS with the combined EPS to calculate accretion dilution.”
Online Finance Course References:
Course 17, Lesson 1 (M&A)
Course 17, Lesson 12 (How M&A Model Works)
–
300. We say “Mergers & Acquisitions”. So the two must not be entirely the same. What’s the difference between “Mergers” and “Acquisitions”?
“Both Mergers and Acquisitions refer to businesses combining together. ‘Mergers’ refers to business combinations where the companies are similar in size. For example, when a $10bn company combines with an $11bn company, that’s probably a Merger. ‘Acquisitions’ refers to business combinations where the acquirer is significantly larger than the target. For example, when a $10bn company combines with a $1bn company, that’s probably an Acquisition.
Mergers are combinations of equals or near-equals. Whereas Acquisitions are more like the acquirers absorbing the targets.”
Online Finance Course References:
Course 17, Lesson 2 (Difference between Mergers and Acquisitions)
–
301. Why would a company want to acquire another company?
“Companies want to acquirer other companies for strategic and financial reasons. Strategically, the M&A could enable the acquirer to gain access to important customers, regulatory approvals, and/or expand into new markets. Financially, the M&A can increase the acquirer’s size and help it achieve synergies that increase shareholder value.”
Online Finance Course References:
Course 17, Lesson 6 (Strategic Rationale)
–
302. Why would a company want to sell to another company?
“Companies want to sell to other companies usually because of three reasons.
First, their owners want liquidity. This is very common among family-held businesses. Maybe the owners need cash. Maybe the owners are retiring and their children don’t want to manage the business. Even big corporations often sell their business units to raise cash.
Second, their owners might own several businesses and want to sell ones they think are ‘non-core’. This way, they can focus on their ‘core’ businesses. This is very common among big corporations.
And lastly, their owners might think they can achieve greater value from selling than they can from continuing operations.
These are some of the common reasons why companies sell.”
–
303. Can Accretion / Dilution analysis serve as a valuation methodology?
“Yes, Accretion / Dilution analysis can serve as a valuation methodology. We can back-solve for the maximum price acquirers can pay and still be able to reach the desired accretion dilution. This maximum price that prospective buyers can pay is itself a form of valuation.”
–
304. After the announcement of an M&A transaction, what happens to the acquirer and the target’s stock price?
“The acquirer’s stock price can move either up or down, depending on the market’s perception of the transaction. The target’s stock price generally goes up.”
–
305. After the announcement of an M&A transaction, can the target company’s stock price increase to the point where it exceeds the offer price?
“Yes, the target company’s stock price can increase to the point where it exceeds the offer price. This isn’t common. However, it can happen if the market believes the acquirer will be forced to pay more than what it offered.”
–
306. After the announcement of an M&A transaction, can the target company’s stock price be below the offer price?
“After the announcement of an M&A transaction, the target company’s stock price usually increases to slightly below the offer price. And so not only can the company’s stock price trade below the offer price, it’s nearly always the case.”
For example, suppose the target’s stock price prior to the announcement of the M&A transaction is $20. Then comes the news that the acquirer will purchase the target for $28. The target’s stock price may increase to a level such as $27.70 – just slightly below $28.
–
307. Can you make an offer to acquire a company at the current stock price?
“Yes, you can.”
–
308. What about an offer below the current stock price?
“Yes, you can.”
This happened to the storied former bulge bracket investment bank Credit Suisse. On Sunday March 19, 2023, UBS announced that it will acquire Credit Suisse for ~CHF 0.76 per share. Credit Suisse shares closed at CHF 1.86 per share on the Friday before. This represents ~59% offer discount to the market price.
This doesn’t happen frequently, but it absolutely does happen.
–
309. What is Precedent Premia Analysis and why would you do it for an M&A transaction?
“Precedent Premia Analysis gathers the offer price premium percentages from comparable precedent acquisitions of public companies. We do it for M&A transactions to understand how the premium in our transaction compares to the market environment.”
