Investment Banking Interview Questions and Answers
by Bharathkumar, on Sep 9, 2022 9:27:55 AM
Q1. What is working capital?
Working capital is equal to current assets minus current liabilities. It informs a user about how much money is being used for business operations, and how much more will be necessary throughout the year.
Q2. What do you look for in a good LBO candidate?
There are a variety of characteristics to look for in an ideal leveraged buyout candidate. You will need to search for a company that is mature and consistent. Strong cash flows must be present as well, in order to pay down acquisition debt. In addition, a company being considered for an LBO should provide established services, and be well positioned within its industry. Other important characteristics of an LBO candidate include a firm that is under-valued or has fallen out-of-favor, an institution with a capable management team and a realistic exit strategy.
Q3. Why should a company buy back stock?
When the company believes that the stock is undervalued and can make money by investing in itself. It can happen in a variety of situations. For example, if a company has suffered decreased earnings because of an inherent cyclical industry and its stock price is unjustifiably low, it will buy back its own stock. On other occasions, a company would buy back its stock if investors drive down the price precipitously.
Q4. What does WACC mean?
It stands for weighted average cost of capital, and this is a calculation of an organization’s capital that is weighted proportionally. It includes every source of capital, and takes into account factors like depreciation, tax rates, debt, and equity.
Q5. Usually, we hire job candidates with a higher GPA, why you?
Many companies will have a threshold they don’t intend to drop below in terms of employees’ college GPA. While there are a number of young professionals who will love to hear this question, there are also a lot who dread the GPA question. Investment banking jobs require intelligent people, and so interviewers will be apprehensive about a low GPA, but this can be overcome. Take assurance in the fact that your GPA wasn’t low enough to get you tossed from the resume screening process. If your GPA dropped for a reason such as family issues during a semester, that distracted you from your academic work, make sure you explain this to the interviewer. When answering, own your GPA but explain it in a way that demonstrates your other valuable characteristics.
Q6. Why would an investor buy preferred stock?
Reasons to buy preferred stock are –
An investor who wants upside potential of equity but wants to minimize risk will buy preferred stock. The investor will receive dividends from preferred stock that are more assured than dividends available from common stock
The preferred stock owner also gets a superior right to the company’s assets when the company goes bankrupt
A corporation would prefer to invest in preferred stock as the interest rates on bonds is at a higher rate than the dividends on preferred stock
Q7. How does a comparable company analysis work?
This is a relative valuation technique that compares a company’s valuation to that of its peers. The first step involves finding a firm that is similar to the one in question. You will have to search for a company in the same industry, and of a similar size. Factors that should be comparable include operational, growth, risk and return on capital. While you will be hard-pressed to find two companies that are indistinguishable, you should find two institutions that are as similar as they possibly can be. You should be able to run a thorough analysis of each company in order to determine valuations. Using factors such as earnings per share, market cap and more, compare the two firms.
Q8. Difference between an acquisition and a merger
A merger occurs when two separate entities join forces to create a new organization. 2 companies consolidate their assets, management structures and hence form an organization. An example – Daimler-Chrysler
An acquisition refers to the takeover of 1 organisation by another. A new company does not emerge from an acquisition instead a smaller company is consumed by the bigger company. Its assets become a part of the bigger company. An example – Sun pharma acquiring Ranbaxy
Mergers are quite uncommon and acquisitions are taken in a negative view so hence the name M&A is used as a general term for both the things.
Q9. If depreciation is a non-cash expense, why does it affect the cash balance?
It is tax-deductable. Since taxes are a cash expense, depreciation affects cash by reducing the amount of taxes you pay.
Q10. What is the financial impact of a business buying a new piece of equipment, in terms of income statements, balance sheets, and cash flows?
There is no initial impact on the income statement, but PP&E (property, plant, and equipment) will go up and cash will go down on the balance sheet. This represents a cash outflow. Depreciation causes net income to go down, as well as PP&E and retained earnings. Because depreciation is a non-cash expense that ends up reducing net income, this value is added back into the cash flow in the operations section.
Q11. What is a green shoe option?
Green shoe option is an option of allocating shares in excess of the shares included in the initial public issue and thus operating a post listing pricing. Its a provision in an underwriting agreement that allows the underwriter to sell the additional shares than the original number offered. It is normally done to reduce the risk of the IPO.
Q12. What is a deferred tax asset?
A deferred tax asset is created when a business pays more tax to the IRS than is reported on their income statement. They can be created from net operating losses and differences in revenue recognition.
Q13. As per you what are skills needed by an investment banker?
Some of the skills required by an investment banker are-
Intellect- An investment banker should be able to quickly break down the industry, market, and business ideas
Presentation and Communication Skills- The primary skill of investment banking is the ability to persuade and convince. He must be able to convince clients to buy-in to his ideas. These also include making good spreadsheets, documents, and slideshows.
Entrepreneurial- Investment banking involves helping a business build from scratch by funding a team of partisans, or spotting expansion or mergers opportunities within existing businesses. Lack of such skills will limit such business identifying potential.