–
310. Walk me through a standard sell-side M&A process.
“In a standard sell-side M&A process, our first job is to pitch and win the opportunity to advise the client. Then we prepare the teaser, sign NDAs with interested buyers, share the CIM and receive first round bids. From here, we select the highest bidders, open up data rooms, arrange management meetings and solicit final bids. Then we negotiate with the buyers, select a winner, sign the contract and announce the deal.”
–
311. Walk me through s standard buys-side M&A process.
“In a standard buy-side M&A process, our first job is to pitch and win the opportunity to advise the client. Then we contact the sell-side advisor, sign NDA, analyze the CIM, build financial model and submit first round bid. If our bid is competitive, the sell-side advisor will advance us to the next round. We can then dig through the data room, meet with management, conduct in-depth due diligence. In addition, we should also contact lenders for debt financing. Then we submit our final bid and if we win, we can sign the contract and announce the deal.”
–
312. What are the different parties involved in an M&A process?
“The main parties in an M&A process are the buyer and seller, their financial advisors, lenders, and lawyers. Buyers and sellers are integral to every M&A process. Financial advisors advise their clients to maximize client value. Lenders provide financing to facilitate the transaction. Lawyers prepare the contracts.”
–
313. What do you think you’ll be doing as an Analyst / Associate in an M&A process?
“As an Investment Banking Analyst / Associate, my primary responsibilities will revolve around building financial models, creating discussion materials and coordinating the deal logistics.
The main work streams are building the operating model and valuation analysis, drafting the CIM and management presentation, managing the data room, tracking the due diligence questions, and coordinating logistics with all the parties involved in the process.”
Please note, even as an Associate, you are still at the entry-level. You are supposed to team up with the Analyst to produce the deliverables. For example, the Analyst might create some presentation pages and you create the others. The Analyst might build most of the financial models and you build the comps or precedents. As you gain experience, you start taking on increasingly client-facing and “high-level” responsibilities. Successful Associates may start to become a semi-VP on deal teams in their 3rd year.
–
314. Why do you think many M&A transactions fail to create value for acquirers?
“Many M&A transactions fail to create value for acquirers often because the acquirers either overpaid or were unable to integrate with the target after the acquisition. Integrating the target with the acquirer can be especially challenging. As a result, they have to record an impairment charge.”
–
315. What are some important documents in the M&A process?
“Some important documents in the M&A process are the teaser, non-disclosure agreement, confidential information memorandum, management presentation, bid letters, and merger agreement.”
–
316. Do you think acquirers pay a higher multiple to purchase a majority equity stake or the remaining minority equity stake in a target company that they already have a majority equity stake in?
“Acquirers pay a higher multiple to purchase the remaining minority equity stake in a target company that they already have a majority equity stake in.”
Acquisition Currencies
317. How can you quickly tell if an M&A transaction is accretive or dilutive?
“For all-cash transactions, you can compare the sum of Incremental Interest Expense, Foregone Interest on Cash, Amortization of Financing Fee, and Incremental D&A against the sum of the target’s Pre-Tax Income and Synergies. If the former is larger, the transaction is likely dilutive. If the latter is larger, the transaction is likely accretive.
For all-stock transactions, you can compare the acquirer’s P/E multiple with the target’s P/E multiple. If the acquirer has a higher P/E than the seller’s, the transaction is likely accretive. If the target has a higher P/E than the seller’s, the transaction is likely dilutive.”
–
318. What is meant by “Acquisition Currencies” and what are the different ones available to the acquirer in an M&A transaction?
“The term ‘Acquisition Currencies’ refers to how the acquirer plans to pay for the purchase of another business. There are generally three types of Acquisitions Currencies: Cash, Debt and Stock.”
Here’s a common source of confusion. You should know that both Cash and Debt are technically “cash” transactions. The former “Cash” refers to the company’s existing Cash & Cash Equivalents. The latter “cash” describes the payments being settled via fiat currencies (i.e. US Dollar, Euro). Therefore, when we say a transaction is “all-cash”, it means the acquirer can finance the transaction with 100% Cash, 100% Debt, or a mixture of Cash & Debt.
Online Finance Course References:
Course 17, Lesson 16 (Acquisition Currency)
–
319. Can you order these different currencies from most attractive to least attractive for a typical M&A transaction?
“I would order the currencies’ attractiveness based on their respective Cost of Capital. Assuming the acquirer’s stock is appropriately valued, the order is Cash, Debt, and Stocks.”
Pay attention to the assumption that the acquirer’s stock is appropriately valued. The answer could be different if the acquirer’s stock is meaningfully overvalued.
Online Finance Course References:
Course 17, Lesson 16 (Acquisition Currency)
Course 17, Lesson 17 (Cost of Capital)
–
320. Can you estimate the Cost of Capital for each currency for a typical company?
“I would say ~1-2% for Cash, ~7-8% for Debt (High Yield; Pre-Tax), and ~9% for Equity.”
This answer is as of January 2023. These numbers change over time.
–
321. If a company can pay for the acquisition using Stock, why would it choose to pay with Cash and Debt?
“Companies generally prefer not to use Stock because Cash and Debt are cheaper than Stocks. So this is actually companies’ default preference. This is especially the case if management believes the market is undervaluing the company’s Stocks.”
Online Finance Course References:
Course 17, Lesson 19 (Choosing Acquisition Currency)
–
322. If a company can pay for the acquisition using Cash and Debt, why would it choose to pay using Stock?
“There are a few reasons for this. First, acquirers want to pay using Stocks if they can’t gather enough cash to finance the deal. This is often the case in mergers where the acquirer and target are relatively equal in size. The acquirer simply won’t have sufficient cash and debt capacity to make such a large purchase. Second, acquirers want to pay using Stocks if they believe their stocks are significantly overvalued. And lastly, acquirers want to pay using Stocks if they want the target’s owners to keep working at the target. Stocks act as an incentive to motivate the target’s owners to create value for the acquirer post the transaction.”
Online Finance Course References:
Course 17, Lesson 19 (Choosing Acquisition Currency)
–
323. If the acquirer’s stock is trading at 10x P/E and the Pre-Tax Cost of Debt is 5% to finance the acquisition, would the acquirer prefer to finance it using Stock or Debt?
“The acquirer would prefer to finance it using Debt.”
–
324. In an all-stock transaction, the acquirer’s Stock is trading at $90 per share while the target’s Stock is trading at $20 per share. As part of the transaction, the acquirer will pay a 50% offer premium. What is the Exchange Ratio of this transaction?
“If the target’s stock price is $20 and the acquirer offers a 50% premium, then the Offer Price is $30. If the acquirer’s stock price is $90, then the Exchange Ratio is 3 ($90 / $30).”
Exchange Ratio = Target’s Offer Price / Acquirer’s Stock Price
–
325. In an all-cash transaction, the acquirer is borrowing $100 million of Debt at 5% interest rate maturing in 5 years with a 2% financing fee. It’s also using $100 million of its Cash that was earning 1% interest rate. The target has a Pre-Tax Income of $3 million. The acquirer expects to achieve $2 million in Cost Synergies from the transaction. Is the transaction accretive or dilutive?
“In this transaction, the acquirer will incur an $5 million of Incremental Interest Expense, $0.4 million of Amortization of Financing Fee, and $1 million of Foregone Interest on Cash. This means that the acquirer is incurring $6.4 million of incremental cost to facilitate this transaction. However, it’s only getting $3 million of target’s Pre-Tax Income and $2 million of Cost Synergies, totaling $5 million. Therefore, the acquirer is losing more money from the M&A transaction than it’s making. The transaction is dilutive.”
–
326. In an all-stock transaction, the acquirer is trading at 17x P/E while the target is trading at 11x P/E. Is the transaction likely accretive or dilutive?
“Because it’s an all-stock deal and the acquirer’s P/E multiple is higher than that of the target, the transaction is likely accretive.”
–
327. In an all-stock transaction, the acquirer is trading at 40x LTM P/E and its EPS is growing at a rate of 100% a year. The target is trading at 20x LTM P/E and its EPS is growing at a rate of 10% a year. Is the transaction accretive or dilutive?