Analytical skills – Analytical expertise is required by investment bankers with good quantitative abilities to present business plans with risk-returns strategies
Networking skills – Investment Bankers should present the ability to deal with unfamiliar situations and maintain healthy client relationships
Q14. Where does depreciation usually show up on the Income Statement?
It could be a separate line item.
It could be embedded in COGS or Operating Expenses
Q15. If the U.S. dollar weakens, interest rates generally rise, fall or stay the same?
Rise. A weak dollar means that prices of imported goods will rise when measured in U.S. dollars i.e. it would take more money to buy the same goods. When the prices of imported goods rise, it contributes to higher inflation, which raises interest rates.
Q16. So why are you interested in investment banking?
This is a delicate question that you will have to answer properly. You may be starting out in investment banking with high hopes of moving further in the industry, quickly. Don’t lie, but don’t share everything either. You may eventually want to move on to hedge funds, but for now you will have to convince the interviewer that you are totally committed to the industry. Both of you may know that you plan on leaving in a couple years, but don’t make that obvious, or reveal all your intentions just yet.
Q17. Can you explain how companies should plan mergers ?
First a company should identify the synergies of the 2 businesses. It also needs to ensure that the merger will not raise antitrust issues with Federal Trade Commission (FTC). For example, Apple and Microsoft should merge, but the combined company will have an unfair monopoly and the FTC will not approve the merger. Also the top people running the two companies don’t like each other and would not want to merge.
Q18. What are the steps that occur during a cash flow statement?
Begin with the net income, and examine each line of the major adjustments. These include changes in deferred taxes and working capital, as well as depreciation. Be sure to mention asset purchases and sales, investment securities, and capital expenditures. Create cash flows for financing, business operations, and investments, and add them together to get the total cash flow. The end-of-period balance can be derived by adding the change in cash to the beginning-of-period balance.
Q19. Challenges faced by an Investment Bank
Some of the challenges faced by an investment bank are –
1 Cyber Crime- The IT systems of the investment banks are now the focus of criminals who can transfer millions of dollars within seconds to different accounts
2 Restructuring the Investment Bank- banks are pulling back to streamline flow of products, and looking towards technology platforms for answers
3 Improving Surveillance and Mitigating Conduct Risk- Regulators have become very thorough in terms of measuring, monitoring and mitigating different kinds of risks. People still look at this with skepticism
4 Sustainable Funding- Firms are investing their development dollars on cross product systems, trying to lower cost of complexity and custom systems
Q20. A company makes $100 cash purchase of equipment on Dec. 31. How does this impact the three financial statements this year and next year?
Year 1 Assume FY ends Dec. 31. Why? No depreciation for the first year.
IS: Capital expenditure so no affect on net income, i.e. no change on IS.
CFS: No change in net income = no change in cash flow from operations; however, $100 increase in capex ($100 use of cash in cash flow from investing activities) = $100 use of cash.
BS: Cash down $100, PP&E up $100.
Year 2 Assume straight line depreciation over 5 years with 40% tax rate.
IS: $20 of depreciation = $12 reduction in net income.
CFS: Net income down $12 and depreciation up $20 = Net effect is cash up $8.
BS: Cash (asset) up $8 and PP&E (asset) down $20. Retained earnings down $12 to balance.
Q21. What is a leveraged buyout? How is it different than a merger?
A leveraged buyout occurs when a group, after refinancing a company with debt, is able to increase the valuation of the company. Either financial groups or company management typically accomplish LBOs, whereas M&A deals are led by companies in the industry.
Q22. What is the appropriate numerator for a revenue multiple?
The correct answer to this question is enterprise value. This question is asked by interviewers in order to determine whether you understand the difference between equity value and enterprise value, and how they relate to multiples. The difference between the two is that equity value is enterprise value minus the net debt. EBIT, EBITDA, and revenue multiples each have enterprise value as the numerator since the denominator is a pre-debt calculation of profitability. Equity value serves as the numerator for EPS, after-tax cash flows, and book value of equity because the denominator is post-debt.
Q23. Talk about Currency Devaluation and Revaluation
Under a fixed-exchange-rate system, where exchange rates are changed only by official government action, different terms are used. Instead of depreciation, weakening of the currency is called “devaluation.” When a government devalues its currency, it is often because of the interaction of market forces & policy decisions that has made the currency’s fixed exchange rate indefensible. Taking a recent example, devaluation is what occurred in Indonesia in 1998. The strengthening of the currency under fixed exchange rates is called revaluation.
Q24. If cash collected is not recorded as revenue, what happens to it?
Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.
Over time the Deferred Revenue balance turns into real revenue on the Income Statement
Q25. What is a DCF?
A discounted cash flow. This type of cash flow is used to determine how lucrative a potential investment might be. It is similar to the cash flow described above, but uses future projections of free cash flow to discount the price on the investment. Taking into account future trends results in a more accurate valuation to judge the investment by.