“The transaction is likely accretive in the near-term but dilutive in the long-term.”
–
328. Do sellers prefer to be paid in Stock or Cash?
“Sellers generally prefer to be paid in Cash.”
–
329. What is an earn-out?
“An earn-out is a pricing structure in M&A where a portion of the purchase price for the target is contingent upon the target’s performance after the acquisition. For example, the acquirer can structure the deal such that the target’s owners get an extra $100 million if the target grows at 20% a year for 2 years.”
Synergies
330. Can you give some examples of Revenue Synergies and Cost Synergies?
“An example of Revenue Synergies is Google’s acquisition of YouTube. Through this acquisition, Google was able to link its ad network to YouTube. This allowed Google to earn incremental Revenue through a more effective monetization method.
An example of Cost Synergies is Charter Communication’s series of acquisitions. Through acquisitions, Charter became larger and more powerful in negotiations with its suppliers, allowing it to achieve lower cost.”
Online Finance Course References:
Course 17, Lesson 26 (Revenue Synergies)
Course 17, Lesson 27 (Cost Synergies)
–
331. If you can have $1 of Revenue Synergy or a $1 of Cost Synergy, which one would you prefer?
“I would prefer the $1 of Cost Synergy because it flows entirely to EBITDA. By contrast, the $1 of Revenue Synergy will likely incur COGS, so less than $1 will flow to EBITDA.”
Online Finance Course References:
Course 17, Lesson 26 (Revenue Synergies)
Course 17, Lesson 27 (Cost Synergies)
–
332. If you can have $1 of Cost Synergy or a $1 reduction in CapEx, which one would you prefer?
“I would prefer the $1 reduction in CapEx because it increases Free Cash Flow (both UFCF and LFCF) by $1. By contrast, we need to pay taxes on the $1 of Cost Synergy. Therefore, the accretion to Free Cash Flow will be less than $1.”
Online Finance Course References:
Course 17, Lesson 26 (Revenue Synergies)
Course 17, Lesson 27 (Cost Synergies)
–
333. What are Cost to Achieve Synergies and can you provide some examples?
“Cost to Achieve Synergies refers to the cost acquirers need to incur in order to make Revenue Synergies happen.
For example, there might be Cost Synergies from layoffs after the acquisition. To do that, the acquirer would need to pay severance to the former employees. These severance payments are a form of Cost to Achieve Synergies”
Online Finance Course References:
Course 17, Lesson 28 (Cost to Achieve Synergies)
–
334. In a typical transaction, can the acquirer achieve all of the synergies in Year 1? Explain.
“No, the acquirer cannot achieve all of the synergies in Year 1. That’s because the post-transaction integration takes time to execute. The integration could take several years. As a result, it is uncommon for the acquirer to achieve 100% of synergies in the first year.”
Financial Model
335. How do you calculate Offer Premium in an M&A model?
“We can calculate Offer Premium by dividing Offer Price by the target’s current Stock Price and then minus 1.”
Online Finance Course References:
Course 17, Lesson 15 (Modeling Target Valuation)
–
336. In an M&A transaction, should you use options outstanding or options exercisable to calculate the purchase price?
“We should use Options Outstanding.”
Online Finance Course References:
Course 17, Lesson 15 (Modeling Target Valuation)
–
337. How do you determine the target’s purchase price in an M&A model?
“If the target is public, we can multiply the Offer Price by the Fully-Diluted Shares Outstanding to calculate Equity Value. Then we can bridge to Enterprise Value based on its standalone capital structure.
If the target is private, we can just multiply its LTM EBITDA by a multiple.”
Online Finance Course References:
Course 17, Lesson 15 (Modeling Target Valuation)
–
338. Do you have to build all three financial statements for the accretion dilution analysis?
“Technically, no, we don’t have to build all three financial statements for the accretion dilution analysis. We only need the full Income Statement and select lines from the Cash Flow Statement and Balance Sheet.”
Online Finance Course References:
Course 17, Lessons 14-15, 20-21, 31-34 (Modeling M&A)
–
339. What are the main drivers of accretion / dilution in the M&A model?
“The main drivers of accretion dilution in the M&A model are i) Purchase Price, ii) Acquisition Currencies, and iii) Synergies.”
Online Finance Course References:
Course 17, Lessons 35 (Drivers of Accretion Dilution)
–
340. How do you calculate accretion or dilution in the M&A model?
“We can calculate the accretion dilution in the M&A model by comparing acquirer’s EPS before and after the transaction.
If the acquirer’s EPS after the transaction is higher than the EPS before the transaction, the deal is accretive.
If the EPS after the transaction is lower than the EPS before the transaction, the deal is dilutive.”
Online Finance Course References:
Course 17, Lessons 11 (Accretion Dilution)
Course 17, Lessons 34 (Modeling Accretion Dilution)
–
341. Why do Deferred Tax Assets and Deferred Tax Liabilities get created in M&A transactions?
“DTAs and DTLs often get created in M&A transactions due to write-downs and write-ups that may be tax-deductible on a financial accounting basis but not deductible on a tax accounting basis.”
–
342. Why do Goodwill get created in M&A transactions?
“Goodwill gets created in M&A because the acquirers often pay a price greater than the fair market value of the target’s identifiable net assets. We know there must be something else that the company owns to warrant this extra price. We just can’t pinpoint exactly what that is. Therefore, we record Goodwill as a catch-all number to represent the value of these unidentifiable assets.”
–
343. When you value the target in a DCF in the context of an M&A transaction, should you use the acquirer’s WACC or the target’s WACC?
“It depends on the purpose of the DCF. If the purpose is to determine what target is worth to the sellers, we should use the target’s WACC.
However, if the purpose is to determine what the acquirer is worth after buying the target, we should consider the size of the acquirer and target. If the acquirer is significantly larger than the target, the we should use the acquirer’s WACC. If the acquirer and target are relatively similar in size, we may consider a blended WACC.”
VII. Capital Structure
344. Tell me about the different tranches of debt and their characteristics.
“The four main debt tranches are Revolver, Term Loan, Bond and Mezzanine. Revolver is like a corporate credit card that the company can borrow and repay repeatedly within the debt limit. Term Loan is a type of debt that allows repayment before maturity. Bond is a type of debt that does not allow repayment before maturity. Mezzanine is a type of debt that has PIK (Paid-in-Kind) interest expense.”
Online Finance Course References:
Course 15, Lessons 1-3 (Different Tranches of Debt)
–
345. Tell me as many differences as you can between Term Loan and Bond.
“Term Loan has shorter maturity than Bond.
Term Loan has lower interest rate than Bond.
Term Loan has floating interest rate while Bond has fixed interest rate.
Term Loan allows repayment before maturity while Bond does not.
Term Loan requires partial repayment every year while Bond does not.
Term Loan is more senior than Bond.
Term Loan is often secured by collateral whereas Bond is often unsecured.
Term Loan has Maintenance Covenants while Bond has Incurrence Covenants.”
Online Finance Course References:
Course 15, Lessons 27-28 (Loan vs. Bond)
–
346. Can you explain why some companies would want to borrow Bond instead of Term Loan?
“There are a few reasons why some companies might want to borrow Bond instead of Term Loan. The first reason is if they are cash flow constrained. Term Loan requires the company to repay a portion of the debt principal every year while Bond does not. Second reason is if they believe the macroeconomic interest rate will increase in the foreseeable future. Term Loan is floating, so if the macroeconomic interest rate increases, so will the Term Loan interest rate. Bond allows the companies to lock-in the current interest rate over the borrowing period. Third reason is if they don’t want to be restricted to the maintenance covenants. This is a common reason why companies borrow Bond instead of Term Loan.”
–
347. In a cyclical industry, would you rather have Term Loan or Bond?
There’s no right answer to this question. Either Term Loan or Bond can work depending on the cash flow profile of the company.
“In a cyclical industry, I would rather have Term Loan than Bond. During downturn, I can use excess cash flow to repay debt and quickly de-lever.”
“In a cyclical industry, I would rather have Bond than Term Loan. During downturn, I can preserve cash flow without having to worry about the mandatory repayments.”
–
348. A company has positive earnings and positive cash flow just went bankrupt. What can cause this to happen?
We’ll leave this one as food for thought 🙂
–
349. Why would some companies want to borrow Mezzanine?
“There are three main reasons for this. First, companies may want to borrow more debt than what Term Loan and Bond creditors are willing to lend. Second, companies may want to conserve cash flow and don’t want to pay cash interest expense. Third, the company has weak credit and therefore a hard time obtaining debt from anywhere else but a Mezzanine lender.”
Online Finance Course References:
Course 15, Lesson 29 (Mezzanine)
–
350. What are Maintenance Covenants and Incurrence Covenants?
“Maintenance Covenants require the borrower to always satisfy certain requirements. For example, they can require the borrower to maintain a Leverage Multiple below 4.0x.
Incurrence Covenants prohibit the borrower from certain actions. For example, they can prohibit the borrower from selling any of its patents.”
Online Finance Course References:
Course 15, Lesson 24 (Maintenance Covenants)
Course 15, Lesson 25 (Incurrence Covenants)
–
351. What is the difference between Leverage Multiples and Coverage Multiples? How do you calculate them?
“Leverage Multiples is a ratio measuring the company’s debt relative to its EBITDA. Coverage Multiple is a ratio measuring the company’s EBITDA relative to its Interest Expense.”
Online Finance Course References:
Course 15, Lesson 20 (Leverage Multiples)
Course 15, Lesson 22 (Coverage Multiples)
–
352. A company has $200 million of EBITDA. It raised $100 million of Revolver that is left undrawn at close, $800 million of Term Loan and $400 million of Bond. What is the Leverage Multiple for each tranche?”
“The Leverage Multiples are 0x for Revolver, 4x for Term Loan, and 6x for Bond.”
Online Finance Course References:
Course 15, Lesson 20 (Leverage Multiples)
Course 15, Lesson 21 (Calculating the Leverage Multiples)
–
353. A company decides to raise $1 billion of debt with 5-year tenor at 98 OID and pays the investment bankers 1% underwriting fee. Walk me through the impact to the three financial statements.
“No changes to the Income Statement.
On the Cash Flow Statement, no changes to Cash Flow from Operations and Cash Flow from Investing. Under Cash Flow from Financing, Proceeds from Debt Issuance increases cash flow by $970 million. Therefore, Net Change in Cash goes up by $970 million.
On the Balance Sheet, on the Assets side, Cash goes up by $970 million.
On the Liabilities and Equity side, Debt goes up by $970 million. And the Balance Sheet balances.”
–
354. Two bonds are exactly the same: same amount, same interest rate, etc. However, one is a convertible bond and the other is a non-convertible bond. Which one would you prefer as an investor?
“As an investor, I would prefer the convertible bond because it gives me the option of additional upside.”
–
355. Continuing from the previous question, which one would you prefer as management?
“As management, I would prefer the non-convertible bond because it’s less expensive and less dilutive to current shareholders.”
—
The End
—
[1] If D&A increases by $20 and the tax rate is 25%, Unlevered Free Cash Flow should increase by $5.
[2] Companies often collect cash 30-365 days before they recognize the revenue because they usually offer Monthly or Annual billing methods. As such, customers pay for a full-month or a full-year in advance.
Next Article:
Investment Banking Cover Letter Template & Tutorial
About 10X EBITDA
We are a small team composed of former investment banking professionals from Goldman Sachs and investment professionals from the world’s top private equity firms and hedge funds, such as KKR, TPG, Carlyle, Warburg, D.E. Shaw, Citadel, etc. Our mission is to cultivate the next generation of top talent for Wall Street and to help candidates bring their careers to new heights. We’re based in the United States, but we have expertise across Europe and Asia as well.
Comments
2 Responses to The Core Technicals Guide